First American Financial Corporation (NYSE:FAF) is a relatively small insurance company with a market capitalization of $3.0 billion, that specializes in title insurance and related services. The insurance company has a strong market position in title insurance and has substantially increased its free cash flow over the last three years.
In addition, management has successively increased its dividend, which adds to the appeal of First American Financial as a niche insurance and dividend income play.
First American Financial looks back on 125 years experience in the insurance industry and has a leading market position in residential and commercial title insurance.
Title insurance is a special form of insurance, that protects buyers of real estate from losses sustained from title-related issues such as fraud, forgery and liens. Insurance services are usually offered to (home-)buyers, sellers, real estate agents, developers, mortgage lenders and legal professionals.
First American Financial's title insurance services are complemented by a host of related services that facilitate low-risk real estate transactions such as escrow and settlement services.
It is straightforward to see, that the demand for title insurance is high during periods of buoyant activity in the real estate market: The more purchases and sales are being conducted, the higher the demand for title insurances and the need for smooth real estate transactions.
The collapse of the U.S. housing market in 2008 also led to a serious decline in mortgage originations and, by extension, to a bad title insurance business as evidenced by record low title insurance margins. A more dynamic housing market, on the other hand, will certainly help First American Financial on the revenue and on the margin side of the business.
Strong market position in title insurance
The title insurance market clearly is a niche market and not as fragmented as other markets for insurance products such as worker compensation or property- and casualty.
As mentioned above, title insurance is what drives First American Financial's business.
The insurance company has 800 offices throughout the U.S. with over 6,000 employees which support 7,800 agencies in order to capitalize and build on its leading market position in title insurance.
First American Financial has a roughly 27% market share in the market compared to roughly 33% of Fidelity National Financial, Inc.
Its strong market position in an insurance market niche is also what will drive First American Financial's cash flow and earnings when the U.S. housing market continues to recover.
Generally speaking, if the residential real estate market recovers, First American Financial should benefit from both better title insurance pricing and higher sales activity which should underpin its dividend and free cash flow growth.
Dividend and free cash flow growth
Over the last three years, First American Financial has produced a strong dividend and free cash flow growth record.
First American Financial uses its free cash flow generally for three purposes: Dividends, share buybacks and the pursuit of selective M&A opportunities.
First American Financial has substantially hiked its dividend from $0.18 per share in 2010 to $0.48 per share in 2013 and the insurance business is now well on its way to pay out $0.96 per share in 2014 (based on an annualized Q2 2014 dividend of $0.24 per share).
As a result, First American Financial currently yields 3.45% and further dividend hikes may be just around the corner if mortgage originations experience a meaningful uptick in 2014 or 2015.
Underpinning First American Financial's dividend growth is its free cash flow, which has increased dramatically from $67 million in 2011 to $346 million in 2012 and $291 million in 2013 giving the company enough room to both reward shareholders and invest in the expansion of its title insurance business.
The strong market position in title insurance and First American Financial's solid dividend yield contribute to a premium valuation in the marketplace.
The insurance company currently trades at a 21% premium to book value. The valuation still seems low relative to its earnings prospects which could be meaningfully fueled by a recovery in residential real estate.
The Foolish Bottom Line
Title insurance is a cyclical business. With more mortgage originations and higher transaction activity in the housing market, demand for residential and commercial title insurance should grow.
With its 27% market share in the title insurance market, First American Financial should be able to capitalize on its existing relationships and technology platform to further increase cash flow and dividends for shareholders.