Description

Stewart Information Services (STC) is the third largest title insurance company in the United States. After reporting eight consecutive quarters of losses, investors are wrongly assuming that profits will remain subdued in the short-term, whereas the company has positioned itself to report significant profits in 2010-2012 even if housing market conditions remain subdued.

Longer-term Picture
Over the past decade, Stewart has two distinct chapters. From 2001-2006, EPS and ROE averaged $4.49 and 15%, respectively. Operating margins averaged 8.0%. In 2007-2008, EPS was -$15.58 and 2009 consensus is -$3.78. In '96-'06, loss provisioning as a percentage of revenue averaged 4.5%. Provisioning is currently running at 10-11% which is normal during housing downturns. Claims should lessen over the next thre years and any revenue uptick will further reduce this ratio.

Even I one assumes that long-term margins are only 4.0% (1/2 of 2001-2006 margins), EPS = $2.08, or 5x EPS. During normal times, Stewart generates significant free cash flow. In 2001-2003, STC generated $373mm in FCF, exactly equal to the company's current Enterprise Value. In 2001-2006, FCF was $709mm - 1.9x EV. This data point reveals just how cheap Stewart is at current prices (if the housing markets normalize). BVPS = $24.13 and Tangible BVPS = $12.10.

Short-term Picture
When it issued it converts, STC revealed that ex-loss reserve adjustments, it operated at break-even in July and August. Fidelity National (47% market share) just released Q3-09 earnings and cited improved open order counts in September and October. Freddie Mac recently reported that 30-yr fixed rates have only been lower 12 of the past 500 weeks. So Sept/Oct should be good months for STC, particularly considering that its business structure has been right-sized. 

Consensus expects only $0.47 of EPS in 2010 despite the fact that STC has positioned its cost structure for $10bn of industry originations in 2010, down from $12bn in 2009. Some of this is analyst anchoring as 2007-2009 are the first money-losing periods since 1974. 

So is the housing market really stabilizing or is recent data just a head-fake? In 2009, new home sales were the lowest since 1963, the year recordkeeping began for this statistic. YTD, existing home sales increased 16.7 percent from January 2009 to July 2009. Pending home sales have increased in September, according to the National Association of Realtors. The Case-Shiller 20-City Home Price Index has risen for two consecutive months, with only two cities posting a price decline from May to June 2009, the latest period available. 

Another interesting aspect of STC is that the company appears to significantly over-reserve relative to peers. In 2000-2008, actual cash claim payments as a % of loss provisioning has averaged about 70% and has never exceeded 83% in a calendar year. This "over-reserving" is one reason that I think earnings could outperform in the future, as STC may be able to release reserves in 2010 and beyond.

 
BACKGROUND
Stewart Information Services is a title insurer that has been around for 116 years. Title insurance is required by lenders to determine lien priority and protect the lender in case of ownership dispute. Typically a real estate broker or lender selects the title company and orders a policy paid for by the real estate buyer at closing. Premiums are a function of the value of the real estate and are nominally state regulated. For lenders the policy covers the amount of the mortgage. Owners can buy a policy to cover the amount of purchase. The policy terminates upon sale of property or mortgage satisfaction (refinance). Title insurance is substantially different from other types of insurance. Fire, auto, health and life insurance protect against future losses and events. In contrast, title insurance insures against losses from past events and seeks to protect the public by eliminating covered risks through the examination and settlement process. The title insurance industry is cyclical but requires less capital than other insurance types because of low losses. 

Stewart also provides post-closing lender services, automated county clerk land records, property ownership mapping, geographic information systems, property information reports, flood certificates, document preparation, background checks and expertise in tax-deferred exchanges. Its international division delivers products and services protecting and promoting private land ownership worldwide. Currently, our primary international operations are in Canada, the United Kingdom, Central Europe, Mexico, Central America and Australia.

40% of Stewart's premiums come from 4 states: Texas (18%), California (9%), New York (9%), Florida (5%)

 
THE TITLE INSURANCE INDUSTRY
The top 5 title firms control 92% of premiums, 40 companies control the remaining 8%. The big four are Fidelity National Title (47%), First American (26%), Stewart (13%) and Old Republic (7%). These four companies all have significant amounts of goodwill from consolidation. None of the top four are 100% pure plays on title insurance, as title companies typically own financial services / systems companies plus other types of insurance, flood, homeowners, and home owner's warranty (HOW). Title companies generate significant amounts of excess capital. All have repurchased significant amounts of stock over the years and into 2008 but have suspended buybacks.

 
The primary sources of title insurance business are attorneys, builders, developers, home buyers and home sellers, lenders and real estate brokers. Titles insured include residential and commercial properties, undeveloped acreage, farms, ranches and water rights. Service, location, financial strength, size and related factors affect customer acceptance. Increasing market share is accomplished primarily by providing superior service. The parties to a closing are concerned with personal schedules and the interest and other costs associated with any delays in the settlement. The rates charged to customers are regulated, to varying degrees, in many states.

 
The financial strength and stability of the title underwriter are important factors. Among the nation's leading title insurers, Stewart earned one of the highest ratings awarded by the title industry's leading rating companies. Its principal underwriter, Stewart Title Guaranty Company (Guaranty) is currently rated A" by Demotech, Inc., A- by Fitch and B by LACE Financial.

 
Title insurance is delivered via two channels, agency and direct. In the direct channel, the title insurer employees perform a title search and the title insurer earns 100% of the fee. In the agency channel, the agent performs the search and earns 80% of the premium but the title company retains the claims risk for 20% of the premium.

 
Title insurers are facing two primary challenges right now: 1) High claims and 2) declining mortgage originations.

 
High Claims
Losses on policies occur when a title defect is not discovered during the examination and settlement process. Reasons for losses include forgeries, misrepresentations, unrecorded liens, the failure to pay off existing liens, mortgage
lending fraud, mishandling or defalcation of settlement funds, issuance by title agencies of unauthorized coverage and defending insureds when covered claims are filed against their interest in the property. Some claimants seek damages in excess of policy limits, based on various legal theories.

 
Most policy claims and claim payments are made in the first six years after the policy has been issued, although claims are also incurred and paid many years later. By their nature, claims are often complex, vary greatly in dollar amounts and are affected by economic and market conditions and the legal environment existing at the time claims are processed. Claims usually range from 4% to 5% of revenues during normal times and 8-11% during housing downturns ('80-'82, 91-'93, '07-'09).

 
In response to declining originations since 2006, title insurers are closing offices, terminating agents and other personnel, in an effort to preserve margins. This is almost impossible to do, as orders have declined at such a rapid rate in 2007-2008 that the title insurers have not been able to keep pace. The pendulum does swing both ways and should orders increase at some point, positive operating leverage should occur.

 
Balance Sheet
On October 8, 2009, Stewart offered $60 million of convertible senior notes due 2014, the proceeds of which are being used to repay all outstanding callable bank debt. Pursuant to this successful offering, Stewart has only $17 million of debt maturing in the next two years. Stewart's investment portfolio looks very straightforward (very limited portion of either CMBS, non-investment grade paper or exotic instruments).

 
The insurance regulators of the states in which Stewart's underwriters are domiciled require statutory premium reserves to be fully funded, segregated and invested in high-quality securities and short-term investments. At 12/31/08, investments funding the statutory premium reserve aggregated $384.2 million and statutory estimate of claims that may be reported in the future totaled $326.4 million. In addition to this restricted cash and investments, Stewart had unrestricted cash and investments (excluding investments in affiliates) of $200.1 million which is available for their operations, including claims payments.

 
Capital expenditures will remain muted in 2009-2011 as Stewart continues to manage cash flow closely and has no material commitments for capital expenditures.

Recent Events
In conjunction with its October 8th convertible debt offering, Stewart provided an update on operations. The company noted that revenues for July and August 2009 were generally consistent with expectations. Title order counts were trending up in September corresponding to the decline in mortgage interest rates to new recent lows. Increasing title orders generally precede increases in revenues.

 
Stewart performed its normal quarterly review of title loss reserves in September rather than October in conjunction with the offering and strengthened reserves by $12.5 million relating to 2006-2007 policy years. No further reserve strengthening was deemed necessary for the 2005 policy year. The company also revised its title loss accrual rate for all of 2009, resulting in a policy loss adjustment expense of $3.8 million relating to the eight months ended August 31, 2009. During August, Stewart recorded a $2.2 million impairment charge on cost-basis investments in two real estate partnerships due to write-downs taken by the partnerships on the underlying properties. After accounting for the $18.5 million of charges and year to date accruals discussed above, the company's pre-tax loss for July and August 2009 is approximately $12.1 million.

 
The company reported that it was pleased with current operating results for July and August. Its affiliated title operations generated income before taxes for the six months ended June 30, 2009, and have continued to perform well in July and August. Agency operations continued to show improvement. Average remittance per agent has risen significantly from 2008 levels and claims generated by the current agent network are significantly less than those generated by cancelled agents.

 
Stewart's market share has increased from 11.7% at year-end 2007 to 13.1% at 6/30/09. The company believes these market share gains coupled with actions to align controllable costs have positioned it to take advantage of higher real estate transaction volumes fueled by low interest rates, which drive increases in both refinance activity and home sales.

Catalyst

I am assuming significantly higher consensus estimates than the sell-side, due largely due to recent order strength, over-reserving and continued housing market stability. STC is also selling below tangible book value which should provide a margin of safety longer-term assuming losses are coming to an end, which I believe to be the case.