The selected consolidated financial data for the Company for the five-year period ended December 31, 1998, has been derived from the audited Consolidated Financial Statements. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and Notes thereto, "Item 1 -- Business -- Acquisitions," and "
Overview - As with all providers of real estate-related information products and services, the Company's revenues depend, in large part, upon the level of real estate activity and the cost and availability of mortgage funds. The majority of the Company's revenues for the title insurance and real estate information segments result from resales and refinancings of residential real estate and, to a lesser extent, from commercial transactions and the construction and sale of new housing. Revenues for the Company's home warranty segment result primarily from residential resale activity and do not benefit from refinancings. Traditionally, the greatest volume of real estate activity, particularly residential resale, has occurred in the spring and summer months. However, in recent years, interest rate adjustments by the Federal Reserve Board, as well as other economic factors, have caused fluctuations in the traditional pattern of real estate activity. Mortgage interest rates peaked in January 1995 and decreased throughout the remainder of the year prompted by Federal Reserve Board actions to stimulate the economy. This resulted in a resurgence of real estate activity in the last half of 1995, and generated a high inventory of open transactions going into 1996. This, together with an improving national real estate economy (including the beginnings of a recovery in California) and the Company's successful integration of its diverse businesses, resulted in strong revenues and profits for 1996. These favorable conditions continued throughout 1997. Stability in the real estate marketplace coupled with increasing prices prompted a resurgence in refinance and home equity transactions, primarily towards the latter part of the year. These factors, as well as market share increases in all of the Company's primary business segments, culminated in a record-setting 1997. Further rate declines started in the fourth quarter of 1997 and continued throughout 1998. This, coupled with higher consumer confidence, led to nationwide record-setting residential resale and refinance transactions in 1998. These factors, including a particularly strong California real estate market, contributed to record- setting revenues and net income for the Company in 1998.
Operating revenues - A summary by segment of the Company's operating revenues is as follows:
Real estate information operating revenues increased 92.0% in 1998 over 1997 and 30.2% in 1997 over 1996. These increases were primarily attributable to the same factors affecting title insurance mentioned above and $144.5 million and $53.8 million of operating revenues contributed by new acquisitions in 1998 and 1997, respectively. Effective January 1, 1999, the Company will implement a change to its revenue recognition accounting policy for tax service contracts. The new policy provides for a more ratable recognition of revenues, reducing the amount recognized at the inception of the contract and recognizing it over the expected service period. The Company estimates that adoption of this new policy will reduce the revenue recognized in 1999 from new tax service orders by approximately 50%. See Note 1 to the consolidated financial statements for a more detailed description of the accounting change.
Home warranty operating revenues increased 24.2% in 1998 over 1997 and 22.2% in 1997 over 1996. These increases were primarily attributable to improvements in certain of the residential resale markets in which this segment operates, successful geographic expansion, increased consumer awareness and increases in the number of annual renewals.
The Company's title insurance segment (primarily direct operations) is labor intensive; accordingly, a major variable expense component is salaries and other personnel costs. This expense component is affected by two competing factors: the need to monitor personnel changes to match corresponding or anticipated new orders, and the need to provide quality service. In addition, the Company's growth in operations that specialize in builder and lender business has created ongoing fixed costs required to service accounts.
Consumer risk management personnel expenses increased 30.1% in 1998 over 1997 and 120.4% in 1997 over 1996. These increases were primarily attributable to additional personnel required to service the increased business volume.
Insurers are generally not subject to state income or franchise taxes. However, in lieu thereof, a "premium" tax is imposed on certain operating revenues, as defined by statute. Tax rates and bases vary from state to state; accordingly, the total premium tax burden is dependent upon the geographical mix of title insurance and home warranty operating revenues. The Company's underwritten title company (non-insurance) subsidiaries are subject to state income tax and do not pay premium tax. Accordingly, the Company's total tax burden at the state level is composed of a combination of premium taxes and state income taxes. Premium taxes as a percentage of title insurance operating revenues were 1.0% in 1998, 1.1% in 1997 and 1.3% in 1996. These decreases were attributable to changes in the geographical mix of title insurance revenues, as well as changes in the Company's non-insurance subsidiaries' contribution to revenues.
Interest - Interest expense increased 79.8% in 1998 over 1997 and 108.3% in 1997 over 1996. The increase for 1998 was primarily due to $5.5 million of interest expense related to the senior debentures as well as incremental interest expense of $2.8 million related to the mandatorily redeemable preferred securities (outstanding for full year). The increase in 1997 was primarily due to $5.7 million of interest expense related to the mandatorily redeemable preferred securities (outstanding for eight months), offset in part by a 23.7% reduction in the average outstanding debt balance. See Note 8 to the consolidated financial statements for a description of the Company's borrowings under its bank credit agreement and its senior debentures and Note 14 to the consolidated financial statements for the description of the mandatorily redeemable preferred securities.
Income before income taxes and minority interests - A summary by segment of the Company's income before income taxes and minority interests is as follows:
The Company's profit margins vary according to a number of factors, including the volume, composition (residential or commercial) and type (resale, refinancing or new construction) of real estate activity. For example, in title insurance operations, commercial transactions tend to generate higher revenues and greater profit margins than residential transactions. Further, profit margins from refinancing activities are lower than those from resale activities because in many states there are premium discounts on, and cancellation rates are higher for, refinancing transactions. Cancellations of title orders adversely affect profits because costs are incurred in opening and processing such orders but revenues are not generated. Also, the Company's direct title insurance business has significant fixed costs in addition to its variable costs. Accordingly, profit margins from the Company's direct title insurance business improve as the volume of title orders closed increases. Title insurance profit margins are also affected by the percentage of operating revenues generated by agency operations. Profit margins from direct operations are generally higher than from agency operations due primarily to the large portion of the premium that is retained by the agent. Real estate information profits are generally unaffected by the type of real estate activity but increase as the volume of residential real estate loan transactions increases. Home warranty profits improve as the volume of residential resales increases.
Income taxes - The Company's effective income tax rate, which includes a provision for state income and franchise taxes for non-insurance subsidiaries, was 35.3%, 37.8% and 38.4% for 1998, 1997 and 1996, respectively. The differences in effective rate were primarily due to changes in the ratio of permanent differences to income before income taxes and minority interests and changes in state income and franchise taxes resulting from fluctuations in the Company's non-insurance subsidiaries' contribution to pretax profits. Information regarding items included in the reconciliation of the effective rate with the federal statutory rate is contained in Note 10 to the consolidated financial statements.
Minority interests - Minority interests in net income of consolidated subsidiaries increased $31.3 million in 1998 over 1997 and $1.1 million in 1997 over 1996. The increase for 1998 was primarily due to the strong operating results of the Company's joint venture with Experian.
Cash provided by operating activities amounted to $361.6 million, $112.4 million and $114.3 million for 1998, 1997 and 1996, respectively, after claim payments of $95.4 million, $81.6 million and $78.0 million, respectively. The principal nonoperating uses of cash and cash equivalents for the three-year period ended December 31, 1998, were for additions to the investment portfolio, capital expenditures, company acquisitions in 1997 and 1996 and the repayment of debt. The most significant nonoperating sources of cash and cash equivalents were proceeds from the sales and maturities of certain investments, proceeds in 1998 from the issuance of senior debentures and proceeds in 1997 from the issuance of mandatorily redeemable preferred securities. The net effect of all activities on total cash and cash equivalents were increases of $193.2 million, $8.4 million and $27.5 million for 1998, 1997 and 1996, respectively.
On April 7, 1998, the Company issued and sold $100.0 million of 7.55% senior debentures, due April 1, 2028. The Company used a portion of the net proceeds from the sale to repay certain obligations and purchase land for the Company's new corporate facilities. The remaining proceeds were invested in debt and equity securities.
The awareness phase involves communicating the nature and scope of the Year 2000 Problem to the management of the business units in order to engender strong management support for its resolution. The inventory/assessment phase involves the identification of information systems and non-information systems that require renovation or replacement to become Year 2000 compliant. The renovation phase involves the repair and/or replacement of the systems identified in the prior phase. The testing phase involves the testing of repaired and replaced systems. The implementation phase involves the integration of tested systems into daily operations.
Review of the year 2000 plan - The Company engaged a consultant to review its Year 2000 plan. Under the terms of this engagement, the consultant (1) reviewed the operations of the Year 2000 Program Management Office, (2) reviewed the Company's Year 2000 plan, and (3) reviewed the implementation of the Year 2000 plan at selected locations. From time to time during the review, the consultant reported its findings to the Audit Committee of the Company's Board of Directors and appropriate actions were taken by the Company in response.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of The First American Financial Corporation and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
The First American Financial Corporation (the Company), through its subsidiaries, is engaged in the business of providing real estate-related financial and information services to real property buyers and mortgage lenders. These services include title insurance, tax monitoring, mortgage credit reporting, property data services, flood certification, field inspection services, appraisal services, mortgage loan servicing systems, mortgage document preparation and home warranties. In addition, credit and various database- related services are provided to automotive dealers, consumer lenders, employers and property management companies. The Company also provides investment, trust and thrift services.
Deposits with savings and loan associations and banks are short-term investments with initial maturities of more than 90 days. The carrying amount of these investments is a reasonable estimate of fair value due to their short- term nature.
Effective January 1, 1999, the Company will adopt Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." SOP 98-1 will require the Company to capitalize interest costs incurred and certain payroll-related costs of employees directly associated with developing software, in addition to incremental payments to third parties. The Company does not believe that the adoption of SOP 98-1 will have a material effect on its financial condition or results of operations.
Goodwill recognized in business combinations is amortized over its estimated useful life ranging from 20 to 40 years. Other intangibles, which include customer lists, covenants not to compete and organization costs, are amortized over their estimated useful lives, ranging from 3 to 20 years. The Company periodically evaluates the amortization period assigned to each intangible asset to ensure that there have not been any events or circumstances that warrant revised estimates of useful lives.
To the extent that the undiscounted cash flows related to other long- lived assets are less than the assets' carrying value, the carrying value of such assets is reduced to the assets' fair value.
The Company recognized revenues from tax service contracts over the estimated duration of the contracts as the related servicing costs were estimated to occur. The majority of the servicing costs, approximately 70%, are incurred in the year the contract is executed, with the remaining 30% incurred over the remaining service life of the contract.
Revenues from home warranty contracts are recognized ratably over the 12-month duration of the contracts.
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share." SFAS No. 128 became effective for 1997 and requires the presentation of basic and diluted earnings per share on the face of the income statement. Basic earnings per share are computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding. The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the weighted-average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if potential dilutive common shares had been issued.
Investments carried at $17.3 million were on deposit with state treasurers in accordance with statutory requirements for the protection of policyholders at December 31, 1998.
Sales of debt and equity securities resulted in realized gains of $1.3 million, $0.7 million and $3.3 million and realized losses of $0.2 million, $0.3 million and $0.7 million for the years ended December 31, 1998, 1997 and 1996, respectively. The fair value of debt and equity securities was estimated using quoted market prices.
Real estate loans are secured by properties located in California. The average yield on the Company's loan portfolio was 10% and 11% for the years ended December 31, 1998 and 1997, respectively. Average yields are affected by amortization of discounts on loans purchased from other institutions, prepayment penalties recorded as income, loan fees amortized to income and the market interest rates charged by thrift and loan institutions.
The above amounts are net of valuation reserves of $12.3 million and $11.1 million at December 31, 1998 and 1997, respectively.
The carrying value of the passbook accounts approximates fair value due to the short-term nature of this liability. The fair value of investment certificate accounts was $55.4 million and $49.4 million at December 31, 1998 and 1997, respectively, and was estimated based on the discounted value of the future cash flows using a discount rate approximating current market for similar liabilities.
In April 1997, the Company paid off the variable rate indebtedness portion of the amended credit agreement with proceeds received from its mandatorily redeemable preferred securities (see Note 14).
The fair value of notes and contracts payable was $130.9 million and $44.3 million at December 31, 1998 and 1997, respectively, and was estimated based on the current rates offered to the Company for debt of the same remaining maturities. The weighted average interest rate for the Company's notes and contracts payable was 7 1/2% and 8% at December 31, 1998 and 1997, respectively.
The Company has pension and other retirement benefit plans covering substantially all employees. The Company's principal pension plan, amended to be noncontributory effective January 1, 1995, is a qualified defined benefit plan with benefits based on the employee's years of service and the highest five consecutive years' compensation during the last 10 years of employment. The Company's policy is to fund all accrued pension costs. Contributions are intended to provide not only for benefits attributable to past service, but also for those benefits expected to be earned in the future. The Company also has nonqualified unfunded supplemental benefit plans covering certain key management personnel. Benefits under these plans are intended to be funded with proceeds from life insurance policies purchased by the Company on the lives of the executives.
The rate of increase in future compensation levels for the plans of 4 1/2% and the weighted average discount rates of 6 3/4% and 7 1/4% were used in determining the actuarial present value of the projected benefit obligation at December 31, 1998 and 1997, respectively. The majority of pension plan assets are invested in U.S. government securities, time deposits and common stocks with projected long-term rates of return of 9%.
The Company's principal profit sharing plan was amended effective January 1, 1995, to discontinue future contributions. The plan holds 6,081,000 and 6,576,000 shares of the Company's common stock, representing 10% and 12% of the total shares outstanding at December 31, 1998, and 1997 respectively.
Effective January 1, 1996, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." In accounting for its plan, the Company, in accordance with the provisions of SFAS No. 123, applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." As a result of this election, the Company does not recognize compensation expense for its stock option plans. Had the Company determined compensation cost based on the fair value for its stock options at grant date, as set forth under SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts as follows:
The fair value of each option grant is estimated at the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1998, 1997 and 1996, respectively; dividend yield of 1.0%, 1.2% and 1.9%; expected volatility of 36.0%, 38.1% and 41.0%; risk-free interest rate of 5.7%, 6.3% and 6.5%; and expected life of six years. The weighted-average fair value of options granted during 1998, 1997 and 1996 was $9.71, $4.26 and $2.19, respectively.
On April 22, 1997, the Company issued and sold $100.0 million of 8.5% trust preferred securities, due in 2012, through its wholly owned subsidiary, First American Capital Trust. In connection with the subsidiary's issuance of the preferred securities, the Company issued to the subsidiary trust 8.5% subordinated interest notes, due 2012. The sole assets of the subsidiary are and will be the subordinated interest notes. The Company's obligations under the subordinated interest notes and related agreements, taken together, constitute a full and unconditional guarantee by the Company of the subsidiary's obligations under the preferred securities. Distributions payable on the securities are included as interest expense in the Company's consolidated income statement.
its holder to purchase, at the Right's then-current exercise price, common stock of such other person (or its parent) having a value of twice the Right's exercise price.
On January 15, 1998, the Company distributed a 3-for-2 common stock split in the form of a 50% stock dividend. This resulted in an increase of 5,791,492 common shares outstanding with the par value of these additional shares being capitalized by a transfer from additional paid-in capital to the common stock account. All references to common stock, additional paid-in capital, number of shares of common stock and per share amounts for this stock split were restated in the Company's consolidated financial statements for the year ended December 31, 1997. On July 17, 1998, the Company distributed a 3- for-1 common stock split in the form of a 200% stock dividend. This resulted in an increase of 37,895,936 common shares outstanding with the par value of these additional shares being capitalized by a transfer from additional paid-in capital to the common stock account. This stock split has been reflected in the consolidated statements of stockholder's equity on a retroactive basis as of December 31, 1995. In order to effect the stock split, the Company increased its authorized shares from 36,000,000 to 108,000,000. All references in the consolidated financial statements with regards to common stock, additional paid- in capital, number of shares of common stock and per share amounts have been restated to reflect the July 17, 1998 stock split.
On January 1, 1998, the Company formed a limited liability corporation (LLC) with Experian Group (Experian). The purpose of the LLC is to combine certain operations of the Company's subsidiary, First American Real Estate Information Services, Inc. (FAREISI), with Experian's Real Estate Solutions division (RES). The LLC is 80% owned by the Company and 20% owned by Experian. RES is a supplier of core real estate data, providing, among other things, property valuation information, title and tax information and imaged title documents. The Company treated the transaction as an acquisition of the assets and liabilities of RES in consideration of a 20% interest in FAREISI. This business combination has been accounted for under the purchase method of accounting and, accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on the estimated fair values at January 1, 1998. In addition, as a result of the transaction, the Company recognized an investment gain of $32.4 million in the first quarter 1998. The operating results of the LLC are included in the Company's consolidated financial statements commencing January 1, 1998. Assuming the combination had occurred January 1, 1997, pro forma revenues, net income and net income per diluted share would have been $2,001.6 million, $69.6 million and
$1.25, respectively, for the year ended December 31, 1997. Pro forma results for the year ended December 31, 1998 are not presented because the combination occurred January 1, 1998.
In addition, during the year ended December 31, 1998, the Company also acquired 27 companies. The purchase method of accounting was used for 24 of the acquisitions and the pooling of interests method was used for three.
The 24 acquisitions accounted for under the purchase method of accounting were individually not material and all in the title insurance or real estate information services business. Their aggregate purchase price was $8.8 million in cash, $1.5 million in notes and 3,114,508 shares of the Company's stock. The purchase price for each was allocated to the assets acquired and liabilities assumed based on estimated fair values and approximately $30.8 million in goodwill was recorded. Goodwill is being amortized on a straight- line basis over its estimated useful life ranging from 20 to 30 years. The operating results of these acquired companies were included in the Company's consolidated financial statements from their respective acquisition dates. Assuming these acquisitions had occurred January 1, 1997, pro forma revenues, net income and net income per diluted share would have been $2,908.9 million, $199.8 million and $3.27, respectively, for the year ended December 31, 1998, and $2,045.7 million, $71.7 million and $1.22, respectively, for the year ended December 31, 1997 (the 1997 pro forma results include the business combination with Experian mentioned above). All pro forma results include amortization of goodwill and interest expense on acquisition debt. The pro forma results are not necessarily indicative of the operating results that would have been obtained had the acquisitions occurred at the beginning of the periods presented, nor are they necessarily indicative of future operating results.
The three acquisitions accounted for under the pooling of interests method of accounting were individually not material. In the aggregate, the Company issued 2,362,178 shares of its common stock in exchange for 100% of the outstanding stock of each acquired company. Two of the companies are in the consumer risk management business and one is in the real estate information business. The Company has restated prior year results to reflect these three acquisitions. Costs incurred to consummate the acquisitions were not material. Combined and separate results of First American and the three acquisitions during the periods preceding the acquisitions were as follows:
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement is effective for 1998 and requires certain information about a company's operating segments and products and services.
least two credit bureau sources, flood zone determination reports that provide information on whether or not a property is in a special flood hazard area, as well as other real estate-related information services. The home warranty segment issues one-year warranties which protect homeowners against defects in home fixtures. The consumer risk management segment provides credit and various database-related services primarily to automotive dealers, consumer lenders, employers and property management companies. The trust and banking segment provides full-service trust and depository services, accepts deposits and makes real estate-secured loans.
Note A - After adjustment for 3-for-1 stock split effected July 17, 1998.
Note A - Amount represents accounts written off, net of recoveries. Note B - Amount represents $355,000 in purchase accounting adjustments, net of a reclassification of $3,951,000 to the reserve for assets acquired in connection with claim settlements. Note C - Amount represents claim payments, net of recoveries. Note D - Amount represents elimination of reserve in connection with disposition and/or revaluation of the related asset. Note E - Amount represents elimination of reserve in connection with the expiration of the related temporary differences.