FIDELITY NATIONAL FINANCIAL – LONG IDEA

Quick Summary: Call Option on Housing Recovery w/ Little Downside

Fidelity National Financial (“Fidelity,” “FNF,” or the “Company”) is the nation’s largest title insurance company with a 38% market share.  The title insurance industry has many favorable characteristics including low competition, high barriers to entry, and customers that are not price sensitive.  Within the title industry, Fidelity is the most efficient operator.  Over the past decade, its margins have consistently been better than its peers.  This outperformance is driven by Fidelity’s intense focus on cost instead of market share and provides Fidelity with a solid pricing umbrella.

Fidelity is cheap and industry fundamentals are at a trough.  This year, mortgage originations are projected to be $1T vs. an average of $2.4T over the past decade.  In addition, investment income on Fidelity’s float is depressed due to low interest rates and claims are at an all-time high.  These fundamentals will improve, however the timing is uncertain.  Based on what I believe to be normalized fundamentals, Fidelity trades at 5x earnings, 3.5x EBITDA, and 4x EBITDA – Capex.  This compares to its 5-year median P/E multiple of 12.1x and EV/EBITDA multiple of 7.3x.  Assuming a 10x P/E multiple, which is a discount to Fidelity’s historic range, there is 100% upside in the stock over the next 2-3 years.

*****BUSINESS DESCRIPTION*****

Fidelity’s business is comprised of two segments: Title and Specialty.  The Title segment is the most important and accounts for approximately 90% of Fidelity’s total revenue and earnings.  The Title segment generates revenue mainly from title insurance premiums while the Specialty segment earns premiums from flood, home warranty, and personal lines of insurance.  Outside of its core business, Fidelity also has several minority investments including: Ceridian Corporation, Remy International, Inc., Fidelity National Information Services, Inc., Cascade Timberlands, and American Blue Ribbon Holdings, LLC.  In total, these investments represent approximately $2.75 per share.

TheU.S. title insurance industry is concentrated among a handful of industry participants.  The top four title insurance companies account for 90% of the market – FNF 38%, FAF 27%, Stewart 15%, Old Republic 10%, and Other 10%.

Most real-estate transactions consummated in theU.S.require the use of title insurance before a bank will lend and the transaction can be completed.  Generally, the fee for a title insurance policy is directly correlated with the value of the property involved in the transaction.  Therefore, revenues, in addition to average home values, are driven by factors affecting the volume of residential real-estate transactions, such as the state of the economy, the availability of mortgage funding, and changes in interest rates.

Real-estate buyers and mortgage lenders each purchase title insurance to insure good and marketable title to real-estate and priority of lien.  In a real-estate transaction financed with a mortgage, virtually all mortgage lenders require that borrowers obtain a title insurance policy at the time the mortgage is made.  This policy protects the lender against any defect affecting the priority of the mortgage in an amount equal to the outstanding balance of the related mortgage loan.  An owner’s policy is typically also issued, insuring the buyer against defects in title in an amount equal to the purchase price.  In a refinancing transaction, only a lender’s policy is generally purchased because ownership of the property has not changed.  In the case of an all-cash real-estate purchase, no lender’s policy is issued, but an owner’s title policy is typically issued.

Title insurance premiums paid in connection with a title insurance policy are based on either the size of the mortgage loan or the purchase price of the property insured.  Notably, policies for refi’s are typically half of the cost of purchases because they involve less work.  Also, during a refi, borrowers only need to buy a new lender’s policy, and do not need to buy an additional owner’s policy.  Therefore, title insurance companies are much more levered to the purchase market than the refi market.

In title insurance, the majority of the premium is used to pay for the upfront diligence process.  If done right, most title issues are resolved beforehand.  This is why a title insurer’s income statement looks opposite to that of companies in different lines of insurance:

• Typical Insurance Company: $100 Premium ($85) claim losses ($10) SG&A expenses
• Title Insurance Company: $100 Premium ($10) claim losses ($85) SG&A expenses

Though the above is a rough and general illustration, it points out the drastically different nature of title insurance.  Rather than being insurance, it is more of a service – the company makes sure a property title is clear, and then it provides a guarantee that it is.  Typical insurance companies assume risk.  Title insurance companies, on the other hand, seek to identify risk and eliminate it from coverage.  Because of this risk elimination, the number of claims for title insurers are relatively low.  Furthermore, it is cheaper to incur those few claims rather than expend the additional resources to eradicate all claims.  In summary, I believe title insurance companies are much more akin to service businesses rather than traditional insurance companies.

*****INVESTMENT THESIS*****

Mortgage Originations ($B) – Purchase and Refi (Source = MBA)

                     Purchase ($B)  Refi ($B)         Total ($B)        Purchase (%)

1990                389                  70                    459                  85

1991                385                  177                  562                  69

1992                472                  421                  893                  53

1993                486                  535                  1,021               48

1994                557                  211                  768                  73

1995                494                  145                  639                  77

1996                559                  225                  784                  71

1997                590                  243                  833                  71

1998                795                  862                  1,657               48

1999                878                  500                  1,378               64

2000                905                  234                  1,139               79

2001                960                  1,283               2,243               43

2002                1,097               1,757               2,854               38

2003                1,280               2,532               3,812               34

2004                1,309               1,463               2,772               47

2005                1,512               1,514               3,026               50

2006                1,399               1,326               2,725               51

2007                1,140               1,166               2,306               49

2008                731                  777                  1,508               48

2009                700                  1,295               1,995               35

2010                473                  1,099               1,572               30

Based on my analysis, the “new normal” is probably closer to $1.5-2.0T of total (purchase and refi) mortgage originations per year, not $2.4T.  Due to a prolonged period of low interest rates, refi volume has been unsustainably high.  Over the past 20 years, 13% of total mortgage debt outstanding was refinanced each year.  In my view, because we are likely entering a rising interest rate environment, this number should normalize at 4-5% each year instead of 13%.  I believe 4-5% is conservative even though rates will rise because the increased complexity in the mortgage market (ARMs, teaser rates, etc.) will drive future refi’s regardless of where rates are.

Purchase originations, the other component of mortgage originations, have averaged 14% of total mortgage debt outstanding per year over the past 20 years.  Similar to refi’s, housing velocity was likely inflated over the same time period due to easy credit; however, I believe it was inflated to a much lesser extent.  Housing turnover, a good proxy for housing velocity and purchase originations, averaged 4.8% from 1990-present.  This is only 10% higher than it averaged from 1968-1990.  If I assume purchase originations were only inflated by 10%, the “new normal” amount of purchases originations each year as a percent of total mortgage debt would be 12-13%.  To be conservative, I assume the “new normal” is 10-11% per year, another 20% lower.

In total, my “new normal” assumes 15% of total mortgage debt will be originated each year, which is well below the 20-year trailing average of 27%, and implies the normal amount of mortgage originations is $1.5-2.0T.

Mortgage Originations (% of Total Mortgage Debt Outstanding) (Source = Federal Reserve, MBA)

                        Purchase (%)               Refi (%)          Total (%)

1990                14.9                             2.7                   17.6

1991                13.8                             6.4                   20.2

1992                16.0                             14.3                 30.3

1993                15.6                             17.2                 32.8

1994                16.9                             6.4                   23.3

1995                14.3                             4.2                   18.4

1996                15.1                             6.1                   21.2

1997                15.0                             6.2                   21.2

1998                18.5                             20.1                 38.6

1999                18.6                             10.6                 29.2

2000                17.7                             4.6                   22.2

2001                17.0                             22.8                 39.8

2002                17.4                             27.8                 45.2

2003                18.0                             35.6                 53.5

2004                16.2                             18.1                 34.3

2005                16.2                             16.2                 32.3

2006                13.4                             12.7                 26.1

2007                10.2                             10.4                 20.6

2008                6.6                               7.1                   13.7

2009                6.5                               12.1                 18.6

2010                4.5                               10.4                 14.9

3. Investment income on float is near a trough and will rebound as interest rates rise.  Fidelity has nearly $3.5 billion of float that it invests in fixed income securities.  Its portfolio is mainly comprised ofU.S. government and agencies, states and political subdivisions, corporate debt securities, and mortgage-backed/asset-backed securities.  Well over half of these securities are rated AA or better and approximately 80% are rated A or better.  Furthermore, over half of these securities mature in less than five years which will give Fidelity flexibility to rotate into new, higher yielding securities if rates rise.

Relative to the past 15 years, yields are at low levels.  As interest rates rise, Fidelity will be able to invest its new float and rotate its maturing float into higher yielding securities which will cause investment income to rise.  Fidelity’s current portfolio is yielding 4.1%.  For every 1% increase in yield, Fidelity’s EPS will increase by 10 cents.  However, it is important to note that rising rates will negatively impact bond prices causing Fidelity to suffer mark-to-market losses in its current fixed income portfolio.  If rates increase 1%, the fair value of Fidelity’s fixed income portfolio will decline by $112 million which will negatively impact book value per share by $0.49.

4. Best in class operator.  Of the major title insurers, Fidelity is the best operator.  As depicted in the chart below, its margins have exceeded its peers in each of the last 10 years.

Pre-tax Margin Comparison

                        FNF (Margin %)         Peers (FAF, STC, ORI) (Margin %)

2000                9.7                               4.2

2001                14.7                             7.8

2002                17.2                             10.4

2003                18.3                             10.9

2004                15.0                             7.9

2005                13.7                             8.5

2006                11.0                             4.7

2007                8.3                               (1.3)

2008                6.2                               (2.3)

2009                6.9                               1.4

2010                9.5                               2.3

Unlike most of its peers who focus on market share, Fidelity focuses on its cost structure and margins.  It does not try to forecast revenue, and does not take a view on housing or employ internal economists.  Management openly admits that there is nothing they can do to stimulate revenue growth.  For example, they cannot run a Super Bowl ad that will cause people to buy homes again.  Instead, management runs its business with real-time info.  Every Monday morning, Fidelity’s senior management team meets to discuss open orders, which are a good leading indicator of future revenue.  If orders are down, management will start to cut headcount.  If orders are flat-to-up, management does nothing.  Management only begins to add staff when they see open orders trend up significantly.

Fidelity is able to manage its cost structure so well because most of it is variable.  Agent commissions and provisions for claim losses are both 100% variable.  Personnel cost is mostly variable.  Each salesperson is supported by 4-5 back-office people who research and examine the title.  This allows Fidelity to flex the number of back-office people up and down as volumes increase and decrease, but not cut the number of salespeople it employs.  This is important because the salespeople are the people who generate revenue and have the important relationships in the field with real-estate agents, lawyers, and lenders.

5. Oligopolistic industry with high barriers to entry.  The title industry is dominated by two players – Fidelity and FAF.  Together, they have 65% market share.  Including the next two largest players, Stewart andOldRepublic, four companies control 90% of the market.  This large amount of concentration keeps competition rational.  Barriers to entry are also high.  In order to be successful, title companies need three things: (1) scale, (2) relationships, and (3) a robust balance sheet.  A new entrant would struggle to build enough scale quick enough to achieve profitability.  It would also take several years, if not a decade, to build out a network of agents who have strong relationships with local real-estate agents, lawyers, and lenders.  These relationships are key to generating revenue.  Lastly, customers may be hesitant to do business with a new company that cannot stand behind a title policy with a robust balance sheet.

Even with scale, the three next largest players after Fidelity struggle to make money when the market is at a bottom.  Last quarter, FAF (the #2 player behind Fidelity with 27% market share) earned a pre-tax margin of 6.8%, Stewart earned 1.7%, andOldRepublicearned 1.7%.  This compares to Fidelity’s pre-tax margin of 11.5%.  This large profit differential provides Fidelity with a nice pricing umbrella.  It’s hard to imagine one of these companies getting more aggressive when their margins are already so low.  These low margins also make it less likely that a new entrant tries to enter the industry.

6. Solid capital allocation.  Fidelity has a solid track record of good capital allocation.  Over the years, it has made several savvy acquisitions at both the subsidiary and holding company level including LandAmerica during its bankruptcy, Sedgwick, Remy, and FIS.  In addition to these acquisitions, Fidelity is focused on monetizing value for its own business.  If management believes the market is not properly valuing the Company, it will take action.  For example, Fidelity spun off FIS in 2006 because it felt that it was not being valued appropriately.  Subsequent to the spin-off, FIS common stock appreciated nearly 50%.  Management has also recently agreed to sell its flood business for $210 million, a substantial premium to where many Wall Street analysts valued it at.  According to the CEO, “everything is always for sale.”

Stock buybacks and dividends are another important part of Fidelity’s capital allocation strategy.  Over the past five years, Fidelity has bought back over $400 million of stock and paid nearly $1 billion of dividends, which compares to its current market capitalization of $3.5 billion.  Management is typically opportunistic with its buybacks.  For example, in October 2010, management announced it was moving to a dividend payout ratio policy instead of a fixed dividend policy due to the uncertainty in the real-estate market causing its stock to decline by over -10%.  In reaction to the stock decline, management bought back nearly $80 million of shares and ended up spending more money on the buyback than it saved on the dividend cut.

*****INVESTMENT CONCERNS*****

In addition to an improving trend in claims, Fidelity is the most conservative among its peers regarding its total claims reserve.  As depicted in the table below, Fidelity has currently reserved 4.2 years worth of claims which is 1-2 years more than its peers.

Claims Reserve Comparison – Total Reserve / Last Year’s Claims Paid

FNF = 4.2 years

FAF = 2.4 years

STC = 3.1 years

ORI = 3.9 year

5. Major decline in the credit market.  Fidelity has nearly $3.5 billion of float invested in fixed income securities and many investors believe the credit market is poised for a correction.  If it does, Fidelity could experience mark-to-market losses in its portfolio; however, historically Fidelity has avoided major losses in its fixed income investments due to its focus on higher quality investments.  As of last quarter, over half of Fidelity’s current portfolio was rated AA or better and approximately 80% was rated A or better.

 

2011 estimates are consensus.  2012 estimates are my estimates in a "normalized" mortgage origination / housing market.  When will the mortgage origination market recover to my "new normal" of $1.5-2T?  2-3 years.  The most compelling part of the investment is that Fidelity continues to make money at the bottom and grow book value, therefore this housing call option has little downside while you wait.

Housing recovery