Description

Overview

I believe Fidelity National Financial (FNF) is a compelling long investment with limited downside.  The company is just beginning to realize the benefits of its improved cost structure and should experience significant operating leverage as the mortgage origination market reverts to a more normalized level of purchase and refinance origination volumes.  The Fidelity National Financial VIC post in November 2011 by Ragnar0307 provides a good overview of the company and industry.  The company has since delivered four quarters where earnings have beat street estimates.  FNF’s operational performance through the first nine months of 2012 demonstrates the company’s earnings potential as the origination market normalizes between purchase and refinance volumes.  I believe the company can earn between $3.50 and $4.00 in a more normal origination market.  FNF has traded at a median forward P/E of 13x since 2005.  This multiple on $3.75 implies nearly 100% upside in the next two to three years.  I believe downside is relatively limited by the company’s current valuation which, unlike many other housing related companies, is not pricing in a robust housing recovery.  The combination of a low valuation and low expectations provides a compelling risk reward investment.

Background

FNF is the largest title insurance company in the United States with 33% overall market share and 40% direct market share.  Title insurance protects real estate purchasers and/or lenders from losses that arise after a real estate settlement as a result of unknown liens, encumbrances or other defects upon the title that existed prior to settlement.  Examples of title defects include outstanding property taxes not paid by a previous owner and fraud or forgery of a prior deed or transfer.  If a claim were made, defending the claim could cost thousands of dollars. And, if the claim were valid, it could potentially result in the loss of the property.  A title insurance policy provides coverage for legal defense, as well as the coverage amount listed in the policy, which usually equals the purchase price of the property.

The company’s earnings are depressed for two reasons: total mortgage originations are down dramatically from peak levels, and the mix between purchase and refinancing has been very unfavorable.  Conditions are already improving for the company and have a lot of room to improve further. Total mortgage originations are down 67% from the peak in 2003, and refinance as a percentage of originations has been as high as 74% recently (Q3 2012 per Fannie Mae).  Historically, refinancing has accounted for 25% to 35% of originations.  The steep decline in volumes has led to a meaningful drop in profitability.  The company’s ROE has averaged 5.4% in the past five years, versus 21.9% in the previous five year period.  Mix has exacerbated the decline in volumes. The company earns approximately $2,000 per file on a purchase transaction compared to a $1,000 per file for a refinance transaction.  Refinance origination volumes will likely remain strong through at least the first half of 2013, partly aided by government programs.  However, over the next couple of years refinancing should decline as a percentage of total originations as purchase volumes increase.  This shift will increase FNF’s fee per file and drive significant operating leverage.

Industry

The title insurance industry is depressed, but, structurally, it remains a very attractive industry.   The top four title insurance groups accounted for 89% of net premiums written in 2010.  Fidelity National Financial is the largest, followed by First American, Old Republic, and Stewart Title. Over 30 independent title insurance companies accounted for the remaining 11% of net premiums written in 2010. The industry possesses significant barriers to entry. Title companies rely on deep relationships with local brokers, lenders and agents, and scale is critical to operate efficiently nationwide. For the first nine months of 2012, FNF accounted for 58% of the industry’s profitability.  It is also very time consuming and costly to recreate or maintain title plants.  It costs FNF almost $130 mm a year to update their title records nationally. Pricing and demand characteristics are attractive as most real estate transactions consummated in the US require the use of title insurance by a lending institution before the transaction can be completed, and most customers are not price sensitive. Title insurance represents a small percentage of the overall purchase. 

Cost Structure

Management has made a concerted effort to size its cost structure for a $1.5 to $2.0 trillion origination market as opposed to the $3 trillion origination market experienced in the early part of the last decade, and there is significant operating leverage in the business. The company has reduced its locations by 30% and its payroll by 50% from peak levels.  Breakeven volume levels have been dramatically reduced.  This is evident in 3Q2012 results when the title business recorded a 14.4% pre-tax margin. Originations in the quarter were approximately $500 billion and refinance represented 74% of the mix (total originations should be around $1.9 trillion for 2012).  The last time FNF achieved similar margins was in 2005, when origination market was 50% larger ($2.9 trillion), and the purchase and refinance split was at 50/50.

Management

FNF’s management team has a demonstrated track record of monetizing undervalued assets and has created considerable shareholder value over the years.  In the past seven years, the company has distributed nearly $50 per share in special dividends and distributions of spin out companies based on today’s values. Currently, in addition to the core business, FNF has non-core assets worth about $4.00 per share. I believe management will ultimately monetize these assets to the benefit of shareholders.  In addition, I believe FNF has the strongest management team in the industry.  This is evidenced by the company’s leading margins through the cycle.  Based on conversations with industry participants, including competitors, I believe FNF’s management team is more intensely focused on monitoring order counts/volumes than anyone and will actively manage its cost structure to maintain margins though down environments.

Summary

FNF is a high quality business trading at a depressed valuation on trough-like fundamentals with the potential for earnings upside as end markets improve and the company’s operating leverage materializes. Importantly, downside is limited by the company’s valuation.  FNF is trading at 12.5x 2013 EPS and 1.2x book value.  FNF should be able to earn a pre-tax title margin of 18% to 20% in a more normalized mortgage origination market of $1.5 trillion to $1.8 trillion and 50% purchase/50% refinance.  This will probably take two to three years but the mix shift is likely to begin improving in 2013.  Fannie Mae is estimating refinance originations decline to 60% of total originations in 2013 from 72% of total originations in 2012.  The 18% to 20% pre-tax title margin would equate to $3.50 to $4.00 earnings power.  Headcount reductions and facility closures over the past few years along with a more normal provision for claims losses (5-6%) will be the greatest drivers of the company’s improved margin structure.  Currently, three analysts cover this stock, and their consensus estimate for 2013 is $2.02 earnings per share.  There are no estimates for 2014.  If these expectations are realized, to the surprise of analyst estimates, the combination of earnings growth and modest multiple expansion should result in a doubling of the stock in the next two to three years.  Additionally, the company’s non-core assets provide an added margin of safety.

Risk Factors

Mortgage origination volumes: refinance volumes decline before purchase origination volumes increase to offset the decline.  Mitigating this risk is management’s intense focus on order counts and willingness to reduce costs rapidly to maintain margins through the cycle.

Regulatory uncertainty: there is risk that increased oversight and regulation will reduce mortgage credit availability.  Partially offsetting this risk is the government’s desire to support a housing recovery through programs like HARP.

Catalyst