Earnings Call Transcript - FAF Q3 2023

Operator, Operator

Greetings, and welcome to the 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/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 13741673. We will now turn the call over to Craig Barberio, Vice President, Investor Relations to make an introductory statement.

Craig Barberio, Vice President, Investor Relations

Good morning, everyone and welcome to First American's earnings conference call for the third 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 reflect or relate to strictly 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 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 presentations 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.

Ken DeGiorgio, CEO

Thank you, Craig. The rapid increase in interest rates to levels not seen in many years continues to produce challenging market conditions. With housing affordability currently at its lowest point in over three decades, existing home sales this year have declined to the slowest annual pace since the global financial crisis. Moreover, sales volumes in the commercial market have reverted to pandemic low levels and are down approximately 50% from the peak year of 2021. Despite these historically difficult conditions, our continued focus on expense management and strong growth in net investment income enabled us to deliver a pre-tax title margin of 12% on an adjusted basis. On a consolidated basis, we generated adjusted earnings of $1.22 per diluted share. Our residential purchase business continues to reflect these market headwinds, but appears to have stabilized at trough levels. For the first three weeks in October, open purchase orders are down 7% compared with September which is consistent with normal seasonality but are up slightly compared with the prior year. While this performance is mostly driven by a historically low comparison period, it also reflects the results of our industry-leading homebuilder division and is further indication that the market has stabilized. Refinance open orders remained at trough levels in the third quarter averaging 350 per day, a level they have held all year. Given the current pool of mortgage loans outstanding and the outlook for interest rates, it remains unlikely we will see a significant uplift in refinance in the foreseeable future. Our commercial business revenue declined 39% compared with last year, consistent with the first half of the year. Average revenue per order also declined again this quarter for the fifth consecutive quarter, which suggests that price discovery is well underway as the market corrects. Commercial open orders for the first three weeks of October are down 5% compared with last year and are down 3% sequentially. There is still a high degree of uncertainty concerning the commercial market. However, based on our market intelligence, we continue to expect higher commercial revenues in the fourth quarter which is consistent with the normal seasonal pattern. While our key purchase commercial and refinance markets appear to have troughed, we expect the difficult market conditions to persist well into next year. Despite the uncertainty of the timing of a recovery in these markets, the strength of our business along with our financial discipline and strong balance sheet allow us to continue to invest for long-term growth while returning capital to our shareholders. This quarter we raised our common stock dividend by 2% to an annual rate of $2.12 per share. We also repurchased $9 million of our shares in the third quarter and have accelerated our purchases in October already purchasing an additional $9 million of our common shares. In closing, given the importance of people to our business, I am pleased that First American has been named one of the best workplaces for women by Great Place to Work and Fortune Magazine for the eighth consecutive year. This accomplishment is a tribute to our workforce, approximately two-thirds of which are women. I'm proud that First American's commitment to advancing the careers of women and our world-class culture enables us to achieve this recognition year after year. Now I'd like to turn the call over to Mark for more detailed discussion of our financial results.

Mark Seaton, CFO

Thank you, Ken. This quarter we generated a loss of $0.02 per diluted share. Our adjusted earnings per share was $1.22. Our adjusted earnings exclude net investment losses of $164 million, primarily due to unrealized losses recognized in the venture portfolio and changes in the fair market value of equity securities, as well as purchase-related intangible amortization of $10 million. As of September 30th, the book value of our venture portfolio totaled $301 million, which equates to approximately 7% of our equity and 2% of our total assets. Revenue in our title segment was $1.5 billion, down 19% compared with the same quarter of 2022. Commercial revenue was $160 million, a 39% decline over last year. Our average revenue per order for commercial transactions declined 15% this quarter to $10,763 due to a combination of fewer large transactions and lower valuations as prices in the commercial market reset. Purchase revenue was down 15% during the quarter, driven by an 18% decrease in the number of orders closed, partially offset by a 3% increase in the average revenue per order. Refinance revenue declined 41% relative to last year due to the increase in mortgage rates. In the agency business, revenue was $665 million, down 27% from last year. Given the reporting lag in agent revenues of approximately one quarter, these results reflect remittances related to Q2 economic activity. Our information and other revenues were $240 million, down 14% relative to last year. This decline was the result of lower transaction levels across several business units driven by 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 $142 million, a 35% increase relative to the prior year. The increase was primarily due to rising interest rates, which drove higher investment income from the company's cash and investment portfolio, escrow balances, and tax-deferred property exchange balances. The impact of higher interest rates was partially offset by lower average balances primarily in the company's escrow and tax-deferred exchange balances. We continue to manage expenses given the decline in transaction activity. Our success ratio was 50%, meaning that our personnel and other operating expenses declined $127 million and our net operating revenue declined $253 million. The provision for policy losses and other claims was $35 million in the quarter, or 3.0% of title premiums and escrow fees, down from the 4.0% loss provision rate in the prior year and down from the 3.5% loss provision rate in the first half of this year. The 3.0% loss rate reflects an ultimate loss rate of 3.75% for the current year with a $9 million release for prior policy years. Over the last several quarters, we have highlighted the margin drag in the title segment related to three strategic initiatives: ServiceMac, Endpoint, and instant decision for purchase transactions. This quarter, these initiatives together generated a pre-tax loss of $12 million, impacting our pre-tax title margin by 110 basis points, an improvement from the 130 basis point drag in Q2, primarily driven by deep boarding fees received by ServiceMac. Pre-tax margin in the title segment was 10.5% or 12.0% on an adjusted basis. Total revenue in our home warranty business totaled $108 million, a 3% increase compared with last year. Pre-tax income in home warranty was $9.4 million, up 124% from the prior year. The loss ratio in home warranty was 55%, down from 59% in 2022, driven by lower frequency and severity of claims. The effective tax rate for the quarter was 29.4%, higher 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 pays state premium tax in lieu of income taxes. In the third quarter, we repurchased 161,000 shares for a total of $9 million at an average price of $57.87. So far in October, we have ramped up our purchases buying 162,000 shares for $9 million at an average price of $52.90. Our debt-to-capital ratio as of September 30 was 29.7%. Excluding secured financings payable, our debt-to-capital ratio was 23.5%. Now I would like to turn the call back over to the operator to take your questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Thank you. Our first question comes from the line of John Campbell with Stephens. Please proceed with your question.

John Campbell, Analyst

Hi guys. Good morning.

Ken DeGiorgio, CEO

Good morning.

Mark Seaton, CFO

Good morning, John.

John Campbell, Analyst

Hey. I just want to make sure I heard you correctly on the order commentary for October. You said that purchase is trending up year-over-year thus far in October?

Mark Seaton, CFO

Yeah. So purchases, it's up slightly for the first three weeks in October, very slightly. And a lot of it is driven, because included within the purchase transactions is resale which is most of them. And we also have New Homes and New Homes is performing pretty well. So when you mix those two together, yes we do have a slight increase in purchase which is again nice to see the lines cross here.

John Campbell, Analyst

Yeah. Absolutely, I mean just given the backdrop of continued upward pressure on rates, that's a great outcome. New Home sales I think maybe a little bit less than 10% of the national mix. What does that look like for you guys a little bit higher?

Mark Seaton, CFO

It's a little bit higher. Historically, the long-term average is about 13% of our purchase orders related to new homes. So far in October, that figure is 19%, which is a bit above average. Our mix is slightly higher than usual.

John Campbell, Analyst

Okay. Thank you.

Ken DeGiorgio, CEO

I'd add to that John. I mean one thing to keep in mind, we have an outsized share of the market in New Home, which obviously is a good competitive advantage for us.

John Campbell, Analyst

Yeah. Absolutely. And then last question here on the interest expense. That's obviously been up a good bit the last two quarters. I wanted to get a better grip on that. I know that's influenced by the bank deposits. So maybe if you could unpack that kind of you could decouple those two items just underlying interest expense versus the bank effect? And then how we should be thinking about the run rate of interest expense here just assuming that rates stay near current levels?

Mark Seaton, CFO

When reviewing the interest expense in our Corporate Segment, it typically amounts to around $12 million to $13 million each quarter, mainly due to the interest on our bonds. Additionally, we incur interest expense in our Title Segment, which is primarily influenced by the cost of funds in our banking operations, including our First American Trust and warehouse lending business. These are the two main components that contribute to the $23.5 million of interest expense reported in the Title Segment this quarter.

John Campbell, Analyst

Okay. That’s helpful. Thank you, guys.

Mark Seaton, CFO

Thanks, John.

Ken DeGiorgio, CEO

Thanks, John.

Operator, Operator

Our next question comes from the line of Soham Bhonsle with BTIG. Please proceed with your question.

Soham Bhonsle, Analyst

Hey guys. Good morning. Hope you are doing well.

Ken DeGiorgio, CEO

Good morning.

Soham Bhonsle, Analyst

I would like to begin with a question about investment and interest income. Mark, could you provide us with an update on the year? Additionally, can you help us understand what needs to be replaced due to the roll-off in ServiceMac and how quickly you can accomplish that? Thank you.

Mark Seaton, CFO

Thank you for the question, Soham. Looking at the year so far, with three quarters completed, we anticipate that investment income may decrease slightly in Q4, by around $5 million, give or take. This is primarily due to the loss of Home Point loans that we have discussed in previous quarters. Over the past month, we’ve seen approximately $300 million in deposits related to those loans, which were contributing to earnings. This will create a headwind for our investment income in the fourth quarter. However, it's important to note that about 75% of this decrease will be mitigated by a reduction in interest expenses within the title segment, meaning only about 25% of the decline will impact our bottom line.

Soham Bhonsle, Analyst

Okay. And then, on Endpoint Ken, I think you've previously talked about the opportunity there sort of being twofold right? Like, where you could potentially get some efficiency gains but then there's also sort of this enabling of better customer service. I was hoping you could maybe dig a little bit deeper on the efficiency piece of the value proposition there. What sort of efficiencies do you sort of envision? And how does that maybe translate to margins versus call it the legacy title business?

Ken DeGiorgio, CEO

Yeah. Thanks for the question. I mean, I think it's early days to exactly measure the efficiencies. But we anticipate sort of increasing the efficiency of an escrow officer fairly substantially. Again, it's hard to put a number on that at this point. But we know there will be efficiency gains as we automate some of the more mundane tasks that an escrow officer does and free them up to do the more people-intensive tasks. There are also other efficiencies that we'll gain. And we have already started gaining from Endpoint just by deploying some of their technology in other parts of our company. We've mentioned in the past about JOT, which is our Mobile Notary Management Systems. We relied on third parties for that in the past. We're now able to do it more efficiently in-house and have made a lot of progress rolling that out in the direct division. It will probably be fully rolled out in the direct division sometime next year.

Soham Bhonsle, Analyst

Okay. And just one more Mark, I think on the loss provision rate I guess you lowered it 25 basis points. But as we sort of go into next year and we potentially are in a more sort of uneven macro environment right? I mean, how are you thinking about that line I guess?

Ken DeGiorgio, CEO

This is Ken. I'll start on that. And yes, we did lower the loss rate. And one thing I'll point out, as you recall during the pandemic we actually took the rate up, which I think reflects our pretty conservative approach when it comes to building our reserves. The concerns we had when we did that in the pandemic didn't come to fruition. Some of the concerns we had during the current market also haven't come to bear. So we've built an extremely healthy level of reserves. In fact, we're probably pushing the upper bounds, I mean, and I want to emphasize the upper bounds of reasonableness. We think it was the right time to decline it. We obviously continuously monitor our reserving level. The situation could change. But I think more directly to your question, I think you could probably expect this rate to prevail at least through 2024.

Soham Bhonsle, Analyst

Okay. Great. Thanks a lot.

Operator, Operator

Our next question comes from the line of Bose George with KBW. Please proceed with your question.

Bose George, Analyst

Hey, good morning. So the first question just on the deboarding fees from ServiceMac how much was that this quarter? And is there more of that to come before that fully rolls off?

Mark Seaton, CFO

Yes. Hi. Good morning, Bose. So this quarter we had a $3 million benefit because of deboarding fees. And roughly about 40% of the loans were deboarded. So we have another call it 60% to come at some point next year. We're not exactly sure about the timing.

Bose George, Analyst

Thanks. Can you discuss the priorities for capital return? Will we see an increase in the pace of buybacks? Also, from a leverage perspective, is that something you are considering? I’m interested in your broader thoughts on this.

Ken DeGiorgio, CEO

Thanks for the question. I'll start Bose. Obviously, as we talked about earlier, we've accelerated the pace of buybacks. We've already in October bought back shares at the same pace we did in the entire third quarter. And right now I think our stock is attractive. We've accelerated repurchases and we think it's very attractive. But obviously we weigh repurchases against other uses of capital such as reinvesting in the business and M&A. But we're obviously committed to returning capital to our shareholders and we think buybacks right now are a pretty attractive alternative.

Mark Seaton, CFO

And Bose, I'll just comment on the debt leverage part of that question. So our debt to cap we look at it excluding secured financings payable because there’s sort of gross up there. And if you do that it's 23.5% this quarter, we've talked about like 18% to 20% being our long-term target. But we're very comfortable, especially here at the trough of the market being higher than our target. So 23.5% is a very comfortable place to be. I think particularly since when you look at the balance sheet we've got $1 billion of AOCI and we feel really great about the credit there. So we think that's temporary and now I'll just kind of help our debt to cap as we go along. So we're in a very comfortable place in terms of our debt right now.

Bose George, Analyst

Okay. Great. Thanks. Just one more. In terms of investment income, if the investment income is coming from deposits at your bank versus escrow that you send to third parties, does it make a difference on the return or are you kind of agnostic in terms of that? Or could you sort of increase one or the other if the returns are better?

Mark Seaton, CFO

There is a difference. I mean, typically, when we give our deposits to third-party banks, the general rule of thumb is that we'll typically earn Fed funds. When we invested at the bank our cash that's at the bank will earn Fed funds. And then the rest of it, most of the escrow deposits we push to the bank, we buy mortgage-backed securities. And so we're really getting kind of a mortgage-backed security rate as opposed to Fed funds. And sometimes that could be higher and sometimes that could be lower. And Fed funds right now is lower just because of the fact that rates have risen.

Bose George, Analyst

Okay. That's helpful. Thanks a lot.

Mark Seaton, CFO

Thanks, Bose.

Operator, Operator

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

Geoffrey Dunn, Analyst

Thanks. Good morning.

Mark Seaton, CFO

Good morning, Geoff.

Geoffrey Dunn, Analyst

I'm hoping you could talk a bit about the commercial market. In particular where are the large deals down the most? I'm assuming it's office but I'm interested in a little more color. And more importantly where are the areas that you're seeing opportunity versus drag outside the office market?

Mark Seaton, CFO

This quarter, we had four significant deals exceeding $1 million, compared to seven a year ago. The number of large deals has decreased, and among those we're seeing, about half are in the multifamily sector. We also had one deal related to a development site, but overall, large deals are not as prevalent this quarter. In terms of our key asset classes, multifamily represents 22% of our commercial revenue, and activity in this area is strong. Industrial remains robust, contributing 17% to our revenue, while development sites account for 16%. These are our top three sectors. Retail makes up 10%, and office contributes 5%. There are additional asset classes to consider, including energy and hospitality, but these are the main ones driving our revenue.

Ken DeGiorgio, CEO

I would add that in terms of the outlook for asset classes, the more attractive options are likely to be those where we have already seen significant price discovery, such as suburban office, multifamily, and energy, which is expected to be a major asset class for us. When I mention suburban office, I mean properties located outside of major central business districts, which are currently facing challenges for various reasons.

Geoffrey Dunn, Analyst

Great. So as you look out to 2024, your commentary is cautious in your press release. What is your number one concern? Is it commercial? Is it direct resi? What one is more uncertain at this point in your mind?

Ken DeGiorgio, CEO

Well, I mean I'm uncertain and concerned about all of them, except refi, I know that's not going to get better. So I think there's concern in all of them. I think if you have forced me to weigh the two, I'm probably a little more optimistic about Commercial, just because I feel like we're making our way through this price discovery. And I think we anticipate to see transaction levels tick up a little bit in commercial next year albeit, keep in mind at lower prices. So we'll see more orders, but they'll be at lower prices given this price discovery. But we're cautious about all of it into 2024. Now we may get some relief if interest rates go down, when I last checked the forward curve which was yesterday, I don't know where it is today, where they had three rate decreases next year beginning in the middle of next year. Now the forward curve is historically inaccurate. But if that comes to fruition, that will help but that's middle to end of next year.

Geoffrey Dunn, Analyst

All right. Okay. Thank you.

Operator, Operator

Our next question comes from the line of Mark Hughes with Truist Securities. Please proceed with your question.

Mark Hughes, Analyst

Yeah. Thank you. I'm not sure if this may be too granular, but I'm curious whether you saw any impact in the purchase market through these weeks of October, with the interest rate fluctuations.

Ken DeGiorgio, CEO

No, we haven't seen it, Mark. It's a bit surprising because our purchase orders have been following the typical long-term seasonal pattern all year. On the residential side, our purchase orders are currently at low levels, but they haven't worsened. They are declining now due to seasonality. However, for the past 9.5 months, they have aligned with the usual seasonal trend, which is unexpected, especially considering that mortgage rates have risen to about 8% in the last 90 days. To answer your question, we have not observed any decline in purchase orders due to the recent rate fluctuations.

Mark Hughes, Analyst

In the warranty business, I've heard you mention that direct-to-consumer has been a strong channel, even though real estate is weak. How is that performing? Are you seeing success there?

Ken DeGiorgio, CEO

Yes, we are generally seeing success with direct-to-consumer. When we increase our marketing expenses, we notice an immediate impact on contracts and direct-to-consumer, although it takes some time to see profitability. In the home warranty area, they have effectively managed claims during inflation, which has been beneficial. While frequency is down due to fewer policy counts, severity is also down. Over time, we're seeing the benefits of some pricing actions we've implemented. We are very optimistic about home warranty and the progress that team has made in the direct-to-consumer channel. There is significant opportunity there.

Mark Hughes, Analyst

Understood. And then finally, any update on instant decisioning either from the rollout potential benefit expense standpoint?

Ken DeGiorgio, CEO

Yes, it's still early days, but we expect to begin testing in two markets at the start of next year. They are meeting their milestones, and we are optimistic about that. Additionally, as we have noted previously, the great advantage is that it is challenging to accomplish without the necessary data, and we possess more data than anyone else. Therefore, it is trending well.

Mark Hughes, Analyst

Thank you very much.

Ken DeGiorgio, CEO

Thanks, Mark.

Operator, Operator

Thank you. We have reached the end of the allotted time we had for questions. And 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 enter the conference ID 13741673. The company would like to thank you for your participation. This concludes today's conference call. You may now disconnect.