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Title insurer First American Financial (NYSE:FAF) is of interest as a way to play a potential resurgence in housing. The industry verges on a duopoly, shared between the company and its larger competitor, Fidelity National Financial (NYSE:FNF). When housing recovers, the increasing volume of transactions, compounded by increasing margins, can be expected to increase income, with a similar effect on share prices.

I opened a position in FAF in May this year, when the shares were trading at $15.55. Having taken a ride down to the $11 area, I conducted a review, and recently enlarged my position. This article presents the information developed and interpreted to support the decision.

Studying FAF in the context of its competitive environment, the issue of margins is of primary importance. FNF, operating under very similar conditions, has been achieving substantially better operating margins. This is not a trivial issue: Harry Domash, in "Fire Your Stock Analyst," presents an analysis of Bed Bath & Beyond vs. Linens 'n Things, demonstrating that an operating margin disadvantage compared to a major competitor can be an early sign of serious trouble.

Significant Metrics

Metric

FAF

FNF

Price

$11.28

$15.78

Trailing P/E

14.12

10.84

Forward P/E

9.72

13.96

Price/Book

0.60

1.00

Price/Tangible Book

1.08

2.39

Price/Sales

0.31

0.64

Dividend

2.13%

3.04%

Operating Margin (ttm)

4.44%

10.05%

Profit Margin (ttm)

2.21%

6.04%

FAF is trading at a discount to FNF on forward P/E, P/B and P/S. If it were to trade at similar multiples to its competitor, a price of about $19 would be indicated. Noting the discrepancy in margins, corrective action on that item is the first step to closing the valuation gap.

Margins Have Management Attention

From Fidelity National Financial's November 2011 Investor Presentation (click to enlarge images):

From First American Financial's Presentation at the KBW Insurance Conference:

Reviewing these slides side by side, the investor may safely conclude that FNF is proud of their margins, and does not intend to lower them; equally important, FAF is clearly motivated to increase theirs, to the 8% to 10% target area.

IBNR and Earned Premium

Title insurers perform a title search as part of their underwriting process, and the resulting insurance policy covers any defects that were not discovered by the search. The expected loss ratio over the life of the policies will range from 5% to 10%, so the bulk of the premium is related to the services performed, as well as agent's commissions, fees, and taxes.

Title insurers recognize the full premium as earned at the time of sale. Future policy losses are estimated for the full life of the policy and booked as IBNR (incurred but not reported), at the same time as the corresponding revenue.

Losses from the 2005-2007 vintages have been developing more rapidly than expected, and the companies have strengthened reserves accordingly. There is some question as to whether the business insured during that period was of lower quality, with more defective titles included, or whether discovery of losses was accelerated by the financial crisis. Probably some of both. To the extent losses were accelerated by the crisis, the troubled 2005-2007 vintages should perform better going forward.

In any event, business written from 2009 forward has been developing favorably, so that expected loss ratios are less than for the 2005-2007 period. Title insurance losses have historically increased during times of economic stress, and the improving economy together with more careful underwriting can be expected to lead to profitable business.

Loss estimates are reviewed by 3rd party actuaries, and there is no reason to suspect the current level of reserves does not represent management's best estimate of future losses.

A Digression on Duopoly

In a situation where there are two major competitors, number two can be expected to take the we try harder approach. Obviously shareholders would prefer that FAF refrain from going toe to toe on price with its competitor, which currently enjoys an advantage in its cost structure. To this observer, it appears that the competition is not about price, or even market share: it's about margin.

That would be duopoly for you. Doo-Wop is a musical genre, popular in the 1950's, featuring a capella singing, or vocals with limited instrumental accompaniment, and a rhythmic background of nonsense words or syllables. I recently located a fine example of this genre, featuring Solomon Linda, doing the original version of Wimoweh. Doo-Wop-oly.

Duopoly, or any competitive system involving a limited number of players, can go through periods of stability, interrupted by occasional episodes of disruptive competition. Disk-makers Western Digital (NASDAQ:WDC) and Seagate Technology (NASDAQ:STX) were briefly troubled when competitor Hitachi (HIT) began competing aggressively. However, WDS is working to acquire Hitachi's disk-making operations, which will bring that industry closer to a true duopoly.

Valuation - Normalized Earnings

For a cyclical business, an investor might look to pay a P/E of 12 on mid-cycle earnings. While the ticker symbol for FAF goes back many years, the company as presently constituted dates back to 2010, and prior periods include unrelated operations that have since been spun off. Using historical closed orders, I think a midpoint in a housing recovery would reflect 30% more transactions, compared to 2011, with revenue rising in sync. Title insurance has a definite fixed expense constituent, so that margins improve as revenue increases.

I believe FAF could earn $2 per share in a housing recovery, and apply a multiple of 12X to arrive at a target of 24, within 4 years. That amounts to price appreciation of 20% annualized, to which could be added the dividend, 2.14% at current prices. Patience is required.

Tangible book value per share is $10.49, providing margin of security at a recent share price of $11.28.

Strategy and Tactics

There's really no reason why FAF shouldn't trade in the $15 area. The tactical challenge here is to get paid for waiting, without giving away the easy part of the move, which would be from the current level up into the $15 area.

The stock is optionable, with wide bid/ask and low open interest. I've been able to get prices that I regard as fair when trading options on this situation. This isn't likely to be easy to trade in and out, so players using options should be comfortable holding to expiration.

My broker doesn't provide a beta computation. The somewhat similar FNF has a beta of 0.5. FAF has somewhat higher historical volatility, 37% vs. 27% for FNF.

Being dependent on the housing cycle, seasonality could be a factor here. After studying the seasonal patterns on FNF, as well as mortgage insurers Radian (NYSE:RDN), and MGIC (NYSE:MTG), I would look for FAF to outperform from November through May. It seems that the housing industry is most hopeful early in the year, leading up to the summer selling season, and then languishes as summer fades into fall.

An investor looking to play for a housing recovery might take a position now, with the idea of selling covered calls in April or May, when the shares may be trading higher based on seasonal factors, an uptick in the pace of sales, or an improvement in margins.

Monitoring

FAF makes monthly information on open and closed orders for title insurance available on it website. This makes it easy for an investor to track the trajectory of the business relatively closely.

Also, because efforts to bring margins within the target range are critical to profitability and share price appreciation, this item should be tracked quarterly, in order to exit or reduce the position if the company can't make progress to get in the same ballpark as its competitor.

Source: First American Financial Vs. Fidelity National Financial: It's About Margins