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STEWART INFORMATION SERVICES STC
June 26, 2013 - 3:06pm EST by
oldyeller
2013 2014
Price: 25.15 EPS $2.85 $3.60
Shares Out. (in M): 24 P/E 8.8x 7.0x
Market Cap (in $M): 595 P/FCF 0.0x 0.0x
Net Debt (in $M): -135 EBIT 0 0
TEV (in $M): 460 TEV/EBIT 0.0x 0.0x

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  • Underfollowed
  • Depressed Earnings
  • Management Change
  • Insurance
 

Description

Note: realize this is a repost of alcideholder’s great call on 10/29/11. We have recently done a significant amount of field research on STC & industry and believe we have incremental value to bring to the situation. 

Thesis:

  1. We believe STC's business mix is misunderstood in a way that's important and timely.  STC doesn't do conference calls, is covered by two small sell side firms and is often lumped in with larger competitors FNF and FAF.  However, very importantly, STC's title business mix is 65% purchases/35% refis, while FNF/FAF are both currently 35% purchases / 65% refis.   Magnifying the difference even more, purchase revenue is 1.7x that of a refi, and incremental contribution margins are 60% for purchases vs. 40% for refis.  In the current envirnment (and the envirnment we expect over the next few years), this mix difference is critical.  With interest rates rising, the refi business is taking a big leg down, while the purchase business is actually accelerating.  
    1. To make this very tangible with a current example, just this morning the MBA announced that mortgage applications were down 3% last week.  http://www.marketwatch.com/story/us-mortgage-applications-down-3-last-week-mba-2013-06-26-74855720.   For STC, with a purchase/refi mix of 65/35, this equates to roughly a (0.65*0.02*1.7*.6)+(0.35*-0.05*-.4) = +.6% contribution margin gain on the week.  For FAF and FNF, with a purchase/refi mix of 35/65, this means roughly (0.35*0.02*1.7*.6)+(0.65*-0.05*-.4) = -.6% contribution margin decline. While this [weekly] difference might not seem large, if you do the math over the actual larger moves the numbers become quite significant.  
  2. Cheap today + significant earnings growth:
    1. STC currently trades at under 9x our estimate of their 2013 EPS ($2.85) and is a solid, defensible business with a great balance sheet.   
    2. However, the reason we like STC is not because it’s cheap today, but because we believe it has substantial EPS growth over the next few years “built in” as loss reserving and purchase/refi mix revert to normalized levels. 
      1. So far, a large part of the title insurance “rebound” has been driven by refi activity.  We believe that is shifting and purchases (both volume and price) are going to drive the next leg of activity. For reasons outlined below, Stewart has significantly higher earnings leverage to purchase activity. 
      2. We estimate EPS grows to 4.60/share in 2015 based on MBA estimates.  In addition to the currently changing purchase/refi mix, our field research is showing that STC has made significant changes to its agent network, risk controls, and internal cost controls post 2008.  We believe they are set to earn substantially more than prior cycles as the real estate mortgage [purchase] market recovers (unlike refis, this has only just started).
    3. Peers FNF and FAF have traded at 12x EPS over time and currently trade slighly below that on 2013E estimates (even though they face major refi headwinds, while STC’s business mix is facing big purchase tailwinds). With a discounted multiple of 10x applied to $4.60/sh+ of 2015 EPS, STC would trade at $46/sh, implying upside of 80%. However, as outlined below, we believe there’s a case that investors begin to appreciate the significant operational changes Stewart has made along with their much-improved management, and wouldn’t be surprised to see the market apply peer multiples of 12x as they outperform expectations, implying a double from here. 
  3. New Management / potential for changed investor perception. 
    1. Stewart has been the industry laggard in terms of value creation and operational consistency, but the new CEO, Matt Morris, has culled STC’s agent network in half to one that is twice as productive, reduced internal headcount by a similar amount, and created a more operating metrics focused company. 
    2. Yes, Matt took over from his father and uncle, so that’s a big knock on him. That said, we’ve met with him and the rest of the team and believe he (a) knows his father/uncle messed up and wants to make it right, (b) is intelligent, understands the business, and has taken the right steps to clean house, (c) is honest, ethical, and (d) in addition to significantly improving operations, understands he needs to communicate with investors and is starting to move in that direction. 
    3. Good management is important to us.   We were particularly skeptical due to STC’s past reputation and did a significant number of research calls with competitors and people who have worked with Matt in the past.   Across the board we heard good things about his abilities, and many of the people went out of their way to point out the significant improvement vs prior management.   
    4. Importantly, STC is starting to communicate with investors and pick up street coverage. We believe better, more communicative management will have a big effect on investor’s perception of the “new” Stewart and its increased operating leverage. 
  4. Balance Sheet: 
    1. Stewart is currently at the tail end of a significant strengthening of their balance sheet. At 30% of title revenues, reserves are near all time-highs, even though losses are coming down significantly.   While not part of our thesis, there's a case to be made that they may be significantly overreserved (we know a large holder who believes they may ultimately have $100-200MM of excess reserves available to return to shareholders - if you look at the numbers it's hard to argue they don't appear to be significantly overresearved, although managment says they're not based on [backwards looking] actuarial models).  
    2. We believe they will likely achieve investment grade ratings before the end of 2013. Among other positives, this will allow them to retain significantly higher levels of commercial title policies thereby adding potential earnings upside not captured in our estimates.  Commercial title insurance is significantly more proftiable than residental - currently STC's commerical mix is 1/2 of FNF/FAF (10% of revenues vs ~20%), at least partly due to being blocked from higher retention levels because of their lack of an investment grade rating.  
    3. Importantly, they will soon be in a position to start returning capital to investors. We believe they’ll likely do a small tack-on acquisition in the Mortgage Services business (which we fully support at a reasonable valuation as it will reduce their dependence on default services and increase the value of the overall business on a standalone basis) and then will be in a position to return the majority of net income to shareholders.

Background:
Stewart Information Services is the third largest title insurance underwriter in the U.S. Title insurance is purchased by real estate lenders and buyers to protect against any potential unknown liens or debts outstanding against the property each time a property is sold (a “purchase”) or the loan is refinanced (a “refi”). Although profits can vary significantly year-to-year, market share in the title insurance business is extremely stable due the relationships and infrastructure needed to compete. Over the last 10 years, Stewart’s market share has trended up from less than 11% in 2002 to 13% in 2012, while the combined market share of the top two has ranged from 60% to 75%, trending down since 2008 as a result of electively cutting large amounts of weak agents.

Of note, Stewart is much stronger in purchases (vs refis) so as the purchase market recovers and refis decline, we believe there is a built in mechanism for them to gain significant market share. 

Our initial research on Stewart provided four key findings:

  1. Mortgage originations for purchases stand at historic lows ($500 billion in 2012 vs. a peak of $1.5 trillion in 2005 and a prior decade yearly average of almost $1.0 trillion) and are in the early stages of a turnaround,
  2. Stewart’s business mix is much better positioned than its peers for a rebound (65% purchases compared to the industry average volume mix of 65% refis),
  3. Stewart has grown market share over the last 10 years even though it is much more heavily weighted to the part of the market that is down substantially. As purchases become a larger portion of the industry mix, Stewart stands to gain substantial market share, and 
  4. Stewart’s current year profitability has been masked by elevated reserving due to losses generated from policies written during the real estate bubble. On this last point, our field research shows that the Company has substantially changed its systems and tightened controls and that actual losses will return to historical norms, if not lower from more stringent compliance and vetting systems put in place for agents. 


With the purchase market forecast to grow 18% in 2013 and 2014 and the refi market forecast to decline 35% and 55% in 2013 and 2014, respectively, we believe Stewart’s earnings are set to rise substantially. Stewart is within a few quarters of reaching its goal of an investment grade rating, after which the majority of earnings will be available for dividends, buybacks, and small bolt-on acquisitions in the Mortgage Services segment. At under 10x 2013 earnings that are poised to grow substantially over the coming years as the purchase market recovers and as loss ratios return to normalized levels, we believe Stewart is one of the cheapest and most mispriced ways to play a recovering real estate market.

With a new management team, Stewart is not just a story of underappreciated earnings power but one where negative investor perception from years of underperformance should meaningfully change along with Stewart’s discounted valuation relative to its peers, Fidelity National Financial (“FNF”) and First American Financial (“FAF”). Since 2008, Stewart has culled its agent network in half to one that is twice as productive, reduced internal headcount by a similar amount, and created a more operating metrics focused company.

Sell side analysts (Stewart is covered by two!) significantly underestimate STC’s future earnings power due to misunderstanding the Title business mix and using overly draconian assumptions for Stewart’s Mortgage Services business that is expected to decline with an improving housing market. We believe STC’s earnings power should be north of $3.60/sh in 2014 vs. street estimates of $3.20/sh and north of $4.50/sh in 2015, a year that no analysts have forecasted. Of note, these numbers assume a mortgage origination market of $1.1 TN in both 2014 and 2015 vs. $1.9 TN in 2012.

We believe STC’s valuation gap will close from:

  1. Margin leverage created by operational improvements as the Title business grows, 
  2. Growth of the Mortgage Services business to diversify business mix and customer concentration, via either buy or build strategies, which Stewart is heavily focused on,
  3. Management’s efforts to better communicate with investors via enhanced disclosures, more conference attendances and ideally quarterly earnings calls, and,
  4. Increased sell side coverage. 
Progress has been made in four of these areas. First, the operational leverage started to emerge in Q113 with normalized EPS of $0.36 that exceeded street estimates of $0.32 from effective cost controls. Second, on 5-1-13, Stewart made its first key hire under Jason Nadeau, Jim Davis, to expand the Mortgage Services client base. Third, STC has initiated improved marketing efforts by registering to attend the Stephens conference in June 2013, the first such appearance for Stewart. Fourth, Stephens picked up coverage on 4-22-13, becoming the second firm to cover Stewart. We believe these are good initial steps as the Company becomes more externally focused with investors.

 

Key Risks:

  1. Housing Market Stagnation: We have modeled refinancing transactions declining substantially per the origination forecasts provided by the GSE’s, along with the offsetting growth in purchase transactions. The risk is that home purchases could grow below current projection levels, thereby reducing earnings power.
  2. Mortgage Services Business Default Cycle & Customer Concentration: While we have modeled a sizably declining default business for Mortgage Services, it could decline at a higher rate than we expect, thereby reducing earnings power.  The majority of STC’s loss mitigation business, which comprises ~75% of STC’s Mortgage Services business, is driven by one large bank customer. If STC loses that customer, the Mortgage Services business would be severely impaired. However, this customer continues to award more non-loss mitigation business to STC as experienced in Q113 where Mortgage Services revenue increased almost 15% Y/Y. Furthermore, given the growth in the title business, even if the default business totally went away, we believe Stewart would still be significantly undervalued.  
  3. Family Ownership: The Company is controlled by the Morris family.  In the past, the family run culture has resulted in STC underperforming its peers, hence the stock’s meaningful valuation discount. While we believe that the reasons for past underpeformance have been specifically addressed and that current managment is good, the risk is that the Company’s recent efforts to trim costs under Matt’s CEO tenure do not result in future operating margin expansion or a change in investor perception.
  4. Capital Allocation: The best thing STC’s owners could hope for is the use of excess cash to buy back undervalued stock. Historically Stewart has been very conservative but with a goal to grow Mortgage Services from ~15% of net sales to 25% the Company could make value destructive acquisitions.  That said, in addition to buy backs, we believe that a *reasonably-priced* tack-on acquisition in the Mortgage Services business - balancing it away from its current default focus - could actually be a productive use of capital.  


Business Overview & Competitive Landscape
STC operates two segments: Title Insurance and Mortgage Services:

Title Insurance (91% of 2012 Sales): The Title Insurance business underwrites and sells titles for residential and commercial real estate. The insurance ensures there are no unknown debts or claims encumbering the real estate. U.S. title insurance is a $12.5B market (2012). The market is mature and cyclical, correlating heavily with the housing market. Market share is relatively stable and fluctuates with either an acquisition or with agents switching companies as relationships drive the business, which are locally developed and quite sticky, which is the competitive moat that drives the market share stability.

Typically 90% of all claims are paid out within 5 years, and unlike traditional insurance, the loss rates are a small piece of the cost structure, just 5% of sales through-cycle. Claims are generally filed when unknown debts, taxes or other liens against the property are realized. Loss rates spiked during the financial and housing recession due to a host of poorly underwritten policies from low quality agent networks in conjunction with the declining standards on the mortgage origination side of the business.  STC’s loss rates peaked just north of 11% in 2009 but have been declining below the sub-8% range. Again, through-cycle averages are roughly 5% for STC (and the rest of the industry).

Claims are sold through either internally (“direct” business) or externally via agents (“agent” business). Under the agent model, the third party agent performs most of the search and underwriting work and keeps a percentage of the title revenues. For STC’s agents, that amount is 82.5%. While this equates to fewer profit dollars to STC, it is still good business if the agent base and the related policies are of high quality. Agent retention rates vary by state, and STC pays out the highest retention rates in the industry due to its heavy agent exposure in high-retention states, such as CA and FL. The largest market for STC’s direct and overall title business is TX, unsurprisingly. Heavy TX concentration bodes particularly well for STC if it receives a ratings upgrade as it increases the Company’s ability to underwrite commercial business. TX has fixed commercial premium rates, unlike other states in the country, which prevents price competition, making the business particularly profitable.

What is perhaps most interesting about STC’s business model at this stage of the cycle is that its title volumes breakdown is 65% purchases / 35% refis. Stewart has never built a centralized refi platform whereas its two larger peers, FAF and FNF, have. This provided FAF and FNF with the ability to process massive amounts of refi transactions as the market boomed over the past three years with low interest rates. While Stewart never capitalized on this the past three years, it benefits from today’s outlook in light of the mortgage origination industry forecasting a heavily declining refinancing market along with an improving purchase market.

Mortgage Services (9% of 2012 Sales): Mortgage Services may be just 9% of 2012 sales, but it comprises almost 23% of 2012 EBITDA, pre-corporate overhead. The business is more labor intensive than Title but its operating margins are significantly higher. Approximately 75% of Mortgage Services is loss mitigation, which entails curing home borrowers who have entered default. It requires call center reps, cash flow pay-down models and technology to understand the borrower in great detail and answer questions such as whether the borrower would ever begin to repay, and if so, when and how, along with other items such as whether the borrower is likely to walk away or destroy the property. The objective and general outcome is a loan modification, which could be deferred payments of principal, interest rate changes or outright principal reductions. Often times the borrower re-defaults, so the property moves several times through default, then to REO/foreclosure, which STC also services. This business requires heavy documentation and printing as the loans often sit inside of MBS structures that require amendments to their large documents. STC’s Mortgage Services business is driven largely by one large bank client.

Loss mitigation is very much of a niche industry driven primarily by two large providers, STC and Urban Lending Solutions. The industry was essentially created in 2009 by James Smith, the former President of privately held Urban Lending Solutions (“Urban” or “ULS”). Urban and STC share the same large bank customer, which splits its business 60/40 between Urban and STC. To this day, this bank largely is THE loss mitigation business for both vendors while STC has a few additional customers, namely the GSE’s and other top 10 banks. STC’s current focus is finding new revenue streams for Mortgage Services to offset customer concentration and the anticipated decline in the default cycle.

When we look at earnings power over the next two years, we assume they are not able to replace a slowdown in defaults and this business contracts by 30% over 3 years - of note, the company has recently made key hires in this area and has a goal to actually grow this business.  As of Q1 2013, this business was actually growing year-over-year (up 15%).


Earnings Power:
STC’s earnings power is poised to grow significantly over the next two years as the purchase/refi mix returns to normal levels and reported loss ratios converge with actual loss ratios of ~5%. Below are our EPS projections and key assumptions:

2013E EPS: $2.99

  • Title Revenue = $1,855.2 MM (growth = +7.5%)
  • Mortgage Services Revenue = $139.8 MM (decline = -14%)
  • Agent Retention Rate = 82.5% (constant)
  • Loss Ratio = 7.2% (90 bps improvement) – of note, we believe current-year vintages have loss ratios inline with historical averages of ~5%. The elevated overall rate is the result of continued reserve adds from bubble era vintages. All title insurers are going through the same thing right now. As noted, our field research shows that processes have improved significantly and we expect actual loss ratios to return to, or even be better than, historical levels. 
  • Employee + Other Operating Expenses Margin = 42.1% (110 bps improvement)

2014E EPS: $3.60

  • Title Revenue = $1,966.5 MM (growth = +6%)
  • Mortgage Services Revenue = $125.9 MM (decline = -10%)
  • Agent Retention Rate = 82.5% (constant)
  • Loss Ratio = 6.5% (70 bps improvement). See above note. 
  • Employee + Other Operating Expenses Margin = 41.0% (110 bps improvement)

2015E EPS: $4.60

  • Title Revenue = $2,084.7 MM (growth = +6%)
  • Mortgage Services Revenue = $119.6 MM (decline = -5%)
  • Agent Retention Rate = 82.5% (constant)
  • Loss Ratio = 5.5% (100 bps improvement). See above note. 
  • Employee + Other Operating Expenses Margin = 40.0% (100 bps improvement)

 

DISCLAIMER: The views expressed here are merely the opinion of the author. Please do your own research.  We may change our position at any time without posting an update.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  1. In the shorter term, they are set to beat "street" estimates, bringing to light the significant mix differences vs FNF/FAF.  
  2. Balance sheet reaching investment grade within 2013.  Starting to return capital to shareholders.  
  3. With the operational improvements and more stringent agency vetting and compliance processes put in place post 2008, our 2015E EPS of $4.60 should be quite attainable, and at 10x to 12x EPS, implies a stock price of $46 - $55/sh within the next year and a half, upside of 80% to 100% - with additional upside from there if we have a recovery to historical pre-bubble levels of real estate transactions.
  4. Investors get to know the new CEO and team and see the significant improvements vs the prior team.   
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