First American Financial shares (NYSE:FAF) has returned more than 25% this year, including dividends, largely keeping pace with the broader market, although its title insurance business has faced a significant slowdown. I expect recovery in this unit Lower interest rates could begin to reduce investment income by mid-year. As such, I view the shares as fully valued.
First American generates 95% of its non-investment income from title insurance and has a 25% market share. With interest rates rising, we have seen a significant decline in real estate transactions, which has naturally reduced the premiums earned on title insurance (as this product is purchased when a home is purchased with a mortgage or refinanced). This slowdown began in 2022 with revenues falling from $9.2 billion to $7.6 billion. This continued into 2023.
In the business third quarter, it gained $1.22 excluding unrealized investment losses, as revenue fell another 19% to $1.5 billion. Title insurance revenue is down 26% so far this year, and from peak to trough, revenue could fall by about 40%. As with any company whose revenues decline this much, margins have compressed. Pre-tax margins are down to 12%, compared to 13.3% last year. This is despite the fact that personnel costs fell by 15%, to $486 million. Management has taken aggressive steps to cut costs, but the decline in real estate activity has simply been too great to mitigate.
First American ended the third quarter with open orders down about a quarter, indicating continued weakness in the fourth quarter, although management expects title insurance margin to approach $2 billion. dollars in 2024, up about $300 million, helped by cost reductions and some rebound in activity. Although I expect improvement in 2024, I am cautious about its magnitude.
Today, the rise in mortgage lending has clearly slowed down activity. This means that refinancing operations have practically stopped. Additionally, they made monthly payments much less affordable for new home buyers, thereby reducing purchases. As you can see below, rates are down sharply compared to two months ago. This should make purchasing activity easier, and some recent buyers may consider refinancing. However, mortgage rates remain higher than at the start of the year. In other words, this drop in interest rates is less likely to trigger a surge in real estate transactions than to halt the decline we otherwise would have seen if mortgage rates had remained at 8%.
Now, if mortgage rates continue to fall and the Federal Reserve follows through on its planned rate cuts in 2024, that could help boost housing demand. While I favor the thesis that housing demand will increase in 2024, this could increase housing prices more than First American’s activity, which is more closely tied to transaction volumes.
The challenge is that we still have a very limited market in terms of supply (which is why increasing demand could push prices up). As you can see below, the number of existing homes for sale remains extremely low, although it has increased from its low point. Until supply increases in the market, it will be difficult to see a significant increase in transactions, even if rates continue to fall. With so many homeowners having mortgages below 4%, they remain strongly incentivized to stay in their homes rather than sell them. This factor risks suppressing supply for an extended period of time.
Apart from residential volumes, commercial transactions also saw a significant decline due to rising rates. Commercial revenue is down 39% this year. As you can see below, activity has halved since 2021. Management expects a recovery of more than 20% in 2024 to return to the levels observed over the 2026-2017 period. Given that rates remain significantly higher in absolute terms, a recovery of this magnitude seems aggressive to me.
To be clear, I expect commercial and residential volumes to improve in 2024 compared to 2023, barring a recession or surprise interest rate increase. Given the rate cut and some pent-up demand, activity should improve. However, given supply constraints, I expect a single-digit improvement rather than a full recovery unless mortgage rates fall much more aggressively, to around 5%, which could start to unlock more supply.
Now, while rising rates have hurt its core insurance business, FAF has seen a profit on its investment portfolio. Net investment income increased to $142 million in the third quarter from $105 million last year, driven by reinvestment of short-term securities at higher interest rates. As you can see below, FAF maintains a high-quality investment portfolio with an average AA rating, giving it minimal credit risk. Management estimates that each 25 basis point decision by the Fed has an annual impact of $15 million to $20 million.
This becomes the challenge of determining how much profit and cash flow can be recovered next year. If we assume the Fed makes three rate cuts, that will represent an annualized hurdle of about $60 million. Assuming an additional 15% margin, FAF will need to increase its securities revenue by $400 million to offset this loss. This represents approximately 7% growth over 2023 levels. If the market price for 5 or 6 reductions materializes, the transaction growth required is even greater.
In my opinion, high single-digit growth is a reasonable expectation, but due to headwinds on its investment portfolio, this may not allow the company to significantly grow its earnings relative to its earnings rate. running about $4.50 with about $550 million in annual operating cash flow. to flow.
Now the company has also increased its split by 2% to $2.12 per year, and although it has slowed buybacks by $441 million in 2022, the share count is 1% lower than that of ‘one year ago. However, with $1.9 billion in debt, FAF has a debt-to-capitalization ratio of 23.5%, compared to a target of 18-20%. Beyond the dividend, which costs about $220 million, that means operating cash flow for the next 12 to 24 months should go toward deleveraging the balance sheet rather than buybacks.
I would also like to note that the business suffered a cybersecurity incident, but operations have since been back online 28/12. Bank accounts have always been secure, limiting the financial risk of this event, although fourth-quarter results could be weaker due to systems outages. Ultimately, I do not see any significant ongoing financial risk from this event that would be material and change the investment thesis.
With mortgage rates falling, I can understand investors looking to play the housing recovery. Given the limited supply, I tend to think that increased demand is more likely to drive up prices than trading volumes, thereby limiting FAF’s upside potential. That’s why I always loved house builders, like Toll Brothers (TOL). Additionally, investment income could face challenges that offset transaction growth as the Fed cuts rates. With the stock at 14x, minimal earnings growth, and debt above long-term targets, I view the stock as fully valued and likely to be dead money. While there may not be a major downside in the absence of a recession, I would take advantage of the recovery to leave the FAF.