First American Financial: Patience Should Be Rewarded (NYSE:FAF)

First American Financial (NYSE:FAF) has seen its share of ups and downs over the past year, driven by uncertainty around inflation and higher interest rates. As shown below, the stock is down materially over the past 12 months, and at the current price of $58, trades well below its $52-week high of $81. In this article, I highlight why now may be a great time to layer into the stock while it remains undervalued, so let’s get started.

Why FAF?

First American Financial is a leading provider of title insurance, settlement services, and risk solutions for real estate transactions. It was founded in 1889 in Orange County, California, and today, serves nearly every region of the U.S. Over the trailing 12 months, FAF generated $8.3 billion in total revenue.

It’s fairly obvious that FAF has seen headwinds from higher interest rates and a slowdown in the housing market. This is reflected by a 29% YoY decline in revenue to $1.8 billion during the third quarter compared to the prior year period, when the housing market and the refinancing activity were going strong amidst historically low interest rates.

It’s worth noting however, that FAF’s core business was down by just 10% YoY, when excluding for net investment losses related to FAF’s insurance business, some of which were unrealized losses due to market fluctuations.

While the headwinds haven’t gone away, I do see reasons to be optimistic, as mortgage rates have trended down since hitting a near-term high of 7.0%+ in November, as shown below.

Moreover, according to Freddie Mac, there appears to be plenty of pent up demand from homebuyers who are just waiting for lower rates before making the leap, as noted below in this month’s report:

Mortgage application activity sunk to a quarter century low this week as high mortgage rates continue to weaken the housing market. While mortgage market activity has significantly shrunk over the last year, inflationary pressures are easing and should lead to lower mortgage rates in 2023.

Homebuyers are waiting for rates to decrease more significantly, and when they do, a strong job market and a large demographic tailwind of Millennial renters will provide support to the purchase market. Moreover, if rates continue to decline, borrowers who purchased in the last year will have opportunities to refinance into lower rates.

FAF also has the potential to emerge out of the current cycle in stronger position, as it’s gained market share in purchase and commercial transactions, where it’s stronger. It’s also gaining scale in its mortgage servicing business, which is less vulnerable to housing downturns, and investing in digital capabilities to make its close process faster and more efficient, as highlighted during the last conference call:

As we discussed on our last call, we remain committed to investing in strategic initiatives that support our company’s long-term growth and operational efficiency despite their near-term impact on profitability. Our initiative to deliver instant title decisioning for purchase transactions and Endpoint, our digital title and settlement company continue to make progress.

ServiceMac, our mortgage sub-servicing business, is rapidly achieving scale, and we now expect ServiceMac will be profitable in the final quarter of the year, a significant improvement from the $11 million pre-tax losses booked in the second quarter.

Importantly, FAF maintains an investment grade rated BBB- balance sheet with a safe debt to equity ratio of 30.5%. It also pays a respectable 3.6% dividend yield that’s well-covered by a 29% payout ratio. Notably, FAF has increased its dividend every year for 12 years, and has a 5-year CAGR of 7.4%, including the slower growth rate last year due to a difficult environment.

Lastly, I see value in FAF at the current price of $58.59 with a forward PE of 9.5, sitting below its normal PE of 12.7. Management also appears to think that the share are cheap, as FAF repurchased 7% of its outstanding shares in the first ten months of 2022 alone. Analysts have a consensus Buy rating on the stock with a conservative price target of $60.

Investor Takeaway

Overall, I believe that FAF is positioned to do well in the long run due to its strong balance sheet, market share gains in purchase and commercial transactions, plus its investment into digital capabilities and mortgage sub-servicing business.

Plus, the company is buying back shares at an attractive valuation and it pays a respectable dividend yield that’s well-protected. While FAF’s near-term headwinds won’t go away immediately, long-term investors may want to consider the stock at the current value level.