Fidelity National Title FNT W
August 11, 2006 - 6:13pm EST by
dionis589
2006 2007
Price: 18.81 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 3,279 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Summary:
  • FNT is the largest title insurance company in the US and has the highest operating margins. 
  • It has a safe dividend yield of 6.2% (dividend likely to be increased again early next year)
  • Unlike most ‘mortgage stocks’ FNT has no consumer credit exposure
  • FNT has excess cash and debt capacity equal to about a quarter of its proforma market cap (I expect much of this to be used for buyback)
  • Within FNT are less cyclical/higher multiple businesses that have the potential to be spun/sold.
  • Valuation compelling at 7.4x ’06 estimates ... and earnings are almost all cash. 
  • FNT (FNF) has historically performed very well immediately following a tightening cycle
 
Background:
 
In October of 2005 FNF spun out their title company and created FNT.  FNF continued to own 83% of FNT (the rest was distributed to FNF shareholders).  FNT paid a regular large dividend in the hopes of dampening the cyclicality of the share price.  In theory this would also reduce the cyclicality of FNF’s share price without compromising FNF’s capital flexibility (FNF retained the dividend income they ‘earned’ from FNT).   FNF essentially became a holding company with majority stakes in FNT and FIS. 
 
The experiment didn’t work.  FNF traded at a significant discount to its sum of the parts.  In April management decided to shut down the FNF holdco and distribute the shares of FIS and FNT to FNF shareholders.  FNT will acquire all the holdco assets of FNF (namely cash, a specialty insurance operation, and a 40% ownership in a claims processing business).  FNT will issue about 46mm shares in exchange for these holdco assets (those shares will in turn be distributed to FNF shareholders).  The deal is expected to close in early Q4.
 
Catalysts:
 
1)  Lots of liquidity: 
FNT has $150mm in cash outside of regulated entities.  They could take another $215mm out of the regulated title sub.  They will also get another $275mm in cash from their acquisition of the FNF assets = total proforma cash balance of $640mn (they went over these numbers in their recent conference call). 
They also are under-levered and have additional debt capacity of $600mn or more.  This only is assumes that debt/cap ratios reach about half the level they were at in 2000 following the acquisition of Chicago Title. 
 
 
2)  I think much of this capital will be directed towards share repurchase: 
Quote from 2Q conference call:
 
“Obviously, if we're going to be a 6% dividend yielder, it makes a lot of sense for us to engage in a pretty aggressive share repurchase program assuming we don't have a more appropriate use for our cash resources.”   …  “ But for the first time in several years, really, we're taking a very, very hard look at a pretty aggressive stock repurchase program at the point in time when we can do so, which will be following the shareholder vote. And we should -- if the shares are going to be trading at a level like they are today, then it's time for the Company to do what did back in the mid '90s, and that's repurchase a significant number of shares.”
 
Cash and debt capacity is equal to about 25% of the proforma market cap (after the issuance of 46mm shares).   Some capital will also be going towards acquisitions (this was discussed as a likely use of capital on the call as well) but I suspect much of it will go towards share buyback.  FNF mgmt/board has a history of aggressively repurchasing shares and managing capital (FNF paid a $10/share dividend in 2005). 
 
 
3)  The end of a tightening cycle has historically been a very good time to buy the stock. 
Numbers below show the FNF performance for the twelve months following the last rate hike in each of the last few cycles.  FNF legacy operations are now in FNT.
 
3/89 - 3/90   +30%
2/95 - 2/96   +73%
5/00 - 5/01   +62%
 
 
4) Other ‘unappreciated’ businesses (to be acquired in restructuring in early Q4):
 
In early 2006 FNF acquired a 40% interest in Sedgwick, a leading provider of outsourced insurance claims management services to large corporate and public sector entities.  Private equity interests control the other 60%.  Mgmt has been very forthright in explaining that their goal is grow the business through acquisitions and monetize the asset within 18 months.  Sedgwick has announced two acquisitions within the last six months.  Following the completion of these acquisitions Sedgwick will have ~$90mm in EBITDA.  There are likely to be more acquisitions over the next 18 months and then the business will likely be spun.  Claims mgmt is a good business with predictable cash flows.  Sedgwick is probably worth another $2/share to FNT and I think they get close to zero credit for it today. 
 
FNF is also a leading provider of specialty insurance products, including flood insurance, homeowners insurance and home warranty insurance.  Like Sedgwick, these businesses generate predictable, recurring income and are not subject to the cyclicality of the title industry.  Most of the business is administering the federal flood insurance program.  They take zero underwriting risk and earn about $0.32 cent on every dollar of premiums and 3% of every claim paid.  1st half pretax income was $48mm, up 90% from ’05. 
 
Both Sedgwick and specialty insurance deserve higher valuations than the title company.  While I am skeptical that this value ever be will be realized while they are part of FNT, I think a sale/spin is possible (likely in the case of Sedgwick)
 
 
5)  FNT/FNF/FIS  has been a very confusing story over the last couple of years I believe that the simplicity and transparency of the new corporate structure will be a big help to the company.
 
 
 
The core businesses:
FNT is primarily a title insurance company.  Real estate buyers are required by mortgage lenders to purchase title insurance to insure that the title is ‘good’ (the person selling the property is the rightful owner and that there are no liens on the property).  Title insurance premiums are typically based on the purchase price of the property insured. 
 
The revenues are cyclical and largely dependent upon mortgage volumes.  The cyclicality of revenues is slightly less than that of the mortgage market because refinance premiums (which are the most cyclical portion of the mortgage market) are lower than purchase premiums (which are less cyclical). 
 
FNT has zero exposure to consumer credit (the insurance is written on the title … not the borrower’s ability to pay).  Title insurance losses have very little correlation to the economy and are relatively stable at about 5% of premiums. 
 
The expense structure is weighted toward underwriting expenses… the bulk of which is variable compensation and agent commissions which helps to protect margins in softer environments.  Margins at FNT typically vary from about 10% in trough periods to about 20% during the peak of mortgage origination cycles. 
 
Assuming a $1.8trillion dollar origination market the management believes that they can generate $5bn in revenue, a 10% pretax margin, and EPS of about $2.00 per share (this is before considering the potential for share repurchase; work I have done confirms that mgmt estimates are plausible).  Also worth noting that the Mortgage Bankers Association is forecasting about $2.3 trillion in originations this year and next which implies that earnings should be higher that the “trough” scenario. 
 
 
One very important risk to consider:
Regulation is a very real risk.  It seems as though almost every state is looking in to the pricing and practices of the title insurance industry.  Title insurance is a cost of homeownership that most people do not understand and get zero value from.  Title companies have few supporters and are an easy/non-controversial target for politicians which means they will probably continue to come under fire every few years
 
Garamundi (the CA insurance commish) announced that he is seeking a rollback of title rates to the dollar levels in 2000 (a reduction of about 25%).   He want to see this reduction despite the fact that the assets that are insured (i.e. homes) have increased in value significantly.   This would be a blow to FNT as California represents about 20% of FNT’s revenues and industry margins are only about 10% (though FNT’s are typically higher). 
 
However it is worth noting that Spitzer did not affect any real change despite a 4 year investigation into pricing and procedures and I don’t think Garamundi will either.  Spitzer’s investigation recently concluded and the settlement should have no material effect on the industry.  The title companies that settled agreed to marginally reduce certain refi premiums.
 
Title insurance rates should track with property values.  The liability of title insurers increases with the value of the assets they insure (i.e. homes...which have gone through the roof in CA).  Premiums should go up at the same pace as the asset that is insured.  In reality premium growth has actually trailed home price appreciation… so rates as a percent of value insured have been coming down already. 
 
Furthermore, the majority of the cost structure at FNT is compensation and commissions.  If premiums are reduced I would expect the agent to feel the pinch the hardest and the bottom line impact to be less (though still obviously negative).  Also worth noting that Garamundi is currently running for lieutenant governor.  If he wins it is possible that his successor may not have the same passion for reducing title rates.  
 
 
What’s it worth? 
There aren’t many companies yielding an entirely safe 6.2% dividend (that is probably going up).  Cash flow and balance sheet are both strong.  Mgmt has been doing the right things.  There are catalysts.  They will earn well north of $3.00 in a better environment (they earned $3.22 in ’04).  12x trough earnings gets you to $25 plus the nice yield.  If the environment/sentiment improves and they do the right things with regards to buybacks and other I can get to $30.  Admittedly this could take a while but in the mean time you enjoy a nice dividend. 
 
 
FNF is actually a cheaper way to buy FNT:
Shareholders of FNF will receive 1.05 shares of FNT and 0.55 shares of FIS following the completion of the restructuring in early Q4.  FNF is trading at about a 2.8% discount to its sum of the parts.  If one desires exposure to FIS as well FNF is an easy way to buy both companies at a discount.  While not the topic of this note, I find the investment case at FIS to be merit worthy as well. 
 
 

Catalyst

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