Three activist funds hold significant stake in Stewart Information Services. (NYSE:STC) In this article, I explain why activists are targeting this company, how much value activists think they can realize by changing the structure of the company, and what all this means for other shareholders or potential shareholders of the company.
What went wrong with Stewart?
Stewart is the No. 3 title insurance provider in the U.S. However, its profit margin persistently and significantly lags behind its competitors due to its bloated expenses. Activist Foundation Asset Management’s presentationshowed that while the company has only a meager 4.4% pre-tax operating margin, its main competitors First American Financial (NYSE:FAF), Fidelity National Financial (NYSE:FNF), and Old Republic International (NYSE:ORI) have operating margins of 11.5%, 9.2%, and 8.0%, respectively. Despite management’s promise to improve profitability, the earning results have not met investors’ expectation.
One major factor behind the company’s underperformance is the current management itself. Previously, the company had a dual class stock structure that essentially gave control of the company to the Morris family who held the class B shares because the class B shareholders can elect 4 out of 9 board members and the company bylaw dictated that any board action required 6 votes out of the 9 members. Without class B shareholder’s consent, any corporate action wouldn’t be able to gather the required 6 votes. To make matter worse, the CEO is also a member of the Morris family. Under the protection of the class B shares’ power, the CEO could underperform without being held responsible and surely they did.
Before the activists’ campaign, this 2013 shareholders’ annual meeting filingshowed a perfect example of bloated expenses: ” For many decades, the Company has maintained and utilized a collection of antique and replica carriages for business promotion and customer entertainment purposes.” The horses are owned by the Morris family but ” the Company was responsible for the labor, maintenance, housing and operating costs of these assets(carriages).” Well, I’ve seen shareholders pick up the bills for private jets but here we are talking about carriages and horses! This is probably one of the most outrageous examples I’ve ever read.
How much value could the company be worth?
Stewart’s title insurance business essentially sells a warranty that the title of a house is free of defects when lenders make a loan, including securitization. The title insurer takes a one-time fee calculated based on the transaction price and guarantees lenders’ lien priority. If for any reason lenders’ lien positions were compromised, the insurer will have to pay for the lenders’ losses. The American Land Title Association has a very comprehensive collection of data about this industry and this excel file from its website showed market share information dated all the way back to 1989. According to their data, the whole industry’s revenue grew consistently from 3.5 billion in 1989 to 13.2 billion in 2015. Market share of the big 4 — Fidelity, First American, Stewart, and Old Republic — was over 96% in 1989 and gradually declined to 87% as of 2015. But the decline was mainly at the expense of the largest player Fidelity. First American, Stewart, and Old Republic all significantly expanded their share over this period. Stewart, specifically, grew its market share from 7.3% in 1989 to 14.8% in 2015.
These data make it clear why Stewart is valuable. First of all, the industry is growing because of the housing market. America’s population is still growing at a very healthy rate which translates into mores houses and higher housing prices, a trend in turn means higher title insurance volume and higher title insurance premium. Moreover, Stewart is the last stand-alone title insurance franchise and is based in Texas, a state which is among the fastest growing states. Second, the industry dynamics looks very stable and it doesn’t seem that any disrupting force is coming anytime soon. For any spirited disrupters, chances are they haven’t even heard of title insurance.
So this is why Stewart is very appealing for either companies that want to enter this market or rival companies that want to expand its market share. IfStewart is in the hands of better management, this would be a terrific company. The easiest way for improvement, proposed by one of the activists Foundation Asset Management in their presentation to the board, is an outright sell to its rival companies or a private equity firm. Foundation Asset Management estimates that Fidelity or First American can improve the company’s margin to north of 10% and pay a fair price of $60/share forStewart. In the other scenario that the company is acquired by Old Republic or a PE firm, the margin would be a bit lower and the acquirer should be comfortable buying Stewart’s shares at $55/share. I feel their margin assumptions under various scenarios are very achievable because again if there was cost associated with horses there is probably a lot of low-hanging fruit in cost improvement.
And just for analysis’ sake, let’s back off and think about the unlikely but possible scenario in which no company is willing to take Stewart. If activists can simply replace the management and achieve an 8% pre-tax margin, a margin that is the lowest generated among its peers, as a stand-alone company Stewart would have a net income of 112 million dollars, based onStewart’s TTM revenue of around 2 billion and a 35% tax rate. As of Sep 02,2016, the company has a market cap of 1.1 billion so a 112 million net income would put the P/E ratio at right around 10 times. Old Republic, the company with an 8% pre-tax margin and the lowest P/E among Stewart’s 3 competitors, has currently a P/E ratio of 12.6. But as Foundation pointed out earlier in their presentation, compared to Old Republic, Stewart actually has a better revenue mix between its direct and agency channels (agency charges commission and hence generates lower margin for the company) so it’s quite possible for Stewart to achieve a pre-tax margin above 8%.
History of activists’ campaign against the Morris family
If the chance of improving the company’s results is relatively high as we discussed, the key question is whether activists can gain control of the company and effect a change. I will briefly list key events happened so far from the fights between activists and the Morris family. (All information related to Foundation’s involvement mentioned below is referenced from their recentletter to the board dated July 28th,2016. )
- Foundation invested in Stewart in 2013 and started conversation with management
- In Feb,2014, Foundation reached a stand-still agreement with the Company and elected two board members
- In 2015,another activist Bulldog Investors joined the fight and attempted to nominate 5 directors. The fund later on settled with management and elected one director to the board.
- In 2015’s annual meeting,shareholders overwhelmingly approved the proposal that will dismantle the dual class structure
- In 2016’s annual meeting, shareholders approved i)the elimination of dual class structure ii) ability to call a special meeting if the meeting proposal has more than 25% votes iii) the elimination of requirement that any corporate action needs 6 out of 9 votes iv) the elimination of fixed 9-member board size
- On July 28,2016, Foundation wrote a letter to the board and announced intention to call for a special meeting that will replace board members Malcom Morris and Stewart Morris with its own nominees. The meeting date has not yet been set but it will be sometime this year
- On Aug 12,2016, Starboard announced its initial 9.9% ownership of Stewart in a 13D filing.
What does this all mean for other common shareholders?
From the above brief history, it’s clear to see that things are gradually falling into pieces and activists are very close to claiming the ultimate victory. And that is a good thing for every other shareholder. Let me explain.
According to the latest filings, Foundation owns 5.6% of total Stewart shares and Bulldog Investors owns another 4.85% on top of Starboard’s 9.9%. So the 3 activists altogether own around 20.5% of the total stock. They just need a mere 4.5% percent vote from other shareholders to call the special meeting. The voting results in 2015 and 2016 showed that proposals related to corporate governance improvement mentioned above gathered over 95% of votes. The past voting results firmly indicate that common shareholders like the activists’ ideas and no one is on the management’s side. Therefore, the occurrence of shareholders’ special meeting and the replacement of the Morris members are very high probability events.
Then what happens? Once the board members shuffle, we will have 7 common shareholders elected directors on the 9-member board. What’s even more important is that 4 directors are nominated by Foundation and 1 director by Bulldog. Since any decision of the board now only requires a simple majority, with at least 5 members on their side, the activists can easily push for a sale of the company. Also these 2 nominees might be very instrumental in the eventual sale of the company down the road: one nominee Earnest Smith held various positions including Co-Chief Operating Officer of Fidelity National,Stewart’s biggest competitor and the other nominee Roslyn Payne served on the board of First American, Stewart’s second biggest competitor. We can easily see where this is going if the two nominees are elected.
And this is just Foundation’s plan for Stewart. We do not know at this point if Starboard has any plan of its own for the company. But even if the prominent Starboard simply tag along and vote with the other activists, we will very likely see some favorable voting results for all shareholders out of the special meeting in the near future.
This is an uncommon situation in which average investors can buy a stock at a level close to a famous activist’s entry point (the 13D showed that Starboard’s entry price is around $43.3/share, about 7.4% less than current price). The underlying business is very stable and desirable. The activists have a very high chance of succeeding and a sale of the company could happen as early as sometime next year. The lowest estimated sale price $55/share would generate a return of around 20% within a relatively short holding period. This is not a stock that will produce a ten bagger but the risk/reward is still quite favorable.
Disclosure: I am long STC.