First American Financial Corporation
Q3 2008 Earnings Call Transcript

Published: 31 Oct 2008

[Operator:]

Good morning and thank you all for holding. At this time, I would like to inform our participants that your lines have been placed on listen-only until the question and answer portion of today's conference. [Operator Instructions]. Also, today's call is being recorded. If you have any objections, you may disconnect at this time. Also, a copy of today's press release and the accompanying presentation are also available at the company's website at www.firstam.com/investor. And I would now like to turn the conference over to Jo Etta Bandy, Senior Vice President of Corporate Communications to make an introductory statement. Thank you, ma'am. You may begin.

[Jo Etta Bandy:]

Thank you. Good morning everyone and we appreciate you joining us on this morning's third quarter conference call. At this time, we would like to remind listeners that management's commentary and responses to your questions may contain forward-looking statements such as those described on page two of the company's slides and other statements that do not relate strictly to historical or current facts. The 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. Factors that could cause the anticipated results to differ from those described in the forward-looking statements are described on slide 2. As indicated on slide 3, management's commentary and responses to your questions also contain certain financial measures that are not presented in accordance with Generally Accepted Accounting Principles. The company does not intend for these non-GAAP financial measures to be a substitute for any GAAP financial information. In the slide presentation, these non-GAAP financial measures have been presented with and reconciled to the most directly comparable GAAP financial measures. Investors should use these non-GAAP financial measures only in conjunction with the comparable GAAP financial measures. Joining us on today's call will be our Chairman and Chief Executive Officer, Parker Kennedy; Dennis Gilmore, First American's Chief Operating Officer; Frank McMahon, our Vice Chairman and Max Valdes, Chief Financial Officer. During the call, we will be referring to a slide presentation which is currently available on First American's website at firstam.com/investor. At this time, it is my pleasure to turn the call over to Park Kennedy.

[Parker S. Kennedy:]

Thank you Jo and thank you to everyone on the call. Please direct your attention to slides 4, 5 and 6 of our presentation. During the third quarter of 2008, we posted adjusted earnings per share of $0.19. This result includes on an after-tax basis net realized investment losses of $29.6 million employee separation and other restructuring costs of $12.3 million, a reduction in employee benefit costs of $6 million and a reduction in a reserve for estimated tax exposure of $10 million. Including these items, our GAAP loss per share was $0.09. In light of market conditions, our Title Insurance business achieved strong operating results with an adjusted pre-tax margin of 3.2%. Our loss provision increased slightly from 6.2% last quarter to 7.1% this quarter, primarily due to an adjustment to the ultimate loss ratio for policy year 2008. We experienced minor adjustments for policy years prior to 2008. Generally speaking, our loss reserves remained stable during the quarter. During '06 and '07, we booked a total of $520.9 million in reserve strengthening adjustments and based on our claims experience to date, we are comfortable with the level of our claims reserves. Dennis and his team continue to react quickly and assertively with expense controls. The Information Solutions company posted adjusted EBITDA of $102 million during the quarter. Our mortgage risk analytics and default-related businesses continue to post solid growth. Our cash flow and liquidity at the holding company remains strong. In the third quarter of 2008, cash flow from operations totaled $115 million. We have $160 million available on our credit facility, which is due in 2012. We have $150 million of senior debentures due in 2014 and an additional $100 million of senior debentures due in 2028. Our debt to capital ratio is 22.4%, a conservative level given the current mix of our businesses. As previously announced, we wrote off $34.8 million due to the impairment of investments in Fannie and Freddie preferred securities. Although this impairment was disappointing, our investment portfolio remains sound. 73% of our portfolio is held in assets guaranteed by the U.S. government. We have $150.2 million of non-agency mortgage-backed securities, over 90% of which are rated AAA today. We have no subprime exposure, no asset-backed commercial paper and just $5 million of auction rate securities. We continue to operate in a difficult real estate market. The Mortgage Bankers Association recently revised its forecast for Q4 of '08 and for '09. The MBA predicts that mortgage originations in dollar terms will decline 21% in Q4 of '08 when compared to Q3. The MBA anticipates a further decline of 7% from Q4 of '08 to Q1 of '09. Thereafter, the MBA anticipates an increase of over 40% for Q2 and Q3. This could provide relief from the steady declines we have experienced over the last year. In sum, the next two quarters are predicted to be slow and we continue to reduce expenses as quickly as we can. At this point, I will turn the call over to Dennis Gilmore who overseas our Financial Services Group.

[Dennis J. Gilmore:]

Thank you, Park. Our Title Insurance segment continues to make progress towards our goal of becoming the most profitable company in the title insurance industry throughout the cycle. During the quarter, our Title Insurance segment posted a GAAP pre-tax loss of $27 million. However, this does not reflect the significant operating improvements the company has made during the quarter. The current quarter's results include a net realized investment loss of $44.6 million, lease termination costs of $5.5 million and severance costs of $8.6 million. Excluding these charges, our pre-tax income for the Title Insurance segment was $31.7 million, representing a pre-tax margin of 3.2%. These operating results and in the face of an extremely challenging market condition, are evidence of the meaningful progress the company has made to rationalize its cost structure in 2008. The structural changes we have made and will continue to make throughout the organization will position us well when the market rebounds. Please direct your attention to page 9 of the earnings presentation for information on the Title Insurance segment. The company closed 323,000 title orders during the third quarter, a decline of 22% relative to the third quarter of 2007. Direct revenue declined 23% over the prior year due to decreases in the number of title orders closed and the average revenue per order. Our average revenue per order declined 1% relative to the prior year, primarily as a result of declines in the average resale value and mortgage amounts. This was offset, though, by improvements in our mix versus resale versus refinance. Our agency revenue declined 37% over the prior year. This decline was the result of the same factors affecting our direct operations as well as termination of certain agency relationships. Our salaries and other personnel costs decreased 25.5% over the prior year. During the third quarter, the Title Insurance segment reduced its number of employees by approximately 1250, producing an annualized cost savings of $65.9 million. There are $8.6 million of severance costs associated with the third quarter employee reductions, and we continue to manage our labor costs aggressively and expect continued reductions during the fourth quarter. Other operating expenses declined 20% over the prior year. The primary driver in the decline in other operating expenses were decreases in our occupancy costs, our production costs and our other cost containment programs. The company closed 68 offices during the third quarter, yielding an annualized savings of $6.3 million. These savings represent lease expenses only and do not include property taxes, utilities and other expenses associated with occupying office space. The company has identified an additional 30 offices that will be closed by the end of the year and continues to seek office consolidation opportunities where appropriate. By the end of 2008, the company will close 365 offices. Our loss provision for claims was 7.1% of our operating revenue for the third quarter of 2008 versus 6.2% during the second quarter. The current quarter rate reflects expected claims experienced for policy year 2008 with minor reserve adjustments for prior policy year. The increase in loss provision was driven by a modification to our ultimate loss ratio for policy year 2008, which increased from 6.2% to 6.5% during the quarter. As of September 30th, we have booked our IBNR to our actuary best estimate. Turning to page 10, our total revenue in our National Commercial segment declined 34% relative to the third quarter of 2007. Our commercial transactions have declined due to the lack of available credit and wide valuation gaps between buyers and sellers. After several years of continuous growth, we expect the commercial market to remain challenging for the first half of 2009. Our international title insurance business generated revenues of $102.9 million, representing a 16.9% decrease over the prior year. The global financial turmoil has adversely impacted our international division. Our Canadian operations remain relatively strong due to the health of the Canadian marketplace. However, our UK and Australian operations have experienced lower volumes due to their economic environment. Despite the challenging economic conditions, our international division continues to generate meaningful earnings and remains core to our long-term growth strategy. Our total revenues for our Specialty Insurance segment were $72.8 million, a 12% decrease over the prior year. The decrease was primarily due to a decline in business volumes impacting our property and casualty insurance division and our home warranty division. The combined ratios for home warranty and property casualty insurance businesses were 106% and 83% respectively. Our pre-tax income for the segment was $316,000. Included in the Specialty Insurance segment was $3.1 million of net realized investment losses. Excluding these losses, our pre-tax income for the segment was $3.4 million. To summarize, we are managing through the current market with a keen focus on expense control. The outlook for the next six months remains challenging. Thus far in October, our open orders per business day are down 19%, lower than September, indicating a weak inventory of orders entering the fourth quarter. We will continue to adjust our expenses accordingly and have made several cost containment programs underway. We believe the company's leading market position and financial strength positions us well to navigate the current economic environment. I'd now like to turn the call over to Frank McMahon who will comment on Information Solutions company.

[Frank V. McMahon:]

Thank you, Dennis. Our third quarter results were impacted by meaningful declines in revenue of our mortgage origination-related products such as appraisal, flood and electronic title plan information. However, many of our products, in particular our default-related and mortgage risk analytics solutions, experienced excellent growth relative to the third quarter of 2007. In spite of the challenging external environment, we continue to make considerable progress toward our financial and operational objectives. We have begun to realign our organizational structure and streamline our operations to centralize more functions. This effort will allow us to optimize resource allocation, promote best practices and eliminate redundancy. In the third quarter, we announced our plans to consolidate a number of our product companies into two new verticals

[Operator:]

Thank you. We will now begin the question and answer session. [Operator Instructions]. Our first question comes from Nik Fisken with Stephens Inc. Please go ahead.

[Nikolai D. Fisken:]

Good morning everybody

[Parker S. Kennedy:]

Hi Nik.

[Nikolai D. Fisken:]

Can you walk us through what you are thinking and where you are going to spend the $200 million in cash that you have referenced in the press release?

[Parker S. Kennedy:]

Well Nik, this is Park. We look our capital every quarter and actually we look at it everyday and determine what the best use of the capital is. It's hard to say what we are going to do with it. It's probably not a bad time to hold on to a little bit of it and just make sure we're in good shape from a financial standpoint no matter where the market goes. But we'll keep an eye on it and we'll do what's best for the shareholders and what's best for the company. That's not a very interesting answer, I'm sorry.

[Nikolai D. Fisken:]

Got it. Well, and you guys have done a great job cutting heads and consolidating facilities and I applaud you for it. Can you kind of walk us through what inning you think we're in and what's left to do?

[Dennis J. Gilmore:]

Yes, this is Dennis. Let me start with the title company. We've been very focused on our operating metrics all year long. We'll continue to be very focused on our operating metrics going through the next two quarters. Clearly, it's going to get tough over the next two quarters with what the MBA is predicting. I'm not going to give you an exact inning because it's a long game, let's put it that way. But we are going to continue to do what we've done throughout the year into the fourth quarter. And we still have room, we still have opportunities and we are focused on those right now. We're also very focused on productivity, Nik. What we look at was a couple of things. First, our open orders per employee, which is an internal statistic, we've gained productivity gains... we have productivity gains every quarter on a sequential basis year-over-year. And we're looking to match that in the fourth quarter. That will be difficult, but we are looking to match that. Also, we look very, very closely Nik at our operating ratios on labor and OpEx. I think we are in a position now where we may be industry leading on those ratios. So we'll be very focused on those also going through the fourth quarter. And so again, hunker down to the fourth quarter and prepare for the first and second of '09.

[Frank V. McMahon:]

On the Information Solutions side, the way we're looking at next year is we're not expecting a recovery of those businesses that will benefit from the type of environment that we're in today which would our risk analytics and our default loss mitigation businesses. We continue to invest in those and the businesses that will be hampered by an environment of low originations, we'll continue to adjust our cost structure in those businesses.

[Nikolai D. Fisken:]

Dennis on the title side, did you think we have collapsed the regional state and kind of middle management title team you had set up there?

[Dennis J. Gilmore:]

Well, we've done I think a pretty good job through the year. We've got a very, very focused management team and what we've done is worked to simplify our organizational structure really throughout the year. And we're down now to our core operating groups. Those core operating groups have responsibility for large parts of the country or specialized products. So there is still a little more to go there and we're going to always be focused on optimizing our organizational structure. But we've made pretty significant changes through the past year.

[Nikolai D. Fisken:]

And Frank, can you give us some detail on the second lien product?

[Frank V. McMahon:]

Sure. I mean Dennis has commented earlier in the year that the title company basically changed the second lien product. We wanted to make sure that we had our... gave our clients ample notice there, so that was announced mid year. And so there is a product redesign that's occurred, and that has been introduced to our client base. We expect that redesign product to have much better underwriting results going forward and the plan was for ELS to become an agent and be at the information company and for the title company to be the underwriter. But the expectation is that the underwriting results will be much better with this new product that will be introduced 1/1/09.

[Nikolai D. Fisken:]

Okay.So that kind of loss should be expected for 4Q?

[Frank V. McMahon:]

We would hope it would be better than the third quarter, but we won't see a complete change until 2009.

[Nikolai D. Fisken:]

Okay. Last thing I've got is can you give us some specifics in... I think somewhere I read that you had some market share gains on the tax side.

[Frank V. McMahon:]

Yes. We already have a pretty commanding number one position in that business, but two very, very large lenders have decided to convert from other tax service providers to our company. And those conversions are in process and will happen in the fourth quarter of this year and first quarter of next year.

[Nikolai D. Fisken:]

Great, thank you.

[Parker S. Kennedy:]

Thank you.

[Operator:]

Thank you. Our next question comes from Nat Otis with KBW. Please go ahead.

[Nathaniel Otis:]

Good morning gentlemen.

[Parker S. Kennedy:]

Good morning.

[Frank V. McMahon:]

Hi Nat.

[Nathaniel Otis:]

First question, one of your competitor is already out there talking about the possibility for maybe increasing title premiums kind of on a national go forward basis. Just wanted to see if you had any commentary on premium increases across the board.

[Dennis J. Gilmore:]

Sure, Nat. First of all, we have an obligation to make sure that our premiums are adequate, that they are not excessive and they are not discriminatory. And then we go through and we do that process every quarter. We've done that for years and we'll continue to do that. Now if we think there's a situation where premiums maybe low, we will deal with individual insurance agency or department on a one off basis and that'll be more of a private discussion, not a public discussion. So now we're comfortable where we are and we're going to continue to look at our rates just overall across the country.

[Nathaniel Otis:]

Okay. Just then maybe any color with your thoughts on where rates could go in some of the promulgated states that might be reviewing where premiums could go in the next year or two?

[Dennis J. Gilmore:]

I really don't want to comment on that. Again, it's a state-by-state evaluation and we'll look at them state-by-state and we'll work with the insurance commissioners where appropriate.

[Nathaniel Otis:]

All right, fair enough. Just a quick comment here on the commercial business. You've talked about it obviously weakening right now and into the first half of '09. Any commentary? Fourth quarter usually is a quarter that you can actually see a little bit of uptick as people try to close transactions before the end of the year. Any chance of seeing that type of seasonality this year or is it just kind of wait and see what goes on in the fourth quarter?

[Dennis J. Gilmore:]

I don't want to answer and look too optimistic. I think we'll have some commercial closings like we normally do in the fourth quarter. But it's a tough environment right now with what happened in the credit crisis. So, again, like all other businesses, we're just watching our expenses and prepared for a tough two quarters ahead of us.

[Nathaniel Otis:]

All right. And then just on the Specialty business, you were talking... talked about revenues being down, and it looked like the expense base was relatively stationary. Any thoughts on ways you might be able to cut the expense base there if revenues continue to fall?

[Dennis J. Gilmore:]

Yes, thanks. We are working on that right now and we are really focused on our home warranty company. But we've done some employee reductions in that company over the last quarter. We are looking at the overall business mix in that business right now and the states we are operating in and we are pretty focused on our average claim cost there too. So a lot of focus going on at home warranty, and I do think there is opportunities to improve that business on a go forward basis even in this difficult environment.

[Nathaniel Otis:]

Okay, great. And just one last kind of clean up question. That tax exposure reserve reduction, where did that come out of? Was that in corporate? I didn't see it in presentation where it would have come out of, the $10 million.

[Parker S. Kennedy:]

Yes, what that was is really a reduction in a reserve for uncertain tax positions. And it deals with our business in India. And what it represents is the Indian taxing authorities have proposed a higher transfer price on what we've been using. And so we've been accruing to that potential exposure. And then what happened during the period, well, and that exposure includes tax and penalties. And then during the quarter, we got some new facts that companies with similar issues have worked their differences through the administrative process in India and they've reached favorable outcomes. So we reduced that tax exposure.

[Nathaniel Otis:]

Okay.So that... okay so that would have been in then your title segment, the tax benefit?

[Parker S. Kennedy:]

It's really in Information... if you are trying to apply it to either Information Solutions or title, it would be Information Solutions.

[Nathaniel Otis:]

Okay, alright. Great, thank you.

[Parker S. Kennedy:]

You're welcome.

[Dennis J. Gilmore:]

Thank you.

[Operator:]

Thank you [Operator Instructions]. Our next question comes from Jason Delu [ph], Piper Jaffray. Please go ahead.

[Unidentified Analyst:]

Thank you and good morning.

[Unidentified Company Representative:]

All right.

[Parker S. Kennedy:]

Good morning Jason.

[Unidentified Analyst:]

I just want to dig into the FinTech businesses a little bit more. On the default services business, what's the revenue growth outlook for that? It's already grown nicely. I'm trying to get a sense for how much more growth runway you think is left.

[Frank V. McMahon:]

Jason, it's Frank. We think there is quite a bit of growth left and it's important to note that both of our companies, both the title company as well as the information companies have meaningful default-related revenue. And in total between the two companies, we had $144 million of default-related revenue, and that was up 41% year-over-year. Given the level of foreclosures that are expected in 2009 going into 2010, given the amount of loss mitigation work that we think servicers are going to go through, we do not see that business slowing down over the next four quarters probably.

[Unidentified Analyst:]

Okay. Thanks, that's helpful. And then in that data and analytics I mean in the tax in flood and default services businesses what's the margin decline sequentially the adjusted margin down 17.7%. There is a lot going on and that with the volumes declining and the tax and flood. So you got mix issues under revenue, you got restructuring. What, I mean what do you think, where do you think the margin can go from here? As given what we saw in the third quarter?

[Frank V. McMahon:]

Well. We don't give guidance, but you are right, there is some mix issues there. Tax and flood are some of our most profitable businesses from a margin perspective. So as you see those businesses decline and you see some of the collateral valuation and even some of the default businesses, not all of them, but some of them have lower margin. So as you see that mix change, then that will put some margin pressures on us. So we still have our goal... our goal is to have all of our businesses try to get in total to 20% EBITDA margins, and so those are our goals. Those are our long-term goals. We are not going to hit that every quarter. We are going to have to deal with fluctuations quarter-to-quarter, but we will continue to take steps so that over long term, we think we can hit those goals.

[Unidentified Analyst:]

On the tax and flood business since you're gaining some market share, do you have some pricing power there too? And then is there any way you could give us some sense for the dollar revenue you think the conversions could bring?

[Frank V. McMahon:]

Yes, I would say that the reality given what's going on with our clients. They're looking to produce cost everywhere they can. So we don't feel like we have in the short-term meaningful pricing power. So we are going to continue to try capture share in the market. And I would say on the tax side, both of those are multi-million dollar relationships. But I don't think we'll provide anymore information than to say they are significant.

[Unidentified Analyst:]

Thanks. And then on the TARP, I mean when do you expect to hear from that and can you give us any sense? I mean it's obviously very early, but I mean this could be a sizeable opportunity for you. Can you give us a sense on what you guys expect from this?

[Frank V. McMahon:]

Yes. As I am sure you know, the Treasury has shifted course a little bit and they have dedicated most of their time and energy over the last few weeks to the process of infusing capital into financial institutions of all types and have kind of slowed down the RFP process to select managers for both the home loan and the securities program. To be a manager of those program, you have to be a financial institution. So we've had direct conversations with Treasury. We have also had conversations with all of our good clients that we think are pretty well positioned to be those managers. But there has not been a set... a date set to select those managers, and I think that's the next step in the process. We continue to have discussions and make sure that we are well positioned when that process accelerates. But right now, it seems to be a little bit on the back burner and the government seems to be more focused on the capital infusion program.

[Unidentified Analyst:]

Thanks. And then just lastly on the provision rate, you had 6.2% last quarter, or 7.1% this quarter because of 2008. I mean what can we expect going forward? What's a more appropriate rate?

[Dennis J. Gilmore:]

Yes, this is Dennis. You should model out at 6.5% on a go forward basis for policy year 2008.

[Unidentified Analyst:]

Thank you very much.

[Parker S. Kennedy:]

Thank you, Jason.

[Operator:]

Thank you. That's all the time we have for questions today. That concludes this morning's call. We'd like to remind listeners that today's call is available for replay by dialing 203-369-0172. Copies of the press release announcing First American's second quarter results and the slide presentation are available on First American's website at www.firstam.com/investor. The company would like to thank you for your participation. That concludes today's conference call. You may now disconnect. .