Description

Fidelity National Financial (FNF)

The nation’s largest mortgage loan processor, largest flood insurance processor, a bank processor for 25% of the top U.S. banks, and oh yeah, they are the dominant leader in the title insurance business.

Who would ever recommend a title insurer in a rising interest rate environment? Didn’t someone tell me that refinances were at an historical high this past year? Didn’t I hear that refinances have fallen off a cliff the past few months and will continue to deteriorate significantly the next few years? Didn’t I hear that all mortgage companies and even Washington Mutual are warning of future earnings? I’m quite aware of all of the above however I believe FNF is significantly better positioned than its competitors and is substantially improved operationally/structurally to weather a rising interest rate environment. If you’ve made up your mind that this is purely an interest rate cyclical business, you can stop reading as the following facts will fall on deaf ears – for the rest of you, read on.

It is a relatively common misconception that Fidelity is purely a title insurance and escrow company. FNF is made up of three primary divisions: 1) Title insurance and escrow services (Title); 2) Real estate related services (RERS); and 3) Information services (FIS).

The significant difference this time around, is that FNF has utilized its significant cash flow over the past couple years to buy non-capital intensive, high cash flow businesses that are not as dependent on low interest rates. This is what differentiates FNF from their competition. On their face, all title insurers look quite inexpensive at this point, but FNF is in a much different situation than all of their competition going forward. I’ll detail FNF’s pre-tax margins later in this write-up.

Simply, Bill Foley the CEO at FNF, has demonstrated exceptional management and has built a company with a distinct moat that operates at much higher returns than its competition. FNF has returned an average annual compounded return of 21% since it began trading in 1987. He has built a company that can now not only withstand, but thrive in all interest rate environments. This is a rare large cap idea that should continue to above average returns for the next many years. Let’s take a look at their three divisions.


Title Insurance and Escrow Services
This group is made up of Alamo Title, Chicago Title, Fidelity National Title, Security Union, and Ticor Title. FNF is the leading title insurer in the nation with over about 29% market share and is the leading title insurer in California, Texas, Florida and New York. There is no doubt we’ll see a significant decrease in title insurance business the next few years from the levels they’ve been at the past few years. One of the compelling reasons for this idea is that historically in dramatic rising interest rate environments, FNF has managed to maintain between a 12% and 15% ROE – IN A TROUGH EARNINGS ENVIRONMENT. As a comparison, recent ROE’s (in the favorable environment) for FNF have been in excess of 25%.


An important aspect to understand about the business model of the title side of the business is the significant portion of variable costs that can be managed on this side. FNF continually monitors staffing needs and title order volume. As an example, by October of this year the title and escrow workforce had been rationalized by over 16%. As order flows fluctuate, FNF will make personnel adjustments. Also, many title managers compensation packages are heavily tied to volume and this incremental cost will decrease as volume recedes. And lastly, a fact that not all recognize is that revenue from a typical refinance (which has created the lion’s share of the mortgage volume buzz) is about half of what exists from a typical buy/sell transaction. Thus, the decrease in refinance business will have an obvious impact on the revenue of FNF, although it will not be as great as one might expect at first glance.

Real Estate Related Services (RERS)
The business is currently an $850MM annual revenue business and it made up of flood insurance, tax escrow, and credit reporting processing, along with default management services and other real estate related servicing products. This is a significant portion of business that will see solid growth going forward and is not as dependant upon interest rate cyclicality as the title business.

Information Services (FIS)
This division will see the most growth going forward. It primarily consists of bank processing software as well as mortgage loan processing. Fidelity is the nation’s largest mortgage loan processor accounting for 46% of the nation’s mortgage loans. The annual revenue base for information services is also $850MM and FNF has stated they project to grow this revenue base to over $2B by the year 2006. This growth will take place through a target of 10% organic growth and continued future acquisitions as the Company continues to find high return opportunities for its significant cash flow.


Earnings Power
During 2002 and 2003, FNF will have generated over $1.8 Billion in FCF. Should they have owned all of their current businesses at the beginning of 2002, this number would be substantially higher. So, their FCF yield has been in excess of 17% annually the past 2 years. For a company their size, this is amazing. What have they done with the FCF? They have bought the following businesses:

Alltel Information Systems business for $1.050 Billion - FIS
The remaining minority interest in FNIS - RERS
Webtone Technologies - FIS
The acquisition of ANFI, Inc. - RERS
The flood insurance subsidiary of Mutual of Omaha - RERS
The remaining minority interest of Micro-General - RERS






Margins and Trough Earnings

During the past year, the pretax margins for all three of their business segments have exceeded 20%. Warren Buffett has consistently stated that his criteria for investment is a high probability of a 10% pretax margin in a business into the future. We all know that the last couple of years have been great years for FNF and that it will take an unforeseen act for their 2004 earnings to exceed their 2003 earnings. So, let’s take a look at trough earnings. FNF recently published figures for trough earnings. They haven’t identified what interest rate increase is assumed, but that the increase is significantly greater than a 1% annual increase in interest rates. In a trough environment, they expect to see the following:

Annual Revenue Pretax Margin
FIS $925 20%
Default Mgmt $400 25%
Flood $100 12%
RERS $400 15%
Title $3,000 10%

If we add to that an additional $150 in investment income, the total earnings should be approximately $500MM after tax, or about $3.25 a share.

As I mentioned earlier, FNF has generated between a 12% and 15% ROE in times of rising interest rate environments. If this is the case, they would earn between $440MM and $550MM, or $3.00 - $3.50 a share. Importantly, these historical numbers were generated when FNF was primarily a title and escrow company.

To illustrate, if we look back to just the year 2000, FNF had non-title revenue of $167MM, and their current annualized revenue for non-title business is $1.7 Billion. This trend will continue to grow significantly through both organic and acquisition growth. The non-title business has an approximate 19% pre-tax margin and on $1.7 Billion, that results in over $320MM in pre-tax profits alone.

Going forward, there is no doubt that strategic acquisitions will continue in the non-title business. When opportunities in the title business present themselves we will see more acquisitions there as well as evidenced by the recent purchase of Land Canada – the 2nd biggest title company in Canada. Within the next few years, it is the goal of FNF to have 50% of revenues come from Title and Escrow, 30% from FIS and 20% from RERS.

Currently, FNF is trading at 6X ttm eps, 1.47X book, 5.8X ttm FCF, and about 0.75X revenue on over $7 Billion in annual revenue. It is amazing to me that the powers that be at Standard & Poors won’t allow this company into the subjective S&P500 Index. About one-third of the companies currently in the index have less revenues than FNF and they were number 326 on the latest Fortune 500 list.

I firmly believe rates will increase over the next few years. Should that rate increase be at a rate that is lesser than expectations, FNF will have large benefits and will continue to generate large FCF. Another aspect is that the commercial mortgage market has not been as strong as it has been historically and as the economy improves, more commercial title revenue will be generated.

With trough earnings at approximately $3.25 a share, we expect to see earnings greater than $4.00 in 2004 on the low end. FNF certainly has the earnings power to generate much higher earnings next year and if history is any indication, they will far exceed my expectations. We do not anticipate a trough scenario in 2004.

FNF currently yields about 2% after increasing their dividend 50% this past year and has just announced the continuation of their stock buyback program. Management continues to reward shareholders in the manner it has over the past 16 years.

Catalyst

Investors will eventually understand FNF’s diverse revenue streams and earnings potential.

FNF’s margins and high returns on capital will be recognized as a competitive moat.

11X trough earnings, 17% current FCF yield for the undisputed market leader is too cheap.

Recently announced stock buyback

Future inclusion into the S&P500 Index will increase the attention of this business.