Description

First American Corporation (FAF) is involved in the title insurance and real estate information industries. It is the second largest title insurer with approximately 23% of the market and the leading player in several real estate information businesses including tax service, credit reporting, default management, appraisals and flood zone certification. Its business is innately cyclical and is affected by both the state of the economy and nature of interest rates. At this point you are probably thinking, “but interest rates are about to go up and the housing market is in a huge bubble.” Given the current state of the economy, the nature of interest rates and the complexity of predicting economic cycles, it is extremely hard to predict exactly what FAF and its competitors are going to earn in the next year or two. However, this confusion as well as what I believe to be a market mis-perception of their business, has created a buying opportunity by allowing FAF to sell at an approximate 30% discount to what I consider to be its intrinsic value (based on a “normalized” and conservative estimation of its earning power).

First American was founded over 115 years ago by the grandfather of Don Kennedy who is currently the Chairman Emeritus of the company. His son, Parker S. Kennedy, is the Chairman, President, and CEO of First American Corporation and the owner of approximately 4.4% of the company. I have included this information because I like that the founding family is still running the business (and of course maintains ownership) and if you peruse through the annual report, you will see that the CEO loves the business and is passionate about what he does (the necessary ingredients for a superior manager).

In 1986, the company began a diversification program by acquiring and developing business information companies closely related to the real estate transfer and closing process. And in 1998, it expanded its diversification program to include business information companies outside of the real estate transfer and closing process. The real estate information businesses made up approximately 23% of revenues and 43% of income before taxes and minority interests in 2003. Through continued organic growth and acquisitions, FAF predicts that the REI (Real Estate Information) segment will make up 50% of revenues by 2010 (implying an even larger share of pre-tax income). This segment has higher margins due to greater economies of scale and as a result it has better ROE characteristics and generates more cash than the title business (which has good cash flow dynamics).

The REI segment will help FAF further gain market share as it allows them to offer a customized bundle of real estate closing products at discounted prices. Due to the economies of scale, especially in the information businesses, the increased volume will significantly improve incremental cash flows. FAF is essentially becoming a one-stop shop for all real estate closing products which will help mitigate earnings depression when the business cycle softens. More importantly, their trough earnings will be higher than historical levels given the higher margin information businesses. In addition, the REI segment has already increased and will continue to increase FAFs exposure to the non real-estate business services industry primarily through FADV and its property information businesses (which offers subscription based access to real estate information databases).

I have outlined FAFs REI products in the first paragraph and will not waste space explaining each service since they are pretty self-explanatory, but I do feel it is necessary to add a few words on the title business. In most real estate transactions, mortgage lenders and purchasers of real estate want to be protected from loss or damage in the event that title is not as represented. In the US, title insurance has become the most efficient means of providing such protection. Title insurance policies are issued on the basis of a title report, which is prepared after a search of public records, maps, documents and prior titles in order to ascertain the existence of easements, restrictions, conditions, encumbrances, etc.

By its very nature, title insurers have lower loss expenses and higher operating expenses than most other property/casualty lines of business. Therefore, the majority of its costs are upfront operating expenses related to examining documents and searching for information on prior titles in order to reduce the chance of future losses. This causes title companies to retain a lower percentage per policy as float up-front, but they maintain longer tails on that float. It also has allowed title insurers to improve the efficiency of the business by automating much of the title production process (decreasing the operating expenses associated with doing the title search). FAF utilizes a technology called FAST that has significantly improved the efficiency and speed of a title search. As a result, over the past few years, FAF has improved the number of orders handled per employee from 5 to 11. This has helped FAF manage the variable costs of employment by not having to increase headcount during peak times and then shed headcount during trough years. FAF has publicly stated that 90% of title production can be centralized and they expect that over the next couple of years they will be able to go from roughly 300 production offices nationwide to seven. This will result in increased cost savings and margin expansion. In addition, many parts of the business are being moved off-shore to places such as Bangalore and the Philippines that can take care of much of the data entry previously performed in a production office.

Given this improved efficiency that I have indicated and resulting excess cash that will be generated, one could ask why regulators would not step in and lower premiums. After speaking with FAF, they stated that title insurance regulators are very old-fashioned and that there is huge lag (we’re talking 10+ years) between when they recognize an excess and they actually implement a rate change. Having said that, competitors can lower rates in non-title products which they have bundled together. FAF was the first title insurer to offer these bundled packages and the only competitor that really offers competing bundles at this point is Fidelity National (FNF). Over time, this could be more of an issue, but the current competitive landscape isn’t too worrisome. Other than FNF, FAF competes with three other title insurers and together, all five companies control approximately 88% of the market. At this point, I see FAF as the best value among its peers, although I do believe that some of its competitors are also not completely understood and there may be other opportunities in this sphere.

Given the cyclical nature of FAFs business, I have analyzed the earnings stream of FAF over the last 10 years to get a better idea of what their “normalized” earnings power is. I would like to point out for theoretical purposes that my “normalized” earnings power is a conservative estimate given that FAF has historically over-provisioned by approximately 10-15% which I have not made adjustments for, FAF has improved its market position significantly over the past 10 years so historical profitability will put a slight drag on the average, Cap-Ex includes both maintenance and growth cap-ex and FAF owns 72% of FADV which implies that I should add a control premium to the value of this ownership as opposed to just using its public market cap (as long as I believe that FADV is not publicly over-valued). Having said that, I feel that the following valuation is the best way to value this company without getting alittle too carried away with academic theory.

One other note to keep in mind. FAF currently has a $2.3 billion market cap, a 72% ownership interest in First Advantage Corp. (FADV) which has a market cap of $400 million and about $430 million in cash (after netting out $566 million in debt and $100 million in mandatorily redeemable preferred shares). In my analysis I ignore the cash because FAF also has a pension liability of about $218 million (leaving $200+ million) and I believe that they are undervalued even without this excess cash. And this excess cash is actual excess cash (even after netting out cash that regulators require title insurers to keep on the balance sheet).

Title and Related Insurance Business:
10 year average ROA(1) = 10.60%
2003 Year End Assets = $2.66 billion
Implied “Normalized” Levered FCF = $282 million

Real Estate Information Business (2):
10 year average ROA(1) = 14.65%
2003 Year End Assets = $1.85 billion
Implied “Normalized” Levered FCF = $271 million

Corporate
“Normalized” Levered FCF Expense = -$50 million

Intrinsic Value
Implied “Normalized” Levered FCF = $503 million
Tax Affected Levered FCF @35% tax rate (which is its average tax rate for the last 5 years) = $326 million
Tax Affected Levered FCF (netting out minority interest expense(3) ) = $261 million
Applying a blended 11x business multiple: $2.9 billion.
Current FAF Market Cap (netting out the 72% interest in FADV(4)) = $2.0 billion
Implied Return: 43%
FAF has increased its book value at a compound annual rate of 17% over the past 9 years so I expect that this stock offers continued growth in business value while also providing a great return as the market price moves more in line with intrinsic value.


(1) The calculation for ROA is as follows: (Income Before Income Taxes and Minority Interest + D&A – Cap-Ex) / Assets.
(2) Due to FAFs 72% interest in FADV which is public, I have excluded FADV financial stats from the ROA and year-end asset calculations so that it is not factored into the REI segment valuation.
(3) If you look at FAFs income stream over the past 5 years, it has had an annual minority interest expense equal to roughly 20% of income. As a result, I have assumed that only 80% of the FCF contributes to the value of FAFs business. This 20% number is conservative and varies from year to year depending on which business segment experiences the greatest volume and profitability.
(4) Considering that I excluded the contribution that FADV has made to FAFs earning power, the capitalized earnings should be compared to FAFs market cap after netting out the ownership in FADV which is .72*400 = $288 million.


Just as another spot check on the above analysis, FAF has had an average 15% ROE over the past 10 years. If you calculate a “normalized” earnings stream off of the 2003 ending equity balance and make the minority interest expense adjustments as done above, the numbers are close.

I would also like to point out that FAF has traded at a 5 year and 10 year average p/e multiple of 11x and 12x respectively while it’s peers have traded at a 5 year and 10 year p/e multiple of 9x and 12x (calculated by taking a median of its peers 5 yr. avg. and 10 yr. avg. p/e) which is why I applied the 11x multiple to the “normalized” cash flow (as noted above, the “normalized” cash flow proxy I have used is very close to a “normalized” earnings number as dictated by the proximity in value calculated by using an average ROE). As FAF expands its information business, the higher margin business mix will improve its earnings characteristics and thus help valuation and it is very conceivable that FAF will receive multiple expansion due to increased information business. In addition, FAF currently trades at about 1.00x book while its 5 yr. average p/b ratio is 1.40x. FAF has stated that they will buy back shares if they are trading at or below book value which provides a good indication of a benchmark valuation as determined by management. And so with the excess cash that FAF holds on its balance sheet and will continue to generate, it will either give out increased dividends (currently it offers a 2.4% yield), buyback shares if the market provides the opportunity or continue to acquire companies in the title or data business.

Catalyst

-As rates change, FAFs business will hold up better than historically

-FAF is no longer simply a title insurance business and through improved IR and improved profitability, investors will recognize this fact

-Ultimately, as Benjamin Graham said, “in the longer-term the market is a weighing machine” as opposed to the short-term which he described as a voting machine and as a result, the true earning power of FAF will be recognized and market value will move more in line with intrinsic value

- Fidelity National has been approved for a tax-free spin-off of their information and outsourcing business (ticker: FIS) and the S-1 has been filed. The public value attributed to this business should make investors recognize the hidden value inherent in FAF