First American Financial Corp quarterly report, Q3 FY2019

First American Financial Corporation (NYSE: FAF) — Q3 2019 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2019. Unaudited consolidated financial statements; amounts below are in U.S. dollars.

Business context and results

First American provides title insurance and real-estate transaction services, specialty insurance (including home warranty and property-and-casualty products), and related services. Results are sensitive to real-estate and mortgage activity, interest rates, and seasonality.

Metric	Q3 2019	Q3 2018	Nine months 2019	Nine months 2018
Total revenue	$1.671 billion	$1.542 billion	$4.473 billion	$4.331 billion
Income before taxes	$245.3 million	$195.6 million	$616.5 million	$490.6 million
Net income attributable to FAF	$187.2 million	$151.5 million	$483.4 million	$382.8 million
Diluted EPS	$1.65	$1.34	$4.26	$3.38
Approx. pretax margin	14.7%	12.7%	13.8%	11.3%

Financial position, cash flow and capital

Nine-month operating cash flow was $611.7 million, versus $484.9 million a year earlier; cash and cash equivalents were $1.711 billion at September 30, up from $1.467 billion at year-end 2018.
Investing activities used $425.1 million and financing activities provided $58.2 million during the first nine months. Cash dividends paid were $141.2 million; capital expenditures were $78.2 million.
Total assets were $11.804 billion and total equity was $4.246 billion. Notes and contracts payable were $728.3 million; secured financings payable were $233.5 million. Deposits, including customer-related balances, were $3.841 billion. Debt-to-capitalization was 18.5%, compared with 17.8% at year-end 2018.
The $700 million unsecured revolving credit facility had $160 million drawn and $540 million available; the borrowing rate was 3.54%. The company reported compliance with financial covenants.
Escrow deposits totaled $8.7 billion and trust assets $4.1 billion. Much of these customer assets are off balance sheet and are not company assets, but the company may be contingently liable for their disposition.

Material changes and operating drivers

Q3 revenue rose 8.4% and attributable net income rose 23.6% year over year. For nine months, revenue increased 3.3% and attributable net income increased 26.3%.
Title Insurance and Services Q3 pretax income increased 22.8% to $253.6 million; pretax margin rose to 16.5% from 14.6%. Direct premiums and escrow fees rose 13.9%, and agent premiums rose 6.7%. Domestic direct title orders closed increased 21.5% in Q3.
Residential refinancing drove much of the Q3 lift: direct title revenue from refinance transactions increased 110.0%, while purchase revenue increased 3.4%. Lower average revenue per direct order in the quarter reflected a shift toward lower-premium refinance work.
Specialty Insurance Q3 pretax income increased 77.7% to $11.0 million, with margin of 8.5% versus 5.0%. Home warranty premiums grew, while lower claims ratios supported results; property-and-casualty claims ratios also benefited from wildfire recoveries.
Net investment income increased 18.4% in Q3 and 38.3% for nine months, reflecting higher average balances and short-term rates. Nine-month realized investment gains were $42.6 million, versus $11.0 million, principally reflecting gains in equity-security fair values.
Q3 title loss provision remained 4.0% of title premiums and escrow fees, unchanged year over year. The total claims reserve was $1.055 billion at quarter-end.

Outlook, risks and unusual items

Management said the 50-basis-point Federal Reserve rate reduction during Q3 is expected to weigh on Q4 net investment income; further rate or average-balance declines could also reduce future investment income. No specific earnings or revenue guidance was provided.
Management expects to continue quarterly cash dividends at or above the current level, subject to board discretion. The Q3 dividend was $0.42 per share. The $250 million repurchase authorization had $161.6 million remaining; $2.1 million of shares were repurchased in the first nine months.
A Q2 2019 information-security incident investigation concluded in Q3. Imaged documents relating to 32 consumers likely were accessed without authorization; the consumers were notified and offered credit monitoring. The company described costs and expected business impact as immaterial, but the incident prompted private lawsuits and regulatory inquiries whose outcomes and potential losses were not estimable.
Other contingencies include a Canadian tax assessment of $14.4 million, which the company is appealing and for which it recorded no liability because it did not consider a loss probable; and an Indiana title-pricing matter involving alleged overcharges and a pending civil-penalty proceeding. The company said class-action loss probabilities or ranges often could not be estimated.
Title claims reserves are a key estimation risk: management stated a 50-basis-point change in expected loss rates for each of the six most recent policy years would change the IBNR reserve by about $124 million.
Lease accounting adopted January 1, 2019 added $288.4 million of operating lease assets and $319.4 million of operating lease liabilities. The filing identifies real-estate market weakness, interest-rate changes, regulation, data privacy and cybersecurity, investment losses, title-agent conduct, and industry disruption as significant risks.

Important facts for investors to verify

Whether refinancing volumes and title orders remain elevated, and how the mix of refinance, purchase, commercial, and agency business affects revenue per order and margins.
Whether the post-Q3 interest-rate environment reduces net investment income as management expects.
Development and any financial or operational consequences of the security-incident lawsuits and regulatory inquiries, the Indiana matter, and the Canadian tax assessment.
Claims-reserve adequacy, particularly the sensitivity of recent title-policy-year estimates, and the sustainability of specialty-insurance claims improvement.
Availability of holding-company liquidity and subsidiary distributions, given regulatory limits and the company’s dividend and capital-allocation plans.