First American Financial Corp Q3 FY2021 Earnings Call

Greetings, and welcome to the First American Corporation’s Third Quarter 2021 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. As a reminder, this conference is being recorded. It is now my pleasure to hand the call to Craig Barberio, Vice President, Investor Relations, for a brief introductory comment. Thank you, Craig. You may begin.

Good morning, everyone, and welcome to First American’s earnings conference call for the third quarter of 2021. Joining us today on the call will be our Chief Executive Officer, Dennis Gilmore; our President, Ken DeGiorgio; 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 fact. 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 into the operational efficiency and performance of the Company relative to earlier periods and relative to the Company’s competitors. For more details 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, which is available on our website at www.firstam.com. I will now turn the call over to Dennis Gilmore.

Thank you. And good morning, and thanks for joining our third quarter earnings call. First American has again delivered outstanding financial results. All of our core businesses continue to perform well, and we’ve made progress on a number of strategic initiatives. Today, I’ll discuss a few of those initiatives, and then Ken will provide an update on the current order trends and business outlook. Mark will conclude by providing details on our third quarter results. As I said before and it’s worth repeating, First American is laser-focused on innovation. As real estate transactions become increasingly digital, we are leveraging our unique data assets and technology to enhance the customer experience and to make the settlement process more efficient for all parties. One of our largest initiatives was the launch of Endpoint in 2018. While Endpoint is wholly owned by First American, it is by design also a native digital start-up committed to reimagining the closing experience for buyers, sellers, and real estate professionals. Endpoint has captured a 3% market share in its initial market of Seattle, and currently operates in 11 additional markets across California, Texas, and Arizona, and we plan to add more markets in the near future. A major factor in Endpoint’s success has been its ability to track world-class technology talent. Endpoint has approximately 100 product managers, engineers, and designers, and plans on doubling the team over the next 12 months. Fully embracing the tech ethic of continuous improvement, Endpoint often releases enhancements to its technology designed to further improve efficiency. As a result, Endpoint is increasingly becoming the first choice of digital-forward companies, including those in the PropTech ecosystem. Given this track record earlier this week, we announced an additional $150 million commitment to Endpoint. Endpoint will use these funds to continue to hire the best tech professionals, further improve the digital closing experience, and expand its capabilities for PropTech companies and digitally forward real estate professionals. We are about to close on our previously announced acquisition of ServiceMac, an innovative mortgage subservicer with unique solutions. Founded in 2017, ServiceMac will complement our title and closing operations and over time will add assets to our Trust Bank and will enhance our ability to provide additional offerings to lenders and servicers. Turning to our venture portfolio, we continue to believe our investment strategy is creating both value strategically and financially. We’ve made direct investments in 16 companies in the PropTech ecosystem. Through these investments, we have gained valuable insights into these companies, many of which have become strategic partners. Financially, our investments generated $278 million of gains this quarter, led by Offerpad, which went public via SPAC in September. Based on the strength of the real estate markets and our strategic position as an innovator in the title and settlement space, in August, we announced an 11% increase in our dividend, and our Board also approved an additional $300 million share repurchase authorization. I will now turn the call over to Ken to discuss our recent order trends and our outlook.

Thank you, Dennis. As you mentioned, our business continues to perform well. And with the strong real estate market, we expect these trends to continue. So far in October, commercial orders are up 14% over prior year. And while our residential purchase orders at 2,000 per day are down 7% compared to an unusually strong October 2020, they are up 11% compared to October of 2019. As expected, due to the recent uptick in mortgage rates, refinance orders have fallen from 1,700 per day in September to 1,500 per day in October. That said, our outlook for the remainder of this year and into the next is positive. The housing market remains healthy. And although home price appreciation is expected to moderate, which will impact the growth in average revenue per order we’ve experienced recently, we expect purchase volumes to continue to grow as demand remains strong and more supply comes on to the market. Our commercial business continues to experience an elevated amount of activity as deals that were delayed in 2020 due to the pandemic are now closing, and we believe uncertainty around tax law changes could be pulling certain deals forward into this year. Despite these tax uncertainties, we expect that a favorable economic backdrop and relatively low interest rates will deliver another strong year in commercial in 2022. While we expect residential refinance volumes to continue to decline as mortgage rates increase, we believe we will be able to offset this decline with increased investment income generated by our bank and from escrow deposits. During the last cycle, growth in investment income more than offset the decline in refinance revenue. I’ll now turn the call over to Mark for a more detailed review of our financial results.

Thank you, Ken. We’re pleased to report excellent results this quarter. We earned $4 per diluted share, which includes $1.85 of net realized investment gains. Excluding these gains, we earned $2.15 per diluted share. I’ll start with our title business, where revenue was $2.1 billion, up 21% compared to the same quarter in 2020, driven by the strength of the purchase and commercial markets. Purchase revenue increased by 9%, thanks to a 12% rise in average revenue per order. Commercial revenue set a new record at $262 million, an 84% increase from last year, with a boost in large deals as we closed 89 transactions in the U.S. with premiums above $250,000, up from 31 last year. We continue to anticipate a record year for our commercial sector. Refinance revenue, however, dropped 36% compared to last year as mortgage rates have risen since the start of the year. In the agency business, revenue reached a record $999 million, a 38% increase from last year. Due to a one-quarter reporting lag in agent revenues, we are currently seeing a surge in remittances related to Q2's economic activity. Our information and other revenues amounted to $308 million, reflecting a 9% increase from last year, primarily due to higher demand for the Company’s title information and loss mitigation products. Investment income in the Title Insurance and Services segment was $50 million, up 11%, largely due to increased average balances in our investment portfolio. In our title segment, the pretax margin stood at 16.4%. Moving on to the Specialty Insurance segment, our home warranty business reported $108 million in revenue, a 7% increase year-over-year. Pretax income for home warranty was $9 million, up from $4 million in the previous year. The loss rate in home warranty decreased from 64% to 57%, as we believe factors that previously led to heightened claims during the pandemic are reversing. Our property and casualty business reported a pretax loss of $11 million this quarter. By the end of the third quarter, our policies-in-force had fallen by 40% since the beginning of the year, and we anticipate a 70% decline by year-end. We expect to fully wind down the property and casualty business by the third quarter of 2022. The effective tax rate for the quarter was 25.3%, higher than our normalized tax rate of 24% due to increased state taxes linked to investment gains realized during the quarter. As Dennis mentioned, we’ve made direct investments in 16 venture-backed companies in the PropTech industry. The $292 million invested in this initiative had a market value of $669 million as of September 30th. This quarter, we recognized $278 million in gains from our venture investments, the largest being a $195 million gain from our investment in Offerpad, an iBuyer that has recently merged with a SPAC. This investment is subject to considerable market volatility, which we expect will influence our quarterly results. Alongside Offerpad, we also achieved a combined $79 million in gains from our investments in Orchard, Sundae, and Picasso. Starting this quarter, all our venture-related activities have been moved to our corporate segment. Before the third quarter, realized investment gains from our venture portfolio were recorded in the Title Insurance segment. In the third quarter, we raised our share repurchase authorization by $300 million, leaving $463 million available as of September 30th. During the quarter, we repurchased 208,700 shares for a total of $14 million at an average price of $67.37. Cash flow from operations grew to $399 million in the third quarter, representing a 27% increase compared to the previous year. Additionally, we issued $650 million in 10-year senior notes at a 2.4% interest rate. We plan to utilize our cash reserves for acquisitions in our core title and settlement business in adjacent markets, invest in innovative solutions like Endpoint, and return capital to our shareholders. Our debt-to-capital ratio as of September 30th was 28.5%, or 22.7% when excluding secured financings payable, slightly above our target ratio of 18% to 20%. Now, I would like to turn the call back over to the operator to take your questions.

Thank you. Our first question comes from Mark DeVries with Barclays.

Yes. Thanks. I was hoping, Dennis, maybe you could elaborate more on some of the more recent investments you’ve made. I think you provided some good color, but I’m interested to hear more about what some of these businesses do, how they fit within your strategy. And then more broadly, how you think about exiting these eventually. At what point after equity events like this quarter do you look to exit?

Mark, you’re specifically talking about our venture investments?

Yes.

Yes. Okay. Just kind of a recap. We’ve got 16 right now. We look at them really from two angles, both strategically and then secondarily financially, and they performed very well financially for us. In the quarter, we had $278 million of gain. So, that’s great. But more importantly for us is a strategic fit. We want to continue to invest in the PropTech ecosystem in our world. We want to get closer and closer to those customers become strategic partners in many cases and customers for us, and we’ll continue with that activity. Now, the second part of your question is, our strategy longer term will likely be not holding concentrated positions in public companies. But, we’re in a lockout period right now on Offerpad. So, we’ll evaluate that in the future.

Okay. With that specific example, are there ongoing business synergies that would lead you to focus on ongoing learnings? How do you view those kinds of partnerships compared to more financial investments?

The overlay would be none of them are just financial. So, they all have a strategic component, specifically referencing Offerpad, we’re very close to them. A large customer for us is a very good strategic partner. So, we’ll weigh all of that together when we look at growing our ownership position in public companies, but they are close partners.

Okay, great. And then, just one question on commercial. I think, you alluded to the fact that it feels like some of the volume you’re seeing is a pull forward of volume just because of potential tax changes. Could you just talk about what it is that kind of caused you to come to that conclusion what you’re seeing? And then, given that potential tough compare, what’s kind of behind the optimism for next year?

Yes. Mark, this is Ken. Thanks for the question. I mean, I think a lot of what we’re seeing with respect to the pull forward is probably by and large anecdotal, what we’re hearing on the street, that gain around the expectations with respect to tax changes. And with respect to the outlook, I don’t think we’ll probably achieve the exalted heights that we’ve achieved in our commercial business in the third quarter. But, as I mentioned, we do expect to have a strong remainder of the year and going into 2022. And there really are a handful of factors. The economy is strong. We expect that to continue. And while interest rates are ticking up a bit, from a historical perspective, they’re still pretty low. And then, thirdly, there’s a lot of capital still chasing deals. So, again, all those factors together, notwithstanding some of this pull forward, we’re pretty optimistic on commercial for again the rest of the year and into 2022.

Thank you. Our next question comes from Bose George with KBW.

Actually one follow-up on the venture investments. Are you guys still seeing opportunities out there to do incremental stuff on that side? And then, just on Endpoint, the revenues for that going forward, is that going to be through the corporate segment, or here does that flow through?

Hey Bose. This is Mark. We are still seeing opportunities in venture. I mean, so far, year-to-date, we’ve put $100 million of cash to work in venture. The deals are getting more expensive. There’s more money chasing fewer deals. And so, I would say, there’s fewer, but we’re still finding opportunities, and we’ll see more of that in the fourth quarter, here too. In terms of the Endpoint, all of the Endpoint revenue and financials go through the title segment. So, it’s just really immaterial from a revenue perspective today, but it’s growing quickly. But to answer your question, it’s all in the title segment.

Thanks for your insights. I understand you prefer not to provide specific margin guidance, but any additional information would be appreciated. You've mentioned that commercial and purchases will stay strong and that investment income will help counterbalance the drop in refinances. The margin range is still around 11% to 13%, and you're currently performing above that. I'm interested in any further details on where margins might be heading.

Well, yes, I’ll start with that, Bose. So, the margin guidance that we’ve given in the past is really dated. I mean, we talked about 13% margins in the past, but that was given a certain origination environment that we’ve really blown past. So when we look at margins going out to 2022, I mean, there are positives and negatives, right? I mean, we feel like the purchase market is still going to be very strong. We think the commercial market is going to have a good year. We’re always eking out efficiencies in our business. You’ve seen us for the most part increase margins for the most part, every year because we continue to drive efficiencies. All that is positive. The negative obviously is refis. I mean, we don’t expect at least to have as strong a refi next year. So, that’s going to be a headwind. And then, we always spend more on technology. So, when you mix that together, I mean, revenue should be very similar to where it was in 2021. And the margins are also a function of the mix of business. Obviously, commercial is a very high-margin business. Agency is a great business for us with its low margin. But one thing I’d point out to longer term is that we’ve got a catalyst when it comes to investment income. So, we’re not really sure when the Fed is going to increase. But, when the Fed does increase, we’ve talked about how we’re going to generate $12 million to $15 million of annualized investment income every time the Fed raises. And given where our deposit levels are, it’s going to be on the high side of that because our deposit levels have just risen. So, that’s a little bit how we think about margins in the future.

Our next question comes from Geoffrey Dunn with Dowling & Partners.

I was wondering if you could give maybe some specific revenue color on the influent other line and title. That continues to show good growth. And it certainly looks like it’s less sensitive to volumes, making it obviously a bit more difficult to project. So, can you give us some rough breakdowns or specific breakdowns in terms of the different offerings in there to give us a better line of sight on how it could perform out in ‘22, ‘23?

Yes, Geoff, this is Mark. As you know, the information and other line item includes various businesses, not just one. We are pleased with the growth, which was at a 9% rate this quarter. While this is lower than what we experienced in direct and agency, there are a few reasons for that. In this quarter, we generated about $92 million in revenue from our data business, which represents the largest portion of our revenue. Additionally, Docutech contributed around $25 million. We also sell many title information reports, which are not risk-based and have no associated claims. This includes property reports and search packages, amounting to about $70 million in that type of business. Our international business contributed approximately $45 million in revenue this quarter. These are the major revenue segments, among other smaller ones.

So, when we look at the sensitivities, can you talk about each one? I mean the data business, does that really track your order flow and real estate demand kind of go maybe through those four buckets and give an idea of the sensitivity to volumes versus being less sensitive?

Well, I would say, the property reports are very tied to just order counts. And for the most part, these businesses really are tied order counts, right? So, when you look at Docutech, we’re going to get paid for every transaction. It’s not like we get paid 2.5 times for a purchase transaction and a refi like we do with power premium. Same thing goes for our data business, right? Data business, there are minimums involved, right? But, if they go over our minimum monthly contracts that our customers pay kind of per hit, right, per order, right? So, none of the businesses in info and other really get that 2.5 times leverage that we see. So, I would say, as a general statement, the way to think about it is based off of orders as opposed to premiums that we see on the title business.

Jeff, this is Dennis. I’ll just add additionally. There’ll probably be a little headwind here in these businesses. They’re still going to perform very well. But, there’ll be a little headwind in the next couple of quarters probably because of refinance dropping, and that’s going to impact the transaction side only.

Thank you for your insights. I’d like to discuss our cash position. Specifically, I’m interested in the cash balance of the holding company following the significant debt raise this quarter. My assumption is that the gains reported this quarter primarily reflect increases on the balance sheet rather than actual cash gains. How do you plan to monetize these investments, and what will you do with the cash generated? Will it primarily be reinvested in the business, or should shareholders expect some of these gains to be distributed, especially given the substantial profits from these investments? I understand that you're typically cautious about providing details on capital redeployment, but with the recent buyback, it appears that you have a strong cash position. Could you provide further clarification on these points?

Yes, Geoff. Starting off, we currently have $714 million in cash at the holding company. We completed a $650 million senior notes deal and have two bond deals maturing in the next two years, totaling $550 million of debt due by November 2024. We pursued the bond deal as an opportunistic move, capitalizing on favorable market conditions. Cash is flexible, but in terms of our spending, we invested $140 million in our bank in the third quarter to strengthen its capital. Our bank deposits have surged from an average of $4 billion at the start of the year to $7 billion now. For every $1 increase in deposits, we put in $0.07 in capital, which we’re pleased to do. In this interest rate environment, the bank is achieving a 10% after-tax return on equity with minimal risk on the asset side, and this should improve as rates rise. We plan to add another $25 million to $50 million in the fourth quarter. Additionally, we have a strong acquisition pipeline. While we aren't announcing anything today, a significant portion of our holding company cash is likely to be allocated towards acquisitions in the near future. Regarding our venture investments, they are all under the holding company and not locked away. These investments tend to be illiquid, but they represent excess capital. Our approach will continue to be opportunistic when they convert to cash. I anticipate that we’ll return more capital to shareholders in the future than in the past while also focusing on business growth. We're taking an opportunistic stance.

Our next question comes from John Campbell with Stephens Inc.

I just want to touch first on the title plant expansion efforts. If you guys can maybe just kind of give us a sense of where you are relative to the original plan of I think 1,500 for the year. I think, that’s 80% or so coverage of the U.S. So, give us an idea of where we are as far as that goal? And then, I don’t know if there’s plans to eventually go to 100%, if that makes sense or not?

John, thanks for the question. We’re right on track. Actually, in the third quarter, we had 1,300 new go-forward plants. We’ll hit our objective 1,500 by year-end. Again, John, they are go-forward plants. We’re using our extraction technology that’s just completely changed our ability to do this at a completely different economic model than we have historically. So, we’ll hit our 1,500 objective. The second part of that question, will we go to 100% coverage? That’s really going to be questionable in the sense that we’ll have to be opportunistic. We’re turning to really get into the very small counties at that point. So, the 80% allows us to have the level of automation long term that we want for our title automation objectives. So, bottom line, on track, continuing to grow, doing well.

Okay. That’s helpful. And then, if I’m thinking about this correctly, I think you guys are generating kind of immediate savings, as you open up those plants, but you’re kind of recycling that back into further plant expansion. So, just give us a sense for I guess, average cost per plant expansion? And then, if you can maybe frame up the associated cost savings with each?

Yes. I’ll start. Mark may come in on it, but it’s pretty de minimis, John. It’s from the size of our company, our technology such now that it doesn’t cost us much at all to put a new plant online like this on a go-forward basis one or two. You’re kind of hitting on two things. We’re not doing this for cost savings play, if you will per se, what we’re really doing is to expand our data content and our coverage. So, not only are we building plants, we’re capturing significantly more content that we think we can use to automate our titling processes in the years to come. So, don’t think of it so much as a cost arbitrage but more from the strategy of automation going forward.

John, regarding the cost of building the additional 1,000 plants, we currently have 500 and are adding another 1,000. The cost going forward is $2 million. A significant portion of this is due to having the images already; we have the history and the images, and we’re mainly paying to input them electronically. Therefore, the cost is minimal.

One last thing, I don’t want to get too detailed on this, John. But what has changed for us is that historically, we were very efficient at manually inputting data, but now there is a very different cost structure since this process is being automated electronically.

Okay. That makes sense. One last question from me is, I've asked this before and I believe you said there hasn't been any change. I just want to double-check on this, but the closing ratio, which is clearly influenced by the order flow, seems to show that you are closing orders at a faster rate over the last couple of years. Am I interpreting that correctly or is there something specific to note?

No, there’s nothing to mention there. It does fluctuate monthly, depending on whether we have a strong order month in new applications or a good month for closing. However, when we analyze the orders we open and how many close, it's typically about 72% of the long-term average, which is where we stand today, both for refinancing and purchases. Therefore, we haven’t noticed any significant change in our closing ratio.

Yes. John, if you notice any fluctuations in the numbers, particularly the closing ratios, it may be linked to the variations we see in refinances. However, as Mark mentioned, the purchase activity is consistent with our historical averages.

Thank you. That is all the questions that we have for today. This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation. And have a wonderful day.