First American Financial Corp. (FAF) is a major global provider of title insurance and settlement solutions for real estate transactions, and it’s currently faring a good deal better than a number of its market competitors, including Fidelity National Financial (FNF).
Title insurance company profits and revenue generally ebb and flow along with those of the real estate market, though oftentimes there is a lag in impact when real estate indexes show ups or downs, which can make title companies good investment options for both bulls and bears in the short-term.
With housing starts up almost 16% in July, moving to an annual rate of 1.093 million units, according to the latest figures from the Department of Commerce, we’re seeing the highest construction levels since November. At the same time, the Pending Homes Sales Index rose 3.3 % to 105.9 in July.
Does this make now a good time to jump on the First American bandwagon, or should you bail, given that mortgage rates will ultimately rise in the long view? Here is the HousingWire case study of both sides.
THE BEAR CASE
Are the bulls likely overly optimistic when it comes to First American, particularly as a long-term investment? While it’s true pending home sales are on the uptick, the July PHSI of 105.9 is still 2.1 % below what it was a year ago. July 2013’s index stood at 108.2.
According to second-quarter financial reports, total revenue has dropped 11% since last year, with second-quarter revenue standing at $1.1 billion, and refinance-closed orders down 57%. Title Insurance and Services segment pretax margin stood at 8.0% with a loss ratio of 8.9%. However, bears should note that includes a $25.1 million strengthening in reserve funds due largely to a recent commercial claim from policy year 2007. It can be argued that the company has had pretty disappointing returns on equity.
Direct premiums and escrow fees dropped 13% in the second quarter compared to a year earlier. That was the result of a 33% decline in direct title orders closed from April 1 through June 30, reflective of a slowing housing market this year. However, that decline was, according to First American’s second-quarter financial results, offset by a 27% increase in the revenue per direct title order, which now averages $1,830. That’s because the title order mix has been shifting to higher-premium purchases and commercial transactions.
Bulls point to gains in housing starts as evidence the housing market is moving out of sluggish mode, but if mortgage rates rise, as they are expected to, this year’s growth could quickly plummet. Fannie Mae’s economics group, anticipating higher credit costs with little income growth, downgraded its forecast for both home sales and construction in July. The government-sponsored enterprise now projects construction of 1.43 million single-family units in 2014 and 2015 combined. That’s a drop from Fannie’s earlier forecast of 1.6 million.
There just isn’t any catalyst for major growth in the title insurance industry overall in the coming years, leading bears to give First American stock a thumbs down.
If you’re bent on investing in title insurance company stock, then take a look at First American’s smaller cousin, Stewart Information Services Corp (STC), which has shown a 52-week earnings high of $37.55 and a P/E ratio of 26.23, though even Stewart is better to hold if you’ve already got it.
THE BULL CASE
The PHSI showed a rebound in July with pending home sales rising in four of the last five months, according to the National Association of Realtors, which reported “healthy gains” across the country as of Aug. 28, save for in the Midwest, which is seeing some slight decline.
With the PHSI at its highest level since August 2013, things look promising for the housing industry and for the companies, like First American, that ride its waves. The index has been above 100, which is considered an average level of activity, for three months running.
NAR Chief Economist Lawrence Yun commented on favorable housing conditions, noting in a recent news release that “interest rates are lower than they were a year ago, price growth continues to moderate and total housing inventory is at its highest level since 2012.”
He does expect existing-home sales to be down 2.1% this year, closing 2014 at 4.98 million. 2013 closed with 5.09 million existing-home sales. Home prices are up though and are expected to grow between 5% and 6% this year and 4% to 5% in 2015. So that means companies like First American will receive more revenue per transaction. As of July, existing homes for sale stood at 2.37 million.
Housing starts are also up, having jumped 22% this year through July, and increasing building permit applications point to likely further growth before the year’s close. John Ryding, an economist with RDQ Economics, said in a recent note to clients, “With housing starts up 22 % over the last year, the Fed’s concern about a ‘slow’ recovery in the housing market looks misplaced to us.”
And while First American has seen declining revenue, that’s primarily due to a commercial claim arising out of transactions in 2007. Even with the decline in closings and refinancings, First American average revenue per direct title order is up 27%, according to the second- quarter financial data. That’s because transactions are slowly shifting to higher-premium purchases, and commercial transactions are up. Average revenue per purchase transaction is up 6 % from a year ago due to rising home values.
Bears might argue that First American’s commercial revenues, which stood at $132.1 million at the close of the second quarter, are down 4% compared to a year ago, but the overall picture is promising. Commercial revenue numbers were up 7% in the first quarter of this year.
Specialty Insurance segment total revenues were up 9% last quarter with a pretax margin of 12.1%. First American’s debt-to-capital ratio stood at 15.1% as of the end of June. The company also amended the terms of its revolving credit access with improved terms that have increased borrowing capacity to $700 million and extended terms to May 2019.
And while total revenue for First American dropped 11% in the second quarter compared to the second quarter of 2013, net income in the second quarter was $50.6 million compared to $34.7 million a year ago. That translates into 47 cents per diluted share in the second quarter of 2014. Net income was 31 cents per diluted share in the second quarter of 2013. First American also reported net realized investment gains of $6.3 million, 4 cents per diluted share, in the second quarter compared to net realized investment gains a year ago of $4.5 million, 2 cents per diluted share.
“During the second quarter we benefited from the normal seasonal growth in purchase transactions, continued strength in our commercial business and the full realization of expense management actions taken in previous quarters,” said First American CEO Dennis Gilmore in a preface to the release of second-quarter earnings.
Brokers overall are recommending a “buy” on First American stock. While a few are neutral, no one is advocating selling at this point. The Street has rated the company a buy due to “its solid stock price performance, increase in net income, largely solid financial position with reasonable debt levels by most measures and growth in earnings per share.”
As of the end of August, First American stocks were holding at $28.26 with a 52-week high of $28.62 and a low of $20.90. Expected returns now stand at 13% with a 10-year average return on investment of 10%. First American’s P/E stands at 16 compared to an industry average of 12.9, though it’s a bit less than the S & P 500 average of 18.4.
According to Zacks Investment Research, First American ranks 19 out of 86 for sales in its industry, and its net income ranks 37 out of 86. Zacks ranked the company 9 for appreciation.
First American stands out for its solid and steady growth when others in its market segment are struggling to show significant earnings.
Editor’s note: Bull vs. Bear is a non-positional column designed to present both “bull” and “bear” cases surrounding a publically traded stock representative of the U.S. housing economy. Analysis focuses primarily on macro economic factors, and the column is designed to allow investors to choose for themselves which case presented makes the most sense for their own investment objectives. HousingWire does not recommend any specific investments.
