LFG is a title insurance company that has underperformed its peers (~15%) and the market because of the 1) slowdown in mortgage originations (originations directly drive title insurance sales), 2) a 3Q charge from underestimating policies written in 2004/05 of $1.11 (which caused the stock to drop from $68 to $60), and 3) expectation that LFG may need to take another charge which would reduce BV by $8 for an acquisition they made in 10/03

 

From an analyst on the 3Q print

 

“The most disappointing aspect of the quarter and the primary reason for our downgrade was the need to boost the provision for claims by an extra $20 million due to negative development in the 2001-2005 timeframe.  Management indicated the increase in claims activity was mostly related to frequency and not severity of claims. The increased claims activity was broad-based and not centered in any particular geography or product line. This decision was the result of the company’s regular quarterly review of its claim activity that does involve a third-party actuary. The company indicated “assuming no further deterioration is found’ that the provision should return to more normal levels. Given the potential deterioration in the economy and particularly in real estate values, the timing of this event bothers us and makes us worry that deteriorating claims trends could emerge in the short-term. This action was not influenced by the recent Capital Title acquisition.”

 

 

We believe that LFG will close the valuation gap with its peers beginning in late February

 

1)      4Q Beat: we have conviction they will beat the 4Q numbers (we are at $1.94 vs. street at $1.86) b/c of a) improved mortgage origination environment since 11/06, b) a 3.8MM ($.13) one-time cost in the 3Q that is being modeled in the 4^th Q, and c) capturing 1/3 of the Stuyvesant Town deal in the 4Q ($.01-$.02).

2)      Massive buybacks: as of the end of the 4Q, LFG will have $100MM on its balance sheet that can be used to buyback shares and by the end of the 1Q they will be getting and additional $150MM from changing the domicile of their insurance charter to NB which has a lower reserve requirement.  LFG will use $100MM to pay down debt.  They currently repurchase 5% of their shares a year and pay a 1.5% dividend.  However, I expect them to authorize a bigger buyback at their April board meeting to utilize the additional $150MM to buy back about 15% of their float b/c they are trading below their book value and repurchases are immediately accretive to book.

3)      No further write downs from higher claims history.  We have consulted with an expert in the field and found that the LFG write down was a catch-up to reserve levels of other players and should be in-line with management guidance going forward.  We believe that the higher level of claims was a result of either

a.       Increasing level of refinancing which causes title defects to be discovered earlier (title is checked after each refi) but does not affect the ultimate amount of claims paid.  Actuaries are extrapolating that the first year equals 10% of ultimate claims, when a higher level of refi’s means that more like 15%-20% of defects are being discovered in year 1.  This is actually bullish for LFG as we expect claims provisions to be reversed as ultimate payouts do not increase.

b.      More errors by title checkers made during 04/05 when mortgage originations were peaking.  Volumes are now off by 20% and no longer think this is an issue.

4)      No $8 write down of BV from past acquisition: when LFG made their Loretta acquisition they recognized two types of intangibles, a) $180MM of goodwill and b) $65MM related to the customer relationships that Loretta had.  In 10/05, LFG wrote off $37MM when Wamu decided to in-source half of their business, leaving $28MM of this intangible.  If there is any write-off of BV it will be exclusively related to the $28MM the customer intangible not the $180MM in goodwill.  As a result it is only $1 at risk not $8.   The reason for this is that LFG has gained new customers which support the $180MM goodwill but the smaller intangible can only be related to past customers not those gained since the purchase.

5)      An improved mortgage origination environment which should lead to an upward revision in 2007 numbers (we are at $7.68 vs. street at $6.21).  The housing market has had a negative impact on the title insurance business with volumes down 20% from last year.  However, since 11/06 the Mortgage Bankers Association has raised their estimate twice for the amount of mortgage originations in the 4Q (relates to LFG 4Q print) and 2007.  The increase in originations is a result of lower long-term interest rates fueling a mini-refi boom.

6)      Cost initiatives and synergies: LFG has the 2^nd lowest profitability of the group.  Since new management took the helm two years ago they have instituted a cost reduction platform that should lead to 1% margin improvement and 2% of ROE by reducing computer systems from 250 to 50 (currently have only reduced platforms to 200, most of cost reduction will occur in 2007).  In addition the Company closed an acquisition in the 3Q06 that should lead to over $14MM in synergies at full run rate in 2^nd half of this year.

Valuation:

With no upward revision in estimates, we believe that the stock will trade to $71 when they beat this quarter and there are no more write downs to book value (.94x P/BV and $75 BV).  We derive the .94 P/BV based on our regression of ROE vs. BV shown below.

With upward revision in LFG’s estimates we can get to a premium of BV of 1.10x or a PT of $82.50.