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.
▪ 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
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.
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.