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STC > SEC Filings for STC > Form 10-Q on 2-Aug-2013All Recent SEC Filings

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Form 10-Q for STEWART INFORMATION SERVICES CORP


2-Aug-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT'S OVERVIEW

We reported net earnings attributable to Stewart of $26.9 million, or $1.09 per diluted share, for the second quarter 2013, representing an improvement of $2.0 million over the second quarter 2012 net earnings of $24.9 million, or $1.05 per diluted share. Pretax earnings for the second quarter 2013 were $48.9 million, an improvement of $17.7 million over the second quarter 2012 pretax earnings of $31.2 million. For the first six months of 2013, net earnings attributable to Stewart of $30.1 million, or $1.25 per diluted share, represent an improvement of $17.3 million over the same period in 2012. Results for the first six months of 2013 include a non-cash charge of $5.4 million, or $0.22 per share, relating to the early retirement of $37.1 million of our 6% Convertible Senior Notes (Notes) due October 2014, as well as a gain of $1.7 million, or $0.07 per share, on non-title-related insurance policy proceeds (no tax benefit or expense is associated with either item; thus no tax-related earnings per share effect).

Total revenues for the second quarter 2013 were $517.2 million, an increase of $33.5 million, or 6.9%, from $483.7 million for the second quarter 2012. Operating revenues increased 7.0% to $512.8 million in the second quarter 2013 compared to $479.2 million in the second quarter 2012. Compared to second quarter 2012, title revenues increased 9.7% in the second quarter 2013, while mortgage services revenues decreased 22.2%. Total revenues for the first six months of 2013 were $940.9 million, an increase of $72.2 million, or 8.3%, from $868.7 million for the same period in 2012.

Revenues from our title segment increased 9.2% and 24.3% from the second quarter 2012 and first quarter 2013, respectively. Revenues from direct operations for the second quarter 2013 increased 12.6% compared to the same quarter last year and increased 32.7% sequentially from the first quarter 2013. Our direct operations include local closing offices, commercial, and international operations. We generate commercial revenues both domestically and internationally; U.S. and Canadian commercial revenues increased 21.6% to $37.3 million from the second quarter 2012 and sequentially by 40.9% from the first quarter 2013. This was the best second quarter for commercial revenues since 2007. International operating revenues (including foreign-sourced commercial revenues) declined 6.3% to $30.6 million from the second quarter 2012 and increased sequentially from the first quarter 2013 by 53.6%.

Revenues from our mortgage services segment decreased 15.8% from the second quarter 2012 and decreased 9.4% sequentially from the first quarter 2013. The decline in revenues is largely due to the scheduled expiration of certain contracts providing distressed loan services. During the second quarter, preparatory work began on several recently signed contracts, which should generate revenues beginning in mid-third quarter 2013 and partially offset the revenue loss from the expiring contracts. As a result of the decline in revenues, mortgage services pretax earnings in the second quarter 2013 were $5.2 million (13.9% margin) as compared to $12.8 million (28.8% margin) in the second quarter 2012 and $9.8 million (23.8% margin) in the first quarter 2013.

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CRITICAL ACCOUNTING ESTIMATES

The preparation of the Company's Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of certain assets, liabilities, revenues, expenses and related disclosures surrounding contingencies and commitments.

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.

During the six months ended June 30, 2013, the Company made no material changes to its critical accounting estimates as previously disclosed in Management's Discussion and Analysis in the Company's Annual Report on Form 10-K for the year ended December 31, 2012.

Operations. Our business has three main operating segments: title insurance and related services, mortgage services and corporate.

Our primary business is title insurance and settlement-related services. We close transactions and issue title policies on homes, 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; 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 mortgage services segments include:

• mortgage interest rates;

• inventory of existing homes available for sale;

• 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.

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. Premiums are determined in part by the insured values of the transactions we handle. These factors may override the seasonal nature of the title insurance business. Historically, our first quarter is the least active and our third and fourth quarters are the most active in terms of title insurance revenues.

RESULTS OF OPERATIONS

Comparisons of our results of operations for the three and six months ended June 30, 2013 with the three and six months ended June 30, 2012 follow. Factors contributing to fluctuations in the results of operations are presented in the order of their monetary significance, and we have quantified, when necessary, significant changes. Results from our mortgage services and corporate segments are included in the discussions and, when relevant, are discussed separately.

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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. We continue to see benefits in our results of operations from the improving real estate market, particularly in existing home sales. Quarterly data as of June 30, 2013 compared with the same period in 2012 indicates, on a 12-month moving average seasonally adjusted basis, annualized sales of existing homes increased 10.5% and new homes increased 22.4%. June 2013 existing home sales were at a seasonally adjusted annual rate of 5.1 million versus 4.4 million a year earlier. In addition, median home prices increased 10.0% from the second quarter 2012 and sequentially 2.8% from the first quarter 2013. A 5.0% increase in home prices results in an approximately 3.5% increase in title premiums. Interest rates, although rising late in the quarter, continue to remain low by historical standards. While job growth remains tepid and unemployment high, the housing market appears to be on a continuing path of recovery in sales volume and prices for new and existing homes. The inventory of available listings for sale on the market is less than normal, portending ongoing rising prices. According to Fannie Mae, one-to-four family residential lending increased from an estimated $474 billion in the second quarter 2012 to $566 billion in the second quarter 2013, primarily driven by an estimated $63 billion increase in refinance originations from the second quarter 2012 to the second quarter 2013. Sequentially, residential lending for purchase volumes increased as expected given seasonality in home sales from $108 billion in the first quarter of 2013 to $183 billion in the second quarter of 2013. Residential refinance lending volumes likewise increased from $352 billion in the first quarter 2013 to $384 billion in the second quarter 2013. On average, refinance premium rates are 60% of the title premium revenue of a similarly priced sale transaction.

Title revenues.Revenues from direct title operations increased $23.7 million, or 12.6%, and $31.8 million, or 9.4%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. Revenues in the second quarter and first six months of 2013 increased primarily due to the increase in orders closed, home price appreciation and, to a lesser extent, a premium rate increase in Texas that was effective May 1. The largest increases in revenues in the second quarter 2013 were in Texas, New York, Louisiana and Ohio, partially offset by decreases in California and Canada. The largest increases in revenues in the first six months of 2013 were in Texas, New York, Ohio and Louisiana, partially offset by decreases in California and Canada. Revenues from commercial and other large transactions increased $6.6 million, or 21.5%, and $10.1 million, or 18.8%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012.

Direct orders closed increased 7.4% and 5.6%, respectively, while the average revenue per file closed (including large commercial policies) increased 5.2% and 3.2%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. Direct operating revenues, excluding commercial and other large transactions, increased 11.3% and 7.1%, respectively, while the average revenue per closing increased 3.6% and 1.4%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012.

Revenues from independent agencies increased $18.8 million, or 7.5% and $50.1 million, or 11.2%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. The largest increases in revenues from independent agencies in the second quarter 2013 were in Texas, New Jersey, Michigan, New York, Florida and Massachusetts, partially offset by decreases in California. The largest increases in revenues from independent agencies during the first six months of 2013 were in New York, Texas, New Jersey, Pennsylvania, Michigan, Georgia and Florida, partially offset by decreases in California. Revenues from independent agencies net of amounts retained by those agencies increased 14.2% and 16.8% in the second quarter and first six months of 2013 compared to the same periods in 2012, respectively.

We began the process of vetting our independent agencies several years ago with the goal of achieving the highest-quality network of independent agencies. Since the fourth quarter 2008, our average annual premium revenue received per independent agency has

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increased more than 125% and we have reduced the number of independent agencies in our network by approximately 42%. Further, the policy loss ratio of our current independent agency network for the second quarter 2013 is less than one-fourth of its level in the fourth quarter 2008. As the operating environment for independent agencies evolves due to proposed new regulation by the Consumer Financial Protection Bureau and increased lender due diligence, we have taken a lead in preparing our independent agencies for the market changes by offering regular educational opportunities and effective solutions. We have also provided leadership to the American Land Title Association in its efforts to develop title insurance and settlement company best practices. Our focus on partnering with the highest quality independent agencies in the industry should yield consistent and improving profitability.

The Texas Department of Insurance increased title insurance premium rates in the state of Texas by 3.8% effective May 1, 2013. The impact on our consolidated financial position or results of operations from this rate increase has been incrementally positive to second quarter revenues.

Mortgage services revenues. Mortgage services operating revenues decreased $8.9 million, or 22.2% and $5.3 million, or 7.4%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. The decline in revenues is largely due to the scheduled expiration of certain contracts providing distressed loan services. Although revenues from such services have persisted longer than expected, we anticipate further decline in mortgage services revenues during the second half of 2013 as additional contracts expire. During the second quarter, preparatory work began on several recently signed contracts, which should generate revenues beginning in mid-third quarter 2013 and partially offset the revenue loss from the expiring contracts. However, by their nature, revenues from contracts will fluctuate on a quarterly basis as projects conclude and start-up activities overlap or gap. We continue to invest in our mortgage services businesses, expanding our product set within the broad category of origination and servicing support to include additional services not related to distressed properties, such as loan due diligence and quality control. These services have been well received by existing customers and have attracted new customers, thereby creating a more diverse client base and providing the foundation for revenues that are less distressed property-based and more balanced over market cycles. Our focus for this business continues to be on providing mortgage support services that capitalize on our expertise in providing high quality, on-demand specialized outsourcing solutions.

Investment income. Investment income increased $0.9 million, or 25.8% and $1.4 million, or 21.3%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. Investment income increased primarily due to increases in average balances invested in the second quarter 2013 and increases in average yield and balances for the first six months of 2013 compared to the same periods in 2012. 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.

In the second quarter 2013, investment and other gains (losses) - net included a $1.4 million loss on the sale of an equity investment offset by realized gains of $1.6 million from the sale of debt and equity investments available-for-sale. For the six months ended June 30, 2013, investment and other gains (losses) - net included a $5.4 million non-cash charge relating to the early retirement of $37.1 million of Notes and a $1.5 million loss on the sale of an equity investment offset by realized gains of $1.9 million from the sale of debt and equity investments available-for-sale and $1.7 million gain on non-title-related insurance policy proceeds.

In the second quarter and first six months of 2012, investment and other gains - net included realized gains of $1.1 million and $1.9 million, respectively, from the sale of debt and equity investments available-for-sale.

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 81.3% and 82.4% in the second quarters of 2013 and 2012, respectively and 81.7% and 82.6% in the first six months of 2013 and 2012, respectively. The decrease in the average retention percentage for the three and six months ended June 30, 2013 was largely due to a shift in revenue mix, as agency revenues in high retention states either declined or did not increase as fast as agency revenues in relatively lower retention states. The average retention percentage may vary from quarter-to-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 continue to improve 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 somewhat faster than the nation as a whole, which has resulted in our average retention percentage remaining in the 82% - 83% range. We

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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.

Employee costs. Our employee costs and certain other operating expenses are sensitive to inflation. Employee costs for the combined business segments increased 11.7% and 9.2%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. The increase in employee costs for these periods is due primarily to higher headcount to handle increased business activity. In addition, employee costs were influenced by higher incentive compensation due to the improved operating results, an increase in group insurance costs and the reinstatement of the employer match of the 401(K) employee benefit program. As a percentage of total operating revenues, however, employee costs increased to 28.5% in the second quarter 2013 from 27.4% in the second quarter 2012 and decreased from 32.3% in the first quarter 2013.

In the second quarter and first six months of 2013, employee costs in the title segment increased 13.8% and 9.9%, respectively, over the same periods in 2012 primarily due to higher headcount to handle increased business activity as well as the increased incentive compensation and employee benefit costs discussed above. In our mortgage services segment, total employee costs as a percentage of operating revenue increased to 74.2% from 60.7% in the second quarter 2012 and increased to 69.4% from 63.3% in the first six months of 2013. Actual costs increased $1.1 million, or 4.2% and $3.7 million, or 7.3%, respectively, in the second quarter and first six months of 2013 compared to the same periods in 2012. The increase is primarily due to maintaining headcount as revenues declined in order to prepare for production on recently signed contracts. Many of the employees servicing expired contracts will be utilized for the new contracts as production ramps up in the third quarter 2013.

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 and professional fees, equipment rental, insurance, 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 mortgage services expenses, copy supplies, delivery fees, outside search fees, postage, premium taxes and title plant maintenance expenses. Costs that fluctuate independently of revenues include auto expenses, general supplies, litigation defense and settlement costs, business promotion costs and travel.

In the second quarter and first six months of 2013 compared to the same periods in 2012, other operating expenses for the combined business segments increased $3.0 million, or 4.3% and $1.9 million, or 1.4%, respectively. Costs fixed in nature increased $0.4 million, or 1.1%, in the second quarter 2013 primarily due to increases in professional fees offset by decreases in telephone costs and attorney fees. For the first six months of 2013, costs fixed in nature were comparable to the same period in 2012.

Costs that follow, to varying degrees, changes in transaction volumes and revenues increased $0.5 million, or 1.8% and $2.1 million, or 4.1%, in the second quarter and first six months of 2013, respectively. The increases in these costs for the second quarter and first six months of 2013, respectively, are primarily due to increases in outside search fees and premium taxes offset by decreased bad debt expenses. Costs that fluctuate independently of revenues increased $2.1 million, or 19.6% and $0.1 million, or 0.2%, in the second quarter and first six months of 2013, respectively, primarily due to increases in travel, business promotion and litigation-related costs in the second quarter 2013 and increases in travel and business promotion partially offset by a decrease in litigation-related costs for the first six months of 2013.

Title losses. Provisions for title losses, as a percentage of title revenues, were 5.0% and 8.7% in the second quarter 2013 and 2012, respectively, and 5.5% and 8.8% in the first six months of 2013 and 2012, respectively, including adjustments to certain large claims. Our title policy loss development continued to improve during the second quarter 2013, reflecting a decline in prior policy years loss experience as well as our attention to prudent risk management and emphasis on quality and profitability of our network of

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independent agencies. Due to this ongoing improvement, we lowered our overall loss provisioning rate effective with policies issued in the second quarter 2013, and recorded a policy loss reserve reduction of $6.6 million relating to prior policy years. Excluding this reserve reduction and adjustments related to large claims (recorded in the second quarter 2012), title losses were 5.9% and 7.5% in the second quarter 2013 and 2012, respectively, and 6.0% and 7.7% in the first six months of 2013 and 2012, respectively.

Title losses for the second quarter 2013 decreased 36.6% on the 9.7% increase in title operating revenues when compared to the second quarter 2012. For the first six months of 2013, title losses decreased 31.3% on the 10.4% increase in title operating revenues when compared to the same period in 2012. The title loss ratio in any given quarter is significantly influenced by new large claims incurred or adjustments to reserves for existing large claims. Adjustments to new and existing large losses did not exceed our normal provisioning rate during the first six months of 2013. Although there can be no assurances that this result for large losses will continue for the remainder of 2013, we continue to manage and resolve large claims prudently and in keeping with our commitments to our policyholders.

Cash claim payments in the second quarter and first six months of 2013 increased 7.4% and 6.5%, respectively, from the same periods in 2012 as payments on previously reserved large losses were made.

Our liability for estimated title losses as of June 30, 2013 comprises both known claims ($115.5 million) and our estimate of claims that may be reported in the future ($385.6 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.

Income taxes. Our effective tax rates were 41.3% and 11.3% for the second quarter 2013 and 2012 and 41.5% and 32.0% for the first six months of 2013 and 2012, respectively, based on earnings before taxes and after deducting noncontrolling interests, which when aggregated are $45.9 million and $28.1 million for the second quarter 2013 and 2012 and $51.5 million and $18.8 million for the first six months of 2013 and 2012, respectively. In the fourth quarter 2012, we released a significant portion of a previously established valuation allowance against deferred tax assets. As a result, our effective tax rates for the quarter and six months ended June 30, 2013 reflect a more normalized rate based on domestic and international operating results, although the effective tax rates for these periods are higher as a result of non-deductible costs associated with the conversion of the Notes. A valuation allowance against certain foreign tax credit carryforwards, which may not be utilized in the future, remains at June 30, 2013.

LIQUIDITY AND CAPITAL RESOURCES

Our liquidity and capital resources represent our ability to generate cash flow to meet our obligations to our shareholders, customers (payments to satisfy claims on title policies), vendors, employees, lenders and others. As of June 30, 2013, our cash and investments, including amounts reserved pursuant to statutory requirements, aggregated $756.1 million.

A substantial majority of our consolidated cash and investments as of June 30, 2013 was held by Stewart Title Guaranty Company (Guaranty) and its subsidiaries. The use and investment of these funds, dividends to the holding company, and cash transfers between Guaranty and its subsidiaries and the holding company are subject to certain legal and regulatory restrictions. In general, Guaranty may use its cash and investments in excess of its legally-mandated statutory premium reserve (established in accordance with requirements under Texas law) to fund its insurance operations, including claims payments. Guaranty may also, subject to certain limitations, provide funds to its subsidiaries (whose operations consist principally of field title offices) for their operating and debt service needs.

Guaranty cannot pay a dividend to its parent in excess of certain limits without the approval of the Texas Insurance Commissioner. As of December 31, 2012, the maximum dividend that could be paid in 2013 after such approval in 2013 is $85.8 million. Guaranty did not pay a dividend in the six months ended June 30, 2013 or 2012. However, the maximum dividend permitted by law is not necessarily indicative of Guaranty's actual ability to pay dividends, which may be constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect its ratings or competitive position, the amount of insurance it can write and its ability to pay future dividends. Further, depending on business and regulatory conditions, we may in the

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future need to retain cash in Guaranty or even raise cash in the capital markets to contribute to it in order to maintain its ratings or statutory capital position. Such a requirement could be the result of investment losses, reserve charges, adverse operating conditions in the current economic environment or changes in interpretation of statutory accounting requirements by regulators.

Cash held at the parent company totaled $9.2 million at June 30, 2013. As noted . . .

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