First American Financial Corp Q3 FY2020 Earnings Call

Greetings, and welcome to the First American Financial Corporation's Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. A copy of today's press release is available on First American's website. Please note that the call is being recorded and will be available for replay from the company's investor website. We will now turn the call over to Craig Barberio, Vice President, Investor Relations, to make an introductory statement.

Good morning, everyone, and welcome to First American's earnings conference call for the third quarter of 2020. Joining us today will be our Chief Executive Officer, Dennis Gilmore; and Mark Seaton, Executive Vice President and Chief Financial Officer. Some of the statements made today may contain forward-looking statements that do not relate strictly to historical or current facts. These forward-looking statements speak only as of the date they are made and the company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. Risks and uncertainties exist that may cause results to differ materially from those set forth in these forward-looking statements. For more information on these risks and uncertainties, please refer to this morning's earnings release and the risk factors discussed in our Form 10-K and subsequent SEC filings. Our presentation today contains certain non-GAAP financial measures that we believe provide additional insight due to the operational efficiency and performance of the company relative to earlier periods and relative to the company's competitors. For more information on these non-GAAP financial measures, including presentation with and reconciliation to the most directly comparable GAAP financials, please refer to this morning's earnings release. I will now turn the call over to Dennis Gilmore.

Good morning and thank you for joining our call. I'll start with a review of our third quarter results, provide perspective on the actions we are taking with our property and casualty business, and discuss our outlook for the remainder of 2020. Mark will discuss our earnings in greater detail and provide an update on our company's capital position. We delivered strong financial results in the third quarter. Revenues were $1.9 billion, up 15%, and earnings per share of $1.62. Our pretax margin in our Title segment hit a record 19%. As volumes increased, we also kept our focus on cost efficiency, achieving a 40% success ratio, well ahead of our 60% target. Purchase revenues were up 20% in the third quarter, driven by closed order growth and higher fee per file. Loan mortgage rates are driving substantial demand and given the limited inventory of houses for sale, price appreciation has been robust. Our pipeline is strong heading into the fourth quarter, as purchase open orders were up 14% in the third quarter and this trend continues in October. Refinance revenues were up 92% in the third quarter, driven by strong growth in closed orders. Low rates continue to support elevated open orders, which were averaging 3,200 per day in the third quarter. So far in October, we are opening 2,800 orders per day. Our commercial business revenues in the third quarter declined 29%, improving from the 39% decline of the second quarter. The overall commercial market continues its recovery with improvements varying by asset class. This quarter we started to see a return of large transactions. We are encouraged that our open orders improved throughout the third quarter, with orders down only 7% year-over-year. Commercial orders over the last six weeks are flat to last year. Turning to our Specialty Insurance segment. We have initiated a process to sell the property and casualty business. While this business has performed well over the years, based on recent financial results we have decided to focus on our core business and redeploy our capital to areas with higher expected returns. Our home warranty business delivered strong growth, improved retention rates, and effective expense management throughout the quarter. The business continues to experience an increase in claim frequency, particularly in the appliance and plumbing trades, which we believe are attributable to the pandemic. Due in part to this trend, we are in the process of making policy changes and adjusting our pricing to offset cost pressure in the business. We expect the home warranty business to continue to generate strong margin performance this year. Going into the fourth quarter, we are optimistic that low rates and demographic tailwinds will continue to drive strong purchase and refinance activity. And as we have indicated throughout the year, we expect refinance volumes to remain elevated well into next year. While our improving commercial pipeline increases our optimism going forward, we do not anticipate the business will meet last year's record performance. Throughout the third quarter we experienced elevated order volumes and the vast majority of our workforce continues to work remotely. Our performance has demonstrated the strength and flexibility of our business. And while the pandemic has greatly slowed major sectors of the economy, it has accelerated the digital innovation in our markets, validating our strategy and the investments we've made over the past few years to secure our leadership position in data, title automation, and digital closings. I'd now like to turn the call over to Mark.

Thank you, Dennis. In the third quarter, we earned $1.62 per diluted share. This includes net realized investment gains totaling $45 million or $0.30 per diluted share and impairment on assets held for sale of $73 million or $0.49 per diluted share. Excluding these two items, we earned $1.80 per share. In the Title Insurance and Services segment, direct premium and escrow fees were up 12% compared with last year. This growth reflects a 30% increase in the number of closed orders, partially offset by a 13% decline in the average revenue per order. The average revenue per order decreased to $2,193 due to a shift in the mix of direct title orders to lower premium refinance transactions. At a product level, we continue to see higher average revenue per order for purchase transactions, which increased 8% this quarter, as well as for refinance transactions, which increased 4%. The average revenue per order for commercial transactions declined 17% as the number of large transactions lagged the prior year. Agent premiums, which are recorded on approximately a one-quarter lag relative to direct premiums, were up 10%. The agent split was 79.3% of agent premiums. Information and other revenues totaled $283 million, up 38% compared with last year. A number of factors contributed to this growth, including the growth in mortgage originations that led to higher demand for the company's title information products and our acquisition of Docutech, which isn't included in the prior year results. Additionally, we benefited from services provided to support a temporary pandemic-related government program in Canada. Investment income within the Title Insurance and Services segment was $45 million, down 38%, primarily due to the impact of the decline in short-term interest rates on the investment portfolio and cash balances. Personnel costs were $481 million, up 8% from the prior year. This increase was primarily due to higher incentive compensation expense, salary expense, and higher costs as a result of recent acquisitions, partially offset by lower employee benefit expense. Other operating expenses were $251 million, up 15% from last year. The increase was primarily due to higher production-related costs as a result of the growth in order volume. The provision for title policy losses and other claims was $70 million or 5.0% of title premiums and escrow fees, an increase from the 4.0% loss provision rate in the prior year. Claims experience continued to be favorable relative to our expectations. Incurred title claims totaled $33 million in the third quarter, a 21% decline relative to 2019. To date, we have not seen an uptick in claims. Our intent is to maintain a 5% loss rate until we have more visibility into how the current environment will affect our claims experience. The depreciation and amortization expense was $36 million in the third quarter, up $6 million or 21% compared with the same period last year, primarily due to higher amortization of intangibles related to recent acquisitions. Pre-tax income for the Title Insurance and Services segment was $337 million in the third quarter compared with $254 million in the prior year. Pre-tax margin was a record 19.0% compared with 16.5% last year. Excluding the impact of net realized investment gains, pre-tax margin was 17.1% this quarter compared with 16.4% last year. As Dennis mentioned, we have initiated a plan to sell our property and casualty insurance business. For the first nine months of 2020, our property and casualty business recorded a pre-tax loss of $91.5 million. This amount includes two items: first, an impairment on assets held for sale of $73.3 million, which was recorded this quarter, and second, a $5.6 million reserve strengthening recorded in the first half of 2020. The results of the property and casualty business will continue to be recorded in the Specialty Insurance segment until a sale is completed. Net expenses in the corporate segment were $22 million, up $3 million compared with last year, largely due to higher interest expense associated with our $450 million senior notes transaction, which closed in May. The effective tax rate for the quarter was 24.6%, in line with our normalized tax rate. Notes and contracts payable on our balance sheet totaled just over $1 billion as of September 30, consisting of $992 million of senior notes, $13 million of trustee notes, and $6 million of other notes and obligations. I would now like to turn the call back over to the operator to take your questions.

Thank you. We will now be conducting a question-and-answer session. Our first question is from John Campbell with Stephens Incorporated. Please proceed with your question.

Hey, guys. Good morning.

Good morning.

I just want to clarify a couple of things on the P&C business. So you guys are just selling P&C and not home warranty, that's right?

That is correct, yes.

Okay. And then Mark, thanks for the earnings breakdown. But if you could maybe provide what the P&C revenue was over the last nine months?

Yes John. So year-to-date it's $101 million in revenue.

Okay. And I think you also said you're going to hold that in the specialty segment. You're not moving that to discontinued ops, is that right?

Yes. We looked at that and it's just not material enough to move it to discontinued ops, so it's just going to be recorded in Specialty Insurance just like it always has been. So we consummate a transaction.

Yes. John I'll just give you some additional detail. I mean, the results will stay in the specialty segment and we're looking to get the transaction completed by the first half of next year. So we'll give a further update at that point.

Okay. And then on the higher home warranty claims you guys highlighted the pandemic is maybe influencing trends. How did you guys get to that conclusion? And I guess what is it about the pandemic? Is it just people at home more? Or just kind of more wear and tear on the home?

Exactly. It's kind of what we mentioned within the second quarter if I'm not mistaken and the business is doing really well. It's interest and our sales are really strong both consumer direct and our real estate channels. And I think John as you know our seasonally worst quarter, our toughest quarter is always the third quarter. So no surprise there. But inside the quarter we saw an uptick of our appliance trade, our clients' claims and our plumbing claims. And we can't draw a straight line back to the pandemic, but it's just logical, the way you relate about people who are home more they're putting more stresses on our housing system. So we're going to take a look at some of our policies right there and do some price adjustments to make sure that our returns are appropriate for that business. But all in all that business is doing well. We think we'll have a very strong fourth quarter in 2021.

Okay. That's helpful. If I could squeeze in maybe one more on the P&C business. Any kind of rough estimate about the capital being released? Any kind of idea about proceeds and maybe what you would do with that?

Well, the carrying value on the book side of 9.30% was $50 million. So we're going through a process. And ultimately we don't know what the proceeds will be but the carrying value is $50 million right now.

John with regards to the process I mean the bottom line here is this business has been a good business for over the years but it's been very volatile. It's a little drag on earnings over the last couple of years. And we're just going to redeploy back into more of our core business where we have a more consistent higher return profile.

Yes. Makes sense to me. Thank you, guys.

Thanks.

Our next question is from Bose George with KBW. Please proceed with your question.

Hey, guys. Good morning. Dennis you made a comment about the performance expectations for next year. Could you just repeat that? I wasn't sure if you're comparing it versus 2020 or 2019?

On in general or any specific segment?

I believe your comment was regarding overall performance.

I believe we are actually optimistic about the future. It's been a very volatile year. However, when we take a step back and analyze the current situation, purchases are exceptionally strong. To provide a bit more detail, we are still seeing some of our seasonal patterns. For instance, total orders are up 17% compared to a year ago. We anticipate continued seasonality in the fourth and first quarters, but at a slightly elevated lower volume. Regarding refinancing, we consider the 3,000 daily order volumes to be solid. Lenders are expanding their capacity, and spreads remain high, so we see this as a positive indicator moving forward. The area where our optimism is growing more rapidly than we anticipated just a couple of quarters ago is in the commercial market. We’ve observed some notable improvements, including stable order volumes over the past six weeks compared to last year, which is very encouraging. Although our revenue was down 29%, the business remains highly profitable, which is a strong sign. Additionally, we have seen a resurgence of larger deals within the market. Overall, we are observing increasing strength in various segments, particularly in commercial spaces such as warehouses and office buildings. However, there are still challenges in the hotel and some retail sectors. All things considered, we are encouraged by how quickly the commercial market is starting to recover, even more so than we expected just two months ago.

Thanks for that. I'm curious about your views on stock buybacks. Given that earnings are strong but the stock has declined significantly and has underperformed for a while, do you believe that now is a good time to consider that as a use of capital?

Yes, Bose, this is Mark. We're always evaluating our situation. Our earnings have been strong, and they are higher than they were a year ago. However, our stock has not recovered to pre-pandemic levels, which is something we continually consider. We're currently assessing this, and despite that challenge, our earnings remain very strong, and we are optimistic about the future.

Okay, great. Thanks guys.

Our next question is from Jack Micenko with Susquehanna Financial Group. Please proceed with your question.

Good morning. I wanted to discuss revenue per order. Typically, you see a significant increase in the fourth quarter compared to the third quarter, much of which is driven by commercial factors. I'm considering that the purchasing market has remained stronger than usual for this time of year. While refinancing is dilutive, the commercial market is rebounding, and there might be a catch-up effect since some transactions could have been delayed in previous quarters. Do you think that given the current observations, the increase in revenue per order could be unusually higher sequentially than in previous years?

Historically, we have often seen a higher fee per file in the fourth quarter for the reasons you mentioned. Last year, fees increased by about $100 from the third to the fourth quarter. It's difficult to predict, but it primarily depends on the strength of the commercial market, which is somewhat uncertain. However, we anticipate there will be an increase, as is usually the case, so we expect the fee per file to be higher in the fourth quarter. The exact increase will depend on how strong the commercial market is.

Okay. And then on the specialty loss ratio. I know that obviously the severity and the volatility from the P&C business is much, much greater. But if we were to sort of back out the P&C volatility, conceptually how should we think about that loss ratio with just home warranty on a go-forward basis?

The loss ratio for home warranty is very seasonal, right? So, we got a lot of claims in the summertime when air conditioners go out. We don't get many claims in the wintertime. Through the cycle on an annualized basis, typically we're somewhere in the 52% to 54% range somewhere in there. But obviously that's going to be higher or lower depending on the quarter. But annually it's about 52% to 54%.

Sure. You mentioned implementing some policy changes in addition to the price adjustments. Could that include something like a freeze period before a claim can be made? I'm just curious about the changes you're making to handle the rise in claims.

Sure. Yes. It's a multiple thing. You look at price, you look at coverage, you look at service fees, so you'll get a lot of different issues to make sure you're priced appropriate for the returns.

Okay, all right. Thank you.

Thank you.

Our next question is from Chad Key with Intrinsic Edge. Okay. Moving on to Mark Hughes with SunTrust. Please proceed with your question.

Yes. Thank you. Good morning. The 8% appreciation in residential ARPO and the purchase ARPO. Was that a mix shift or how much of that might have been just home price appreciation?

The vast majority of the increase was due to home price appreciation. As you know, our future file, which we report, is fundamentally linked to our Directors and primarily our direct operations in the western states. Looking specifically at California, this was our largest state where we saw an 8% increase in fee per file. Similar trends were observed in Oregon, Washington, and Arizona, all fluctuating around that same range. Therefore, the improvement can largely be attributed to home price appreciation without significant changes in the mix.

And your agent premium was up 10%, a pretty strong number but is reported on a one-quarter lag your direct was down 4% last quarter. Is that a mix shift? It seems pretty strong if I'm thinking about it properly.

I would say that typically, the one-quarter lag serves as a reliable indicator for four out of five quarters. This time, it really stood out. So, you’re correct. We anticipated a lower agency growth due to what occurred in Q2, but remittances were favorable. Refinances and commercial for agencies are performing quite well. It's not so much a shift in the mix; rather, it seems to be related to the timing of remittances more than anything else.

Yes, it seemed like you closed more of the orders than you have historically it's hard to judge precisely. Any comments other than the obvious which is people are pretty committed to the refi and purchase at this time but anything on top of that?

I would say we're very busy and efficient right now. I wouldn't elaborate further than that. We're doing an excellent job, and the operation is running very smoothly.

Thank you.

Thank you.

Our next question is from Mark DeVries with Barclays. Please proceed with your question.

Yeah. Thanks. I had a clarifying question around commercial. I think as you alluded to obviously, you're already seeing a return of big deals. And I think that's reflected in the ARPO being up pretty materially in commercial. Are you continuing to see an increase in larger deal sizes in your pipeline, and should we expect that commercial ARPO to continue to drift higher in the fourth quarter?

Yeah. Thanks for the question. Yes, we are. So kind of like I mentioned, we're starting to see the return of the large deals, you'll see the impact in the fourth quarter. I do want to caution that we're not going to match fourth quarter 2019. That was a record quarter. But the market started to improve faster than we thought it would even two quarters ago. So we're encouraged right now from what we're seeing in commercial.

Okay. But remind me what the normal lag is between opening and closing a commercial order? And is there anything in this environment that's like pushing that out at all?

No, I would say that the normal lag is about 55 to 60 days for a purchase transaction. However, with commercial orders, there’s much more variability. We can open an order and it might take us a year to close it, or we could close it just two weeks later. It doesn’t follow the same timeline as a purchase or refinance, where we have more certainty. Commercial orders are much more variable.

Got it. Finally, as you mentioned in your prepared comments, the success ratio was significantly better than your target. Should we anticipate a catch-up on that? Or does that indicate some expense discipline that might keep your success ratio below target in the near term?

There won't be a catch-up. We're operating very efficiently. The decisions we made earlier this year are reflecting well into the second quarter; they were smart choices. We didn't need to rehire anyone. All the work we've been doing on title automation, both in our data strategy and digital closing strategies, is currently yielding positive results. We're experiencing benefits in our operations at this time.

Okay. Are you now running at closer to fuller capacity, such that if you see more volume you may need to at least be closer to that 60% target to scale up?

I can't predict the future. But we're staffed accordingly right now. So we don't have any issues with that. We've augmented our staff role slightly with some temps to deal with some of the volume searches. But we're feeling good about the business. We're feeling good about our position right now.

Got it. Thank you.

Thank you.

Our next question is from Mark Hughes with SunTrust. Please proceed with your question.

Yes. The Canada revenue you referenced in the release, how much was that? And is that continuing into the fourth quarter here?

In the third quarter was $18 million. We're talking about the temporary revenue that we're getting from this Government's relief program that we're a subcontractor too. So, it's $18 million in the third quarter and it really ends in October. So there'll be a little bit in the fourth quarter, but most of it will go away in Q4.

Thank you.

Our next question is from John Campbell with Stephens Incorporated. Please proceed with your question.

Hi everyone. Thank you. I just wanted to follow up briefly. Since the crisis began, we haven't discussed the default business much. As we look forward to next year, there are many concerns. It seems that everyone is increasing their reserves, and I assume Stuart is doing the same in anticipation of these issues. However, there may also be positive aspects related to defaults. Could you provide some insight into the assets you currently have in that area? How have revenues been affected by the moratorium? Additionally, what do you anticipate for next year if default activity increases?

Yeah. Thanks John. So, we have a really good default business. And it serves as a great hedge for us right? As you mentioned before back in the last financial crisis, the default business was like our highest profit center in the company, by a huge margin. As things have recovered here these last 10 years or so, the volumes have really fallen off. But it's great to be there in case things in foreclosures use by that. So far this year, our default business is running at about $35 million of revenue or so year-to-date. And it's basically flat versus last year. So we haven't seen a pickup in our really default activity. But again, we haven't seen a pickup in foreclosures too. So we do see that then our default business will start to come up.

Yeah. And John, it's Dennis. So looking ahead, we were the first to increase our reserve rate, anticipating a rise in defaults. I still believe that could happen as we enter 2021 with the expiration of moratoriums and the end of advances. However, we are currently seeing strong appreciation in the housing market. As you know, when people have equity in their homes, they are usually reluctant to face foreclosure. Therefore, I think the equity situation will prevent any significant rise in defaults at this point.

Okay. That's helpful. Dennis, I think we might have discussed this last quarter. Can you update us on your current reserves compared to the estimate? You mentioned previously that you may need to release over 10%. Is that still accurate?

That's correct. And I'll let Mark give the first part of that answer.

As of September 30, we are approximately 5% above the actuary estimates, and while we are not nearing the 10% threshold, we are in a very strong reserve position at the moment.

Absolutely. Okay. Thank you guys.

Thank you.

Our next question is with Mark Hughes with SunTrust. Please proceed with your question.

Yes. Thanks for indulging me. If we think about the impact in the home warranty business from appliances and the plumbing, would it be fair to say that's kind of the 8 points you went from a loss ratio of 61 to 69. Is it fair to say that that represents the increased of frequency that you saw?

Yes. No, that's definitely fair mark. The home warranty business which we talked about is really great. People are staying home. As Dennis mentioned, we're getting higher claims and that's really attributable to people staying at home more. So appliance deployment trade those are causing higher losses for us.

Okay. Thank you very much.

Thank you.

Thank you, Mark.

There are no additional questions at this time. That concludes this morning's call. We'd like to remind listeners that today's call will be available for replay on the company's website. The company would like to thank you for your participation. This concludes today's conference call. You may now disconnect.