HG HOLDINGS, INC. Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-K) – Marketscreener.com

The following discussion should be read in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K.
The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and reflect the consolidated operations of the Company. The consolidated financial statements include the accounts of HG Holdings, Inc. and all 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.
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 on Form 10-K, which is incorporated by reference into this Item 7 of Part II of this Annual Report on Form 10-K.
Despite the widespread availability of vaccines, COVID-19 (including its variant strains) continues to impact U.S. states where the Company conducts business. The COVID-19 pandemic has negatively impacted worldwide economic activity and created significant volatility and disruptions of financial markets. In response, the U.S. government and its agencies have taken a number of 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 2022.
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.
See Item 1A of Part I of this Annual Report on Form 10-K for further discussion of risk factors related to COVID-19.
Title Insurance Segment Trends and Conditions
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 U.S. economy.
As of the February 21, 2023 Mortgage Finance Forecast, the Mortgage Bankers Association (“MBA”) expects residential transactions to see continued declines in 2023 due to higher mortgage interest rates before showing increased transaction volumes in 2024 and 2025, as it projects a decrease in mortgage interest rate during this period. Additionally, the MBA expects residential refinance transactions to continue to decrease in 2023 before starting to show increases in 2024 and 2025 as interest rates are expected to start decreasing in the second half of 2024.
The industry as a whole saw a decline in total real estate transactions in 2022, largely due to higher mortgage interest rates. Mortgage rates remained abnormally high after emergency actions taken by the Federal Reserve to substantially increase its benchmark interest rate in the final three quarters of 2022, in an attempt to slow the quarter over quarter inflation. The Federal Reserve raised the federal funds rate a total of seven times throughout 2022, resulting in a range from 4.25% to 4.50% as of December 31, 2022. It is expected that the Federal Reserve may continue to increase the federal funds rate during 2023 to, among other things, control inflation. Should the Federal Reserve continue to raise rates in the future, this will likely result in further increases in market interest rates. Per the MBA’s Mortgage Finance Forecast, interest rates on a Freddie Mac 30-year, fixed rate mortgage averaged 6.6% in the fourth quarter of 2022 as compared to 3.9% in the first quarter of 2022.
A shortage in the supply of homes for sale, increasing home prices, rising mortgage interest rates, inflation and disrupted labor markets created some volatility in the residential real estate market in 2021 and 2022, which has continued into 2023. Additionally, geopolitical uncertainties associated with the war in Ukraine have created additional volatility in the global economy beginning in 2022.
Because commercial real estate transactions tend to be generally driven by supply and demand for commercial space and occupancy rates in a particular area rather than by interest rate fluctuations, we believe that our commercial real estate title insurance business is less dependent on the industry cycles discussed above than our residential real estate title business. Commercial real estate transaction volume is also often linked to the availability of financing. Factors including U.S. tax reform and a shift in U.S. monetary policy have had, or are expected to have, varying effects on availability of financing in the U.S. Lower corporate and individual tax rates, and corporate tax-deductibility of capital expenditures have provided increased capacity and incentive for investments in commercial real estate.
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. The fourth quarter is typically strong due to the desire of commercial entities to complete transactions by year-end. Seasonality in 2020, 2021 and 2022 deviated from historical patterns due to COVID-19 and the subsequent rapid increase in interest rates. We have noted short-term fluctuations through recent years in resale and refinance transactions as a result of changes in interest rates.
The Company currently owns 300,000 shares of HC Common Stock and 1,025,000 shares of HC Series B Stock of HC Realty. HC Realty currently owns and operates a portfolio of(i) 30 Government Properties leased to and occupied by U.S. government tenant agencies and sub-agencies such as the Federal Bureau of Investigation, the Department of Veterans Affairs, the Drug Enforcement Administration, the Immigration & Customs Enforcement, the Social Security Administration and the Department of Transportation, and (ii) three Government Properties in which HC Realty is engaged in a development capacity. On March 19, 2019, we purchased 300,000 shares of HC Common Stock for an aggregate purchase price of $3,000,000 and 200,000 shares of HC Series B Stock for an aggregate purchase price of $2,000,000. On April 3, April 9, and June 29, 2020, the Company entered into subscription agreements with HC Realty, pursuant to which we purchased 100,000, 250,000, and 475,000 shares of HC Series B Stock, respectively, for an aggregate purchase price of $8,250,000. As a result of these purchases, we currently own approximately 33.9% of the voting interest of HC Realty.
As of December 31, 2022, HC Realty owned 33 Government Properties, comprised of 28 Government Properties that it owns , one Government Property that it owns subject to a ground lease, three Government Properties for which it has all of the rights to the profits, losses, and any distributed cash flow , each of which is leased to the United States government, and one Government Property for which it has been awarded a lease for a newly constructed build-to-suit facility and for which it is under contract to acquire the land. HC Realty’s portfolio properties contain approximately 628,000 leased rentable square feet located in 21 states. As of December 31, 2022, its portfolio properties are 97% leased to the United States government and occupied by 12 different federal government agencies. Based on leased rentable square feet, the portfolio has a weighted average remaining lease term of 9.5 years if none of the tenants’ early termination rights are exercised and 5.9 years if all of the tenants’ early termination right are exercised.
As of December 31, 2022, our sources of income include earnings on our title insurance subsidiaries, dividends on HC Common Stock and HC Series B Stock, premiums related to reinsurance provided to others, management services, and interest paid on our cash deposits. The Company believes that the revenue generating from these sources, and cash on hand is sufficient to fund operating expenses for at least 12 months from the date of the accompanying consolidated financial statements.
The Company generated interest income of $111,000 for the year ended December 31, 2022 as compared to $15,000 for the year ended December 31, 2021. The increase was primarily a result of the increased interest rate environment of cash accounts and the title insurance underwriter being able to invest excess cash in the stocks and bonds. The Company generated dividend income of $1.0 million for both of the years ended December 31, 2022 and 2021, which is reported in our real estate related segment. Dividend income relates primarily to the HC Series B Stock held by the Company.
As a result of the Company’s title insurance operations, the Company generated title premium and other title fee revenue of $6.8 million for the year ended December 31, 2022, as compared to $2.4 for the year ended December 31, 2021. The title insurance subsidiaries’ cost of revenue consists primarily of a provision for title claim losses and underwriting expenses, which primarily consist of 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 year ended December 31, 2022 were $8.5 million, as compared to $2.1 for the year ended December 31, 2021.
As a result of the Company’s reinsurance related segment, the Company generated $6.3 million of written and earned premium for the year ended December 31, 2022, which was offset by operating expenses of $94,000 consisting primarily of premium tax expenses and management fees related to the formation and management of White Rock Cell 47. The Company did not operate in the reinsurance segment during the year ended December 31, 2021.
As a result of the management services related segment, the Company generated $1.36 million of management fees for the year ended December 31, 2022, which was offset by operating expenses of $400,000 consisting of executive management compensation allocated to the time related to providing these services to the outside party, as compared to $37,000 of management fees for the year ended December 31, 2021. Such increase was primarily the result of HGMA being engaged during the year ended December 31, 2022 to develop a restructuring plan for an insurance holding company’s non-statutory entities.
Corporate general and administrative expenses are not directly allocable to any of our reporting segments and consist primarily of wages and personnel costs, legal and professional fees, insurance expense, and stock based compensation. General and administrative expenses of $1.2 million for the year ended December 31, 2022 remained relatively flat as compared to general and administrative expenses of $1.3 million for the year ended December 31, 2021.
Our effective tax rate for the year ended December 31, 2022 was 0.0% due to our net operating loss carryforwards. Our effective tax rate for the year ended December 31, 2021 was effectively (3.8)% resulting from a tax benefit from unrecognized tax benefits position under Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”).
Financial Condition, Liquidity and Capital Resources
Sources of liquidity include cash on hand, earnings from our title insurance subsidiaries, reinsurance premiums earned, management service fees earned, and dividends from our HC Common Stock and HC Series B Stock. We expect cash on hand to be adequate for ongoing operational expenditures for at least 12 months from the date of the accompanying consolidated financial statements. At December 31, 2022, we had $9.5 million in cash and an additional $5.5 million in restricted cash, all of which is cash held in escrow for title insurance transactions. The 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 interest at approximately 3.46% annually. We also received quarterly dividends on our HC Common Stock and HC Series B Stock at annual rates of 5.5% and 10%, respectively, during the year ended December 31, 2022.
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 provided by operations for the year ended December 31, 2022 of $2.7 million consisted of net income from operations of $3.7 million, and dividends on our HC Common Stock of $165,000 offset primarily by $2.5 million in escrow liabilities on the title insurance subsidiaries. Net cash used in operations for the year ended December 31, 2021 of $935,000 consisted of net income from operations of $2.8 million, dividends on our HC Common Stock of $165,000, and dividends on our HC Series B Stock of $1.0 million, offset primarily by $3.3 million in gain on remeasurement of equity interest.
Net cash used in financing activities of $7.8 million for the year ended December 31, 2022 consisted primarily of $5.6 million of cash used for the acquisition of investments in our title insurance underwriter, and $2.3 million in goodwill acquired in a business combination for one of our title agencies, offset by cash received of $204,000 regarding the sale of tangible assets, net of related purchases. Net cash provided by investing activities of $9.4 million for the year ended December 31, 2021 consisted primarily of $9.2 million of investments in subsidiaries, net of cash acquired, and $190,000 of principal payments received on subordinated secured notes receivable.
Net cash used in investing activities stayed relatively flat for the year ended December 31, 2022 as compared to the year ended December 31, 2021 and related to repurchases of common stock in the amount of $21,000 for the year ended December 31, 2022 and redemptions of fractional shares from stock split in the amount of $2,000 for the year ended December 31, 2021.
Recent Accounting Pronouncements
In June 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-13, Financial Instruments – Credit Losses (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 December 15, 2022. Early application is permitted for reporting periods beginning after December 15, 2018, although the 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.
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 consolidated 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 consolidated balance sheets. Investments accounted for under the equity method of accounting are initially recorded at cost and the Company 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: Recognition and Measurement of Financial Assets and Financial Liabilities, 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. Goodwill is recorded as the residual amount by which the purchase price 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.
Note Receivable – In accordance with FASB ASC Topic 810-40-5, upon the sale of substantially all of the assets of the Company, 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 Original Note was part of the 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 March 2, 2018. The fair value of the Original Note was 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 Emerging Issues Task Force (EITF) – Creditors Accounting for Modification or Exchange of Debt 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 the COVID-19 pandemic 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 $992,000 during the year ended December 31, 2022. The Company further ceased accruing interest and 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 consolidated 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 consolidated 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 shares that are expected to vest, over the vesting period. The fair value of stock options is determined using the Black-Scholes option-pricing model. The fair value of restricted stock awards is 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 is 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.
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. 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 consolidated balance sheets reflect reserves for claims gross of reinsurance ceded. The accompanying consolidated 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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