First American Financial's (FAF) CEO Dennis Gilmore on Q2 2014 Results - Earnings Call Transcript

Jul.24.14 | About: First American (FAF)

First American Financial Corporation (NYSE:FAF)

Q2 2014 Earnings Conference Call

July 24, 2014 11:00 AM ET

Executives

Craig Barberio – Director, IR

Dennis Gilmore – CEO

Mark Seaton – CFO

Analysts

Bose George – Keefe, Bruyette & Woods

Eric Beardsley – Goldman Sachs

Mark Hughes – SunTrust

James Spalton – Odey Asset Management LLP

Mark DeVries – Barclays Capital

Ryan Burns – Janney Capital Markets

Operator

Greetings, and welcome to the First American Corporation Conference Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (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 replay from the company’s investor website.

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

Craig Barberio

Good morning everyone, and thank you for joining us for our Second Quarter 2014 Earnings Conference Call. On today’s call, our speakers will be Chief Executive Officer, Dennis Gilmore; and Mark Seaton, Executive Vice President and Chief Financial Officer.

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 4 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 these 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 also described on Page 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, adjusted personnel costs and adjusted other operating costs.

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 the news release that we filed today, which is 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’d now like to turn the call over to Dennis Gilmore.

Dennis Gilmore

Good morning. Thanks. Today, I’ll review our second quarter financial highlights and also provide a few comments on our business outlook.

Total revenues for the second quarter were $1.1 billion, down 11% compared to the second quarter of 2013. Net income in the quarter was $51 million or $0.47 per diluted share.

During the second quarter, we benefitted from normal seasonal growth in our purchase transactions and continued strength in our commercial business.

Furthermore, we realized the full benefit of expense management actions taken in previous quarters. Our total segment pretax margin was 8%. Close orders per day in our title segment fell 33% compared to last year, driven by at 57% decline in refinance orders. Although our refinance volumes declined sharply over the last year, they stabilized during the first quarter and we’ve seen a slight uptick in refinance orders during the second quarter as mortgage rates have fallen.

Our close purchase orders for the quarter were down 4% compared to last year. However, our average fee per purchase order increased 6%, driven by rising home prices.

We expect a modest increase in total purchase revenue for the full year primarily driven by rising home prices rather than transaction growth.

Our commercial business continues its strong performance generating $132 million in revenue during the quarter, a slight decline from last year due to a number of transactions that were scheduled to close in June but slipped into July.

As we enter the third quarter, our commercial revenues were on up to a strong start. On a year-to-year basis, revenue is up 7% and we expect this trend to continue throughout the rest of the year.

Our total results were negatively impacted by a reserve strengthening of $25 million for prior policy years. The majority of this amount was due to a large commercial planning from policy of 2007 and its net of anticipated recoveries.

As we’ve previously discussed, the ultimate loss rate for policy years for 2005 to 2008 have been well above for historical norms. But we anticipate that our paid title clients will trend downward over the next few years as this legacy policy years continue to age.

We also believe that our most recent policy years 2009 to 2014 will continue to benefit from loss rates that are below our long-term averages.

Revenues in our Specialty Insurance segment grew by 9% during the quarter, driven by higher earned premiums in both our home warranty and property and casualty business. Our home warranty business has experienced strong momentum with revenue growth of approximately 30% over the last three years and the business continues to generate attractive returns on capital.

Looking forward, First American is well-positioned for the continued recovery at the purchase market which we expect to see stronger growth beginning in 2015. The investments we made in our people, our technology and our data assets have laid the foundation for us to achieve our vision of being the premier title insurance and settlements service provider.

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

Mark Seaton

Thank you, Dennis. Total revenue in the second quarter was $1.1 billion, down 11% compared with the second quarter of 2013.

Net income was $51 million or $0.47 per diluted share compared with net income of $35 million or $0.31 per diluted share in the same quarter of last year. The current quarter results include net realized investment gains of $6.3 million or $0.04 per diluted share.

Additionally, the current quarter benefitted from a 34% effective tax rate due to a lower effective foreign tax rate as well as the utilization of foreign net operating loss carry forwards.

Our normalized tax rate is 38%. However, we expect the tax rate to improve overtime depending on the future profitability of our international division among other factors.

In the Title Insurance and Services segment, direct premium and escrow fees were down 13% compared with last year due to lower refinance volumes which declined 57%. This decline in orders was partially offset by a 27% increase in the average revenue per order.

The average revenue per order increased to $1,830 driven by the continued shift in the order mix to higher premium purchase and commercial transactions. Additionally, the average revenue per order increased 6% for purchase transactions, reflecting continued growth in home prices.

Agent premiums were down 15%, reflecting the normal reporting lag in agent revenues of approximately one quarter. The agent split was 79.9% of agent premiums.

Information and other revenues totaled $165 million, down 3% compared with the last year, driven by lower demand for the company’s title plan information and default information products as a result of the slowdown in transaction activity. This decline was significantly offset by revenues generated from our recent Interthinx acquisition.

Personnel costs were $327 million, down $13 million or 4% from the prior year, excluding the $13 million impact of recent acquisitions. Personnel costs declined by 8% due to lower salary overtime and intended compensation expenses.

Other operating expenses were $197 million, down $19 million or 9% from last year, excluding the $9 million impact of recent acquisitions. Other operating expenses declined 13% due to lower production related expenses and temporary labor costs. The ratio of personnel and other operating expenses to net operating revenue was 76%.

In the second quarter, the provision for title policy losses and other claims was $77 million or 8.9% of title premiums and escrow fees compared with a loss provision rate of 14.8% in the same quarter of the prior year. The current quarter rate reflects an ultimate loss rate of 6.0% for the current policy year with the $25 million reserves for prior policy years.

Pretax income for the Title Insurance and Services segment was $85 million in the second quarter compared with $73 million in the second quarter of 2013. Pretax margin was 8.0%, up from 6.1% last year.

Turning to the Specialty Insurance segment, total revenues were $91 million, up 9% compared with the same quarter of the prior year, driven by higher premiums earned in both the home warranty and property casualty business lines. The loss ratio for the segment was 58.5%, a decrease from a 60.6% experienced last year. Pretax margin for the segment was 12.1% driven by continued strength in our home warranty business.

Net expenses in the Corporate segment were $19 million in the second quarter, now at 8% relative to the prior year.

In terms of cash flow, cash provided by operations was $150 million versus $209 million in the second quarter of last year. The decline was primarily driven by a reduction in operating earnings during the period. Capital expenditures were $19 million due primarily to investments in software development and fixed assets.

Turning to capital management, debt on our balance sheet totaled $455 million as of June 30th. Our debt consists of $249 million of senior notes, $150 million drawn on our credit facility, $36 million of trust deed notes and $19 million of other notes and obligations.

Our debt to capital ratio as of June 30th was 15%. In May, we amended and extended our revolving credit facility, the capacity of the new facility increased from $600 million to $700 million and [indiscernible] fell 25 basis points to 175 basis points. Additionally, our debt to capital covenant increased from 30% to 35%. As of June 30th, we have $550 million available on this credit facility.

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

Question-and-Answer Session

Operator

Thank you. At this time, we will conduct a question-and-answer session. (Operator instructions) Thank you. Our first question from the line of Bose George of KBW. Please proceed with your question.

Bose George – Keefe, Bruyette & Woods

Hi, guys, good morning.

Dennis Gilmore

Good morning, Bose.

Bose George – Keefe, Bruyette & Woods

Can you discuss your order trend so far in July and just give us the purchase refi mix?

Mark Seaton

Yes. So in July, our purchase transaction basically flat versus last year, so it’s basically continuing on the same trend that we’ve seen for the last few months here on a year-to-date basis.

The purchase mix in terms of refis – percentage refis is 41% in July, it’s a little bit down from the 42% in June. I said one thing about our orders so far in July is we did have a lot of larger commercial deals that were expected to close at the end of June and spilled over into July, so really for the first 15 business days of July, our commercial revenue is up 56% versus last year.

But to answer your question, we’re about 41% refi versus purchase mix in July so far.

Bose George – Keefe, Bruyette & Woods

Thanks. And then, actually on commercial loan that we took the charge this quarter, is there a reinsurance that limits the risk on larger commercial loans like that?

Dennis Gilmore

We do have a reinsurance program in place, so we have it for a number of years. So we do offer reinsurance again in place on this transaction but we’re not going to give any details on it right now.

Bose George – Keefe, Bruyette & Woods

Then as you’re switching to Interthinx, just could you give us the impacts of Interthinx on the P&L this quarter?

Mark Seaton

We did a few requisitions really at the end of the first quarter and the beginning of the second quarter. And that the impact of those acquisitions in the second quarter was $22 million on the revenue side. In terms of profitability, it was basically break even.

The vast majority of that was Interthinx. And this quarter we did have some onetime expenses associated with the integration mainly on the IT side and a little bit on the server [ph] side. But the impact was $22 million top line and basically breakeven in the bottom line.

Bose George – Keefe, Bruyette & Woods

Okay. And just in terms of the expense side, how much of that was one time?

Mark Seaton

There is probably $3 million to $4 million in the quarter on onetime expenses and we’re going to have some head in the third quarter as well.

Bose George – Keefe, Bruyette & Woods

Okay, great. Thanks.

Dennis Gilmore

Thank you.

Operator

Thank you. Our next question is from the line of Eric Beardsley of Goldman Sachs. Please proceed with your question.

Eric Beardsley – Goldman Sachs

Hi, thank you. Just on the commercial revenue, you mentioned that some had flipped into July, do you have a sense of what the dollar amount of transactions would have been in the second quarter in the commercial if they hadn’t flipped?

Mark Seaton

Well, we have a forecast that we do. And our commercial forecast for the month of June came about $6 million in line of our forecast. It’s hard to really determine how much of that was just due to our forecasting ability and how much of that was pushed to July. But we definitely see evidence that were definitely a lot of large deals that were pushed. But it’s hard to say exactly how much.

Dennis Gilmore

I’ll just add that the commercial business had been very strong for us for a number of years. We think that strength will continue throughout ‘14. We’re actually in a year-over-year basis up 7%, so we think the trend will continue throughout ‘14 and into ‘15.

So this is a business that can get lumpy at any one quarter, but we look for strength to continue.

Eric Beardsley – Goldman Sachs

And like when you talk about that strength, I mean on a year-over-year basis, is that 7% gross, a fair proxy if we look at the brokers growth and transaction volumes, we’re still seeing high, I guess teams [ph] and even 20% year-over-year growth. And is it possible that you could continue to see growth of that level?

Dennis Gilmore

Possible, but I think that we’ve seen those kind of numbers for approximately over the last three years. So I do think the growth will start to mitigate at some point but again very strong market for us, very strong performance.

Eric Beardsley – Goldman Sachs

All right. And just on the expense side, were there any headcount reductions in the last quarter other than bureau [ph] related and how should we think about expenses progressing from here?

Dennis Gilmore

Yes, I’ll take that one. Pretty flat on the headcount for the quarter. We really did the most of the heavy lifting on our cost structure over the last three quarters really driven from the interest rate increase in 2013.

So the business right now is running very efficient, running its size appropriately for transaction volumes right now. But I think as everybody knows, this is a business that we always are watching the expenses very closely. And if our accounts change materially, we’ll have to readjust our cost structure.

Eric Beardsley – Goldman Sachs

Great, thank you.

Operator

Thank you. Our next question is from Mark Hughes with SunTrust. Please proceed with your question.

Mark Hughes – SunTrust

Yes, thank you, good morning. Of the one timers, the $3 million to $4 million they had this quarter, you said some of that will extend in the 3Q as well. Would that be about the same magnitude, a little bit less?

Mark Seaton

Yes, it will be less. I mean we closed the Interthinx acquisitions in late March and we’ve been working very hard on the integration. I would say most of it is sort been reflective in the second quarter results. But they will less than $3 million to $4 million will spill over to the third quarter.

Dennis Gilmore

Yes, and I’ll just add that the integration itself is going very well. We’re very excited about this acquisition which we try to wrap up most of the activities in the second and third quarter from an integration perspective. Very focused on the market outlook now, and pushing our sales efforts.

Mark Hughes – SunTrust

Right. And should we assume normalized tax rate, the 38% tax rate in the back half or will it be maybe a little bit lower?

Mark Seaton

I think the safe thing to do is assume the 38%. We’re working on certain tax strategies now that might lead to a lower tax rate in that back half, but those are really uncertain at this point. So I think 38% would be safe for the second half of the year.

The other thing I would say that I mentioned in my remarks is we pay a lower foreign effective tax rates in the international operations. So we feel like our 38% tax rate should come down over time but I think 38% is safe for now.

Mark Hughes – SunTrust

Right. And it sounds like the mix of commercial orders was a little more skewed to the smaller end in 2Q. It sounds like 3Q is off to a good start. Does the revenue per order get back up into the double digits in terms of year-over-year increase in the third quarter?

Mark Seaton

Just in terms of double digits growth in the commercial ARPU?

Mark Hughes – SunTrust

Yes.

Mark Seaton

I think in the back half, I don’t – it’s hard to say. I’d be surprised if it was up double digit over the last year. We do see a lot of seasonality in the commercial business. The fourth quarter is a very strong seasonal quarter for us. Our commercial ARPU in the second quarter was about $6,700.

And in the fourth quarter of last year, it was about $8,400. So we would expect the higher commercial ARPU in the second half for sure based on the seasonality. But for us to be up double digits would be a pretty strong growth rate.

Mark Hughes – SunTrust

Right. And then final question, any sense on the revenue per order so far in the Q3? They’ve been showing some nice improvement accelerated a little bit this quarter. They’re up 6% versus is in the purchase segment. Does that get a little bit better in Q3 or is that a good number?

Mark Seaton

It should get better in Q3. I don’t think that the mix of purchase and refi will change dramatically in the third quarter. But again we’re going to have – based on everything were seeing right now, we’re going to have higher mix of commercial. And of course since commercial has a higher ARPU, whenever – fee per file should increase in kind of the mid-single digit range in the third quarter and it should increase another mid-single digits in the fourth quarter.

Mark Hughes – SunTrust

Thank you.

Dennis Gilmore

Thank you.

Operator

Our next question comes from the line of James Spalton with Odey. Please proceed with your question.

James Spalton – Odey Asset Management LLP

Hello. My question is on the timing of the commercial payment in the quarter. What [indiscernible] are coming to you now just to get an understanding of how that works? And then secondly, a bit related to that, how should we think about the pipeline of future claims and the seasoning of commercial business from the last part of the last cycle?

Dennis Gilmore

Sure. I want to take the first part of your question. This is a late development for a policy of 2007, no question. So it’s fairly unusual for us to have a claim of this magnitude develop this late, but all is possible. And so it’s just how we run the business, how we deal with it.

The second part of your question is the frequency of claims, I think was what you’re driving on the question. Again from time to time we will have large commercial claims, but they aren’t frequent and that’s again the nature of this business.

James Spalton – Odey Asset Management LLP

Okay, should we include the seasoning for commercial payments state following a similar pattern to residential claims?

Dennis Gilmore

By and large, yes. And as we get at the five, six, seven years, we have seasoned of the majority of the claims, but we do stay on risk for a number of – for many years past that. But again the majority of the seasoning occurs in that first five to six, seven years.

James Spalton – Odey Asset Management LLP

Got it, thank you.

Dennis Gilmore

Thank you.

Operator

Our next question is from the line Mark DeVries with Barclays. Please proceed with your question.

Mark DeVries – Barclays Capital

Yes, thanks. First, I just want to clarify your comment, Mark on commercial revenues being up 56% year-over-year, I think I heard that right. Is that just the first two weeks of the quarter versus the first two weeks of the quarter last year or –

Mark Seaton

Yes.

Mark DeVries – Barclays Capital

– or revenues are already strong enough that you could be up to 56% on a full quarter basis?

Mark Seaton

No. No, the 56% is just the for the first 15 business days in July of ‘14 versus the ‘15 business days in July of ‘13. So we wouldn’t expect that to be at that rate for the quarter or for the whole month of July. We just saw some strong closings really in the first week that’s spilled over.

Mark DeVries – Barclays Capital

Got it, got it. And then in the release I think on the call, Dennis, you commented that you’re optimistic in 2015 to see stronger growth in the purchase market. Is that assuming just about a macro growth or are you making investments that you think are going to help you gain some market share at 2015?

Dennis Gilmore

From my perspective, it’s actually both. I’m probably a little more optimistic than what we’re reading in the press right now in the spring season by the way. It’s been good for us, not great but good. Running a little less than we were last year, but we’re coming off a very strong year.

We kind of look at 2014 right now, it’s probably a trough and we think we’ll see a continued growth in the purchase market going in ‘15 and beyond. That’s the market that we’re very well position in.

Mark DeVries – Barclays Capital

Okay. And then on investments you’re making to the gain share in it?

Dennis Gilmore

We continue focus in on share growth in the top 10 states where we feel we have some underrepresentations. So we’ve made good headway there. On the trailing 12-month basis from the first quarter, we’re actually up about 1 point.

Mark DeVries – Barclays Capital

Okay, got it. Thank you.

Dennis Gilmore

Thank you.

Mark Seaton

Thanks, Mark.

Operator

(Operator instructions) Our next question comes from the line of Ryan Burns from Janney Capital. Please proceed with your question.

Ryan Burns – Janney Capital Markets

Great, thanks guys. I just wanted to quickly talk about the redomiciling of the holding company to Nebraska. I just wanted to get the thought of process behind that and see if that frees up any capital going forward for you guys?

Dennis Gilmore

I’ll take the first part of question and I’ll kick it over to Mark for the capital part of it. From an overall perspective, what we’ve done is look at the regulatory environment across the country.

And really, we concluded that Nebraska offered the company some advantages. We think it’s a very efficient, a very effective regulator. They have a lot of experience regulating large title insurers and I think that they would have felt it was the right decision for our company to redomesticate there. From a capital perspective, I’m going to kick the question over to Mark. Up in circle, excuse me.

Mark Seaton

Yes. So in terms of the surplus redomestication, we’re going to have a release of our SPR [ph] one-time release. But that release is going – may be offset by certain factors. So we’re still working through with the ultimate reserves in surplus are going to be once we redomicile to Nebraska. But we think that if anything, it will be a positive to our surplus. but at the same time I don’t think it’s going to be material.

Ryan Burns – Janney Capital Markets

Okay, great. And then you had also mentioned that were some international net operating losses you guys utilized in the quarter. Are there still some more for you guys to cultivate or we’re in the end of that just from a tax ratio rate perspective?

Mark Seaton

There’s still more wells that we have that we’ll use in the future, yes.

Ryan Burns – Janney Capital Markets

Okay. Can you guys quantify those?

Mark Seaton

As of June 30th, it was $50 million.

Ryan Burns – Janney Capital Markets

Okay, great. And then my last one, it’s actually pretty new ones, is that the net investment income in the corporate segment, it tends to bounce surround kind of quarter-to-quarter. I’m just trying to figure out what’s in there and how we should think about that?

Mark Seaton

We have a deferred comp plan for certain our employees here and we recognize the earnings of the gains or losses of the investments, any investments income line item in our corporate segment. And there’s going to be a corresponding increase or decrease in our personnel expense line item. So you’ll see volatility in the investment income, but you’ll see the exact same volatility on the personnel side or personnel cost side.

Ryan Burns – Janney Capital Markets

Got you, great. Thanks for the answer guys.

Mark Seaton

Thank you.

Dennis Gilmore

Thank you.

Operator

Thank you, everyone. This concludes today’s conference. Thank you for your participation. You may now disconnect your lines this time.

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