Should You Follow This Title Insurer Into Mortgage Processing?

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Fidelity National Financial (NYSE: FNF), the country’s largest title insurer, split up its empire last decade in a bid to simplify operations and increase shareholder value.  The spinoff unit, payments technology provider Fidelity National Information Services, subsequently completed its own spinoff in 2008, floating its mortgage processing and technology subsidiary Lender Processing Services (NYSE: LPS), based on the same shareholder value rationale. However, with yields on its fixed income portfolio low and the housing market rebounding, Fidelity National Financial sees value in the processing business, offering to acquire Lender Processing Services for $2.9 billion in May 2013. So, should investors follow the title insurance giant into mortgage processing?

What’s the value?

Lender Processing Services is one of the big providers of technology, data, and processing services to the mortgage industry. It focuses its sales efforts on the largest mega-banks, including Wells Fargo and JPMorgan, which can provide a huge installed base for the company’s mortgage technology platform and the potential for ancillary services. Lender Processing Services also has a large default services unit that has been pressured lately by foreclosure moratoriums and settlements with state attorneys general.

In its latest fiscal year, Lender Processing Services had a weak financial performance, especially in light of the strength in the domestic housing market. For the period, it reported increases in revenues and adjusted operating income of 0.8% and 5.3%, respectively, versus the prior year. While revenue in its origination area was up 20%, the gains were offset by double-digit revenue declines in its default services business. In addition, the company incurred higher technology costs as it continues to try to transition its large customer base to its new cloud computing product offerings.

What’s the rationale?

Fidelity National Financial’s core title business has rebounded sharply lately, in line with higher housing purchase and refinancing activity, approaching its segment sales peak in 2009.  In its latest fiscal year, the title segment reported increases in revenues and operating income of 18.2% and 47.7%, respectively, compared to the prior year. The unit’s operating margin spiked due to both higher production volumes and a greater percentage of business from its internal sales force versus independent agents.

As a title insurer, though, Fidelity National Financial needs to earn a decent return on its large investment balances to offset potential claim losses on its policies, a difficult task in the current rate environment. Consequently, the company has been taking a page from Warren Buffett’s playbook by buying controlling stakes in operating businesses, like auto parts maker Remy International and restaurateur J. Alexander. The title insurer’s management obviously sees the acquisition of Lender Processing Services as a solid investment value, with the potential to cross-sell technology processing and title insurance products.

How to play the sector

While an investor could buy Fidelity National Financial to gain exposure to Lender Processing Services' future profit stream, only about 22% of the combined company’s revenue base will come from the mortgage processing segment. A better approach would be to buy competitor Ellie Mae (NYSE: ELLI), a mortgage technology and processing company that has a leg up on Lender Processing Services in the cloud computing area with over 41,000 current active users. The company’s technology product offers compelling automation capabilities to mortgage professionals, leading to greater assurance that government regulations are being adhered to.

In its latest fiscal year, Ellie Mae reported strong financial results, with increases in revenues and operating income of 83.5% and 1,139.9%, respectively, versus the prior year. The company’s sales growth benefited from a 37% jump in active users and greater use of ancillary services, like web hosting and compliance management. With nearly 74,000 mortgage professionals using the company’s services out of a potential market of 273,000 industry professionals, according to the U.S. Bureau of Labor Statistics, Ellie Mae has strong growth opportunities for years to come.

The bottom line

The mortgage industry is rising once again and so are government regulations, like the federal Dodd-Frank Act, which makes compliance a vitally important area for mortgage professionals. The mortgage processing industry’s software provides the tools to streamline professionals’ workload and to help ensure adherence to the law, ultimately increasing users’ efficiency. While Fidelity National Financial should do okay with its acquisition, Ellie Mae should be better able to ride housing’s growth to a higher valuation.

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Robert Hanley owns shares of Ellie Mae. The Motley Fool recommends Ellie Mae. The Motley Fool owns shares of Ellie Mae. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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