First American Financial Corp quarterly report, Q3 FY2014

First American Financial Corporation — Q3 2014 Form 10-Q

Reporting period: Three and nine months ended September 30, 2014; financial statements are unaudited. Comparisons are with the corresponding 2013 periods unless stated otherwise. Amounts are in U.S. dollars.

Business context

The company provides title insurance and related real estate services, specialty insurance (property and casualty and home warranty), and trust, banking and data-related services. Results are affected by real estate and mortgage activity, with purchase business generally seasonal and refinance activity particularly sensitive to interest rates.

Financial performance

Metric	Q3 2014	Q3 2013	Nine months 2014	Nine months 2013
Revenue	$1.260 billion	$1.301 billion	$3.422 billion	$3.736 billion
Income before taxes	$116.0 million	$107.0 million	$227.7 million	$225.9 million
Net income attributable to company	$80.7 million	$63.9 million	$153.0 million	$134.7 million
Diluted EPS	$0.74	$0.59	$1.41	$1.23
Operating cash flow	Not provided separately	Not provided separately	$166.2 million	$245.8 million

Q3 revenue declined 3.2%; nine-month revenue declined 8.4%. Q3 pretax margin was approximately 9.2%, versus 8.2%; nine-month pretax margin was approximately 6.7%, versus 6.0%.
Q3 diluted EPS increased 25%; nine-month diluted EPS increased 15%. The effective tax rate was 30.2% for Q3 and 32.6% for the nine months, versus 40.1% in both 2013 comparison periods. Management attributed the lower 2014 rates partly to nonrecurring tax benefits.
Nine-month operating cash flow fell approximately 32%, despite higher net income. Cash paid for claims, net of recoveries, was $353.0 million, compared with $348.1 million.
At September 30, cash and cash equivalents were $1.204 billion, up from $834.8 million at year-end 2013. Total investments were $3.693 billion. These consolidated cash figures include funds held at the company’s bank subsidiary against deposit liabilities; customer escrow funds held at third parties are not company assets.
Notes and contracts payable were $450.9 million, versus $310.3 million at year-end; debt as a share of total capitalization rose to 14.9% from 11.2%. The company had a $700 million unsecured revolving facility, with $150 million drawn and $550 million available; it reported compliance with financial covenants.
Declared dividends were $0.24 per share in Q3 and $0.60 per share for the nine months, compared with $0.12 and $0.36, respectively, in 2013.

Material changes and operating drivers

Lower mortgage activity weighed on the title business. Management cited a 44.2% year-over-year decline in U.S. refinance originations in Q3, and its direct title operations closed 32.4% fewer refinance orders per day. Total direct title orders closed were down 20.5% in Q3 and 31.0% for the nine months.
Title Insurance and Services revenue declined 3.9% in Q3 and 9.6% year to date. Segment pretax margin was 10.4% in Q3 (10.3% in 2013) and 7.9% year to date (7.5%). Higher average revenue per direct order and lower operating costs helped offset lower volumes.
Specialty Insurance revenue grew 10.1% in Q3 and 8.6% year to date; pretax income increased to $10.4 million in Q3 from $4.0 million. Home warranty claims rates improved, with management citing milder weather. Property and casualty claims rates increased year to date, reflecting severe winter weather and California wildfires.
Q3 realized investment gains were $14.4 million, versus a $7.0 million loss in 2013; nine-month gains were $24.3 million versus $6.8 million. These gains supported reported earnings. Q3 comprehensive income attributable to the company fell to $54.3 million from $83.2 million, mainly reflecting securities and foreign currency translation losses.
The title-loss provision rate was 6.7% of title premiums and escrow fees in Q3, versus 5.8%; it included a $6.8 million net increase in prior-year reserves. The nine-month rate was 7.2%, versus 9.8% in 2013, when prior-year reserve strengthening included an $89.0 million increase.
Acquisitions totaled $162.1 million in the first nine months, including a $151.2 million loan-quality analytics business acquired in March. The acquisitions contributed to higher goodwill, which increased to $955.8 million from $846.0 million at year-end.

Outlook, risks and unusual items

No specific revenue or earnings guidance is provided. Management said available resources should be sufficient for anticipated operational cash requirements and obligations for at least 12 months. Management expected quarterly dividends at or above $0.24 per share, subject to board discretion and other factors.
Key risks include real estate and mortgage market cycles, interest-rate changes, title claims and reserve-estimate uncertainty, investment losses, regulation and title-rate restrictions, lender concentration, agent conduct, cybersecurity and data protection, and acquisition integration.
The company disclosed numerous title-related lawsuits and ongoing regulatory inquiries, including matters involving pricing, competition, customer acquisition and agency relationships. It said many loss outcomes cannot presently be assessed or estimated; it did not believe the matters would materially harm overall financial condition or liquidity, but unfavorable outcomes could affect individual periods or lead to business-practice changes.
In October 2014, Canadian tax authorities issued internal guidance indicating that certain lender services may be subject to excise tax. The company said an assessment was possible but could not estimate a loss or range; the matter occurred after the quarter-end.
The principal title insurer redomesticated from California to Nebraska effective July 1, 2014. Management did not expect resulting statutory differences to materially affect holding-company liquidity or capital resources.
The filing notes prior-period cash-flow and balance-sheet presentation revisions and an immaterial $4.3 million second-quarter 2014 expense adjustment for prior-period foreign-currency errors. Management said these adjustments were not material individually or in aggregate.

Most important facts for investors to verify

Whether title order volumes and agent premiums stabilize as refinance activity remains weak, and whether acquisition-related revenue offsets organic declines.
Future title and specialty insurance claims experience, reserve development, and the recoveries anticipated for the large commercial claim.
How much of the cash balance is available to the holding company versus associated with regulated subsidiaries, deposits or customer-related activity; also monitor debt and facility availability.
Developments in the Canadian excise-tax matter, regulatory investigations and material lawsuits, including potential operational or financial effects.
Whether the elevated investment gains and reduced effective tax rate are repeatable; both affected period-over-period earnings comparisons.