The Company’s mortgage information business, houses its national operations in a leased 231,000 square foot office building in Dallas, Texas. In 1999, the Company completed the construction of two office buildings in Poway, California. These two buildings, which primarily house the Company’s credit reporting business, total approximately 152,000 square feet and are located on a 17 acre parcel of land. In addition, the Company’s mortgage information, credit information and property information businesses lease office space in more than 75 locations throughout the United States, principally for their respective operations.
The screening information business houses its executive offices in a leased 20,800 square foot building in St. Petersburg, Florida. In addition, this business owns or leases more than 30 offices throughout the United States, principally for its screening information operations.
Income taxes. The Company estimates its quarterly effective income tax rate based upon a variety of factors including, but not limited to, the expected revenues and resulting pretax income for the year, the composition and geographic mix of the pretax income and the ratio of permanent differences to pretax income. Any changes to the estimated rate are made prospectively in accordance with Accounting Principles Board Opinions No. 28, “Interim Financial Reporting.” Additionally, management makes estimates as to the amount of reserves, if any, that are necessary for known and potential tax exposures.
Credit information operating revenues increased 14.7% in 2003 over 2002 and 10.4% in 2002 over 2001. The increase in 2003 over 2002 was primarily due to the growth in demand for credit information in the housing sector, offset in part by a $6.2 million reduction in revenues as a result of the sale of the Company’s subsidiary, FASTRAC Systems, Inc., in August 2002. The increase in 2002 over 2001 was also primarily due to the growth in demand for credit information in the housing sector, and operating revenues of $9.2 million contributed by new acquisitions.
Screening information operating revenues increased 65.3% in 2003 over 2002 and 105.1% in 2002 over 2001. These increases were primarily attributable to $56.0 million and $49.8 million of operating revenues contributed by new acquisitions for the respective periods.
Investment and other income-Investment and other income totaled $105.8 million, $89.8 million and $81.1 million in 2003, 2002 and 2001, respectively, an increase of $16.0 million, or 17.8% in 2003 over 2002, and $8.7 million, or 10.8% in 2002 over 2001. The increase in 2003 over 2002 was primarily due to a $16.5 million increase in equity in earnings of unconsolidated affiliates. The increase in 2002 over 2001 was also primarily due to an $18.3 million increase in equity in earnings of unconsolidated affiliates, offset, in part, by a $9.6 million decrease in net interest and other income, primarily as a result of lower yields on cash equivalents and the Company’s investment portfolio due to the lower interest rate environment. See Note 10 to the consolidated financial statements for additional information.
Net realized investment gains/losses-Net realized investment gains totaled $35.7 million in 2003, compared with net realized investment losses of $18.9 million in 2002 and gains of $6.6 million in 2001. The current year total
included the recognition of a previously deferred gain totaling $14.2 million relating to the sale of the Company’s Contour Software, Inc. subsidiary in the first quarter of 2001. This gain was initially deferred due to the uncertainty relating to the realizability of the consideration received. In the fourth quarter of 2003, management concluded that, based upon the current financial condition and expected future performance of the acquirer, the realization of the consideration was assured and, therefore, recognition of the gain appropriate. Also included in the current year total was a $13.1 million realized gain associated with the merger of the Company’s Credit Online business with DealerTrack Holdings, Inc. The prior year investment losses included a $13.6 million loss resulting from the write-down of WorldCom bonds; a $2.6 million loss associated with the sale of the Company’s subsidiary, FASTRAC Systems, Inc.; and $2.3 million of losses due to the restructuring of the 1031 tax-deferred exchange investment portfolio, which was managed by the Company’s Capital Management division.
Title insurance personnel expenses increased 15.7% in 2003 over 2002 and 20.5% in 2002 over 2001. The increase in 2003 over 2002 was primarily attributable to $29.3 million of personnel costs associated with new acquisitions, $12.0 million of increased employee benefit costs, incremental labor costs incurred to service the increase in business volume and increased commissions associated with the increase in closed orders. The increase in 2002 over 2001 was primarily due to $36.1 million of increased employee benefit costs, $28.2 million of personnel costs associated with new acquisitions, $26.5 million in expenses related to the implementation of the Company’s FAST title production system, incremental labor costs incurred to service the increase in business volume and increased commissions associated with the increase in closed orders. The increase in employee benefit costs was primarily the result of the Company’s discretionary match related to the 401(k) plan, which is profit driven and increases as profits escalate. This match increased $5.8 million in 2003 over 2002 and $16.9 million in 2002 over 2001. Also contributing to the overall increase in employee benefit costs were increases in
health care costs of $6.2 million in 2003 over 2002 and $11.5 million in 2002 over 2001. The Company’s direct title operations opened 2,511,000, 2,184,200 and 1,930,300 orders in 2003, 2002 and 2001, respectively, representing an increase of 15.0% in 2003 over 2002 and 13.2% in 2002 over 2001. From an efficiency standpoint, title insurance personnel costs as a percentage of title insurance operating revenues were 28.3% in 2003, 31.7% in 2002 and 33.7% in 2001.
Information Technology. Personnel expenses in total for the Information Technology group increased 27.6% in 2003 over 2002 and 17.2% in 2002 over 2001. These increases were primarily due to personnel expenses associated with new acquisitions, costs incurred to service the increase in business volume and increased employee benefit costs. Personnel costs associated with new acquisitions totaled $51.1 million in 2003 and $19.1 million in 2002. Employee benefit costs increased $9.8 million in 2003 over 2002 and $12.6 million in 2002 over 2001. From an efficiency standpoint, personnel costs for the Information Technology group as a percentage of operating revenues were 31.9% in 2003, 33.7% in 2002 and 35.2% in 2001.
Corporate. Corporate personnel expenses increased $3.1 million in 2003 over 2002 and $17.9 million in 2002 over 2001. The increase in 2002 over 2001 was primarily attributable to an increase of $13.3 million in employee benefit costs, increased technology personnel costs and higher general costs associated with the support effort needed to service the Company’s expanded national and international operations.
Financial Services. The Company’s title insurance segment comprised 95.1% of total other operating expenses for the Financial Services group. Title insurance other operating expenses (principally direct operations) increased 22.4% in 2003 over 2002 and 23.3% in 2002 over 2001. These increases were primarily due to incremental costs (i.e., messenger costs, reproduction costs, title plant maintenance costs, etc.) associated with servicing the increases in total order volume and costs associated with new acquisitions. Other operating expenses associated with new acquisitions were $19.6 million in 2003 and $9.6 million in 2002. Title insurance other operating expenses as a percentage of title insurance operating revenues were 16.3% in 2003, 17.2% in 2002 and 17.9% in 2001.
Corporate. Corporate other operating expenses increased $5.9 million in 2003 over 2002 and $16.7 million in 2002 over 2001. The increase in 2002 over 2001 was primarily due to $15.0 million of technology expenses, primarily consulting and outsourcing costs, required to expand the Company’s e-commerce capabilities, and higher general costs associated with the support effort needed to service the Company’s expanded national and international operations.
The provision for title insurance losses, expressed as a percentage of title insurance operating revenues (excluding the one-time 2001 adjustment mentioned below), was 4.1% in 2003, 4.0% in 2002 and 4.0% in 2001. During the third quarter of 2001, the Company recorded a $7.9 million adjustment to a purchase accounting estimate for loss reserves at one of its title insurance subsidiaries, which was purchased in 1998. This adjustment strengthened loss reserves to reflect subsequent adverse development.
Depreciation and amortization-Depreciation and amortization increased 18.2% in 2003 over 2002 and decreased 10.6% in 2002 from 2001. The increase in 2003 over 2002 was primarily due to an increase in the amortization of intangibles as a result of acquisition activity and an increase in amortization of capitalized data and software. The decrease in 2002 was primarily due to the elimination of goodwill amortization as a result of implementing SFAS No. 142. See Note 5 to the consolidated financial statements. Depreciation and amortization, as well as capital expenditures, are summarized in Note 20 to the consolidated financial statements.
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 operating revenues. The Company’s underwritten title company (noninsurance) subsidiaries are subject to state income tax and do not pay premium tax. Accordingly, the Company’s total tax burden at the state level for the title insurance segment is composed of a combination of premium taxes and state income taxes. Premium taxes as a percentage of title insurance operating revenues remained relatively constant at approximately 1.0%.
The Company’s title insurance 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. Commercial transactions tend to generate higher revenues and greater profit margins than residential transactions. 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.
Most of the businesses that are included in the Information Technology group are database intensive, with a relatively high proportion of fixed costs. As such, profit margins generally improve as revenues increase. Revenues for the mortgage information segment, like title insurance, are primarily dependent on the level of real estate activity and the cost and availability of mortgage funds. Revenues from the property information segment are, in part, dependent on real estate activity, but are less cyclical than title insurance and mortgage information revenues as a result of a significant subscription-based revenue stream. Revenues for the credit information segment are, in part, impacted by real estate activity, but also by the consumer and automobile sectors.
In the first quarter of 2004, the Company began the expansion of its corporate office campus. This expansion will add two 4-story office buildings totaling 225,000 square feet, and a single-story, free-standing, 50,000 square foot technology center. The construction is estimated to be completed by the third quarter of 2005 with an estimated total cost of $69.0 million. The Company anticipates funding the corporate office expansion with internally generated funds.
Off-balance sheet arrangements and contractual obligations. The Company administers escrow and trust deposits as a service to its customers. Escrow deposits totaled $4.5 billion and $5.6 billion at December 31, 2003 and 2002, respectively, of which $260.2 million and $176.6 million were held at certain of the Company’s subsidiaries. The remaining escrow deposits were held at third-party financial institutions. Trust deposits totaled $2.3 billion and $1.9 billion at December 31, 2003 and 2002, respectively, and were held at the Company’s trust subsidiary. Escrow and trust deposits are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the disposition of these deposits.
In addition, The Company facilitates tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code. As a facilitator and intermediary, the Company holds the proceeds from sales transactions until a qualified acquisition occurs. Like-kind exchange deposits totaled $1.1 billion and $978.0 million at December 31, 2003 and 2002, respectively. The Company also facilitates tax deferred reverse exchanges pursuant to Revenue Procedure 2000-37. These exchanges require the Company, using the customer’s funds, to acquire the qualifying property on behalf of the customer and take temporary title to the customer’s property until a qualifying acquisition occurs. Reverse exchange property totaled $229.4 million and $154.6 million at December 31, 2003 and 2002, respectively. Due to the structure utilized to facilitate these transactions, like-kind exchanges and reverse exchanges are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the transfers of property, disbursements of proceeds and the return on the proceeds at the agreed upon rate.
Pursuant to various insurance and other regulations, the maximum amount of dividends, loans and advances available to the Company in 2004 from its insurance subsidiaries is $313.4 million. Such restrictions have not had, nor are they expected to have, an impact on the Company’s ability to meet its cash obligations. See Note 2 to the consolidated financial statements.
The consolidated financial statements include the accounts of The First American Corporation and all controlled subsidiaries. All significant intercompany transactions and balances have been eliminated. Certain 2001 and 2002 amounts have been reclassified to conform to the 2003 presentation. In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). This interpretation requires the consolidation of variable interest entities (VIEs) created or acquired if certain conditions are met. During December 2003, the FASB issued FIN 46 revised (FIN 46R) to defer the implementation date for pre-existing VIEs that are not special purpose entities until the end of the first interim or annual period ending after December 15, 2003. For VIEs that are not special purpose entities, companies must apply FIN 46R no later than the end of the first reporting period ending after March 15, 2004. The adoption of FIN 46 as revised by FIN 46R did not have a material impact on the Company’s financial condition or results of operations.
The Company classifies its debt and equity securities portfolio as available-for-sale. This portfolio is continually monitored for differences between the cost and estimated fair value of each security. If the Company believes that a decline in the value of a debt or equity security is temporary in nature, it records the decline as an unrealized loss in stockholders’ equity. If the decline is believed to be other than temporary, the debt or equity security is written down to the carrying value and a realized loss is recorded on the Company’s statement of income. Management’s assessment of a decline in value includes, among other things, its current judgment as to the financial position and future prospects of the entity that issued the security. If that judgment changes in the future, the Company may ultimately record a realized loss after having initially concluded that the decline in value was temporary.
On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). This statement addresses financial accounting and reporting for goodwill and other intangible assets. In accordance with the provisions of SFAS 142, goodwill is no longer amortized but is rather tested annually for impairment. The Company has selected September 30 as the annual valuation date to test goodwill for impairment.
Information Technology Group-The Company’s tax service operations defer the tax service fee and recognize that fee as revenue ratably over the expected service period. The amortization rates applied to recognize the revenues assume a 10-year contract life and are adjusted to reflect prepayments. The Company reviews its tax service contract portfolio quarterly to determine if there have been changes in contract lives and/or changes in the number and/or timing of prepayments. Accordingly, the Company may adjust the rates to reflect current trends. Revenues earned by the other products in the Information Technology group are recognized at the time of delivery, as the Company has no significant ongoing obligation after delivery.
The Company administers escrow and trust deposits as a service to its customers. Escrow deposits totaled $4.5 billion and $5.6 billion at December 31, 2003 and 2002, respectively, of which $260.2 million and $176.6 million were held at certain of the Company’s subsidiaries. The remaining escrow deposits were held at third party financial institutions. Trust deposits totaled $2.3 billion and $1.9 billion at December 31, 2003 and 2002, respectively, and were held at the Company’s trust subsidiary. Escrow and trust deposits are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the disposition of these deposits.
The Company facilitates tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code. As a facilitator and intermediary, the Company holds the proceeds from sales transactions until a qualified acquisition occurs. Like-kind exchange deposits totaled $1.1 billion and $978.0 million at December 31, 2003 and 2002, respectively. The Company also facilitates tax-deferred reverse exchanges pursuant to Revenue Procedure 2000-37. These exchanges require the Company, using the customer’s funds, to acquire the qualifying property on behalf of the customer and take temporary title to the customer’s property until a qualifying acquisition occurs. Reverse exchange property totaled $229.4 million and $154.6 million at December 31, 2003 and 2002, respectively. Due to the structure utilized to facilitate these transactions, like-kind exchanges and reverse exchanges are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the transfers of property, disbursements of proceeds and the return on the proceeds at the agreed upon rate
Investments carried at $31.7 million were on deposit with state treasurers in accordance with statutory requirements for the protection of policyholders at December 31, 2003.
The Company’s title insurance subsidiary, First American Title Insurance Company, maintained statutory capital and surplus of $746.6 million and $651.3 million at December 31, 2003 and 2002, respectively. Statutory net income for the years ended December 31, 2003, 2002 and 2001, was $229.9 million, $132.0 million and $118.7 million, respectively.
The amortized cost and estimated fair value of investments in debt securities are as follows:
The amortized cost and estimated fair value of debt securities at December 31, 2003, by contractual maturities, are as follows:
In accordance with the enhanced disclosure provisions of Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than Temporary Impariment and Its Application to Certain Investments,” the Company, at December 31, 2003 had gross unrealized losses of $1.5 million from debt securities that had been in an unrealized loss position for less than 12 months. The fair value of those debt securities that had been in an unrealized loss position for less than 12 months is $16.1 million. At December 31, 2003, the Company had gross unrealized losses of $8.9 million from equity securities that had been in an unrealized loss position for 12 months or greater. The fair value of those equity securities that had been in an unrealized loss position for 12 months or greater was $19.3 million.
Real estate loans are collateralized by properties located primarily in Southern California. The average yield on the Company’s loan portfolio was 8.0% and 9.0% for the years ended December 31, 2003 and 2002, 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 fair value of loans receivable was $105.3 million and $108.4 million at December 31, 2003 and 2002, 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.
The Company has determined that its flood zone certification database, which is included in “Title plants and other indexes,” is an intangible asset with an indefinite life. Accordingly, this asset is not amortized but rather tested annually for impairment by comparing the fair value of the database with its carrying value. In addition, the Company had $113.6 million of intangible assets included in “Other assets” at December 31, 2003, with definite lives ranging from three to ten years. These assets, comprised primarily of customer lists and noncompete agreements, are being amortized in a manner consistent with periods prior to the adoption of SFAS 142.
In accordance with the provisions of SFAS 142, the Company completed the required annual impairment tests of goodwill and intangible assets with indefinite lives for the years ended December 31, 2003 and 2002, and determined that there was no impairment.
In October 2003, the Company obtained a $55.0 million loan collateralized by its corporate headquarters. This loan will be repaid over a 20-year period and requires the Company to maintain certain minimum levels of capital and earnings.
The Company has one primary bank credit agreement that provides for a $200.0 million unsecured line of credit. Under the terms of the credit agreement, the Company is required to maintain certain minimum levels of capital and earnings and meet predetermined debt-to-capitalization ratios. The line of credit remains in effect until October 2006 and was unused at December 31, 2003 and 2002. The Company’s publicly traded subsidiary, First Advantage Corporation also has a bank credit agreement that provides for a $15.0 million collateralized line of credit. Under the terms of that credit agreement, First Advantage Corporation is required to satisfy certain financial requirements. The line of credit remains in effect until July 2005 and had a balance due of $9.0 million at December 31, 2003.
The fair value of notes and contracts payable was $564.5 million and $442.4 million at December 31, 2003 and 2002, 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 5.5% and 6.0% at December 31, 2003 and 2002, respectively.
The fair value of the Company’s mandatorily redeemable preferred securities was $100.0 million at December 31, 2003 and 2002 and was estimated based on the current rates offered to the Company for debt of the same type and remaining maturity.
The exercise of stock options represents a tax benefit and has been reflected as a reduction of taxes payable and an increase to the additional paid-in capital account. The benefits recorded were $5.8 million, $1.5 million and $2.6 million for the years ended December 31, 2003, 2002 and 2001, respectively.
For the three years ended December 31, 2003, 2002 and 2001, 1.0 million, 3.6 million and 2.8 million options, respectively, were excluded from the weighted-average diluted common shares outstanding due to their antidilutive effect.
The Savings Plan allows for employee-elective contributions up to the maximum deductible amount as determined by the Internal Revenue Code. The Company makes discretionary contributions to the Savings Plan based on profitability, as well as contributions of the participants. The Company’s expense related to the Savings Plan amounted to $48.4 million, $39.6 million and $16.0 million for the years ended December 31, 2003, 2002 and 2001, respectively. The Savings Plan allows the participants to purchase the Company’s stock as one of the investment options. The Savings Plan held 9,982,000 and 8,906,000 shares of the Company’s common stock, representing 12.7% and 12.0% of the total shares outstanding at December 31, 2003 and 2002, respectively.
The asset allocation for the Company’s defined benefit pension plan trust is as follows:
Included in the domestic equities amount above are common shares of the Company with a market value of $12.1 million as of December 31, 2003.
On April 24, 1996, the Company implemented The First American Corporation 1996 Stock Option Plan (the Stock Option Plan). Under the Stock Option Plan, options are granted to certain employees to purchase the Company’s common stock at a price no less than the market value of the shares on the date of the grant. The maximum number of shares that may be subject to options is 14,625,000. Currently, outstanding options become exercisable in one to five years, and expire ten years from the grant date. On April 24, 1997, the Company implemented The First American Corporation 1997 Directors’ Stock Plan (the Directors’ Plan). The Directors’
Stock options outstanding and exercisable at December 31, 2003, are summarized as follows:
The Company leases certain office facilities, automobiles and equipment under operating leases, which, for the most part, are renewable. The majority of these leases also provide that the Company will pay insurance and taxes. In December 2000, the Company’s subsidiary, First American Real Estate Information Services, Inc. and, in 1999, the Company entered into sale-leaseback agreements with regard to certain furniture and equipment with a net book value of $30.7 million and $65.7 million, respectively. Proceeds from the sales, which amounted to $33.8 million and $80.1 million and gains of $3.1 million and $14.4 million for the years ended December 31, 2000 and 1999, respectively, have been included in “Deferred revenue” and will be amortized over the life of the leases. Under the agreements, the Company’s subsidiary and the Company agreed to lease the equipment for three to five years with minimum annual lease payments of $3.3 million and $9.3 million, respectively. At the end of the term of the leases, the Company has the option to acquire the equipment or return it to the lessor.
The Company and Experian Information Solutions, Inc. (Experian) are parties to a joint venture that resulted in the creation of the Company’s First American Real Estate Solutions, LLC (FARES) subsidiary. Pursuant to the terms of the joint venture, Experian has the right to sell to the Company its interest in FARES at a purchase price determined pursuant to a specified formula based on the after-tax earnings of FARES. Experian may only exercise this right if the purchase price is greater than $80.0 million and less than $160.0 million. As of December 31, 2003, the purchase price exceeded $160.0 million and, therefore, Experian’s right was not exercisable as of such date. In addition to the agreement with Experian, the Company is also party to several other agreements that require the Company to purchase some or all of the minority shares of certain less-than-100.0% owned subsidiaries if certain conditions are met. The total potential purchase price related to those agreements that have met the necessary conditions as of December 31, 2003, was not material.
The Company and certain of its subsidiaries on October 2, 2002, settled the lawsuit filed against certain of the Company’s subsidiaries by the state of California in the California state court in Sacramento, California. On or about September 18, 2002, the Company and certain of its subsidiaries settled a related class action lawsuit filed in the state court in the county of Los Angeles, California.
Under the terms of the settlements, the Company will pay up to $5.5 million to certain customers in the form of cash refunds and discounts against future title insurance and escrow services. The settlements further required the Company to pay approximately $2.5 million to specified governmental agencies; counsel to the class action plaintiffs; and the Consumer Protection Prosecution Trust Fund, a trust fund established to assist consumers in protecting their rights.
On June 5, 2003, the Company formed First Advantage Corporation, which was created through the merger of First American Corporation’s screening information businesses with the operations of US SEARCH.com Inc. Under the terms of the agreement, the former stockholders of US SEARCH received 0.04 of a Class A common share of First Advantage for each share of US SEARCH owned prior to the merger. The former stockholders of
The Company provides its title services through both direct operations and agents throughout the United States. It also offers title services in Australia, The Bahama Islands, Canada, Guam, Hong Kong, Ireland, Mexico, New Zealand, Puerto Rico, South Korea, the United Kingdom, the U.S. Virgin Islands and other countries abroad. The international operations account for less than 1% of the Company’s income before income taxes and minority interests. Home warranty services are provided in 40 states throughout the United States. Property and casualty insurance is offered nationwide. Trust and other services products are provided in Southern California. The products offered by the four segments included in the Information Technology group are provided nationwide.