Yesterday, title insurer and mortgage-information provider First American Corporation (NYSE: FAF ) reported earnings that were down year over year. The declining earnings aren't really a surprise. Analysts expected that First American would have difficulty matching last year's stellar results, and competitors such as Fidelity National Financial (NYSE: FNF ) and LandAmericaFinancialGroup (NYSE: LFG ) also reported lower numbers this week.
One thing that does look a bit out of place was that the top line seemed relatively strong, particularly compared with earnings. Year over year, revenues were up by 8%, implying that First American was taking a serious hit on margins. This implication is borne out when you examine its two business units. The pre-tax operating margins of its financial services unit -- primarily title insurance -- fell from 11.3% to 9.1%, while the margins of its information technology unit fell from 27.6% to 23.3%.
The combination of increased revenue, reduced margins, and First American indicating that it picked up market share seems to imply that the company is competing on price. This can be a red flag to investors fearful that competition will squeeze all the profits out of the business. However, this seems unlikely.
First American's four-year average financial service margins are about 9.0%, while the information technology margins are 24.4%, both quite close to this year's numbers. These numbers, particularly in context of the fantastic market last year, make it more likely that last year's success was a positive anomaly and First American is now returning to more typical performance.
When summarizing the business, First American's CEO noted that refinancing transactions are slowing down more than new and resale transactions. This is to be expected. Mortgage rates are up over last year, meaning that anyone who benefited from refinancing recently is unlikely to be able to get a better deal. But mortgage rates are still low relative to historical levels, so it also makes sense that the overall housing market is hot.
However, this raises the question of when the other shoe will drop and whether that shoe will hit investors in the head on the way down. If mortgage rates continue to rise, then eventually the housing market will cool off. However, predicting interest rates is predicting where a market will go, something that people, in general, are not very good at doing. The fact that everyone seems to be predicting increased rates makes me wonder whether rates will, in fact, increase slower than expected. If so, then at current valuations, First American could be cheap.
Inside Value editor Philip Durell thinks so. Since he recommended it a few months ago, First American is up by 24%, handily beating the S&P 500's return of 8.4% in the same time frame.
Check out more Foolish information on:
- How First American qualifies as having good potential earnings power.
- What else Philip's recommends.
- Why buying First American is like getting three tens for a twenty.
Fool contributor Richard Gibbons wishes he owned billions of dollars of each stock mentioned in this article. Regrettably, he owns none. But he does own a shoe.