First American Financial Corp Q1 FY2024 Earnings Call

Greetings, and welcome to the First American Financial Corporation First Quarter Earnings Conference Call. 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 this call is being recorded and will be available for replay from the company's investor website and for a short time by dialing (877) 660-853 or (201) 612-7415 and enter the conference ID 13745815. And we will now turn the call over to Craig Barberio, Vice President, Investor Relations, to make an introductory statement.

Thank you, operator. Good morning, everyone, and welcome to First American's earnings conference call for the first quarter of 2024. 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 yesterday's earnings release and the risk factors discussed on 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 risk and reconciliation to the most directly comparable GAAP financials, please refer to yesterday's earnings release, which is available on our website at www.firstam.com. I will now turn the call over to Ken DeGiorgio.

Thank you, Craig. Market conditions in the real estate and mortgage industries continued to be a challenge in the seasonally weak first quarter. Elevated mortgage rates and low, albeit growing inventory levels have caused transaction volumes to remain near historically low levels. During this period, we've maintained our focus on managing operating expenses while continuing to invest in long-term strategic initiatives, such as expanding our title plant assets and building technology solutions to increase efficiency, reduce risk and enhance our customers' experience. Although our financial results this quarter were a function of the tough mortgage origination market, we have recently started to see signs of a measured recovery. In March, our open resale orders per day were up 5%, and that positive trend has continued so far in April with open resale orders up 2%. Growth in our resale orders so far this year is the first positive change we've seen in this key market since June of 2021. We are also seeing improvement in our commercial business with open orders up 1% in the first quarter, and we have seen further growth in April with open orders up 5%. Our home warranty segment had another strong quarter, delivering a pretax margin of 19% and is positioned well for future growth. On our last earnings call, we stated that we expect modest revenue growth this year and that we can achieve title margins similar to what we posted in 2023. After closing the books on the first quarter and looking at the order pipeline in April, our expectations remain unchanged. I'd like to take a moment to address the recent attention our industry has received from Washington, D.C. This attention is the product of a broader effort, an effort that all of us at First American wholeheartedly support to make the purchase of a home more affordable. However, the focus on our industry reveals that as an industry, we need to do a better job educating policymakers and other stakeholders about the critical role title insurance plays in protecting people's investments in their homes, which are the primary vehicle for wealth creation for the majority of Americans. This role includes not only paying claims when they arise, but also the extensive work we do to correct title defects before the transaction closes, the cost of which is not reflected in our industry's claims rate. This important curative work protects consumers and lenders from hundreds of billions of dollars of title risk exposure per year. Moreover, title and settlement fees are among the smallest cost components over the life of a mortgage and, as a result, are not a barrier to homeownership. The discussions in Washington are still in the early stages, and we believe that ultimately, our industry will be successful in reaffirming the value of title insurance to policymakers. But irrespective, we are uniquely positioned to meet the demands of an evolving market because of our growing leadership in title data, which is fueled by our proprietary data extraction technology, our national closing platform and deep distribution relationships, our extensive underwriting expertise, our commitment to and continued investment in cutting-edge technology such as Endpoint, our digital settlement platform and automated underwriting for purchase transactions and, most importantly, our world-class workforce and culture, which recently resulted in our recognition as one of the 100 best companies to work for by Great Place to Work and Fortune Magazine for the ninth consecutive year. Though we are the leader in the digital transformation of our industry, fundamentally, we are a people business, and it is the quality, talent and dedication of our people that ensure our company's long-term success. 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 generated earnings of $0.45 per diluted share. Our adjusted earnings per share, which excludes the impact of net investment gains and purchase-related amortization, was the same as our GAAP earnings at $0.45 per share, as $0.07 of realized gains were offset by $0.07 of purchase-related amortization. Turning to our Title segment, revenue was $1.3 billion, down 2% compared with the same quarter of 2023. Purchase revenue was up 2% during the quarter, driven by a 2% increase in the average revenue per order. Commercial revenue was $143 million, a 4% decline over last year. Though our closed commercial orders fell 4%, the average revenue per order for commercial transactions increased 1%. Refinance revenue declined 13% relative to last year. With mortgage rates hovering around 7%, they are still at levels materially above what is needed to generate a significant rise in refinance activity. In the Agency business, revenue was $564 million, down 5% from last year. Given the reporting lag in agent revenues of approximately one quarter, these results primarily reflect remittances related to Q4 economic activity. Our information and other revenues were $217 million, down 2% relative to last year. This decline was primarily due to an increase in the capture rate of title premiums from an affiliated title agent, which caused a decline in information and other revenue and a comparable increase to direct premium and escrow fees. Investment income within the Title Insurance and Services segment was $117 million, down $8 million relative to the prior year due to lower average interest-bearing balances in the company's escrow and tax-deferred property exchange business that were partly offset by higher interest income from the company's warehouse lending business. The provision for policy losses and other claims was $29 million in the first quarter or 3.0% of title premiums in escrow fees, down from the 3.5% loss provision rate in the prior year. The 3.0% loss rate reflects an ultimate loss rate of 3.75% for the current year with a $7 million release from prior policy years. Over the last several quarters, we have highlighted the margin drag in the title segment related to both Endpoint and instant decisioning for purchase transactions. Together, these two strategic initiatives reduced our pretax margin in the title segment by 150 basis points this quarter. Pretax margin in the Title segment was 5.5% or 4.8% on an adjusted basis. These margins reflect a $6.2 million write-off of uncollectible balances impacting the margins by 50 basis points. Total revenue in our home warranty business totaled $105 million, a 1% increase compared with last year. Pretax income in home warranty was $20 million, up 28% from the prior year. The loss ratio in home warranty was 42%, down from 47% in 2023, driven by lower frequency and severity of claims. Adjusted pretax margin in the home warranty segment was 18.8%, up from 15.2% in 2023. The effective tax rate for the quarter was 19.9%, lower than our normalized rate of 24% due primarily to research and development tax credits recognized during the quarter. In the first quarter, we repurchased 58,600 shares for a total of $3.5 million at an average price of $59.37. Our debt-to-capital ratio as of March 31 was 30.3%. Excluding secured financings payable, our debt-to-capital ratio was 22.5%. Now I would like to turn the call back over to the operator to take your questions.

The first question comes from the line of Bose George with KBW.

I wanted to first ask just about investment income. I mean, Mark, you noted the reduction year-over-year was lower escrow and I think on 1031 balances. Can you just dig into some of the drivers of that?

Sure, Bose. So one of the things we've seen here as interest rates have risen is that more of our customers are electing to earn interest on their escrow deposits. We have two basic types of deposits, savings deposits and checking deposits. More of our customers are electing for savings deposits. This should really have an impact on our investment income because we can monetize savings deposits when a lot of our peers can't because of our bank. But another dynamic that's happening in addition to the shift to savings deposits is that more of those savings deposits are going to third-party banks as opposed to our own bank, First American Trust. A lot of it is really the economic reasons because third-party banks will pay a higher rate than First American Trust. So if we have a higher mix of our deposits at third-party banks, we can earn interest on those. When you look at the total mix of deposits that we don't earn interest on today, it's 30%. A year ago, it was 18%. So that mix shift has been a little bit of a headwind for us for investment. The second factor, of course, is just that 1031 business volumes are lower today than they were a year ago.

Yes. Great. That's helpful. And just to be clear, is it the commercial customers who have the ability to kind of direct that escrow versus residential? Or how does that work?

Everybody has the ability to do it, whether you're a consumer or a large commercial client; you have the ability to request a savings account, but typically commercial customers are the ones that really drive that trend.

Okay. Great. And then just in terms of expectations for that investment income line item for the remainder of the year, can you just talk about that?

Yes, sure. So when we look out over the next couple of quarters, we think our investment income in the title segment will be somewhere between $120 million and $125 million per quarter. We'll probably be at the higher end of that range in Q2 and a little bit lower as the year goes on in that range. This assumes a couple of things: one, just the normal seasonality of the business; typically, Q1 is kind of a low point in terms of investment income because escrow balances are lower there. The second thing is we expect the home point balances to leave somewhere around Q2, creating about $20 million of annualized investment income. This will also be roughly the same in annualized interest expense. So it sort of washes on a net basis. But if you're just looking at our investment income, it will go down about $5 million a quarter once we lose those balances. The third factor we assume is just two Fed rate cuts. Now I know I was looking at this morning in markets assuming one Fed rate cut, but we're looking for two. Mixing all of that together, we think we should be somewhere between $120 million and $125 million per quarter in the title segment.

And the next question comes from the line of Terry Ma with Barclays.

Can you maybe just speak at a high level about your confidence level in achieving the revenue growth and margin guide? It's a pretty uncertain macro and interest rate outlook.

Yes, Terry, thanks for the question. This is Ken. Yes, I mean, listen, we think that the challenging conditions will persist for the year though we think 2024 will be slightly better. I have a high degree of confidence in that. But again, I want to emphasize it's slightly better. We look at things like the commercial business. While it was weak in the first quarter, we're seeing open orders, as we mentioned, up 1% in the quarter, up 5% in April so far. In the commercial business, our ARPO will have the typical seasonal decline; however, it is up 1% over the prior year, which suggests that maybe the price discovery has concluded or at least is well along the way. I noted that there was an article in the Wall Street Journal earlier this week about Blackstone thinking that commercial real estate is at the bottom. Obviously, they have their finger on the pulse of the commercial real estate market, which gives us some confidence in the purchase and commercial market. On the purchase market, affordability will continue to be a challenge with mortgage rates and prices, along with low supply. However, we are seeing some green shoots with open resale orders up 5% in March and 2% so far in April. Again, we're confident that 2024 will be better than '23, but it won't be meaningfully better.

Got it. That's helpful color. And then my second question, just on the margin drag from Endpoint and instant decision. I think you said it was 150 basis points this quarter. I think you guys quoted 130 last quarter. So what drove the delta? And how should we think about that drag evolving throughout the rest of the year?

Really what drove the drag was we had a little bit less revenue at Endpoint and a little bit more expenses at both Endpoint and our instant decision for first transactions. We're making a lot of progress with both. The drag should be less going forward just because Q1 is typically the lowest revenue. The fact that our revenue at the title segment is expected to improve from here on out should reduce the drag as well.

And the next question comes from the line of Soham Bhonsle with BTIG.

Mark, I just want to dig a little bit into the margin guide. So if I sort of take what you're implying, right, sort of flattish margins for this year, that would imply margins for every quarter sort of going forward are just, I guess, higher from last year to hit that double-digit margin. Can you just walk us through some of the moving parts? I think you just mentioned some of the drag factors, but a little bit more detail would be helpful.

Yes, sure. So with our margin outlook, there are a few things going on. Just to reiterate, we think that the margins will be comparable to last year. It's still early in the year, and things are still in motion. On the positive side, we're off the bottom now. We're finally seeing open orders up, which bodes well for later in the year. After two years of negative growth, we anticipate growth in our core businesses of purchasing and commercial. We have tailwinds concerning the loss rate and many of the cost-cutting efforts we did last year. We do have headwinds, such as about $20 million more in depreciation this year due to some capital expenditures we've made previously, and some of our benefits and 401(k) matches getting reset. There are also some headwinds with respect to investment income. I think the second quarter will be challenging to exceed our results from last year, but we expect the margins in the second half of the year to be better than we had last year. Combining all of that, we should be in line with last year's performance.

Okay. Got it. And then just on investment income. So you noted noninterest-bearing deposits moving to third-party banks. In your guide of $120 million, are you assuming that trend continues, or do you see more normalization?

Yes, thanks for that. First of all, they're interest-bearing accounts that are going to these third parties. I just want to clarify that. In our guide, we don't assume that the 30% mix will change. That's a risk. If the 30% continues to climb, that's going to be a risk to our $120 million to $125 million guide. We're also in the early stages of developing plans to reverse that trend by offering higher rates at our bank. So we believe maintaining that 30% mix of third-party accounts is a reasonable assumption, but it could fluctuate depending on market conditions.

Our next question comes from Mark Hughes with Truist Securities.

More detail you can discuss on the potential regulatory changes if buyers are not required to purchase title insurance, but it's bundled in with the mortgage. How do you view that as a competitive evolution in the business?

Yes. And I assume you're talking about the CFPB request for information prohibiting lenders from passing through the cost of title. This has been attempted before by HUD and it didn't gain traction. A significant reason likely is the lack of transparency. Policymakers prefer that borrowers know exactly what they're paying for, as ultimately, borrowers will still pay for lenders' title insurance policies, which would just be wrapped up in the interest rate or loan-level price adjustments. Therefore, I don't think this will significantly impact the lender side of our business or the industry.

The commercial ARPO, you suggested that was an indication that price discovery is progressing. Was there a shift to larger deals due to price discovery?

Yes. The larger deals are always a component we monitor. We had four so-called mega deals with premiums over $1 million in the most recent quarter, which affects the commercial ARPU. We believe that after several quarters of declines, commercial ARPU has finally leveled off, reflecting the bottoming we've seen on the residential side.

Yes. And then purchase ARPO, there wasn't much movement, but last quarter it was up 4%. Any detail on that? Was there just a geographic mix shift?

It’s a combination. Housing prices are still rising, and given where housing prices are, we would expect kind of a 2% fee per file. The mix can also affect this; if we have significant business in California, for example, that has a higher fee per file, that could drive things as well. However, it's primarily related to current housing prices.

Our next question comes from the line of John Campbell with Stephens.

Just back to the transition of the home point loans. It sounds like you're expecting some of that offboarding to take place in Q2. Will that be the bulk of it? And can you maybe talk to the offboarding fees, their size and timing?

Yes. Thanks, John. Today, we have roughly $380 million of deposits, and we think that around $50 million will leave around May 1, and $330 million will leave on July 1. At that point, we won't have any more home point loans. As I mentioned earlier, losing those deposits at our bank will equate to $20 million of annualized investment income and about $20 million of annualized interest expense as well.

Are there fees associated with that offboarding that are paid to you?

There are deboarding fees, but they're pretty minimal, less than $1 million. So they're not material.

That's helpful. And then from a CapEx standpoint, last quarter, Mark, I think you mentioned expecting $30 million of relief just from winding down some software projects. Obviously, that's ramped and you expect higher depreciation from here. What are you expecting for overall CapEx for this year? And do you have visibility on next year?

We believe our CapEx has peaked. Last year, we were at $260 million. We expect CapEx will decline somewhere between 15% and 20% this year. A lot of this shift is due to the initiatives we've been pursuing; we're currently operating more efficiently. We've found that hiring great tech talent and engineers has improved our product development over relying on third parties. This transition is showing early signs of success, which will also have a cost-saving effect, specifically regarding CapEx. So we're projecting a 15% to 20% decline this year while still making all the necessary strategic investments.

That's helpful. And if I could squeeze in one more. Did you comment on the April refi month-to-date orders?

The April refi orders are running at about 371 per day, which is consistent with where it was last year and about 6% over last month.

There are no additional questions. That also 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 entering the conference ID number 1345815. The company would like to thank you for your participation. This concludes today's conference call. You may now disconnect.