First American Financial Corp Q4 FY2021 Earnings Call

Greetings, and welcome to the First American Financial Corporation's Fourth Quarter and Full-Year 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. A copy of today's press release is available on First American's website at www.firstam.com/investor. Please note that the call is being recorded and will be available for replay from the company's investor website and for a short time by dialing (877) 660-6853 or (201) 612-7415 and enter the conference ID 13726034. 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 fourth quarter and year-end 2021 earnings conference call. Joining us today on the call will be Dennis Gilmore, Former Chief Executive Officer and recently appointed Chairman of the Company's Board of Directors; Ken DeGiorgio, First American's new Chief Executive Officer; 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.

Thanks, Craig. Good morning and thank you for joining our call. In addition to our record earnings, we recently announced that our company's President, Ken DeGiorgio has been promoted to Chief Executive Officer. Over his 23 years of service to First American employees, customers and shareholders, Ken has acquired an in-depth understanding of our business and demonstrates that he has the vision, strategic insight and skills to lead our company. Under Ken's leadership, First American will continue to lead the digital transformation of the title insurance and settlement industry. Ken and his team will continue to capitalize on the many opportunities the company has to grow our business. At the request of our board of directors, I'm honored to continue to serve on the board now as its Chairman, immediate past Chairman Parker Kennedy will remain on our board as Chairman Emeritus and Lead Director. During my 12 years as CEO, I've had the incredible privilege to work alongside First American's great people. Our company culture that puts people first has driven our success. As I've said many times, we will put our people first; they'll take care of our customers. And when they do and we run the business efficiently, we will deliver superior results to our shareholders. I know that Ken and his leadership team and all of our employees, when we attain our exceptional culture will continue to raise the bar on our performance. I'd now like to turn the call over to Ken.

Thank you, Dennis. On behalf of First American's 22,000 employees, I want to recognize and thank you for your inspirational leadership and dedication over your nearly three decades with our company. Your focus on fostering a world-class culture, while delivering an annualized total shareholder return of 18.2% during your 12-year tenure as CEO has set the bar high. Your vision for our company to be the premier title insurance and settlement services company, the vision that has guided us to where we are today, will continue to guide our future success. And the strategy we developed to achieve that vision, a strategy that has served us well for over a decade will not change. We will continue to strive to profitably grow our core title and settlement business, including through innovation and the acquisition of companies that are compatible with our culture and advance our vision. We will continue to strengthen our business by leveraging data and process advantages and, where we have a strategic advantage, we will continue to manage and actively invest in businesses that are complementary to our title and settlement business. Thank you again, Dennis. Your impact on First American will be lasting. Turning to our financial results, 2021 capped off record revenue of $9.2 billion, record Title margin of 16.3%, and record earnings per share of $11.14. Even excluding net investment gains, EPS was $8.17, yet another record. While we are proud of these achievements, our focus continues to be on the things that will drive future growth. At the beginning of 2021, we announced our intention to expand our title plant footprints in 500 counties to 1,500 by the end of that year. Leveraging our proprietary data extraction technology, we are currently maintaining more than 1,600 title plants, covering nearly 80% of the U.S. population. This data is critical as it fuels our operational efficiency initiatives, our title automation efforts, and our ongoing efforts to digitize the real estate closing experience. You can't automate unless you have data, and we are the industry's undisputed leader in title data. Last month, we announced an agreement to acquire Mother Lode Holding Company, a title company with 92 offices across 11 states, including the key markets of California, Texas, and Arizona. Mother Lode is an important transaction for us in many ways. First, we have the opportunity to welcome amazing talent to our organization. Second, we further expand our distribution network as Mother Lode's 10 brands are among the best within their respective real estate communities. Lastly, Mother Lode is a key step in a multi-brand strategy for our title company that will accelerate our growth efforts. The transaction is awaiting regulatory approval and is expected to close in the coming months, after which we will provide additional details. We're excited to welcome Mother Lode to the First American family and look forward to growing together in the future. In terms of the outlook for 2022, it will be a year of transition we are well-positioned for. We expect market conditions in our purchase and commercial businesses, which account for approximately 80% of our direct revenue, to remain favorable. Refinance volumes will continue to wane as mortgage rates tick up. But we believe increased investment income due to a rise in short-term rates will help offset the decline. As short-term rates rise, we will benefit from higher investment income from our cash and escrow balances, 1031 Exchange deposits, and bank portfolio. We believe our bank is a competitive advantage and serves as a natural hedge when higher mortgage rates drive refinance volumes lower. In January, we opened 2,000 purchase orders per day, a 7% decline from strong January 2021, and a 9% increase relative to January of 2020. Our refinance orders were 1,200 per day steady with what we experienced in December. Now I'd like to turn the call over to Mark for a more detailed discussion of our financial results.

Thank you, Ken. We're pleased to report excellent results this quarter. We earned $2.33 per diluted share. Included in this quarter's result were $0.05 of net investment gains. Excluding these gains, we earned $2.28 per diluted share. I'll start with our title business. Revenue in our Title segment was $2.3 billion, up 13% compared with the same quarter of 2020 due in part to a record quarter in our commercial business. Commercial revenue was $377 million, a 66% increase over last year. We experienced strength across the board in terms of geography, asset class and deal size. We closed 117 transactions in the U.S. with premiums greater than $250,000 up from 58 last year. For the year, our commercial business generated over $1 billion in revenue, eclipsing our prior record achieved in 2019 by 34%. Purchase revenue was up 2% during the quarter, driven by a 7% increase in the average revenue per order, partially offset by a 3% decline in the number of orders closed. Our purchase orders declined from an unusually strong quarter in Q4 of 2020, which experienced the release of tenant demand due to the pandemic. Looking at a more normalized two-year trend, our closed purchase orders this quarter were up 15% relative to the fourth quarter of 2019. Refinance revenue declined 46% relative to last year due to the increase in mortgage rates. In the agency business, revenue was a record $1 billion, up 20% from last year. Given the reporting lag in agent revenues of approximately one quarter, we are experiencing growth in remittances related to Q3 economic activity. Our information and other revenues were $322 million, up 15% relative to last year. Revenue growth was primarily due to the recently completed acquisition of ServiceMac and higher demand for the company's loss mitigation products. Investment income within the Title Insurance and Services segment was $49 million, down 8% primarily due to lower interest income from the company's warehouse lending business and other cash balances. If the Federal Reserve raises rates, we expect to generate additional investment income from our escrow deposits, cash balances, 1031 Exchange deposits, and our bank investment portfolio where we have over $1 billion of floating rate securities. We estimate based on current deposit balances that a 25 basis point increase in the federal funds rate will equate to a $15 million to $20 million increase in our annualized investment income in the Title segment. Pretax margin in the Title segment was 16.3%. Turning to the Specialty Insurance segment, revenue in our home warranty business totaled $104 million, up 1% compared with last year. Pretax income in home warranty was $17 million, down from $21 million in the prior year primarily due to elevated claims activity as the loss rate rose to 52.0% from 50.5%. Our property and casualty business had a pretax loss of $6 million this quarter. At year-end, our policies-in-force had declined by 71% since the beginning of the year, and we expect a full wind down of the property and casualty business to be completed in the third quarter of this year. The effective tax rate for the quarter was 21.6%, lower than our normalized tax rate of 24% due primarily to reduced state taxes as a result of larger than forecasted insurance income in the quarter, which is generally not subject to state income tax. This quarter, we recorded $7 million of net investment gains on a consolidated basis. We generated $52 million of gains related to three PropTech investments and $26 million of gains from our public equities portfolio. Those gains were offset by a $75 million decline in the market value of our stake in Offerpad. Cash flow from operations was $344 million in the fourth quarter, down 15% in the prior year, due to a change in working capital accounts. In the fourth quarter, we repurchased 270,400 shares for a total of $20 million at an average price of $74.38. So far in Q1, we repurchased approximately 345,000 shares, for a total of $27 million. Our debt-to-capital ratio as of December 31st was 27.4% or 22.2% excluding secured financings, slightly higher than 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. We will now be conducting a question-and-answer session. Our first question comes from Mark DeVries with Barclays. Please proceed with your question.

Yes, thank you and congratulations, Dennis and Ken on your new roles. So Ken, I appreciate you've been there for a long time. And also you were kind of joining at the time when FAF is doing quite well. So I'm sure there's a sense of like if it didn't break, don't fix it. But I'm interested to get your thoughts on kind of your early priorities, kind of whether there is anything different or any new levels of infrastructure investment that you're kind of focused on?

Yes, thanks Mark for your kind initial comments. And I've been working with Dennis for 23 years at his side for the last 12 years as CEO. So I don't anticipate any dramatic shift in our strategy. The vision that Dennis initiated for our company is going to remain our vision, and that is to be the premier title and settlement services company. And obviously, as demonstrated by the results, that has worked well for us. Yes, and to execute on that vision, we're going to execute on the same strategy. We've got to grow our core title and settlement business, leverage data and process advantages to the benefit of the business, and invest in our complementary business. So I don't really see the need to initiate any dramatic change. Obviously, there are going to be things we're going to focus on going forward as the market changes. But I don't think we're going to be doing anything dramatically different than what Dennis has done. And the other thing I'll add is that one of Dennis's many lasting legacies here is the team he built, and he built an incredible team, which by the way includes Mark Seaton, who I know you know well, and in my opinion is probably the best CFO in any public company. We built the strategy, so it's all of our strategy, including mine.

Okay, great. Turning to Mark, I have a question about how investment income is affected by rising rates. You mentioned that for every 25 basis points, there's an increase of $15 million to $20 million annually. That's quite a range. What accounts for the difference between the $15 million and the $20 million outcomes?

Yes, thanks Mark. There are many factors involved in that estimate. Currently, we have our bank floaters, escrow deposits, operating cash, and 1031 exchanges to consider. We believe that during our conversations with other banks, especially with the first couple of rate increases, we could find ourselves at the lower end of the range. However, as the Fed continues to raise rates, which is anticipated, we are likely to be closer to the upper end of the $20 million range as banks increase lending. At present, banks don’t really require deposits and don't highly value them, which is why interest rates remain low. It may take a few rate increases for banks to genuinely start seeking deposits. So, initially, we might see lower figures, but we are confident that over time we will reach the higher end of the range, assuming our deposit balances remain stable.

Okay, got it. And it sounds like it ramps a little bit with more rates. But is that in general, the guidance fairly linear? So in other words, if the 5.5 or so increases implied by the forward curve is accurate, that by the end of the year you could have almost somewhere between $75 million and $100 million of incremental run rate investment income?

I think so on an annualized basis. Yes, in the title business. And again, it'll be a little bit less at the beginning, a little more at the end. But overall, yes, I think it's fairly linear.

Our next question is with Andrew Kligerman with Credit Suisse. Please proceed with your question.

Good morning. Continuing on the topic of incremental investment income, I understand you've made efforts to enhance your bank for agents to make deposits. How might that impact the $15 million to $20 million in income? How soon do you anticipate having that bank component operational? Additionally, what amount in deposits do you expect to collect in 2023 and beyond?

Yes, thanks for that question, Andrew. So the $15 million to $20 million that we've been talking about here, that's assuming, again, deposit levels stay the same. Now, you've pointed out the fact that we're growing our bank, and we're growing it through our agency deposits. As of the end of the year, we had about $250 million of agency deposits. And we had almost $7 billion of deposits at our bank. So it's growing, we think it'll double this year. It's not going to have a huge impact. But over time, we think that's a big growth area for the bank is having agents deposits or funds for us, but I don't think that will be material for 2022 maybe even 2023.

Got it. With personnel costs increasing approximately 9% to 19% compared to the fourth quarter of last year, could you provide some additional insight into the outlook for personnel costs and the reasons behind this significant year-over-year increase?

Well, I'll chime in, Andrew, and then Mark can finish off with some more definitive numbers. But on personnel costs, I think we expect personnel costs to remain steady. But I will note that I don't think there's any mystery that we're going to have inflation pressure. So there is some risk of increased personnel costs going into the year. And then, obviously, as we've done historically, we watch our personnel cost tie to our entire cost structure very closely and adjust as necessary to the market.

Yes, I believe our current headcount is suitable. In 2021, we hired throughout the year, which means we will see higher personnel costs in 2022 compared to 2021 due to that hiring. Additionally, our acquisitions will further increase our headcount. However, as Ken mentioned, we feel properly staffed, and our personnel costs next year will reflect these rate dynamics.

Our next question comes from Mark Hughes with Truist. Please proceed with your question.

Yes, thank you. Good morning. And just to follow up on that, when you say steady personnel costs, are you talking in absolute terms, are you talking as a ratio?

Well, really both. I mean, we're going to have higher personnel costs on an absolute basis. And when you look at our personnel costs as a percentage of our net operating revenue, which is a metric we look at that depth, as well next year.

Okay. And then, did you hear you properly that purchase orders in January were 2,000 per day? And what was that year-over-year change?

It was 2,000 a day, which is down roughly 7% compared to the prior year. However, keep in mind that January of last year was particularly strong due to pent-up demand from the pandemic. While it is down from last year, looking at a two-year trend shows a much more positive outlook.

Yes. The commercial revenue per order are quite strong. You talked about large orders. Did that kind of unusual pent-up demand or is that the new reality?

I would say we had an extraordinary fourth quarter. This is the best fourth quarter we've ever had, and as I mentioned earlier, this has been a record year for commercial. We've never experienced anything like the fourth quarter, but we have a good pipeline heading into this year. For the first six months, we know we will have very strong commercial activity, as shown by our escrow deposits, which are a leading indicator of commercial activity and haven't declined much since the fourth quarter. We anticipate a good six months in commercial, but after that, it's difficult to predict. However, in our conversations with customers, there's a lot of capital available, and we've observed an increase in transactions that we believe can continue.

Then one more if I could. The Mother Lode acquisition, is that just a good opportunity? Or does it represent some sort of a not shift in strategy, but growing preference for similar deals?

Yes, this is Ken, and I appreciate the question. First and foremost, it was a fantastic opportunity, which doesn't come around often. I'm referring to a company of their size and reputation in the industry, coupled with the quality of their team and a compatible culture. So, it was indeed an opportunity. Additionally, as I've mentioned before, it's a crucial step for us towards a multi-brand strategy. While we already have other brands in our title company, such as Republic Title of Texas, which is a premier brand, we view Mother Lode as a chance to enter markets that we haven't been able to tap into yet. Others have managed to penetrate these markets, and we aim to leverage their unique approach. Each title company has a distinct strategy in the market, and we plan to incorporate that into our own.

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

Hey everyone, good morning. Thank you. Just a follow-up on Mother Lode, have you said anything about accretion from that acquisition?

No, we haven't yet. And the transaction is subject to regulatory approval. So it's not going to close probably for a couple of months at least. And once it does close, we'll provide some additional information, hopefully on our next call to you.

Okay, great. Thanks. And then actually just in terms of your other investments, there has been a pretty big sell-off in the PropTech public stocks at least. Has that created opportunities for you like what's going on there on the private market side?

Yes, well, I think there are opportunities. I'll say we haven't seen a decline in valuations in the types of companies we look at. But yes, I would anticipate that there will be more opportunities for us at probably more favorable pricing going forward. And I'll note on our venture portfolio, I mean you have that, as Mark has indicated performing well financially. I mean, we've booked gains of $355 million at year-end. But I'll remind you, we're not just doing these investments for financial returns, we're doing it for strategic reasons. We want to invest in PropTech companies that give us insights into what companies like that need, so we can adapt and adjust our products. And also, they might hopefully become customers or good customers of ours. And we've actually seen that in the past. So, when we talk about the opportunities, we look at it not just from a valuation or a financial perspective, but from a strategic perspective, and probably first and foremost from a strategic perspective. So we think those opportunities will continue to present themselves.

Okay, great. Thank you. Just one more just swinging back to expenses. Can you just talk about your success ratio, was that versus your expectations this quarter?

Yes. We've always aimed for a success ratio of 60%, which we have maintained most years over the past 15 years. However, achieving this consistently is not sustainable, as a 60% ratio each year leads to continually increasing margins. In 2021, we ended with a 59% success ratio, which met our target, and in the fourth quarter, it was even higher at 87.5%. A few factors influenced this. We didn’t have any significant one-time expenses, but our 401(k) costs for the quarter were $8 million more than last year due to a compensation-based matching increase from $0.75 to $1.50. We also incurred $9 million for a healthcare true-up at the year's end. Additionally, some of our entities, such as Endpoint and ServiceMac, reported losses, impacting the success ratio. Overall, we are pleased with our expense management for the year and the quarter, but the success ratio will be affected by these mentioned factors.

Our next question is from Geoffrey Dunn with Dowling & Partners. Please proceed with your question.

Thank you. Mark, I'm quite surprised by your outlook for personnel expenses. Considering how much of that line includes commissions, bonuses, temporary help, and other variables. As you think about the overall increase year-over-year, can you relate that to revenue? It seems to me that this outlook is quite unusual unless you anticipate revenue to decline only about 5% or so; otherwise, it seems like a more significant compression than I would expect in a declining environment. Can you clarify?

Well, sorry, Geoff, I could go after. Last call, we talked about how we thought we could have flat revenue in 2022 versus 2021. And now, in this call, I think we still stand by that. So we don't know. I mean, as we've talked about, there's a lot of things that were happening in 2022. We never really know. But based on where we're sitting right now, we don't see a decline in revenue but that could happen. But we think we'll be closer to flat.

Okay, that makes more sense. And then, if you are in a flat, your success ratio is designed for year-over-year increase in revenue. So if we're in a flat or down revenue scenario, how do we think about judging your expense management against that framework?

Yes, so the success ratio itself it's really a metric that we came up with a long time ago to determine, are we doing a good job of managing expenses when the market is up or down? It's less relevant if you have flat revenue, right, because you can get some pretty wild numbers for the success ratio. I think, at the end of the day, we want to have strong margins; we look at each one of our businesses that have different margin dynamics. And we want to make sure that we have good returns on capital and good margins, and in a flat revenue environment, again, to your point, the success ratio isn't as meaningful.

Our next call comes from Ryan Gilbert with BTIG. Please proceed with your question.

Hi, thanks. Good morning, guys. First question for me is on just competitive dynamics in the core title business? Any details or color you can add on what you saw on the market in the fourth quarter? And how you think about competition developing over the course of 2022?

Yes, I don't think we anticipate seeing dramatic change in the competitive environment. Obviously, interest rates are going to have a headwind. And I think a lot of the upstart title companies that are refinance driven are going to have a critical inflection point for them. But I think in terms of the larger competitors in particular, I don't see that dynamic changing too dramatically.

Could you provide an update on Endpoint and your progress in expanding into new markets, along with your current customer pipeline?

Yes, I believe Endpoint is performing well overall. They are maintaining their market share in their test market, which is Seattle, and have been expanding into new markets. They are currently operating in 20 markets across seven states. One significant indicator for me is our net promoter score within Endpoint, which is above our target, indicating that we are gaining traction with our customer base. It appears to be well-received by customers.

Okay, great. Last question for me, just on share repurchases. It seems you increased the volume significantly in January. How are you balancing share repurchases with other investment opportunities, and how should we forecast repurchases in 2022 and 2023?

We always evaluate opportunities in the market. We've been very active in mergers and acquisitions, especially over the last year and beyond. We're also investing significantly in our core business to develop software and tools that enhance our connection with customers. These investments are substantial, and we're fortunate to be able to make them while still repurchasing shares. We believe our stock is undervalued, which is why we're buying back shares. Currently, we're trading at 11 times earnings according to Bloomberg, which suggests we might be at the peak of the cycle. However, this isn't the case regarding refinances or investment income. Considering those factors, our multiples could potentially be higher. Additionally, we have assets at First American that might not be fully reflected in our public market value, such as our PropTech portfolio, which had a carrying value of $673 million at the end of the year. When looking at the fee based trading, it seems that value isn’t fully captured in our share price. We also have some assets at First American that presently show losses, like Endpoint, Point, ServiceMac, and our property and casualty business. However, we believe these assets hold value. For these reasons, we've been active in the market recently, and we'll see how things unfold for the rest of the year. While I don't have a specific forecast, we have indicated in previous calls that we're more likely to buy back shares in the future than we have in the past, and we're beginning to demonstrate that.

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

Hey, guys, good morning and Dennis, congrats on an outstanding run. Happy you're still going to be around at the Chairman seat. And then, Ken, congrats to you as well. We're looking forward to working with you.

Thanks John.

Thank you, John.

Sure. You guys are going to get this question. So on title pretax margin, I mean you guys obviously in the past have talked to I think 11% to 13% range. Obviously, in past few years really good mortgage backdrop, you guys have been at 15% to 15% margins. You got to refi headwind this year. You got what seems like a pretty sturdy business on purchasing commercial. You guys talk to maybe flattish revenues. I think we certainly see that as well. You've got the investment income pick up. With all that said, I'm just kind of curious about how to think about pretax margins. I know, it's going to probably be hard to keep it at 2021 levels with the wage pressure, but it seems like you've got enough things cooking to maybe kind of keep it close, so just curious about commentary there.

Let me quickly address the outlook, and Mark can add if needed. This morning's inflation report was disappointing, which likely means the Fed will raise rates. However, I see some reasons to be optimistic, at least for the first half of this year. On the purchase side, interest rates remain relatively low; although they are increasing, they are still manageable. We also have demographic advantages, such as millennials entering the market. Despite low inventory levels, I believe we can anticipate some increase in inventory, which should positively impact our purchase business. Additionally, our commercial sector is coming off a record year, providing us with momentum as we enter this year. The pipeline looks promising, and rates remain relatively low, which bodes well for the commercial market. There's significant capital seeking opportunities as well. Regarding refinances, we have noted a strong link with interest rates, and while we expect refinancing activity to decrease as rates rise, we are well-positioned to balance that with our investment income, especially given our unique asset in the industry: our bank. Overall, I feel confident about our margins as we move into 2022, although we are fully aware of the challenges posed by rising rates. As mentioned earlier, we will be vigilant in monitoring our cost structure.

Okay, that's helpful. I appreciate that. And then in your prepared remarks around Mother Lode, you guys talked to the multi-franchisee. It seems like that's a fairly big pivot for you guys. I mean, it seems like you guys have had a single-brand strategy that's probably more cost-efficient, but maybe there's that growth benefit to kind of come back. So maybe if you could talk to that and then why you're exploring that now, what triggered the change?

I believe part of this is due to the opportunity that has arisen. Mother Lode possesses ten exceptional brands, and it would not be wise for us to consolidate them into one brand given their success. Therefore, I view this not as a pivot but rather as a shift, as we also have other brands in our portfolio, such as Republic Title and Title Best. We see this as a chance to approach the market differently.

Mr. Gilmore, there are no additional questions at this time. That concludes this morning call. We would like to remind listeners that today's call will be available for replay on the company's website or by dialing (877) 660-6853 or (201) 612-7415 and enter the Conference ID 13726034. The company would like to thank you for your participation. This concludes today's conference call. You may now disconnect.