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Executives

Craig Barberio - Director, IR

Dennis Gilmore - CEO

Mark Seaton - EVP and CFO

Analyst

Mark DeVries - Barclays Capital

Brett Huff - Stephens

Eric Beardsley - Barclays Capital

Geoffrey Dunn - Dowling & Partners

First American Financial Corporation (FAF) Q4 2013 Earnings Conference Call February 13, 2014 12:00 PM ET

Operator

Welcome and thank you all for standing-by. At this time, all participants are in a listen-only mode. We will have a question-and-session at the end of the discussion. (Operator Instructions) 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 a replay from the Company’s investor website and for a short time by dialing in 203-369-0421.

We will now turn the call over to Craig Barberio, Director of Investor Relations, to make an introductory statement.

Craig Barberio

Good afternoon everyone, and thank you for joining us for our Fourth Quarter and Year-End 2013 Earnings Conference Call. Joining us on today’s call will be our Chief Executive Officer, Dennis Gilmore; and Mark Seaton, Executive Vice President and Chief Financial Officer.

At this time, we’d like to remind listeners that management’s commentary and responses to your questions today may contain forward-looking statements, such as those described on Pages 4 and 5 of today’s news release, and other statements that do not relate strictly to historical or current fact. 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 these forward-looking statements are also described on Pages 4 and 5 of today’s news release.

Management’s commentary contains, and responses to your questions may also contain, certain financial measures that are not presented in accordance with generally accepted accounting principles, including personnel and other operating expense ratios.

The Company is presenting these non-GAAP financial measures because they provide the Company’s management and investors with additional insight into the operational efficiency and performance of the Company relative to earlier periods and relative to the Company’s competitors. The Company does not intend for these non-GAAP financial measures to be a substitute for any GAAP financial information.

In today’s new release that we filed, which is also available on our website www.firstam.com, the non-GAAP financial measures disclosed in management’s commentary are 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.

With that, I’ll now turn the call over to Dennis Gilmore.

Dennis Gilmore

Thanks for joining our call. I’ll begin with a review of 2013 results followed by our fourth quarter highlights. I’ll also discuss our recently announced agreement to acquire Interthinx. And conclude with a few comments on our 2014 outlook.

Company revenues for 2013 were 5 billion, up 9% compared to 2012. Revenue growth was led by our Purchase business which grew by 26% as both transaction volumes and real estate prices increased in 2013. Commercial revenue grew by 23%, its strongest year ever. Refinance volumes were strong in the first half of 2013, but declined sharply throughout the second half of the year due to higher interest rates. Given this decline in refinance activity, the Company is focused on expense management, reducing headcounts by 1,300 during the third and fourth quarters. We finished the year with an EPS of $1.71 and the Title segment margin of 7.6%.

Turning to the fourth quarter, total revenues for the Company were 1.2 billion, a 4% decline compared to last year, driven by lower revenues in our Title segment. EPS was $0.48 per share. Title segment revenues in the fourth quarter were 1.1 billion, down 6% compared to the same period in 2012, with a pre-tax margin of 7.8%. Closed orders in the quarter were at the lowest level of the year, driven by a 61% decline in closed refinanced orders. In response to the sharp decline in volumes, headcounts were reduced by 600 in the fourth quarter and reductions continue into 2014.

However, the shift in the mix of Title revenues from refinance to higher premiums purchased and commercial transactions drove our average revenue per direct title order up 34% helping to offset a sharp decline in closed orders during the quarter.

Turning to our Specialty Insurance segment which had a strong quarter, total revenues in our property and casualty and our home warranty businesses were up 10% with a pre-tax margin of 17%. Last week we announced the signing of an agreement to acquire Interthinx, a leading provider of loan quality analytics, decision support tools and loan reviewed services for the mortgage industry. Interthinx is complementary to our quartile and settlement service business. It deepens our relationships with our lender clients, by expanding our current product offerings to include new solutions that solve critical compliance and loan quality needs.

The extensive market and regulatory changes over the past several years have led to a more demanding loan origination requirement. To help comply with these new requirements our clients have expressed a desire for tighter integration between loan origination activity, loan quality verification and title and settlement services. With the acquisition of Interthinx, First American will be in a unique position to provide the industry’s most robust loan quality solutions by providing fraud analytics, identity, income and collateral verification services.

This acquisition also represents a key step in our ongoing effort to leverage our significant data assets, and will enable us to create innovative solutions for the mortgage industry and enhance our title and settlement offerings. The early feedback from our clients has been extremely positive. This transaction is expected to be accretive to earnings this year with an anticipated closing by March 31st.

Our capital management strategy remains consistent; first, make value creating investments in our core business; second; continue to acquire businesses that fit with our core strategy, including companies that enhance our risk profile offerings; third, return access capital to shareholders through dividend and share repurchases.

Regarding the 2014 outlook, we expect volumes to soften relative to 2013 as a result of a weaker refinance market. We expect continued growth in our higher premium resale and commercial businesses. However, the strength of the purchase market will not be evident until we enter the spring selling season. We will continue to focus on gaining profitable market share and aggressively managing our expenses.

I’d now like to turn the call over to Mark for a more detailed review of our financial results.

Mark Seaton

Thank you, Dennis. Total revenue in the fourth quarter was 1.2 billion, down 4% compared to the fourth quarter of 2012. Net income was 52 million or $0.48 per diluted share, compared with net income of 93 million or $0.85 per diluted share in the same quarter of last year.

The current quarter results include net realized investment gains of 2.4 million and impairment of equity investments of 7.8 million which together reduce net income by $0.03 per diluted share, the fourth quarter of 2012 included net realized investment gains of $0.04 per share.

In the Title Insurance and Services segment, direct premium and escrow fees were down 12% compared to last year, due to a 35% decline in closed orders, driven by lower refinance volumes which were down 61% relative to the prior year. This decline in orders was partially offset by a 34% increase in the average revenue per order. The average revenue per order increased to $1,878 driven by the continued shift in the order mix to higher premium purchased and commercial transactions.

Additionally, the average revenue per order increased 4% for purchase transactions and 15% for commercial transactions, reflecting continued growth in real estate values.

Agent premiums were up 5%, reflecting the normal reporting lag in agent revenues of approximately one quarter. The agent split was 80.2% of agent premiums, unchanged from last year.

Information and other revenues totaled $144 million, down 11% compared to last year, driven by lower demand for the Company’s title plan information and default information products due to the slowdown in transaction activity during the quarter.

Personnel costs were 331 million, down 3% primarily due to lower incentive-based compensation. The Title segment reduced headcount by 600 in the fourth quarter. As a result the Company recorded $5 million of severance expense.

Other operating expenses were 207 million, down 2% from last year, primarily due to lower production-related expenses. The ratio of personnel and other operating expenses to net operating revenue was 77%.

In the fourth quarter, the provision for title policy losses and other claims was 56 million or 5.8% of title premiums and escrow fees, compared with a loss provision rate of 7.0% in the same quarter of the prior year. Incurred title claims in the fourth quarter continued to be in line with our expectations.

Pre-tax income for the Title Insurance and Services segment was 88 million in the fourth quarter, compared with 153 million in the fourth quarter of 2012. Pre-tax margin was 7.8%, down from 12.7% last year, primarily attributable to a decline in order volumes.

Turning to the Specialty Insurance segment, total revenues were 88 million, up 10% compared with the same quarter of the prior year, driven by higher premiums earned in both the home warranty and property and casualty business lines. The loss ratio for this segment was 53%, an increase from the 51% experienced last year. Our home warranty business had another seasonally strong quarter, which contributed to a pre-tax margin for the Specialty Insurance segment of 17%.

Net expenses in the Corporate segment were $18 million which includes 4 million of realized gains. In terms of cash flow, cash provided by operations was 133 million, down from 178 million in the fourth quarter of last year, primarily driven by a year reduction in net income from the prior year.

Capital expenditures were $26 million, the majority of which were related to fixed asset purchases and capitalized software.

Turning to capital management, debt on our balance sheet totaled 310 million as of December 31st. Our debt consists of 249 million of senior notes, 38 million of trust deed notes and 23 million of other notes and obligations. Our debt-to-capital ratio as of December 31st was 11%. To finance the Interthinx transaction, we intend to draw $150 million from our revolving credit facility.

On a pro forma basis, our debt-to-capital ratio will be 16%, and we will have 450 million remaining on our $600 million credit facility. However, we’re reviewing longer-term debt financing alternatives with the intent to enhance our holding company liquidity, and extend the duration of our liabilities.

Over the last few years, we have moved some of our operating subsidiaries, including home warranty, database solutions and certain title operations from being owned by our primary regulated insurance company, to directly under the holding company.

This allows dividends paid by these subsidiaries to flow directly to the holding company providing greater financial flexibility for capital management activities including acquisitions, share repurchases and dividends. We expect this reorganization to be substantially complete by year-end at which point we will have increased the annual expected divided payments from operating subsidiaries by approximately 50%.

I would now like to turn the call back over to the operator to take your questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) Our first question is from Mr. Mark DeVries of Barclays. Your line is open sir.

Mark DeVries - Barclays Capital

Yes, thanks. So, my first question is around expense management, I think you guys normally guided us to expect a expense ratio in kind of 60% range where in a quarter were expenses, if your revenues dropped you would look to take out $0.06 on every dollar from your expenses. You came up a decent amount of short of that this quarter, can you talk about why and kind of what the outlook is for expenses as we go into 2014?

Dennis Gilmore

Yes this is Dennis, thanks for the question. A couple of things, number one, we aggressively started lowering our headcounts in the quarter by 600 and we really won’t see the benefit of that until the first quarter and beyond. And by the way we think that’s in the $45 million to $50 million range just on the salaries alone there. The second thing is, we had a number of non-recurring items going on the other OpEx line to about 80 million in the quarter and then Mark can go into details if you want but those won’t reoccur in the quarter.

The third thing we had happening going on in the year and that impacted us in the second half as we’ve been aggressively adding to our revenue attached employee base and that’s always an investment in the business and we won’t see the benefit of that investment probably until ’14 as we’re looking for the return there, and just kind of wrap it all up we’re going to continue to aggressively manage our expenses across our revenue lines.

Mark DeVries - Barclays Capital

Okay. And Mark, could you give us on the detail on that non-recurring expense that Dennis...?

Mark Seaton

Yes. Well, in the quarter we had about 5 million of severance expense, we had a legal settlement of about $5 million and we had a premium tax true-up for $3 million that ran through the other operating expense line item. So, that was about $13 million of unanticipated items that hit in the fourth quarter.

Mark DeVries - Barclays Capital

Okay got it. That’s helpful. And next question just around commercial revenues, I mean that continues to surprise to the upside. Could you give us just some high level comments and kind of what your expectations are for that business in 2014 and 2015?

Dennis Gilmore

Sure, first of all we had great performance as our commercial grew companywide all through ’13. We actually had a record year on our commercial division in ’13. We clearly see the strength continuing going into ’14, I do think it will moderate after the ’13 growth, but we look for a strong ’14 and it’s really coming across all geographic areas and really almost all asset bases right now. So, we look for continued strength in commercial going into ’14.

Mark DeVries - Barclays Capital

I appreciate the conservative assumption that it’s going to moderate, but as we look out at just kind of CMBS maturities around for the next couple of years, it looks like there is a case to be made that it could accelerate I mean are you guys thinking about that at all and as you kind of plan for the next year?

Dennis Gilmore

We are, but again if we look back over the last couple of years, we’ve had growth rates compounding over 20% for the last couple of years. So, I do think that ’14 will -- I don’t know if ’14 is going to grow at that rate, I think it will definitely go down somewhat and I think the MBA right now if I am not mistaken is forecasting commercial to grow on a 7% rate in 2014.

Mark DeVries - Barclays Capital

Okay, got it. Finally just on your Interthinx acquisition, you talked a little bit about how you’re -- about Interthinx acquisition cost, expected synergies and how you’re going to be funding that?

Dennis Gilmore

Well, in terms of funding it, we’re going to draw 150 million from the line and we’re going to look to turn that net debt out with other debt instruments, we’re viewing alternatives right now. So, our debt to cap as I mentioned is going to go from 11% to about 15%. The acquisition itself, we’re looking at somewhere around 6 million to 8 million of cost synergies and there is going to be some one-time integration cost that hit in 2014, so obviously we’re not going to realize all those in ’14 but certainly by the time we get to ’15 we expect to capture those.

Mark DeVries - Barclays Capital

Okay. And in any chance for what the cost of that term debt might end up looking like?

Dennis Gilmore

It’s too early to tell right now. On our line we pay LIBOR plus 200 basis points. So, we’re probably somewhere north of that, but it’s too early to tell at this point.

Mark DeVries - Barclays Capital

Okay. Great, thanks.

Dennis Gilmore

Thank you.

Operator

Thank you. Then next question will be coming from Brett Huff. Your line is open sir.

Brett Huff - Stephens

Hello.

Dennis Gilmore

Good morning.

Brett Huff - Stephens

I want to get just a sense from you on what your -- can you give us more detail on your purchase outlook in terms of unit volume and/or home price appreciation just roughly. I’m not sure if you guys use the MBA sort of outlook or if you have a particular spin on it? And then particularly some seasonality, it seems that 1Q might be a little harder just given weather and et cetera? But any commentary on that would be helpful too.

Dennis Gilmore

Sure right now we’re forecasting off the MBA. They are looking at a 4% increase in the purchase transaction. I think that might be a little pessimistic, so we think it will be a tad better than that, we think. No question on how the year started a little rough because of the weather. Our orders have come in the line on our January forecast, but we really won’t know the overall strength of the purchase market until we get well into the spring buying season.

Bottom-line, we’re optimistic. We’re optimistic we’re going to continue to see growth there. We’re actually a little more optimistic again in the MBA. And we’re also thinking that we’re going to see some price appreciation again in’14.

Brett Huff - Stephens

Okay. And then Mark, getting to the question for you, the impairment is included in the 7.8%, it negatively impacted 7.8% Title pre-tax margin or did that run through Corporate?

Mark Seaton

Yes, the vast majority of that ran through the Title segment.

Brett Huff - Stephens

Okay. So, we thought that Title was a little -- our margin was a little light and I think that’s probably why. And then in terms of staffing cuts, Dennis, I think you mentioned that there is more to come. How do you guys kind of decide when it’s appropriate to cut or not, is there a metric that you look at or how does that kind of work internally when you debate number?

Dennis Gilmore

Well, I guess, not a lot of debate. What we do is we match our revenues against our expense lines. Obviously our early indicator would be orders per employee and foreseeing that drop we continue to adjust our staffs; what we do also is look at the business segment themselves. For example, as you would imagine our refinance businesses have taken the bulk of the staff cuts and at the same time we’ve added to our commercial population, so we’ll target in on the orders, we’ll target in on what type of orders they are.

Brett Huff - Stephens

Okay. And then two last questions for me; one, can you give us a revenue profit and valuation thoughts such that you can on Interthinx? And then the second question is, what’s the outlook for a dividend raise and/or a buyback in the future? And then I’ll get off. Thanks for your help.

Mark Seaton

I’ll take that, the first part of that and I’ll hand it over for Dennis for the second part. On Interthinx there are certain -- there are customer sensitivities around the numbers, but I would just say that in general, it’s about $100 million revenue business and the margins, the pre-tax margins are somewhat higher than our overall Title Insurance segment for 2013.

Dennis Gilmore

Yes, and specifically on dividend raise, I'm not going comment directly on that but little bit I’ll tell you as our capital deployment strategies remains very consistent. First and foremost, we’ll always invest in the business. Second, we’ll look for strategic acquisitions, opportunities that are going to give us the necessary return for us. And then we’re always going to evaluate the appropriateness of our dividend and our share repurchase, and we’ll look to return capital to shareholders when appropriate.

Brett Huff - Stephens

Great. Thank you for your help.

Dennis Gilmore

Thanks, Brett.

Operator

Thank you. The next question is coming from Ryan Burns. Your line is open.

Unidentified Analyst

Yes, great, I'm actually all set. Brett asked all my questions. Thank you.

Dennis Gilmore

Okay, thanks Ryan.

Operator

Thank you. And the next question will be coming from Eric Beardsley. Your line is open sir.

Eric Beardsley - Barclays Capital

Hi, thanks. In the past you’ve talked about what percentage of your personnel and other OpEx is fixed. As you have gone through these expense cuts, where do you think that stands today?

Mark Seaton

Yes, it’s changed a little bit, right now in terms of our personnel costs, it’s about 22% variable, if you just look at our fourth quarter costs, when you look at our other operating expense line item, it’s about 49% variable. So obviously that changes every quarter, but that’s where we stood in Q4.

Eric Beardsley - Barclays Capital

Okay, great. Thanks. And I guess as you go through the first quarter, we’re expecting additional declines in refi, do your fourth quarter expense cuts, and what you’ve done so far in the first quarter fully reflect that, or do you think that there is more room to go based on where volumes are coming in?

Dennis Gilmore

There is continued more room and we've continued our cuts going into the first quarter.

Eric Beardsley - Barclays Capital

Okay. Is there any way to size those?

Dennis Gilmore

At this stage no, I’d rather not, but we’re going to continue this just natural revenue, and expense lines for our revenue so we’ll continue to watch our expenses very aggressively.

Eric Beardsley - Barclays Capital

Okay. Great, thank you.

Operator

Thank you. The next question is coming from Geoffrey Dunn. Your line is open.

Geoffrey Dunn - Dowling & Partners

Thanks, good morning.

Dennis Gilmore

Good morning.

Geoffrey Dunn - Dowling & Partners

First just a point of clarification, are you allocating more regional business to your commercial segment? I noticed that your year-over-year number went up.

Mark Seaton

We are just -- and historically we've just disclosed our National Commercial Services division revenue. But this quarter we started providing additional disclosures around the order counts. If you look at Page 11 of the press release that we issued this morning, historically we’ve just disclosed total open orders and total closed orders. And now we bifurcate it with purchase orders, and refinance orders, commercial orders and other orders to foot.

And we disclose that for opened, closed and average revenue per order. And so those numbers are total commercial including our National Business and Commercial has done in our local operations. And so that’s the number, the commercial number we’re going to start reporting on going forward.

Geoffrey Dunn - Dowling & Partners

So, the one 177 this quarter is all of your Commercial across the board, which is why the year comparison is up 10 million to 156?

Mark Seaton

Yes it’s our U.S. Commercial business all across the board and most of it is in our National Commercial Services business but you’re right it’s everything.

Geoffrey Dunn - Dowling & Partners

Okay, great. And then, this is probably more for Dennis. Obviously the Interthinx deal, I guess my first reaction when it was announced was, if the businesses seem like it could fit, are you guys over CoreLogic. I know you’re now looking to rebuild a CoreLogic. So, can you talk a little bit about the types of deals, vertical what not that makes sense for FAF going forward, that doesn’t kind of recreate your neighbor.

Dennis Gilmore

Yes, we’re definitely not looking to recreate CoreLogic, that’s for sure. What we’re looking to do always is. We take a look at our businesses number one, our core title business and our core specialty insurance business. And we look to do consolidation opportunities there in all of those product lines. So, maybe where have a geographic coverage gap or we’re going to add some bulk and have a good cost stakeout, we’ll look at those kinds of transactions.

And then second we’re going to continue to look Geoff to expand our product lines around those key segments for us and then specifically in Interthinx deal, we do a great job around the titling and the vesting aspect of it and all we wanted to do is move up the value chain down and get some of the activity going on at the beginning of the origination process in segments we thought were growth segments.

So what intrigued us about Interthinx for example is because of the regulatory changes going on right now, we’ve seen higher demands for those products early on in the origination cycle and it flows really nicely into our Title offerings. And in the last aspect of the transaction and we’ll look to continue to do in the future, is to give us a nice opportunity, a very nice opportunity to leverage our databases across the organization.

Geoffrey Dunn - Dowling & Partners

Is there any add-on sector in particular that you think incrementally makes sense that you could identify?

Dennis Gilmore

Well, I think there’s still some gaps in our overall product offerings for our lender customers right now. With Interthinx we picked up a nice component of valuation, but I still think there’s some opportunities for us to add to our valuation services.

Geoffrey Dunn - Dowling & Partners

Okay, great. Thank you.

Dennis Gilmore

Thank you.

Operator

Thank you. There are no additional questions at this time.

Dennis Gilmore

Thank you.

Operator

Thank you. That concludes this morning’s call. We’d like to remind listeners, that today’s call will be available for a replay on Company’s website or by dialing 203-369-0421. The Company would like to thank you for your participation. This concludes today’s conference call. You may now disconnect.

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