First American Financial Corporation — Q2 2013 Form 10-Q
Business context and period. The unaudited quarter ended June 30, 2013; comparisons are with Q2 2012 unless stated otherwise. First American provides title insurance and related real estate services, as well as property and casualty insurance and home warranties. Results are materially affected by real estate and mortgage activity, interest rates, claims experience, and seasonality. Dollar amounts below are in millions unless noted.
Financial performance and position
| Metric | Q2 2013 | Q2 2012 | Change |
|---|---|---|---|
| Revenue | $1,288.5 | $1,089.8 | +18.2% |
| Income before income taxes | $59.2 | $112.3 | -47.3% |
| Net income attributable to First American | $34.7 | $73.0 | -52.5% |
| Diluted earnings per share | $0.31 | $0.68 | Down $0.37 |
| Cash dividends declared per share | $0.12 | $0.08 | +50.0% |
- Consolidated pretax margin was approximately 4.6%, compared with 10.3% a year earlier. Revenue growth did not translate into higher earnings, principally because of substantially higher claims provisions and increased operating costs.
- Title Insurance and Services revenue rose 19.1% to $1,205.0 million, while pretax income fell to $73.0 million from $118.4 million; its pretax margin declined to 6.1% from 11.7%. Specialty Insurance revenue increased 5.6% to $84.0 million, while pretax income fell to $7.3 million from $13.3 million; its margin declined to 8.7% from 16.7%.
- For the six months ended June 30, revenue was $2,435.2 million versus $2,056.6 million (+18.4%); net income attributable to the Company was $70.9 million versus $104.3 million. Operating cash flow was $158.4 million, up from $104.3 million.
- Cash and cash equivalents were $861.8 million at June 30, versus $627.2 million at December 31, 2012. The filing reports $266.9 million of holding-company cash and $600 million of undrawn revolving credit capacity; consolidated cash includes banking operations and should not be equated with unrestricted parent-company cash.
- Notes and contracts payable totaled $314.8 million, compared with $229.8 million at year-end; debt was 11.8% of total capitalization, up from 8.9%. In January, the Company issued $250 million of 4.30% senior unsecured notes due 2023 and used part of the proceeds to repay credit-facility borrowings. The $600 million revolver was undrawn at quarter-end and matures in 2016.
- Title and other claims reserves were $1,054.5 million, up from $976.5 million at year-end. The Company recorded a $89.0 million net increase in prior-policy-year title loss reserves in Q2. Consolidated provision for policy losses and other claims was $198.8 million, versus $95.4 million.
- Investment securities had a $22.5 million net unrealized loss at June 30, versus a $45.4 million net unrealized gain at year-end. Q2 other comprehensive loss attributable to the Company was $12.1 million, versus comprehensive income of $74.1 million a year earlier; the decline primarily reflected lower securities values.
Material changes and management commentary
- Higher mortgage originations, closed title orders, and average revenue per order supported title revenue. Direct title orders closed increased 11.1%; average revenue per closed order increased 8.7%. Purchase and commercial activity strengthened, while refinance order activity weakened as interest rates rose sharply beginning in May.
- Management reported refinance orders opened per day fell from 3,100 in May to 2,300 in June and approximately 1,800 through the first three weeks of July. It expected the refinance pipeline to remain strong into August, but was managing costs in anticipation of lower closings from September onward.
- The $89.0 million title reserve strengthening reflected claims development above expectations, primarily domestic lenders’ policies ($58.7 million, mainly policy years 2004–2008) and the Canadian guaranteed valuation product ($12.9 million). Management expected elevated domestic lender claims to continue through 2013 and for a period thereafter.
- Specialty Insurance claims ratios also increased: home warranty claims were 64.1% of premiums in Q2 versus 59.6%; property and casualty claims were 53.9% versus 48.1%. The filing attributes the increases mainly to weather-related home warranty claims and large single-incident property and casualty losses.
- Management stated that resources were sufficient for anticipated operational cash requirements and obligations for at least the next 12 months. It expected to continue quarterly dividends at or above the current level, subject to board discretion and other factors. The Company contributed $17.2 million to pension and supplemental plans in the first half and expected another $25.8 million in the remainder of 2013; the pension plan was underfunded by $118.9 million at June 30.
Risks, contingencies, and unusual items
- Key risks include real estate and mortgage-market volatility, higher interest rates and falling refinance volumes, elevated or changing title claims, investment-market losses, and dependence on large mortgage lenders and title agents.
- Numerous title-related class actions and governmental examinations or investigations are ongoing, including matters concerning rates, competition, settlement-service practices, and agency relationships. For many cases, the Company could not assess the probability of loss or estimate a loss range. It did not believe the matters then known would materially harm overall financial condition or liquidity, but acknowledged potential material effects on results in a period or from changes to business practices.
- Customer escrow, trust, and like-kind exchange funds are substantial but generally excluded from Company assets: escrow deposits totaled $5.0 billion, trust assets $3.0 billion, and like-kind exchange funds $941.4 million at June 30. The Company noted contingent liability exposure for disposition and transfers of certain customer funds.
- Guarantees of indebtedness totaled $18.3 million at June 30; no related liability was recorded. The Company disclosed no material change in market risks since its 2012 Form 10-K and no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether domestic lenders’ claims remain elevated and whether further reserve strengthening is required; the filing notes that a 50-basis-point change in loss rates for the six most recent policy years could change IBNR reserves by approximately $107.2 million.
- Actual title order volumes, especially refinance closings after the reported July decline, and the effectiveness of planned cost adjustments.
- Development of home warranty and property and casualty claims, alongside the resulting segment margins.
- Investment portfolio valuation and interest-rate exposure, including unrealized losses and the downgraded non-agency mortgage-backed securities, all of which were below investment grade at June 30.
- Availability of holding-company liquidity, regulatory limits on subsidiary distributions, debt and pension funding needs, and any changes in litigation or regulatory exposure.