Value Investors Club / KINGSWAY FINANCIAL SVCS INC (KFS.)

Description

Kingsway Financial is a 20% compounder with no sign of that yet in the financials and a stock price that

doesn’t fully recognize it yet either. Kingsway has been digging out of debt from a near bankruptcy

situation left by prior management who operated insurance operations for growth rather than

profitable underwriting. But while CEO Larry Swets has mostly been playing defense since taking control

in 2010, the deals he and Gordon Pratt have made have been remarkably successful. The problem has

been that a lot of the created value has gone to creditors who were paid in full by an essentially

bankrupt company. With near-term debt maturities now fully paid, the company will be playing offense

going forward and to the benefit of shareholders. Most of KFS investments have been, and will continue

to be in financials, where management’s expertise lies. Financial investments can yield high returns on

equity (as long as you know what you’re doing). Kingsway’s returns will be aided by an $850 million NOL

(20 times bigger than current book value) courtesy of prior management. Larry’s goal is to compound

book value at 20% going forward. Based on recent investment success, I expect that until the NOL’s are

used up he’ll meet or exceed it. Buy and hold investors who tuck a little KFS into their taxable accounts

and forget about it may compound their own money at 20% for the next 20 years.

Kingsway Financial historically was a sizeable insurance company writing well over $2 billion in annual

premiums in 2008. The company's successful core business of non-standard auto insurance was

supplemented with numerous empire building acquisitions of other insurance companies including

trucking insurance, property & liability, commercial auto, and customs, bails, and surety bonds. The

2007-2008 recession made it clear that most of these insurance companies had underwritten bad risks

and the company lost money profusely. Joseph Stillwell of Stillwell Financial bought up shares beginning

in 2008, started a proxy battle, and eventually gained control of the company. Larry Swets took the CEO

role in 2010 and began selling off and shutting down companies as well as using company cash to buy

back their bonds trading at a large discount. Only a few non-standard auto companies remain and they

have shrunk such that they write only approximately $120 million a year in premiums.

Larry Swets notes that after reviewing the operation as CEO in 2010, he assessed the company was

bankrupt. But he pressed on divesting insurance companies, running some off, raising capital through a

rights offering, raising more through a private placement, buying back debt at a discount, and finally

paying off debt as it matured for total debt retirement exceeding $250 million. Larry noted it was worth

the effort to avoid bankruptcy in order to preserve the NOL’s. In the mean time, 1347 advisors was

created as their merchant banking vehicle led by Gordon Pratt. They’ve made a number of deals with

attractive risk reward characteristics in recent years. The outcome of some of the deals is now evident,

rather remarkable, and more deals like these are the reason to invest in KFS going forward. Twenty

percent return on equity is an ambitious goal even when aided by NOL’s, so here’s the investment

record that makes it plausible going forward.

Assigned Risk Solutions: Combination of 2010 acquisition JBA associates and legacy business Northeast

Alliance Insurance Agency. Sold to National General Holdings in 2015. Total money in was $16.3 million

and money out from dividends, sales price, and first earnout payment was $54.2 million with some

earnouts possibly still to come. Not bad.

Atlas Financial Holdings: Formed from a pair of legacy Kingsway taxi insurance companies whose

business was reduced to just $20 million as Kingsway’s financial problems limited underwriting. This

business was saved by injecting some outside capital, spinning it into a Canadian shell initially, and later

a U.S. IPO and listing on NYSE (ticker AFH). This business has fully recovered and grown to a market cap

of $208 million. KFS managed to retain a good fraction of that value for its shareholders. Buyers of the

IPO at $5.80 also made money as the stock currently trades over $17. Kingsway sold shares at $12.90 in

2013 and recently $18.06 in the open market.

1347 Property Insurance Holdings: A startup property insurance company in 2012 with a March 31,

2014 IPO (ticker PIH). Kingsway has $9.3 million invested with a return of $12.8 million in cash and

marketable securities. Performance awards of PIH stock of as much as $8.55 million begin to be

awarded when PIH trades above $10 with the full amount awarded at $18. PIH hasn’t made IPO

investors money yet with an IPO price of $8 and a current trading price of $7.25. Results of a strategic

review are expected in March and I expect there will be some plan to create value here that works.

Limbach Holdings: A building construction HVAC and electrical contractor that Kingsway took public by

a SPAC that closed in the Summer of 2016. Kingsway invested $1.8 million with a fair value of stock and

warrants worth approximately $11.0 million at November 2016 valuations. Kingsway actually made an

additional few million investing in Limbach shares through Kingsway’s approximately 31% ownership of

Itasca Capital detailed below. Importantly, SPAC investors have made money too as Limbach shares

(ticker LMB) have appreciated to $14 since the SPAC close.

Itasca Capital: Formerly Kobex Capital , a listed Canadian commodities company trading well below

cash value that Kingsway purchased a significant interest in from a large investor in 2015. Kingsway

eventually offered to take control of the company and bought many investors out for the level of cash.

The remaining company now called Itasca Capital ( TSXV ticker ICL) used most of the remaining cash to

purchase Limbach shares at the SPAC close. By purchasing Kobex shares below cash level and then

investing in the SPAC that appreciated promptly, KFS has realized 50%+ returns in less than 2 years.

CMC Industries: Kingsway acquired for $1.5 million an 81% interest in this company that owns a rail

yard in Texas triple-net leased until 2034 to BNSF. At the November investor conference Larry outlined

a possible scenario where the rail yard were sold on lease termination with Kingsway realizing a total of

$69.5 million. That works out to about 25% annualized. Such a high return is possible because the lease

is producing taxable income while all of the lease payment is going to the mortgage. So the lease owner

has to pay cash taxes as the mortgage is paid down even though there is no cash to the owner. Of

course, taxes aren’t a problem for Kingsway. This is Larry’s innovation to realize value from Kingsway’s

tax NOL’s and he wants to do more deals like this.

1347 Energy Holdings, LLC: Kingsway bought mineral leases in an oil field for around $3 million total

costs while oil prices were depressed. At the investors meeting in November he noted that he couldn’t

say for sure what would happen but he views this as an option on the price of oil. If oil appreciates a bit

he could see it worth $35 million. Oil has appreciated a little already since the purchase.

So that’s a sample of Larry Swets work to make the case that he’s a good deal maker with access to

private merchant banking deals not available to the average passive investor. There’s a pretty good

track record of making 20% a year or more. While Larry is a deal maker, he also believes that they own

and operate some businesses (Warranty and Mendota) with potential to earn high return on equity. He

admitted that he’s not an operations guy himself and that these businesses haven’t been operated

particularly well the last few years. So he has brought on help with the acquisition of Argo in 2016.

Argo uses search funds to acquire private businesses from owners who want to retire. Then Argo uses

professional management techniques to improve the financials. When I asked, Larry noted he wasn’t

sure if they would continue with search funds or not. So it was evident to me that the Argo purchase

was intended primarily to acquire Argo’s manager, J.T. Fitzgerald. He’s the new manager of Kingsway’s

warranty businesses.

1347 Warranty Holdings includes Trinity Warranty Solutions and IWS acquisition Corporation. Trinity

sells HVAC warranties and IWS sells car warranties through credit unions making car loans. Both have

been operated sub-optimally and J.T. joined a year or so ago to improve operations. J.T. noted that he

learned his tricks from a guy that worked for Danahaer. Danahaer is a terrifically successful publicly-

traded company and they use the "Danahaer business system". J.T. is using those same Danahaer

methods (Lean methods and stuff) to improve the warranty businesses. J.T. and Larry think Warranty

can be a jewel and intend to expand it both organically and via acquisition. The recent private

placement funds (at $6.50 which was a significant premium to market) will be used to acquire warranty

businesses. Meanwhile efforts are underway to improve IWS through organic growth. The IWS

founder's son has been running IWS for Kingsway. But a severance charge writeoff was just taken as the

son wasn't on board with the changes J.T. wanted to make. IWS sells car warranties which are quite

profitable but also a competitive business. IWS differentiates itself from the competition by

selling through credit unions making car loans rather than car dealerships. The business has declined

since Kingsway's acquisition but J.T. is now growing it through new sales efforts. They have about 100

credit unions as customers but there are 900 more that are not. They've signed deals with 3 new credit

unions to date and have 90 more new ones in the pipeline as of November. There's a slide in the

November investor presentation showing the growth of in-force contracts in 2016 after declines in 2015.

The improving operating profit is also shown. Trinity sells warranties on HVAC systems and has had two

managers attempt to fix it with failure. But J.T. has improved profitability since taking over a year ago as

you can see on the investor presentation slide. They're not as excited about Trinity's prospects but it is

profitable now with 2016 revenue at $6 million.

Sam Duprey joined Kingsway in the spring of 2016 and has been searching for acquisition targets.

They're after warranty businesses and are looking to avoid companies up for auction which typically sell

for 7 times ebitda. Instead they're looking to use industry veterans to make introductions to people

who might sell with a hope to acquire at 5 times ebitda. Note that 5 times ebidta gets you 20% returns

if you don’t pay taxes. Regulation of warranty business generally doesn’t require tying up capital;

instead the warranty liabilities are protected by reinsurance. The warranty businesses can grow rapidly

without requiring much capital.

Mendota is a legacy Kingsway business that has also not been operated well in Larry's opinion, noting

that this has been his biggest disappointment with KFS since he's been running it. They've done well

investing the float but underwriting profit has not been good. He recently hired industry veteran Steve

Harrison to improve operations. Mendota was formed by acquisition of several little non-standard auto

businesses but these businesses were never integrated together. Steve is bringing new common

software to all of them to operate the business more efficiently. He's also relocated operations to

Tennessee where costs are lower. Larry says he'll be happy if they get the combined ratio down to 98%.

Steve noted that Progressive operates at 96% and his goal was to get there. Part of the strategy is to

stop writing business in states where their market share is too small to be profitable. They have

sufficient capital to increase their business by 20% without putting more money in. They seem much

more interested in putting capital to work in warranty rather than expanding non-standard auto which

Larry noted is the worst type of auto insurance business. If Steve Harrison can achieve a 96% combined

ratio and Larry continues to work magic with the float this business can achieve 20% return on equity.

So in summary, Kingsway is a pair of financial operating businesses (Warranty and Mendota), a

merchant banking platform that takes companies public, and Larry Swets collecting together high-return

private investment opportunities. The investment case is that these businesses, aided with $850 million

in tax NOL’s, will compound at 20% for many years without extravagant risk. In fact, Larry and Pratt

have been doing just that for some time but all the debt pay down, restructuring, and the value of

warrants and contingent payments not appearing in the financials has hidden the success. Going

forward, the value created will begin to accrue to shareholders rather than debtors and the profitability

will become evident in the financials.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Profitability becomes evident in financials

Acquisitions in warranty provides profitable growth

show sort by

			2017	2018
Price:	6.25	EPS	0	0
Shares Out. (in M):	22	P/E	0	0
Market Cap (in $M):	134	P/FCF	0	0
Net Debt (in $M):	30	EBIT	0	0
TEV (in $M):	164	TEV/EBIT	0	0