HG HOLDINGS, INC. – 10-K – Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the Consolidated
Financial Statements and the Notes thereto and Selected Financial Data included
elsewhere in this Annual Report.
Principles of Consolidation
The consolidated financial statements have been prepared in accordance with GAAP
and reflect the consolidated operations of the Company. The consolidated
financial statements include the accounts of
controlled subsidiaries. All significant intercompany transactions and balances
have been eliminated. Equity investments in which the Company exercises
significant influence but does not control and is not the primary beneficiary,
are accounted for using the equity method of accounting. Equity investments in
which the Company does not exercise significant influence over the investee and
without readily determinable fair values, or non-marketable equity securities,
are accounted for at cost, less impairment, and are adjusted up or down for any
observable price changes.
Overview
For a description of our business, including descriptions of segments, see the
discussion under Business in Item 1 of Part I of this Annual Report, which is
incorporated by reference into this Item 7 of Part II of this Annual Report.
COVID-19 Pandemic
Despite the widespread availability of vaccines, COVID-19 (including its variant
strains) continues to impact
The COVID-19 pandemic has negatively impacted worldwide economic activity and
created significant volatility and disruptions of financial markets. In
response, the
significant measures to provide fiscal and monetary stimulus. Such actions have
included an unscheduled cut to the federal funds rate, the introduction of new
programs to preserve market liquidity, extended unemployment and sick leave
benefits, mortgage loan forbearance actions, low-interest loans for working
capital access and payroll assistance, and other relief measures for both
workers and businesses. Many such actions have lapsed or otherwise been reduced
as time has passed since the onset of the pandemic. The Company and its
subsidiaries have remained fully operational throughout the pandemic and did not
have any reductions in workforce during 2021.
The COVID-19 pandemic has caused the Company to modify its business practices
(including employee travel, employee work locations and cancellation of physical
participation in meetings, events and conferences). The COVID-19 pandemic and
any of its variants could continue to affect the Company in a number of ways
including, but not limited to, the impact of employees becoming ill,
quarantined, or otherwise unable to work or travel due to illness or
governmental restriction, potential decreases in net premiums written in the
future, and future fluctuations in the Company's investment portfolio due to the
pandemic and the economic disruption it is causing. Because of the inherent
uncertainty regarding the duration and severity of the COVID-19 pandemic
(including any of its variants) and its effects on the economy, as well as
uncertainty regarding the effects of government measures already taken, and
which may be taken or continued in the future, to combat the spread of the virus
and any of its variants, and/or provide additional economic stimulus, the
Company is currently unable to predict the ultimate impact of the pandemic.
17 --------------------------------------------------------------------------------
Title
Our title insurance segment revenue is closely related to the level of real
estate activity that includes sales, mortgage financing and mortgage
refinancing. Declines in the level of real estate activity or the average price
of real estate sales will adversely affect our title insurance revenues.
We believe that real estate activity is generally dependent on mortgage interest
rates, access and availability to mortgage debt, residential housing inventory,
home prices, commercial property supply and demand, and the general economic
conditions in the
As of the
Association
increase through 2023 before leveling out in 2024. Additionally, the MBA expects
residential refinance transactions to steadily decrease in 2022 and 2023 before
leveling out in 2024 as interest rates are expected to rise. The MBA expects
overall mortgage originations to decrease in 2022 and thereafter as compared to
2021 levels.
The industry as a whole saw growth in total real estate transactions in 2021,
largely due to a strong residential real estate market driven by increasing home
prices and low mortgage interest rates. Mortgage rates remained historically low
after emergency actions taken by the Federal reserve to reduce its benchmark
interest rate in first quarter 2020. Despite the lingering impact of COVID-19 in
2021, purchase and refinance activity grew due to migration of out of dense
urban areas into less populated geographies as well near historically low
interest rates. Per MBA's Mortgage Finance Forecast, interest rates on a Freddie
Mac 30-year, fixed rate mortgage averaged 3.1% in 2021.
See Item 1A of Part I of this Annual Report for further discussion of risk
factors related to COVID-19.
Historically, real estate transactions have produced seasonal revenue
fluctuations in the real estate industry. The first calendar quarter is
typically the weakest quarter in terms of revenue due to the generally low
volume of home sales during January and February. The second and third calendar
quarters are typically the strongest quarters in terms of revenue, primarily due
to a higher volume of residential transactions in the spring and summer months.
Real Estate Related
The Company acquired an equity interest in
and operates a portfolio of 27 single-tenant properties leased entirely to
United States of America
Bureau of Investigation
Enforcement Administration
Security Administration
we purchased 300,000 shares of HC Common Stock for an aggregate purchase price
of
price of
into subscription agreements with
100,000, 250,000, and 475,000 shares of Series B Stock, respectively, for an
aggregate purchase price of
currently own approximately 33.9% of the as-converted equity interest of
Realty
On
into a loan agreement (the "Loan Agreement") with
partnership, and
which the Lenders provided
Loan, of which
pursuant to the terms of the Loan Agreement,
repaid the loan in full, including all accrued interest and make whole interest.
For the year ended
comprised of 23
it owns subject to a ground lease and three
of the rights to the profits, losses, any distributed cash flow and all of the
other benefits and burdens of ownership including for federal income tax
purposes, each of which is leased to
properties contain approximately 508,092 rentable square feet located in 18
states. As of
United States of America
agencies. Based on net operating income of each property, the portfolio has a
weighted average remaining lease term of 8.8 years if none of the early
termination rights are exercised and 4.9 years if all of the early termination
right are exercised.
18
--------------------------------------------------------------------------------
Results of Operations 2021 Compared to 2020
As of
insurance subsidiaries, dividends on HC Realty Series B Stock, and interest paid
on our cash deposits. The Company believes that the revenue generating from
these sources, dividends paid on HC Realty Common Stock, and cash on hand is
sufficient to fund operating expenses for at least 12 months from the date of
these consolidated financial statements.
The Company generated interest income of
2021
decrease was primarily a result of decreased interest income from the Second
Amended and Restated Subordinated Secured Promissory Note (the "Second A&R
Note") pursuant to the
Agreement") with Buyer and payoff of that note in
income from the HC Realty Loan Agreement as a result of the payoff of that note
in
quarter 2020, recognizing interest payments on the S&L Note as principal
payments, and lower interest rates on our cash deposits. The Company generated
dividend income of
to
segment. The increase resulted primarily from the receipt of a full year of
dividends from the
additional HC Realty Series B Stock.
As a result of the Company's acquisition of the title insurance operations, the
Company generated title premium and other title fee revenue of
management fees of
consists primarily of a provision for title claim losses and underwriting
expenses, which is primarily commissions to title agencies. The title insurance
operating expenses consist primarily of personnel expenses, office and
technology expenses and professional fees. Operating expenses for the period
subsequent to the Company's acquisition of NCTIC on
acquisition of TAV on
Corporate general and administrative expenses are not directly allocable to
either of our reporting segments and consist primarily of wages and personnel
costs, legal and professional fees, insurance expense, and stock based
compensation. Corporate general and administrative expenses of
the year ended
compared to the year ended
administrative expenses incurred in the year ended
approximately
costs related to the acquisitions of the title insurance business.
Our effective tax rate for the year ended
(3.8)% resulting from a tax benefit from unrecognized tax benefits position
under FASB Interpretation No. 48 ("FIN 48"). Our 2020 effective tax rate was
0.0% due to our net operating loss carryforwards.
Financial Condition, Liquidity and Capital Resources
Sources of liquidity include cash on hand, cash interest earned on our cash on
hand and the S&L Note, earnings from our title insurance subsidiaries, and
dividends from our
to be adequate for ongoing operational expenditures for at least 12 months from
the date of these consolidated financial statements. At
had
which
company records an offsetting escrow liability given that we are liable for the
disposition of these escrowed funds. A portion of our unrestricted and
restricted cash is currently held in savings accounts earning approximately
0.05% annually. We also received quarterly dividends on our
Series B Stock at annual rates of 5.5% and 10%.
Cash flows provided by operating activities differ from net income due to
adjustments for non-cash items, such as gains and losses on investments and
affiliates, impairment losses on note receivables, the timing of disbursements
for taxes, claims and other accrued liabilities, and collections or changes in
receivables and other assets. Net cash used in operations for the year ended
stock of
income tax refund of
escrow liabilities on the title insurance subsidiaries, personnel costs of
million
Cash provided by investing activities of
acquisition of our title insurance subsidiaries offset by cash acquired of
million
was restricted cash held in escrow for title insurance transactions, and the
cash principal payments received on the S&L Note of approximately
19 --------------------------------------------------------------------------------
Recent Accounting Pronouncements
In
(Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU
2016-13"). The amendments in ASU 2016-13 require the measurement of all expected
credit losses for financial assets held at the reporting date based on
historical experience, current conditions, and reasonable and supportable
forecasts. In addition, ASU 2016-13 amends the accounting for credit losses on
available-for-sale debt securities and purchased financial assets with credit
deterioration. The amendment is effective for public entities for annual
reporting periods beginning after
permitted for reporting periods beginning after
Company has not opted to do so. The Company does not anticipate the adoption of
ASU 2016-13 to have a material impact to the consolidated financial statements.
Critical Accounting Policies
We have chosen accounting policies that are necessary to accurately and fairly
report our operational and financial position. Below are the critical accounting
policies that involve the most significant judgments and estimates used in the
preparation of our financial statements.
Equity Investments - Long-term investments consist of investments in equity
securities where our ownership is less than 50% and the Company has the ability
to exercise significant influence, but not control, over the investee. These
investments are classified in "Investment in affiliate" on the balance sheets.
Investments accounted for under the equity method of accounting are initially
recorded at cost and subsequently increases or decreases the investment by its
proportionate share of the net income or loss and other comprehensive income or
loss of the investee. For investments that do not have readily determinable fair
values, the Company made an accounting policy election for a measurement
alternative. Upon adoption of ASU 2016-01, the Company carries these investments
at cost minus impairment, if any, plus or minus any changes resulting from
observable price changes in orderly transactions for the identical or a similar
investment of the same issuer.
If the Company believes a decline in market value below cost is other than
temporary, a loss is charged to earnings, which establishes a new cost basis for
the security. The Company determination of whether an equity investment is other
than temporarily impaired incorporates both quantitative and qualitative
information. The Company considers a number of factors including, but not
limited to, the length of time and the extent to which the fair value has been
less than cost, the length of time expected for recovery, the financial
condition of the investee, the reason for decline in fair value, the ability and
intent to hold the investment to maturity, and other factors specific to the
individual investment.
Fair Value of Assets Acquired and Liabilities Assumed in Business Combinations -
FASB Accounting Standards Codification ("ASC") Topic 805, Business Combinations,
requires an acquirer to recognize, separately from goodwill, the identifiable
assets acquired, liabilities assumed, and any noncontrolling interest in the
acquiree, and to measure these items generally at their acquisition date fair
values.
exceeds the fair value of the net assets acquired. If the initial accounting for
a business combination is incomplete by the end of the reporting period in which
the combination occurs, we are required to report provisional amounts in the
financial statements for the items for which the accounting is incomplete.
Adjustments to provisional amounts initially recorded that are identified during
the measurement period are recognized in the reporting period in which the
adjustment amounts are determined. This includes any effect on earnings of
changes in depreciation, amortization, or other income effects as a result of
the change to the provisional amounts, calculated as if the accounting had been
completed at the acquisition date. During the measurement period, we are also
required to recognize additional assets or liabilities if new information is
obtained about facts and circumstances that existed as of the acquisition date
that, if known, would have resulted in the recognition of those assets and
liabilities as of that date. The measurement period ends the sooner of one year
from the acquisition date or when we receive the information we were seeking
about facts and circumstances that existed as of the acquisition date or learn
that more information is not obtainable. Contingent consideration liabilities or
receivables recorded in connection with business acquisitions must also be
adjusted for changes in fair value until settled.
20 --------------------------------------------------------------------------------
Note Receivable - In accordance with the Financial Accounting Standard Board's
("FASB") Accounting Standards Codification ("ASC") Topic 810-40-5, upon the sale
of substantially all of the assets the Company recorded a gain on the
deconsolidation of a group of assets based on the difference between the fair
value of the consideration received and the carrying amount of the group of
assets. As the Subordinated Secured Promissory Note with Buyer in the principal
amount of approximately
consideration received for the sale of substantially all of the Company's
furniture related assets and liabilities, the Company recorded the Original Note
at its fair value on
estimated using discounted cash flow analyses, using market rates at the
acquisition date that reflect the credit and inherent rate-risk inherent in the
Original Note. The discount resulting from the fair value adjustment was
recorded as a direct reduction to the original principal balance and amortized
to interest income using the effective interest method. As of the date of the
assignment and transfer from the Buyer to S&L, it was determined that the
Original Note was extinguished and therefore both the A&R Note and the S&L Note
were measured based on their fair value in accordance with
Force
Instruments. The discounts resulting from the fair value adjustments for the A&R
Note and the S&L Note were recorded as a direct reduction to the original
principal balance and amortized to interest income using the effective interest
method. When impairment is determined to be probable, the measurement will be
based on the fair value of the collateral securing the notes. The determination
of impairment involves management's judgment and the use of market and
third-party estimates regarding collateral values.
The Company concluded, based on current information and events, including the
impact of COVID-19 on S&L's business and its customers, that the Company did not
believe it would be able to collect the amount due under the S&L Note and
determined that the note was other than temporarily impaired. The evaluation was
generally based on an assessment of the borrower's financial condition and the
adequacy of the collateral securing the S&L Note. Given the facts and
circumstances, the Company recorded an impairment loss of
year ended
accreting interest income on the fair value discount of the S&L Note on the date
in the third quarter of 2020 it determined the note was other than temporarily
impaired
Interest Income - Interest income is recorded on an accrual basis based on the
effective interest rate method to the extent that we expect to collect such
amounts.
Deferred taxes - We recognize deferred tax assets and liabilities based on the
estimated future tax effects of differences between the financial statements and
the tax basis of assets and liabilities given the enacted tax laws. We evaluate
the need for a deferred tax asset valuation allowance by assessing whether it is
more likely than not that the company will realize its deferred tax assets in
the future. The assessment of whether or not a valuation allowance is required
often requires significant judgment, including the forecast of future taxable
income. Adjustments to the deferred tax valuation allowance are made to earnings
in the period when such assessment is made.
In preparation of our financial statements, we exercise judgment in estimating
the potential exposure to unresolved tax matters and apply a more likely than
not criteria approach for recording tax benefits related to uncertain tax
positions. While actual results could vary, we believe we have adequate tax
accruals with respect to the ultimate outcome of such unresolved tax matters.
Long-lived assets - Property, plant and equipment is reviewed for possible
impairment when events indicate that the carrying amount of an asset may not be
recoverable. Assumptions and estimates used in the evaluation of impairment may
affect the carrying value of long-lived assets, which could result in impairment
charges in future periods that would lower our earnings. Our depreciation policy
reflects judgments on the estimated remaining useful lives of assets.
Stock-Based Compensation - We record share-based payment awards at fair value on
the grant date of the awards, based on the estimated number of awards that are
expected to vest, over the vesting period. The fair value of stock options was
determined using the Black-Scholes option-pricing model. The fair value of the
restricted stock awards was based on the closing price of the Company's common
stock on the date of the grant. For awards with performance conditions, we
recognize compensation cost over the expected period to achieve the performance
conditions, provided achievement of the performance conditions are deemed
probable.
Premiums Written and Commissions to Agents - Generally, title insurance premiums
are recognized at the time of settlement of the related real estate transaction,
as the earnings process is then considered complete, irrespective of the timing
of the issuance of a title insurance policy or commitment. Expenses typically
associated with premiums, including agent commissions, premium taxes, and a
provision for future claims are recognized concurrent with recognition of
related premium revenue. Fee income related to escrow and other closing services
is recognized when the related services have been performed and completed.
Rather than making estimates that could be subject to significant variance from
actual premium and fee production, the Company recognizes revenues from those
sources upon receipt. Such receipts can reflect up to a three to four month lag
relative to the effective date of the underlying title policy, and are offset
concurrently by production expenses and claim reserve provisions.
21 --------------------------------------------------------------------------------
Quarterly, the Company evaluates the collectability of receivables. Write-offs
of receivables have not been material to the Company.
Reserve for Title Claims - The total reserve for all reported and unreported
losses the Company incurred is represented by the reserve for title claims. The
Company's reserve for unpaid losses and loss adjustment expenses (LAE) is
established using estimated amounts required to settle claims for which notice
has been received (reported) and the amount estimated to be required to satisfy
incurred claims of policyholders that may be reported in the future ("IBNR").
The Company continually reviews and adjusts its reserve estimates as necessary
to reflect its loss experience and any new information that becomes available.
Adjustments resulting from such reviews may be significant.
Reinsurance - The accompanying balance sheets reflect reserves for claims gross
of reinsurance ceded. The accompanying statements of operations reflect premiums
and provision for claims net of reinsurance ceded. The reinsurance arrangements
allow management to control exposure to potential claims arising from large
risks and catastrophic events. Amounts recoverable from reinsurers are estimated
in a manner consistent with the reserves associated with the reinsured policies.
Reinsurance premiums, losses, and LAE are accounted for on bases consistent with
those used in accounting for the original policies issued and the terms of the
reinsurance agreements.
Off-Balance Sheet Arrangements
We do not have transactions or relationships with "special purpose" entities,
and we do not have any off-balance sheet financing other than normal operating
leases for office space.
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