First American Financial Corp quarterly report, Q3 FY2015

First American Financial Corporation — Q3 2015 Form 10-Q

Reporting period: Three and nine months ended September 30, 2015; unaudited. First American provides title insurance and related real estate services, as well as property and casualty insurance and home warranties. Unless noted otherwise, amounts below are in U.S. dollars.

Financial performance

Metric	Q3 2015	Q3 2014	Nine months 2015	Nine months 2014
Revenue	$1,383.9 million	$1,259.7 million	$3,818.8 million	$3,422.5 million
Income before income taxes	$115.4 million	$116.0 million	$316.0 million	$227.7 million
Net income attributable to the Company	$75.5 million	$80.7 million	$206.5 million	$153.0 million
Diluted EPS	$0.69	$0.74	$1.88	$1.41
Operating cash flow	Not separately stated	Not separately stated	$352.2 million	$166.2 million

Q3 revenue rose 9.9%, while pretax income was nearly flat and net income attributable to the Company declined about 6%. Q3 included $3.1 million of net realized investment losses, versus $14.4 million of gains a year earlier; the 2015 quarter’s losses primarily reflected the sale of a subsidiary.
Nine-month revenue increased 11.6%, pretax income 38.8%, net income attributable to the Company 35.0%, and diluted EPS from $1.41 to $1.88. The nine-month 2014 comparison included higher investment gains.
Consolidated pretax margin was approximately 8.3% in Q3 2015 versus 9.2% in Q3 2014, and 8.3% for the first nine months of 2015 versus 6.7% in 2014.
Title Insurance and Services generated Q3 revenue of $1,288.2 million, up 10.5%, and pretax income of $137.0 million, up 13.2%; its pretax margin improved to 10.6% from 10.4%. Higher commercial and residential purchase activity, average revenue per order, and closed orders supported results.
Specialty Insurance Q3 revenue increased 6.7% to $101.2 million, but pretax income fell to $1.7 million from $10.4 million. Higher home warranty claims and wildfire-related property and casualty losses pressured results; its pretax margin was 1.7% versus 11.0%.
Nine-month capital expenditures were $94.3 million, up from $66.1 million. Cash dividends paid were $81.3 million; declared dividends were $0.25 per share for Q3, versus $0.24 a year earlier.

Balance sheet, debt and liquidity

At September 30, 2015, cash and cash equivalents were $894.4 million, down from $1,190.1 million at December 31, 2014. Total investments were $4,766.1 million; total assets were $8,121.1 million and total equity was $2,693.1 million.
Notes and contracts payable were $585.0 million, compared with $587.3 million at year-end 2014. Debt was 17.8% of total capitalization, down from 18.6%. The $700 million revolving credit facility had no borrowings outstanding and matures in May 2019; the Company reported compliance with its covenants.
The holding company had $230.2 million of cash and $700 million available under the revolver. Management said resources were sufficient for anticipated operational cash requirements and obligations for at least 12 months. Up to $515.6 million of dividends, loans and advances from insurance subsidiaries was available without regulatory approval for the remainder of 2015.
Cash from operations increased to $352.2 million for the first nine months, after $364.3 million of net claims payments. Investing activities used $850.9 million, principally reflecting purchases of securities and capital spending; financing activities provided $209.4 million. Net cash decreased $295.7 million.
Escrow deposits were $8.0 billion, including $2.5 billion held at the Company’s bank subsidiary; like-kind exchange funds were $2.9 billion and trust assets were $3.0 billion. Some customer funds and trust assets are not Company assets on the balance sheet, but the Company could be contingently liable for their handling.

Changes, outlook and risks

Management attributed broad revenue growth to improved commercial business and residential purchase transactions. Direct title orders closed increased 3.0% in Q3 and 10.9% for the first nine months; higher commercial deal sizes and property values lifted average revenue per order.
Title loss provision rates were 6.5% for Q3 and the first nine months of 2015, versus 6.7% and 7.2% in the comparable 2014 periods. The 2015 rate included a $5.5 million net increase in prior-year reserve estimates. Total claims reserves were $971.5 million, down from $1,011.8 million at year-end, largely reflecting settlement payments on large claims.
Management expected to continue quarterly cash dividends at or above the current level, but future dividends remain subject to board discretion. No specific earnings or revenue guidance was provided.
New CFPB integrated mortgage disclosure rules took effect for applications made on or after October 3, 2015. Management warned implementation could cause mortgage processing delays or lower volumes; the outcome depends in part on lenders, agents and other market participants.
Key exposures include real estate and mortgage-market cyclicality, interest-rate and investment risks, changes in claim estimates, regulation and title-insurance rate constraints, CFPB oversight, cyber and system incidents, and dependence on agents and large lenders.
Numerous lawsuits and regulatory examinations remain pending, including matters involving title rates, referral practices, fees and other business conduct. The Company said many potential losses cannot be estimated; it did not expect the matters described to materially affect overall financial condition or liquidity, but adverse outcomes could affect individual periods or business practices.
A Canadian excise-tax matter could result in an assessment, but the amount was not estimable. The Company believed it was reasonably likely to prevail, while acknowledging a possible loss. The pension plan was underfunded by $86.7 million at September 30; the Company had contributed $31.6 million and expected to contribute another $4.2 million in 2015.
The Company reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. Its investment portfolio was 94% investment grade, based on amortized cost; interest-rate risk was its primary market risk, and it did not use derivatives on a significant scale to hedge it.

Important facts for investors to verify

Whether the sharp Q3 decline in Specialty Insurance profitability persists, and how wildfire losses and claims frequency develop.
Future title and specialty claims experience, including the sensitivity of incurred-but-not-reported reserves; management estimated a 50-basis-point change in recent policy-year loss rates could change the IBNR reserve by approximately $102.5 million.
The effect of CFPB disclosure-rule implementation on transaction volumes, processing timelines, costs and agent coordination.
Developments in material lawsuits, regulatory inquiries and the Canadian excise-tax matter, including whether losses become estimable or require additional accruals.
Cash generation, investment portfolio values and liquidity, particularly given the decrease in cash, higher securities purchases and customer-related deposit obligations.