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| STC > SEC Filings for STC > Form 10-Q on 3-Aug-2012 | All Recent SEC Filings |
3-Aug-2012
Quarterly Report
MANAGEMENT'S OVERVIEW
We reported net earnings attributable to Stewart of $12.8 million for the six months ended June 30, 2012 compared with a net loss attributable to Stewart of $4.4 million for the same period in 2011. On a diluted per share basis, our net earnings attributable to Stewart was $0.59 for the first six months of 2012 compared with a net loss attributable to Stewart of $0.23 for the same period in 2011. Revenues were $868.7 million for the six months ended June 30, 2012 compared with $771.3 million for the six months ended June 30, 2011.
Overall results for the second quarter 2012 improved to a pretax profit of $31.2 million from a pretax profit of $5.7 million in the second quarter 2011. In the first half of 2012, we achieved a pretax profit of $23.3 million compared to a pretax loss of $0.7 million for the same period in 2011.
Total title revenues in the second quarter 2012 increased 15.9% and 25.7% compared to the same quarter last year and sequentially from the first quarter 2012, respectively. Revenues from direct operations for the second quarter 2012 increased 13.1% and 23.7% compared to the same quarter last year and sequentially from the first quarter 2012, respectively. Revenues from commercial transactions, which are included in direct operations, increased 3.7% in the second quarter 2012 compared to the same quarter last year and increased 34.1% sequentially from the first quarter 2012. International revenues, which are also included in direct operations, increased 4.7% in the second quarter 2012 compared to the same quarter last year and increased 45.9% sequentially from the first quarter 2012.
We are encouraged by the results of our strategic initiatives and believe that we are now beginning to reap the benefits of more scalable operations. While strong order counts drove our 15.6% increase in title operating revenues, our much stronger 510% increase in title pretax results demonstrates improved operating leverage. For 2012 year-to-date, the $78.4 million increase in total title revenues resulted in an increase in title pretax earnings of $28.5 million. We are encouraged by sustained order counts through July which should yield satisfactory results in the third quarter, although we are mindful of industry projections that call for a decline in mortgage originations in the fourth quarter, and we continue to simplify and align our operations to better adapt to market fluctuations.
We continue to experience solid growth in revenues from services provided by our REI segment. As anticipated, the revenue mix generated in the REI segment has shifted over the last twelve months from higher-margin loan modification services to more sustainable servicing support and REO-related services. Nonetheless, pretax margins in this segment improved to 33.3% from the 27.4% achieved in the first quarter 2012 when we were increasing staff to service new contracts.
As a percentage of title revenues, title losses were 8.7%, 9.0% and 9.2% in the second quarter 2012, first quarter 2012 and second quarter 2011, respectively. Title losses increased 8.9% on the 15.6% increase in title operating revenues, when compared to the second quarter 2011, including adjustments to certain large claims. Although we continue to experience a higher than normal provisioning rate, the overall loss provision continues to decline on a sequential quarterly basis. Cash claim payments in the second quarter 2012 decreased 6.3% from the second quarter 2011. Losses incurred on known claims decreased 2.1% compared to the second quarter 2011. The decline in cash claim payments and losses incurred on known claims continues a trend noted for several quarters.
CRITICAL ACCOUNTING ESTIMATES
Actual results can differ from our accounting estimates. While we do not anticipate significant changes in our estimates, there is a risk that such changes could have a material impact on our consolidated financial condition or results of operations for future periods.
Title loss reserves
Our most critical accounting estimate is providing for title losses associated with issued title insurance policies. Our liability for estimated title losses as of June 30, 2012 comprises both known claims ($132.6 million) and our estimate of claims that may be reported in the future ($378.1 million). The amount of the reserve represents the aggregate future payments (net of recoveries recognized) that we expect to incur on policy and escrow losses and in costs to settle claims.
Provisions for title losses, as a percentage of title operating revenues, were 8.8% and 9.3% for the six months ended June 30, 2012 and 2011, respectively. Actual loss payment experience, including the impact of payments on large losses as well as changes in estimates for large losses, is the primary reason for increases or decreases in our loss provision. A change of 100 basis points in this percentage, a reasonably likely scenario based on our historical loss experience, would have increased or decreased our provision for title losses and pretax operating results approximately $7.9 million for the six months ended June 30, 2012.
Our method for recording the reserves for title losses on both an interim and annual basis begins with the calculation of our current loss provision rate, which is applied to our current premiums resulting in a title loss expense for the period. This loss provision rate is set to provide for losses on current year policies, including the costs of administering, investigating, and/or defending claims, and is determined using moving average ratios of recent actual policy loss payment experience (net of recoveries recognized) to premium revenues.
At each quarter end, our recorded reserve for title losses begins with the prior period's reserve balance for claim losses, adds the current period provision to that balance and subtracts actual paid claims, resulting in an amount that our management compares to its actuarially-based calculation of the ending reserve balance to provide for future title losses. The actuarially-based calculation is a paid loss development calculation where loss development factors are selected based on company data and input from our third-party actuaries. We also obtain input from third-party actuaries in the form of a reserve analysis utilizing generally accepted actuarial methods. While we are responsible for determining our loss reserves, we utilize this actuarial input to assess the overall reasonableness of our reserve estimation. If our recorded reserve amount is within a reasonable range (+/- 4.0%) of our actuarially-based reserve calculation and the actuary's point estimate, but not at the point estimate, our management assesses the major factors contributing to the different reserve estimates in order to determine the overall reasonableness of our recorded reserve, as well as the position of the recorded reserves relative to the point estimate and the estimated range of reserves. The major factors considered can change from period to period and include items such as current trends in the real estate industry (which management can assess, although there is a time lag in the development of this data for use by the actuary), the size and types of claims reported and changes in our claims management process. If the recorded amount is not within a reasonable range of our third-party actuary's point estimate, we will adjust the recorded reserves in the current period and reassess the provision rate on a prospective basis. Once our reserve for title losses is recorded, it is reduced in future periods as a result of claims payments and may be increased or reduced by revisions to our estimate of the overall level of required reserves.
Large claims (those exceeding $1.0 million on a single claim), including large title losses due to independent agency defalcations, are analyzed and reserved for separately due to the higher dollar amount of loss, lower volume of claims reported and sporadic reporting of such claims. Large title losses due to independent agency defalcations typically occur when the independent agency misappropriates funds from escrow accounts under its control. Such losses are usually discovered when the independent agency fails to pay off an outstanding mortgage loan at closing (or immediately thereafter) from the proceeds of the new loan. Once the previous lender determines that its loan has not been paid off timely, it will file a claim against the title insurer. It is at this point that the title insurance underwriter is alerted to the potential theft and begins its investigation. As is industry practice, these claims are considered a claim on the newly issued title insurance policy since such policy insures the holder (in this case, the new lender) that all previous liens on the property have been satisfied. Accordingly, these claim payments are charged to policy loss expense. These incurred losses are typically more severe in terms of dollar value compared with traditional title policy claims because the independent agency is often able over time to conceal misappropriation of escrow funds relating to more than one transaction through the constant volume of funds moving through its escrow accounts. As long as new funds continue to flow into escrow accounts, an independent agent can mask one or more defalcations. In declining real estate markets, lower transaction volumes result in a lower incoming volume of funds, making it more difficult to cover up the misappropriation with incoming funds. Thus, when the defalcation is discovered, it often relates to several transactions. In addition, the overall decline in an independent agency's revenues, profits and cash flows increases the agency's incentive to improperly utilize the escrow funds from real estate transactions.
Internal controls relating to independent agencies include, but are not limited to, pre-signing and periodic audits, site visits and reconciliations of policy inventories and premiums. The audits and site visits cover examination of the escrow account bank reconciliations and an examination of a sample of closed transactions. In some instances, we are limited in our scope by attorney agents who cite client confidentiality. Certain states have mandated a requirement for annual reviews of all agents by their underwriter. We also determine whether our independent agencies have appropriate internal controls as defined by the American Land Title Association and us. However, even with adequate internal controls in place, their effectiveness can be circumvented by collusion or improper management override at the independent agencies. To aid in the selection of agencies to review, we have developed an agency risk model that aggregates data from different areas to identify possible problems. This is not a guarantee that all agencies with deficiencies will be identified. In addition, we are typically not the only underwriter for which an independent agency issues policies and agencies may not always provide complete financial records for our review.
Due to the inherent uncertainty in predicting future title policy losses, significant judgment is required by both our management and our third party actuaries in estimating reserves. As a consequence, our ultimate liability may be materially greater or less than current reserves and/or our third party actuary's calculated estimate.
Agency revenues
We recognize revenues on title insurance policies written by independent agencies (agencies) when the policies are reported to us. In addition, where reasonable estimates can be made, we accrue for revenues on policies issued but not reported until after period end. We believe that reasonable estimates can be made when recent and consistent policy issuance information is available. Our estimates are based on historical reporting patterns and other information about our agencies. We also consider current trends in our direct operations and in the title industry. In this accrual, we are not estimating future transactions. We are estimating revenues on policies that have already been issued by agencies but not yet reported to or received by us. We have consistently followed the same basic method of estimating unreported policy revenues for more than 10 years.
Our accruals for revenues on unreported policies from agencies were not material to our consolidated assets or stockholders' equity as of June 30, 2012 and December 31, 2011. The differences between the amounts our agencies have subsequently reported to us compared to our estimated accruals are substantially offset by any differences arising from prior years' accruals and have been immaterial to consolidated assets and stockholders' equity during each of the three prior years. We believe our process provides the most reliable estimate of the unreported revenues on policies and appropriately reflects the trends in agency policy activity.
Goodwill and other long-lived assets
Our evaluation of goodwill is normally completed annually in the third quarter using June 30 balances (our current annual review has been completed), but an evaluation may also be made whenever events may indicate impairment. This evaluation is based on a combination of a discounted cash flow analysis (DCF) and market approaches that incorporate market multiples of comparable companies and our own market capitalization. The DCF model utilizes historical and projected operating results and cash flows, initially driven by estimates of changes in future revenue levels, and risk-adjusted discount rates. Our projected operating results are primarily driven by anticipated mortgage originations, which we obtain from projections by industry experts. Fluctuations in revenues, followed by our ability to appropriately adjust our employee count and other operating expenses, are the primary reasons for increases or decreases in our projected operating results. Our market-based valuation methodologies utilize (i) market multiples of earnings and/or other operating metrics of comparable companies and (ii) our market capitalization and a control premium based on market data and factors specific to our ownership and corporate governance structure (such as our Class B Common Stock). To the extent that our future operating results are below our projections, or in the event of continued adverse market conditions, an interim review for impairment may be required, which may result in an impairment of goodwill.
We evaluate goodwill separately for our two reporting units (Title and REI). Goodwill is assigned to these reporting units at the time the goodwill is initially recorded. Once assigned to a reporting unit, the goodwill is pooled and no longer attributable to a specific acquisition. All activities within a reporting unit are available to support the carrying value of the goodwill.
We also evaluate the carrying values of title plants and other long-lived assets when events occur that may indicate impairment. The process of determining impairment for our goodwill and other long-lived assets relies on projections of future cash flows, operating results, discount rates and overall market conditions, including our market capitalization. Uncertainties exist in these projections and they are subject to changes relating to factors such as interest rates and overall real estate and financial market conditions, our market capitalization and overall stock market performance. Actual market conditions and operating results may vary materially from our projections.
Based on these evaluations, we estimate and expense to current operations any loss in value of these assets. As part of our process, we have an option to assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we decide not to use a qualitative assessment or if we fail the qualitative assessment, then we obtain input from third-party appraisers regarding the fair value of our reporting units. While we are responsible for assessing whether an impairment of goodwill exists, we utilize the input from third-party appraisers to assess the overall reasonableness of our conclusions. We utilized a qualitative assessment for our annual goodwill impairment test and, based on our analysis, determined it was not more-likely-than-not that the fair value of our two reporting units were less than their carrying amounts as of June 30, 2012. There were no impairment write-offs of goodwill or other long-lived assets during the six months ended June 30, 2012 or 2011.
Operations. Our business has two main operating segments: title insurance-related services and real estate information (REI). These segments are closely related due to the nature of their operations and common customers.
Our primary business is title insurance and settlement-related services. We close transactions and issue title policies on homes and commercial and other real properties located in all 50 states, the District of Columbia and international markets through policy-issuing offices and agencies. We also provide loan origination and servicing support; loan review services; loss mitigation; REO asset management; home and personal insurance services; tax-deferred exchanges; and technology to streamline the real estate process.
Factors affecting revenues. The principal factors that contribute to changes in operating revenues for our title and REI segments include:
mortgage interest rates;
availability of mortgage loans;
ability of potential purchasers to qualify for loans;
ratio of purchase transactions compared with refinance transactions;
ratio of closed orders to open orders;
home prices;
volume of distressed property transactions;
consumer confidence;
demand by buyers;
number of households;
premium rates;
market share;
opening of new offices and acquisitions;
number of commercial transactions, which typically yield higher premiums;
government or regulatory initiatives, including tax incentives; and
number of REO and foreclosed properties and related debt.
Premiums are determined in part by the insured values of the transactions we handle. To the extent inflation causes increases in the prices of homes and other real estate, premium revenues are also increased. Conversely, falling home prices cause premium revenues to decline. These factors may override the seasonal nature of the title insurance business.
RESULTS OF OPERATIONS
Comparisons of our results of operations for the three and six months ended June 30, 2012 with the three and six months ended June 30, 2011 follow. Factors contributing to fluctuations in our results of operations are presented in the order of their monetary significance and we have quantified, when necessary, significant changes. Results from our REI segment are included in our discussions regarding the three and six months ended June 30, 2012 and 2011, and when relevant, we have discussed REI segment's results separately.
Our statements on home sales and loan activity are based on published industry data from sources including Fannie Mae, the National Association of Realtorsฎ, the Mortgage Bankers Association and Freddie Mac. We also use information from our direct operations.
Operating environment. Data as of June 2012 compared with the same period in 2011 indicates annualized sales of new homes, seasonally adjusted, increased 19.3%, and annualized sales of existing homes, seasonally adjusted, increased 4.5%. June 2012 existing home sales were at a seasonally adjusted annual rate of 4.4 million versus 4.2 million a year earlier. Even though interest rates continue to be low by historical standards, general economic conditions conducive to the housing market such as low unemployment and increasing household formation are not present. One-to-four family residential lending increased from an estimated $282 billion in the second quarter 2011 to $383 billion in the first quarter 2012 (most recent actual data available), primarily driven by an estimated $137 billion increase in refinance originations from the second quarter 2011 to the first quarter 2012 (most recent data available). Commercial lending activity industry-wide improved by 36% in the first quarter 2012 (most recent data available) compared with the same period of 2011.
Three months ended June 30, 2012 compared with three months ended June 30, 2011
Title revenues. Revenues from direct title operations increased $21.7 million, or 13.1%, in the second quarter 2012 compared to the second quarter 2011 primarily due to the increased number of closings, along with an increase in commercial and large transactions. The largest revenue increases were in Texas, Canada and California. Revenues from commercial and other large transactions increased $1.0 million, or 3.7%, in the second quarter 2012 compared to the second quarter 2011.
Direct orders closed increased 18.5%, while the average revenue per file closed decreased 4.8%, in the second quarter 2012 compared to the second quarter 2011 due to an increase in residential refinancing closings in the same periods. Direct operating revenues, excluding large commercial policies, increased 14.5% in the second quarter 2012 compared to the second quarter 2011. The average revenue per closing, excluding large commercial policies, decreased 3.4% in the second quarter 2012 compared to the second quarter 2011. On average, refinance premium rates are 60% of the title premium revenue of a similarly priced sale transaction.
Revenues from independent agencies increased $37.3 million, or 17.4%, in the second quarter 2012 compared to the second quarter 2011. The largest increases in revenues from independent agencies were in California, New York, Utah, New Jersey and Florida, partially offset by decreases in Ohio. Revenues from independent agencies net of amounts retained by those agencies increased 20.8%.
REI revenues. Operating revenues from services provided by the real estate information segment increased $17.9 million, or 79.5%, in the second quarter 2012 compared to the second quarter 2011. The increase was primarily due to an increase in lower margin servicing support and REO related services partially offset by a decline in revenues from higher margin loan modification services. We expect REI revenues to increase in 2012 as recently awarded contracts continue to mature. However, demand for REI services will continue to be dependent on the number and scale of governmental programs and lender projects and can fluctuate significantly on a quarterly and annual basis.
Investment income. Investment income decreased $0.5 million, or 12.2%, in the second quarter 2012 compared to the second quarter 2011, primarily due to decreases in average yield. Certain investment gains and losses, which are included in our results of operations in investment and other gains (losses) - net, were realized as part of the ongoing management of our investment portfolio for the purpose of improving performance.
For the second quarter 2011, investment and other gains (losses) - net included a $3.9 million charge representing the payoff value on a defaulted third party loan on which we served as guarantor.
Retention by agencies. Amounts retained by title agencies are based on agreements between agencies and our title underwriters. On average, amounts retained by independent agencies, as a percentage of revenues generated by them, were 82.4% and 82.9% in the second quarters of 2012 and 2011, respectively. The average retention percentage may vary from year-to-year or quarter-over-quarter due to the geographical mix of agency operations, the volume of title revenues and, in some states, laws or regulations. Due to the variety of such laws or regulations, as well as competitive factors, the average retention rate can differ significantly from state to state. Although, general conditions in the real estate industry are improving nationwide, the recovery in specific markets has varied considerably. In addition, a high proportion of our independent agencies are in states with retention rates greater than 80% and the markets in those states have recovered relatively faster than the nation as a whole, which has resulted in our average retention percentage remaining in the 82% - 83% range. We expect our average retention rate to remain in this range over the near to medium term. However, we continue to adjust independent agency contracts in an economically sound manner, and we expect the mix of agency business to normalize as real estate markets continue to stabilize nationally resulting in lower average retention percentages in the aggregate.
We continue to focus on improving the quality of our network of independent agencies in order to achieve an increase in the average revenue per agency and reduce our risk of future loss. Since we began the process of rationalizing our network of independent agencies in 2008, our average annual remittance per independent agency has increased approximately 75%, while the number of independent agencies in our network has fallen by half. In addition, the policy loss ratio of our current agency base for the trailing twelve months as of June 30, 2012 is approximately one-third of its level in the comparable period in 2008.
Employee costs. Our employee costs and certain other operating expenses are sensitive to inflation. Employee costs in the second quarter 2012 increased 12.4% from the same period in 2011 and 2.2% sequentially from the first quarter 2012. The increase in employee costs compared to last year is primarily related to increases in our REI operations and was expected as a result of staffing requirements to provide services under new contracts awarded in the fourth quarter 2011. As a percentage of total operating revenues, however, employee costs declined to 27.4% in the second quarter 2012 from 29.0% in the second quarter 2011 and 33.7% in the first quarter 2012. Employee costs in the title segment increased 3.1% over the second quarter 2011 to support the 15.6% increase in title operating revenues.
Other operating expenses. Other operating expenses include costs that are fixed in nature, costs that follow, to varying degrees, changes in transaction volumes and revenues and costs that fluctuate independently of revenues. Costs that are fixed in nature include attorney fees, equipment rental, insurance, professional fees, rent and other occupancy expenses, repairs and maintenance, technology costs, telephone and title plant rent. Costs that follow, to varying degrees, changes in transaction volumes and revenues include fee attorney splits, bad debt expenses, certain REI expenses, copy supplies, delivery fees, outside search fees, postage, premium taxes and title plant expenses. Costs that fluctuate independently of revenues include auto expenses, general supplies, litigation defense and settlement costs, promotion costs and travel.
In the second quarter 2012 compared with the same period in 2011, other operating expenses for the combined business segments increased $6.2 million, or 9.6%. Costs fixed in nature increased $3.3 million, or 11.7%, in the second quarter 2012, primarily due to increases in technology costs and professional fees, as a result of outsourcing the internal audit function. Costs that follow, to varying degrees, changes in transaction volumes and revenues increased $4.2 . . .
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