I have spent some time taking stock of the real estate market in the US. As we know, the market has been improving for the last 1 year or so but with the Fed tapering their bond purchases and possibility of the rise in interest rates (already happening to some extent), there are certain short term headwinds. In the long run though, the demographic factors and better employment numbers will keep the buyers in the market. Appreciating property values should also help Title insurance companies like Stewart grow their revenues and margins.
We should keep in mind the key difference between Title insurance and other types of insurance. The Title insurance is written when a new owner purchases the property and remains valid until the property is refinanced, sold or ceases to exist. There is no recurring premium revenue on any policy, the only time the insurance company receives a payment is during the property transaction. Also, in majority of cases, once the Title insurance is written, the insurance company has no idea if the policy is still valid unless either a new policy is issued to supersede the existing one, or a claim is made. In many ways, this can simplify the underwriting process as the insurance company has to only consider the statistical trends and claim history per market served to set their prices. Claims are low, however they can be substantial when they come considering the insurance premium is typically small relative to the property value.
Stewart Information Systems (STC) has three main operating segments: title insurance and related services, mortgage services and corporate. The primary business is title insurance and settlement-related services that includes closing transactions and issuing 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. They 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.
Historical Earnings Performance
The historical revenues and the earnings of Stewart mirrors the ebb and flow of the real estate market in the US. As a result, the company ended up accumulating considerable valuation allowances against tax deferred assets in 2008. Until Dec 31 2011, the company had a 3 year history of net operating losses and these valuation allowances could not be reversed. In 2012, the company released $72.6 million of Valuation Allowances, with some minor adjustments in 2010 and 2011. The resultant tax benefit has the effect of muddying up the reported financials. The following table illustrates the effect
|Q2 2013||Q1 2013||2012||2011||2010|
|Direct Operations||$ 211.90||$ 158.54||$ 718.79||$ 627.81||$ 625.89|
|Agency Operations||$ 269.90||$ 227.66||$ 1,007.38||$ 877.23||$ 914.58|
|Title Operating Revenues||$ 481.80||$ 386.21||$ 1,726.20||$ 1,505.00||$ 1,540.00|
|Mortgage Service Revenues||$ 31.01||$ 37.17||$ 162.80||$ 112.10||$ 91.70|
|Investment Income||$ 4.29||$ 3.64||$ 13.80||$ 15.50||$ 18.40|
|Investment Gains (Losses)||$ 0.12||$ (3.31)||$ 7.60||$ 2.30||$ 21.80|
|Total Revenues||$ 517.22||$ 423.71||$ 1,910.40||$ 1,634.90||$ 1,672.40|
|Agency Commissions||$ 219.49||$ 187.07||$ 829.07||$ 723.94||$ 753.44|
|Employee Costs||$ 146.40||$ 136.83||$ 542.46||$ 469.84||$ 467.49|
|Other Operating Expenses||$ 73.43||$ 63.80||$ 286.50||$ 256.19||$ 273.25|
|Title Losses and Claims||$ 24.17||$ 23.56||$ 140.03||$ 142.10||$ 148.44|
|Depreciation and Amortization||$ 4.22||$ 4.36||$ 17.78||$ 19.54||$ 21.42|
|Interest||$ 0.66||$ 0.95||$ 5.24||$ 5.27||$ 5.42|
|Total Expenses||$ 468.36||$ 416.57||$ 1,821.07||$ 1,616.89||$ 1,669.47|
|EBIT||$ 48.86||$ 7.15||$ 89.30||$ 18.00||$ 2.90|
|Income Taxes||$ 18.96||$ 2.39||$ (29.64)||$ 9.34||$ 8.08|
|Net Income||$ 29.90||$ 4.76||$ 109.20||$ 2.30||$ (12.60)|
|Net Income attributable to Stewart||$ 26.90||$ 3.21||$ 118.98||$ 8.68||$ (5.15)|
|Per Share Reported|
|Diluted EPS||$ 1.09||$ 0.15||$ 4.61||$ 0.12||$ (0.69)|
|Dividends||$ 0.10||$ 0.05||$ 0.05|
|NOL and Valuation Allowance Adjustments|
|Loss Carrybacks||$ (1.44)||$ (1.83)|
|Valuation Allowance||$ (71.11)||$ (7.16)||$ (1.15)|
|Total Adjustments taken||$ (72.55)||$ (8.99)||$ (1.15)|
|Adjusted Income backing out Valuation Allowances|
|Steady State Income Taxes||$ 18.96||$ 2.39||$ 42.91||$ 18.33||$ 9.22|
|Adjusted NI||$ 29.90||$ 4.76||$ 46.39||$ (0.33)||$ (6.32)|
|Adjusted NI to Stewart||$ 26.90||$ 3.21||$ 50.54||$ (1.26)||$ (2.58)|
|Adjusted Diluted EPS||$ 1.08||$ 0.15||$ 2.07||$ (0.07)||$ (0.14)|
In the last section of the table I have taken out the effect of these valuation allowances since these do not reflect on the actual performance of the business and are necessarily a tax artifact. As you can see, this gives a better and more even picture of how the company’s bottom-line has performed over the years. In 2012, the Adjusted diluted EPS goes from $4.61/share that was reported to $2.07/share. At the current share price of 31.45, the Adjusted P/E ratio becomes 15.19 (based on 2012 earnings). As a comparison, Fidelity National Financial trades at a P/E of 9.22, and operates in pretty much the same markets.
Improving Loss Reserves
A pure P/E based comparison is however not enough. A higher P/E ratio that is currently ascribed to STC has an implied earnings growth baked into it. To see why, lets look at how the Title Loss Reserves have changed over the years.
|Q2 2013||Q1 2013||2012||2011||2010|
|Reserves as % of Premiums||5.90%||6.10%||8.10%||9.40%||9.60%|
|FNF Title Loss Reserves||6.90%||7.00%||6.80%||6.80%|
Why does this matter? According to the company estimate, a 1% improvement in the Title Loss Reserve adds $17.3 million to the pretax earnings per year at 2012 earnings level. This means if 2013 Title Loss Reserve averages to 6.10%, we are looking at $34.6 million in improvement in pre-tax earnings, all other things being equal. After tax EPS improvement is approximately $34.6*.65 (35% tax rate)/24.89 = $0.91/share on a same share basis. This would provisionally give an EPS (assuming constant revenue) of $2.98/share resulting in a forward P/E ratio at the current prices of 10.55. Much more reasonable compared to the competition.
As you can see, Fidelity National has been able to manage its business over the years much more consistently. The current price of the STC stock however is based on an improving Loss Reserve ratio in the future so that adds to a level of uncertainty in the valuation of the stock.
A Brief on the Earnings Growth and Its Effect on the Forward P/E
Title premiums are correlated to 3 main drivers
- Higher property prices means higher premiums
- Number of property transactions, and,
- Title insurance rates
The company has already started to experience lower refinancing in Q2 due to an increase of 100 basis points in the interest rates. Refinancings constitute 73% of the origination in 2012 industry wide which is likely to be similar for Stewart. Higher property prices and a rate increase of 3.8% in Texas that went into effect on May 1 (17% of the title revenues) will also help in 2013. On an annualized basis, the following trends can be used to get some feel for what 2013 might hold (the data is for the housing market overall and there is an implied assumption that impact on Stewart will be in line with the overall market in US). As you read this, keep in mind that a 5% increase in property prices equate to 3.5% increase in Title Premiums.
|2013 over 2012 Increase (annualized)||Estimated Prop. Value Increase||Net Estimated Revenue Change||% of Title Portfolio|
|Blended Topline Change (Estimate)||20.4%|
|Incremental Revenue due to 3.8% rate hike in Texas (May-Dec, 7 months)||0.4%|
|Total Expected Rev Improvement||20.8%|
All things being equal, using the base of $1,726.20 of 2012 Title revenues and adjusting it for expected title revenue increase in 2013, gives us an estimated increase of $359 million. As the interest rates rise in 2013, refinancings will slow and possibly the property value increases in existing home sales may turn out to be less than expected (the data above is from Q1/Q2 of 2013). New property sales are much more driven by demographic factors such as new household formation and are less likely to experience the same level of moderation as the refinancings. To be safe and conservative I would water down my estimate of 2013 revenue gains by 30%. So we will work with $359*0.7 ~ $250 million. The following shows the calculation of how an additional $250 million in title revenues is likely to translate to the bottomline. We have only included the variable expenses and the incremental title loss reserve is kept at 6.10% for 2013 and actuals are used for the earlier years.
|Incremental Title Revenue change on EPS|
|(in 000s)||2013 Incremental||2012||2011||2010|
|Title Revenues as % of Total||90%||90%||92%||92%|
|Variable Expenses (ex Title Loss Reserve)|
|Other Operating Expenses||286.50||256.19||273.25|
|Allocated to Title Segment||220.69||1498.16||1334.77||1376.34|
|Title Loss Reserve||15.25||140.03||142.10||148.44|
|Net EPS Contribution from Title Segment||14.06||88.01||28.13||15.72|
With 24.89 million shares outstanding, this translates into an additional 14.06/24.89 = $0.56/share in EPS on a same share basis (assuming no dilution or buybacks).
So wrapping up, the pro-forma estimate of 2013 EPS rises to $2.98+$0.56 = $3.54/share giving us a forward P/E ratio of 8.88. Much better and more in line with the competition which is operating at a steady state. Note that we had ratcheted down the incremental revenue estimate for 2013 by 30% to account for uncertainty. If we had not done this, the forward P/E ratio would have been much lower. This gives us a reasonable margin of safety going forward.
The average industry P/E ratio is close to 15 but given the structural changes in the real estate industry in the last 5 years, this number is likely to be contaminated.
Other Earnings Considerations
We have made plenty of assumptions to make this pro-forma calculation. For example, one implied assumption is that Title Revenues as a % of the Total revenues will stay close to historical ratio. We also assumed that the cost structure will stay fairly constant. These will not be the case. For example, the company is working to grow its mortgage services line of business and they are also streamlining their portfolio of agencies to reduce revenue leakage and tighten up control. Possibility of further loss ratio improvement exists, although it will likely plateau soon. All these should be positive and as they bear fruit will be the cherry on the top. Also keep in mind that this business is seasonal, with Q1 typically the weakest and Q3 the strongest. Q4 tends to be better than Q2 as market actors rush to complete transactions before the new year sets in.
For Stewart, the Balance Sheet does not offer many clues for valuation. The story is mainly related to revenue and earnings growth. However, we should always examine the balance sheet to make sure that there are no red flags. Investments in debt/equity securities and Cash – Statutory Reserve Funds in the Current Assets are loss reserves they are legally required to maintain so this asset is not touchable for corporate use or shareholder return. Net of this, the company has about $245 million in cash on a consolidated basis but most of these reside at the subs and the subs are restricted in the amount of dividend they can pay to the holding company (which trades as STC). Currently the company pays a $0.10/share in annual dividend, payable once every December, and there is no reason to expect that the dividend level will change anytime soon.
|Q2 2013||Q1 2013||2012||2011|
|Cash/Equivalents||$ 208.79||$ 169.69||$ 196.47||$ 117.20|
|Cash – Statutory Reserve Funds||$ 7.80||$ 5.69||$ 12.07||$ 23.65|
|Total Cash||$ 216.59||$ 175.38||$ 208.54||$ 140.84|
|Short Term Investments||$ 36.89||$ 36.15||$ 37.03||$ 33.14|
|Investments in debt/equity securities avalable for sale, fair value||$ 441.39||$ 450.16||$ 444.58||$ 397.07|
|Other||$ 61.20||$ 71.90||$ 58.68||$ 63.91|
|Total Investments||$ 502.59||$ 522.05||$ 503.26||$ 460.99|
|Notes||$ 5.31||$ 8.48||$ 10.39|
|Premiums from Agencies||$ 41.94||$ 36.51||$ 45.46||$ 47.35|
|Income taxes||$ 3.90||$ 3.26||$ 7.41|
|Other||$ 52.26||$ 50.37||$ 56.31||$ 39.66|
|Uncollectible allowance||$ (10.78)||$ (10.44)||$ (12.82)||$ (16.06)|
|Total Receivables||$ 85.65||$ 100.69||$ 23.60|
|PPE @ cost|
|Land||$ 5.85||$ 5.85||$ 6.43|
|Buildings||$ 26.76||$ 26.89||$ 23.82|
|Furniture/Equipment||$ 243.84||$ 241.69||$ 234.26|
|Accumulated Depreciation||$ (221.54)||$ (219.72)||$ (208.08)|
|Total PPE||$ 53.42||$ 54.91||$ 54.71||$ 26.19|
|Title Plants||$ 77.05||$ 78.05||$ 77.36||$ 77.41|
|Real Estate||$ 3.78||$ 3.94||$ 5.24|
|Equity investments||$ 13.21||$ 13.89||$ 18.06|
|Goodwill||$ 220.98||$ 220.98||$ 220.96||$ 214.49|
|Intangibles||$ 5.89||$ 6.65||$ 7.02||$ 8.69|
|Deferred tax asset||$ 0.98||$ 6.84||$ 7.56|
|Other assets||$ 74.68||$ 59.01||$ 56.23||$ 52.10|
|Total Assets||$ 1,272.48||$ 1,262.66||$ 1,291.20||$ 1,156.10|
|Notes Payable||$ 5.89||$ 6.43||$ 6.48||$ 11.72|
|Convertible Senior Notes||$ 27.79||$ 27.77||$ 64.69||$ 64.51|
|Long Term Debt||$ 33.68||$ 34.19||$ 71.20||$ 76.20|
|Accounts Payable/Accrued Liabilities||$ 100.76||$ 95.95||$ 116.62||$ 86.39|
|Estimated Title Losses||$ 501.07||$ 508.76||$ 520.38||$ 502.61|
|Deferred Income Taxes||$ 2.48||$ 2.65||$ 2.65||$ 27.45|
|Total Liabilities||$ 637.99||$ 641.54||$ 710.81||$ 692.68|
|Stock Holder’s Equity||$ 634.49||$ 621.11||$ 580.37||$ 463.46|
|BV/Share||$ 28.27||$ 27.70||$ 29.91||$ 24.01|
The current Price/Book ratio is about 1.11 and Price to Tangible Book ratio is about 1.73 (eliminating Goodwill and Intangibles). I am not too worried about these ratios, they are currently reasonable enough to allow us to look at the stock as primarily an earnings growth story.
I believe the stock is still attractive value at $31/share or below and expect a 30%-40% rise in 1 – 2 years. However, it is worth keeping a close eye on the industry and Stewarts company performance as it continues to work on improving its fundamentals. The next quarter is going to be weak due to the interest rate impact and it has already been communicated.
- Stock: STC
- Purchase Price: $31/share or below
- Target: $41.85
- Holding Period: 1- 2 years
- Initial Allocation: 5%, will review again after Q3 earnings
Why not FNF? First, it is much more exposed to California which I am less comfortable with. Second, by my estimates there is additional $10 million in Valuation Allowance left at STC which they will likely take sometime this year causing their earnings to appear better than they are. Yes, it is all perception, but will likely result in our target reaching earlier.