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STC > SEC Filings for STC > Form 10-Q on 6-Nov-2013All Recent SEC Filings

Show all filings for STEWART INFORMATION SERVICES CORP

Form 10-Q for STEWART INFORMATION SERVICES CORP


6-Nov-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 $15.4 million, or $0.63 per diluted share, for the third quarter 2013, representing a decrease of $19.3 million from the third quarter 2012 net earnings of $34.7 million, or $1.45 per diluted share. Year-over-year comparisons of net earnings are adversely affected by income tax expense, as the third quarter 2013 experienced a more-typical income tax provision while the third quarter 2012 benefited from the utilization of net operating loss carryforwards. Pretax earnings for the third quarter 2013 were $29.6 million, a decrease of $9.8 million over the third quarter 2012's $39.4 million. The decline in pretax earnings is attributable to an approximate $13.8 million decrease from the prior year quarter in our mortgage services segment, partially offset by improved results in our title segment. For the first nine months of 2013, net earnings attributable to Stewart of $45.5 million, or $1.88 per diluted share, represent a decrease of $1.9 million from the same period in 2012. Pretax earnings for the first nine months of 2013 were $85.6 million, an increase of $22.9 million from the same period in 2012. Results for the first nine months of 2013 include a non-cash charge of $5.4 million, or $0.22 per share, relating to the early retirement of $37.8 million of our 6% Convertible Senior 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 there was no tax-related effect on earnings per share).

Total revenues for the third quarter 2013 were $536.8 million, an increase of $16.1 million, or 3.1%, from $520.7 million for the third quarter 2012. Operating revenues increased 3.6% to $532.2 million in the third quarter 2013 compared to $513.8 million in the third quarter 2012. Compared to the third quarter 2012, title revenues increased 7.1% in the third quarter 2013, while mortgage services revenues decreased 36.5%. Total revenues for the first nine months of 2013 were $1,477.8 million, an increase of $88.4 million, or 6.4%, from $1,389.4 million for the same period in 2012.

Revenues from our title segment increased 7.0% and 5.4% from the third quarter 2012 and second quarter 2013, respectively. The title segment generated a pretax margin of 12.3%, an improvement of 1.5 percentage points from third quarter 2012 and sequentially a decline of 3.1 percentage points from second quarter 2013. Revenues from direct operations for the third quarter 2013 increased 4.6% compared to the same quarter last year and decreased 6.1% sequentially from the second quarter 2013. We generate commercial revenues both domestically and internationally. U.S. and Canadian commercial revenues increased 5.7% to $31.4 million from the third quarter 2012 and decreased sequentially by 15.9% from the second quarter 2013. This was the best third quarter for commercial revenues since 2007. Fitch Ratings upgraded Stewart's Insurer Financial Strength rating in August 2013 from BBB+ with a positive outlook to A- with a stable outlook. This upgrade will likely yield greater commercial revenues in the future. International operating revenues (including foreign-sourced commercial revenues) increased 7.5% to $34.4 million from the third quarter 2012 and sequentially by 12.5% from the second quarter 2013.

Our mortgage services segment reported a pretax loss of $1.4 million as compared to a pretax profit of $12.4 million and $5.2 million for the third quarter 2012 and second quarter 2013, respectively. Revenues from our mortgage services segment decreased 31.3% from the third quarter 2012 and decreased 15.9% sequentially from the second 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 nine months ended September 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; loan due diligence; compliance solutions; service performance management 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, including employment trends;

• 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.

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RESULTS OF OPERATIONS

Comparisons of our results of operations for the three and nine months ended September 30, 2013 with the three and nine months ended September 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.

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 September 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 11.7% and preliminary new sales increased 19.9% with median price up 10.4% on a 12-month moving average. September 2013 existing home sales were at a seasonally adjusted annual rate of 5.3 million versus 4.8 million a year earlier. In addition, median home prices increased 11.2% from the third quarter 2012 and sequentially 3.3% from the second quarter 2013. A 5% increase in home prices results in an approximately 3.6% 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 decreased from an estimated $596 billion in the third quarter 2012 to $457 billion in the third quarter 2013, primarily driven by an estimated $176 billion decrease in refinance originations from the third quarter 2012 to the third quarter 2013. Sequentially, residential lending for home purchase volumes increased from $196 billion in the second quarter of 2013 to $208 billion in the third quarter of 2013. Residential refinance lending volumes decreased from $359 billion in the second quarter 2013 to $249 billion in the third 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 $8.8 million, or 4.6%, and $40.5 million, or 7.6%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012. Revenues in the third quarter and first nine months of 2013 increased primarily due to a shift in order mix to more resale orders, home price appreciation and, to a lesser extent, a premium rate increase in Texas that became effective May 1, 2013. The largest increases in revenues in the third quarter 2013 were in Texas, Ohio and international, partially offset by decreases in Pennsylvania and California. The largest increases in revenues in the first nine months of 2013 were in Texas, Ohio, New York and New Mexico, partially offset by decreases in California and Canada. Revenues from commercial and other large transactions increased $1.7 million, or 5.7%, and $11.8 million, or 14.1%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012.

Direct orders closed decreased 6.0% and increased 1.5%, respectively, while the average revenue per file closed (including large commercial policies) increased 10.3% and 5.5%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012. Direct operating revenues, excluding commercial and other large transactions, increased 3.3% and 5.8%, respectively, while the average revenue per closing increased 9.9% and 4.2%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012.

Revenues from independent agencies increased $25.0 million, or 8.9% and $75.1 million, or 10.3%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012. The largest increases in revenues from independent agencies in the third quarter 2013 were in New York, Pennsylvania, Texas and Utah, partially offset by decreases in California and New Jersey. The largest increases in revenues from independent agencies during the first nine months of 2013 were in New York, Texas, Pennsylvania and Michigan, partially offset by decreases in California. Revenues from independent agencies net of amounts retained by those agencies increased 13.5% and 15.5% in the third quarter and first nine months of 2013 compared to the same periods in 2012, respectively.

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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 increased more than 135% and we have reduced the number of independent agencies in our network by approximately 41%. Further, the policy loss ratio of our current independent agency network for the third 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 helping our independent agencies prepare for the market changes by offering regular educational opportunities and effective solutions. We continue to emphasize partnering with the highest quality independent agencies in the industry, and are focusing our growth efforts in those states with relatively high remittance rates, to 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 and third quarter revenues.

Mortgage services revenues. Mortgage services operating revenues decreased $15.3 million, or 36.5%, and $20.7 million, or 18.1%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012. The decline in revenues is largely due to the nature of the contract-based revenue in this segment. The ongoing recovery in the housing markets has resulted in less demand for distressed loan management services, which the expiring contracts provided. Although such contracts expired this quarter, we maintained the existing operational infrastructure to support newly acquired contracts that are in the process of ramping up to their full revenue potential. While we have seen an increase in non-default related revenue, revenues will likely remain depressed over the next several quarters while this line of business is in a transitional phase. We continue to execute on our longer-term strategy of providing mortgage process outsourcing services which are high-quality, flexible and responsive. Our expectation is that new service capabilities within the broad category of servicing and origination support will create a more diverse client base and less cyclical revenues. Additionally, the acquisition of the key assets of Allonhill, LLC during the third quarter 2013 diversifies our revenue base and we expect it to be accretive to earnings during the first half of 2014.

Investment income. Investment income increased $0.1 million, or 1.6% and $1.5 million, or 14.2%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012. Investment income increased primarily due to increases in average balances invested in the third quarter 2013 and increases in average balances and, to a lesser extent increases in yield, for the first nine 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.

For the nine months ended September 30, 2013, investment and other gains (losses) - net included a $5.4 million non-cash charge relating to the early retirement of $37.8 million of Notes and a $1.5 million loss on the sale of an equity investment offset by realized gains of $2.5 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 third quarter 2012, investment and other gains - net included realized gains of $2.1 million from the sale of debt and equity investments available-for-sale and $1.6 million from the sale of property. For the nine months ended September 30, 2012, investment and other gains - net included realized gains of $3.9 million from the sale of debt and equity investments available-for-sale and $2.2 million from the sale of property.

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 81.6% and 82.3% in the third quarters of 2013 and 2012, respectively and 81.7% and 82.5% in the first nine months of 2013 and 2012, respectively. The decrease in the average retention percentage for the three and nine months ended September 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

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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 81%-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.

Employee costs. Our employee costs and certain other operating expenses are sensitive to inflation. Employee costs for the combined business segments increased 6.4% and 8.3%, respectively, in the third quarter and first nine 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 in the third quarter of 2012. As a percentage of total operating revenues, employee costs increased to 27.6% in the third quarter 2013 from 26.9% in the third quarter 2012 and decreased from 28.5% in the second quarter 2013.

In the third quarter and first nine months of 2013, employee costs in the title segment increased 7.5% and 10.3%, 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 revenues increased to 91.5% from 63.6% in the third quarter 2012 and increased to 75.7% from 63.4% in the first nine months of 2013. Actual costs decreased $0.3 million, or 1.1% and increased $3.4 million, or 4.3%, respectively, in the third quarter and first nine months of 2013 compared to the same periods in 2012. The increase, as a percentage of operating revenues, is primarily due to maintaining headcount as revenues declined in order to prepare for production on recently signed contracts and due to the increase in employees related to the acquisition of certain assets of AllonHill, LLC. Many of the employees servicing the expired contracts will be utilized for the new contracts as production ramps up in the fourth 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 expenses. 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 third quarter and first nine months of 2013 compared to the same periods in 2012, other operating expenses for the combined business segments increased $1.5 million, or 2.0%, and $3.4 million, or 1.6%, respectively. Costs fixed in nature increased $3.4 million, or 12.1%, in the third quarter 2013 primarily due to increases in technology costs, professional fees, insurance and rent and other occupancy expenses. For the first nine months of 2013, costs fixed in nature increased $3.2 million, or 3.6%, primarily due to increases in professional fees, insurance and technology costs partially offset by attorney fees and telephone expense.

Costs that follow, to varying degrees, changes in transaction volumes and revenues decreased $2.2 million, or 7.6%, and $0.2 million, or 0.2%, in the third quarter and first nine months of 2013, respectively. The decreases in these costs for the third quarter are primarily due to decreases in outside search fees, certain mortgage services expenses and postage. The decreases in these costs for the first nine months of 2013 are primarily due to decreases in bad debt expenses, certain mortgage services expenses and title plant expenses, partially offset by increases in premium taxes and outside search fees. Costs that fluctuate independently of revenues increased $0.3 million, or 2.4%, and $0.4 million, or 1.0%, in the third quarter and first nine months of 2013, respectively, primarily due to increases in business promotion and technology related costs partially offset by decreases in litigation-related costs in the third quarter 2013 and for the first nine months of 2013, respectively.

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Title losses. Provisions for title losses, as a percentage of title revenues, were 6.5% and 7.3% in the third quarter 2013 and 2012, respectively, and 5.8% and 8.3% in the first nine months of 2013 and 2012, respectively, including adjustments to certain large claims. Our title policy loss development continued to improve during the third quarter 2013, reflecting an ongoing decline in prior policy year loss experience on non-large title losses as well as our continued attention to prudent risk management and emphasis on quality and profitability of our independent agency network. We recorded policy loss reserve reductions relating to non-large incurred losses on prior policy years of $11.2 million and $6.6 million in the third quarter and second quarter 2013, respectively. Adjustments to new and existing large losses resulted in charges of approximately $11.2 million and $2.5 million in the third quarter and second quarter 2013. Similar charges for large losses totaling $13.1 million were recorded in the first nine months of 2012. The overall effect of the third quarter 2013 adjustments was a reallocation of policy loss reserves from non-large claims to large claims. Excluding these reserve reductions and adjustments related to large claims, title losses were 6.5% and 6.4% in the third quarter 2013 and 2012, respectively, and 6.1% and 7.2% in the first nine months of 2013 and 2012, respectively. As a result of the policy loss development improvement, we lowered our overall provisioning rate on non-large claims effective with policies issued in the second quarter 2013.

Title losses for the third quarter 2013 decreased 5.5% in connection with the 7.1% increase in title operating revenues when compared to the third quarter 2012. For the first nine months of 2013, title losses decreased 22.8% in connection with the 9.2% 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 as well as adjustments to reserves for existing large claims, and we continue to manage and resolve large claims prudently and in keeping with our commitments to our policyholders.

Cash claim payments in the third quarter and first nine months of 2013 decreased 18.7% and 4.0%, respectively, from the same periods in 2012.

Our liability for estimated title losses as of September 30, 2013 comprises both known claims and our estimate of claims that may be reported in the future ("IBNR"). Known claims reserves are reserves related to actual losses reported to us. Our reserve for known claims comprises both claims related to title insurance policies as well as losses arising from escrow, closing and funding operations due to fraud or error (which are recognized as expense when discovered). The amount of the reserve represents the aggregate, non-discounted future payments (net of recoveries) that we expect to incur on policy and escrow losses and in costs to settle claims.

                                           September 30,      December 31,
                                               2013               2012
                                                   ($000 omitted)
           Known claims                             129.0             137.9
           IBNR                                     380.4             382.5

           Total estimated title losses             509.4             520.4

Title claims are generally incurred three to five years after policy issuance, and the timing of payments on these claims can significantly impact the balance of known claims, since in many cases claims may be open for several years before resolution and payment occur.

Income taxes. Our effective tax rates were 42.9% and 6.1% for the third quarters 2013 and 2012 and 42.0% and 14.8% for the first nine months of 2013 and 2012, respectively, based on earnings before taxes and after deducting noncontrolling interests, which when aggregated were $27.0 million and $36.9 million for the third quarters 2013 and 2012, respectively, and $78.4 million and $55.7 million for the first nine 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 nine months ended September 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 September 30, 2013.

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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 . . .

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