Description

THESIS SUMMARY: FAF is a financial services holding company with 3 financial processing businesses, 2 insurance businesses (including the largest title insurance company in the US) and various real estate.  As its businesses are tied to the real estate cycle, FAF has been hit hard – from $55 (May ’07) to $33 today.  At current prices, you are paying 3.5x ’08 EBITDA, 11x P/E, and an 11% FCF yield.  (As described below, ’08 numbers have been taken down significantly to account for the current state of the real estate market.)  If one puts reasonable peer multiples on FAF’s various businesses, it is easy to reach a $55 target (~80+% upside).  Unlike many theoretical sum-of-the-parts stories, FAF management has indicated that they intend to unlock the value within the company (i.e., splitting up the company). 

BUSINESSES

FAF is not the easiest company to understand given its numerous divisions and joint venture structure with Experian.  The analyst day presentation is a decent place to start (http://media.corporate-ir.net/media_files/irol/11/118425/FAF_IRDay_FullPresentation_final.pdf).

All of FAF’s divisions generate high growth, margins and returns, including the title insurance division.  As a result, FAF’s 5 and 10-year shareholder returns have widely outperformed the market (21% and 20% CAGR, respectively, vs. 7% and 8% for the S&P).  However, the hidden gem within FAF is the Information Technology division.

INFORMATION TECHNOLOGY (IT) DIVISIONS (58% of ‘08 EBITDA).  FAF has 3 IT divisions: the Property Information and Mortgage Information divisions that make up the FARES joint venture with Experian (80% FAF owned/20% EXPN) and the publicly-traded First Advantage (FADV, 76% FAF owned).  These three divisions generate high growth and returns and account for roughly 60% of FAF pretax profit.

·         FADV (First Advantage, 22% of ‘08 EBITDA).  FADV is publicly traded and FAF’s second-best business.  FADV also owns a public stake in Dealertrack (TRAK) that is worth roughly 20+% of its market cap. 

FADV primarily provides credit information products including: distribution of tri-bureau credit reports to mortgage lenders and auto dealers; sub-prime delinquency database for payday lenders; and credit database on shippers and freight brokers for trucking customers.  FADV has #1 or #2 market share in all these products.

While I simply value FADV at market value, there is significant reason to believe its current 14x forward P/E and 6x EBITDA is way too low.  Competitors include EXPN, EFX and FIC that trade at 8-10x forward EBITDA.  Kroll has a comparable division to FADV’s and was acquired by MMC in 2004 for 24x forward P/E.  TALX is somewhat comparable to parts of FADV as well and was acquired by EFX recently for over 25x forward P/E.

·         FARES Joint Venture (36% of EBITDA)

o        Mortgage Information.  Outside of title insurance, this is arguably the most cyclical division given the tax and flood divisions (~70% of sales) are driven by mortgage originations. 

The Tax segment handles outsourced property tax services for mortgage lenders; services include payment processing/delivery, bank account reconciliation and review of delinquent taxes.  The Tax segment charges a fixed, up-front fee of roughly $50-$65/loan that is recognized over the life of the loan.  It currently services 27 M properties. This is a processing/servicing business that deserves a high multiple and generates high returns. 

Default-related services account for ~30% of sales and are counter-cyclical in nature.  This segment handles loss mitigation, delinquent loan solicitations and property inspection/maintenance and has seen a significant increase in sales recently (~25%).

Property Information.  This is FAF’s best division.  Its real-estate database contains difficult-to-assemble information on over 97% of the properties in the US.  Property Information generates the highest margins within FAF (27% pretax) and extremely high, consistent growth (24% CAGR) and returns (12% ROA).  Roughly half of the revenues are through an annual subscription model. 

This division owns the title database (DataTrace) that FAF and many of its competitors (750+ customers) use to evaluate title policies.  The title database accounts for about 25% of sales.  The real estate property database (43% of total Property Info. sales) stores property characteristics (incl. ownership, size, financing, mortgage delinquency, etc.) as well as loan quality analytics.

Within the real estate database, the LoanPerformance product has the largest mortgage performance database in existence and provides analytics to the majority of top 100 lenders and MBS investors.  Arguably, FAF has enough data within this division to operate as a credit rating agency to compete with MCO and MHP.  Given the backlash against those companies, it is possible the SEC sanctions another Nationally Recognized Statistical Rating Organization.

FAF also has an in-house business process outsourcing (BPO) company in India with over 4K employees.  As First Indian diversifies its customer base away from FAF, it could become a valuable asset.

Comparable Valuation.  There are no great comps for the FARES joint venture.  However, based on Experian’s valuation, the Property and Mortgage Information divisions are worth ~$3 B ($30+/share).  EXPN owns 20% of the Property and Mortgage Information divisions through the FARES JV, and FARES accounts for roughly 6% of EXPN’s EBIT.  Also, after its spin off, Fidelity National Information (FIS) traded at about 8-9x forward EBITDA and 17x-18x P/E.  Currently, FIS trades at 9+x 07 EBITDA and 18x P/E. 

INSURANCE DIVISIONS (42% of EBITDA)

o        SPECIALTY INSURANCE (7% of EBITDA).  This division offers Home Warranty insurance, or one-year warranties for household appliances and systems like water heaters, furnaces, plumbing, A/C units, etc.  Also includes a P&C that offers homeowners insurance and flood/fire insurance. 

o        TITLE INSURANCE (35% of EBITDA).  This is a high growth (10+% CAGR) and typically a strong margin (13-20% pretax margins) business, even over a volatile real estate cycle.  Roughly 30% of sales are from commercial, international or default properties while the rest is from residential properties.  Title insurance protects buyers and mortgage lenders against deed defects that existed prior to the closing of the transaction.  Coverage lasts for as long as the property is owned or the mortgage is outstanding. 

WHAT IS FAF WORTH?

Based on a conservative sum-of-the-parts valuation, FAF is worth $50-$60/share now.  Several options add another $10/share in value over the next 2 years:  $5+/share for the 20+% share repurchase; $4/share for 100 bps of title insurance margin improvement; and $3/share if FADV were to trade at low end of comps at 8x EBITDA.

Currently, FAF has a significant margin of safety as the market is assuming no value for the title division and only a 5x EBITDA for the IT divisions (after marking FADV to market).  

CATALYSTS

·         Separation of Information Technology divisions.  Basically, FAF can follow FNF’s prior example of separating the title and IT divisions into FNF and FIS.  Recently, FAF management has completely changed its long-held opposition to a separation of the IT divisions, driven by the new CFO (Frank McMahon).  As recently as Sept 2006 at the KBW conference, the CEO, Parker Kennedy, said that a separation of the title company is “very unlikely.”  His historical rationale was that the IT divisions partially share a sales force with the title division and that several of the products are bundled together.  However, even FAF will admit that FNF had similar issues with FIS that were resolved through long-term contracts between FNF and FIS.

Since the hire of the new CFO in Feb 2006, FAF management has slowly changed its attitude toward a separation of the title company.  Prior to joining FAF, Frank was FAF’s banker at Lehman.  He was involved in carving out the FADV division in 2003 through a reverse merger.  Then, in 2005, he was involved in the sale of FAF’s Credit Information Group to FADV.  Both transactions created value for shareholders as FADV now trades at a 2.5 EBITDA multiple premium to FAF.

Now, Frank considers realizing the value at the IT divisions one of his three main goals.  While senior management is tight lipped about their exact strategy, their actions clearly point toward a separation of the IT divisions.  Since joining FAF, Frank began allocating corporate expense to the various segments.  This seems like a logical first step in a separation.  Then, in February, FAF’s Property Info division acquired CoreLogic.  As part of the transaction, FAF offered CoreLogic management and TA associates demand registration rights that could force an IPO within the next 2-3 years.  This offers another avenue to realize the value at the IT divisions.  Then, at the analyst day in March, management said they will take action within the next year to “improve the float and liquidity at FADV”.  When FADV was $17-$18 and trading at 5+x EBITDA, Frank said that the lack of liquidity in the market did not eliminate any of their alternatives.  Given the ~25% decline in FADV and its cheap valuation, it is unlikely that FAF was considering a secondary offering.  A secondary would also have large tax consequences.  A spin off of FADV seems most likely as there are no other real alternatives to improve liquidity.

Furthermore, at the Lehman conference in September, even the CEO clearly changed his attitude and stated that “we are very focused on accomplishing that, and by that I mean realizing the value of those [IT] businesses.”  In speaking with senior management, they will even admit there has been a change in their attitude.  They also realize that having a holding company with public stakes in FADV and potentially CoreLogic and/or Property Information will not cut it.  Given FAF’s lack of success with a carve out of FADV and FNF’s similar lack of success with FNT/FIS, the only logical step seems a separation of the IT divisions.

While there are numerous ways to structure a transaction, one possibility is selling the Property and/or Mortgage Information division into FADV and then spinning off FADV to shareholders.  This would improve the liquidity at FADV and take care of CoreLogic’s demand registration rights.  For the first time, the CEO mentioned on the 3Q conference call that they were considering this possibility.  In addition, FADV has been monetizing assets, including a partial sale of its shares in TRAK (DealerTrack) for $133 M and a sale of its US SEARCH division for $26.5M.  This could be in preparation for an acquisition of the IT divisions from FAF.  While it sounds like the timing of a separation is being pushed back possibly given the difficulties in the title division, it seems a separation is in the plans.

·         Potential for large share repurchase with extremely under-levered balance sheet.  FAF can easily repurchase 20+% of its shares outstanding over the next 2 years.  FAF is extremely under-levered, with roughly $7/share in net cash and investments.  While roughly $4/share of that is tied up at the title insurance company, FAF will be able to dividend it up to the holding company over time.  FAF also is generating an 11% FCF yield.  As a result of the new CFO, FAF’s frantic acquisition pace has stopped as well.  This will free up considerable cash flow as FAF has used 65% of its FCF for acquisitions over the past 4 years.

FADV is under-levered as well at 1.0x net debt/EBITDA.  A sale of the IT divisions to FADV could allow FADV to lever up its balance sheet as well.  FNF basically did this with the spin of FIS.

Since the end of its stock option investigation in March, FAF has aggressively repurchased stock.  In 7 months (March-Sept ‘07), FAF has repurchased almost 6% of its shares outstanding.  Those repurchases were in the $40’s and low $50’s, suggesting that FAF could be even more aggressive at the current share price.

·         Repurchase of Experian’s minority interest in FAF’s Real Estate Services division (FARES).  FARES is a joint venture with Experian (EXPN) and is essentially the Mortgage Information and Property Information divisions. FAF owns 80% of the JV and has the ability to call EXPN’s 20% minority interest at essentially 12.5x trailing 2-year earnings, beginning in October 2008.  Using comparable valuations for FARES, this transaction would generate $3/share in value for FAF shareholders.  However, EXPN can postpone the sale for the maximum 2-year period so a transaction may not occur until October 2010.

·         Incentivized Management Team and New CFO (Frank McMahon) with investment banking background.  The senior management team own 6% of the shares outstanding, and the employees own another 12% through the ESOP.  However, since 1889, FAF has been run poorly by the Kennedy family.  It has been a second-tier competitor in the title industry. 

However, since the new CFO joined in March 2006, he has become a catalyst for change within FAF.  In addition to his focus on realizing value at the IT divisions, he has focused more on capital management.  Three months after he joined, FAF doubled its historically meager stock repurchase plan.  He has also stopped acquisitions at the title division.  Operationally, he has begun to trim down the unnecessary infrastructure within the title division.  For example, he plans to centralize many administrative functions like accounting, claims processing, HR and purchasing.

·         Restructuring Story at the Title Division.  FAF title margins have averaged 600 bps less than that of its main competitor, FNF, over the last 4 years.  Historically, FAF’s vastly different M&A and operational strategy drove this under-performance.  FAF typically rolled up small title agencies with the primary goal of increasing market share.  Over the past 3 years, FAF has acquired 103 title agencies for roughly $900 M.  Afterwards, FAF did little to integrate the operations.  As a result, FAF still has over 12 back office operations all over the country. 

Headcount alone at FAF is extremely high.  FAF has roughly 6,500 more employees than FNF, despite roughly similar title originations.  At $55K/employee, this is over $2/share in EPS for FAF.  Every 100 bps of title margin is $0.30-$0.35 of earnings to FAF.

RISKS

·         Higher Loss Claims.  The elevated loss rate for the industry is the result of numerous factors, including high mortgage volumes in the last several years (which can lead to less due diligence) and higher foreclosure rates (which leads to greater scrutiny/discovery of title errors).  Title insurance involves more of a due diligence process vs. “real” insurance products and proper due diligence can lead to lower loss rates.  So industry loss rates should trend down for current policy years as fewer originations should lead to better due diligence.

While higher losses are a concern, FAF has boosted significantly its reserves over the past year.  FAF is now more conservative than industry leader, FNF, in its reserves: FAF reserves equal 5.6% of 2003-2006 title revenues vs. 5.0% at FNF.  Also, 75% of losses occur within the first 3-4 years so FAF has already paid a significant portion of and seen the loss rates for those years. 

Currently, FAF is reserving at a mid 6% loss rate for the years.  Even if you believe loss rates will be 10% for those years (which is very unlikely given 05/06 are likely the worst years and they have seen almost 2 years of data on those vintage years), the total reserve increase would be only $4/share.  This is not a blackhole of potential losses.

Catalyst