Description

INTRODUCTION

The common stock of Fidelity National Financial (FNF) trades at an 8-9% earnings yield. This is a bargain considering the chairman Bill Foley has utilized the durable free cash flow from the title insurance business to deliver a 15-20% compound annual growth rate in value during the past 30 years.  The bargain exists for several reasons.  One, the earnings yield is obscured by the company's large ownership of Black Knight Financial Services (BKFS).  Two, the historical record is obscured because an investment made 30 years ago in Fidelity National turned into six securities and many more cash and stock dividends.  Finally, higher mortgage rates will probably cause a near term decline in mortgage originations, the key driver of earnings for title insurers.  

OUTSTANDING MANAGEMENT — 15-20% CAGR FOR 30 YEARS

Bill Foley is an exceptional manager.  Each of the four preceding posts to this community has described his outstanding record.

• In 2003, grant387 said Foley had demonstrated "exceptional management."
• In 2006, sandman898 pointed out Foley's "phenomenal track record."
• In 2011, Ragnor0307 wrote that Foley has a "solid track record and good capital allocation."
• In 2013, om730 pointed out that management has "created considerable shareholder value over the years."

Foley delivered 15-20% annual returns for investors in the 1987 initial public offering of FNF.  The positive commentary from this community about Foley piqued my curiosity, so I set out to measure Foley's contribution for shareholders.  In short, $10 invested in FNF at the IPO in 1987 would have turned into $387 of stock today, and one would have received $220 in cash dividends.  The CAGR is 16% before any return on the cash dividends.  If the dividends had been reinvested at 16% per annum, then the total return increases to 19%.  

Foley's 15-20% return for investors is not advertised and is hard to calculate, so Foley's outstanding results are not as widely appreciated as others.  Consider the contrast with Warren Buffett (or Prem Watsa, or Joe Steinberg and Ian Cumming).  Warren's record is presented on the first page of every Berkshire annual letter to shareholders.  He does the math for the public.  And the math is simple because Berkshire has not paid a cash dividend, has issued shares infrequently, and has not spun off any subsidiaries.  By my math, Berkshire's return since 1987 is also around 16%.  So Foley's performance is noteworthy.

Foley directed FNF to repurchase one-third of the company in 1994-95 at 4x earnings.  Foley's business acumen is evident in Fidelity National's low cost strategy and in the company's industry leading returns, as well as in his savvy investments in service oriented (low capital intensity) businesses.  The former has propelled Fidelity National to the leading market share in title insurance.  The latter delivered shareholders valuable investments in Fidelity National Information Services (FIS), Lendor Processing Services (LPS), and most recently Black Knight Financial Services (BKFS). 

Foley's buyback performance may be less obvious.  At the end of 1993, Fidelity National had an equity market capitalization of $300 million.  It had been a record year, with earnings of $36 million, a 40% return on equity.  But the stock had fallen from $27 to $20 as the market anticipated a weaker near term future, which Foley pointed out in the annual letter.  "1994 will be a challenging year, not only for Fidelity, but for the entire title insurance industry."  

He was correct.  A rise in interest rates would reduce revenue and earnings.  Earnings fell to $12 million, still a respectable 13% ROE.  The next year, 1995, was no better.  Earnings fell further, to $7 million.  Foley responded by repurchasing one third of the company for $56 million, or a $170 million valuation.  This purchase price proved to be low in relation to subsequent earnings, which summed to 100% of the purchase price in the next four years.

TITLE INSURANCE IS A DURABLE BUSINESS

The financial record of Fidelity National indicates that title insurance is an above average business.  The return on capital (EBIT/assets) has averaged 13% over the past 20 years without the use of significant financial leverage.  The profit margins (EBIT/revenue) have averaged 12%.  

Demand for title insurance is inelastic.  Title insurance is critical to home ownership.  Home ownership is widely considered part of the American dream.  And a home is typically the largest single asset that consumers own.  Since the 1950s, homes have accounted for 20-30% of total assets for consumers.  When making a $200,000 home purchase, the $2,000 outlay for title insurance is not viewed as a major expenditure.  It protects the investment against unforeseen liens or encumbrances on the home.  Regardless, lenders require title insurance as part of a mortgage approval, and most homes are financed with mortgages. 

Demand fluctuates, however.  The key driver of demand is mortgage originations, which can be especially volatile because of refinance activity.

Barriers to entry keep returns on capital decent.  The supply of title insurance is consolidated amount four companies.  There have been no notable new entrants in decades.  Rather, undisciplined suppliers were flushed in the global financial crisis.  The research required to build a title plant consumes significant man hours of serching local courthouse records and cannot be easily centralized. Moreover, title insurance is regulated by state governments.

In 2003, Fidelity's CEO stated that during a trough environment, the title business would earn a 10% pre-tax margin.  The margin fell below 10% in three years during the financial crisis, and it was below 10% before 1997 when Fidelity National had lower market share and operating leverage.  Today, management states that "normalized" pre-tax title margins would be 15-20%.

GROWTH CONCERNS OVER-EMPHASIZE THE NEAR TERM HEADWINDS

Long term drivers look okay.  The key driver for title insurance revenue is the value of transactions in residential real estate.  The long term drivers of this are household formation and home price appreciation.  The volume of residential mortgage refinancing can cause variability around the trend line.  

A decline in residential mortgage refinancing is currently a headwind to near term growth.  Mortgage rates have been in a downtrend since 1981.  While rates are falling, homeowners have a financial incentive to refinance.  And every refinancing requires a title search.  Leading up to the US presidential election, rates were near an all-time low, so that over 70% of mortgages could be refinanced at a lower cost to the borrower.  Since the election results in November, rates have jumped so that fewer homeowners have a financial incentive to refinance.  As a result, pundits are calling for refinance originations to decline sharply in 2017-18.  

In the small set of data that is readily available (1990-2016), mortgage refinancing bottoms out at around 4% per year of the outstanding stock.  That was the level in 1990, 1995, 2000 and 2014.  The Mortgage Bankers Association forecast for 2018 is 20% below the 2014 level.  So expectations seem low.

But don't ignore the positives surrounding purchase originations. This investment case is not predicated on any sort of "housing recovery" view.  Nonetheless, it seems that the stock market has focused on the negatives for FNF associated with higher mortgage rates without giving proper weight to the potential positives.  If the housing market really struggles, then the bullish sentiment surrounding banks is misplaced.  Consider BAC, which has appreciated by 35% since the election and trades at 1.4x tangible book and 6-7% earnings yield.  Much of the optimism about BAC's earnings outlook stems from expectations for less regulation, higher consumer confidence, and higher economic growth.  If interest rates are rising for these reasons, then that seems favorable for purchase originations.  And while investors tend to focus on refinance because it fluctuates most, purchase originations are more valuable to title insurers.  The price is about double, and the margins are at least as high. 

Purchase originations have steadily recovered from the global financial crisis, and several underlying drivers of continued recovery are in place.

• Household formation has improved gradually to more normal growth of 1% per year.  The portion of 18-34 year olds living with their parents is just beginning to decline from an all-time high.  A continuation of this reversal should support continued momentum in the rate of household formation.

• The rate of homeownership hit the lowest level since 1965 earlier last year.  Some argue that demographics, particularly the growth in the 18-34 year old cohort, will cause the homeownership rate to continue the rebound that began in the second half of 2016.

• The availability of credit has expanded recently as banks have adjusted to heightened regulatory scrutiny, and non bank alternatives have re-emerged.  This is reflected, to some degree, in a declining portion of home closings in cash (from a peak of 40% in 2011 to 30% today and still above the 20-25% during 1990-2006).  This could increase demand for homes, especially from first time buyers. Likewise, the average credit score for mortgage approvals recently peaked and has started to decline.  If regulation softens under a new political regime, then further expansion in credit availability seems likely.

8-9% EARNINGS YIELD IS TOO CHEAP FOR THIS TRACK RECORD

BKFS stake distorts P/E.  The 8-9% yield is obscured by Fidelity National's 55% ownership in Black Knight Financial Services (BKFS), for which management is pursuing a tax-free spin-off.  Fidelity had 279 million shares outstanding during 3Q16, and the company owned 83 million shares of BKFS.  So each share of FNF includes 0.3 shares of BKFS.  The table below illustrates the point.

The company is repurchasing significant amounts of stock.  The conversion of earnings to free cash flow is strong in the title business.  This has allowed Foley to invest in other businesses, and to purchase stock (e.g. 1994-95).  During the first nine months of 2016, the company paid out over 90% of earnings in $171 million of dividends and $251 million of buybacks.  Note that in early 2011 the company cut its dividend in order to free up cash flow for share repurchase.

According to management, the spin-off of Black Knight will reduce Fidelity National's financial leverage (debt-to-capital) from 28% to 17% and "provide meaningful financial flexibility for FNF to potentially embark upon a more aggressive stock repurchase program."

Several hedge ideas.  One might wish to hedge the BKFS portion.  FAF and STC are inferior title insurers that trade at 12x and 35x earnings, compared with 11x for FNF, which has both a superior franchise and a superior management.  Given my recent post, I would also consider selling short community banks trading at over 20x earnings and 2x tangible book value with nearly zero credit costs and significant earnings from refinance mortgage originations.  ABCB is one example. 

Catalyst

Spin-off of BKFS in 3Q17 and increased stock repurchase