First American Financial Corp Q1 FY2023 Earnings Call

Greetings, and welcome to the First Quarter 2023 First American Financial Corporation 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 entering the conference ID 13738122. We will now turn the call over to Craig Barberio, Vice President, Investor Relations to make an introductory statement. Please go ahead sir.

Thank you. Good morning, everyone, and welcome to First American's earnings conference call for the first quarter of 2023. Joining us today on the call will be our Chief Executive Officer, 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 would now like to turn the call over to Ken DeGiorgio.

Thank you, Craig. Ongoing challenges and market conditions in the first quarter continued to weigh on our results, although a 136% increase in net investment income along with our expense management efforts enabled us to deliver a pre-tax title margin of 6.5%. Our home warranty segment had a strong quarter with a pre-tax margin of 15.3%. On a consolidated basis we earned $0.44 per share or $0.49 before net investment losses. A sharp decline in affordability driven by mortgage rates above 6% along with low inventory and elevated home prices adversely impacted the housing market and as a result our residential purchase business. Currently however the purchase market appears to have stabilized. For the first three weeks of April, we are seeing typical seasonal improvement in the purchase order trend with open orders up over 5% compared with March. Refinance open orders remained at trough levels in the first quarter, averaging 350 per day. The current pool of mortgage loans would need to see rates drop well below 5% to incentivize a significant uplift in refinance activity, which is highly unlikely in the near future. The weakness in the commercial market, which began in the back half of 2022 also impacted our results this quarter with our commercial revenue down 39%. The decline in activity was seen across all regions and asset classes including industrial and multifamily and large deals were down 50% from last year. Commercial open orders were down 28% in the first quarter and that order trend has continued into the first three weeks of April with orders down 30%. While there is a high degree of uncertainty concerning the commercial market outlook based on feedback we are getting from customers, we remain optimistic that transaction activity will improve in the second half of the year given the progress made on price discovery during the first quarter and ample capital availability, notwithstanding the potential impact of the banking crisis on available credit. Our financial strength allows for continued investment in our innovation and other strategic initiatives, which are imperative to our long-term growth strategy. We continue to make progress at Endpoint, our digital title and settlement company, which now has a national presence. This month, Endpoint announced the launch of its mobile notary platform, which streamlines the process of signing documents in real estate transactions. Our title company has begun to use the platform, the first time that the broader company has leveraged Endpoint's proprietary technology. As Endpoint continues to reengineer the closing process, it will drive efficiency and improve the customer experience not only for itself but for other divisions of First American as well. During the last few quarters, we have discussed our initiative to develop instant title decisioning for purchase transactions, which also promises to improve our operational efficiency and expand our competitive advantage. Given the success of our early testing, we expect to deploy it in two markets within the next year. This next-generation technology is made possible by a number of factors unique to First American, including our talented technology data sciences and underwriting teams and the most comprehensive title and real property database in the industry which is fueled by our proprietary data-extraction technology. We also continue to make progress at ServiceMac which turned cash flow positive last quarter and is now the fifth largest subservicer in the market, after experiencing 62% revenue growth this quarter. In closing, I want to thank our employees, who have shown resiliency through difficult market conditions. They've remained steadfast and committed to our company and our customers, enabling us to grow our market share by over two percentage points in 2022 which will pay dividends when the current cycle turns. I am also pleased to announce that First American has been named one of the 100 best companies to work for by Great Place to Work and Fortune Magazine for the eighth consecutive year. This accomplishment is a tribute to our unique culture and our people, who in addition to delivering best-in-class service, continuously find new and innovative ways to meet our customers' needs. Now I'd like to turn the call over to Mark, for a more detailed discussion of our financial results.

Thank you, Ken. This quarter we earned $0.44 per diluted share. Included in this quarter's results, were $0.05 of net investment losses. Excluding these losses we earned $0.49 per diluted share. Revenue in our title segment was $1.3 billion, down 32% compared with the same quarter of 2022. Commercial revenue was $148 million a 39% decline over last year. Our average revenue per order for commercial transactions declined 25% this quarter to $9,900 due to a combination of lower valuations as prices in the commercial market reset and fewer large transactions. Purchase revenue was down 32%, during the quarter, driven by a 33% decrease in the number of orders closed partially offset by a 2% increase in the average revenue per order. Refinance revenue declined 75% relative to last year due to the increase in mortgage rates. In the Agency business revenue was $590 million, down 38% from last year. Given the reporting lag in agent revenues of approximately one quarter, these results reflect remittances related to Q4 economic activity. Our Information and Other revenues were $222 million, down 26% relative to last year. This decline was the result of lower transaction levels across several business units, including the company's data and property information products and post-close and document generation services. Investment income within the Title Insurance and Services segment was $125 million, a 136% increase relative to the prior year. Rising short-term interest rates are benefiting the interest income we receive on our cash and investment portfolio, escrow balances and tax-deferred property exchange balances. As short-term rates have risen we expect investment income to continue to be a tailwind for earnings in 2023. On the expense side, we continue to manage expenses given the decline in transaction activity. Our success ratio was 50%. Maintenance and personnel and other operating expenses declined $206 million and our net operating revenue declined $409 million. Though below our long-term target of 50%, we believe our success ratio was a good outcome given the sharp decline in transaction activity and our commitment to continue to fund strategic initiatives. The provision for policy losses and other claims was $35 million in the first quarter or 3.5% of title premiums and escrow fees down from the 4.0% loss provision rate in the prior year. The 3.5% loss rate reflects an ultimate loss rate of 3.8% for the current year, with a $3 million release for prior policy years. As of now we expect to book at 3.5% for the remainder of 2023 but that may change depending on claims activity. As Ken highlighted, we continue to invest in businesses and innovation initiatives that we believe will positively contribute to our profitability in the long term. But at this point in their life cycle adversely impact our financial results. We have discussed three initiatives: ServiceMac, Endpoint and instant decisioning for purchase transactions, which together generated a pre-tax loss of $18 million this quarter, impacting our pre-tax title margin by 150 basis points. Pre-tax margin in the Title segment was 6.5% or 6.1% excluding net investment gains. Included in this result were $10 million of intangible asset amortization related to acquisitions and $4 million of severance incurred during the quarter. Beginning this quarter we moved our Property and Casualty results to our Corporate segment and are disclosing our Home Warranty result as a stand-alone reporting segment. Total revenue in our Home Warranty business totaled $104 million, slightly ahead of last year. Pre-tax income in Home Warranty was $16 million, unchanged from the prior year. The loss ratio in Home Warranty was 47% up from 46% in 2022 driven by a higher severity of claims partially offset by lower frequency. The effective tax rate for the quarter was 22.8%, lower than our normalized rate of 24% due primarily to the mix of income between our insurance and non-insurance businesses since our insurance business generally paid state premium tax in lieu of income taxes. In the first quarter we repurchased 556,000 shares for a total of $30 million at an average price of $54.75. Our debt-to-capital ratio as of March 31 was 28.4%. This ratio was impacted by both our accumulated other comprehensive loss and our secured financing payable. Excluding these two items, which is more in line with our bank fee ratio, our debt-to-capital ratio was 20.1%. As we discussed last quarter on February 1, we repaid $250 million of senior unsecured notes that matured using cash on hand at the holding company. Later in the year we expect to draw on our line to partially replace this debt. 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 Bose George with KBW. Please proceed with your question.

Hey, guys. Good morning. I wanted to ask about margins. Is there – just given the weakness in sort of the broader markets, can you just talk about margin expectations for the year? And if this persists is there more you can do on the expense side to kind of address it?

Thanks for the question, Bose. So the challenge we have is obviously the market. When you look at purchase and commercial refinance, which really drives our business, I mean all those are going to be headwinds going into this year certainly relative to last year. The good news is that we've seen evidence of the purchase and the refi, markets have really bottomed out and commercial is really close to getting there. But yet we'll still face year-over-year headwinds. I think on the positive side for margins this year, investment income obviously is going to be a tailwind for us, looking at a year-over-year basis. We've got the full year of a few acquisitions we did last year that will be incorporated this year. It's not material but it will be a little bit of a help for us. We still are going to get a lot of efficiencies based off of some of the expense measures we took last year. And we've talked about these strategic investments and we think that the loss will continue to narrow this year. You saw that we lowered the loss rate to 3.5%. Obviously, that's going to help our margins. And then lastly I'll just say that our P&C business lost $18 million last year and obviously that loss is going to narrow this year. So when you mix that all together, I mean even though we're in a – what we think is going to be a trough year, we're still looking at double-digit margins this year. And in terms of – can we do more? I mean there's always more that we can do with the market is sort of worse than our expectations. But we're looking at at least double-digit margins in 2023 based on what we see today.

Okay. Great. That's helpful. And then actually on interest income you noted that it remains a tailwind. Any change to the guidance you gave in the past, obviously forward rate expectations have changed a little bit?

Well, what I'd say for that is going back to Q3, we said that we could hit $600 million of investment income in 2023, assuming two things happen. One is that the forward curve for Fed funds rate played out like the market thought it was going to and the second thing was that balances were even with Q3 levels, that they didn't change. And what's happened now is the Fed funds rate has really played out like the market has thought but balances have fallen. And certainly our commercial business was down 40% sequentially from Q4 to Q1. And so our investment income was down sequentially just because the balances fell. So when we look at kind of the outlook for investment income this year, we feel like Q1 of $125 million of investment income in Title is a trough. We don't see it getting any lower than that. We sort of update – if we're going to update our sort of guidance that we gave and we just took March balances and kept them flat and assume the forward curve. Now, we look at somewhere around $535 million of investment income this year. But again that's based off of March balances. And March balances are typically lower than the average balances. So as Commercial sort of picks up throughout the year, we think we'll hit higher than that. So we're still positive on investment income but it was just down this quarter just because of balances.

Okay. Great. That’s helpful. Thank you.

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

Yes, thank you. Just Mark to your last point there about how balances ought to build as the year progresses. Is there a decent visibility for that? I think you gave the Commercial orders down, was it 30% in the first three weeks of April, but is there reason to think the balances will progress from here?

Hi, Mark, this is Ken. I'll address that. I believe there is reason to be optimistic about a rebound in the commercial market during the second half of the year. The commercial sector significantly influences our balances, accounting for about 70% of them. Much of this optimism stems from customer feedback indicating they expect a stronger second half, primarily because price discovery will have largely finished. Anecdotally, we are hearing that there is still sufficient capital available despite the banking crisis. We are closely monitoring loan availability, especially within the smaller to medium-sized commercial market. Overall, everything we are hearing suggests that the commercial sector should perform fairly well this year, although it will likely be lower than the record levels seen in 2022.

Yes. When we look at the cost structure and compare it to your direct premiums and escrow fees, it’s quite similar this quarter to what you experienced in the first quarter of 2019, when you had a 10% pretax margin in Title with significantly less investment income. Could you provide some perspective on this? The expense structure seems to have been built up over the last few years during a period of strong volume, and there might be some expenses that could be reduced if a rebound is not expected. I know you've mentioned the investments in growth initiatives. I would like to hear your thoughts on how the current cost structure differs from what it was four years ago. This comparison, although from some time ago, is quite striking.

Well, I'd just say back in 2019, it was certainly a better market particularly when you look at the number of transactions. So, you look at what really the big three markets that drive our business commercial purchase refi was all much stronger back in 2019. 2023 at least so far in terms of transaction accounts we're seeing lows we haven't seen since the great financial crisis and even before that in some of those markets. So, when you look at like the cost structure of our individual business units whether it's our commercial business or direct it's very similar. It's just we have been investing more in some of these initiatives that we've been talking about and just technology in general. So, that's what I'd just say relative to 2019.

I'm sorry. Mark, I would add that regarding the strategic initiatives and as Mark mentioned earlier, the investments are significant. We can, of course, reduce or stop those investments, but we believe that would not make sense from a long-term strategic perspective, although it's an option we have.

Yes. And then on the Home Warranty business I wonder if you could maybe give some thoughts about what you think might happen with the topline there.

Yes, I think well our Home Warranty business had a strong quarter as we noted. I think on the topline I mean there's two channels in the Home Warranty business the real estate channel and the direct-to-consumer channel. The real estate channel there's a high degree of correlation with our Purchase business. So, as we see real estate transactions fall if they continue to fall that will put pressure on their revenue. But they've had a lot of success in the direct-to-consumer business. In the first quarter, for example, it was up 12% whereas the real estate channel was down almost 35%. So there's opportunity there. The other thing we're seeing is some good performance with respect to renewals in both channels actually the real estate channel the renewals have been up almost 5% in direct-to-consumer just over 14%. So, we think there's some opportunity there but they're facing certainly in the real estate channel the same headwinds that are in our residential Title businesses.

Thank you very much. Appreciate it.

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

Yes, thanks. I wanted to drill down a little more on the commercial outlook for the back half of the year. I appreciate all the color you provided. I think one question is the price discovery issue is that impacting the larger transactions sizes more? And if so is we find an equilibrium at these higher rates? Does that kind of have an upward impact on the fee per file? And the second question is how much concern is there from you're hearing from your customers that even as they begin to reach that equilibrium and find price discovery that banks tightening in the wake of this regional banking crisis kind of tightened disproportionately on their CRE business. And you see kind of a lack of supply of credit just as commercial investors are looking to transact.

Mark, it's uncertain if price discovery is affecting larger transactions significantly more than smaller ones. However, the fact that our large transaction volume declined by 50% in the first quarter suggests that price discovery is indeed having an impact. Regarding the fee per file, if large transactions return to the market, it should positively influence our average revenue per order. However, we expect that the overall value of large transactions will decrease. We're observing a 10% to 15% drop in prices in commercial markets and a 25% decline in the office sector. Therefore, we believe prices across the board will decrease.

Okay. Got it. And any concerns around the availability of funding from banks?

Yes. As I mentioned, we're hearing anecdotally that there's sufficient capital available. However, we do have some moderate concerns about the situation and are monitoring it closely. There's been considerable discussion in the trade media regarding mid-tier banks providing credit for smaller and medium-sized commercial deals. This is a point of concern that we're keeping an eye on. Nevertheless, feedback from our customer base indicates they are not currently facing issues. That said, we recognize that many factors are still uncertain.

Okay. Got it. And next question, I mean, this environment has got to be particularly challenging for subscale players in the title business. Are you seeing improving opportunities to do acquisitions here, just given some of the distress some of these players may be under? And if so, are you kind of prepared to be aggressive in acquiring?

Yes, it's interesting, Mark. We haven't encountered many appealing opportunities lately. There are some prospects, especially in the proptech sector, but they aren't very strong. However, considering the current market conditions, we anticipate seeing some opportunities. If the ongoing challenges persist, I believe there will be more chances to act. The good news is that we have the capital to take advantage of them. As always, we are being very disciplined with our M&A activities, but we believe opportunities are on the horizon.

Okay. Great. Thank you.

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

Thanks. Good morning. Mark, I know you put it in the Q, but can you front run and give the actual balances for escrow deposits in 1031 as of the end of the quarter?

Yes. Thanks, Jeff. At the end of the quarter we had $2.1 billion of 1031 exchange deposits. Was that your question, 1031?

Yes, that's part of it. Do you have the escrow as well?

I'm sorry. Yes. We had about $10 billion in total escrow deposits.

So that's flat?

Sequentially, it was about $11 billion. Yes. We're reviewing our bank balances, and the reported book balance has a slight timing difference. By the end of the year, we had $11.0 billion in escrow bank balances, while as of March 31, we recorded $10.3 billion. So those figures are down sequentially, specifically for escrow.

Okay. Your net investment income was down significantly. What yield are you getting on 1031? It seems like there’s a substantial change with a $700 million decline in 1031 balances, especially since your balance sheet assets have increased while your escrow remains unchanged. Can you elaborate on that?

The average rate we're seeing on 1031 right now is about 4.5 for the quarter. Generally, we receive Fed funds for our 1031 business, which fluctuate throughout the quarter.

And how does that compare to escrow?

Escrow, we're getting about Fed funds as well, same thing, maybe a little bit less. So we get probably a little bit more on 1031, but it's generally about Fed funds.

Okay. All right. And then, the other question, obviously, you just talked about M&A and having the capital for that. How do you weigh buyback capital return in a tough macro environment? Last year you indicated you were going to increase that activity you did. How do you think about that in the current macro challenges?

Yes, Geoff, this is Ken. I mean, listen, our priorities always remain the same. One is to reinvest in the business, which, as we've talked about a couple of times today, we're doing with Endpoint and title decision and other innovations and strategic initiatives and then M&A, which I talked about earlier. And then, thirdly, returning capital to shareholders. With respect to repurchases, I mean, the current price is certainly attractive. In Q1, we repurchased over 550,000 shares. Last year we repurchased over 7% of our shares outstanding. But we're going to be opportunistic, given all the demands on our capital, including as I had mentioned our expectation that there's going to be some attractive M&A opportunities forthcoming.

Okay. Thank you.

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

Hey, guys. Good morning.

Good morning.

Hey. So back to the margin for Title, I mean if we back up the investment income impact and then if you add back the severance charge and then the $18 million in investment headwinds you guys called out, I'm getting to like a negative 2% kind of underlying Title pre-tax margin. I think you had to go back to 1Q 2009 so during the housing crisis to see a similar margin. On Mark's question you guys provided a couple of moving parts there, but I'm trying to get a better sense for maybe the excess costs you might be carrying because it does sound like you guys expect things to improve a bit on the resi side as well as commercial, which we agree with for sure. But as a hypothetical, if you looked at next year, next 1Q, if you just hold everything flat, what type of margin lift you think you might get from just kind of pairing some of these investments and then maybe taking cost actions if this current environment kind of holds?

There are a few points to consider, John. First, excluding our investment income means also setting aside the operating costs associated with the businesses generating that income. For instance, if we exclude all revenue from our bank, we still need to account for personnel and other operational expenses tied to the bank and our 1031 business, which makes it a bit more complicated. Additionally, our bank incurs interest expenses that also need to be considered. Reflecting on 2019, it's challenging since it's been quite a while since then. Regarding our margins, we expect to achieve double-digit margins this year, which we view as a positive result given the tough market conditions. Looking ahead to 2024, 2025, and beyond, we anticipate several factors will contribute to improvement. Firstly, we hope for favorable market trends. Secondly, our ongoing management of normal operating expenses should continue to yield positive results, as we've seen in the success ratio over the past few quarters. Lastly, we expect our strategic initiatives to bear fruit. Collectively, the highest margins we've recorded at our company are 15%, which we achieved in 2021. Though we are experiencing a downturn this year, we expect to move closer to that 15% margin in the coming years as these factors come into play.

Okay. That's a great point. I didn't really think about the incremental excess cost that kind of comes with that higher level of investment income. So that's a good point. On the outlook, Mark you mentioned kind of expectations for a baseline or the low point of like at least 10% Title pre-tax margin this year. I'm curious if that's 100% contingent on the resi market improving as well as commercial at least what you saw in 1Q, or do you think you'd still be able to get there with cost action as the market sags a little bit?

No, I would say that's assuming a pretty tough environment. We are currently in April, so we have visibility into June revenue based on the order count. For the first half, we have a good idea of what we'll achieve. The second half still holds some uncertainty, especially regarding commercial performance and the strength of Q4. However, the double-digit margin assumption doesn't take into account a market recovery. We are not anticipating a significant rebound in the residential sector. It assumes a stable purchase market with no increase in refinancing and some typical seasonality in commercial. Therefore, there are no aggressive assumptions in that outlook.

Okay. That's helpful. And one last question for me, just a housekeeping matter. With P&C now moved to Corporate, I want to clarify that. I noticed the $1.7 million in claims costs. How much additional expenses associated with P&C are now included in Commercial or rather in Corporate?

So for the quarter, we had about $5 million of losses at Corporate because of P&C. We think that's really going to narrow to a couple of million here in the next quarter or two. We don't have any remaining policies outstanding. We've got roughly about 300 claims that we're still kind of working through the pipeline and we just have very minimal operating expense. So I would say it's negligible from here on out.

Okay. Thanks guys.

Thanks, John.

There are no additional questions at this time. This 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 or by dialing 877-660-6853 or 201-612-7415 and then by entering the conference ID 13738122. The company would like to thank you for your participation. This concludes today's conference call. You may now disconnect.