First American Financial Corp quarterly report, Q2 FY2011

First American Financial Corp. — Q2 2011 Form 10-Q

Business context and reporting period. Unaudited results cover the three and six months ended June 30, 2011, compared with the corresponding 2010 periods. First American provides title insurance and related services, as well as property and casualty insurance and home warranties. It became a standalone public company after its June 1, 2010 spin-off from The First American Corporation, now CoreLogic; accordingly, the 2010 comparison includes pre-separation periods that may not reflect standalone costs.

Financial performance and position

Amounts below are in millions of dollars except per-share data and percentages.

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Revenue	$927.3	$969.9	$1,859.0	$1,878.3
Income before taxes	$49.2	$57.0	$25.8	$81.5
Net income attributable to First American	$32.3	$33.8	$17.0	$47.6
Diluted EPS	$0.30	$0.32	$0.16	$0.45
Cash dividends per share	$0.06	$0.06	$0.12	$0.06
Operating cash flow	Not reported quarterly	Not reported quarterly	$(27.0)	$(40.1)

• Q2 revenue declined 4.4% year over year; pretax income fell 13.6%. Six-month revenue declined 1.0%, while pretax income fell 68.4%. Approximate consolidated pretax margins were 5.3% versus 5.9% in Q2 and 1.4% versus 4.3% for the six-month periods.
• Title Insurance and Services reported Q2 revenue of $857.3 million and pretax income of $56.9 million, compared with $901.6 million and $60.9 million. Six-month pretax income fell to $38.3 million from $88.2 million, with segment margin declining to 2.2% from 5.1%.
• Specialty Insurance Q2 revenue was $71.6 million and pretax income $10.2 million, versus $70.9 million and $10.6 million. Six-month pretax income rose to $22.5 million from $20.1 million; margin improved to 16.0% from 14.4%.
• At June 30, cash and equivalents were $600.7 million, investments totaled $2.77 billion, total assets were $5.78 billion, and total equity was $2.03 billion. Cash decreased $128.1 million from year-end 2010.
• Notes and contracts payable were $286.2 million. The company had borrowed $200 million under its $400 million revolving facility, bearing 3.00% interest at June 30 and maturing June 1, 2013; it reported compliance with debt covenants. Deposits were $1.51 billion and include obligations related to banking operations.
• Operating cash use of $27.0 million included $233.2 million of net claim payments. Investing activities used $108.8 million; financing activities provided $7.7 million. Six-month capital expenditures were $28.4 million.

Material changes and unusual items

• Direct title orders closed fell 18.1% in Q2 and 12.9% in the first half. Direct premiums and escrow fees declined 8.1% and 4.5%, respectively; higher average revenue per order partly offset lower volumes. Information and other revenue rose 2.6% in Q2.
• Title loss provision was $136.6 million for the first half, up $48.0 million year over year. It included a $45.3 million first-quarter reserve strengthening for a Canadian guaranteed valuation product and a $14.6 million charge for adverse development in prior policy years, primarily 2007. Q2 title loss rate was 5.9% of title premiums and escrow fees; the six-month rate was 9.9%.
• Q2 net realized investment losses were $1.9 million, versus gains of $7.0 million a year earlier. Six-month losses were $2.5 million, versus gains of $10.6 million. The company recorded $1.3 million of debt-security OTTI losses for the first half.
• A $4.2 million release of an Australian tax valuation allowance reduced Q2 tax expense. Effective tax rates were 34.7% for Q2 and 34.4% for the first half, compared with 40.1% and 41.3% in 2010.
• Other comprehensive income attributable to the company was $34.0 million for the first half, compared with $28.0 million in 2010; it included favorable changes in securities, foreign currency translation and pension adjustments.

Outlook, risks and contingencies

• Management said mortgage credit remained tight and economic uncertainty continued to weigh on demand. MBA estimates cited in the filing showed U.S. mortgage origination dollar volume down 21.0% in Q2 year over year, with purchase originations down 29.3% and refinancings down 15.5%. Management said the usual seasonal increase in spring real estate activity was limited.
• The company initiated and substantially completed an expense-reduction program expected to generate approximately $40 million in annualized savings, with savings beginning in Q3 2011. No specific earnings or revenue guidance was provided.
• Management expected available resources to meet operational cash requirements for at least the next 12 months and anticipated quarterly dividends at or above historical levels, subject to board discretion. Up to $144.7 million of dividends, loans and advances could be available from insurance subsidiaries for the remainder of 2011. A $150 million share-repurchase authorization had been approved; no shares had been repurchased by June 30.
• The defined-benefit pension plan was underfunded by approximately $100.2 million. The company contributed $16.2 million in the first half and expected to contribute a further $20.8 million during the remainder of 2011.
• The Bank of America lawsuit alleges more than $235 million of losses from denied claims and more than $300 million from delayed responses. The company has not estimated whether exposure exceeds related routine title-claims reserves; it said an unfavorable outcome could materially affect financial condition, results, cash flows or liquidity. The first two stages of nonbinding mediation with Bank of America and Fiserv concluded in June and July; mediation was expected to conclude by the end of August 2011.
• Other putative class actions and regulatory audits involve alleged title-rate, referral, competition, unauthorized-practice, fee and consumer-protection issues. For many matters, loss probability or range could not be estimated. The company did not believe identified audits and investigations would individually or collectively have a material adverse effect, but acknowledged that resulting business-practice changes could be consequential.
• Investment risks include exposure to real estate and credit conditions, interest rates, and CoreLogic stock. The company held $149.3 million of CoreLogic common stock at fair value; 99.6% of its non-agency mortgage-backed securities by amortized cost were non-investment-grade or unrated. It noted that further impairments remained possible.
• Other key risks include real-estate-market weakness, foreclosure-related revenue declines and defense costs, title-claims reserve variability, regulation and rate restrictions, pension funding, customer concentration, data and system security, and limits on subsidiary distributions. Customer escrow, trust and like-kind exchange funds may also create contingent responsibilities; much of these customer funds is not recorded as company assets.

Important facts for investors to verify

• Whether the $45.3 million Canadian-product reserve strengthening and other prior-year development adequately reflect ultimate title claims, and how subsequent claims experience affects reserves.
• Developments and eventual resolution of the Bank of America/Fiserv dispute, including any change in estimated exposure or mediation outcome.
• Whether the expected $40 million annualized savings are realized on schedule and without impairing service or revenue generation.
• Cash generation, claim payments, pension contributions and liquidity under continued weak mortgage and real estate conditions.
• Valuation and credit developments affecting the CoreLogic shareholding and non-agency mortgage-backed securities, as well as any additional impairment charges.
• Changes in litigation, regulatory investigations, title-insurer ratings or statutory surplus, and the company’s capacity to maintain dividends.