Stewart Information Services: A few degrees removed
If you think back to the glory days of investing (circa 1999), you'll remember how investors morphed their philosophy to fit their dreams of infinite Internet riches.
If your memory fails, here's a refresher: In the early stages of Internet mania, retail merchants like Yahoo! Inc. (Nasdaq: YHOO) and Amazon.com, Inc. (Nasdaq: AMZN) took to orbit. When they free-fell back to earth, backbone providers like Cisco Systems, Inc. (Nasdaq: CSCO) and JDS Uniphase Corporation (Nasdaq: JDSU) were launched. When they fizzed, energy companies (which were painted as “Internet” plays, because—as the logic of the day went—they powered the whole system) where ignited.
In short, investors stepped back from each successive layer of Internet exposure as the risks of each layer became obviously apparent.
Circuitous as the logic appeared, it was grounded (somewhat) in rationality. Risk-adverse investors want to avoid risk when confronted with it. The risk usually manifests first in front-line companies.
In today's market, investors are stepping back from the front-lines of housing. Indeed, price movement suggests investors are more willing to invest in the sector through home improvement centers like Home Depot, Inc. (NYSE: HD) and Lowe's Companies, Inc. (NYSE: LOW) than through homebuilders like Lennar Corporation (NYSE: LEN) and Hovnanian Enterprises, Inc. (NYSE: HOV).
Investors with even less risk tolerance, but still desiring housing exposure, are stepping back further to the less-roiled environs of title insurance providers—the folks who ascertain the property's ownership and indebtedness status.
One company on these back lines that has maintained a semblance of balance is Stewart Information Services Corporation (NYSE: STC), one of the nation's largest title insurance groups, with a national market share of 11.8%. Over the past year, its share price has fluttered between $34 and $44 a share (currently fluttering around $36), which compares favorably to the homebuilders, many of whom have seen their share prices plummet by 50% to 70%.
Stewart distributes its back-line real estate services through more than 9,500 locations spread through all 50 states and a few foreign countries. Nearly half of Stewart's premiums originate from its four largest markets: Texas, California, New York and Florida.
And that's been a problem of late. Business has been tough, thanks in no small part to the recalcitrant residential real estate markets in California and Florida. For proof, second-quarter 2007 earnings plunged 36% to $10.1 million, or $0.55 per share, from $15.7 million, or $0.86 per share, in the prior year quarter. Revenue, meanwhile, declined 11% to $573.4 million from $644.7 million in the second quarter of 2006.
The situation is unlikely to improve in 2007, at least according to analysts. The most contemporary estimates come courtesy of Keefe, Bruyette & Woods analyst Nathaniel Otis, whose full-year 2007 EPS estimate is $1.53 on revenue of $2.27 billion, compared to 2006 EPS of $2.36 on revenue of $2.47 billion. Both sets appear abysmal compared to 2005 EPS of $4.86 on revenue of $2.43 billion. Otis currently has a “market perform” on Stewart.
Improvement before 2007 appears unlikely. Demand for title insurance and real estate information services depends in large part on the volume of residential and commercial real estate transactions, which historically have been influenced by mortgage interest rates and the overall state of the economy. Typically, when interest rates are increasing or when the economy is slowing, real estate activity declines. As a result, the title insurance industry tends to experience decreased revenues and earnings. What's more, rising interest rates also adversely impact bond portfolios and interest on bank debt.
Fortunately, Stewart has the financial wherewithal to weather a prolonged housing slump. Fitch Ratings has affirmed the company's “A+” rating because of “strong balance sheet fundamentals, including a solid risk-adjusted and absolute capital position, conservative reserving practices, minimal debt leverage, high quality and very liquid investment portfolio, and moderate operating leverage.”
Stewart's conservative capital structure, along with ample its cash reserves, has enabled it to authorize a stock repurchase plan of up to 1.5% of its 18.3 million shares and to continue to fund a $0.75 per share annual dividend, which produces a 2.1% yield at current prices.
The capital structure and cash account have also enabled Stewart to implement a shared-services initiative that management believes will produce efficiencies to enhance services related to real estate transactions through electronic delivery. These services include title reports, flood determinations, property appraisals, mortgage documents and credit reports. Stewart expects to realize a meaningful, income-statement-changing return on its investment within the next 18 months.
In the meantime, investors will need to be patient. Housing will recover, to be sure, and so will Stewart. The question is, when? Bad news in the sector is disseminated as frequently as Britney Spears digressions. But that's okay; back-line guards like Stewart don't have the pressure of the front-line grunts, which means potential Stewart investors need not time their purchase so presciently.
