First American Financial Corporation

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

A title insurance and services provider, FAF also offers settlement, data, and transaction services, as well as a variety of other financial services.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

FAF’s primary focus is on title insurance, offering policies on residential and commercial property. This is a key aspect of their business, providing revenue and stability as it operates in the regulated real estate sector.

Business Overview:

First American Financial Corporation (FAF) operates primarily within the real estate industry, providing title insurance, settlement services, and related financial products and services. The company’s business is categorized into two main segments: Title Insurance and Services, and Specialty Insurance.

  • Title Insurance and Services: This segment is the largest revenue driver for FAF, and the company has a national scale in the US as well as a presence in a few international locations. It provides title insurance policies for lenders, home buyers, and real estate professionals, which are often required for property transfers and mortgage transactions. Additionally, this segment provides closing and settlement services, document preparation, and other real estate related support services. This segment is tied to the real estate cycle.
  • Specialty Insurance: This segment is smaller than the Title Insurance and Services segment, and it provides insurance coverage for manufactured homes, residential service contracts, and various other insurance policies. * Geographic Distribution: FAF’s operations are primarily centered within the United States. It has a presence in the UK, South Korea, and Australia. But the lion’s share of business comes from operations in the US.

Competitive Landscape:

The title insurance industry is characterized by intense competition, and has a tendency to consolidate. Large title insurance players compete across geographies and against local and regional firms.

FAF’s top three competitors in the US market hold the largest market share. These competitors are Fidelity National Financial, Old Republic International and Stewart Information Services. FAF is the second-largest market shareholder in the US. The industry has seen some consolidation lately, and the top few players are gaining more control over the market share.

Key competitive areas include:

  • Cost efficiency and technological capabilities: To keep costs low as well as offer technology that makes operations fast and accurate
  • Accuracy of data and process efficiency : This involves ensuring claims are handled smoothly and accurately while having data to back it up.

Financial Analysis:

  • Revenues: In the most recent quarter, total revenues decreased by 9.9% compared to the previous year, driven by a decline in title insurance premiums. For the first 9 months of 2023 FAF reports revenues of around $4.88 Billion. This represents a YOY decline of 19.3%.

    • Revenue Distribution: The majority of revenues come from the Title Insurance and Services segment. Given FAF’s core business is related to the real estate industry, revenue is cyclically correlated to the overall real estate cycle.
    • Revenue Drivers: FAF revenues are affected by volume of residential sales transactions, level of refinance activity, commercial and international activity as well as volume of agency and direct channel business. Interest rates affect the overall mortgage environment, therefore they affect the business volume.

  • Margins: The company’s margins are under pressure due to the slowdown in the real estate market and increased competition. The operating margin for the first three months of 2023 was 11.8% which is down significantly from 15.5% in the prior year.

    • Expense Management: The expenses that are being faced are mostly related to employee salaries, policy claims, interest expenses, and agent commission. Most of the expenses come from the title insurance business. Management has been looking at expense optimizations.
  • Financial Health: The company maintains a relatively healthy balance sheet. Liquidity is solid, with $2.4 Billion in cash and short term investments. Long term debt is manageable, at $1.49 Billion. The company has a debt-to-equity ratio of around .64 in the most recent quarter.
  • Cash Flow: Operating cash flows have been relatively strong. In 2022, the company generated $1.46 Billion from operations, although that declined to $102 million for the first 9 months of 2023.
  • Recent Performance: The company is seeing a significant reduction in revenues from reduced real estate transactions and refinance activity. Also, expenses related to claims and employee compensation have gone up, further hurting the bottom line of the company. The overall effect of all of this is an increasing pressure on margins and profitability of the company. This recent effect has led to a decline in earnings by -34.2%, relative to the previous year for the three months ended September 30th 2023.

First American is also dealing with legacy cyber security issues stemming from a security breach in late 2023. This could expose it to significant financial and reputational risk.

Economic Moat Assessment:

FAF possesses a narrow economic moat, largely derived from a strong, long-standing brand presence. Here’s the breakdown:

  • Intangible Assets (Brand): FAF’s brand is recognized in the title insurance industry, and has been established over many years. However, brand alone is insufficient in creating a wide moat, as it is not a truly unique offering, and competing title insurance providers can operate profitably.

  • Cost Advantages (Scale): FAF’s large size and established distribution network do provide some cost advantages over smaller competitors; however, those are not insurmountable. The company also has scale advantages on a local scale.

  • Customer Switching Costs: For most customers, switching from one title insurance provider to another would only result in minimal costs, as there are no major implications to a customer or a broker. However, many real estate agents, brokers, and financial institutions, tend to develop relationships with a certain company, which leads to a level of customer lock-in. This is seen more in the commercial or high dollar real estate transactions. In some instances, that is the case for a lot of smaller players, but it’s unlikely to create big differentiation for a large player. In areas with very high regulations, having experience with the legal environment can also lead to more stickiness.

  • Network Effect: Title insurance services are not related to networking as the number of buyers or sellers is not related to each other, as for an auction. In this case, no network moat is present.

  • Regulatory Moats: Regulation does play a significant role by limiting the number of industry participants, as it requires state approvals and adherence to the regulatory framework. However, the regulations are quite similar across all of the players and thus, they do not offer a true advantage in long term.

Overall, FAF possesses some advantages related to its size, reputation and the long term relationships with players in the real estate industry. However, it also struggles against a fiercely competitive environment and is not really a high barrier to entry for new players. As such, the economic moat for FAF is fairly narrow, compared to an industry with structural advantages.

Risks to the Moat:

Several legitimate risks could erode FAF’s moat and impact its business performance:

  • Economic Downturn: The company’s results are directly correlated with the real estate cycle, which is impacted by interest rates and economic conditions. If the economy declines, volumes decline in the company’s main operating divisions of real estate transactions.

  • Increased competition: The title insurance industry is a mature market, with a lot of major players. Increased competition can lead to pricing pressure and reduce profit margins. FAF has the second largest market share in the US, so many competitors will directly try to steal market share from them, which could lead to a slow attrition of revenues. Also smaller, more flexible companies might create significant challenges in the future, with new offerings and technological innovations.

  • Technological Disruption: The title insurance industry is ripe for technological change. The company’s data systems may become obsolete or vulnerable to disruption. Although there is little disruption at the moment, it could be a risk in the longer term.
    • Cybersecurity Risks: FAF experienced a cyber security breach in late 2023, which could create a myriad of long term consequences if not properly handled by management.

  • Regulation: The title insurance industry is highly regulated, and changes in regulation can impact FAF’s business. Specifically changing capital requirements or an increase in regulatory burden could disproportionately affect the company.

  • Adverse legal conditions: Legal claims and litigation will definitely cause operational, financial, and regulatory risk to the company.
  • Lack of Differentiation: Title insurance products, for all intents and purposes, are almost all identical. There is nothing that differentiates two different players except the price and sometimes services. This makes it extremely difficult to create strong loyalty to any one brand.

Business Resilience:

Despite the risks, FAF exhibits some signs of resilience:

  • Brand recognition: FAF’s established brand and long standing reputation is hard for a competitor to easily replicate.
  • Scale: FAF’s has large operations as well as huge network distribution that give it some advantages in comparison to newer entrants to the market.
  • Experienced management: FAF’s management has many years of experience in the industry and they should be capable of handling various challenges.
  • The company has tried to address the recent drop in revenues by cutting spending. This cost efficiency will lead to a strong bottom line in the long run, and give better opportunities to the company.

Understandability: The company’s business model is fairly straightforward: it provides insurance to protect against losses due to issues regarding titles of properties. The company also has operations in other services that are closely related to it. FAF’s business operates in a well-defined market with limited scope of growth unless the US real-estate market grows. Although their business operations are relatively straightforward, the company financial statements are relatively complex. A lot of items in non-core operations are listed as part of the company’s performance, which can be difficult to discern. A complex accounting is also required for the various divisions of the company and especially goodwill. Overall the business model is not very complicated and it’s easy to understand why it does what it does, but the accounting side does make it hard to make accurate valuations. Rating: 3 / 5

Balance Sheet Health:

FAF’s balance sheet is relatively healthy, and here’s why:

  • Liquidity: FAF has a large amount of liquid assets in cash and short term investments that should allow it to weather difficult economic conditions.
  • Debt: The company has a reasonable amount of long term debt that can be easily managed as the interest expenses for debt are low.
  • Leverage: FAF’s debt to equity ratio of 0.64 which suggests there is no big problem with leverage, and it will not lead to significant liquidity issues or bankruptcies.

  • Future Liabilities: FAF does not seem to have any significant unmanaged liabilities.

  • The company did see a drop in tangible book value due to some impairment charges related to goodwill. But the book value is still significantly higher than the market cap. This book value is not affected by the mark-to-market accounting of financial assets. Overall, the company’s balance sheet is relatively healthy and there is no cause for concern. Rating: 4 / 5