Description

The market is paying investors to "buy" shares in Fidelity National Financial (NYSE: FNF), an outstanding company that has compounded the value of its stock by 25% per year since inception. This "negative stub" is available because the market value of FNF's ownership stakes in two companies, which have recently become publicly traded through a spin-off and a reverse merger, is currently greater than the value of FNF. Furthermore, one could argue that these two businesses are currently slightly undervalued relative to peers and, to top it all off, FNF also has a specialty insurance business as well as $475MM in net cash. I recommend that investors create the stub and reinvest the proceeds in FNF, essentially establishing a position in FNF for free.

COMPANY DESCRIPTION

FNF owns three core businesses: Fidelity National Title Group (NYSE: FNT), the leading title insurance business; Fidelity National Information Services (FIS), the leading software and processing services provider to financial institutions; and a Specialty Insurance business. Specifically, FNF owns 82.5% or 143MM shares of FNT, 75.0% or 99MM shares of FIS, and 100% of its Specialty Insurance business. In addition, FNF had approximately $475MM in net cash at year end.

Market Value: $6.9B
Net Cash: $475MM
Enterprise Value: $6.4B
52-Week Range: $30/$47
Dividend: $1.00 (2.6%)
Shares Out: 173.5MM
Fully-Diluted Shares Out: 178MM
Float: 171.4MM (98.8%)
Short Interest: 3.2MM (1.9%)
Avg. Volume: 1.3MM (0.8%)
Liquidity (30% of 30-Day Average Volume): $15MM

SUM-OF-THE-PARTS

Despite its phenomenal track record, in our recent conversations with management we were told that, “there appears to be a definite discount,” in the company’s market value. At its current price, FNF stock is essentially trading at or below liquidation value.

99MM shares of New-FIS $3.980B ($22.40 per share)
143MM shares of FNT $3.489B ($19.60 per share)
Sedgwick CMS at Purchase Price $0.475B ($2.70 per share)
Specialty Insurance @ 10x EPS $0.374B ($2.10 per share)
Total $8.318B ($46.70 per share)

FNT WORTH $19.60 PER SHARE

On October 18, 2005, FNF spun-off 17.5% of its title insurance business by distributing 0.175 shares of FNT for each FNF share outstanding. FNT shares promptly rose 14% as investors were able to allocate capital directly to the largest title insurer in the world. FNF continued to own 143MM or 82.5% of the remaining FNT shares and has no plans of decreasing its stake. FNF kept more than 80% of FNT in order to continue collecting dividends on a tax-efficient basis, but it would be possible to spin-off these remaining shares to shareholders. Since the FNT shares are publicly traded, they are fairly straightforward to value. FNF’s 143MM shares at $24.37 per FNT share is worth $3.5B or $19.60 per FNT share.

NEW-FIS WORTH $22.40 PER SHARE

The FIS shares are a little bit more complicated and require additional explanation. In March 2005, FIS recapitalized itself by borrowing $2.8B and distributing $2.7B to FNF. FNF used $400MM to repay the outstanding balance of its credit agreement and the remainder to pay a $10 one-time dividend to shareholders. FNF also sold 25% of its stake in FIS to two private equity firms, Texas Pacific Group and Thomas H. Lee Partners, for $500MM. Management had originally tried to IPO FIS but was unable to get an acceptable price and it is believed that the private equity sale was completed at a substantial discount in order to gain some assistance in unlocking the value in FNF’s remaining stake. FNT used the proceeds of the private equity sale to repay $410MM of its former credit facility and to fund $80MM in transaction expenses.

On September 15, 2005, FIS announced an agreement to effectively purchase Certegy (NYSE: CEY) through a reverse-merger. The combined company will be renamed Fidelity National Information Services (New-FIS), will trade under the ticker symbol (FIS) and will be the second-largest company, based on revenues, in the payments processing and card services business. Prior to the transaction closing on February 1, 2006, CEY will pay its current shareholders a $3.75 dividend and then purchase FIS by issuing 132MM CEY shares to FIS shareholders. Since CEY currently has 64MM diluted shares outstanding, New-FIS will have 196MM fully-diluted shares outstanding when it begins trading. Following the announcement, shares of CEY increased 15% from $33.52 to $38.70 and proceeded to increase another 14% to $43.93 over the following months as a number of shareholders who owned FNF specifically for the FIS asset dumped their shares in FNF and purchased shares of the much faster growing CEY.

FNF’s tax basis on the 75% of FIS that it owns is essentially zero so if distributed, FNF would be responsible for a hefty tax bill. Fortunately, for FNF shareholders, management is intent on maintaining its investment in New-FIS into the foreseeable future and has even expressed an interest in increasing its stake. As long as this remains true, the tax liability should remain deferred in perpetuity and thus not pose a realistic concern for long-term oriented shareholders. CEY currently trades for $43.93 per share. Subtracting a $3.75 dividend implies a New-FIS share price of $40.18. FNF’s 75% stake in FIS will result in a 50.3% stake in New-FIS, or 99MM shares, which is worth $4.0B or $22.40 per share.

SPECIALTY INSURANCE WORTH $2.10 PER SHARE

In 2004, the Specialty Insurance business reported 13.3% operating margins on $240MM in revenues, generating $32MM in EBIT and $20MM in net income. 2005 was a better year and though it is not yet reported, Lehman Brothers estimates that this business generated $57MM in EBIT, representing a 16.2% operating margin, on $351MM in revenues. For 2006, analysts expect this business to generate between $25-50MM in net income, or $0.14-0.28 per share, to which they apply a forward P/E multiple of 9-11x. Assuming that Specialty Insurance trades at 10x the midpoint of earnings estimates, this business is worth $2.10.

SEDGEWICK CMS WORTH $2.70 PER SHARE

According to FNF’s Q3 earnings call on October 26, 2005, the company has approximately $475MM in net cash. On December 27, 2005, FNF announced the acquisition of Sedgwick CMS Holdings, one of the country's largest providers of claims administration services, for $635MM. The purchase should be funded by the company’s cash balance with the remainder from drawing down on FNF’s existing lines of credit. The transaction is expected to close on January 31, 2006. Assuming that management does not create any incremental value for FNF shareholders, the company’s investment in Sedgwick CMS is worth $475MM or $2.70 per share.

STUB TRADE

It is our belief that the opportunity exists for a "negative stub" partially because of the complexities of the reverse merger between CEY and FIS made it difficult for investors to realize that the market value of the subsidiary businesses was increasing at the same time that the value of the holding company was staying relatively flat. Over the next few months, the math for calculating FNF's stake in FNT and New-FIS should become much more straightforward, and there is a higher likelihood that the stub corrects itself. Put another way, investors will have to come to terms with the fact that FNF owns 143MM shares of FNT and 99MM shares of New-FIS, the sum of which will have a publicly traded valuation in excess of FNF.

Each share of FNF entitles the owner to 0.556 shares of CEY and 0.804 shares of FNT. The CEY is worth $24.43 (0.556 * $43.93) per share and the FNT is worth $19.60 (0.804 * $24.37). Shorting these two securities in these amounts would raise $44.03. However, short sellers of CEY would have to pay the dividend of $2.09 (0.556 * $3.75) resulting in $41.95 in short-sale proceeds. The buyer could be then purchase a share of FNF for $38.50 and pocket the $3.45 stub value. In addition, he or she would also receive $2.60 worth of Sedgewick CMS and $2.10 worth of the Specialty Insurance business. Thus the total stub of $8.20 represents an 18% discount off of FNF’s intrinsic value.

Investors could also short only one of the subsidiary businesses, effectively purchasing either CEY at a 33% discount or FNT at a 42% to the current market price.

SHAREHOLDER RETURNS

Assuming the reinvestment of dividends, shares of FNF have increased at a rate of 25% per year since going public on February 25, 1987, more than double the return of the S&P 500. Surprisingly, these superior results have been rather consistent over this timeframe. In fact, investors could have purchased shares of FNF at almost any point in its history and doubled their money every five years. The track record is so stunning that the company lets investors calculate returns over any holding period on its website www.investor.fnf.com/calculator.cfm.

Bloomberg lists the price of Berkshire class A shares staring on November 5, 1987 as the oldest date. At that time, a share of Berkshire Hathaway would have cost an investor $2,900. Eighteen and a quarter years later, that same share of Berkshire Hathaway would have increased at an annual compounding rate of 20.7% to $90,200. Had that investor instead elected to invest his or her $2,900 into FNF and reinvest dividends back into the stock, their investment would have grown at a compounded rate of 24.8% to $165,600.

TITLE INSURANCE

Title insurance protects both the ownership interest of the property owner as well as the lien position of the mortgage lender in the event that there are any adverse claims of ownership, liens, defects or encumbrances associated with the transfer of the property. Normally, title insurance is required by the lenders for a mortgage to be approved.

Title insurance is an incredibly profitable insurance product. While property and casualty insurance providers typically have claims costs that average 75-80%, title insurance claims losses are generally only 4-6%. These impressive margins are due to two reasons, inelastic demand and large barriers to entry.

Demand for title insurance is fairly inelastic for three reasons. First, title insurance is purchased infrequently by consumers who are unfamiliar with the product. Second, the cost of title insurance is marginalized relative to the price of the home. Third, title insurance providers are usually picked by the lender based on long-term established relationships.

There are three main barriers to entry to the title insurance business. First, since the underwriting decision is based on a county-level courts and registries, competition between underwriters is really for entrenched long-term relationships with real estate professionals. Second, when a request for a policy is made, title insurers search through courthouse records to ensure that there are no prior ownership claims on the property in question. This information is then digitally archived in databases, called title plants, for future reference. These title plants serve as a barrier to entry for incumbent firms. Third, unlike P&C insurance, title insurance is a monocline product, which requires other insurance providers to first set up a new title insurance company to compete which requires millions in capital and a detailed application and approval process.

Over the last two decades, the title insurance industry has become incredibly consolidated. The American Land Title Association (ALTA) lists 46 mergers or acquisitions covering the period from 1987 through 1999 and the activity has only accelerated since that point in time. FNT now has a 31% market share and its competitors First American (FAF) has 24.2%, LandAmerica (LFG) has 18.2%, Stewart Information Services (STC) has 11.2%, Old Republic International (ORI) has 6% and the remainder is divided amongst 40 regional underwriters.

FNT BUSINESS DESCRIPTION

FNT operates under Alamo Title Insurance, Chicago Title Insurance, Fidelity National Title Insurance, Security Union Title Insurance and Ticor Title Insurance brands.
A typically residential title premium for a $200,000 loan generates a $400 fee while the average fee for a commercial premium is around $8,000.

FNF’s title insurance is sold by a network of 9,500 independent agents who typically keep 30% of the premium. FNT also operates 1,500 direct offices where it acts as its own agent and thus keeps 100% of the premium. In some states FNT also handles the closing, or escrow, process. This involves acting as a third-party by managing all documents needed to close the deal and insuring that all requirements of the sale have been met before collecting fees and handling payoffs. A typically closing would generate $400 to $600 in revenues. For 2005, Raymond James believes FNT generated $2.2B in revenues from direct, $2.8B from agency, and $1.2B from escrow and other. FNT’s EBIT margins have historically been 2-5% greater than its closest competitor and while its larger size and leaner management structure probably play some part in this, FNT also generates 93% of its California premiums directly, where the agency split is 90/10.

FNT cost structure is predominantly variable as 35% of revenues is spent on agent commissions (directly variable), 30% is allocated to personnel costs (fairly variable), 15% is overhead (primarily fixed), and 5% is set aside as a provision for claim losses (directly variable). This should help the company scale back in a downturn as the cycle changes. Management is keenly aware of this possibility and as early as 2003, FNF’s CEO said that in preparation for a downturn, “We tend to bring in temporary employees. We pay overtime. And when the market turns the other direction we start cutting back and take out last ins, first out… We run very strict metrics in our business; open orders per employee, closed orders per employee, revenue per employee. And so we see, as the market starts turning, we see 60 to 90 days in advance that the market is actually turning. And we start taking action internally to deal with it.”

FNT has historically been able to generate a ROE of 12-15% in periods of dramatically rising interest rates and in excess of 25% in more favorable business mortgage environments. Management has said that in a trough environment they would expect to generate a 10% pre-tax margin. FNT generates a 15% EBIT margin in 2004 and is expected to have generated 14-15% EBIT margins on $6.4B in revenues in 2005. The company generated $558MM in net income in 2004, around $540MM in 2005, and it should be able to generate $500MM ($2.88) plus or minus $50MM ($0.29) in 2006. Cash earnings are typically $100MM ($0.58) more than GAAP earnings. FNT is currently trading at less than 9x forward earnings while its competitors trade between 9-11x earnings.

The short-term catalyst for FNT is a large increase in the dividend. Raymond James believes that FNT can grow its dividend payout 6-12% annually. FNT initially established an annual cash dividend rate of $1.00 per share (4.1% yield) though management has suggested that this is likely to increase in the future. An increase in FNT’s dividend will allow excess cash to make its way back to FNF rather than building at the subsidiary level. Management stated that one of their goals, “is to create within THC [FNT] a yield stock that will trade in the open market on a set of parameters other than the movement of interest rates.”

FIS BUSINESS DESCRIPTION

In January 2003, FNF acquired ALLTELL, which was renamed FIS and became the springboard from which FNF acquired half a dozen other providers of software, services, and ancillary products. It bought companies including WebTone Technologies, Aurum Technology Inc., Sanchez Computer Associates, Bancware and Intercept. FIS also expanded abroad by taking ownership positions in Kordoba GMBH, a German provider of core-banking software and services, and 30% of Covansys, a data processing outsourcer based out of Bangalore, India. FIS is now the largest provider of processing services to large U.S. banks, the largest mortgage loan processor with 50% market share, #2 outsourcer of core processing to community banks and other small financial institutions, and the #2 item processor for U.S. financial institutions.

FIS’s $2.8B in revenue comes from three main operating segments: 55% from Financial Institution Software & Services (FISS), 30% from Information Services (IS), and 15% from Lender Outsourcing Services (LOS). On an EBIT basis, 48% comes from FISS, 43% from IS, and 9% from LOS.

FISS generates $1.6B in revenue from four business segments: 31% from Integrated Financial Solutions (IFS), 26% from Enterprise Banking Solutions (EBS), 23% from Other, and 20% from mortgage loan processing (MSP). FISS provides the underlying software infrastructure that helps financial institutions maintain primary records and customer accounts. FISS also provides a number of other complimentary solutions that interact with the processing applications.

FISS has two sales forces, the IFS segment targets credit unions and thrifts and the EBS segment targets large national bank customers with >$5B in assets. A lot of the services that FISS provides are IT or outsourcing solutions that are more optimal than the in-house solutions that many financial institutions are currently using. IFS provides processing solutions for 2,800 customers on five year contracts while EBS provides solutions to a smaller number of larger customers on five to ten year contracts. Due to a recent agreement with Computer Sciences Corporation (CSC), FIS now has a ten-year reselling contract CSC’s Hogan, the dominant core banking platform. Effectively, the CSC deal will give EBS 60% penetration in U.S. banks with >$5B in assets.

MSP processes 50% of mortgage loans and provides services to 6 of the top 10 and 25 of the top 50 loan originators (Wells Fargo, Washington Mutual and Bank of America), 19 of the top 30 loan servicers and 10 of the top 20 sub-prime loan servicers. The segment gets paid an average of $0.85 per loan per month and produces 35-40% EBIT margins.

IS generates $800MM in revenue from two business segments: 70% from Mortgage Information Services (flood zone certification, tax services, credit reporting, and property records) and 30% from Real Estate-Related Services (valuation, appraisal, collateral scoring, multiple listing, and 1031 exchange intermediary services).

LOS generates $400MM in revenue from two business segments: 55% from Default Management Services (foreclosure posting, loan portfolio services, field services and property management) and 45% from Loan Facilitation Services (streamlining the title and closing process). The Default Management division has a 30% market share, serving 24 of the top 25 mortgage services, 24 of the top 25 sub-prime services, and 16 of the top 25 sub-servicers. Its EBIT margin is in the low teens.

CEY BUSINESS DESCRIPTION

For 2005, CEY generated an estimated $194MM in EBIT (17% margin) on $1.1B in revenue. CEY has two divisions, Card Services and Risk & Payment Services (Check Services). Excluding corporate overhead of $28MM, Card Services generated $148MM (23% margin) in EBIT on $660MM in revenue and Check Services generated $74MM in EBIT (16% margin) on $470MM in revenue.

The Card Services division provides almost every single element associated with a credit card account, allowing issuers to simply set the cardholder criteria and fund the receivables. There are 18,700 community bank and credit unions and CEY has a 73% market share amongst the 7,900 of these that have actually issued cards. From 1998 through 2005, Card Services has grown its account base from 2.6MM to 28MM.

Card Services is paid a recurring fee for every card account issued as well as a fee per transaction. According to Raymond James, CEY’s average monthly fees of $0.40 are composed of the following: $0.22 transaction fees, $0.10 flat account charge, $0.04 statement fee, and $0.04 other. CEY currently only generates 15-20% of its revenues internationally and has a significant number of international growth opportunities over the next few years.

CEY’s Check Services division verifies, guarantees, collects, cashes, and provides risk management for more than 350,000 retail locations that accept or cash checks at the point of sale (POS). CEY either verifies, by helping the retailer determine if it should turndown a check, or guarantees, where CEY guarantees the face value of all checks it verifies. The company receives $0.10-0.15 per check verification and charges 1% of the face value of a check for guarantees. The company maintains a database which includes transaction information on more than 200MM check writers. CEY has gained market share in this business over competitors such as First Data (FDC) and eFunds (EFD). In addition to check guaranteeing, CEY also collects fees charged to delinquent check writers upon collection and is offering payroll check cashing as well as casino check cashing on a guaranteed basis for a 2.00-2.25% fee. While check volume is declining, currently only 19% of $790B in check volume is outsourced, allowing CEY to offset the declining industry trend by expanding its market share. Customers include Wal*Mart, Target, K-Mart, Sears, Costco, Best Buy, Home Depot, Walgreen’s, Lowe’s, etc.

NEW-FIS BUSINESS DESCRIPTION

Through the reverse merger, FIS is essentially acquiring Certegy. In 2005, New-FIS generated an estimated $3.9B in revenues ($2.8B FIS and $1.1B CEY) and $985MM in EBITDA ($739MM FIS and $246MM CEY). Management has projected $50MM in annual cost synergies but since FNF has historically exceeded projections, analysts believe that actual savings could be as much as $70MM. Furthermore, the company should be able to grow its revenues 5-7% organically per year with minimal investment requirements. New-FIS will clearly be sensitive to the overall U.S. economy, but only 23% of the combined company’s revenue is exposed to the volume of real estate loans which is arguably offset by the 7% of revenues from Default Management Services.

CEY’s competitor First Data (FDC) generated $10.35B in revenues in 2004, Fiserv (FISV) $3.7B, TeleCommunication Systems (TSYS) $1.2B, and Jack Henry & Associates (JKHY) $467MM. The fifth largest company in the industry is Metavante, but its revenues are not broken out by its parent, Marshall & Ilsley (MI). A slightly more comprehensive set of comparable businesses trade at average P/E multiples of 24x 2005 and 21x 2006 and average EBITDA multiples of 12x 2005 and 11x 2006.

Analysts estimate that New-FIS will generate EPS of $2.08 in 2006 and $2.34 in 2007. Adjusting for the $3.75 dividend, CEY trades at 19x 2006 EPS. Cash EPS should be in excess of GAAP EPS due to $72MM in purchase amortization. FNF’s management has expressed an interest in owning more of New-FIS and if CEY shares are to be used as an acquisition currency in the future, FNF would need to own more to prevent losing its majority stake.

New-FIS will have 196MM shares outstanding which the market is valuing at $7.9B ($40.18 * 196MM) and has a pro forma net debt structure of around $2.8B ($3B debt and $200MM cash), which management expects to pay down at a rate of $150MM per year. Annualizing the first half of 2005 and assuming $50MM in synergies, New-FIS should generate slightly more than $1B in EBITDA, valuing this business at 10.5x EBITDA.

SPECIALTY INSURANCE BUSINESS DESCRIPTION

The Specialty Insurance business generates 45% of revenue from flood insurance, 34% from personal lines and 21% from home warranty. Flood insurance is generated in conjunction with the National Flood Insurance Program (NFIP), a division of FEMA, that cover up to $250,000 per home and $100,000 for items in a home. Home-warranty insurance is an annually renewable product that protects homeowners against defects in their home systems and appliances. Personal lines include homeowners, auto, inland marina, and umbrella insurance. Approximately 30% of revenues are sold direct with the remainder sold through independent agents and brokers.

Revenue from this business has increased from $47MM in 2002 to $135MM in 2003, $242MM in 2004, and $351MM in 2005. Most of this growth has been organic. At the same time, EBIT margins have increased from 11% to 16%.

On December 27, 2005, FNF announced that it would be using its cash balance to purchase Sedgwick CMS, which has more than 400 clients under multi-year contracts in a wide range of industries, including 25 of the Fortune 100 and 72 of the Fortune 500. The company designs and manages outsourced third-party administration programs for workers' compensation claims management, liability claims management and disability claims management. Revenue in 2005 is expected to be nearly $400MM.

Catalyst

CEY pays one-time dividend
New-FIS receives additional sell-side coverage
FNT increases quarterly dividend
FNF integrates Sedgwick CMS
FNF increases transparency in holdings
FNF continues to generate cash flow