STEWART INFORMATION SERVICES CORP quarterly report, Q2 FY2016

Stewart Information Services Corporation — Q2 2016 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2016. Stewart provides title insurance and real-estate transaction services, with additional valuation, government, and loan-review operations. Amounts below are U.S. dollars; financial statement amounts are in millions unless stated otherwise.

Financial performance

Metric	Q2 2016	Q2 2015	Six months 2016	Six months 2015
Revenue	$489.4	$531.9	$927.7	$980.8
Income before taxes and noncontrolling interests	$41.9	$31.0	$26.2	$12.2
Net income attributable to Stewart	$23.6	$17.1	$12.4	$4.7
Diluted EPS attributable to Stewart	$0.49	$0.72	$0.02	$0.19

Q2 revenue declined 8.0% year over year; first-half revenue declined 5.4%. Q2 pretax income increased 35.1%.
Reported Q2 pretax margin was approximately 8.6%. Management cited a 7.5% margin versus 6.7% a year earlier after excluding policy-reserve releases in both periods and 2015 non-operating charges.
Management reported Q2 title-segment revenue of $467.9 million, down 5.9%, and pretax income of $51.7 million, up from $48.5 million. The segment’s pretax margin rose to 11.0% from 9.8%. Ancillary services and corporate revenue was $21.6 million, with a $9.8 million pretax loss, improved from a $17.5 million loss.
Q2 basic and diluted EPS were $0.50 and $0.49, respectively, compared with $0.72 for each measure in Q2 2015. A $12.0 million cash payment in the Class B share exchange was deducted in calculating EPS; management stated adjusted Q2 diluted EPS excluding that payment would have been $1.00.

Cash, liquidity, and capital

First-half operating cash flow was $18.5 million, versus $5.6 million in 2015. Investing activities used $48.4 million and financing activities used $14.2 million. Cash and cash equivalents fell by $41.8 million to $137.3 million.
At June 30, cash and investments totaled $815.3 million, including statutory-reserve amounts; management reported $309.2 million net of statutory reserves. Statutory funds are not available for general use. Cash held at the parent company was $1.2 million.
Notes payable were $127.7 million and stockholders’ equity was $641.0 million; the debt-to-equity ratio was approximately 19.9%. The $125 million credit line had $118.0 million outstanding and $4.5 million available, net of a $2.5 million letter of credit.
Stewart paid $0.60 per common share in dividends during the first half and paid $12.0 million cash, alongside issuing 1,050,012 common shares, to retire all outstanding Class B shares. Book value per share was $27.43 at June 30.
Estimated title-loss reserves totaled $463.2 million, including $78.8 million for known claims and $384.4 million for incurred-but-not-reported claims.

Material changes and management commentary

Lower refinance activity and reduced independent-agency revenue weighed on title revenue. Direct refinance orders closed fell 23.4% in Q2; purchase and commercial closed orders were broadly comparable with the prior-year quarter.
Ancillary-services revenue fell 38.0% in Q2, primarily reflecting the planned wind-down of delinquent loan servicing, completed in Q1 2016. Cumulative exit charges were $6.4 million; no significant additional exit expenses were incurred in Q2.
Employee costs declined 10.9% in Q2, faster than operating revenue, reflecting cost management and lower staffing. Title-loss expense fell 12.4%; Q2 included a $5.4 million reserve reduction from favorable prior-policy-year experience. The comparable 2015 quarter included a $7.3 million reserve reduction.
The company changed segment reporting in 2016, moving centralized title services into the title segment and reporting remaining ancillary activities with corporate costs.
No formal earnings or revenue guidance was provided. Management said it expects available operating cash and underwriter resources, subject to regulatory restrictions, to fund operations and claims; it also cited continued cost management, outsourcing, automation, and system consolidation as margin-improvement priorities. Management expects agency retention to remain around 81%–82% in the near to medium term.

Risks, contingencies, and unusual items

Title-loss reserves require significant estimates; actual claims and payments may differ materially. Reserve changes, large claims, escrow losses, and mortgage fraud can affect results and cash flow.
Cash and investments at regulated underwriters are subject to statutory and regulatory restrictions. Guaranty paid no dividend to its parent in the first half of 2016; its statutory liquidity ratio was 104% at March 31, against a 100% internal objective.
The company faces ordinary-course claims, title-industry class actions, premium-tax matters, and regulatory inquiries. Management said reserves were adequate and did not expect these matters to materially affect consolidated results or financial condition.
On July 28, 2016, an activist stockholder began soliciting requests for a special meeting, including seeking removal of two directors. Stewart warned that a proxy contest could disrupt operations, divert management attention, increase costs, and affect customer and employee relationships.
Other notable first-half items included $1.6 million of gains from changes in acquisition contingent consideration, $0.9 million of realized investment gains, and $1.2 million of office-closure costs. The company reported effective disclosure controls and internal control over financial reporting as of June 30.

Investor verification priorities

Verify reported versus adjusted Q2 EPS and the accounting treatment of the $12.0 million Class B exchange payment.
Assess the sustainability of favorable title-loss experience, reserve reductions, and the $463.2 million claims reserve.
Track refinance volumes, independent-agency revenue and remittance rates, and the results of the delinquent-loan-servicing exit.
Confirm accessible liquidity after statutory restrictions, credit-line availability, and the regulated underwriter’s capacity to distribute funds.
Monitor developments in the activist stockholder solicitation and any resulting costs or changes to strategy.