Business context and reporting period
First American Financial Corporation filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2016. Its principal businesses are title insurance and related real-estate services, and specialty insurance, including home warranties and property-and-casualty insurance. Results are sensitive to real-estate transactions, mortgage activity, interest rates and claims experience.
Financial performance and position
Amounts below are in millions of dollars except per-share data. Comparisons are with the corresponding 2015 period.
- Second quarter: Revenue was $1,361.5, up 2.9%; pretax income was $153.6, up 8.5%; net income attributable to the Company was $102.1, up 9.4%; and diluted EPS was $0.92, versus $0.85. The consolidated pretax margin was approximately 11.3%, compared with 10.7%.
- First half: Revenue was $2,563.2, up 5.3%; pretax income was $229.2, up 14.3%; net income attributable to the Company was $154.7, up 18.1%; and diluted EPS was $1.40, versus $1.19.
- Segment margins: Title Insurance and Services pretax margin improved to 13.7% for Q2 from 12.6%, and to 11.0% for the first half from 10.0%. Specialty Insurance margin declined to 4.5% from 10.8% for Q2 and to 8.2% from 14.4% for the first half.
- Cash flow and liquidity: First-half operating cash flow was $146.4, down from $166.9; cash and cash equivalents increased to $1,241.8 from $1,027.3 at year-end. The holding company had $231.0 of cash and $700.0 available under its undrawn revolving facility. Management said resources were sufficient for anticipated needs for at least 12 months.
- Debt and capital: Notes and contracts payable were $579.5, versus $581.1 at year-end; the company had no revolver borrowings and was in compliance with its covenants. Notes and contracts payable were 16.4% of total capitalization, down from 17.5%. The quarterly dividend was $0.26 per share.
- Other balance-sheet and investment metrics: Total assets were $8,836.7 and total equity was $2,944.0. The investment portfolio was 93% fixed income; 94% of investments were rated or classified investment grade. Net realized investment gains were $8.1 in Q2 and $13.2 for the first half, compared with $3.9 and $2.9.
Material changes versus the prior comparable period
- Q2 title-insurance revenue growth reflected higher agent premiums and direct revenue from residential purchase transactions. Direct title orders closed fell 0.9% in Q2 and 3.7% in the first half; average revenue per order rose, partly reflecting higher real-estate values.
- First-half agent premiums increased 10.0%, while direct premiums and escrow fees were essentially flat. Management noted that agent premium recognition generally lags the underlying policy issuance.
- Specialty Insurance revenue grew 6.9% in Q2, but pretax income fell 55.4%. Home-warranty claim costs rose, with the claims ratio increasing to 66.6% from 59.6%; property-and-casualty claims severity also increased.
- Title claim provision as a percentage of title premiums and escrow fees improved to 5.5% from 6.6%. The 2016 rate included a $5.2 increase in prior-year reserve estimates.
- First-half operating cash flow decreased despite higher net income, including effects from changes in working capital and claim payments.
Outlook, commentary, risks and unusual items
- Management expects quarterly dividends at or above the current $0.26 level, subject to board discretion and business, legal and capital considerations. No quantified revenue or earnings guidance is provided.
- The company terminated its funded defined-benefit pension plans, effective July 31 and August 31, 2016. It expects about $100 million of additional cash contributions plus other termination costs, and estimates annual personnel-cost savings of approximately $22 million after termination. It expects to recognize approximately $81 million of pretax pension losses in Q4 2016 and approximately $131 million of pretax losses and other expenses by the end of Q3 2017; actual amounts and timing may change, and regulatory review applies.
- Key business risks include real-estate and mortgage-market cyclicality, interest-rate changes, regulated title rates, regulatory scrutiny and litigation, claims-reserve estimation, investment-market losses, reliance on title agents and major lenders, cyber incidents and fraudulent funds transfers.
- The company reported multiple lawsuits and regulatory examinations, including matters concerning title rates, agent relationships, settlement practices and consumer claims. For many class-action matters, the company could not assess probability or estimate a loss range. Management did not expect the described litigation or investigations to materially harm overall financial condition or liquidity, but acknowledged possible effects on results or business practices.
- A potential Canadian excise-tax assessment was not estimable; the company considered a loss possible and said an unfavorable result could affect an individual period. Customer escrow, trust and like-kind exchange balances are largely off balance sheet; the company could be contingently liable for their disposition or transfer. Guarantees of indebtedness totaled $7.4 million.
- Management reported no goodwill impairment trigger in the first half. Certain 2015 revenue and expense classifications were revised; the company said the changes were not material to previously issued financial statements.
Important facts for investors to verify
- Whether lower specialty-insurance profitability persists, particularly the elevated home-warranty claims ratio and property-and-casualty claims severity.
- The timing, total cash cost and earnings impact of pension-plan termination, including funding needs and regulatory approvals.
- Developments in lawsuits, regulatory inquiries and the unquantified Canadian tax matter, including any changes to recorded reserves or business practices.
- Title claims-reserve adequacy: management disclosed that a 50-basis-point change in expected loss rates for the six most recent policy years could change the IBNR reserve by approximately $106.1 million.
- Underlying title transaction volumes, mix and agent-premium recognition lag, alongside operating cash flow and holding-company liquidity.
- Investment portfolio credit quality, interest-rate exposure and potential volatility in investment gains; future accounting for equity investments may also affect reported earnings.