In war, those that profit most stay out of the fight and sell arms to both sides. There’s a war going on between home buyers and sellers and Fidelity National Financial (FNF) is the arms dealer.
The U.S. housing market is tight, to say the least. Since the beginning of the pandemic demand has outstripped supply and prices have skyrocketed. Buyers are capitulating and sellers are standing their ground. Between them is FNF, making record profits off the hot market.
The attractive valuations are hard to believe. After considering worst case scenarios I still expect the company to make double digit returns. At a forward P/CFO of 2.29 my eyebrows are stuck to the top of my head. Let me explain why I’m buying this real estate arms dealer with both hands.
National Leader in Title Services
Fidelity National Financial is the leading provider of title insurance services in the United States. They operate through several subsidiaries to earn 32% of the market share for residential and commercial mortgage transactions, the most of any company. FNF also offers annuity and life insurance products primarily through their F&G segment acquired in 2020.
The business model is strongly correlated with mortgage originations and home sales. The company earns profits from fees, title insurance policies, escrow services, and other title-related services. This means they make more money on higher fees or, primarily, the quantity of mortgages serviced. Since 2020 the number of mortgage originations have grown dramatically, primarily due to increased refinances because of ultra-low mortgage rates. FNF doesn’t need high refinancing activity to grow earnings but it’s more difficult without them. Home sales are more stable as refinancing is volatile with the direction of mortgage rates.
The company will be releasing their Q4 2021 earnings report later this month, which I look forward to. But for now we can examine the results from Q3. EPS came in at $2.12 beating estimates by $0.48. Adjusted net earnings grew 39% QoQ. The levered FCF margin is 20.6% which coincides with their adjusted pre-tax title margin of 21.7% for the quarter. Forward FCF is expected to grow by 22.2%.
Year over year, commercial orders per day were up 15% and revenues up 69%. In addition, Direct and Agency premiums increased 22 and 34%. The debt to equity ratio is a reasonable 37% and the company issued $450 million in debt at 3.2% on a 30 year term. This is about 14.5% of their long term debt.
In 2021, the F&G segment expanded into institutional markets. The segment earns revenue by selling annuity and life insurance products. This diversifies the company’s income sources as these products are better protected from interest rate risk. F&G had adjusted net earnings of $101 million in Q3 which is about 16.7% of total net earnings. The segment is growing fast and exceeding company expectations.
The fly in the ointment is the earnings estimate for 2022. Analysts expect a sudden drop in earnings and this is weighing on the stock. It’s not ideal to experience such a large decline in earnings, if accurate, but it’s manageable with current valuations.
The company is on a hot streak for beating estimates so perhaps they can keep it up and beat this setback:
Management expects strong margins and revenues in 2022 with double digit growth from the core business. A $500 million share repurchase goal was accomplished in 2021 and plans for additional buybacks are in progress. The 3.6% dividend looks solid at a 19% payout ratio after they raised it by 10% in Q3. It’s expected to raise by 13% in 2022.
Title companies, including FNF, rely on mortgage refinances for significant portions of their revenues. This is perhaps the most cyclical product they sell. As you can tell, the volume of refinances changes in negative correlation to the direction of mortgage rates. There’s usually a spike in refinances when mortgage rates reach new lows, which occurred in 2020.
In October, daily refinance orders opened were down 38% YoY for FNF. Refinance orders have been declining since the start of the year and account for 19% of total revenue in Q3. With mortgage rates climbing rapidly the number of refinances are going to decline further.
The company states that the average service fee earned per refinance is $1,000 compared to the service fee of new purchases of $3,400. Because new mortgages and commercial mortgages rose in Q3 the increase in revenues offset the decline in refinances, as you can see from the chart above.
By my calculations, in the worst-case scenario whereas FNF serviced no refinances and the lost revenues translated into a 100% loss in earnings the company’s P/E ratio would increase from 5.32 to 6.73. The 5-year PE mean is 13.1.
It is clear to me that in the near term new originations are going to drive company earnings. Therefore, it is critical to get a sense of the market outlook and trends in demand.
The company is most exposed to the risk of reduced order volumes. This is a function of housing demand and influenced by changes in mortgage rates, but not dependent on them. This is what I love about the business model: it does not matter if home prices are up or down, if people are upgrading or downgrading, or if migration is heading to urban or suburban areas. What matters is that people are moving.
Inflation and Pricing Power
FNF has a unique advantage of inflation protection. Their services are required for most home buyers with relatively inelastic demand. These services are relatively small compared to the total home purchase cost. For these reasons the business has strong pricing power. Their expenses are also less vulnerable to inflation due to the use of automated technology systems and minimal need for raw materials.
J. Robert Hunter, Director of Insurance for the Consumer Federation of America had this to say about title insurance pricing power in testimony he gave to the House Committee on Financial Services:
Consumers don’ t have the market power to discipline title insurance prices… The ultimate consumer has little or no market power in the title insurance transaction because title insurance is required for obtaining the loan or purchasing the property and because the consumer, who infrequently purchases real estate, has relatively little knowledge of title insurance. The entities with the market power in title insurance are those people who are able to steer consumers to particular title agents or title insurers.
Given FNF’s market share and debt structure the company is well positioned to endure inflation.
My Primary Concern: Demand Pulled Forward
The worst thing that can happen to home sales volume is demand being pulled forward from the future because of low mortgage rates. This would subdue company earnings for years. In the Q3 earnings call, management recognized that there may be a minor pull forward of demand for commercial orders based on the volume they are seeing at present.
Let’s begin with a sense of market sentiment. The Zillow 2021 Mover Report found that 11% of Americans have moved in 2020-2021. They refer to this as “The Great Reshuffling.” The report states that 70% of homeowners would become comfortable moving when COVID vaccine distribution is widespread.
This corresponds with data from the Nerd Wallet 2022 Home Buyer Report which found that 58% of homeowners want to sell their home but 89% are prevented from doing so and 31% of those were due to the pandemic. At 40%, the most common reason for not selling was the concern that the sellers could not find a new home due to short supply. The report also indicated that 26 million Americans plan to buy a home in 2022 because 66% of shoppers were unsuccessful in 2021. 33% of those indicated that the pandemic contributed to their postponement.
The monthly Fannie Mae survey concluded that the portion of Americans who think it’s a good time to buy a home hit an all-time low of 25%. This is partly a result of price inflation causing building construction to cost more and preventing renters from saving up down payments.
It’s a bleak battle raging out there and both sides are taking casualties.
Demand pressure is not likely to ease up anytime soon. Demographics in the U.S. suggest that the number of first time home buyers will continue to grow for the next few years as more of the millennial generation reach peak home buyer age.
The shortage is evidenced by the downtrend in number of days homes are on the market and number of unsold new homes:
This incredible demand is a result of pandemic-related changes in circumstances (people wanting to move out of the city, into bigger homes, etc) and affordability due to low mortgage rates. Despite all time highs in home prices, even when adjusted for inflation, the real housing affordability has not made new highs. Real housing affordability is adjusted for the cost of financing and until the recent rise in mortgage rates was below the baseline from 1990.
But this real price index adjusted for financing doesn’t account for change in disposable income. Mortgage debt service as a percent of disposable income is near long term lows:
The U.S. housing market is not in a bubble, in the sense of current affordability. But this could change if rising rates or a recession impacts disposable income and debt service. I’m concerned that falling home prices could beget more falling home prices as homeowners have trouble meeting their debt service and vacate their homes at a loss. I think the Federal Reserve shares that concern and is ready to step in and prevent such circumstance. This is probably why they continue to buy MBS at a steady rate:
The rise in mortgage rates over the past 6 months has put a dent in refinance applications but almost no impact to purchase applications, yet. There’s a standoff between prices, sales, and rates and I’m holding my breath to see which one flinches first.
Here Comes The Cavalry
I believe that a chain reaction of events are preparing to take place which merely requires catalysts, two to be exact:
- Pandemic fears alleviated
- New construction completed
These statistics are important to get a better sense of the housing shortage. The number of households per housing unit peaked in 2017 and has been declining despite little change in the size of households, suggesting an improvement in housing inventory in excess of household formation:
Persons per unit has reached the same low that bottomed in 2008. In contrast, persons per vacant unit is near a long term high. This relationship is the opposite of what happened in 2008:
What could be responsible for this phenomenon? The answer may be found in the construction data. Since the start of the pandemic new homes sold-completed has diverged from new homes sold-under construction. The same relationship existed up to the 2008 housing crash. The peak of housing prices coincided with a reversal of this relationship:
Prices also peaked with housing starts not started and under construction. Curiously, leading up to 2008 new homes completed trended with new homes under construction but in 2020-2021 they trended in the opposite. This is due to labor shortages and supply chain disruptions preventing the completion of new homes. But the disruptions were not severe enough to prevent new construction from beginning. This suggests that the disruptions are in acute sectors like skilled labor or pre-fabricated home parts.
The quantity of housing inventory that will be hitting the market is now at all time highs. Progress has been delayed and the delays are likely to continue as global trade is still experiencing issues and the increase of construction jobs is outpacing the growth of hiring.
End of the Housing Boom
With mortgage rates rising we are beginning to see signs that the housing boom is nearing maturity. Consumer sentiment is turning down sharply which often precedes a drop in new home construction. As we’ve already seen, the rate of growth for new homes under construction and not started has been decelerating. Negative growth foreshadows a peak in housing.
This is while the 10-2yr yield curve is in decline. With tightening by the Fed and increases in the Fed Funds Rate I expect the curve to continue flattening. A negative yield curve predicts near term recession with impeccable consistency. I expect we will receive that signal in 2022 or 2023, which will change the Fed’s narrative.
New COVID cases in the U.S. are dropping precipitously with vaccination rates at 76% fully or partially vaccinated, prompting many States to remove masking requirements. It finally appears that the end of the pandemic is near, but I’m not a medical professional.
It seems that some housing demand has been pulled forward in the last year but there is still plenty of demand unmet. Short supply and the pandemic are the main reasons preventing people from buying their homes. There is a lot of unfinished homes that will be finished eventually.
Given this data, the following is my expectation for the intermediate future:
- Rising mortgage rates temper buyer expectations and pressures prices to decline
- Pandemic fears alleviate and encourage buyers and sellers to move
- Newly completed homes continue to grow and add inventory to the market
- As the market balances out it encourages more market participants
- As recession looms the Fed cuts rates and mortgage rates decline
- New homeowners start refinancing at lower rates
Investors can gain exposure to U.S. housing through rental property, mortgage REITs, equity REITs, home-builders, residential services, and more. Each sector is exposed to different degrees of mortgage rate risk, delinquency risk, default risk, inflation risk, and liability risk. In my opinion, the sector with the least risk in this environment is title insurance. As long as volume keeps up the business should see strong earnings. Of anything, volume is what I am most certain. The threat that could derail their success is another widespread liquidity crisis like 2008 or 2020.
Fidelity National Financial is trading at very low valuations on both the current and forward basis. You can see below that from 2010 to 2019 the company closely tracked adjusted earnings ranging between 13x and 19x P/E.
Since the start of the pandemic the stock has diverged dramatically from those long term trends. It currently trades at a P/E of 6.9. A return to normal P/E by 2023 would result in total returns of 40% CAGR.
Buyers and sellers are still entrenched in this housing battle. Each side wants to charge forward, but lacks the courage. The tide is beginning to turn as new homes hitting the market grows. As pandemic fears subside, increased market activity will spur further activity. The refinance market is drying up and will go dormant until mortgage rates start declining. My prediction: that is sooner than most people expect.
FNF is in position to benefit from these trends with the least exposure to the risks. They will profit from the culmination of The Great Reshuffling. Inflation won’t keep them down. The company is tremendously undervalued so I’m going all-in.