Fidelity National Financial (FNF) and First American Financial (FAF), the two leaders in title insurance, reached the top by pursuing different strategies. Fidelity bought market share through acquisitions, a strategy that resulted in quick increases but has failed to hold gains over the longer term. First American took the other path and internally expanded its business, a strategy that has led to more steady market share increases over time. What's more, Fidelity has attempted to diversify out of its main product line through a number of acquisitions in unrelated businesses, weakening its economic moat. While both companies are exposed to the same industry conditions, we think management style is a differentiating factor between the two and drives our more positive view of First American.
Buying Market Share Only Makes Sense When You Keep It
In 2000 and again in 2008, Fidelity made major acquisitions, each of which gave the firm the leading position in title insurance at the time the transactions closed. Acquisitions make sense in this industry, as economies of scale and cost reductions from eliminating duplicate functions can quickly add to margins. Some fall-off in market share immediately after the acquisition is expected, as a few sales representatives, agents, and even customers will seek alternatives. However, over time the combined entity should gain advantage from improved economies of scale, competitive position, and assimilating the best employees of the companies. But even though Fidelity made sound acquisitions of good title insurers on favorable terms, management has allowed these advantages to slip away. In 2008, after the LandAmerica acquisition, Fidelity's market share increased from about 27% to 46%. However, by the end of the third quarter of 2011, its share had fallen to less than 35%, with more than half of the gained market share gone.
On the other hand, First American has pursued gradual internal growth, aided occasionally by a small acquisition. We think this strategy is inherently better, as it builds loyalty and stickiness among customers. We think this strategy speaks well for First American's management. First American has primarily focused on building the title insurance business, although it has devoted resources at times to ancillary products that have strengthened operations and customer loyalty. Without the distraction of numerous unrelated businesses, management has focused on building and maintaining its core title operations, and the results are readily apparent. Although Fidelity has twice jumped ahead through acquisitions, its management team falters in maximizing the value of the acquisitions.
Fidelity Once Had Far Better Margins Than First American, but That Has Changed
A major acquisition consummated in 2000 made Fidelity the title insurance industry leader, allowing it to realize better underwriting margins from economies of scale and accretion to earnings from elimination of duplicate costs. The acquisition also solidified its leadership position in national commercial business, the segment with the most lucrative margins. While both Fidelity and First American benefited from the explosion in real estate transactions that began in the new millennium, Fidelity had the edge in underwriting profitability. Although the industry combined ratio (expense divided by premium) improved across the industry, Fidelity's underwriting margins (the inverse of the combined ratio) expanded greater than those at First American and the total title insurance industry. For example, from 2003 to 2006, Fidelity's combined ratio averaged 86%, far better than either First American (93%) or the total title industry (94%). All companies in the industry rode the wave of massive increases in the volume of real estate transactions to historic profitability, but all that changed when housing came crashing down. Title insurers across the board found themselves over-expanded and, in most cases, under-reserved from claims incurred during the housing bubble. In 2007, First American booked a huge increase in reserves; Fidelity followed a year later.
Since the housing crisis, Fidelity and First American have both embarked on major programs to increase profitability in core operations. They cut costs, raised prices, and struck better deals with agents, all of which resulted in increased underwriting income. The combined ratios for both insurers improved beginning in 2009, but First American has improved at a faster rate. For the past three years, the two companies' combined ratios have been virtually identical.
Management Is the Difference
We think the management teams have a major impact on the changing dynamics that affect the two firms. A notable point of difference is the focus of the executives. Fidelity views its core title insurance operations as a launching point for investment in non-related business, while First American seems more centered on improving the core title insurance business' margins and market share.
One of the reasons that First American has closed the gap in margins and market share is the increased presence it has developed in its national commercial business. Following Fidelity's acquisition of the title insurance operations from LandAmerica in 2008, which increased Fidelity's share to 46%, and possibly higher in commercial lines, First American has gained ground quickly.
First American's penetration in the commercial sector has taken share from Fidelity. What's more, the high-margin business adds to margins that are now rivaling Fidelity's. Commercial revenue per order is about 5 times higher, and in some cases more, than residential resale or residential refinance. Meanwhile, processing costs, while slightly greater, are not nearly in proportion with the increased premium. Additionally, the difference in the revenue per order in national commercial business indicates that First American is either charging more or procuring larger orders, which also improves margins.
Fidelity's investments outside its core operating business weaken the company's moat, in our opinion. Since 2006, Fidelity, either directly or through special-purpose vehicles, has invested about $875 million in a human resources provider, timberlands, an auto parts manufacturer, and national restaurant chains. The company is buying the remaining 90% that it does not already own of the stock in O'Charley's restaurant chain for another $220 million, and chairman Bill Foley has stated his intention to pursue future investments in this industry. Because of the opaque disclosures (some of the investments are held in unconsolidated subsidiaries and special-purpose vehicles), it's difficult to track the success or failure of many of the investments. Regardless, we think Fidelity's shareholders would be better served if resources were devoted to core operations that have a moat and stand to benefit from the housing recovery.
We think stewardship practices at Fidelity also raise some flags. There have been numerous related-party transactions between Fidelity National Financial and the firm it was spun off from, Fidelity National Information Services. The tone is set by both firms having the same chairman, as well as two other directors. While it was understandable that there would be some related transactions after the spin-off, it's now been more than five years and management still seems inseparable. There are also related-party transactions between Fidelity and its chairman, who also has equity positions in many of its subsidiary investments. Finally, Fidelity's board is far from independent, in our view, with many of the same long-serving directors holding close ties to the chairman.
We think the management of First American has done a far better job of allocating capital. The title insurance industry benefits from significant barriers to entry, and the fact that the product is required on almost all residential and commercial transactions in the United States makes the industry attractive to invest in as real estate markets recover from the financial crisis. We like that First American has chosen to focus on its core operations, which we think will eventually allow it to regain its number-one position while maintaining solid profitability. Fidelity National Financial is embarking on a different course that has the potential to be value-destructive. We think differences observed in the two companies present a compelling example of how management can affect a company's moat.