A Contrarian Bet On Housing: Long Case for First American Corp.

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Includes: FADV, FAF
by: Value Investor Insight

Newsletter Value Investor Insight carried an interview January 31st with John Osterweis (pictured below), whose equity fund has returned 15.3% annually over the past 10 years, versus 8.4% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview (also with analysts Matthew Berler, Michael Hughes and Sasha Kovriga) in which they discuss First American Corp. (NYSE:FAF), a U.S. title insurer, with additional operations focused on the warehousing and sale of real estate- and credit related data and information. It was trading at $42.01 at the time of the interview (current price here):

Given your contrary nature, it’s not surprising that your first specific pick, First American Corp. (FAF), is tied to the housing sector.

Michael Hughes: First American’s primary business is title insurance in the U.S., which produces about half of the company’s total EBITDA. The title insurance business is relatively cyclical – sensitive to interest rates and the overall state of the housing market – but it has excellent cash-flow characteristics when properly run.

The company is also a large real estate-related data provider, having done a great job of using the cash flow from the title business to expand into related areas. Much of the mortgage data used by Wall Street today is owned and sold by First American. They are the largest tax-lien processor, working for lenders to confirm whether people are paying their real estate taxes, and are big in online appraisals and in certifying flood risk. They also own 77% of First Advantage Corp. (FADV), a publicly traded company that provides credit-reporting and a variety of other data services to a range of client segments.

So is this just a cyclical bet on housing eventually getting better?

John Osterweis, Osterweis CapitalJO: This is an obvious time for the market to be ignoring the stock, given the correlation of First American’s business to the housing cycle. We don’t at all mind buying businesses in the down part of a cycle if, at the same time, clear steps are being taken to improve operations, which we see here. At some point there will be another up cycle in housing and, coupled with the efforts they’re making today to improve margins, we expect the next peak in earnings to be significantly higher than the last one.

MH: The big opportunity is to improve margins in the title business, which at 4% are one-third those of their leading competitor, Fidelity National. First American has been decentralized to a fault, with almost everything done at a local level. They buy supplies locally. They manage escrow deposits locally. At the end of last year’s third quarter, escrow balances were more than $7 billion, on which they’re earning sub-par returns. Just managing that money better is worth a minimum of 40 cents per share to the bottom line. Overall, we see no reason they can’t at least double the margins of the title business within a couple of years, which would go straight to the bottom line.

There’s a very clear catalyst for change on this front in the form of a new CFO, an aggressive former investment banker for the company. They realize they’ve underperformed for a long time and are doing something about it.

Another key part of the story is our expectation for a large share-repurchase program. The company is just now putting an options backdating issue behind it, and will be free to buy in shares after reporting earnings on March 1. We think that with a small increase in leverage and one year’s worth of additional cash flow, they could eventually buy back up to $800 million worth of stock – 20% of the shares outstanding.

What upside do you see for the shares, trading recently at $42?

MH: The consensus earnings estimate for this year is $3.70-3.80 per share, but we don’t expect them to earn less than $4 per share, which gives them a less than 11x earnings multiple. At a more favorable point in the housing cycle, with the earnings per share leverage we expect from operating improvements and share repurchases, we expect this to be worth at least $60 per share.