Value Investing Congress Blog

It has been a long time since we’ve had extreme fear in the U.S. equity markets, an observation supported by the historically low volatility in recent years and the low prices one could pay for disaster protection in various forms (U.S. equity index puts, credit default swap spreads, etc) prior to this summer’s credit crunch driven sell-off.

Clearly, we’ve got fear now, and at the epicenter of that fear is the U.S. real estate market. This fear is reflected in extraordinary volatility and stock price declines for those companies seen most vulnerable to the real estate bust – most notably homebuilders, mortgage lenders, and mortgage guarantors – coupled with all-time high prices for disaster protection on these names.

Fear brings opportunity

But as all value investors know, fear brings opportunity. One of the axioms of fear-based selling is that everything viewed as being in proximity to the danger gets sold. Panic selling does not lend itself to careful consideration of relative risk. The market often does not begin to discriminate between those securities with truly high risk and those with low risk until after the crisis has abated. Once time has allowed for a more appropriate discernment of value and risk, the value of those securities that were unjustly marked down inevitably recover the full measure of their value. There is opportunity in virtually any crisis for those investors willing to carefully pick through the rubble. It is never easy, and getting the timing perfect is virtually impossible, but we believe that the recent fear in the real estate sector has provided us with actionable bargains.

We have identified two investments in particular that we believe offer us a unique combination of compelling value and reasonable safety: Fidelity National Financial (FNF) and LandAmerica Financial (LFG). Both are engaged in the somewhat esoteric business of title insurance.

A brief introduction to title insurers

Title insurance sounds a lot like mortgage insurance, but the inherent risk profiles in the two businesses are about as far apart as they can be. The purpose of title insurance is to protect the policy holder from outstanding liens and encumbrances on real estate that are not known to the purchaser at the time of the transaction. Title insurance companies provide a guarantee and insurance to the buyer of a property, and perhaps more importantly, to the lender who finances the transaction – and it is the insistence by the lenders on this guarantee that has made title insurance an indispensable part of the U.S. real estate transaction process.

Virtually every real estate transaction in the U.S. requires title insurance. Because of this, title insurance is a massive market. The estimated title insurance premium revenue for the industry was approximately $16.5 billion in 2006. There are only a few major players in the industry, with 92% of those policies written by one of the top five companies. Fidelity National Financial, which has about 28% nationwide market share, generated about $4.8 billion in title insurance premiums in 2006.

Title insurance has no expiration date, and no time limit on claims filing, but most title insurance losses are reported and paid in the first couple of years of the policy. Often, these losses come in the form of corrections to the title, which have a modest cost and which generally do not require a cash payout to the policy holder. Large title claims are infrequent, but they do occur from time to time, but virtually all title insurers lay off large risks in the reinsurance market. The coverage term of a title policy ends at the sale or transfer of title of the property, so once a property is re-sold, the risk on that policy disappears from the insurer’s books forever.

On top of the title insurance revenues, each of the major title insurers provides some combination of additional services, such as flood certification, escrow, tax-free property exchange services, document preparation, credit reporting, and various other services. For FNF, such additional business added up to over $1 billion in 2006. FNF is also one of the largest players in the home warranty insurance industry and also has a nicely profitable specialty insurance business as well.

Looking backwards

One of the crucial differences between title insurance and other forms of insurance is that title insurance protects against an event that happened in the past, whereas most other types of insurance involve protecting the policy-holder from some unexpected or adverse future event. These are two completely different categories of risks. Most title defects are discovered by the title agent as part of the title examination undertaken at the time the policy is being prepared.

In comparing risk profiles of title insurers to other distressed real estate players, title insurers have nothing like the risks of exposure to rapid increases in default rates to sub-prime loans that could overwhelm their ability to pay the losses, as is the fear with the mortgage insurers. This is why we are not tempted at all by the mortgage insurers, simply because we don’t believe we can adequately handicap the risk of permanent capital loss. Title insurance merely insures against the usually remote possibility that the seller does not actually have proper title to the property that is being sold. Title insurers don’t get hurt when a mortgage holder defaults – so long as the title at time the property was sold was in good shape.

Claims losses for title insurers have averaged about 7% of premiums for about the last twenty five years. In boom times, losses tend to decline somewhat, while in downturns, claims tend to rise a bit. While it is reasonable to believe that claim losses could trend to levels slightly higher than 7% for a year to two, all the publicly traded title insurers appear to be well capitalized and fully able to pay significantly higher claims rates if that were to ultimately transpire.

Title insurers also would seem to be much less risky than the homebuilders, which are entirely leveraged to the market for new home sales. New home sales typically represent just 10-15% of all real estate transactions, and are much more volatile than the level of real estate activity as a whole. In contrast, title insurers get paid on every real estate transaction type, whether it is the sale of a new home, the resale of an existing home, a mortgage refinance transaction, or commercial real estate transactions. In addition, building homes is a capital intensive business model that usually requires significant debt to finance even in the best of times. Because of these risk factors, we believe it is still too early to safely buy the homebuilders, many of which are highly leveraged. For the title insurers, however, we believe that Q3 ‘07 likely represents something close to the bottom, both in terms of fundamental business performance and for the stocks.

Fidelity National Financial

Fidelity National Financial offers investors an eclectic portfolio of businesses that, while still levered to real estate activity, is likely to be far less cyclical than most other real-estate related stocks.

Fidelity National Title (FNT) is the business unit that includes the title and related services businesses and remains the major value driver for FNF. FNT produced $6 billion in revenue and $650 million in pre-tax profit in 2006, which reflected the rapid slowdown in residential housing in the second half of that year. We expect 2007 results to be significantly lower but still profitable. Assuming that real estate activity eventually normalizes at a level approximating 2001 or 2002 activity, we believe FNT can easily produce something in the neighborhood of $400-450 million of free cash flow annually. This is well below the $700 million in free cash flow the business produced on average from 2003-2005. If one assigns a very conservative 10X multiple to the $400-450 million figure, FNT is worth a minimum of $4 to $4.5 billion.

FNF has a specialty insurance group that includes a flood insurance processing business, a home warranty insurer, and a personal lines insurance company. The flood insurance business is a $150-200 million annual revenue business, and is the nation’s largest underwriter of flood insurance, with nearly 660,000 policies in force as of December 31, 2006. Importantly, FNF has no underwriting risk to these policies as the policies are underwritten by the federal government. FNF simply manages the program, for which it receives $0.31 of each dollar in policy premiums for new and renewal policies, plus a 3.3% override on the face amount of the claims processed. This is a very reliable, very profitable, low-risk business. The personal lines business, mostly homeowners’ insurance, does about $160 million in annual revenue, with about 215,000 policies in force as of December 31, 2006, primarily on the West Coast. The home warranty business produces about $80 million per year in revenue and generates pre-tax margins of about 20%. Altogether, the specialty insurance group produced $43 million in net income on about $410 million in revenue in 2006, and 2007 results will likely be similar. Assigning a modest multiple of 12X the annual earnings figure of $42 million yields a value of $500 million for the specialty insurance businesses.

FNF also has a 40% ownership in Sedgwick, a third party administrator that manages workers compensation, liability, and disability claims processing for third parties. The other owners of Sedgwick are private equity investors Thomas H. Lee Partners and Evercore Capital Partners. FNF invested $126 million for its initial stake in January of 2006, and kicked in another $7 million in September 2006. Sedgwick has an annual run rate of approximately $700 million in revenue and generates 15% EBITDA margins. FNF management has stated that its goal for Sedgwick is to reach the $1 billion annual revenue mark, and then seek a value-maximizing transaction for FNF shareholders, most likely a sale or spin-off. Because Sedgwick’s revenues are not consolidated at the FNF level, this asset isn’t immediately visible to investors making a quick read of the GAAP accounting statements. But we believe the value to FNF shareholders will ultimately be realized, and expect that ultimately this value will be at least double what FNF paid for its interest. For now, our working valuation figure is around $200 million.

FNF also has a 71% ownership in Cascade Timberlands LLC, which owns over 290,000 acres of timberland located on the eastern side of the Cascade mountain range extending from Bend, Oregon south toward the California border. FNF paid $89.2 million for its ownership when it bought its interests from the creditors in the bankruptcy of Crown Pacific back in December of 2004. Just doing the math shows that for its pro-rata ownership of about 208,000 acres, FNF paid only about $430 per acre, a substantial discount to publicly traded timber companies. FNF has already announced that some of this acreage will be converted to higher value resort and residential use, and is also negotiating to sell some parcels at prices well in excess of its cost. Using a reasonable comparable multiple of $1,200 per acre, we believe this asset could be worth closer to $250 million.

A free call option?

FNF also has two other interesting assets to which we assign no value at this juncture. One is a 61% ownership in FNRES, which is essentially comprised of the real estate internet portal Cyberhomes.com. Basically a Zillow-like website property with real estate listings and related advertisements, Cyberhomes recently became the official real estate portal for AOL. While we view FNRES as a free call option, it has a chance to be valuable down the road – a recent venture capital funding round for Zillow values that firm at $350 million.

Finally, effective sometime before year-end, FNF will purchase about a 30% equity interest in Ceridian (CEN), a publicly traded payment processing and outsourced human resource services provider, for about $550 million. This investment is another partnership with Thomas H. Lee Partners. At this point, we believe the Ceridian investment is worth about what FNF is paying for it, but we believe there is potential for value to be created here for FNF shareholders over time.

When we add up all the pieces, we come to an intrinsic value estimate ranging from $5 to $5.5 billion, or $22-25 per share, versus the recent price of around $14 and market cap of about $3.1 billion. We believe our estimate is very conservative, given our view that FNF may be chronically overcapitalized at its title insurance subsidiaries and that our estimates of future title insurance profitability are well below the recent demonstrated earnings power of that business. Given that we baked in conservative assumptions throughout, true intrinsic value could easily be north of $30 per share if the real estate market stabilizes relatively quickly. Clearly, FNF management believes its stock to be undervalued, as the company repurchased over $100 million worth of its own shares in Q3 alone. FNF also pays an enormous dividend, currently $1.20 per share annually. The dividend requires some $265 million per year to support, but we believe that it will be supportable in all but the darkest of scenarios – at least through the end of 2009. At the recent price of around $14, the implied dividend yield is north of 8%. In short, we believe that FNF is both safe and cheap at current levels.

LandAmerica Financial

LFG is a bit more of a pure-play on title insurance as compared to FNF, and therefore may not be quite as safe, given that it does not benefit from the diversification in its business that FNF enjoys. However, the stock appears to us to be an extraordinary bargain. The stock was selling for more than $100 as recently as June of this year, at which point it sold at a modest premium to book value. At the current price of around $26, the stock sells for less than 35% of stated book value. Let me state the value proposition another way: LFG investors are paying a purchase price of less than $400 million for a business that produced cumulative free cash flow of over $1.2 billion in the five years from 2002 to 2006. We believe the business has a normalized earnings power of something close to $200 million in free cash flow annually.

Why is LFG so cheap? Well, the third quarter of 2007 was something of a perfect storm for the title insurance companies, and particularly LFG. The quarter featured sharp declines in real estate activity, with mortgage originations nationwide down more than 20% year-over-year. In California, Nevada, and Arizona, markets where LFG has a significant presence, the decline was more like 30% compared to Q3 ’06. As a result, LFG lost money and burned cash in Q3, though the company is still cash flow positive for the first nine months of 2007. LFG also announced that it would have to strengthen its claim reserves in Q3 ’07, the third such announcement in the past year. However, with claim reserves now finally at reasonable levels, any further upward adjustments are likely to be minor.

Q3 represented the worst kind of environment for a title insurance operator. Given that a title insurer has considerable variable costs, a gradual slowdown in real estate is not hard to deal with. Workforce and expense reductions are simply made in proportion to the decline in business activity. While LFG has been aggressively cutting expenses, the sudden decline in Q3 was too fast for LFG to match its cost structure immediately. Nevertheless, LFG has reduced its expenses by about $320 million on an annualized basis in the first three quarters of 2007, and the company will doubtless continue cutting costs until it is able to match its costs to the level of real estate activity.

While the immediate future doesn’t look particularly rosy for LFG, we believe the market is discounting this business way too much. The company accounts for roughly 20% national market share for title insurance, so it is a large and normally very profitable business. In our models, if the real estate environment merely went back to 2002 levels (perhaps by 2009), LFG should easily be able to generate revenue ranging from $2.75 billion to $3.25 billion, with free cash flow margins of 7% or higher. This translates into annual free cash flow of around $200 million. Assuming the market even assigns LFG a measly multiple of six times the $200 million figure, the stock would be worth somewhere close to $75 per share – or right around the current per-share book value of $79. If the market assigned a multiple of eight times cash flow, LFG shares would be at $100 – not quite a quadruple from here.

LFG also features an attractive yield at today’s price, with an annual indicated payout of $1.20 per share on a $26 stock, for a dividend yield of just beneath 5%. LFG has been particularly aggressive in repurchasing stock this year, and bought back 5.5% of the shares outstanding in Q3 alone – at an average price of $48, nearly double today’s price. A similar dollar value repurchase in Q4 would reduce the share count by another 10%, and we believe LFG will continue to aggressively repurchase shares. In summary, while in our view LFG is not as safe an investment as FNF, we believe investors who can hold on for the ride are likely to be amply rewarded once the fear subsides.

We believe the primary risk with these two ideas is that of being early. As Bill Miller has written, if you are early enough, it is indistinguishable from being wrong. More importantly, if one happens to be a professional investor, one also has to take the risk of looking bad, at least for a while. In the short run, this can feel worse than actually being wrong. While we acknowledge these risks, we believe that buying at the point of maximum fear usually results in getting the maximum return. And we think that the point of maximum fear may well be upon us.

Zeke Ashton is the managing partner of Centaur Capital Partners, a Dallas area investment advisor that specializes in value-based strategies. At the time of this writing, Centaur Capital owned shares in both FNF and LFG. Positions may change at any time.
This article is not meant as investment advice for any individual, and should not be considered a recommendation to buy or sell any security. Readers are encouraged to perform independent due diligence before making any investment decision.

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