Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
Part II - Other Information
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 5. Other Information
Item 6. Exhibits
Exhibits
EX-31.1
q3-18ex311.htm
EX-31.2
q3-18ex312.htm
EX-32.1
q3-18ex321.htm
EX-32.2
q3-18ex322.htm
Stewart Information Services Earnings 2018-09-30
STC 10Q Quarterly Report
Balance Sheet
Income Statement
Cash Flow
10-Q 1 a9302018stewartform10-q.htm FORM 10-Q Q3-2018 Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 001-02658
STEWART INFORMATION SERVICES CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
74-1677330
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1980 Post Oak Blvd., Houston TX
77056
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: (713) 625-8100
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes þ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company ¨
Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No þ
On November 4, 2018, there were 23,740,794 outstanding shares of the issuer's Common Stock, $1 par value per share.
As used in this report, “we,” “us,” “our,” "Registrant," the “Company” and “Stewart” mean Stewart Information Services Corporation and our subsidiaries, unless the context indicates otherwise.
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted, except per share)
Revenues
Title revenues:
Direct operations
213,134
216,830
622,886
635,921
Agency operations
272,875
268,545
756,986
736,301
Ancillary services
13,227
12,674
38,790
45,096
Operating revenues
499,236
498,049
1,418,662
1,417,318
Investment income
4,781
4,567
14,732
14,179
Investment and other gains (losses) – net
3,623
(1,047
)
4,345
(1,436
)
507,640
501,569
1,437,739
1,430,061
Expenses
Amounts retained by agencies
224,966
221,460
623,967
605,192
Employee costs
138,288
140,054
423,389
419,184
Other operating expenses
90,810
88,489
257,029
255,593
Title losses and related claims
21,503
25,428
59,181
70,591
Depreciation and amortization
6,221
6,578
18,609
19,397
Interest
1,076
963
2,722
2,492
482,864
482,972
1,384,897
1,372,449
Income before taxes and noncontrolling interests
24,776
18,597
52,842
57,612
Income tax expense
4,371
4,686
8,679
15,536
Net income
20,405
13,911
44,163
42,076
Less net income attributable to noncontrolling interests
2,851
2,967
8,012
8,475
Net income attributable to Stewart
17,554
10,944
36,151
33,601
Net income
20,405
13,911
44,163
42,076
Other comprehensive (loss) income, net of taxes:
Foreign currency translation adjustments
1,140
4,141
(4,490
)
8,670
Change in net unrealized gains and losses on investments
(1,910
)
63
(12,344
)
2,885
Reclassification adjustment for net gains included in net income
(137
)
(331
)
(617
)
(792
)
Other comprehensive (loss) income, net of taxes:
(907
)
3,873
(17,451
)
10,763
Comprehensive income
19,498
17,784
26,712
52,839
Less net income attributable to noncontrolling interests
2,851
2,967
8,012
8,475
Comprehensive income attributable to Stewart
16,647
14,817
18,700
44,364
Basic average shares outstanding (000)
23,556
23,448
23,537
23,442
Basic earnings per share attributable to Stewart
0.75
0.47
1.54
1.43
Diluted average shares outstanding (000)
23,699
23,564
23,677
23,571
Diluted earnings per share attributable to Stewart
0.74
0.46
1.53
1.43
See notes to condensed consolidated financial statements.
3
CONDENSED CONSOLIDATED BALANCE SHEETS
As of September 30, 2018 (Unaudited)
As of December 31, 2017
($000 omitted)
Assets
Cash and cash equivalents
149,669
150,079
Short-term investments
23,954
24,463
Investments in debt and equity securities, at fair value
662,089
709,355
Receivables:
Premiums from agencies
31,656
27,903
Trade and other
44,470
51,299
Income taxes
559
1,267
Notes
3,594
3,203
Allowance for uncollectible amounts
(4,925
)
(5,156
)
75,354
78,516
Property and equipment, at cost:
Land
3,991
3,991
Buildings
23,018
22,849
Furniture and equipment
234,405
226,461
Accumulated depreciation
(196,943
)
(186,279
)
64,471
67,022
Title plants, at cost
74,737
74,237
Investments on equity method basis
8,360
9,202
Goodwill
247,190
231,428
Intangible assets, net of amortization
10,843
9,734
Deferred tax assets
4,186
4,186
Other assets
49,576
47,664
1,370,429
1,405,886
Liabilities
Notes payable
106,440
109,312
Accounts payable and accrued liabilities
97,233
117,740
Estimated title losses
476,870
480,990
Deferred tax liabilities
13,152
19,034
693,695
727,076
Contingent liabilities and commitments
Stockholders’ equity
Common Stock and additional paid-in capital
185,432
184,026
Retained earnings
510,068
491,698
Accumulated other comprehensive (loss) income:
Net unrealized investment (losses) gains on investments available-for-sale
(8,383
)
7,526
Foreign currency translation adjustments
(13,507
)
(8,373
)
Treasury stock – 352,161 common shares, at cost
(2,666
)
(2,666
)
Stockholders’ equity attributable to Stewart
670,944
672,211
Noncontrolling interests
5,790
6,599
Total stockholders’ equity (23,740,900 and 23,719,522 shares outstanding)
676,734
678,810
1,370,429
1,405,886
See notes to condensed consolidated financial statements.
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine Months Ended September 30,
2018
2017
($000 omitted)
Reconciliation of net income to cash provided by operating activities:
Net income
44,163
42,076
Add (deduct):
Depreciation and amortization
18,609
19,397
Provision for bad debt
510
697
Investment and other (gains) losses – net
(4,345
)
1,436
Amortization of net premium on investments available-for-sale
4,617
5,114
Payments for title losses (in excess of) lesser than provisions
(1,106
)
6,697
Adjustment for insurance recoveries of title losses
1,023
757
Decrease (increase) in receivables – net
2,020
(13,032
)
Increase in other assets – net
(406
)
(5,633
)
Decrease in payables and accrued liabilities – net
(23,480
)
(20,482
)
Change in net deferred income taxes
(1,693
)
8,749
Net income from equity investees
(1,344
)
(1,813
)
Dividends received from equity investees
2,187
2,053
Stock-based compensation expense
3,039
2,078
Other – net
(61
)
(46
)
Cash provided by operating activities
43,733
48,048
Investing activities:
Proceeds from sales of investments in securities
32,500
55,533
Proceeds from matured investments in debt securities
25,258
33,867
Purchases of investments in securities
(35,683
)
(125,415
)
Net purchases of short-term investments
(366
)
(327
)
Purchases of property and equipment, and real estate – net
(8,478
)
(12,411
)
Cash paid for acquisition of businesses
(17,639
)
(17,784
)
Other – net
327
960
Cash used by investing activities
(4,081
)
(65,577
)
Financing activities:
Payments on notes payable
(16,767
)
(18,848
)
Proceeds from notes payable
9,583
48,043
Distributions to noncontrolling interests
(8,665
)
(8,376
)
Repurchases of common stock
(687
)
—
Cash dividends paid
(21,195
)
(21,100
)
Payment of contingent consideration related to an acquisition
—
(1,298
)
Purchase of remaining interest in consolidated subsidiary
(1,102
)
(1,014
)
Cash used by financing activities
(38,833
)
(2,593
)
Effects of changes in foreign currency exchange rates
(1,229
)
3,096
Decrease in cash and cash equivalents
(410
)
(17,026
)
Cash and cash equivalents at beginning of period
150,079
185,772
Cash and cash equivalents at end of period
149,669
168,746
See notes to condensed consolidated financial statements.
5
CONDENSED CONSOLIDATED STATEMENT OF EQUITY (UNAUDITED)
Common Stock ($1 par value)
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss
Treasury stock
Noncontrolling interests
Total
($000 omitted)
Balances at December 31, 2017
24,072
159,954
491,698
(847
)
(2,666
)
6,599
678,810
Cumulative effect adjustments on adoption of new accounting standards (Note 1-D)
—
—
3,592
(3,592
)
—
—
—
Net income attributable to Stewart
—
—
36,151
—
—
—
36,151
Dividends on Common Stock ($0.90 per share)
—
—
(21,373
)
—
—
—
(21,373
)
Stock-based compensation and other
38
3,001
—
—
—
—
3,039
Stock repurchases
(17
)
(670
)
—
—
—
—
(687
)
Purchase of remaining interest in consolidated subsidiary
—
(946
)
—
—
—
(156
)
(1,102
)
Net change in unrealized gains and losses on investments, net of taxes
—
—
—
(12,344
)
—
—
(12,344
)
Net realized gain reclassification, net of taxes
—
—
—
(617
)
—
—
(617
)
Foreign currency translation adjustments, net of taxes
—
—
—
(4,490
)
—
—
(4,490
)
Net income attributable to noncontrolling interests
—
—
—
—
—
8,012
8,012
Distributions to noncontrolling interests
—
—
—
—
—
(8,665
)
(8,665
)
Balances at September 30, 2018
24,093
161,339
510,068
(21,890
)
(2,666
)
5,790
676,734
See notes to condensed consolidated financial statements.
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1
Interim financial statements. The financial information contained in this report for the three and nine months ended September 30, 2018 and 2017, and as of September 30, 2018, is unaudited. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
A. Management’s responsibility. The accompanying interim financial statements were prepared by management, who is responsible for their integrity and objectivity. These financial statements have been prepared in conformity with U.S. generally accepted accounting principles (GAAP), including management’s best judgments and estimates. In the opinion of management, all adjustments necessary for a fair presentation of this information for all interim periods, consisting only of normal recurring accruals, have been made. The Company’s results of operations for interim periods are not necessarily indicative of results for a full year and actual results could differ.
B. Consolidation. The condensed consolidated financial statements include all subsidiaries in which the Company owns more than 50% voting rights in electing directors. All significant intercompany amounts and transactions have been eliminated and provisions have been made for noncontrolling interests. Unconsolidated investees, in which the Company typically owns 20% through 50% of the voting stock, are accounted for using the equity method.
C. Restrictions on cash and investments. The Company maintains investments in accordance with certain statutory requirements for the funding of statutory premium reserves. Statutory reserve funds, which approximated $468.8 million and $490.8 million at September 30, 2018 and December 31, 2017, respectively, are required to be fully funded and invested in high-quality securities and short-term investments. Statutory reserve funds are not available for current claim payments, which must be funded from current operating cash flow. In addition, included within cash and cash equivalents are statutory reserve funds of approximately $27.7 million and $14.2 million at September 30, 2018 and December 31, 2017, respectively. Although these cash statutory reserve funds are not restricted or segregated in depository accounts, they are required to be held pursuant to state statutes. If the Company fails to maintain minimum investments or cash and cash equivalents sufficient to meet statutory requirements, the Company may be subject to fines or other penalties, including potential revocation of its business license. These funds are not available for any other purpose. In the event that insurance regulators adjust the determination of the statutory premium reserves of the Company’s title insurers, these restricted funds as well as statutory surplus would correspondingly increase or decrease.
D. Cumulative effect adjustments on adoption of new accounting standards. In February 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-02, Income Statement - Reporting Comprehensive Income, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, which amended its standard on comprehensive income to provide a one-time option for an entity to reclassify the stranded tax effects of the Tax Cuts and Jobs Act (the 2017 Act) that was passed in December 2017 from accumulated other comprehensive income/loss (AOCI) directly to retained earnings. The stranded tax effects result from the remeasurement of deferred tax assets and liabilities which were originally recorded in comprehensive income but whose remeasurement is reflected in the income statement. The Company adopted ASU 2018-02 effective on January 1, 2018 and reclassified $1.0 million of net tax expense from AOCI to retained earnings in the consolidated statement of equity.
In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, which, among others, (i) required equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income, (ii) simplified the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (iii) eliminated the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; and (iv) required separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Company adopted ASU 2016-01 effective on January 1, 2018, which resulted in a reclassification of the outstanding net unrealized investment gains, net of taxes, of $4.6 million relating to investments in equity securities previously carried in AOCI to retained earnings in the consolidated statement of equity.
7
E. Recent significant accounting pronouncements. In February 2016, the FASB issued ASU 2016-02, Topic 842: Leases (Topic 842), which updates the current guidance related to leases. Topic 842 includes the requirement for the lessee to recognize in the balance sheet a liability equal to the present value of contractual lease payments with terms of more than twelve months and a right-of-use asset representing the right to use the underlying asset for the lease term. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Additional financial statement disclosures are required to meet the objective of enabling users to assess the amount, timing, and uncertainty of cash flows arising from leases. In July 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842: Leases and ASU 2018-11, Leases (Topic 842) - Targeted Improvements. ASU 2018-10 clarifies certain aspects of the new lease standard which include amendments addressing, among others, the rate implicit in the lease, lessee reassessment of lease classification, variable payments that depend on an index or rate and certain transition adjustments. ASU 2018-11 provides an optional transition method which will allow the application of the recognition and measurement requirements of Topic 842 in the period of adoption. If elected, the comparative periods would continue to be reported under the legacy lease guidance in Topic 840, including the related disclosures, and a cumulative effect adjustment would be made to retained earnings as of the adoption date. These ASUs are effective for annual and interim periods beginning after December 15, 2018 and early adoption is permitted.
The Company expects to adopt Topic 842 on January 1, 2019 using the optional transition method of adoption. The adoption is expected to result in material increases in the assets and liabilities to be reported on its 2019 consolidated balance sheets based on the Company's estimate of undiscounted future minimum lease payments of approximately $90 million to $100 million as of December 31, 2018. However, the Company expects the new lease standard will likely have an insignificant impact on its consolidated statements of income and comprehensive income and cash flows. The Company is currently in the process of system implementation and data migration, and expects the transition to be completed during the fourth quarter 2018. The Company is planning to elect most of the practical expedients permitted by Topic 842 at adoption date.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, which removes Topic 820 disclosure requirements relating to the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy; the policy for timing of transfers between levels; and the valuation processes for Level 3 fair value measurements. Also, ASU 2018-13 adds new requirements to disclose changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period, and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for annual and interim periods beginning after December 15, 2019 and early adoption is permitted. The Company expects this ASU will have minimal effect on its financial statements and related disclosures when it is adopted on January 1, 2020 considering the Company does not have any Level 3 fair value measurements.
In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract. ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. ASU 2018-15 is effective for annual and interim periods beginning after December 15, 2019 and early adoption is permitted. The Company is currently evaluating the effect that the new guidance will have on its consolidated financial statements and related disclosures.
F. Merger Agreement. On March 18, 2018, the Company entered into an Agreement and Plan of Merger (the Merger Agreement) with Fidelity National Financial, Inc., a Delaware corporation (FNF), A Holdco Corp., a Delaware corporation and a wholly-owned direct subsidiary of FNF (Merger Sub I), and S Holdco LLC, a Delaware limited liability company and a wholly-owned direct subsidiary of FNF (Merger Sub II and, together with Merger Sub I, the Merger Subs). Upon the terms and subject to the conditions set forth in the Merger Agreement, at the Effective Time (as defined below), Merger Sub I will merge with and into the Company (Merger I), with the Company surviving Merger I as a direct wholly-owned subsidiary of FNF, and at the Subsequent Effective Time (as defined in the Merger Agreement), the Company will merge with and into Merger Sub II (Merger II and, together with Merger I, the Mergers), with Merger Sub II surviving Merger II as a direct wholly-owned subsidiary of FNF.
8
Subject to the terms and conditions of the Merger Agreement, at the effective time of Merger I (the Effective Time, each share of the Company's Common Stock outstanding immediately prior to the Effective Time (other than (i) shares owned by the Company, its subsidiaries, FNF or the Merger Subs and (ii) shares in respect of which appraisal rights have been properly exercised and perfected under Delaware law) will be converted into the right to receive cash consideration of $25.00 and 0.6425 shares of FNF common stock, par value $0.0001 per share (FNF Common Stock), subject to potential adjustment as described below. Pursuant to the terms of the Merger Agreement, the Company's stockholders have the option to elect to receive the merger consideration in all cash (the Cash Election Consideration), all FNF Common Stock (the Stock Election Consideration) or a mix of 50% cash and 50% FNF Common Stock (the Mixed Election Consideration), subject to pro-rata reductions to the extent either the election for the Cash Election Consideration or the election for the Stock Election Consideration is oversubscribed. Stockholders that elect to receive the Cash Election Consideration will receive $50.00 per share, subject to potential adjustment as described below and proration to the extent the cash option is oversubscribed. The Stock Election Consideration and the stock portion of the Mixed Election Consideration will be calculated using a fixed exchange ratio that is based on the average of the volume weighted average prices of FNF Common Stock for each of the twenty (20) trading days prior to the signing of the Merger Agreement, or $38.91 (the Parent Share Price). The exchange ratio for the Stock Election Consideration will be equal to 1.2850 shares of FNF Common Stock per share of Common Stock (the Exchange Ratio), subject to potential adjustment described below and proration to the extent the stock option is oversubscribed.
Under the terms of the Merger Agreement, if the combined company is required to divest assets or businesses with 2017 annual revenues in excess of $75 million in order to receive required regulatory approvals (up to a cap of $225 million of 2017 annual revenues), the per share purchase price will be adjusted downwards on a sliding scale between such amounts of divestitures up to a maximum reduction of $4.50 in value in the event that businesses or assets with 2017 annual revenues of $225 million are divested, with such adjustment to consist of (i) in the case shares of Common Stock with respect to which Cash Election Consideration has been elected, a reduction of the amount of cash paid in respect of each share, (ii) in the case shares of Common Stock with respect to which Stock Election Consideration has been elected, a reduction in the Exchange Ratio based on the Parent Share Price, and (iii) in the case of shares of Common Stock with respect to which Mixed Election Consideration has been elected, a reduction in both the amount of cash and the Exchange Ratio to be paid to the holders of such shares, with 50% of the aggregate value of such reduction to consist of a reduction of the cash consideration and 50% of the aggregate value of such reduction to consist of a reduction in the Exchange Ratio based on the Parent Share Price.
The consummation of the Mergers, which is expected during the first or second quarter of 2019, is subject to the satisfaction or waiver of customary conditions, including, among other things, (i) the adoption of the Merger Agreement by the holders of a majority of the outstanding shares of Common Stock entitled to vote on the Mergers (the Company Stockholder Approval), (ii) the absence of any injunction or court or other governmental order (with respect to applicable antitrust or insurance laws, solely with respect to the Required Antitrust Regulatory Filings/Approvals and the Required Insurance Regulatory Filings/Approvals (each as defined in the Merger Agreement)) enjoining, prohibiting or rendering illegal the consummation of the Mergers, (iii) obtaining certain Required Antitrust Regulatory Filings/Approvals, (iv) obtaining certain Required Insurance Regulatory Filings/Approvals, (v) the Securities and Exchange Commission (SEC) declaring the Registration Statement (as defined in the Merger Agreement) on Form S-4 effective, (vi) the shares of FNF Common Stock to be issued in the Mergers having been approved for listing on the New York Stock Exchange, (vii) the representations and warranties made by each of the Company and FNF being true at and as of the Closing Date (as defined in the Merger Agreement), subject to the materiality standards contained in the Merger Agreement, (viii) the performance, in all material respects, by each of the Company, FNF and the Merger Subs of all of their respective obligations under the Merger Agreement and (ix) no Company Material Adverse Effect or Parent Material Adverse Effect (each as defined in the Merger Agreement) having occurred since the signing of the Merger Agreement. The Company Stockholder Approval was obtained during a special stockholders' meeting held on September 5, 2018.
9
The Merger Agreement contains certain customary representations, warranties and covenants made by the Company and FNF. The Merger Agreement also contains customary covenants for each of the parties, including the obligation for the parties to refrain from taking specified actions without the consent of the other party, and, in the case of the Company, conduct its business in the ordinary course and use commercially reasonable efforts to preserve intact its business organizations and relationships with third parties. Under the Merger Agreement, each of the Company and FNF has agreed to use its reasonable best efforts to take all actions and to do all things necessary or advisable under applicable law to consummate the Mergers, including preparing and filing as promptly as practicable with any governmental authority or other third party all documentation to effect all necessary filings, notices, petitions, statements, registrations, submissions of information, applications and other documents and obtaining and maintaining all approvals, consents, registrations, permits, authorizations and other confirmations required to be obtained from any governmental authority or other third party that are necessary, proper or advisable to consummate the transactions contemplated by this Agreement. Notwithstanding such obligation, in connection with obtaining any required regulatory approval, (a) FNF is not required to sell, divest, dispose of, license or hold separate (i) title plants and rights to title plants, businesses, product lines or assets to the extent that such title plants, rights to title plants, businesses, product lines or assets generated 2017 revenues in excess of $225 million in the aggregate, or (ii) any of its own brands in full and (b) FNF and its affiliates are not required to litigate in order to avoid or have terminated any legal restraint that would prevent the Mergers from being consummated.
The Merger Agreement contains certain customary termination rights in favor of either the Company or FNF, which are exercisable (i) by mutual consent, (ii) upon the failure to complete the Mergers by March 18, 2019 (the End Date), subject to certain exceptions and subject to up to two (2) extensions of up to three (3) months each upon the election of either the Company or FNF if, as of such date, all closing conditions (other than the receipt of the Required Antitrust Regulatory Filings/Approvals, the receipt of the Required Insurance Regulatory Filings/Approvals and the absence of any law or court or other governmental order relating thereto) having been met or being capable of being satisfied as of such time, (iii) in the event of a final and non-appealable law or order that prohibits the consummation of the Mergers or (iv) if the Company’s stockholders do not vote to approve the Mergers.
The Merger Agreement contains certain customary termination rights in favor of the Company, which are exercisable (i) for a breach of any representation, warranty, covenant or agreement made by FNF under the Merger Agreement that would result in failure to satisfy a closing condition (subject to certain cure periods) or (ii) if, prior to the Company Stockholder Approval being obtained, the Company’s board of directors authorizes the Company to enter into, and the Company enters into, an alternative acquisition agreement in connection with a superior proposal. Under the Merger Agreement, the Company will be obligated to pay a termination fee of $33 million to FNF if the Merger Agreement is terminated due to the Company’s board of directors changing its recommendation or if the Company terminates the Merger Agreement to enter into an agreement for a superior proposal.
The Merger Agreement also contains certain customary termination rights in favor of FNF. If the Merger Agreement is terminated due to (i) the failure to complete the Mergers by the End Date because of a failure to obtain the Required Antitrust Regulatory Filings/Approvals or Required Insurance Regulatory Filings/Approvals, and all other closing conditions have been or are capable of being satisfied at the time of such termination, or (ii) an injunction or governmental or other court order enjoining, prohibiting or rendering illegal the consummation of the Mergers that is based on the failure to obtain the Required Antitrust Regulatory Filings/Approvals or Required Insurance Regulatory Filings/Approvals, then FNF will be obligated to pay a reverse termination fee of $50 million to the Company.
The Merger Agreement was included as Exhibit 2.1 to the Form 8-K filed with the SEC on March 19, 2018.
10
NOTE 2
Revenues. The Company's operating revenues, summarized by type, are as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted)
($000 omitted)
Title insurance premiums:
Direct
152,739
146,314
444,447
436,803
Agency
272,875
268,545
756,986
736,301
Escrow fees
32,649
37,478
95,984
109,688
Search, abstract and valuation services
24,105
24,201
71,006
80,401
Other revenues
16,868
21,511
50,239
54,125
499,236
498,049
1,418,662
1,417,318
Direct premiums - Premiums from title insurance policies directly issued or issued by affiliate offices are recognized at the time of the closing of the related real estate transaction.
Agency premiums - Premiums from title insurance policies written by independent agencies (agencies) are recognized when the policies are reported to the Company. In addition, where reasonable estimates can be made, the Company accrues for policies issued but not reported until after period end. The Company believes that reasonable estimates can be made when recent and consistent policy issuance information is available. Estimates are based on historical reporting patterns and other information obtained about agencies, as well as current trends in direct operations and in the title industry. In this accrual, future transactions are not being estimated. The Company is estimating revenues on policies that have already been issued by agencies but not yet reported to or received by the Company. The Company has consistently followed the same basic method of estimating unreported policy revenues for more than 10 years.
Escrow fees - An escrow is a transaction pursuant to an agreement of a buyer, seller, borrower, or lender wherein an impartial third party, such as the Company, acts in a fiduciary capacity on behalf of the parties in accordance with the terms of such agreement in order to accomplish the directions stated therein. Services provided include, among others, acting as escrow or other fiduciary agent, obtaining releases, and conducting the actual closing or settlement. Escrow fees are recognized upon closing of the escrow, which is generally at the same time of the closing of the related real estate transaction.
Search, abstract and valuation services - These services are primarily related to establishing the ownership, legal status and valuation of the property in a real estate transaction. In these cases, the Company does not issue a title insurance policy or perform duties of an escrow agent. Revenues from these services are recognized upon delivery of the service to the customer.
Other revenues - Other revenues consist primarily of fees related to tax-deferred property exchange services, information technology products related to real property records and closing settlement services, income from equity investees, and other services performed to facilitate the closing of real estate transactions. For those products and services that are delivered at a point in time, the related revenue is recognized upon delivery based on the unit price of the product or service. For those products and services where delivery occurs over time, the related revenue is recognized ratably over the duration of the contract.
11
NOTE 3
Investments in debt and equity securities. The total fair values of the Company's investments in debt and equity securities are detailed below:
September 30, 2018
December 31, 2017
($000 omitted)
Investments in:
Debt securities
624,422
671,441
Equity securities
37,667
37,914
662,089
709,355
Investments in debt securities are classified as available-for-sale and the net unrealized gains and losses on such investments, net of applicable deferred taxes, are included as a component of AOCI within stockholders' equity. As a result of the Company's adoption of ASU 2016-01 (as discussed in Note 1-D), fair value changes relating to investments in equity securities are recognized as part of investment and other (losses) gains - net in the condensed consolidated statement of income and comprehensive income beginning on January 1, 2018. Previously, the investments in equity securities, which consist of common stocks and master limited partnership interests, were accounted for similar to investments in debt securities.
As of September 30, 2018 and December 31, 2017, the net unrealized investment gains relating to investments in equity securities held were $7.0 million and $5.8 million, respectively.
The amortized costs and fair values of investments in debt securities are as follows:
September 30, 2018
December 31, 2017
Amortized
costs
Fair
values
Amortized
costs
Fair
values
($000 omitted)
Municipal
62,097
61,703
71,581
72,669
Corporate
346,429
340,919
351,477
357,933
Foreign
213,559
209,329
229,750
228,237
U.S. Treasury Bonds
12,948
12,471
12,838
12,602
635,033
624,422
665,646
671,441
Foreign debt securities consist of Canadian government, municipal and corporate bonds, United Kingdom treasury bonds, and Mexican government bonds.
Gross unrealized gains and losses on investments in debt securities are as follows:
September 30, 2018
December 31, 2017
Gains
Losses
Gains
Losses
($000 omitted)
Municipal
261
655
1,263
175
Corporate
2,045
7,555
6,953
497
Foreign
1,115
5,345
1,742
3,255
U.S. Treasury Bonds
—
477
—
236
3,421
14,032
9,958
4,163
12
Debt securities as of September 30, 2018 mature, according to their contractual terms, as follows (actual maturities may differ due to call or prepayment rights):
Amortized
costs
Fair
values
($000 omitted)
In one year or less
48,839
48,844
After one year through five years
364,717
359,727
After five years through ten years
182,578
177,919
After ten years
38,899
37,932
635,033
624,422
Gross unrealized losses on investments in debt securities and the fair values of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2018, were:
Less than 12 months
More than 12 months
Total
Losses
Fair values
Losses
Fair values
Losses
Fair values
($000 omitted)
Municipal
314
33,036
341
6,808
655
39,844
Corporate
6,862
266,231
693
15,359
7,555
281,590
Foreign
1,242
70,048
4,103
104,795
5,345
174,843
U.S. Treasury Bonds
150
4,277
327
8,088
477
12,365
8,568
373,592
5,464
135,050
14,032
508,642
The number of specific debt investment holdings held in an unrealized loss position as of September 30, 2018 was 334. Of these securities, 83 securities were in unrealized loss positions for more than 12 months. The increased gross unrealized losses on corporate and foreign debt securities were primarily driven by increases in the overall rate environment, while the decline in value of the Canadian dollar against the U.S. dollar also contributed to higher gross unrealized losses on foreign debt securities. Since the Company does not intend to sell and will more likely than not maintain each investment security until its maturity or anticipated recovery, and no significant credit risk is deemed to exist, these investments are not considered as other-than-temporarily impaired. The Company believes its investment portfolio is diversified and expects no material loss to result from the failure to perform by issuers of the debt securities it holds. Investments made by the Company are not collateralized.
Gross unrealized losses on investments in debt securities and the fair values of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2017, were:
Less than 12 months
More than 12 months
Total
Losses
Fair values
Losses
Fair values
Losses
Fair values
($000 omitted)
Municipal
58
17,023
117
5,784
175
22,807
Corporate
386
81,632
111
4,926
497
86,558
Foreign
1,528
116,130
1,727
39,031
3,255
155,161
U.S. Treasury Bonds
53
5,830
183
6,772
236
12,602
2,025
220,615
2,138
56,513
4,163
277,128
13
NOTE 4
Fair value measurements. The Fair Value Measurements and Disclosures Topic (Topic 820) of the FASB Accounting Standards Codification (ASC) defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal, or most advantageous, market for the asset or liability in an orderly transaction between market participants at the measurement date. Topic 820 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs when possible.
The three levels of inputs used to measure fair value are as follows:
•
Level 1 – quoted prices in active markets for identical assets or liabilities;
•
Level 2 – observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data; and
•
Level 3 – unobservable inputs that are supported by little or no market activity and that are significant to the fair values of the assets or liabilities, including certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.
As of September 30, 2018, financial instruments measured at fair value on a recurring basis are summarized below:
Level 1
Level 2
Fair value
measurements
($000 omitted)
Investments in securities:
Debt securities:
Municipal
—
61,703
61,703
Corporate
—
340,919
340,919
Foreign
—
209,329
209,329
U.S. Treasury Bonds
—
12,471
12,471
Equity securities
37,667
—
37,667
37,667
624,422
662,089
As of December 31, 2017, financial instruments measured at fair value on a recurring basis are summarized below:
Level 1
Level 2
Fair value
measurements
($000 omitted)
Investments in securities:
Debt securities:
Municipal
—
72,669
72,669
Corporate
—
357,933
357,933
Foreign
—
228,237
228,237
U.S. Treasury Bonds
—
12,602
12,602
Equity securities
37,914
—
37,914
37,914
671,441
709,355
14
As of September 30, 2018, Level 1 financial instruments consist of equity securities. Level 2 financial instruments consist of municipal, governmental, and corporate bonds, both U.S. and foreign. In accordance with the Company’s policies and guidelines which incorporate relevant statutory requirements, the Company’s third-party registered investment manager invests only in securities rated as investment grade or higher by the major rating services, where observable valuation inputs are significant. The fair value of the Company's investments in available-for-sale securities are primarily determined using a third-party pricing service provider. The third-party pricing service provider calculates the fair values using both market approach and model valuation methods, as well as pricing information obtained from brokers, dealers and custodians. Management ensures the reasonableness of the third-party service valuations by comparing them with pricing information from the Company's investment manager.
There were no transfers of investments between levels during the nine months ended September 30, 2018 and 2017.
NOTE 5
Investment and other gains (losses) - net. Investments and other gains (losses) are detailed as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted)
Investment and other gains
1,597
548
2,763
1,392
Investment and other losses
(151
)
(1,595
)
(220
)
(2,828
)
Net unrealized investment gains (losses) recognized on equity securities held
2,177
—
1,802
—
3,623
(1,047
)
4,345
(1,436
)
Investment and other gains for the third quarter and first nine months of 2018 included a net unrealized gain of $1.2 million that resulted from a fair value change of an equity investment with previously no readily determinable fair value.
Following the adoption of ASU 2016-01, as discussed in Notes 1 and 3, net investment gains recognized during the three and nine months ended September 30, 2018 related to investments in equity securities still held as of September 30, 2018 are calculated as follows ($000 omitted):
September 30, 2018
Three Months Ended
Nine Months Ended
($000 omitted)
Total net investment gains recognized on equity securities during the period
2,775
2,161
Less: Net realized gains on equity securities sold during the period
598
359
Net unrealized investment gains recognized on equity securities still held
2,177
1,802
Proceeds from sales of investments in securities are as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted)
Proceeds from sales of debt securities
6,326
1,419
27,475
50,245
Proceeds from sales of equity securities
452
4,459
5,025
5,288
Total proceeds from sales of investment in securities
6,778
5,878
32,500
55,533
15
NOTE 6
Goodwill and other intangibles. The summary of changes in goodwill is as follows.
Title
Ancillary Services and Corporate
Consolidated Total
($000 omitted)
Balances at December 31, 2017
225,699
5,729
231,428
Acquisitions
15,804
—
15,804
Disposals
(42
)
—
(42
)
Balances at September 30, 2018
241,461
5,729
247,190
During 2018, the Company acquired several title businesses which increased goodwill related to the title segment by a total of $15.8 million, which is substantially deductible for income tax purposes over a period of 15 years. Also, in connection with the acquisitions, the Company identified and recorded $4.4 million of other intangibles, primarily related to employment and non-compete agreements, to be amortized between 1 year to 3 years from the dates of acquisition.
The Company evaluates goodwill for impairment annually based on information as of June 30 of the current year or more frequently if circumstances suggest that an impairment may exist. The Company performed its annual goodwill impairment analysis during the quarter ended September 30, 2018, utilizing the quantitative assessment method for its direct operations, agency operations, international operations and ancillary services reporting units. Based on the quantitative analysis performed, the Company concluded that the goodwill related to all reporting units was not impaired.
NOTE 7
Estimated title losses. A summary of estimated title losses for the nine months ended September 30 is as follows:
2018
2017
($000 omitted)
Balances at January 1
480,990
462,572
Provisions:
Current year
62,592
69,067
Previous policy years
(3,410
)
1,524
Total provisions
59,182
70,591
Payments, net of recoveries:
Current year
(9,466
)
(10,403
)
Previous policy years
(50,822
)
(53,491
)
Total payments, net of recoveries
(60,288
)
(63,894
)
Effects of changes in foreign currency exchange rates
(3,014
)
6,576
Balances at September 30
476,870
475,845
Loss ratios as a percentage of title operating revenues:
Current year provisions
4.5
%
5.0
%
Total provisions
4.3
%
5.1
%
During the nine months ended September 30, 2018, the Company decreased its loss provisioning rate due to lower loss experience and also reduced its prior policy year reserves as a result of its semi-annual actuarial reserve review. This primarily resulted in a $3.4 million net favorable loss development for previous policy years and also decreased the total title loss provisions for the nine months ended September 30, 2018 compared to the same period in 2017.
16
NOTE 8
Share-based payments. Prior to 2018, the Company granted executives and senior management shares of restricted common stock, consisting of time-based shares, which vest on each of the first three anniversaries of the grant date, and performance-based shares, which vest upon achievement of certain financial objectives over the period of three years. Starting on January 1, 2018, the Company began granting time-based and performance-based restricted stock units, which have vesting conditions generally similar to those restricted common stock shares awarded previously. Each restricted stock unit represents a contractual right to receive a share of the Company's common stock.
The aggregate grant-date fair values of these awards during 2018 and 2017 were $4.8 million (110,600 shares with an average grant price per share of $43.39) and $5.1 million (120,000 shares with an average grant price per share of $42.55), respectively. Awards were made pursuant to the Company’s employee incentive compensation plans and the compensation expense associated with restricted stock awards is recognized over the corresponding vesting period. Additionally, during the second quarters 2018 and 2017, the Company granted its board of directors, as a component of annual director retainer compensation, 14,300 and 13,000 shares, respectively, of common stock, which vested immediately. The aggregate fair values of these director awards at the grant dates in 2018 and 2017 were both $0.6 million.
NOTE 9
Earnings per share. Basic earnings per share (EPS) attributable to Stewart is calculated by dividing net income attributable to Stewart by the weighted-average number of shares of Common Stock outstanding during the reporting periods. Outstanding shares of Common Stock granted to employees that are not yet vested (restricted shares) are excluded from the calculation of the weighted-average number of shares outstanding for calculating basic EPS. To calculate diluted EPS, the number of shares is adjusted to include the number of additional shares that would have been outstanding if the restricted shares and restricted units were vested. In periods of loss, dilutive shares are excluded from the calculation of the diluted EPS and diluted EPS is computed in the same manner as basic EPS.
The calculation of the basic and diluted EPS is as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted, except per share)
Numerator:
Net income attributable to Stewart
17,554
10,944
36,151
33,601
Denominator (000):
Basic average shares outstanding
23,556
23,448
23,537
23,442
Average number of dilutive shares relating to grants of restricted shares and units
143
116
140
129
Diluted average shares outstanding
23,699
23,564
23,677
23,571
Basic earnings per share attributable to Stewart
0.75
0.47
1.54
1.43
Diluted earnings per share attributable to Stewart
0.74
0.46
1.53
1.43
17
NOTE 10
Contingent liabilities and commitments. In the ordinary course of business, the Company guarantees the third-party indebtedness of certain of its consolidated subsidiaries. As of September 30, 2018, the maximum potential future payments on the guarantees are not more than the related notes payable recorded in the condensed consolidated balance sheets. The Company also guarantees the indebtedness related to lease obligations of certain of its consolidated subsidiaries. The maximum future obligations arising from these lease-related guarantees are not more than the Company’s future minimum lease payments. As of September 30, 2018, the Company also had unused letters of credit aggregating $5.7 million related to workers’ compensation and other insurance. The Company does not expect to make any payments on these guarantees.
NOTE 11
Regulatory and legal developments. The Company is subject to claims and lawsuits arising in the ordinary course of its business, most of which involve disputed policy claims. In some of these lawsuits, the plaintiff seeks exemplary or treble damages in excess of policy limits. The Company does not expect that any of these ordinary course proceedings will have a material adverse effect on its consolidated financial condition or results of operations. In addition, along with the other major title insurance companies, the Company is party to class action lawsuits concerning the title insurance industry. The Company believes that it has adequate reserves for the various litigation matters and contingencies discussed in this paragraph and that the likely resolution of these matters will not materially affect its consolidated financial condition or results of operations.
Additionally, the Company receives from time to time various other inquiries from governmental regulators concerning practices in the insurance industry. Many of these practices do not concern title insurance. To the extent the Company is in receipt of such inquiries, it believes that it has adequately reserved for these matters and does not anticipate that the outcome of these inquiries will materially affect its consolidated financial condition or results of operations.
The Company is subject to various other administrative actions and inquiries into its business conduct in certain of the states in which it operates. While the Company cannot predict the outcome of the various regulatory and administrative matters, it believes that it has adequately reserved for these matters and does not anticipate that the outcome of any of these matters will materially affect its consolidated financial condition or results of operations.
18
NOTE 12
Segment information. The Company reports two operating segments: title and ancillary services and corporate. The title segment provides services needed to transfer title to property in a real estate transaction and includes services such as searching, examining, closing and insuring the condition of the title to the property. In addition, the title segment includes centralized title services, home and personal insurance services and Internal Revenue Code Section 1031 tax-deferred exchanges. The ancillary services and corporate segment includes search and valuation services, which are the principal offerings of ancillary services, and expenses of the parent holding company and certain other enterprise-wide overhead costs, net of centralized administrative services costs allocated to respective operating businesses.
Selected statement of income information related to these segments is as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted)
Title segment:
Revenues
493,186
488,612
1,397,722
1,384,857
Depreciation and amortization
5,362
5,534
15,929
16,081
Income before taxes and noncontrolling interest
35,999
24,610
78,860
76,354
Ancillary services and corporate segment:
Revenues
14,454
12,957
40,017
45,204
Depreciation and amortization
859
1,044
2,680
3,316
Loss before taxes and noncontrolling interest
(11,223
)
(6,013
)
(26,018
)
(18,742
)
Consolidated Stewart:
Revenues
507,640
501,569
1,437,739
1,430,061
Depreciation and amortization
6,221
6,578
18,609
19,397
Income before taxes and noncontrolling interest
24,776
18,597
52,842
57,612
The Company does not provide asset information by reportable operating segment as it does not routinely evaluate the asset position by segment.
Revenues generated in the United States and all international operations are as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($000 omitted)
United States
473,477
464,111
1,347,310
1,335,129
International
34,163
37,458
90,429
94,932
507,640
501,569
1,437,739
1,430,061
19
NOTE 13
Other comprehensive (loss) income. Changes in the balances of each component of other comprehensive (loss) income and the related tax effects are as follows:
Three Months Ended September 30, 2018
Three Months Ended September 30, 2017
Before-Tax Amount
Tax Expense (Benefit)
Net-of-Tax Amount
Before-Tax Amount
Tax Expense (Benefit)
Net-of-Tax Amount
($000 omitted)
Net unrealized (losses) gains on investments:
Change in net unrealized gains and losses on investments
(2,417
)
(507
)
(1,910
)
95
32
63
Less: reclassification adjustment for net gains included in net income
(174
)
(37
)
(137
)
(508
)
(177
)
(331
)
(2,591
)
(544
)
(2,047
)
(413
)
(145
)
(268
)
Foreign currency translation adjustments
1,620
480
1,140
5,817
1,676
4,141
Other comprehensive (loss) income
(971
)
(64
)
(907
)
5,404
1,531
3,873
Nine Months Ended September 30, 2018
Nine Months Ended September 30, 2017
Before-Tax Amount
Tax Expense (Benefit)
Net-of-Tax Amount
Before-Tax Amount
Tax Expense (Benefit)
Net-of-Tax Amount
($000 omitted)
Net unrealized (losses) gains on investments:
Change in net unrealized gains and losses on investments
(15,625
)
(3,281
)
(12,344
)
4,438
1,553
2,885
Less: reclassification adjustment for net gains included in net income
(781
)
(164
)
(617
)
(1,218
)
(426
)
(792
)
(16,406
)
(3,445
)
(12,961
)
3,220
1,127
2,093
Foreign currency translation adjustments
(5,234
)
(744
)
(4,490
)
11,831
3,161
8,670
Other comprehensive (loss) income
(21,640
)
(4,189
)
(17,451
)
15,051
4,288
10,763
20
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT’S OVERVIEW
We reported net income attributable to Stewart of $17.6 million ($0.74 per diluted share) for the third quarter 2018 compared to net income attributable to Stewart of $10.9 million ($0.46 per diluted share) for the third quarter 2017. Pretax income before noncontrolling interests for the third quarter 2018 was $24.8 million compared to pretax income before noncontrolling interests of $18.6 million for the third quarter 2017.
On March 18, 2018, Stewart entered into an agreement and plan of merger with Fidelity National Financial, Inc. (FNF), in which the outstanding shares of Stewart will be exchanged for a combination of cash and shares of FNF, and the Company will be merged into a subsidiary of FNF (the Mergers). Since the announcement, we initiated the regulatory approval process, which included the submission of our Hart-Scott-Rodino Act filings to the Federal Trade Commission (FTC) and the Form A filings to the states of Texas and New York, the domiciles of Stewart’s two main underwriters. Furthermore, the merger was approved by a majority of our stockholders during a special meeting held on September 5, 2018. We continue to work cooperatively with FNF, the FTC and state regulators in the ongoing review process, responding to data and information requests as they arise. Of note, in August 2018, the Canadian Competition Bureau notified FNF that it had no opposition to the completion of the merger. We expect the Mergers to close by the first or second quarter 2019, subject to the remaining federal and state regulatory approvals and the satisfaction of other customary closing conditions.
Summary results of the title segment are as follows ($ in millions, except pretax margin):
For the Three Months Ended September 30,
2018
2017
% Change
Total operating revenues
486.0
485.4
—
%
Investment income and other net gains
7.2
3.2
122
%
Pretax income
36.0
24.6
46
%
Pretax margin
7.3
%
5.0
%
Title operating revenues in the third quarter 2018 were comparable to the prior year quarter, as a result of higher commercial and independent agency revenues, which were partially offset by lower non-commercial direct title revenues. Pretax income improved $11.4 million in the third quarter 2018 compared to the third quarter 2017, primarily as a result of lower overall title operating expenses and higher investment income and other net gains. Included in the segment’s results were $2.2 million of net unrealized gains relating to fair value changes of equity securities investments, which were being recorded to other comprehensive income prior to the adoption of a new accounting standard in 2018.
Included in the non-commercial domestic revenues (as shown under the Results of Operations - Title revenues section) were revenues from purchase transactions, which were roughly flat year-over-year, and centralized title operations (processing primarily refinancing and default title orders), which were down $5.7 million in the third quarter 2018 compared to the third quarter 2017. Total commercial revenues improved $7.3 million, or 16%, from the prior year quarter due to our continued focus on delivering quality service and underwriting to our domestic and international commercial customers. Total international title revenues in the third quarter 2018 decreased $4.2 million, or 12%, compared to the prior year quarter, primarily as a result of lower volumes from our Canada operations.
Both gross and net revenues from independent agency operations in the third quarter 2018 increased 2%, compared to the third quarter 2017, as we maintained our focus on enhancing customer service and technology connectivity. The independent agency remittance rate in the third quarter 2018 remained comparable to the prior year quarter.
21
Summary results of the ancillary services and corporate segment are as follows ($ in millions):
For the Three Months Ended September 30,
2018
2017
% Change
Total revenues
14.5
13.0
12
%
Pretax loss
(11.2
)
(6.0
)
(87
)%
Third quarter 2018 segment revenues increased $1.5 million compared to the prior year quarter, primarily due to a $1.2 million net unrealized gain resulting from a fair value change of an equity investment with previously no readily determinable fair value. The segment’s third quarter 2018 pretax results declined compared to the prior year quarter, primarily due to the $6.8 million of third-party advisory expenses incurred in the third quarter 2018 relating to the FNF merger transaction. Additionally, the segment’s results for the third quarter 2018 and 2017 included approximately $5.8 million and $6.1 million, respectively, of net expenses attributable to parent company and corporate operations.
CRITICAL ACCOUNTING ESTIMATES
The preparation of the Company’s condensed 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, 2018, we made no material changes to our 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, 2017.
Operations. 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, agencies and centralized title services centers. Our ancillary services and corporate segment includes our parent holding company expenses and certain enterprise-wide overhead costs, along with our remaining ancillary services operations, principally search and valuation services.
Factors affecting revenues. The principal factors that contribute to changes in operating revenues for our title and ancillary services and corporate segments include:
•
mortgage interest rates;
•
availability of mortgage loans;
•
number and average value of mortgage loan originations;
•
ability of potential purchasers to qualify for loans;
•
inventory of existing homes available for sale;
•
ratio of purchase transactions compared with refinance transactions;
•
ratio of closed orders to open orders;
•
home prices;
•
consumer confidence, including employment trends;
•
demand by buyers;
•
number of households;
•
premium rates;
•
foreign currency exchange rates;
•
market share;
•
ability to attract and retain highly productive sales associates;
•
independent agency remittance rates;
•
opening of new offices and acquisitions;
•
number and value of commercial transactions, which typically yield higher premiums;
•
government or regulatory initiatives, including tax incentives and the implementation of the new integrated disclosure requirements;
22
•
acquisitions or divestitures of businesses;
•
volume of distressed property transactions; and
•
seasonality and/or weather.
Premiums are determined in part by the values of the transactions we handle. To the extent inflation or market conditions cause increases in the prices of homes and other real estate, premium revenues are also increased. Conversely, falling home prices cause premium revenues to decline. As an overall guideline, a 5% change in median home prices results in an approximate 3.7% change in title premiums. Home price changes may override the seasonal nature of the title insurance business. Historically, our first quarter is the least active in terms of title insurance revenues as home buying is generally depressed during winter months. Our second and third quarters are the most active as the summer is the traditional home buying season, and while commercial transaction closings are skewed to the end of the year, individually large commercial transactions can occur any time of year.
RESULTS OF OPERATIONS
Comparisons of our results of operations for the three and nine months ended September 30, 2018 with the three and nine months ended September 30, 2017 are set forth below. 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. Segment results 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 Realtors® (NAR), the Mortgage Bankers Association (MBA) and Freddie Mac. We also use information from our direct operations.
Operating environment. Actual existing home sales in the third quarter 2018 declined approximately 2% from the third quarter 2017. September 2018 existing home sales totaled 420,000, which was down (seasonally-adjusted) 4% from a year ago and 3% from August 2018. According to NAR, the decline in existing home sales, which is the lowest since November 2015, was primarily the result of rising interest rates and lower affordable home listings in the market. September 2018 median and average home prices rose approximately 4% and 2%, respectively, compared to September 2017 prices. September 2018 housing starts declined 5% sequentially from August 2018, but improved 4% from a year ago. Newly issued building permits in September 2018 were down 1% both sequentially from August 2018 and from a year ago. According to Fannie Mae, one-to-four family residential lending declined 10% to $428 billion in the third quarter 2018 from $477 billion in the third quarter 2017, primarily driven by a 35%, or $54 billion, reduction in refinance originations. Purchase lending slightly improved 2%, or $5 billion, in the third quarter 2018 compared to the prior year quarter. Total lending is forecasted to decrease $42 billion, or 10%, in the fourth quarter 2018 compared to the third quarter 2018, as purchase lending is expected to decline $38 billion, or 12%, primarily due to seasonality and the rising interest rates.
Title revenues. Direct title revenue information is presented below:
Three Months Ended
September 30,
Nine Months Ended
September 30,
2018
2017
% Change
2018
2017
% Change
($ in millions)
($ in millions)
Non-commercial
Domestic
136.2
141.7
(4
)%
397.7
417.8
(5
)%
International
24.9
30.4
(18
)%
65.9
75.9
(13
)%
161.1
172.1
(6
)%
463.6
493.7
(6
)%
Commercial:
Domestic
45.2
39.2
15
%
140.9
127.4
11
%
International
6.8
5.5
24
%
18.4
14.8
24
%
52.0
44.7
16
%
159.3
142.2
12
%
Total direct title revenues
213.1
216.8
(2
)%
622.9
635.9
(2
)%
23
Revenues from direct title operations, which include residential, commercial, international and centralized title services transactions, decreased $3.7 million in the third quarter 2018 and $13.0 million in the first nine months of 2018, compared to the same periods in 2017, due to lower closed orders (primarily on refinancing activities), partially offset by improved commercial title revenues. Residential revenues, which comprise approximately 60% of our total direct revenues, were flat in the third quarter 2018 compared to the third quarter 2017, and slightly declined 1% ($3.5 million) in the first nine months of 2018, compared to the same period in 2017. Revenues from centralized title operations, which primarily process refinancing and default title orders, decreased $5.7 million, or 54%, in the third quarter 2018 and $16.6 million, or 46%, in the first nine months of 2018, compared to the respective periods in 2017, primarily due to decreased refinancing orders and lower demand for default services which are in line with industry trends.
Our direct operations include local offices and international operations, and we generate commercial revenues both domestically and internationally. U.S. commercial revenues increased $7.3 million in the third quarter 2018 and $17.1 million in the first nine months of 2018, compared to the respective periods in 2017, primarily due to our continued focus on delivering quality underwriting service and technological connectivity to our customers. Total international revenues declined $4.2 million, or 12%, in the third quarter 2018 and $6.4 million, or 7%, in the first nine months of 2018, compared to the same periods in 2017, primarily as a result of decreased transaction volume from our Canada operations, partially offset by increased commercial revenues. Direct revenues constituted 44% and 45% of our total title revenues in the third quarter and first nine months of 2018, respectively, compared to 45% and 46%, respectively, in the same periods in 2017.
Orders information for the three and nine months ended September 30 is as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
Change
% Change
2018
2017
Change
% Change
Opened Orders:
Commercial
7,497
10,685
(3,188
)
(30
)%
24,824
32,923
(8,099
)
(25
)%
Purchase
58,928
59,679
(751
)
(1
)%
181,493
188,744
(7,251
)
(4
)%
Refinance
20,441
27,155
(6,714
)
(25
)%
65,188
74,794
(9,606
)
(13
)%
Other
1,825
4,565
(2,740
)
(60
)%
7,369
13,584
(6,215
)
(46
)%
Total
88,691
102,084
(13,393
)
(13
)%
278,874
310,045
(31,171
)
(10
)%
Closed Orders:
Commercial
6,209
7,643
(1,434
)
(19
)%
19,697
23,136
(3,439
)
(15
)%
Purchase
46,041
48,432
(2,391
)
(5
)%
131,791
140,996
(9,205
)
(7
)%
Refinance
13,146
17,965
(4,819
)
(27
)%
42,607
53,471
(10,864
)
(20
)%
Other
1,414
2,872
(1,458
)
(51
)%
7,065
10,205
(3,140
)
(31
)%
Total
66,810
76,912
(10,102
)
(13
)%
201,160
227,808
(26,648
)
(12
)%
Gross revenues from independent agency operations increased $4.3 million, or 2%, in the third quarter 2018, compared to the third quarter 2017, primarily as a result of revenue increases in Texas, Florida and New Jersey, partially offset by declines in Washington and Vermont. Gross agency revenues also increased $20.7 million, or 3%, in the first nine months of 2018, compared to the same period in 2017, primarily as a result of revenue increases in Texas, New York, Pennsylvania, Arizona and Wisconsin, partially offset by decreases in Massachusetts, Michigan, Colorado and Utah. Agency revenues, net of retention, improved 2% ($0.8 million and $1.9 million, respectively) in both the third quarter and first nine months of 2018, compared to the same periods in 2017, primarily driven by the higher gross agency revenues accompanied by comparable average agency remittance rates. Refer further to the "Retention by agencies" discussion under Expenses below.
Ancillary services revenues. Ancillary services operating revenues increased $0.6 million, or 4%, in the third quarter 2018 compared to the prior year quarter as a result of increased revenues from the search services operations, partially offset by lower revenues from the valuation services operations. Revenues decreased $6.3 million, or 14%, in the first nine months of 2018, compared to the same period in 2017, primarily due to lower orders in both the search and valuation services operations.
24
Investment income. Investment income during the third quarter and first nine months of 2018 was comparable to the same periods in 2017.
Investment and other gains (losses) - net. Investment and other gains - net for the third quarter and first nine months of 2018 included net unrealized gains of $2.2 million and $1.8 million, respectively, related to fair value changes of equity securities investments (refer to Note 5 to the condensed consolidated financial statements for details), and a net unrealized gain of $1.2 million that resulted from a fair value change of an equity investment with previously no readily determinable fair value. Investments and other losses - net for the third quarter 2017 included net realized losses of $0.6 million from the sale of investments available-for-sale, while investment and other losses - net for the first nine months of 2017 included a net realized loss of $0.8 million that resulted from a change in the fair value of a contingent liability related to a prior acquisition.
Expenses. An analysis of expenses is shown below:
Three Months Ended September 30,
Nine Months Ended
September 30,
2018
2017
% Change
2018
2017
% Change
($ in millions)
($ in millions)
Amounts retained by agencies
225.0
221.5
2
%
624.0
605.2
3
%
As a % of agency revenues
82.4
%
82.5
%
82.4
%
82.2
%
Employee costs
138.3
140.1
(1
)%
423.4
419.2
1
%
As a % of operating revenues
27.7
%
28.1
%
29.8
%
29.6
%
Other operating expenses
90.8
88.5
3
%
257.0
255.6
1
%
As a % of operating revenues
18.2
%
17.8
%
18.1
%
18.0
%
Title losses and related claims
21.5
25.4
(15
)%
59.2
70.6
(16
)%
As a % of title revenues
4.4
%
5.2
%
4.3
%
5.1
%
Retention by agencies. Amounts retained by title agencies are based on agreements between agencies and our title underwriters. Amounts retained by independent agencies, as a percentage of revenues generated by them, averaged 82.4% and 82.5% in the third quarters 2018 and 2017, respectively, and 82.4% and 82.2% in the first nine months of 2018 and 2017, respectively. The average retention percentage may vary from period to period 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. In addition, a high proportion of our independent agencies are in states with retention rates greater than 80%. We continue to focus on increasing profit margins in every state, increasing premium revenue in states where remittance rates are above 20%, and maintaining the quality of our agency network, which we believe to be the industry’s best, in order to mitigate claims risk and drive consistent future performance. While market share is important in our agency operations channel, it is not as important as margins, risk mitigation and profitability.
Employee costs. Total employee costs decreased $1.8 million, or 1%, in the third quarter 2018 compared to the third quarter 2017, primarily due to lower average employee counts, partially offset by higher commissions on increased commercial title revenues and higher incentive compensation. For the first nine months of 2018, employee costs increased $4.2 million, or 1%, compared to the same period in 2017, primarily due to higher commissions on increased commercial title revenues and additional employee costs attributed to acquisitions in the title segment, which were partially offset by decreased salaries resulting from reduced employee counts. During the third quarter and first nine months of 2018, average employee counts have decreased approximately 8% and 6%, respectively, compared to the same periods in 2017, primarily resulting from continued volume declines in our title and ancillary services operations.
25
Title segment employee costs in the third quarter 2018 were comparable to the third quarter 2017, while employee costs for the first nine months of 2018 increased $10.5 million, or 3%, compared to the first nine months of 2017, primarily due to increased commissions and additional costs from previous acquisitions. In the ancillary services and corporate segment, employee costs decreased $0.9 million, or 12%, and $6.3 million, or 22%, in the third quarter and first nine months of 2018, compared to the same periods in 2017, primarily as a result of the reductions in average employee count.
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, third-party outsourcing provider 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 attorney fee splits, bad debt expenses, ancillary services cost of sales expenses, copy supplies, delivery fees, outside search fees, postage, premium taxes and title plant maintenance expenses. Costs that fluctuate independently of revenues include general supplies, litigation defense, business promotion and marketing and travel.
Consolidated other operating expenses increased $2.3 million, or 3%, and $1.4 million, or 1%, in the third quarter and first nine months of 2018 compared to the same periods in 2017; while as a percentage of total operating revenues, other operating expenses were 18.2% and 17.8% in the third quarters 2018 and 2017, respectively, and 18.1% and 18.0% in the first nine months of 2018 and 2017, respectively. During the third quarter and first nine months of 2018, we incurred $6.8 million and $9.7 million, respectively, of third-party advisory expenses recorded in the ancillary services and corporate segment related to the strategic alternatives review and FNF merger transaction. During the third quarter 2017, we also incurred $1.4 million of acquisition integration costs in the title segment. Excluding these non-operating charges, other operating expenses as a percentage of operating revenues during the third quarter and first nine months of 2018 were 16.8% and 17.4%, respectively, compared to 17.5% and 17.9% for the third quarter and first nine months of 2017, respectively.
Costs that follow, to varying degrees, changes in transaction volumes and revenues decreased $1.7 million, or 4%, and $6.5 million, or 6%, in the third quarter and first nine months of 2018, compared to the same periods in 2017, primarily due to reduced outside title search fees, attorney fee splits and costs of services related to lower revenues from our centralized title, ancillary services and Canada title operations. Costs that fluctuate independently of revenues decreased $0.6 million, or 5%, in the third quarter 2018 compared to the prior year quarter; while they increased $1.7 million, or 6%, in the first nine months of 2018, compared to the same period in 2017, primarily due to increased travel and marketing expenses. Excluding the non-operating charges mentioned above, costs that are fixed in nature decreased $1.1 million, or 3%, and $1.9 million, or 2%, in the third quarter and first nine months of 2018, compared to the same periods in 2017, primarily due to reduced third-party outsourcing provider fees and professional fees.
Title losses. Provisions for title losses, as a percentage of title operating revenues, were 4.4% and 5.2% for the third quarters 2018 and 2017, respectively, and 4.3% and 5.1% for the first nine months of 2018 and 2017, respectively. Title losses decreased $3.9 million, or 15%, and $11.4 million, or 16%, in the third quarter and first nine months of 2018, respectively, compared to the similar periods in 2017, primarily because we reduced our loss provisioning rate in 2018 as a result of better claims experience. The title loss ratio in any given quarter can be significantly influenced by changes in new large claims incurred, escrow losses and adjustments to reserves for existing large claims. We expect our loss provisioning rate will range between 4.0% to 4.5% for the year 2018.
Cash claim payments increased $3.2 million, or 17%, in the third quarter 2018 compared to the third quarter 2017, primarily due to higher payments on existing non-large claims; while payments decreased $3.6 million, or 6%, in the first nine months of 2018 compared to the same period in 2017, primarily due to higher payments on large claims in 2017. We continue to manage and resolve large claims prudently and in keeping with our commitments to our policyholders.
26
The composition of title policy loss expense is as follows: