Description

LandAmerica Financial (LFG) is (1) the nation’s 3rd largest title insurer; (2) a financial services firm that consistently earns greater than its cost of capital; and (3) trading at a discount to its tangible book value, even though 75% of tangible assets are cash, management is repurchasing the equity, and event risk on the policies in force is nil.

Why? Because LFG also (a) has a high fixed cost business model leveraged to the refinancing cycle, which likely has peaked; (b) will likely see its revenues and earnings fall 20% or so next year; and (c) is regarded by Wall Street mostly as a trading vehicle best suited to speculation on the next 50 basis point move on the long bond. There is a potential catalyst. But what we like about this most is the main risk is time.

Background

Title insurance protects the insured against events that have already occurred. Solid due diligence enables the experienced loss rate to be very low, and provision expense as a percent of revenue to remain relatively constant for able insurers. What solid due diligence requires is easy access to the title records and deeds that enable the insurer to price policies efficiently. These records and deeds are public information, but title insurers maintain duplicate copies—constantly updated—that enable fast & unobstructed access to the relevant facts. Title plant maintenance is a substantial fixed cost (and barrier to entry, but more on that below). The size of this fixed cost has led to considerable consolidation within the industry. LFG & 3 other players (FNF, FAF & STC) generate north of 80% of industry revenue. Distribution is 2 tiered: Each insurer has a direct salesforce, and subcontracts business out to independent agents. Various insurers are stronger or weaker in various regions of the country, and the 2 larger insurers (FNF & FAF) have larger commercial title insurance businesses (which typically bring higher premia for the same risk & underwriting expense) than LFG. But the level of competition between insurers in this oligopolistic industry is relatively constrained.

Title insurance earnings are strongly correlated to mortgage refinancing volumes. The purchase mortgage market is relatively stable, as are insurer market shares. On purchase transactions alone, title insurers like LFG generate more than enough revenue to offset their fixed costs. Additional title insurance underwritten on mortgage refinancing transactions, however, involve only the marginal costs of commissions and underwriting expense. Their marginal profitability of a refinancing title insurance sale is high.

The best way of understanding the business is thinking about the following 3 variables together: US mortgage origination volumes, LFG’s title revenues, and LFG’s pretax margin. The following table lays out the recent history:

Year 98 99 2000 2001E
Loan volume $1.7T $1.5T $1.2T $1.9T
LFG Revenue $1.8B $2.0B $1.75B $2.25B
PreTax Margin 8% 4% 3% 6%

One other preface point: LFG’s pretax margin of 6% lags the 8% peak experienced at the top of the last major refi boom. This is due to SG&A LFG has “invested” in diversification efforts aimed at using web technologies to expand LFG’s service offering to include appraisal and other closing services. These efforts have not gone far, and LFG has recently announced their curtailment. Substantial criticism of such efforts is fair, as is concern about management as a steward of shareholder capital. My response to those concerns is three fold: (1) The diversification money pit was not endless, management acted sensibly in cutting it off, and management is now repurchasing stock instead; (2) management owns a substantial portion of the stock (CEO owns about 1.5% of shares); and (3) the valuation provides a considerable margin of safety.

2002

2001 has been a record year for mortgage originations. The outlook for 2002 depends on the outlook for long term interest rates, which depends on the outlook for the economy. A roaring recovery implies higher real rates of return, the potential for inflation concerns, higher mortgage rates, and weak originations. Most industry experts would look at a $1.0 trillion number as reasonable worst case. The less robust the recovery is, the lower rates should be (assuming inflation concerns away), in general, and the higher origination volumes will be. Consensus forecasts for 2002 are in the 1.3-1.4 trillion range.

LFG’s title revenue has tended to be between 0.0011 and 0.0015% of total origination volumes. I am using a $1.35T origination volume number, and 0.0013% title revenue to origination ratio, which implies $1.75B title revenue. I project a pretax margin of 4.9%, which is above the 3-4% earned at the previous trough, for a few reasons. First, the web based diversification expenses will be down a lot in 2002. Second, LFG spent most of 2000 integrating a large acquisition, the benefits of which should be fully reflected through the length of this cycle. Third, LFG scaled the 2001 upturn using more independent agents & fewer hired reps than in 1998. LFG’s share repurchase activity in Q401 also makes me feel better that management has a handle on the profitability at the trough. Projecting no improvement over the 1999-2000 performance is certainly too pessimistic. My sense is reasonable worst case margins at 4.5% on my revenue forecast, and a number less than 5.0% is reasonable.

My 2002 eps estimate is $3.30. The eps for the 4 prior years (ending 2001E) is $5.31, $3.32, $2.20, and $4.52.

What if origination volumes are $1.0T only? Use 0.0013% title revenue ratio, and a 3.5% pretax margin. I get $2.10 in eps.

Valuation

What’s the right way to value a firm as cyclical and macro-economically sensitive as this one? Not an easy question. One thing I like to keep in mind is return on capital, however. LFG’s return on tangible book since 1997 annually is 13%, 22% (1998), 15% (1999), 10% (2000), 17.5% (2001), and projected at 11% (2002). The 02 eps & RoE projections assume no incremental share repurchases beyond announced programs. LFG generates significant free cash flow (I project $40mm in 02, or $2.35 per share), and maintains debt/capital of 24%, below the 30% ratio at which management & the rating agencies begin to get nervous. Additional share repurchase beyond my forecasts is likely. If 02E eps are reasonable worst case, then my bet is my share repurchase estimates are way low. The balance sheet protects your downside.

Throughout the cycle, LFG earns double digit returns on tangible equity. Its peak return on tangible equity is impressive at 22%. Merrill Lynch is going to earn less than 10% on its equity base this year, its peak return over the past 7 years is 23%, and it trades at greater than 2x book. LFG sells at a discount to tangible equity. It is at 12x free cash flow, and 8x earnings. It makes money through the cycle, possesses substantial competitive advantages that are solid barriers to entry, and uses its free cash flow in tough markets to reduce its equity base & preserve returns. The peak-to-peak growth rate of the mortgages market is not as high as the market for M&A & asset management, but evaluate LFG versus the entire business mix of a MER. The peak-to-peak growth across the cycle is not that different.

A lot of names in the mortgage market seem cheap right now, and if we have a roaring macro economy next year, none of them probably work, even if they are all undervalued. The catalyst for this name is a gradual recovery for the economy in 02, and a rally in bonds & mortgage originations. There is a lot more that I could talk about, if people are interested.

Catalyst