KINGSWAY FINANCIAL SVCS INC KFS.
January 05, 2017 - 11:15pm EST by
googie974
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 $M): 30 EBIT 0 0
TEV ($): 164 TEV/EBIT 0 0

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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

    sort by    

    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

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