Stewart Information Services Corp Q1 FY2023 Earnings Call

Thank you for joining us today for Stewart's First Quarter 2023 Earnings Conference Call. We will be discussing results that were released yesterday after the close. Joining me today are CEO, Fred Eppinger; and CFO, David Hisey. To listen online, please go to the stewart.com website to access the link for this conference call. This conference call may contain forward-looking statements that involve a number of risks and uncertainties. Please refer to the company's press release and other filings with the SEC for a discussion of the risks and uncertainties that could cause our actual results to differ materially. During our call, we will discuss some non-GAAP measures. For a reconciliation of these non-GAAP measures, please refer to the appendix in today's earnings release, which is available on our website at stewart.com. Let me now turn the call over to Fred.

Thank you for joining us today for Stewart's First Quarter 2023 Earnings Conference Call. David will review the quarterly financial results in a minute, but before that, I would like to cover our overall view of Stewart and the current market. Our efforts at Stewart over the last three years have focused on fundamentally improving the company's operating performance to better position ourselves on our journey to becoming the premier title services company. The long-term goal remains to create a strong business that can thrive through all real estate cycles and economic conditions. We will focus on improving margins, growth, and resiliency by improving our scale in attractive markets and enhancing our operational capabilities. In challenging markets like we are currently in, it is often difficult to advance long-term goals. However, I am pleased with our progress towards improving our long-term performance as we balance investments with the need to manage expenses carefully. As we discussed before, we anticipated the first quarter to be our most challenging. To prepare for this, we took significant actions to manage costs during the second half of '22 and again in the first quarter of '23. We have been careful not to take actions that we felt would threaten our competitive position and long-term value-creating opportunities. We believe this is a historic cycle lull. And the right answer to get us through this period is to continue to invest in our people and remain focused on our long-term improvement plan and manage through a couple of challenging quarters, which is what we are doing. Earlier in the first quarter, interest rates ticked down very significantly, which resulted in an increase in open orders. However, order volumes slowed again and rates quickly reversed again in February, peaking in mid-March. These challenging market dynamics, along with the impact of seasonality led us to our lowest quarter of closed order lines in over 20 years and resulted in an overall loss for the quarter. As we moved into the second quarter, interest rates moderated slightly but remained elevated. We expect this difficult environment will moderately improve in the second quarter, but the challenging environment will continue into the second half of '23. And we will continue to manage our business with a careful balance of cost discipline and investments in skills and capabilities that we expect will best position us for the long term. Although interest rates have declined in the early second quarter, interest rates, home inventory, and housing affordability will be challenging to any quick return to a normal real estate market. We remain focused on our long-term strategies, enhancing our operating model, investments in technology and customer experience, and improved efficiency of our operations and building scale in targeted areas. While we took additional expense actions this quarter, we recognize that these strategic investments will cause our cost ratios to remain elevated in this market. We believe that the long-term investments, coupled with a thoughtful near-term expense management will improve our structure and financial performance in the long term. In our direct operations, we are making progress on our strategy of scale in attractive markets. Even during this challenging market, we have continued to evaluate a select number of opportunities to increase our scale and footprint. Given the market uncertainty, we will make very thoughtful decisions around the deployment of capital. Positioning our commercial operations for growth across all our business lines has been a key focus in our journey as these operations are an important component of our overall strategy. We made investments in talent during the past year to aid in achieving these objectives, and we believe our focus will create long-term growth in the commercial markets, although we recognize changing financial markets may create headwinds in the short term. In our agency business, we have made excellent progress on our deployment of technology and services that provide greater connectivity, ease of use, and risk reduction for our agent partners. As we move through '23, our platform of services for agents is as strong as it's ever been, and we have begun to see meaningful share growth in our target markets. On the topic of technology, we continue to invest significantly in improving our technology for title production, process automation, and centralization to improve operational efficiencies and capabilities. We've already made significant progress improving customer experience across all channels and rolling out our agency technology platform, which significantly enhances ease of use and connectivity with agents. Additionally, we have made significant integrations of completed acquisitions into our production of other systems, which improves our customer experience as well as the overall operating efficiencies that we've been building on for the past several years. The remaining integrations will be an important focus for the remainder of '23. Maintaining our current strong financial position while investing opportunistically during this market remains a top priority. Financially, our long-term goals remain to generate high single and low double-digit margins over the cycle. However, there will be quarters like the first quarter and the fourth quarter '22 where margins will be challenged. We remain focused on our strategic plan of building an improved competitive position and being more efficient in having a disciplined operating model that functions well through all real estate cycles. We have emphasized growing scale in attractive markets across our business, and we have made significant progress in improving the customer experience in all channels. While we are encouraged by our improvements in all four of our critical fronts: talent, technology, customer experience, and our financial model, we recognize that work remains and our journey is not complete. However, we have seen the results of our efforts to increase year-over-year market share gains in each of our direct agency and commercial businesses. Let me finish by reiterating that we will both manage our expenses and investments with a practical balance between an operating discipline to the current short-term market challenges and a strengthening story for the long-term growth performance. The strong financial footing should best position us to take advantage of the opportunities that this cycle will provide. I'd also like to restate my long-term view on the real estate market and the ability to become the premier title services company. A tremendous thank you to our associates for all their hard work and to our customers for their continued loyalty and support. David will now update everyone on our results.

Good morning, everyone, and thank you, Fred. First, I would also like to thank our associates for their amazing service and our customers for their support. As Fred noted, the first quarter saw a continuation of a difficult real estate market and poor consumer sentiment. Low residential inventory, high mortgage rates, lower commercial real estate activity, and tough economic conditions all contributed to this situation. Yesterday, Stewart reported a net loss of $8 million or $0.30 per diluted share on total revenues of $524 million. After adjusting for net realized and unrealized gains and losses, the adjusted first quarter loss was $7 million or $0.25 per diluted share compared to a net income of $56 million in the first quarter of 2022. The low results for the first quarter were primarily driven by significantly lower revenues caused by volume driven by lower home sales and refinances. Total title revenues in the first quarter decreased by $265 million or 37%, resulting in the Title segment's pretax loss of approximately $1 million from pretax income of $83 million during the prior year quarter. After adjustments for purchase intangible amortization and other items listed in Appendix A of our press release, the segment's pretax income was $4 million or 1% margin compared to $81 million or 11% margin in 2022. In our direct title business, domestic commercial revenues decreased by $24 million or 42%, primarily due to lower transaction volume and size. Average commercial fee per file was approximately $8,300 for the first quarter compared to $12,700 for the prior year quarter. Domestic residential revenues were down $70 million or 32% as a result of significantly lower purchase and refinancing transactions. However, residential fee per file was approximately $3,400, which was 30% higher from last year due to a higher purchase mix. Total international revenues decreased by $16 million or 40%, primarily due to lower transaction volumes in our Canadian operations. Total open and closed orders declined by 37% and 45%, respectively, in the first quarter compared to last year. In line with our direct title revenues, first quarter revenues from our agency operations decreased by $155 million or 38% compared to last year. The average agency rate decreased to 17.4% compared to 18.1%, primarily as a result of geographic mix. In regard to title losses, total title loss expense in the first quarter decreased by $12 million or 40%, primarily driven by lower title revenues. As a percentage of total revenues, the title loss expense was 3.9% compared to 4% last year. For the full year 2023, we expect title losses to average from 4% to 4.2% of title revenues. For the real estate solutions segment, pretax income decreased to $1.4 million for the first quarter from $7 million last year, primarily as a result of 30% lower revenues driven by lower transaction volume. First quarter pretax margin was 2.2% compared to 7.6% last year after adjusting for purchase intangible amortization; the adjusted pretax margin was 11.5% compared to 14.8% last year. The segment's total operating expenses in the quarter decreased by 26%, primarily due to lower costs related to revenues and lower incentive compensation. Consolidated employee costs as a percentage of operating revenues increased to 33% compared to 24% in last year's quarter, primarily due to lower operating revenues in '23. Other operating expenses as a percent of operating revenues were 23%, which was comparable to last year. On other matters, our financial position remains strong to support our customers and employees in the real estate market. At March 31, 2023, our total cash and investments were approximately $340 million over statutory premium requirements, and we also have a fully available $200 million line of credit facility. Total stockholders' equity attributable to Stewart at the end of the quarter was approximately $1.35 billion, and our book value per share was approximately $50. Lastly, cash used in operations was $51 million compared with net cash provided by operations of $35 million last year, primarily driven by the first quarter's net loss. We are always grateful for our customers and associates. We advocate for safety and prosperity and remain confident in our support in real estate markets. I'll now turn the call back over to the operator for questions.

I wanted to ask about the margin, and it might be a tough question. Given the challenging backdrop in both residential and commercial sectors, and assuming that continues for much of this year, what should we expect regarding the margins the business can generate?

Yes, I remain confident that over the next six to eight quarters, we will average in the high single to double digits. The key question is how this evolves this year. We all believe there will be significant improvement in the second half of the year. Currently, I anticipate a more moderate improvement in the second quarter compared to what we expected six weeks ago due to the volumes. Notably, our closed orders dropped by 50% in January, 28% in February, and 40% in March. However, I believe we are better positioned to manage this, and our margins should improve significantly throughout the year. While the second quarter may not see the level of improvement we anticipated earlier, last year's tough fourth quarter ended at 8%, and I think we’ll be slightly below that this year, with hopes for better performance in the latter half. We have considerable leverage because our system has capacity, meaning we won’t need to add many resources as volume increases. Our portfolio is stronger, and based on historical data, our order count suggests we are at a low point now, setting us up for improvements as the year progresses.

Okay. That's great. That's very helpful. And then just on the real estate solutions segment, what's a good way to think about the run rate there? Like how much of that is transaction-dependent versus not?

Yes. This is Dave. It's pretty transaction-dependent. If you think about the mix of businesses, we've got the PropStream business, which is a subscription business, so that's not as transaction-dependent on when people come in and out of that business depending on what's happening in the market. So that's less transaction-dependent. But the other businesses, appraisal, credit, those are transaction-dependent. And so that was what you really saw in this quarter in some of those businesses. Transactions hit pretty hard. We have had some pretty good success in the credit business differentially in the market. I think in general, that business is doing well relative to the market. We're participating in the appraisal program, one of the tenders that were selected for that. So those are the kinds of things that will really help that business sort of be durable and better than some as the market improves. That's the way to maybe think about the puts and takes. So I'd say a good amount, over half is transaction-dependent, and then you've got some stuff that's less transaction-dependent.

Okay, that's helpful. And then just the increase in that segment over last quarter, was that just sort of some of the acquisitions kicking in?

Well, we did have the small account check acquisition in the first quarter. We had a nominal benefit from that. But we also had some customer wins, and so I think it was a combination of those.

Yes. We had some good momentum in a couple of those businesses around products that actually help lenders save money in the mortgage process. And so we're actually getting a little bit of growth happening in a couple of those businesses right now.

Going back to the question, and this is for Fred or maybe David here, but can you talk about the levers to control in the model or you don't think you need to add much additional expense as the revenue builds? Just trying to get a better grip on those incrementals. It would be helpful if you guys maybe provide the all-in fixed cost level as it stands right now, or if you're not able to provide that, maybe just talk broadly to the mix of fixed versus variable costs now and maybe how you expect that to shift from here.

Well, obviously, we have strict fixed costs, right, during the 20% or 30% variation.

Yes, sort of 20% to 30% fixed, then you've got sort of the 40% to 50% variable and then the 30% or 40% of true variable. The challenge is always managing the variable.

Exactly. So what I would say, John, is the personnel lines, like if you're at the 50% point, you can't cut 50% of your resources, personnel, right? And so you're going to be really careful about how you're managing the resources and protect the capabilities of the institution. So what I would say is that we've been very thoughtful and we've done a lot of actions. But the way I think about it is we have excess capacity in that semi-variable component that we've retained to take advantage of the market as it comes back. And so therefore, what you see is in this business, right? And the way up, your margin is higher, right, because you're managing kind of that semi-variable, to Dave's point, in a fixed way and that will increase. And then at some point, you hit in over time, if we hit in '21 if you don't have resources, it really gets exaggerated as far as your margin. So again, the way I look at it is that we're bouncing off the bottom here, we've done a very good job, and I really applaud our team on being across the board, and we've thought about expenses in every dimension. As I look forward, that incremental revenue helps us tremendously on margin. I just think it's going to be a tad slower than we thought before.

Makes sense. That's really good color. I appreciate that. And then on commercial, obviously, a lot of uncertainty out there. I think investor attention is really shifting towards commercial, obviously. If you guys can maybe talk to the order pipeline, what you guys are seeing? I saw March, the open orders are down 40%. Kind of what you're seeing if you've got any insight into April? And then if you could just talk broadly to the mix and the fee for file, maybe what you're expecting around fee per file, there's going to be continued pressure there as you close out in 2Q.

Yes, John. What you're observing in our data aligns with the overall market trends. The office sector is facing challenges, though some areas are faring better than others. Major metrics are struggling more, largely due to the prevalence of remote work. We've not seen a resurgence of larger transactions in cities like New York, which reflects in the longer fee per file. In smaller markets, the situation for office spaces isn't as dire, but we still need to watch the impact of regional banks, as they have been significant lenders to that sector. We noticed a high volume of energy deals towards the end of the year, and I believe there's still considerable activity in that domain, which we expect to see mature and close in the upcoming year.

I believe our situation is different from the residential market. We are expecting a slight decline, but we were lucky to gain market share in commercial last year and have made significant progress. Our energy practice is as active as ever, though it's somewhat unpredictable due to the timing of closings. We have a substantial number of smaller deals in our centralized commercial portfolio. The uncertainty surrounding regional banks is causing some hesitation in the market. We anticipate that this downturn will remain significant for a while, but we expect to see improved results in the latter half of the year. We are quite busy in certain segments, possibly more than ever, and I feel optimistic about our business by year-end. However, the current situation with the banks adds a layer of uncertainty.

But you also, John, have to think about it in the dimensions. It's not only sector-specific but it's type of activity. So new developments, sales and then refinances, right? And you do have that $1.5 trillion maturity ladder mainly this year and next year. That's going to provide some support to commercial. And then it's just a question of what happens with that. You have a lot of restructure. You have some defaults. As it looks like now with all the REITs and everybody reporting, even though people might be increasing reserves, a lot of those loans are still performing, right, which could be positive because it might mean you could actually refinance those and avoid defaults.

Yes, that's helpful. That's great insight. I appreciate that, guys. Last one for me, just a housekeeping question. But David, on the other orders, I know M&A is sort of influencing that, but you've had a pretty big step-up there. If you could maybe talk to the seasonality of those other orders as well as what that kind of average fee per file is.

Others primarily are on a reverse basis through FMC. And yes, I mean, that's going to approximate more, not exactly because the transactions are a little bit smaller, but it's going to be closer to a purchase transaction than a refinance transaction.

We will take our next question from Geoffrey Dunn with Dowling & Partners.

I'm not sure if I'm phrasing this correctly, but given the significant downturn in the commercial market, particularly with developments in office space, do you have any concerns about a potential long-term shift? I ask this because you mentioned investing in commercial talent. Is your commercial talent focused on specific sectors? For instance, if you invested in specialized office talent, is that still a wise investment if office space doesn't rebound? Should we be worried about that, or is your commercial talent more adaptable across the various sectors you've referenced?

It's a good question because it highlights the flexibility we have. Our focus is very geographical. Historically, we were heavily concentrated in New York on the commercial side, lacking geographical breadth. This has allowed us to diversify away from office-oriented developments. I'm quite confident about that. We have made some energy-focused acquisitions, leveraging one of our underwriting strengths, especially given the opportunities arising from current market conditions. Our strategy has been geographically driven, targeting areas like industrial, warehouse, and data centers, which align with emerging trends. I believe we are well positioned. Since the pandemic, expectations have shifted, and the differentiation between primary and secondary cities has been anticipated, particularly in our staffing approach. We've maintained a strong underwriting reputation, and three years ago, due to our uncertain status and limited capital, we were less relevant in the market. Now, we are a key player. The critical question is whether we have the right capabilities in the right markets to drive our business forward. Additionally, this applies to direct offices in the lower end of the commercial sector, where we previously lacked the dedicated personnel that we plan to add, as this segment is set to remain robust, particularly in our secondary cities. Overall, I feel we've approached these changes thoughtfully and I'm not overly concerned about office space dynamics. Retail, on the other hand, has held up more than expected, and we were proactive in anticipating how that would impact our resource allocation.

Right. And then you've mentioned a few times balancing expense management with longer-term investments. But how long can you sustain that balance? You could paint a scenario that maybe mortgage rates start loosening up, but if the consumer starts running into economic pressure, the estimates for originations this year, next year could still prove optimistic, and it looks like the spring selling season starting off soft. At what point do you have to start cutting muscle? Or do you just kind of bear down and endure it?

Yes, I believe we are well positioned to succeed. It's a relevant question. I have identified approximately $18 million to $20 million for discretionary investments in long-term projects this year, which amounts to about $4 million per quarter. This means I could have made a little profit this quarter. Regarding our data management efforts, we are focusing on centralization and balancing where we perform our search work and the associated costs. I anticipate that these initiatives could yield a couple of hundred basis points of margin improvement over the next 18 to 24 months. While some of these efforts could be viewed as catching up with our competitors, I believe we are making the right moves. In fact, we are taking a more active approach than our competitors. However, I don't see many strong alternatives available. As commercial conditions weaken, we could implement targeted actions, but I feel we've already taken appropriate steps. The market might continuously decline by 50%, but the entire industry will face this challenge. We're somewhat insulated due to our seasonal factors, and I believe our expense management has been effective. I feel optimistic about achieving higher margins for the rest of the year. Additionally, I previously mentioned that we have not maximized our interest income from escrow accounts. When we began this process, bank interest rates were very low, and we are now working to form partnerships with banks to generate interest returns on our escrow funds, which could significantly improve our margin given our current volume. I expect we can achieve this by year-end, which could have a substantial positive impact. Regarding our portfolio, our data business has been growing steadily, even at lower volumes. We are taking offensive actions that should enhance our margins if the market remains weak, and I believe we can improve margins across various scenarios. While we are diligently working on these strategies, I am confident in the discretionary investments we have made. Although it may take time for these improvements to show, I am optimistic about increasing volumes in the near future, which will bring more clarity to our efforts.

I want to thank everybody for joining us for this quarter's call. Thank you so much for your attention.

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