First American Financial Corp quarterly report, Q2 FY2010

First American Financial Corporation (FAF) — Q2 2010 Form 10-Q

Business context and reporting period

Quarter and six months ended June 30, 2010. First American Financial became a separate public company on June 1, 2010, following its spin-off from The First American Corporation, renamed CoreLogic. FAF retained the title insurance and services and specialty insurance businesses. Because pre-spin-off results include allocated parent-company costs and do not reflect all costs of operating independently, comparisons with 2009 and with post-separation periods are not fully comparable.

Key financial metrics

Metric	Q2 2010	Q2 2009	Six months 2010	Six months 2009
Total revenues	$969.9 million	$1,025.1 million	$1,878.3 million	$1,913.5 million
Income before taxes	$57.0 million	$64.5 million	$81.5 million	$74.7 million
Net income attributable to FAF	$33.8 million	$28.6 million	$47.6 million	$33.5 million
Diluted EPS	$0.32	$0.27	$0.45	$0.32

• Q2 total revenue fell 5.4% year over year; six-month revenue fell 1.8%. Q2 operating revenue was $944.2 million, down 7.0%.
• Q2 consolidated pre-tax margin was approximately 5.9%, versus 6.3% a year earlier. Title Insurance and Services pre-tax margin was 6.9% versus 7.9%; Specialty Insurance was 15.0% versus 3.1%, largely reflecting lower investment impairment losses than in 2009.
• Operating cash flow was negative $40.1 million for the first half, versus positive $61.3 million in 2009. Investing cash flow was negative $29.5 million and financing cash flow positive $65.5 million. Cash and cash equivalents ended at $579.0 million, down $4.1 million from year-end.
• At June 30, cash was $579.0 million; debt securities were $1.900 billion and equity securities $267.3 million. Total assets were $5.486 billion and total equity $1.880 billion.
• Notes and contracts payable were $308.2 million, up from $119.3 million at year-end; the company also had a $400 million revolving facility, with $200 million borrowed at 3.125% at June 30. Debt was 14.1% of total capitalization, versus 11.3% at year-end. Demand deposits were $1.300 billion, largely associated with banking and customer deposits.
• The effective tax rate was 40.1% for Q2 and 41.3% for the first half, down from 48.3% and 45.4%, respectively, in 2009. A $0.06 per-share dividend was recorded for Q2; management expected annual cash dividends of approximately $25 million.

Material changes versus the prior comparable period

• Management cited a 20.4% decline in U.S. mortgage origination volume in Q2, including a 28.6% decline in refinancing and a 3.0% decline in purchase originations. Direct title operating revenue fell 14.5%; agency revenue grew 4.3%, supported by increased market share.
• Direct operations closed 29.5% fewer title orders in Q2, while average revenue per order increased 20.2%. Title segment Q2 pre-tax income declined 18.4% to $62.0 million; six-month title pre-tax income increased 4.6% to $90.6 million.
• Specialty Insurance Q2 pre-tax income rose to $10.6 million from $2.0 million. The comparison benefited from substantially lower investment impairment charges; first-half claims provisions also reflected $2.1 million of winter-storm losses in property and casualty insurance.
• Net impairment losses recognized in earnings fell to $3.8 million in Q2 from $25.6 million a year earlier. The portfolio nevertheless retained notable credit and valuation exposure, particularly in non-agency mortgage- and asset-backed securities.
• The spin-off drove significant balance-sheet and financing changes: FAF borrowed $200 million and transferred it to CoreLogic, and made a $130 million cash distribution to TFAC/CoreLogic upon separation. The separation also transferred pension obligations and associated accumulated other comprehensive loss to FAF.

Outlook, management commentary, risks and contingencies

• Management expected tight mortgage credit and uncertain economic conditions to continue affecting demand, customers, revenue, claims, earnings and liquidity. It described ongoing cost reductions, office consolidation, centralization, agency profitability reviews, increased offshore leverage and new sales efforts; no quantified earnings or revenue guidance was provided.
• Management stated that available resources and operating cash generation should be sufficient for anticipated operating requirements and obligations for at least 12 months. Operating cash flow was negative in the first half, so this assessment warrants monitoring.
• The pension plan was underfunded by approximately $92.7 million at June 30. FAF contributed $11.3 million in the first half and expected to contribute a further $17.5 million during the remainder of 2010.
• Non-agency mortgage- and asset-backed securities had $75.9 million amortized cost and $50.4 million fair value; 91.6% of their amortized cost was rated non-investment grade. Seven securities with $44.9 million amortized cost were on negative credit watch. Further impairment losses remain possible. FAF also held CoreLogic shares with $242.6 million cost and $228.4 million fair value, subject to market-price risk and a requirement to dispose of the shares within five years or bear potential adverse tax consequences.
• Bank of America litigation alleges mishandling of title-policy claims and seeks monetary and other damages; the company said the outcome could materially affect results in the period of disposition. Government audits and investigations include title pricing, competition, customer practices and asset valuation. Management did not expect the investigations to have a material adverse effect, but acknowledged potential impacts from required business-practice changes.
• Other risks include real-estate market weakness, title-claim reserve uncertainty, investment losses, regulatory and rate-setting changes, customer concentration, pension funding, and possible additional costs of operating as a standalone public company. The company identified no goodwill impairment trigger in the first half.

Important facts for investors to verify

• How standalone-company expenses and transition-service costs develop after the spin-off, and how they affect margins and cash flow.
• Whether title order volumes, mortgage activity and agency market-share gains stabilize or offset continued declines in direct operations.
• Actual claims emergence and reserve adequacy, especially for recent title policy years; management estimated a 50-basis-point change in loss rates across the five most recent years could change IBNR reserves by $118.1 million.
• Investment portfolio marks, credit migration and impairment assumptions, including the value and planned disposition of CoreLogic shares.
• Pension contributions and funding status, litigation and regulatory developments, and compliance with credit-facility covenants.
• Cash availability and the sustainability of the stated annual dividend expectation, considering negative first-half operating cash flow and insurance-subsidiary dividend restrictions.