What Is Going On With First American Financial?

| About: First American (FAF)
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Summary

First American Financial did not participate in the recent rally of the Financials sector.

The company is facing some significant headwinds.

Here are my expectations toward 2017.

The results of the presidential elections led to major changes in the basic assumptions regarding the economy.

Those changes drove dramatic money shifts across securities and investment vehicles. The most significant impact was seen in the bond market where the 10-year Treasury yield jumped from 1.5% to the levels of 2.5% in less than a month.

As investors ran away from bonds, there was a money shift to equities, especially to the Industrials and Financials sectors which are speculated to benefit from both the new administration's big investment plans and the higher interest rate era.

Here is the chart of the iShares U.S. Financial Services ETF (NYSEARCA:IYG) in the recent year. It is clear that the majority of this year's return was delivered in the recent month.

But not all components within the Financials sector are taking part in the rally. Take First American Financial Corporation (NYSE:FAF) as an example. As a dividend investor, I was interested in FAF due to its relatively high dividend (currently 3.6%) and its historical dividend growth rate (an average of ~40% yearly increase during the recent five years).

First American provides financial services through Title Insurance and Services across 49 states in the U.S. alongside Canada, the U.K., Australia and other countries. The company was incorporated in 2008, and it is headquartered in Santa Ana, California.

While the SPDR S&P Insurance ETF (NYSEARCA:KIE) gained 10% during the recent month, FAF lost 3%, and the drop continued into the first trading day of December. The next graph shows the performance of First American compared to the SPDR S&P Insurance ETF and Cincinnati Financial Corporation (NASDAQ:CINF) alongside the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).

It is clear to see the tight connection between the FAF stock and the bond market selloff.

The huge incline in bond yields has an immediate effect on FAF's business as the effective mortgage rates went up as well.

The next table, taken from mortgagenewsdaily.com, illustrates the steep incline the mortgage yields faced throughout the month of November as a result of the selloff in the bond market.

The next table shows the five types of mortgage rates; the lowest rates that were recorded during the recent 52 weeks back in July; the rates as of November 7th (Elections Day); the recent rates as of December 1st.

In less than one month, the rates made a move of ~0.5%, bringing them to the highest levels in the recent two years. If this trend continues, it would have an increasing effect on people's ability to commit to new mortgages or to pay off existing mortgages, and this could lead to dramatic consequences.

The Loan Application Defect Index

The recent Loan Application Defect Index, published by FAF, showed that for the overall country, the frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications decreased by 1.4% compared to the month of September.

The thing that might concern investors is when looking at the per state trend. As stated by FAF Chief Economist Mark Fleming:

"Cotton states in the South are showing the highest levels of risk, compared to the northern rust-belt, where application and defect risk is currently the lowest".

As an example, the next graph illustrates the different trend in Missouri compared to Pennsylvania:

Could this observation stated by the chief economist become more common in other states as rates incline so rapidly?

Here is what the he stated after the report was issued:

"Based on analysis of loan application defect risk trends, purchase loans are riskier, so I expect that the overall decline in loan application and defect risk will slow as rates continue to rise into 2017 and the share of higher risk purchase loans increases."

Modeling FAF's 2017 financials

First American Financial Corporation has $3.9B in market cap. It is expected to generate ~$5.5B of revenue in 2016 with net income of ~$350M. At $36 per share, it is trending at a P/E ratio of ~11.4x. Due to the above-mentioned risks, in order to estimate the 2017 results, I will use two conservative scenarios:

  • A 10% revenue decline compared to 2016.
  • A 20% revenue decline.

"…we'll run the business like we always do and this is will ultimately match our expenses against our revenue. So, that's just how we'll have to run this -- how we do run this business." - Dennis Gilmore - First American Financial Corporation CEO statement from the Q3'16 Earnings Call

The next data point to estimate is the percent of net margin. Based on historical trend, I used 6.3% for both Q4'16 as well as FY17.

Building all these assumptions into the model allowed me to estimate the financials of the two scenarios for 2017.

Using the current stock price at $36, the expected P/E ratio for 2017 is estimated at a range of 12.6x to 14.2x.

When comparing it to the historical P/E ratios, we can see that it is not dramatically off from the range that FAF was trading at in the recent years.

The Dividend

FAF is a Dividend Challenger as it has increased its dividend every year since 2011. Just recently the quarterly dividend went up by 30%, going from $0.26 to $0.34.

Though the message from the Q3'16 earnings call was that management is less focused on the payout ratio, this is an important measurement for me as a dividend investor.

The next graph has the dividend per share alongside the historical payout ratio including the two scenarios for 2017:

Based on this model, the payout ratio in 2017 is expected to be closer to the 2009 payout ratio, which was followed by a dividend cut. This is a disturbing sign for investors who are looking for a growing dividend.

Conclusions

During the recent years, FAF's results were very satisfying for a dividend investor who was looking for both the yield and for the dividend growth. The current environment of rising interest rates is a huge headwind for FAF's business. At current levels, the risk is too high and overweight the dividend yield.

As I doubt that in the coming years the dividend would grow significantly, I would consider making an entry at around $30, which means 4.5% dividend in 2017.

Happy investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The opinions of the author are not recommendations to either buy or sell any security. Please do your own research prior to making any investment decision.