First American Financial Corp quarterly report, Q3 FY2016

First American Financial Corporation — Q3 2016 Form 10-Q

Reporting period: Three and nine months ended September 30, 2016; unaudited. The company operates title insurance and real estate-related services, plus specialty insurance businesses including home warranty and property and casualty insurance. Comparative periods are the corresponding 2015 periods unless noted.

Financial performance

Metric	Q3 2016	Q3 2015	Nine months 2016	Nine months 2015
Revenue	$1,508.3 million	$1,383.9 million	$4,071.6 million	$3,818.8 million
Income before taxes	$166.9 million	$115.4 million	$396.1 million	$316.0 million
Net income attributable to the company	$107.3 million	$75.5 million	$262.0 million	$206.5 million
Diluted EPS	$0.96	$0.69	$2.36	$1.88
Pre-tax margin, calculated	11.1%	8.3%	9.7%	8.3%

Q3 revenue rose 9.0%; nine-month revenue rose 6.6%. Q3 growth was led by agent premiums and refinance-related direct premiums and escrow fees. The company reported U.S. mortgage refinance originations up 71.9% year over year in Q3, citing the MBA forecast.
Title Insurance and Services pre-tax income increased 37.8% to $188.7 million in Q3 and 24.2% to $448.8 million for nine months. Its pre-tax margins were 13.5% and 12.0%, respectively, versus 10.6% and 10.2%.
Specialty Insurance pre-tax income was $1.8 million in Q3, compared with $1.7 million; nine-month pre-tax income declined to $18.7 million from $29.4 million. Higher home-warranty claims and operating costs weighed on results.
Net investment income increased to $34.4 million in Q3 and $92.7 million for nine months. Net realized investment gains were $9.5 million and $22.7 million, respectively, versus a Q3 loss of $3.1 million and nine-month loss of $0.2 million in 2015.

Cash flow, balance sheet and capital

Nine-month operating cash flow was $252.2 million, down from $352.2 million. Investing activities used $416.0 million; financing activities provided $582.2 million. Cash and cash equivalents increased $416.0 million to $1,443.3 million from year-end 2015.
At September 30, 2016, total assets were $9,246.5 million, total equity $3,028.6 million, and notes and contracts payable $737.9 million, up from $581.1 million at December 31, 2015. Notes and contracts payable were 19.6% of total capitalization, versus 17.5% at year-end.
The company borrowed $160 million under its revolving credit facility in September to fund acquisitions and partially fund pension-plan termination obligations. The borrowing rate was 2.28%; $540 million of facility capacity remained available. The company reported compliance with financial covenants.
Holding-company liquidity included $244 million of cash and $540 million of available facility capacity. Management said resources were sufficient for anticipated operational needs and obligations for at least 12 months. This is a management assessment, not a guarantee.
The board increased the quarterly dividend to $0.34 per share, effective with the September 2016 dividend, and management expected quarterly dividends to continue at or above that level, subject to board discretion. Nine-month dividends declared were $0.86 per share.

Material changes, outlook and risks

Real estate and mortgage activity drove improved title results: direct title orders closed rose 19.8% in Q3, while average revenue per order fell 10.5%, reflecting a shift toward lower-premium residential refinance business. Commercial orders opened per day declined 7.5%.
The company terminated its funded defined-benefit pension plans. It contributed $55.9 million in September and expected an additional contribution of about $44 million. It estimated approximately $81 million of pre-tax pension losses in Q4 2016 and a further approximately $131 million of losses and other expenses by the end of Q3 2017; actual amounts and timing could vary. Once termination is complete, the company expects annual personnel-cost savings of about $22 million.
Title loss provision was 5.5% of title premiums and escrow fees, versus 6.6% a year earlier; the 2016 rate included a $5.8 million net increase in prior-year reserves. Management notes that a 50-basis-point change in recent policy-year loss rates could change the IBNR reserve by approximately $108.2 million.
Management highlighted exposure to interest rates, real estate and mortgage cycles, investment losses, claims variability, agent conduct, regulation and title-rate oversight, cyber and funds-transfer risks, and dependence on large lenders. No specific revenue or earnings guidance was provided.
Pending litigation includes putative class actions and regulatory inquiries into title-insurance pricing, competition, customer acquisition and agency relationships. The company said it could not estimate losses for several matters; unfavorable outcomes or required changes in business practices could affect results. A potential Canadian excise-tax assessment also remains unquantified.
Escrow, trust and like-kind exchange funds are largely customer assets excluded from the balance sheet, but the company could be contingently liable for their disposition. At September 30, escrow deposits were $7.5 billion, trust assets were $3.2 billion and like-kind exchange funds were $2.2 billion.

Important facts for investors to verify

Whether refinance-driven title volumes and improved title margins persist, and how changing transaction mix affects revenue per order.
Specialty Insurance claims trends, particularly home-warranty servicing costs and claim rates.
Actual pension contributions, termination charges, timing, and realized cost savings compared with management estimates.
Future title-claim development and reserve adequacy, including sensitivity to changes in expected loss rates.
Developments in litigation, regulatory investigations and the potential Canadian tax assessment, for which some exposures are not estimable.
Debt and holding-company liquidity after acquisitions and pension payments, alongside the cyclicality of operating cash flow and any restrictions on subsidiary distributions.