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 also owns an 18,000 square foot office building located across the street from its main offices. This building is used primarily for storage.
The Company's real estate information subsidiary, First American Real Estate Information Services, Inc. ("FAREISI"), houses its national operations in a leased 231,000 square foot office building in Dallas, Texas. FAREISI's corporate headquarters are housed in a leased office building located in St. Petersburg, Florida. In addition, FAREISI and its subsidiaries lease office space in more than 75 locations throughout the United States, principally for their respective operations.
- -------- Note A--After adjustment for 3-for-2 stock split effected January 15, 1998, and restatement for the adoption of Statement of Financial Accounting Standards No. 128, "Earnings per Share."
Any statements in this document looking forward in time involve risks and uncertainties, including but not limited to the following risks: the effect of interest rate fluctuations, changes in the performance of the real estate markets; the effect of changing economic conditions; and the demand for and the acceptance of the Company's products.
OVERVIEW--As with all providers of real estate-related financial and information 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 properties. Revenues for the Company's home warranty segment result
Home warranty operating revenues increased 22.2% in 1997 over 1996 and 17.9% in 1996 over 1995. 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.
INVESTMENT AND OTHER INCOME--Investment and other income increased 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. Investment and other income increased 14.6% in 1996 over 1995. This increase was primarily attributable to an increase in realized investment gains of $1.7 million, as well as an increase in fixed income securities, offset in part by a 5.4% decrease in the average investment portfolio balance.
The Company's title insurance segment 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 which specialize in builder and lender business has created ongoing fixed costs required to service accounts.
Title insurance personnel expenses increased 20.6% in 1997 over 1996 and 17.1% in 1996 over 1995. These increases were primarily attributable to the costs incurred servicing the increasing volume of title orders and, to a lesser extent, acquisition activity and salary increases. Contributing to the increase for 1997 was an increased mix of more labor intensive residential resale transactions. The Company's direct operations opened 1,173,300, 1,026,900 and 894,400 title orders in 1997, 1996 and 1995, respectively, representing increases of 14.3% in 1997 over 1996 and 14.8% in 1996 over 1995.
PREMIUMS RETAINED BY AGENTS--A summary of agent retention and agent revenues is as follows:
The premium split between underwriter and agents is in accordance with their respective agency contracts and can vary from region to region due to divergencies in real estate closing practices as well as rating structures. As a result, the percentage of title premiums retained by agents may vary due to the geographical mix of revenues from agency operations.
Title insurance other operating expenses increased 14.3% in 1997 over 1996 and 15.9% in 1996 over 1995. 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, offset in part by successful cost-containment programs.
Depreciation and amortization--Depreciation and amortization as well as capital expenditures are summarized in Note 16 to the consolidated financial statements.
Minority interests--Minority interests in net income of consolidated subsidiaries increased 40.1% in 1997 over 1996 and 23.1% in 1996 over 1995. These increases were attributable to the relatively strong operating results of the Company's less than 100% owned subsidiaries, offset in part by purchases of shares from minority shareholders.
Pretax profits--A summary by segment of the Company's pretax profits is as follows:
The Company's profit margins and pretax profits 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 pretax 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 pretax 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 pretax profits improve as the volume of residential resales increases. 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.
PREMIUM TAXES--A summary by pertinent segment of the Company's premium taxes is as follows:
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 1.1% in 1997 and 1.3% in 1996 and 1995. The decrease in the current year was 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.
NET INCOME--Net income and per share information, which has been restated for the 3-for-2 stock split effected January 15, 1998, and the adoption of Statement of Financial Accounting Standards No. 128, "Earnings per Share," are summarized as follows:
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, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, 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.
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.
Depreciation on buildings and on furniture and equipment is computed using the straight-line method over estimated useful lives of 25 to 45 and 3 to 10 years, respectively. Capitalized software costs are amortized using the straight-line method over estimated useful lives of 3 to 10 years.
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.
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.
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 amortized cost and estimated fair value of investments in debt securities are as follow:
The amortized cost and estimated fair value of debt securities at December 31, 1997, by contractual maturities, are as follows:
Sales of debt and equity securities resulted in realized gains of $706,000, $3,257,000 and $1,316,000 and realized losses of $348,000, $646,000 and $358,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The fair value of debt and equity securities was estimated using quoted market prices.
Real estate loans are secured by properties located in Southern California. The average yield on the Company's loan portfolio was 11% for the years ended December 31, 1997 and 1996. 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 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 $49.4 million and $38.0 million at December 31, 1997 and 1996, respectively, and was estimated based on the discounted value of the future cash flows using a discount rate approximating current market for similar liabilities.
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, 1997. In November 1997, the Company further amended the credit agreement to issue a letter of credit in the amount of $5.7 million to secure its fixed rate obligation and release as security the capital stock of its wholly owned subsidiaries.
The fair value of notes and contracts payable was $44.3 million and $70.6 million at December 31, 1997 and 1996, 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 8% and 7% at December 31, 1997 and 1996, respectively.
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 1,875,000. 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 600,000 and the maximum number of shares that may be purchased pursuant to options granted shall not exceed 2,250 shares during any 12-consecutive-month period.
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 indicated below:
At December 31, 1997, the range of exercise prices was $17.08--$39.83 and the weighted-average remaining contractual life of outstanding options was six years. The number of options exercisable was 104,250 and the weighted-average exercise price of those options was $17.08. There were no options exercisable at December 31, 1996.
Total rental expense for all operating leases and month-to-month rentals was $78.3 million, $63.9 million and $58.6 million for 1997, 1996 and 1995, respectively.
On October 23, 1997, the Company adopted a Shareholder 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.
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 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, Guam, Mexico, Puerto Rico, the U.S. Virgin Islands and the United Kingdom. Home warranty services are available in Arizona, California, Nevada, North Carolina, South Carolina, Texas, Utah and Washington. The trust, banking and thrift businesses operate in Southern California.
The Company's primary business segments are cyclical in nature, with the spring and 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 in Part 1, Item 7 of this report for further discussion of the Company's results of operations.
The aggregate annual maturities for notes and contracts payable in each of the five years after December 31, 1997, are $5,711,000, $4,180,000, $582,000, $136,000, and $79,000, respectively.
- -------- 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 A--Amount represents accounts written off, net of recoveries. Note B--Amount represents $10,023,000 in purchase accounting adjustments, net of a reclassification of $3,019,000 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.