The Company owns two adjacent office buildings in Santa Ana, California, which house its executive offices, its trust and banking subsidiary and the Orange County title insurance branch operations. This complex, which contains approximately 105,000 square feet of floor space and an enclosed parking area, comprises one city block. The Company has acquired approximately 31 acres of land at MacArthur Place in Santa Ana, California, to meet its current and potential future expansion requirements. The Company is currently constructing three office buildings in a campus environment, totaling approximately 210,000 square feet. The buildings are scheduled to be completed in 1999 and will be occupied by the Company's executive offices, Orange County title insurance branch operations and certain other operations. After the move to the new facility, it is anticipated that the two existing office buildings in Santa Ana, California, will continue to be occupied by the trust and banking subsidiary along with certain other operations of the Company. The Company also owns an 18,000 square foot office building located across the street from its main offices. This building is used primarily for storage.
Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. --------------
Any statements in this document looking 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; the demand for and the acceptance of the Company's products; and contingencies associated with the Year 2000 issue.
Operating revenues from direct title operations increased 44.1% in 1998 over 1997 and 21.6% in 1997 over 1996. These increases were attributable to increases in the number of title orders closed by the Company's direct operations as well as increases in the average revenues per order closed. The Company's direct operations closed 1,210,200, 885,600 and 775,100 title orders during 1998, 1997 and 1996, respectively, representing increases of 36.7% in 1998 over 1997 and 14.3% in 1997 over 1996. These increases were primarily due to the continuation of lower mortgage interest rates which led to an increase in overall transaction volume nationwide (including California, a state highly concentrated with direct operations) and increases in the Company's national market share. The average revenues per order closed were $907, $860 and $808 for 1998, 1997 and 1996, respectively, representing increases of 5.5% in 1998 over 1997 and 6.4% in 1997 over 1996. These increases were primarily attributable to appreciating home values, an increased mix of resale activity and a resurgence in commercial real estate transactions. Operating revenues from agency operations increased 37.9% in 1998 over 1997 and 9.1% in 1997 over 1996. These fluctuations were primarily attributable to the same factors affecting direct operations mentioned above, compounded by the inherent delay in the reporting of transactions by agents.
Consumer risk management operating revenues increased 39.5% in 1998 over 1997 and 70.5% in 1997 over 1996. These increases were primarily attributable to an increased awareness and acceptance of this business segment's products as well as increased market share.
Investment and other income - Investment and other income increased $47.9 million in 1998 over 1997. This increase was primarily attributable to an investment gain of $32.4 million recognized in the first quarter of 1998 relating to the joint venture agreement with Experian, 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). Investment and other income increased a marginal 3.3% in 1997 over 1996. This increase was primarily attributable to a 4.8% increase in the average investment portfolio balance and increased equity in earnings of unconsolidated subsidiaries, offset in part by an increase of $0.9 million in losses from the sales of fixed assets. See Note 9 to the consolidated financial statements for further details of the composition of investment and other income.
Salaries and other personnel costs - A summary by segment of the Company's salaries and other personnel costs is as follows:
Real estate information personnel expenses increased 71.6% in 1998 over 1997 and 26.3% in 1997 over 1996. These increases were primarily attributable to costs incurred servicing the increase in business volume, $63.0 million and $20.7 million of costs attributable to company acquisitions for 1998 and 1997, respectively, as well as higher overhead costs attributable to the integration of new acquisitions and transitioning new accounts. Contributing to the increases were costs associated with in-house development of new electronic communication delivery systems for information-based products to interface with customer needs.
Home warranty personnel expenses increased 20.4% in 1998 over 1997 and 26.0% in 1997 over 1996. These increases were primarily due to the additional personnel required to service the increased business volume in the states this segment currently services, as well as new geographic expansion and modest salary increases.
Title insurance other operating expenses (principally direct operations) increased 24.0% in 1998 over 1997 and 14.3% in 1997 over 1996. These increases were primarily the result of the impact created by the changes in incremental costs (i.e., office supplies, document reproduction, messenger services, plant maintenance and title search costs) associated with the relative changes in title order volume. Also contributing to the increases were marginal price level increases and acquisitions, offset in part by successful cost-containment programs.
Real estate information other operating expenses increased 89.1% in 1998 over 1997 and 59.2% in 1997 over 1996. These increases were primarily attributable to costs incurred servicing the increased business activity, as well as $62.4 million and $33.5 million of other operating costs relating to acquisitions in 1998 and 1997, respectively, offset in part by cost-containment programs. Contributing to the increases were costs associated with assimilating and expanding this segment's increased operations.
The provision for title insurance losses expressed as a percentage of title insurance operating revenues was 3.3% in 1998, 3.6% in 1997 and 4.6% in 1996. These decreases reflect ongoing improvement in the Company's claims experience. The provision for home warranty losses as a percentage of home warranty operating revenues was 56.2% in 1998, 58.3% in 1997 and 60.1% in 1996. These fluctuations were primarily attributable to the relative changes in the average number of claims per contract experienced during these periods.
Depreciation and amortization - Depreciation and amortization as well as capital expenditures are summarized in Note 18 to the consolidated financial statements.
Consumer risk management profits increase as the volume of transactions increase. 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.
The decrease in corporate expenses for 1998 from 1997 was primarily due to an investment gain of $32.4 million (see Note 17 to the consolidated financial statements). The increase in corporate expense for 1997 over 1996 was primarily attributable to increased costs associated with supporting the overall growth of the Company's businesses, as well as additional unallocated interest expense associated with the Company's mandatorily redeemable preferred securities.
Net income - Net income and per share information, which has been restated for the 3-for-1 stock split effected July 17, 1998, are summarized as follows:
Notes and contracts payable as a percentage of total capitalization as of December 31, 1998, was 12.3% as compared with 7.2% as of the prior year end. This increase was primarily attributable to the issuance and sale of the $100.0 million senior debentures, offset in part by an increase in the capital base primarily due to shares issued in connection with company acquisitions, increased minority interests and net income for the period. The Company maintains a $75.0 million line of credit which remained unused as of December 31, 1998. Notes and contracts payable are more fully described in Note 8 to the consolidated financial statements.
million. Such restrictions have not had, nor are they expected to have, an impact on the Company's ability to meet its cash obligations.
Overview - With the help of an outside consulting firm, in January 1997 the Company created a Year 2000 Program Management Office and adopted a five-step plan to address the Year 2000 Problem. The five steps of the plan are: (1) awareness, (2) inventory/assessment, (3) renovation, (4) testing, and (5) implementation. To implement the plan, the Company was divided into business units comprised of: (a) the reporting regions of the title insurance subsidiaries, (b) the subsidiary companies of the real estate information services business, (c) the home warranty subsidiaries, (d) the trust and banking subsidiaries and (e) various other subsidiaries.
All phases of the plan are currently active. The awareness phase will continue throughout 1999. June 30, 1998 was the target date for completion of the inventory/assessment phase; that phase is substantially complete. However, all of the phases of the plan must be revisited each time the Company acquires a new business. Accordingly, the inventory/assessment phase remains active. December 31, 1998 was the initial target date for completion of renovation. As of such date, 79% of the business units had completed 80% or more of their renovations, 61% of the business units had completed 90% or more of their renovations and 24% had met the target date and completed 100% of their renovations. The Company plans to complete the renovation phase as soon as practicable. Based on current knowledge, the Company has established the following general target dates for the remaining phases: April 30, 1999 for completion of testing and June 30, 1999 for completion of implementation. In each case, completion of the applicable phase is subject to the limitation noted above for newly acquired businesses. Additionally, a limited number of business units have target dates for renovation, testing and implementation that are later than the general dates described above. The Company makes no assurance that it will be able to meet these target dates.
The Company's efforts to survey the Year 2000 readiness of its significant vendors, suppliers and customers continues. To date, the Company has not received sufficient information from these parties about their Year 2000 plans to predict the outcome of their efforts. Even after responses are received, there can be no assurance that the systems of significant vendors, suppliers and customers will be timely renovated.
Costs for the year 2000 problem - To date the Company has spent approximately $11.6 million in implementing the Year 2000 plan. The Company expects to incur an additional $15 million to $25 million in completing the Year 2000 plan. About half the costs will be for hardware and software replacement and about half will be for labor. The costs for hardware and software will be capitalized and amortized over their estimated useful lives. Labor costs will be expensed as incurred. Year 2000 plan costs are being funded through operating cash flow.
Contingency plans - Company-wide and business unit contingency plans for unexpected systems failures as a result of the Year 2000 problem were targeted to be in effect by the end of 1998. The company-wide plan and the contingency plans for 82% of the Company's business units have been completed. The Company is currently working to complete the balance of the business unit contingency plans.
other factors. The Company can give no assurance that these estimates will be achieved, and actual results could differ materially from these estimates.
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 have been restated to reflect the 1998 acquisitions of three separate entities accounted for under the pooling-of-interests method of accounting. Certain 1996 and 1997 amounts have been reclassified to conform with the 1998 presentation.
The Company classifies its debt and equity securities portfolio as available-for-sale and, accordingly, includes unrealized gains and losses, net of related tax effects, as a component of other comprehensive income. Realized gains and losses on investments are determined using the specific identification method.
Furniture and equipment includes computer software acquired and developed for internal use and for use with the Company's products. Software development costs are capitalized from the time technological feasibility is established until the software is ready for use. Capitalized development costs for internal-use software include only incremental payments to third parties.
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans receivable are measured at the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, the loan may be valued based on its observable market price or the fair value of the collateral, if the loan is collateral dependent.
The Company provides for title insurance losses based upon its historical experience by a charge to expense when the related premium revenue is recognized. Title insurance losses and other claims associated with ceded reinsurance are provided for as the Company remains contingently liable in the event that the reinsurer does not satisfy its obligations. The reserve for known and incurred but not reported claims reflects management's best estimate of the total costs required to settle all claims reported to the Company and claims incurred but not reported. The process applied to estimate claims costs is subject to many variables, including changes and trends in the type of title insurance policies issued, the real estate market and the interest rate environment. It is reasonably possible that a change in the estimate will occur in the future.
Effective January 1, 1999, the Company will implement a change to the accounting policy for tax service contracts. The new accounting policy will be adopted prospectively and will apply to all new loans serviced beginning January 1, 1999. 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 amortization rates applied to recognize the revenues assume a 10-year contract life and are adjusted to reflect prepayments. The resulting rates by year (starting with year one) are 32%, 24%, 14%, 9%, 7%, 5%, 4%, 2%, 2% and 1%. The Company periodically reviews its tax service contract portfolio 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. The Company estimates that adoption of this new policy will result in a decrease in diluted earnings per share for 1999 of $0.25 to $0.35. This estimate is heavily dependent on the volume of tax service contracts entered into in 1999. Assuming the new accounting policy had been consistently applied in prior years, the Company would have reported diluted earnings per share of $3.10, $1.02, $0.90, $0.17 and $0.42 for the years ended December 31, 1998, 1997, 1996, 1995 and 1994, respectively.
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. All earnings per share amounts presented have been restated to reflect the adoption of SFAS No. 128.
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 title insurance subsidiary, First American Title Insurance Company (FATICO), operates, the amount of dividends, loans and advances available to the parent company from FATICO is limited, principally for the protection of policyholders. Under such statutory regulations, the maximum amount of dividends, loans and advances available to the parent company from FATICO in 1999 is $158.5 million.
The amortized cost and estimated fair value of debt securities at December 31, 1998, by contractual maturities, are as follows:
The fair value of loans receivable was $72.2 million and $64.2 million at December 31, 1998 and 1997, 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.
"Other" primarily represents reclassifications to the reserve for assets acquired in connection with claim settlements. Claims activity associated with reinsurance is not material and, therefore, not presented separately.
During July 1997, the Company amended the credit agreement to relax and/or eliminate certain restrictive covenants and increase the revolving line of credit to $75.0 million which was unused as of December 31, 1998. In November 1997, the Company further amended the credit agreement to issue a letter of credit to secure its fixed rate obligation and release as security the capital stock of its wholly owned subsidiaries.
The aggregate annual maturities for notes and contracts payable in each of the five years after December 31, 1998, are as follows:
The Company also has a Stock Bonus Plan for key employees pursuant to which 186,000, 258,000 and 225,000 common shares were awarded for 1998, 1997 and 1996, respectively, resulting in a charge to operations of $2.7 million, $2.2 million and $1.3 million, respectively. The Plan, as amended December 9, 1992, provides that a total of up to 1,350,000 common shares may be awarded in any one year.
Effective January 1, 1995, the Company adopted The First American Financial Corporation 401(k) Savings Plan (The Savings Plan), which is available to substantially all employees. The Savings Plan allows for employee elective contributions up to the maximum deductible amount as determined by the Internal Revenue Code.
On April 24, 1996, the Company implemented The First American Financial 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 8,625,000. Currently outstanding options become exercisable one to five years, and expire 10 years, from the grant date. On April 24, 1997, the Company implemented The First American Financial Corporation 1997 Directors' Stock Plan (the Directors' Plan). The Directors' Plan is similar to the employees' Stock Option Plan, except that the maximum number of shares that may be subject to options is 1,800,000 and the maximum number of shares that may be purchased pursuant to options granted shall not exceed 6,750 shares during any 12-consecutive-month period.
At December 31, 1998, the range of exercise prices was $5.69 - $32.00 and the weighted-average remaining contractual life of outstanding options was six years. The number of options exercisable was 593,046 and the weighted- average exercise price of those options was $6.05.
Future minimum rental payments under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1998, are as follows:
Total rental expense for all operating leases and month-to-month rentals was $107.5 million, $78.3 million and $63.9 million for 1998, 1997, and 1996, respectively.
The Company is involved in various routine legal proceedings related to its operations. While the ultimate disposition of each proceeding is not determinable, the Company does not believe that any of such proceedings will have a materially adverse effect on its financial condition or results of operations.
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
On January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." This statement requires the reporting of comprehensive income in addition to net income. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. Prior year financial statements have been reclassified to conform to the SFAS 130 requirements.
The change in other unrealized gains (losses) on debt and equity securities includes reclassification adjustments of $1.1 million, $0.4 million and $2.6 million of realized gains for the years ended December 31, 1998, 1997 and 1996, respectively.
In November 1998, the Company entered into a definitive merger agreement with National Information Group (NAIG). Under the terms of the agreement, which the boards of directors of both companies unanimously approved, the NAIG shareholders will receive .67 of a share of the Company's common stock for each NAIG common share they own. In the merger, the Company expects to issue approximately 3.2 million shares of its common stock. This business combination will be accounted for under the pooling of interests method of accounting and is expected to close by the end of the second quarter 1999. NAIG provides insurance tracking services for mortgage and auto lenders and auto leasing companies. NAIG also provides outsourcing services, lender-placed insurance products, flood zone determinations and real estate tax services.
The Company's operations include five reportable segments: title insurance, real estate information, home warranty, consumer risk management and trust and banking. The title insurance segment issues policies which are insured statements of the condition of title to real property. The real estate information segment provides to lender customers the status of tax payments on real property securing their loans, mortgage credit information derived from at
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. Home warranty services are available in Arizona, California, Georgia, Nevada, North Carolina, South Carolina, Texas, Utah and Washington. The consumer risk management segment serves customers nationwide. The trust, banking and thrift businesses are located in Southern California; its investment services are offered across the U. S.
Corporate consists primarily of unallocated interest expense, minority interests, equity in earnings of affiliated companies and personnel and other operating expenses associated with the Company's home office facilities.
The company's primary business segments are cyclical in nature, with the spring an summer months historically being the strongest. However, interest rate adjustments by the Federal Reserve Board, as well as other economic factors, can cause unusual fluctuations in the Company's quarterly operating results. See Management's Discussion and Analysis on pages 20-23 for further discussion of the Company's results of operations.
All consolidated results have been restated to reflect the 1998 acquisitions of three separate entities accounted for under the pooling-of-interest method of accounting.
Note A - Amount represents accounts written off, net of recoveries. Note B - Amount represents $33,000 in purchase accounting adjustments, net of a reclassification of $4,948,000 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.