LandAmerica Financial Group Will Recover on Top

LandAmerica Financial Group (LFG) principally engages in the title insurance business in the United States and internationally. Its products and services facilitate the purchase, sale, transfer, and financing of residential and commercial real estate. The company operates in three segments: Title Operations, Lender Services, and Financial services.

Title Operations is the company’s primary business at 90% of 2006 revenues. Lender Services is the second largest business with 2006 revenues of 7% and Corporate and Other accounts for the other 3%.

The Title Operations segment includes title insurance, escrow and closing services, and commercial services. The Lender Services segment provides services to regional and national lending institutions which complement those offered in our title insurance business. The Corporate and Other segment includes businesses that are not significant enough in size to be reported as separate segments as well as the unallocated portion of the corporate expenses related to our corporate offices in Richmond, Virginia and unallocated interest expense.

Executive Summary:

▪ LFG is down 66% from its high as a problematic mortgage market has depressed earnings of title insurance companies

▪ LFG is cutting expenses to adjust to the new, lower levels of expected mortgage originations

▪ The mortgage origination market is unsustainably low and will eventually recover

▪ In a normal market LFG could earn $13 - $14 in EPS

Why the Stock Has Sold Off:

▪ EPS revisions

▪ The mortgage origination market is suffering

▪ Risk that 2008 EPS does not cover the dividend

EPS Revisions:

LFG’s consensus EPS estimates have been revised downward several times, which can be good going forward because expectations are low, however it is painful in the near term as more negative revisions may still be on the way. LFG’s earnings are being revised lower due to sharp declines in real estate activity, with mortgage originations nationwide down more than 20% year-over-year. In California, Nevada, and Arizona, where LFG has a significant presence, the decline has been closer to 30%. As a result, LFG has been losing money as they adjust to the new, lower levels of business activity. They are doing this by cutting employee levels, a process which is easier to do during periods of slower variations in real estate business levels than in periods of rapid variations.

Total Mortgage Originations:

Total mortgage originations are expected to fall from an estimated 2007 level of approximately $2.5 trillion to an estimated 2008 level of $1.6 trillion, a 37% decrease. This drop-off in mortgage originations is being driven in part by a lack of demand for some of the non-conforming mortgages that have been so prevalent in the last few years.

Dividend Concerns:

LFG pays an annual $1.20 per share in dividends, which is about $19 million dollars total. This may be a concern to some investors, however LFG has $137 million in capital available to them for dividend payments, so the dividend should be safe. Another factor that leads me to believe that the dividend is safe is the rate at which management has been repurchasing stock. LFG has repurchased 1.9 million shares for a total of $126 million dollars so far this year. One would think that if management foresaw there being a possibility of not being able to meet the company’s dividend requirements that they would not be repurchasing stock at that rate.

LFG Is Cutting Expenses:

LFG is aggressively reducing its number of full-time employees and is consolidating offices. In August of 2007, the company announced planned reductions of 1,100 employees during the second half of 2007 in the residential and lender services groups of its business. During the third quarter they were ahead of that plan and had reduced headcount by 1,200 employees in those 2 channels, and an additional 500 employee positions were eliminated in October. Since the beginning of the year, LFG has eliminated a total of 2,400 positions or 26% of their workforce, with the majority of that being in the back half of the year. These employee reductions produce an average cost savings of $73,000 per employee, for a total cost savings of $175 million.

The company also reduced its number of locations by approximately 70 in the third quarter. Year-to-date, LFG has consolidated 125 locations or about 13% of their offices open at the beginning of the year, producing an annualized rental expense savings of $10.5 million.

Assuming the employee reductions made in and after the third quarter were in place during the third quarter (1,700 employees at $73,000 each) we get an annual cost saving of $124 million and a quarterly cost saving of $31 million. These cost reductions would have made LFG’s Q3 EPS $0.10 instead of the -$1.28 they earned in Q3, provided that they have the 38% tax rate they had in Q306.

Revenue – Expenses = EBT – Tax Expense = NI / Average Shares Out = LFG Q3 “pro forma” EPS

$906.8 – 904.2 (935.2 – 31*) = 2.6 - 0.98 = 1.61 /16.2 = $0.0994, or $0.10 instead of -$1.28.

Also, when you add in the 70 office consolidations that occurred during the third quarter, which is about 56% of the total 125 year-to-date, you get $5.88 million in annual savings and $1.47 million in quarterly savings, given that the total amount of savings from consolidations was about $10.5 million. These cost reductions further impact EPS with the cost savings from employee reductions.

$906.8 – 902.7 (935.2 – 31* – 1.47*) = 4.1 – 1.56 = 2.54 / 16.2 = $0.1568, or $0.16 instead of -$1.28.

This simple analysis is helpful in showing the extreme benefit that LFG gets from cutting costs. The problem is that real estate activity declined so sharply, making it hard for the company to reduce employees fast enough. However, these benefits should be recognized in the coming quarters.

The Mortgage Origination Market Is Unsustainably Low:

The chart below implies a $1.6 trillion mortgage market in 2008, with home turnover at about 4.5%. The level of turnover looks unsustainably low, and did not get this low during the last housing cycle downturn which bottomed in 1995. Additional demand will also come from the refinancing of abnormally high rate mortgages underwritten today which will refinance when the secondary market normalizes. The Fed bias toward cutting rates can also stimulate demand for mortgages.

LFG Can Earn $13 - $14 in a Normal Environment:

When the mortgage market does rebound, EPS will rebound quickly and margins will return to normal levels. The following model exhibits how LFG can earn EPS over $13 per share in a normal mortgage market with a 10% EBIT margin, which is the EBIT margin the company had in 2003. This model estimates the growth of the total mortgage origination market and assumes that LFG grows in line, and calculates the depressed and normalized earnings based on EBIT margins. What the model tells us is that in a normal environment with a $2.4 trillion mortgage origination market, LFG could earn approximately $13.86 in EPS.

In conclusion, what investors get in LFG is a stock that is paying a 3.2% dividend yield that is selling for 2.6x normalized earnings and at 47% of book value. When the mortgage origination market stabilizes and begins to normalize, LFG’s earnings will rapidly increase due to their earnings leverage. Assigning a 10x P/E multiple would value the stock at $138, significantly higher than current levels.

Disclosure: Author and author’s firm have long positions in LFG.

Comments

[User 155569:]

Wow, take off the rose-colored glasses! The company COULD earn $13 in a fantasy world, but lets take a look at what they actually DID earn. In 2006, the best year the company has ever had, LFG earned $165MM, or $10.63 per current share outstanding. Do you expect that we will return to a housing environment similar to 2006 in the next few years? If so, I have some swamp land in Florida to sell you. If not, then how much more fat can LFG trim from its income statement? They already trimmed their salary expense by about 25% (why don't you update your model using Q4 numbers?). If they were to eliminate their net loss and just get back to BREAKEVEN, they would have to cut salaries by ANOTHER 30%....and this assumes their revenues don't continue to deteriorate! If you think their revenues will improve or even remain flat, then you must be smokeing some great marijuana.

Now, the most amusing part of your analysis is the statement about how it is trading at just 47% of book value. Thats great, but the majority (67%) of the company's book value is GOODWILL. Do you really think the premiums they paid for their acquisitions aren't impaired at this point? I would be very surprised if they don't start writing off goodwill soon.

In sum, your definition of "normalized EPS" is quite interesting since it is higher than PEAK EPS. And, your method of arbitrarily applying a 10% EBIT margin is also amusing. Finally, any forecast of revenues improving is about 4 years too early.

2008 Feb 25 09:30 AM

[dwg:]

User 155569- I don't think you understand cyclical businesses... Do you believe that in the middle of a recession Deere would write off all of it's goodwill because it's not making any EPS for 1 year. Have a balanced view...

I think Matthew's normal EPS is based on a higher mortgage orig market that will result in higher margins becuase of a reduced expense base, not that they could cut expenses that much more...

Before the mortgage market blew up LFG mgmt was aiming to get to a 15% margin through a bunch of different initiatives. I don't think 10% is crazy in 3-5 years when the market normalizes, and this one doesn't have crazy credit issues to live through (like the banks)

You'll make money on the short side near-term, but his analysis is not out of line 3-5 years out... So you can see the upside for a long-term investor.

If you're struggling for a long to balance out your portfolio that has big upside without potential for big dilution from capital raises, this one fits the bill.

2008 Feb 25 11:25 AM

[Matthew Gan...:]

Thank you for your comments. I appreciate all responses.


User 155569 said- “Assigning an EBIT margin of 10% is amusing.”

LFG’s EBIT margins 2002-2006:

2002 2003 2004 2005 2006
9.6% 9.8% 8.5% 7.7% 5.1%

LFG has earned EBIT margins near 10% in the past, and they should be able to earn higher EBIT margins when the mortgage market recovers due to their reduced expense base coupled with a more normal level of mortgage originations. A 10% EBIT margin expectation is a long-term expectation and is not unreasonable given what the company has earned in the past. Even if margins only return to 6%, you get a $60 stock, so I don’t see how you get hurt long-term. Moreover, FNF, a large competitor, says that they can earn 15% EBIT margins in a $2.4 trillion mortgage market, which I believe to be a normal market. LFG should be able to earn 10% EBIT margins in that environment, especially if management is able to implement some of its long-term initiatives to improve margins once the mortgage market recovers. Also realize that history has acquisitions that were not fully consolidated.


User 155569 said- “2006 was their best year ever.”

LFG’s EPS from 2002-2006:

2002 2003 2004 2005 2006
$8.06 $10.33 $8.02 $9.31 $5.68

Looking at LFG’s earnings per share from 2002 to 2006, it is evident that this company does have to potential to produce earnings at levels way above what they are currently producing. A simple average produces an earnings number of $8.28, and with the stock currently at $38.41, LFG is selling for 4.6x the average of what they earned from the 2002 to 2006 period.


User 155569 said- “Revenues will not improve from current levels for 4 or 5 years.”

If it does take four or five years, and earnings return to $10+, you could have a stock that is selling for $100+ that is giving you a 3.2% dividend yield on your cost basis. With LandAmerica’s large dividend yield, you are afforded the luxury of being paid to wait. Also, this was meant to be a long-term investment idea.


User 155569 said- “I would be very surprised if they don’t start writing off goodwill soon.”

On goodwill, yes there could be write downs but it is very unlikely that they will write it all off (will the banks write off all their goodwill through this cycle? I doubt it).


Near-term, the stock could be weak as incurred losses increase to build reserves, and the closing rate will probably be weak on this refi boom for a number of reasons. I just think this thing could be north of $100 in 4 years, which is a return that I would like to have. I would look to initiate positions in the low $30's and below.

2008 Feb 26 10:41 AM

[User 155569:]

Matt, this is User 155569. In general, I agree that this stock could be a good long-term hold, especially if you buy below $30 and are willing to hold for 5 years. However, I believe you will be able to purchase LFG at an even better price 1 year in the future, which will improve your IRR on this investment because you pay less and have to hold for a shorter time. Here are my responses to your points:

EBIT margins: again, you have assumed an EBIT margin of 10%, which is above the highest historical margin. While this may or may not be realistic, I do not think it is a conservative estimate. Furthermore, what makes you think that the acquisitions will be accretive to the margin? They bought businesses during the housing bubble and most likely underwrote the transactions using peak margin assumptions that are unsustainable.

2006 best year ever: 2006 had highest revenues. Your argument that you should look at EPS when determing the "best year" is valid. Despite my poor use of words, I was making the point that even at peak revenues they were not able to produce EPS of $13, which you call "normalized." To confuse things, I mistakenly used 2005 net income to calculate my "peak" EPS. However, my point is still valid because 2005 revenues were only 1.4% lower than 2006 (thus still "peak" revenues), and this is when they earned less than $11 per share. I do not think it is realistic for them to earn $13 in a normalized market.

Revenues improve in 4-5 years and stock goes to $100: If you buy at $36, collect a 30 cent div every quarter, and sell on 12/31/2012 for $100, your IRR would be 26%. Not a bad return, but not eye-popping either. I think you can do better, especially considering that it is uncertain that the company can improve as you hope.

Goodwill: Yes, I too doubt they will write it all off during the downturn. However, this is a case of management manipulating EPS. Personally, I am not willing to pay for goodwill that is impaired but not yet written down. Any of my adjusted book value estimates for LFG will use goodwill at 25% or 40% of what they carry it at.

2008 Feb 28 10:01 AM

[Matthew Gan...:]

the 30 year conventional mortgage rate has dipped below 6% for the first time since 2005.

Research from Bear Stearns indicates that the average conventional borrower is paying a coupon of 6.14%, and actual mortgage rates are 5.90%, making 37% of the mortgage universe within the minimum 40 basis point refinancing window, and if mortgage rates decline another 25 basis points to 5.65%, that exposure increases to 50% of the market or $2.47 trillion in conforming mortgages. A 50 basis point decline would take mortgage rates to a record low of 5.4%, increasing exposure to 72%, of $3.53 trillion in mortgages.

It is my belief that a major mortgage refinancing wave will be coming, and whenever someone refinances their mortgage they will need to buy title insurance. LFG will directly benefit from these refi's.

2008 Mar 18 02:45 PM

[User 155569:]

I told you so

2008 Apr 30 12:06 PM

[User 155569:]

now I REALLY told you so

2008 Jun 27 11:14 AM

[r5r5r5:]

Somebody (s) bought puts on the Philly around l:30pm today -in volume, across 3 strike prices, and ended even today with huge gains.
Somehing is going on.
Never mind goodwill....Is tangible book accurate??????????/

2008 Jul 10 08:38 PM

[User 155569:]

Tangible value should be OK--but it will decline due to negative EPS over the next few years. Now that the stock is down near $10, I am considering buying. The price seems alot more fair than when Matt was pumping the stock.

2008 Jul 30 10:08 AM

[Matthew Gan...:]

Classy reply...

LFG hit $50 after my original recommendation at $37 after the Fed's interest rate cuts started. That's a 35% gain in a few months. That was when we got out.

Following that, I kept up with the company and saw that they couldn't cut costs quickly enough, and that they were going to have to write of goodwill. I posted about how I thought they were going to declare bankruptcy before the end of 2008 and gave a very detailed analysis on Yahoo! Finance's LFG message board, which is no longer available.


On 2008 Jul 30 10:08 AM User 155569 wrote:

> Tangible value should be OK--but it will decline due to negative
> EPS over the next few years. Now that the stock is down near $10,
> I am considering buying. The price seems alot more fair than when
> Matt was pumping the stock.

Sep 23 04:11 PM