FAF - First American Financial: Moving To Neutral On Housing Market Risk

2023-05-01 03:04:02 ET

Summary

• I was bullish on title insurer First American last fall, seeing a disconnect between its operating results and the then-prevailing negative sentiment.
• Since then, First American shares have rallied even as operating results have weakened.
• I believe there is no longer any inherent discount in First American stock and as such I am dropping my outlook to a hold.

First American Financial ( FAF ) is America's second largest title insurance company.

I've long been a fan of the title insurers as they are a service that is essential for buying property in the United States. Banks simply won't make a residential mortgage without having title insurance on it. As such, the title insurers can a captive market and can charge high fees, especially as there are only four title insurers that have meaningful market share on a national basis.

Last fall, the title insurers, including First American, saw shares slump as people prepared for the worst on both the economy and housing market. I stepped in with a strong buy call , viewing the panic as overblown.

Shares have delivered a 32% total return since that point. At the same time, I believe the outlook has dimmed to a degree since October 2022. With the stock price up and the earnings picture down, I am moving to a neutral rating. I have also trimmed my holding in the company as the valuation has normalized.

Q1 Earnings: Not Great

First American Financial reported its earnings on Thursday. They were, in a word, underwhelming .

Topline revenues of $1.4 billion came up a whopping $130 million short of expectations and represented a 31% decline year-over-year. Even in the context of a slowing housing market, a 31% revenue decline is eye-catching. Earnings per share weren't much more inspiring. EPS of 44 cents fell far short of the expectations of 71 cents for the quarter and declined by half year-over-year.

I'd note that FAF's earnings had topped expectations each of the past three quarters, implying that the firm was generally performing well despite the complicated macroeconomic environment. This report, however, was a massive miss and sets the stage for sizable analyst estimate cuts.

Analysts are projecting $4.28 of EPS for this year and $5.65 for full-year 2024 as of this writing. However, I'd look for a number well under $4 for this year given the magnitude of the miss this quarter. And it seems optimistic to expect a more than 20% pop to earnings next year given the outlook for the housing market and interest rates at the moment so the 2024 analyst consensus estimate seems much too high as well.

If we figure earnings of $4/share or less for both this year and next year, that implies a nearly 15x P/E multiple for FAF stock at current prices.

Excluding items from last year that are distorting current figures, FAF stock had traded around 8x earnings for most of the past three years. Historically, it has rarely traded above the 15x mark. As such, the current stock price valuation seems to imply a fair bit of optimism about future valuations, or it pencils in a swift rebound in the housing market.

Is There A Soft Landing Argument Here?

More vocal FAF stock bulls could argue that the bearish housing narrative out there has been overblown.

We have seen average housing prices in the United States dip:

However, the decline is only from $553,000 at the peak to $516,000 now. This is hardly a big deal in the grand scheme of things, considering that the average price was a mere $383,000 just prior to the onset of the pandemic. I spoke to one housing industry professional in California who predicted that instead of seeing a bust, we could merely see prices level off for a couple of years to adjust to changing interest rates and absorb the new higher average price level.

Indeed, it's important to remember that 7% mortgage rates are hardly unprecedented historically. Many generations of Americans were able to buy houses despite mortgage rates being this high or even higher. Additionally, people entering the market today, such as younger millennials and Gen Z individuals, never considered a world of 3% mortgage rates and may view a 7% mortgage as no big deal.

There is some merit to the structural housing bull arguments, such as that there is a fundamental shortage of units and that the demographic mix in America will encourage a great deal of household formation in the 2020s. I'm open to the view that housing can stabilize at relatively elevated prices even in the wake of much higher interest rates than we had a few years ago.

However, I'd argue the market might be overly sure of this sort of "soft landing" argument. Look at various leading homebuilder stocks over the past six months, for example:

I'm simply not convinced the market is fairly pricing in risk and reward for homebuilders and related housing stocks after these sorts of sustained rallies.

FAF Stock Bottom Line

I'm of the view that monetary policy has a significant lag to filter into the real economy. The Federal Reserve has continued raising interest rates well into 2023. The rash of tech layoffs has really set in over the past few months, and formerly high-earning tech employees were a key driver of the high end of the housing market. The banking crisis only really kicked off in March and will take months to filter into individual home purchasing decisions. There are a lot of dark clouds on the horizon for housing.

Keep in mind that title insurers get paid as a percentage fee of transactions. As such, a slowdown in either transaction volumes or a drop in average pricing would have a negative impact on revenues.

While pricing has held up, and new homes are doing relatively okay, it appears the bottom may be dropping out on existing home sales. See this from First American's first quarter earnings release :

Challenging market conditions continued into the first quarter," said Ken DeGiorgio, chief executive officer at First American Financial Corporation. " Existing home sales have fallen to levels not seen since the 2008 financial crisis and the commercial real estate market has significantly declined.

Again, there's an argument for a glass half full view of the housing market. But I struggle to justify the full-throated optimism we're seeing at the moment.

I'd also note title insurers earn revenues from some types of commercial mortgage transactions. As you've no doubt heard, some classes of commercial real estate such as offices are in significant distress right now. To that point, First American saw its commercial revenues plunge 39% year-over-year.

I have no doubt First American will be able to navigate the current industry slowdown, just as it has done in the past. And the strong economics and limited competition inherent to the title insurers make them better options than most for riding out a housing industry downturn. But after a big rally and despite such a shaky set of industry fundamentals, this seems like a good time to take some chips off the table.

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