Description

Want 50% upside, virtually no downside, and a business that is resistant to recessions and will perform in a rising rate environment?


I first wrote up KFS in February 2004 at about $US11.10/share. Since that time the company has executed its turnaround and is poised to produce several years of increasing earnings bolstered by a now over-reserved position. During that time, the stock has climbed to $US15.82, but this 40% gain significantly lags the improvement in the business (note that appreciation in Canadian dollars has been less impressive due to the appreciation of that currency and the fact that 80% of KFS business is in the US). At this price, KFS trades at an undemanding 7x 2005 EPS or 1.13x 12/31/2005 book value versus comps at 10x EPS and 1.7x book value.

KFS suffers from (1) a lingering skepticism about its reserve position, (2) sector pressure due to worries the insurance cycle is peaking, and (3) the reinsurance scandals led by AIG. I’ll address all of these below, but first, I’ll review a few brief points from the prior write-up.

For those interested in purchasing the stock, I recommend the TSX for liquidity even though the company trades in the US and is switching its reporting to USD this quarter to better reflect the bulk of its business.

Overview (from prior report)
Kingsway Financial Services (KFS) is a holding company for nine Canadian and US operating companies that focus on specialty property and casualty insurance. KFS also owns a Bermuda-based captive re-insurance firm competes against external re-insurers to insure the risks at the other KFS companies. The holding company was founded in 1989 and has been managed by the same CEO, William Starr, since this date (Mr. Starr founded Kingsway General, an Opco, in 1986). The CFO, Shaun Jackson, has been around since at least 1994 (and probably earlier though I haven’t asked him that specific question yet).

History of Responsible Growth (from prior report)
Bill Starr, in his quest to imitate the performance of Progressive, has produced an impressive record of responsible underwriting (all $ figures in the following table are in Canadian $):

Underwriting History
Premiums Book Val. Company Industry
Per share Comb Rat. Comb Rat.

1990 $18mm $0.78 93.9 110.0
1991 $18 $1.01 88.7 111.8
1992 $14 $1.03 84.8 111.1
1993 $30 $1.12 94.6 110.4
1994 $56 $1.39 93.9 106.9
1995 $60 $1.91 96.6 104.0
1996 $141 $3.27 95.6 104.5
1997 $211 $5.95 95.8 103.2
1998 $409 $6.96 93.9 107.5
1999 $509 $7.12 102.6 106.6
2000 $643 $8.01 101.0 107.8
2001 $1,065 $11.03 99.1 110.3
2002 $2,125 $12.56 99.8 105.8
2003 $2,600 $12.63 101.4 120.0
2004 $2,600 $14.25 97.8 ???

Notes: 2003 accident year combined ratio was 93.1%
12/31/2003 book value would have been $14.50C without currency losses
2004 accident year combined ratio was 94.9%


Valuation
I estimate KFS 2005 earnings at $C2.80/share or $US2.25/share. This performance would produce 12/31/2005 book value of $C17.00/share or $US14.00/share. Excluding Progressive, comparable companies that don’t have reserve problems trade between 10x-13x PE or 1.2x-2.0x BV. This would imply a fair value at 12/31/2005 for KFS of $US22.50 - $US30.00 on a PE basis and $US16.80 - $US28.00 on a BV basis. So, $US24 seems likes a fair price target.

One might argue that the valuation should be more toward the low end of these ranges since KFS is not a “premium” name, but I think that inclination overlooks several facts that will become more clear about the company over the next year or two.

· KFS has dominant positions in several markets:
o #1 North American Trucking
o #1 Canadian non-standard Auto
o #1 North American Motorcycle
o #1 Taxi in several markets
· KFS has huge product and geographic diversity to limit volatility:
o Commercial and personal lines
o US - all 50 states, and Canada
o Trucking, non-standard auto, motorcycle, special commercial
· KFS has a very low severity loss profile w/ max losses on Trucking capped at $1,000,000 per occurrence through reinsurance
· KFS has an exceptionally low tax rate of between 8% and 19% (depends on composition of income) due to a captive reinsurance arm in Barbados (fully consolidated) that is legal and sustainable (repatriation of capital has been successfully completed in past)
· KFS has over-reserved accident years 2003, 2004, and 2005 to date. These reserves will be available for release in the future
· KFS makes an outsize portion of its profits from the investment income of a high quality, short duration bond portfolio (also has about $1.00 of imbedded gains in a small equity piece that aren’t reported in book value).

The following analysis highlights KFS’ valuation discount based on an analysis of its investment portfolio using its equity market capitalization (Market Val Equity) divided by its investment portfolio net of debt (Net Portfolio) as a yardstick. This ratio, 39.3% pre-tax and 48.6% adjusted for KFS 19.3% tax rate compares exceptionally favorably with all of KFS peers that range from 100% on an after-tax basis to over 300% - table might not format well, but very informative if you cut and paste...

Market Val Portfolio Tax After-Tax
Portfolio Debt Net Portfolio Equity Valuation Rate Adj. Disct.
Investment Driven
KFS * 3,129,836 300,252 2,829,584 1,111,350 39.3% 19.3% 48.6%
Northbridge 2,376,814 - 2,376,814 1,506,104 63.4% 36.0% 99.0%
Allstate ** 116,958,000 61,043,000 55,915,000 36,438,000 65.2% 36.0% 101.8%
SAFECO 10,656,100 1,332,900 9,323,200 6,253,031 67.1% 36.0% 104.8%

Underwriting Driven
Progressive 13,082,000 1,284,300 11,797,700 17,342,616 147.0% 36.0% 229.7%
Mercury General 2,921,042 - 2,921,042 3,047,389 104.3% 36.0% 163.0%

Specialty Auto
Direct General 336,479 135,626 200,853 449,489 223.8% 36.0% 349.7%
Bristol West 295,000 73,388 221,612 546,000 246.4% 36.0% 385.0%
Infinity 1,441,000 199,300 1,241,700 676,086 54.4% 36.0% 85.1%

* Assumes 100% combined ratio for tax rate purposes. 93% of investment income from U.S. subs shielded (50% of portfolio).
** Debt includes "contract holder funds" of $55.7 billion representing annuity contracts outstanding.

I believe this metric will be key to KFS out performance in the coming years as insurance company performance is driven more by the size and returns of investment portfolios rather than explosive growth in underwriting profitability. In addition, KFS portfolio duration of 1.5 years and its high quality investments position it very conservatively for a potential hike in interest rates and/or fall in equity markets.

Risk Factor #1 – Reserves
I stated above that KFS is in the penalty box due to lingering skepticism about its reserves. Bill Starr and Shaun Jackson are two of the most honest managers I’ve met and Bill has certainly proved his competence during his 60 years in the insurance industry (he started his career at 15 still runs marathons in his 70s so don’t worry about his health) and over the last 15 years at KFS. Both of them state that they are confident in their current reserve position after increasing reserves by 22% during 2004 while holding premium volume flat. Other data points include:

· 2004-year end results included a charge for prior accident year reserves comprised of a charge for 2000, 2001, 2002 (largely in Canada) and a release of 2003 reserves.
· 2003 reserves “developing favorably.” 2004 reserved at higher loss ratio than 2003 on higher premium charges. 2005 reserved at same loss ratio as 2004.
· AIG Re and Swiss Re agree to quota share deal in 2004 where they, collectively, get $270mm in premiums and share in KFS aggregate loss experience – someone must have liked KFS current book…

Risk Factor #2 – Peak of Cycle
KFS, unlike its competitors, has been “sandbagging” numbers during 2003 and 2004 to build a strong reserve position depressing its reported combined ratios and EPS significantly. KFS also has $270mm in revenue it can reclaim from AIG and Swiss Re. Both of these “cookie jars” should enable KFS to pad revenue and pricing declines.

But the biggest mitigating factor for KFS is its investment portfolio. KFS should earn almost $US1.60 or $C2.00 (after taxes) from its investments using modest return assumptions. This number deserves a high multiple due to its stability and the current low rate environment.

Risk Factor #3 – Industry Shenanigans
KFS already had its problems, has worked through them, and denies any issues like those currently in the news at other companies. When industry problems blow over KFS will benefit.

Conclusion
A 10 to 1 upside to downside ratio with no real downside is hard to come by in today’s markets especially in a stock with adequate liquidity like KFS (on TSX).

Catalyst

Clean underwriting quarter reported on 5/4/2005.
Clean year reported Jan/Feb 2006.