Ready for a Housing Rebound

07/19/2010 12:02 pm EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Jim Ryan say the stock of a leading title insurance company should recover nicely, along with the housing market’s recovery.

The “new” First American Financial (NYSE: FAF) is now a pure title company.

First American is the United States’ second-largest title insurer and also offers similar products internationally. The firm also has a small presence in specialty insurance, primarily homeowners and home warranty insurance. First American aims to internally expand title insurance market share while reducing costs from automated Production services. It has expanded its customer base into Canada and has shifted employees offshore to reduce costs.

Prior to the spin-off [of the Information Solutions company], First American parlayed the significant cash flow and the automated database of title records from title insurance operations into real estate data and information businesses.

First American maintains a sustainable competitive advantage because of its size and office/agency network. Title insurance is a necessary function in the US real estate transfer process, and First American has continually increased its footprint in the industry.

Following the multiyear real estate crisis that saw 2009 title premium and fees fall to a level 40% below the peak recorded in 2006, First American had to act quickly and dramatically to salvage profitability.

Offices were closed, staff reduced, nonperforming agents canceled, and other cost-saving measures implemented in an effort to shore up the bottom line. The up side to the process, however, is that the firm is now more appropriately staffed to service a reduced market. Coming out of the trough in the industry, First American has now rightsized its operations.

Adding to the moat is First American’s leading technology that improves title operation productivity and adds new products that are generating revenue while building a new business.

All this said, we don’t think the company can widen the moat any further. The title business sis mature, cyclical, and has meager growth except for unusual times like the mid-2000s when residential and commercial real estate benefited from extraordinarily expansive policies.

Over the long run, this prevents First American from achieving exceptional returns.
We project total title and specialty premium growth to average 8% annually through 2016, tapering to about 5% in the last year of the forecast with underwriting margins averaging 7% in that period. Following the split from Core Logic (NYSE: CLGX), our fair value estimate is $26. (The stock closed below $13 Friday—Editor.)

Going forward, we think First American will average about 14% return on equity over a cycle.

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