Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. -------------
Any statements in this document that look forward in time involve risks and uncertainties, including but not limited to the following: the effect of interest rate fluctuations; changes in the performance of the real estate markets; the effect of changing economic conditions; general volatility in the capital markets; the demand for and the acceptance of the Company's products; changes in applicable government regulations; continued consolidation among the Company's significant customers; consolidation among significant competitors; the impact of legal proceedings commenced by the California attorney general and related litigation; the continued ability to identify businesses to be acquired; and changes in the Company's ability to integrate businesses which it acquires. The Company's actual results, performance or achievement could differ materially from those expressed in, or implied by, any forward-looking statements. Accordingly, no assurances can be given that any of the events anticipated by the forward-looking statements will transpire or occur or, if any of them do, what impact they will have on the results of operations or financial condition of the Company.
Overview - The majority of the revenues for the Company's title insurance and real estate information segments depend, in large part, upon the level of real estate activity and the cost and availability of mortgage funds. Revenues for these segments result primarily from resales and refinancings of residential real estate and, to a lesser extent, from commercial transactions and the construction and sale of new housing. The majority of the revenues for the Company's consumer information segment result from activities not related to real estate. Traditionally, the greatest volume of real estate activity, particularly residential resale, has occurred in the spring and summer months. However, changes in interest rates, as well as other economic factors, can cause fluctuations in the traditional pattern of real estate activity. 1997 was a year in which relatively low mortgage interest rates, stability in the real estate marketplace and increasing property values 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 businesses, culminated in a record-setting year. 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, which, together with the particularly strong California real estate market, resulted in record-setting revenues and net income for the Company in 1998. The favorable conditions present throughout 1998 continued into 1999, resulting in record-setting revenues for the first half of the year. However, commencing in the second quarter 1999, new orders began to soften as rising interest rates led to a significant decline in refinance transactions, although residential resale and commercial activity remained relatively strong. During the second half of the year, the trend of higher interest rates continued. New orders, including residential resale orders, continued to decline. This, coupled with fourth quarter seasonal factors, led to a decrease in operating revenues. In response, the Company instituted personnel reductions and other cost- containment programs; however, because of separation costs, the benefits of the reductions in the latter part of the year will not be fully realized until 2000. Also impacting 1999 were a revenue recognition accounting change for the Company's tax service contracts, which decreased revenues by $22.7 million, and Y2K expenses of $24.8 million. See Operating Revenues in Note 1 to the consolidated financial statements for a detailed description of the accounting change. Results for 1998 and 1997 have been restated to reflect the 1999 acquisition of National Information Group (NAIG), accounted for under the pooling-of-interests method of accounting.
Operating revenues from direct title operations decreased 2.8% in 1999 from 1998 and increased 44.1% in 1998 over 1997. The decrease in 1999 from 1998 was attributable to a decrease in the number of title orders closed by the Company's direct title operations, offset in part by an increase in the average revenues per order closed. The increase in 1998 over 1997 was attributable to an increase in the number of title orders closed by the Company's direct title operations, as well as an increase in the average revenues per order closed. The Company's direct title operations closed 1,119,900, 1,210,200 and 885,600 title orders during 1999, 1998 and 1997, respectively, representing a decrease of 7.5% in 1999 from 1998 and an increase of 36.7% in 1998 over 1997. The decrease in 1999 from 1998 was
Investment and other income - Investment and other income decreased $24.8 million in 1999 from 1998 and increased $47.7 million in 1998 over 1997. The decrease in 1999 from 1998 was primarily due to an investment gain of $32.4 million recognized in 1998 relating to the joint venture agreement with Experian, offset in part by a 24.8% increase in the average investment portfolio balance and a $5.2 million gain resulting from stock received in the demutualization of a life insurance company which insures a large portion of the Company's corporate-owned life insurance portfolio. The increase in 1998 over 1997 was primarily attributable to the investment gain of $32.4 million mentioned above, as well as a 36.9% increase in the average investment portfolio balance due to the investment of excess cash flow from operations and a portion of the proceeds from the Company's $100 million senior debentures (see Note 8 to consolidated financial statements).
Title insurance personnel expenses increased 10.7% in 1999 over 1998 and 32.3% in 1998 over 1997. The increase in 1999 over 1998 was primarily due to the relatively high number of employees added during the latter part of 1998 and the beginning of 1999 in order to service the volume of orders processed during those periods. The Company initiated personnel and other cost reduction programs in response to the subsequent decrease in business volume. During the fourth quarter and full year 1999, title insurance staffing levels were reduced by approximately 6% and 14%, respectively; however, because of separation costs, the benefits of the fourth quarter reductions will not be fully realized until 2000. Contributing to the increase in salaries and other personnel costs in 1999 were $20.8 million of personnel costs associated with new acquisitions. The increase in 1998 over 1997 was primarily attributable to the costs incurred servicing the increasing volume of business and $63.0 million of personnel costs associated with new acquisitions, offset in part by productivity gains as measured by new orders per person. Contributing to the increases for both 1999 and 1998 was an increased volume of labor-intensive residential resale transactions. The Company's direct title operations opened 1,334,100, 1,585,400 and 1,173,300 title orders in 1999, 1998 and 1997, respectively, representing a decrease of 15.9% in 1999 from 1998 and an increase of 35.1% in 1998 over 1997.
Real estate information personnel expenses increased 4.7% in 1999 over 1998 and 67.4% in 1998 over 1997. The increase in 1999 over 1998 was primarily attributable to $7.6 million of personnel costs associated with new acquisitions and costs incurred in connection with Y2K. The increase in 1998 over 1997 was primarily due to costs incurred servicing the increase in business volume and $61.9 million of costs associated with new acquisitions. Contributing to the increases in both 1999 and 1998 were higher overhead costs attributable to the integration of new acquisitions and costs associated with in-house development of new electronic communication delivery systems for information-based products to interface with customer needs.
Consumer information personnel expenses increased 14.9% in 1999 over 1998 and 25.8% in 1998 over 1997. These increases were primarily attributable to additional personnel required to service the increased business volume and acquisition activity. Personnel expenses associated with new acquisitions were $2.7 million and $1.1 million for 1999 and 1998 respectively.
Premiums retained by agents - A summary of agent retention and agent revenues is as follows:
Consumer information other operating expenses increased 25.3% in 1999 over 1998 and 77.4% in 1998 over 1997. These increases were primarily attributable to costs incurred servicing the increased business volume, as well as acquisition activity. Other operating expenses associated with new acquisitions were $3.3 million in 1999 and $1.8 million in 1998.
Interest - Interest expense decreased 8.9% in 1999 from 1998 and increased 85.5% in 1998 over 1997. The decrease in 1999 from 1998 was primarily due to $2.5 million of capitalized interest expense related to the development of internal- use software and the construction of the Company's new corporate headquarters, offset in part by increased interest expense associated with debt incurred in connection with company acquisitions. The increase in 1998 over 1997 was primarily due to $5.5 million of interest expense related to the 7.55% senior debentures issued in April 1998, as well as incremental interest expense of $2.8 million related to the mandatorily redeemable preferred securities (outstanding for the full year 1998).
Income before income taxes, minority interests and cumulative effect of a change in accounting principle - A summary by segment is as follows:
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. Consumer information profits increase as the volume of transactions increases and are not affected by real estate activity. In general, the title insurance business is a lower-margin business when compared to the Company's other segments. The lower margins reflect the high fixed cost of producing title evidence, whereas the corresponding revenues are subject to regulatory and competitive pricing constraints.
Income taxes - The Company's effective income tax rate, which includes a provision for state income and franchise taxes for non-insurance subsidiaries, was 36.7%, 35.2% and 37.5% for 1999, 1998 and 1997, respectively. The differences in the effective tax 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 decreased $16.0 million in 1999 from 1998 and increased $31.3 million in 1998 over 1997. These fluctuations were primarily due to the relative change in the operating results of the Company's joint venture with Experian.
Cash provided by operating activities amounted to $173.2 million, $361.6 million and $117.4 million for 1999, 1998 and 1997, respectively, after net claim payments of $119.3 million, $100.9 million and $88.1 million, respectively. The principal nonoperating uses of cash and cash equivalents for the three-year period ended December 31, 1999, were for capital expenditures, additions to the investment portfolio, company acquisitions in 1999 and 1997, dividends 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 1999 from the sale-leaseback of certain
Due to the Company's significant liquid asset position and its consistent ability to generate cash flows from operations, management believes that its resources are sufficient to satisfy its anticipated operational cash requirements. The Company's strong financial position will enable management to react to future opportunities for acquisitions or other investments in support of the Company's continued growth and expansion.
To the Board of Directors and Stockholders of The First American Financial Corporation:
As discussed in Note 1 to the financial statements, the Company changed its method of recognizing revenue for tax service contracts in 1999.
The consolidated financial statements include the accounts of The First American Financial Corporation and all majority-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. All consolidated results reflect the 1999 acquisition of National Information Group accounted for under the pooling-of-interests method of accounting. Certain 1997 and 1998 amounts have been reclassified to conform with the 1999 presentation.
Effective January 1, 1999, the Company adopted Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." SOP 98-1 requires 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 adoption of SOP 98-1 did not have a material effect on the Company's financial condition or results of operations.
Depreciation on buildings and on furniture and equipment is computed using the straight-line method over estimated useful lives of 25 to 45 and three to 10 years, respectively. Capitalized software costs are amortized using the straight-line method over estimated useful lives of three to 10 years.
Consumer Information - Revenues from home warranty contracts are recognized ratably over the 12-month duration of the contracts. Interest on loans with the Company's thrift subsidiary is recognized on the outstanding principal balance on the accrual basis. Loan origination fees and related direct loan origination costs are deferred and recognized over the life of the loan.
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.
The Company's only potential dilutive common shares are stock options (see Note 12). Stock options are reflected in diluted earnings per share by application of the treasury stock method.
Real estate activity is cyclical in nature and is affected greatly by the cost and availability of long-term mortgage funds. Real estate activity and, in turn, the Company's revenues can be adversely affected during periods of high interest rates and/or limited money supply.
Pursuant to insurance and other regulations of the various states in which the Company's insurance subsidiaries operate, the amount of dividends, loans and advances available to the Company is limited, principally for the protection of policyholders. Under such statutory regulations, the maximum amount of dividends, loans and advances available to the Company from its insurance subsidiaries in 2000 is $133.1 million.
The amortized cost and estimated fair value of investments in debt securities are in the table below. The fair value of debt and equity securities was estimated using quoted market prices.
The amortized cost and estimated fair value of debt securities at December 31, 1999, by contractual maturities, are as follows:
Sales of debt and equity securities resulted in realized gains of $3.5 million, $1.4 million and $0.7 million; and realized losses of $1.6 million, $0.2 million and $0.3 million for the years ended December 31, 1999, 1998 and 1997, respectively.
The fair value of loans receivable was $87.7 million and $72.2 million at December 31, 1999 and 1998, respectively, and was estimated based on the discounted value of the future cash flows using the current rates being offered for loans with similar terms to borrowers of similar credit quality.
December 31 (in thousands) 1999 1998 - ------------------------------------------------------------- Notes receivable $10,863 $11,833 Real estate 2,720 4,880 Judgments and other 10,613 338 - ------------------------------------------------------------- $24,196 $17,051 - -------------------------------------------------------------
The fair value of notes receivable was $11.1 million and $12.2 million at December 31, 1999 and 1998, respectively, and was estimated based on the discounted value of future cash flows using the current rates at which similar loans would be made to borrowers of similar credit quality.
NOTE 7. Reserve for Known and Incurred But Not Reported Claims:
"Other" primarily represents reclassifications to the reserve for assets acquired in connection with claim settlements. "Other" for 1999 includes $7,955 in purchase accounting adjustments related to Company acquisitions and $11,251 related to Company dispositions. Claims activity associated with reinsurance is not material and, therefore, not presented separately.
The aggregate annual maturities for notes and contracts payable in each of the five years after December 31, 1999, are as follows:
(in thousands) Year - ----------------------------------------------------------- 2000 $23,004 2001 $21,203 2002 $13,982 2003 $12,260 2004 $ 9,893
The fair value of notes and contracts payable was $195.7 million and $130.9 million at December 31, 1999 and 1998, 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 7.5% at December 31, 1999 and 1998.
(in thousands) 1999 1998 1997 - ------------------------------------------------------------------------------ Interest: Cash equivalents and deposits with savings and loan associations and banks $11,921 $10,706 $ 7,051 Debt securities 15,199 14,547 11,354 Other long-term investments 5,163 7,023 3,550 - ------------------------------------------------------------------------------ 32,283 32,276 21,955 - ------------------------------------------------------------------------------
Investment gain 5,160 32,449 - Dividends on marketable equity securities 630 409 469 Equity in earnings of unconsolidated affiliates 3,553 4,614 2,304 Net gain on sales of debt and equity securities 1,854 1,154 445 Other 8,493 5,871 3,923 - ------------------------------------------------------------------------------ $51,973 $76,773 $29,096 - ------------------------------------------------------------------------------
in thousands 1999 1998 1997 - ---------------------------------------------------------------------------- Taxes calculated at federal rate $52,830 $115,514 $38,819 Tax exempt interest income (1,367) (1,684) (839) Tax effect of minority interests 826 1,273 1,286 State taxes, net of federal benefit 5,071 9,043 3,941 Exclusion of certain meals and entertainment expenses 4,519 3,794 2,889 Other items, net 421 572 (3,160) - ---------------------------------------------------------------------------- $62,300 $128,512 $42,936 - ----------------------------------------------------------------------------
Deferred tax liabilities: Depreciable and amortizable assets 31,616 21,426 Investment gain 11,357 11,357 Claims and related salvage 8,679 (3,139) Accumulated other comprehensive income 2,271 4,166 Other 2,440 6,654 - ---------------------------------------------------------------------------- 56,363 40,464 - ---------------------------------------------------------------------------- Net deferred tax asset $ 48,284 $16,324 - ----------------------------------------------------------------------------
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 Company's principal profit sharing plan was amended effective January 1, 1995, to discontinue future contributions. The plan holds 5,799,000 and 6,081,000 shares of the Company's common stock, representing 9% and 10% of the total shares outstanding at December 31, 1999 and 1998 respectively.
The Company's expense related to The Savings Plan amounted to $13.7 million, $14.4 million and $6.4 million for the years ended December 31, 1999, 1998 and 1997, respectively.
Pro forma Basic .34 $ 3.05 $ 1.17 Diluted .33 $ 2.93 $ 1.14
The following table summarizes stock options outstanding and exercisable at December 31, 1999:
Future minimum rental payments under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1999, are as follows:
In December 1999, the Company announced plans to repurchase up to 5% of its then issued and outstanding shares. The amount of any share repurchases will depend on, among other factors, the market performance of the shares; the availability of, and alternate uses of, the Company's funds; and Securities and Exchange Commission regulations. Pursuant to the terms of the repurchase program, the Company had repurchased and retired 140,000 of its issued and outstanding shares as of December 31, 1999.
On October 23, 1997, the Company adopted a Shareholder Rights Plan (the Rights Plan). Under the Rights Plan, after the close of business on November 15, 1997, each holder of the Company's common shares received a
dividend distribution of one Right for each common share held. Each Right entitles the holder thereof to buy a preferred share fraction equal to 1/100,000 of a share of Series A Junior Participating Preferred Shares of the Company at an exercise price of $265 per preferred share fraction. Each fraction is designed to be equivalent in voting and dividend rights to one common share.
The Rights will be exercisable and will trade separately from the common shares only if a person or group, with certain exceptions, acquires beneficial ownership of 15% or more of the Company's common shares or commences a tender or exchange offer that would result in such person or group beneficially owning 15% or more of the common shares then outstanding. The Company may redeem the Rights at $0.001 per Right at any time prior to the occurrence of one of these events. All Rights expire on October 23, 2007.
Each Right will entitle its holder to purchase, at the Right's then- current exercise price, preferred share fractions (or other securities of the Company) having a value of twice the Right's exercise price. This amounts to the right to buy preferred share fractions of the Company at half price. Rights owned by the party triggering the exercise of Rights will be void and therefore will not be exercisable.
In addition, if after any person has become a 15%-or-more stockholder, the Company is involved in a merger or other business combination transaction with another person in which the Company's common shares are changed or converted, or if the Company sells 50% or more of its assets or earning power to another person, each Right will entitle 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.
The plaintiffs allege that the defendants unlawfully (i) failed to escheat unclaimed property to the Controller of the State of California on a timely basis; (ii) charged California home buyers and other escrow customers fees for services that were never performed or which cost less than the amount charged; and (iii) devised and carried out schemes with financial institutions to receive interest, or monies in lieu of interest, on escrow funds deposited by defendants with financial institutions in demand deposits.
Subsequent to the filing of the action by the State of California, First American Title Insurance Company was named and served as a defendant in two private class actions. The allegations in the complaints include some, but not all, of the allegations contained in the class action filed by the State of California. The private class actions independently seek injunctive relief, attorneys' fees, damages and penalties in unspecified amounts. The private class actions have been stayed by court orders pending settlement negotiations relating to the class action filed by the State of California.
The Company is involved in various routine legal proceedings related to its operations. While the ultimate disposition each proceeding is not determinable, the Company does not believe that any such proceedings will have a materially adverse effect on its financial condition or results of operations.
Effective May 14, 1999, the Company completed its merger of National Information Group (NAIG). Under the terms of the definitive merger agreement, each of the NAIG shareholders received .67 of a share of the Company's common stock for each NAIG common share they owned. To complete the merger, the Company issued 3,004,800 shares, in exchange for 100% of the outstanding common stock of NAIG. The information services provided by NAIG include outsourcing services, flood zone determination services, real estate tax tracking, hazard and motor vehicle insurance tracking, lender-placed insurance and flood insurance. This merger was accounted for under the pooling-of-interests method of accounting and, as a result, the Company has restated all previously reported results to reflect this merger.
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, 1998, pro forma revenues, net income and net income per diluted share would have been $3.07 billion, $36.8 million and $.55, respectively, for the year ended December 31, 1999; and $3.08 billion, $207.6 million and $3.25, respectively, for the year ended December 31, 1998. 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.
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 for a 20% interest in FAREISI. 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.
The title insurance and real estate information segments operate through networks of offices nationwide. The Company provides its title services through both direct operations and agents throughout the United States. It also offers title services abroad in Australia, the Bahama Islands, Canada, England, Guam, Ireland, Mexico, Puerto Rico, Scotland, South Korea, and the U.S. Virgin Islands. To date, the international title operations have not been material to the Company's financial condition or results of operations. The consumer information segment provides home warranty services in Arizona, California, Georgia, Nevada, North Carolina, South Carolina, Texas, Utah and Washington. Trust, banking and thrift services are provided in Southern California. Investment advisory, automotive tracking, resident screening, pre-employment screening and lender-placed flood and hazard insurances are offered nationwide.
Title Insurance $ 245,376,000 $ 14,429,000 Real Estate Information 16,600,000 213,880,000 Consumer Information 11,534,000 11,748,000 51,457,000 Corporate ----------- ------------- ------------- Total $11,534,000 $ 273,724,000 $ 279,766,000 =========== ============= =============
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.