FAF - First American Financial: Cooling Volumes Makes For A Hold

2023-08-09 02:45:49 ET

Summary

• First American Financial Corporation has solid earnings but is trading at a high valuation compared to peers.
• FAF has two segments: Title Insurance and Services, and Specialty Insurance.
• The real estate market has cooled down, impacting FAF's top and bottom line, but stability in demand is a positive sign for the company's outlook.

Introduction

Despite the solid earnings beats from the last report, I think that First American Financial Corporation ( FAF ) is trading at a pretty high valuation in comparison to peers in the same industry. The Q2 report showed a beat on both the top and bottom line and FAF is set to achieve an EPS of $4.45 for FY2023. This is in line with levels back in 2018 meaning that FAF is more or less a turnaround company right now as they seek to regain results achieved in 2021 when the market and earnings were growing at impressive rates.

Focusing on various forms of insurance services FAF has grown its margins quite impressively over the last years, but right now sits at some of the lowest levels in the last 5 years with ROE at 4.9% for example. I am looking at FAF from the perspective that a rebound in margins and the market is necessary if we want to see a return to former earnings. I am rating FAF a hold until that conviction comes along.

Company Structure

In the property and casualty insurance industry FAF has made a name for itself as the earnings rose quickly during 2021. The market cap sits at $6.4 billion and despite some of the challenges in the industry, the market seems quite positive on the outlook for FAF still. I am not as convinced as persistent interest rates might suppress volumes and in turn the revenues and earnings from FAF.

The operations for FAF revolve around providing financial services related to insurance. The company is built up through two segments, those being, Title Insurance and Services; and Specialty Insurance too. Within the first one, FAF offers title insurance policies on residential and commercial properties in the United States. Besides that, they also have services related to closing and/or escrow and services to facilities transactions for properties.

2021 produced some record results for the company as the volumes in the commercial real estate market went through the roof. But with a cooldown in the volumes and a more neutral sentiment the top and bottom line of FAF has been hurt. The priority for FAF instead lands on ensuring they have solid margin retention and don’t tick downwards too much.

What is reassuring about FAF's historical performance is the fact the title insurance margins are still trending upward and sit above 10% currently. But there are clear positives and negatives with the recent raises of the interact rates in the US. It has helped cool down some of the volumes, but for FAF it has meant stronger net investment income instead.

For every 25 basis points of increases, FAF is generating $15 - $20 million more each year in interest incomes. Throughout the long term, this should translate to strength in downturns in the real estate market and more stable overall performance. I can see this being a cause for the higher valuation that FAF receives right now. But still, no reason for an investment to be made, unfortunately. Having some immediate margin of safety is key and right now we aren't getting that with FAF.

Earnings Transcript

From the last earnings call that FAF had on July 27, the CEO Ken DeGiorgio made some great comments on the market environment and outlook for them.

• “ The commercial market, which began to deteriorate in the back half of 2022, appears to have stabilized. While commercial revenue was down 39% year-over-year, it was up 20% on a sequential basis, in line with the typical seasonal trend ”.

Seeing some stability in terms of demand for the real estate market is reassuring for the outlook of the company. There are still a lot of improvements necessary for FAF to return to where it used to be. But a stabilization in demand is a first step for sure.

• “ While our key purchase commercial and refinance markets appear to have troughed, the timing of a recovery in these markets remains unclear. Despite these challenging conditions, our financial discipline and strong balance sheet allow us to continue to invest in strategic initiatives for the long-term benefit of the company as well as return capital to our shareholders ”.

Going forward I don’t think we should be expecting a quick recovery though. The market and interest rates remain relatively unclear as to what the expectations are. But for FAF it means they need to keep a capital strict allocations strategy where no unnecessary spending is performed. The ROE is disappointing for them but that will come back, what they need to do right now is make sure they have sufficient capital to maintain the dividend and not risk having to cut it. That would likely result in the share price plummeting to where the rest of the sector is, around a 9x p/e.

Risk Associated

By excluding the distortions caused by last year's exceptional items, we can observe that FAF stock has maintained an approximate earnings multiple of 8x over the past three years. Throughout its history, the stock has rarely ventured beyond the 15x earnings multiple threshold. This pattern serves as a contextual backdrop when assessing the current valuation dynamics.

It's crucial to underscore that the market's assessment of risk and reward within the homebuilders and housing stocks sector might not be entirely aligned with the sustained rallies these stocks have experienced. The extended upward trends in these stock prices could potentially have created an environment where investor sentiment might have outpaced the fundamental realities of the market.

The valuation metrics for homebuilders and housing-related stocks have been underpinned by a range of factors, including low mortgage rates, robust demand for housing, and a favorable economic environment. However, these factors can be subject to change, especially in light of evolving macroeconomic trends, changes in interest rates, and unforeseen market shocks.

Investor Takeaway

The revenues and earnings of 2021 are unlikely to return for FAF anytime soon I think. It was an extraordinary year as the real estate market went ballistic. Now the prices and volumes have dropped and this has negatively impacted FAF. Going forward I don’t think we should expect FAF to post double-digit EPS growth as long as the interest rates remain where they are right now. Investors should be looking at margin improvements instead, like the ROE. For those interested in FAF I think there are better times ahead to buy if we see a further deterioration of the residential market. Those already in FAF might want to stay for the long term and right now least collect the nice 3% dividend. Concluding the article I am rating FAF a hold right now.

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