First American Financial Corp Q3 FY2024 Earnings Call

Greetings, and welcome to First American Financial Corporation Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. A copy of today's press release is available on First American's website at www.firstam.com/investors. Please note that this call is being recorded, and we 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 13749447. We will now turn the call over to Craig Barberio, Vice President, Investor Relations, to make an introductory statement. Please go ahead.

Good morning, everyone, and welcome to First American's earnings conference call for the third 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 facts. These forward-looking statements speak only as of the date they are made, and the company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. Risks and uncertainties exist that may cause results to differ materially from those set forth in these forward-looking statements. For more information on these risks and uncertainties, please refer to yesterday's earnings release and the risk factors discussed on our Form 10-K and subsequent SEC filings. Our presentation today also 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 yesterday'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. In the third quarter, we benefited from measured improvement in market conditions. Our adjusted revenue was up 4%, the first year-over-year growth we've experienced since the second quarter of 2022. And our adjusted earnings per diluted share were $1.34, an increase of 10%. Title premiums and escrow revenues were up across all key business lines, but most notably in our commercial division where revenues were up 19%, also the first increase since the second quarter of 2022. Growth in commercial revenue was driven by a sharp increase in the fee per file to which an 80% increase in large transactions contributed. In the purchase market, demand started to pick up late in the quarter with a decline in mortgage rates to around 6% ahead of the Fed's 50 basis point cut in mid-September. Demand, however, softened as mortgage rates backed up 50 basis points soon after the Fed meeting and other factors impacting affordability persisted. As a result, our closed purchase orders per day this quarter declined 2% compared with last year. While continued, albeit moderating, home price appreciation was one of the factors that negatively impacted affordability. It did drive an increase in our average revenue per order and a resulting 3% increase in our purchase revenue. Closed refinance orders were up 12% in the third quarter with transaction activity increasing as the quarter progressed. The improved order flow combined with a higher fee per file resulted in a 20% increase in our refinance revenue. Although our title segment investment income declined this quarter compared with last year, it grew sequentially as we began to realize the benefit of our investment portfolio rebalancing project. Mark will discuss that in greater detail in his remarks. Our Home Warranty segment delivered an adjusted pre-tax margin of 7.7%, down from 9.3% last year. Though a slight improvement in the claims rate helped the margin, we deliberately increased marketing spend in our direct-to-consumer channel. This direct-to-consumer investment is expected to drive increased profitability as the lifetime value of new contracts is realized over time. As we've discussed on prior calls, we are committed to developing innovative proprietary technologies that promise to boost our productivity and enhance the customer experience in ways that will create a sustainable competitive advantage. We believe, however, that an opportunity exists to reduce our technology spend without compromising on this commitment by centralizing, standardizing, and simplifying our technology operations. We have already implemented certain changes that have reduced costs and we expect to realize additional benefits as we make further progress in this effort. Turning to the outlook for the remainder of the year. We expect challenging conditions in the purchase market to persist. For the first three weeks of October, our open purchase orders are down 3% though our open resale orders are up 1.4%. The refinance market should continue to improve though off a low base. Our refinance business accelerated in the first three weeks of October with open orders up 76%. And we remain optimistic that the commercial business will perform well in the fourth quarter given higher term refinancing demand, continued progress on price discovery and our own robust pipeline of large transactions. As we indicated last quarter, we expect that modest revenue growth for the full year of 2024 will enable us to achieve title margins similar to what we posted in 2023. We now have stronger conviction in that outcome given the recent performance of our commercial business and the increase in interest income resulting from our portfolio rebalancing project. The first year-over-year growth in revenue in nine quarters that I mentioned earlier coupled with our expectation that affordability challenges will gradually abate also make us cautiously optimistic that we are in the beginning stages of a new cycle that will drive further improvement in 2025. While we have been operating through a cyclical downturn since the Fed began its historic interest rate hike cycle in early 2022. Our operating strength and strong balance sheet has enabled us to make meaningful investments in our business while maintaining our commitment to return capital to shareholders. Since the beginning of 2022 we have repurchased 10 million shares for a total of $574 million at an average price of $57.74 per share. During the same period we have also increased the common stock dividend by 6% to an annual rate of $2.16 per share. In closing, I would like to comment on the widespread damage and devastation that the recent hurricanes inflicted across several Southeastern states. Many of our employees and the communities in which they live have endured profound hardships. While we are grateful that all of our people are safe, we know that many now face the difficult task of recovery. I want to thank our people for all they have done to lend a hand to those impacted and to reiterate our company's commitment to support our people and their communities. 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 a GAAP loss of $1 per diluted share. Our adjusted earnings, which exclude the impact of net investment losses and purchase-related amortization, was $1.34 per diluted share. During the third quarter we rebalanced our investment portfolio by selling certain debt securities in an unrealized loss position. Our net realized investment losses of $312 million this quarter were primarily due to this rebalancing. As a result, we expect to save $90 million of cash taxes in the near term and we expect to increase investment income by approximately $67 million per year beginning in Q4 by reinvesting the proceeds in higher-yielding securities. The average duration and credit quality of the portfolio is unchanged as a result of this rebalancing. Turning to our title segment. Revenue was $1.3 billion, down 15% compared with the same quarter of 2023. Excluding net investment losses, revenue increased 4% from last year. Purchase revenue was up 3% during the quarter, all driven by an improvement in our fee per file. Commercial revenue was $190 million, a 19% improvement over last year. Though our closed commercial orders fell 5%, the average revenue per order for commercial transactions surged 23%. Refinance revenue climbed 20% relative to last year. Despite growth in order activity, refinance still accounts for just 5% of our direct revenue. In the agency business, revenue was $684 million, up 3% from last year. Given the reporting lag in agent revenues of approximately one quarter, these results primarily reflect remittances related to Q2 economic activity. Information and other revenues were $242 million during the quarter, up 1% compared with last year due to an uptick in the demand for the company's information products. Investment income was $136 million in the third quarter, down $5 million compared with the same quarter last year due to lower average interest-bearing escrow and tax-deferred property exchange balances. However, our investment income was up $11 million on a sequential basis. As I mentioned earlier, we expect our investment portfolio rebalancing to generate approximately $67 million of additional interest income per year beginning in the fourth quarter. We estimate that the third quarter benefited by $8 million related to this initiative as we ramped up fixed income security purchases throughout the quarter. We'd like to provide a little more visibility into our investment income line item going forward. In Q4, we now expect between $140 million and $145 million of investment income in the title segment. This includes the full run rate of our portfolio rebalancing projects. It also assumes a 25 basis point Fed cut in November and a second 25 basis point cut in December. Based on current average cash and escrow balances, we estimate that each 25 basis point cut in the Fed funds rate will reduce annual investment income in the title segment by $15 million. The provision for policy losses and other claims was $37 million in the third quarter or 3.0% of title premiums and escrow fees unchanged from the prior year. The third quarter rate reflects an ultimate loss rate of 3.75% for the current policy year and a net decrease of $9 million in the loss reserve estimate for prior policy years. Adjusted pre-tax margin in the title segment was 11.6%, excluding both net realized losses and purchase-related amortization. Total revenue in our Home Warranty business totaled $111 million, up 2% compared with last year. Pre-tax income in Home Warranty was $9 million, down 4% from the prior year. The loss ratio in Home Warranty was 54%, down from 55% in 2023 due to lower claim frequency that was partially offset by higher claim severity. Adjusted pre-tax margin in the Home Warranty segment was 7.7% compared to 9.3% last year. The effective tax rate for the quarter was 28.4%. Excluding the impact of net realized investment losses and purchase-related amortization, the tax rate was 20.5%, lower than our normalized rate of 24% due to $6 million of research and development and foreign tax credits recognized during the quarter. Our debt-to-capital ratio as of September 30th was 34.8%. Excluding secured financings payable, our debt-to-capital ratio was 26.6%. In September, we raised $450 million in a public offering of 10-year senior notes. $300 million of the proceeds will go toward paying off notes that mature on November 15th of this year. Now I would like to turn the call back over to the operator to take your questions.

Thank you. We’ll now be conducting a question-and-answer session. The first question comes from the line of Bose George with KBW. Please go ahead.

Hi, everyone. Good morning. I wanted to start with just a question on margins. In the past, you guys did give ranges for what you thought margins could be. Can you just give us an update on where you think that range is? And what do you see as kind of a normalized margin if home sales sort of get back to some normal level?

Thank you for the question. I'll begin by stating that we have strong confidence in our margin outlook for this year, particularly due to the performance of our commercial business. We anticipate further improvement in 2025. However, I'm not entirely sure what a normal market looks like anymore. What I can say is that we will revisit the margin once we have a better understanding of how 2025 develops.

Okay. Great. And then actually just the comment, I think Ken you mentioned earlier on tech spend. So it sounds like there could be some cost savings. Can you sort of discuss that and tie that into the impact that the endpoint in instant titling had this quarter? Are those two kind of related in terms of the tech spend?

Yes. As I mentioned, we see a significant opportunity to reduce technology spending without compromising the innovative work we are doing and the progress we are making. We believe there is potential to centralize, standardize, and simplify our operations, which will help lower costs. In fact, we have already noticed some cost reductions primarily from transitioning high-cost external partners to in-house developers. We are currently conducting a zero-based budgeting review, evaluating all our projects to identify ways to enhance efficiency and assess the return on our investments. However, we are not slowing down. We remain committed to our escrow efficiency initiatives and the Sequoia project, and we will continue to advance those efforts.

Okay. Great. Thanks.

Thank you. Next question comes from the line of John Campbell with Stephens Inc. Please go ahead.

Hey guys, good morning. On the rebalancing efforts so $67 million annualized impact. That's obviously a really good addition to the P&L, so great work there. I'm thinking that this uptick does not have a corresponding effect on interest expense, but I wanted to check on that first.

Yes, you got that right, John. No effect.

Okay. And then, it sounds like you guys are I think you mentioned cautiously optimistic about a turn in the cycle or beginning stages of the turn of the cycle. I think we typically agree with you guys there. But if we assume enough growth next year where the success ratio is going to actually matter, would you guys expect to manage to that historical success ratio? Is it possible you might be able to move a little bit higher than that next year?

I think in general, John, as a general statement, I mean we stand by the 60% target. Of course, there's a lot of differences and a lot of it depends on how much our revenue will grow next year. We've got tailwinds in commercial. We've got tailwinds in purchase. We've got tailwinds in refi. We've got tailwinds in investment income. And so, if there's, in theory, if there's small changes in revenue, then you get some funky outcomes with the success ratio. But if revenue grows more than let's say 5% or so, then I think the success ratio really comes into play. And so, we stand by that at least heading into next year.

Okay, that's great. If I could squeeze in one more. I'm just curious about the direct-to-consumer efforts within Home Warranty. If maybe you could size up the higher marketing spend. I don't know if you can maybe talk to the LTV-to-CAC framework. And then, just maybe more broadly the long-term opportunity you see for Home Warranty.

Yes, as I mentioned, we made an investment this quarter and have made previous investments in direct-to-consumer spending. We are strategic about these investments, considering the costs tied to generating leads and the conversion rates from those leads. We believe this is a solid long-term investment, but it typically takes about a year to fully appreciate the value of these investments. Therefore, it's still early for us to assess the impact and value of our recent direct-to-consumer investments. We are monitoring the situation closely and believe that, given the current cost of leads, it is wise to keep investing.

Okay. And if I could just ask one more thing. How do you measure success in that venture? Do you believe it is significant enough to significantly boost growth over the next couple of years?

Are you talking about in the direct-to-consumer channel in Home Warranty?

Right.

We think that's where the opportunity is, particularly given that the purchase market is under such pressure. So in our real estate channel where we're selling through real estate agents in connection with home transactions and given the pressure in that market, we think there's real opportunity in the direct-to-consumer channel. Keeping in mind, there's a lot of open space in the Home Warranty business. Not many homes have home warranties on them. So, we don't have to go chase down customers from our competitors in order to realize a competitive advantage in that business because there's a lot of open space.

Okay, great. Thanks guys.

Thank you. Next question comes from the line of Terry Ma with Barclays. Please go ahead.

Sorry, I was on mute. Thank you. Good morning. So, it seems like the reinvestment of the repositioning of the investment portfolio the $67 million benefit will mostly just kind of offset the first 50 basis point rate cut and then the two more anticipated ones. Is that a fair way to kind of think about it? And then as we kind of look forward to 2025, are there any other actions that you can kind of take to optimize or get more out of your investment portfolio to maybe offset any additional rate cuts?

First of all, Terry, yes, that's the right way to think about it. I mean for every 25 basis points in the Fed funds rate, right now given where our current balances are, we expect a $15 million reduction in investment income. So, really the $67 million benefit we're going to get will basically fund at least 4-plus Fed cuts. Now, there's a lot of other factors too. I mean one thing that could offset that is if we have rising commercial volumes next year and purchase volumes that will generate additional investment income and that could insulate some of these Fed cuts that might come our way next year. So, that's kind of how we think about our investment income.

Got it. Okay, that's helpful. And then any other color you can provide on what you're seeing in commercial so far this quarter? Anything that kind of gives you confidence that the momentum you saw in the third quarter will continue?

Thank you for the question, Terry. I believe that the results we observed in the third quarter are significant indicators. Having the first year-over-year increase in revenue in our commercial business is definitely a positive sign. We're experiencing strong demand and making considerable progress on price discovery. Additionally, our pipeline of deals gives us a lot of confidence. In fact, during the first three weeks of October, we've also seen an increase in revenue. While we understand that things can change and the market is volatile, we feel optimistic about the remainder of the year in our commercial business.

Got it. Okay, that’s helpful. Thank you.

Thank you. Next question comes from the line of Mark DeVries with Deutsche Bank. Please go ahead.

Yes. Thanks. First question on the securities reposition; is there more that you might look to do in 2025 or are you kind of positioned now the way you want to be?

I would say the bulk of it is done. There is still some that we could consider doing. However, the potential losses from that could be about $100 million, and we haven't made a decision on whether to proceed with it yet. Most of the work has already been completed.

Okay. And then I think you alluded to some potential offsets on investment income from higher commercial and/or purchase. Can you help us think through which is more impactful, if either one is, in terms of like incremental volume from commercial versus purchase?

In terms of investment income, commercial real estate is more valuable to us. This is primarily because the deals tend to be larger, and they generally take longer to finalize compared to residential transactions, which allows us to hold the deposits for a longer period. We estimate that approximately 60% of our escrow deposits are related to commercial real estate, making it a significant factor in our overall escrow deposits.

Okay. Got it. And then just last question. Are you seeing any signs that efforts by certain lenders to kind of use Attorney Opinion Letters as an alternative title is gaining traction in the market?

I believe we've observed a slight increase in the use of Attorney Opinion Letters, but it's quite minimal. Ultimately, when lenders and others understand that these letters do not expedite the attorney's opinion process, which is actually slower than underwriting a title policy, they realize they may not be superior due to limitations in coverage and the potential need to pursue legal action against the attorney for malpractice. Additionally, considering the loan-level price adjustments often associated with these letters, they are not more cost-effective. Therefore, while we might see a minor increase in the use of Attorney Opinion Letters, it has not yet had a significant impact.

Got it. And ALTA obviously is making quite an effort in D.C. to kind of educate policymakers around the value of title versus AOLs. Ken, any sense on how much traction they're getting and how effective they are in kind of moving perceptions?

I believe the key indicator will be the outcome of the election. There has been some progress with options like AOLs and title waivers, but we've seen significant resistance from regulators and lawmakers, including members of Congress. Our trade group has been effective, and I feel that legislators and regulators have started to recognize the importance of title insurance compared to these alternatives. It's crucial for us to stay alert and continue promoting the benefits of title insurance. I genuinely feel that our industry is making headway in this regard.

Thank you.

Thank you. Next question comes from the line of Mark Hughes with Truist Securities. Please go ahead.

Yes. Thank you. Good morning. On the commercial side, any particular end-markets or property types where you're seeing the price discovery proceed? Or you talked about a healthy pipeline of larger transactions, any more on the mix of that?

Yes. We're seeing price discovery, and a lot of this is anecdotal, but we're seeing it across the board. Obviously, the one asset class that continues to struggle, as you'd expect, is office, particularly CBD office. Suburban office is probably doing a little better. But the one thing I'll point out, that the nice thing about our commercial business markets, we're pretty diversified. We have a strong presence in all asset classes. So we're not buffeted for better or for worse by any one asset class. We're in the mall and we're in the mall pretty deep.

Yeah. When you see kind of an uptick in the size of transactions like this, is it just the normal variability, or were these deals that are hanging on the sidelines waiting for a little better interest rate environment? What do we make of that?

It's a hard thing to determine in terms of what our future fee per file is. I mean year-to-date through June, our commercial revenue was down 2%, and we just saw it surge here 19% in Q3. And so sometimes those things are difficult to forecast. But we're seeing broad-based strength, and as Ken said, we're really optimistic heading into Q4. But we don't really know what our fee per file is until we get the deals in the door on the open size, and then we can somehow predict. But predicting anything further than a quarter is tough to do in commercial in terms of the fee per file.

Yeah. Anything on the CFPB front from a regulatory perspective? Anything there?

We haven't received much information regarding the CFPB lately. I don't believe they have overlooked our concerns. As I mentioned earlier, I anticipate that after the election, we might observe an increase in activity from the CFPB. The Request for Information is still active and our industry has responded to it. For the time being, they seem to be concentrating on other areas, but I don't think for a moment that they have forgotten about us.

Yeah. Okay. Thank you very much.

Thanks, Mark.

Thank you. Next question comes from the line of Geoffrey Dunn with Dowling & Partners. Please go ahead.

Thanks. Good morning. Given the change in the sales approach in Home Warranty, can you talk a bit about how you think about the strategic value of the platform to the company?

I wouldn’t describe it as a change in the sales platform; rather, it's an evolution. One competitor, in particular, has been quite aggressive and has done well with direct-to-consumer sales. However, we have been working on it as well and are increasing our investment. I see it more as an evolution than a change. We are confident in the business. It may be somewhat distant from our core title and settlement operations, but we see significant potential, especially considering how under-penetrated the market is. Though the real estate segment of that business is currently struggling along with the purchase market and title companies, I believe that once the purchase market rebounds, our expertise and strong presence in the real estate sector will benefit this business.

All right. Thank you.

Thank you. There are no additional questions at this time. That concludes this morning's 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 entering the conference ID 13749447. The company would like to thank you for your participation. This concludes today's conference call. You may now disconnect.