Description

Kingsway Financial rights (KFSVF) are currently trading for a penny or two.  Four of these rights together entitle their owner to buy a share of Kingsway Financial (KFS) and a pair of out of the money long-term warrants for $4 while the stock currently trades at $2.80.  The rights have been trading for a little over a week and expire on September 6th.  Kingsway has a durable long term competitive advantage in $832 million in historical losses, more than 22 times its current market capitalization.  The company will benefit from tax NOL's for perhaps the next 20 years.  Activist investor, Joseph Stillwell of Stillwell Financial took control of the company a few years ago and currently serves as Chairman of the board.  Stillwell, who specializes in financials, has a successful track record and has installed well-regarded Larry Swets as CEO.  Stillwell, Swets,  Kavanaugh (director), and Hannon (director) have added  significantly to their KFS holdings in the last year at prices higher than the current price.  The rights prospectus notes that  "certain directors and executive officers of Kingsway have indicated their current intention to participate in the Rights Offering in amounts at least equal to their basic subscription privileges".  Long-term investors might do well by buying and exercising these rights alongside the insiders.  The company is still posting large losses, however, even after three years of restructuring under their new CEO, so this investment may not be suitable for the risk averse.

Kingsway Financial historically was a sizeable insurance company writing well over $2 billion in annual premiums a few years ago.  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.  Stillwell 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 $100 million a year in premiums. 

Stillwell and Swets intend to use Kingsway as a tax-advantaged investment vehicle to acquire financial companies.  Stillwell is a Wharton graduate with a long and mostly successful track record investing in insurance companies and small banks often as an activist.  Kingsway is his black eye now trading at only about 1/5th his initial acquisition price.  Thirty-eight year old Larry Swets, CFA, founded and ran Itasca Financial before joining Kingsway as part of the hostile takeover (by settlement) in January 2010.  He became CEO in June 2010 when the CEO at the time resigned.  Itasca Financial is a Chicago-area advisory and investment firm specializing in the insurance industry.  Swets' training includes an MBA in finance from DePaul University and time in the Kemper Scholars program before taking the role as Director of Investments and Fixed Income Portfolio Manager for Kemper Insurance.   While still young, he has many years of experience in the insurance industry including business unit evaluation, divestitures and other corporate transactions during the runoff stage of Kemper Insurance.

Toronto-based Kingsway has made three acquisitions under Swets even as they were divesting and running off the company's many money-losing insurance companies.  In June 2010, for $16.3 million, they acquired Assigned Risk Solutions (ARS) which is a licensed property and casualty insurance agency focused on the assigned risk market.  ARS is licensed in 22 states but sells auto and commercial lines of insurance only in New Jersey and New York.  They do not retain underwriting risk but sell it to other parties such as Berkshire Hathaway's National Indemnity Company.  The second acquisition of Intercontinental Warranty Services (IWS) closed in November 2012 for $4.9 million in cash, future contingent payments, and equity in a newly formed entity .  Goodwill of $9.0 million and $12.4 million of other intangible assets were recorded on the balance sheet so this acquisition is much larger than the $4.9 million cash payment would suggest.  IWS, based in Florida, sells car warranty services through a network of participating credit unions usually at the same time the credit union makes an auto loan.  The third acquisition of Lombard, Illinois based Trinity Warranty Services was completed in May, 2013 for $1.1 million and future contingent payments.  Trinity provides and administers heating ventilation and air conditioning (HVAC) warranties to consumers and businesses.   Kingsway management intends to grow the Insurance Services side of their portfolio with further acquisitions of service type businesses like IWS and Trinity.  Revenue run rate of the Insurance Services segment consisting of the three acquisitions is approximately $50 million a year not counting newly acquired Trinity. Operating income for the segment in 2012 was $3.5 million compared to $2.1 million in 2011 but 2013 earnings have so far been down.   A fourth new business, Louisiana based Maison Insurance Company that provides primarily wind and hail coverage to homeowners, was started from scratch in November, 2012.

The legacy non-standard auto insurance businesses remains challenged.  In September, 2012 Kingsway noted that underwriting results were improving at their Mendota and Advantage Auto franchises, but the Florida-based Amigo operations aimed at Hispanic customers remained challenged.  The company would begin a restructuring of their operations that included consolidating all their non-standard property and casualty insurance companies (Mendota, Mendakota, Universal Casualty Company, Amigo,and  KAI Advantage Auto) under one management team to reduce operating costs.  Since this announcement the company has put Amigo into run-off.  Revenues for insurance underwriting run about $100 million a year with Amigo revenues falling while other segments are experience revenue increases.  Underwriting losses remain horrific, however, with the company posting a $0.74 per share loss in just the most recent quarter.   The run-off of Amigo and the restructuring are intended to return the underwriting segment to profitability and "begin to create real value for Kingsway's shareholders".  The non-standard auto business has had too much competition and generally been a bad industry to be in since 2007.  Recently the industry has started to improve and according to Stone Ridge Advisors is expected to continue to improve in coming years (http://www.stoneridgeadvisors.com/Content/View_From_The_Ridge_August_2012.pdf).  At $100 million in revenue the insurance underwriting segment could eventually become a significant source of value compared to Kingsway's current $37 million market cap.  Right now the underwriting losses scare me and  my principal misgiving about this investment is that the high-risk auto business winds up being of negative value as they try to save it.  The losses scare the market too, as Kingsway trades at a $37 million market cap despite roughly $150 million in revenue.

The rational for the rights offering is to get book value back above $50 million to prevent delisting from the New York Stock Exchange.  The terms of the offering look to me like the purpose is not to raise money from shareholders but from insiders.  First note that for $4 (and 4 rights) participants will receive one Kingsway share (currently trading at $3), one 7 year warrant exercisable at $4.50 with a call provision if the stock trades above $6, and a second 10 year warrant exercisable at $5 that cannot be called.  If my goal was to raise money from shareholders, I'd simply offer a right to buy a share below market (maybe $2.50) like most companies do.   Many investors will not want illiquid warrants and don't know how to value them.  Why pay $4 for a sub $3 stock and warrants that your fund may not even be allowed to own and there's no liquid market to sell into?  The low trading price of the rights seems to vindicate that few people want them.  Why structure a rights offering to raise capital that your shareholders don't want to participate in?  My suspected answer is because there's an oversubscription privilege.  Shareholders that exercise all their rights may request up to 5 additional units available from rights that were not exercised.  If you want to request all five, however, you have to write a massive check to cover them all even though you know full well you won't get more than 1.5 or so.  I'm buying the rights mostly in an IRA and can't put up $24 to buy 6 units, even if for just a few days before they return $18 or so to me.  If you just ask for two units because you can put up $8 then you'll hardly get anything.  Over-allotment shares aren't divided proportionately among shareholders according to the number of rights owned, but rather they are divided proportionate to the number of units requested.  So I suspect 20% owner Stillwell, who can put up huge money for a few days, will request all five and get a disproportionate share.  It's only my suspicion, but I think the insiders want to get their hands on all the shares they can.  They have been buying KFS shares in the open market for nearly a year now about as aggressively as they can given the limited liquidity.  If the warrants are eventually exercised, Stillwell will increase his ownership of shares by 75% with this offering, even more if he buys up rights on the open market and requests over-allotments as I suspect.   I can see the possibility for the stock to trade at $10 or $15 some years out if they turn around non-standard auto and acquire aggressively as planned.

Companies with big tax NOL's like Kingsway have a competitive advantage.  They can make acquisitions at prices that are fair to the seller but a bargain to them.  They simply eliminate the income taxes and the profitability of the acquired company goes up 42% (assuming 30% income tax rates).  Only the IRS gets screwed in the deal.  So the strategy going forward is to issue preferred stock to raise capital for acquisitions particularly in the insurance services segment.  In the mean time, divest money-losing Amigo and consolidate the remaining non-standard insurance companies that have shrunk from more conservative underwriting to reduce costs.  Hopefully, the weak market of the last six years for higher-risk auto turns into a hard market where policies can be written profitably.  I wouldn't be surprised if there's another rights offering or other capital raise as the $832 million in NOL's needs a bigger company to take full advantage.

Owning warrants in this situation is attractive.  The businesses are large but the market cap is small as the underwriting businesses are performing poorly and the company has a disastrous history.  If the businesses can turn around they are big enough for the stock to really pop.  Furthermore, management will act to grow aggressively and the warrants give you the upside while limiting your loss to what you paid for them (about $1.20 for two).  Out of the money warrants are attractive for investing in high risk potentially high growth situations like this. 

Finally, I would note that Kingsway has historically been a disaster but the management and most of the businesses that did the damage are gone now.  The new operations have a significant competitive advantage in the tax NOL's especially in light of the strategy to grow through acquisitions. Furthermore, the management should have the know-how to take advantage.   COB Stillwell has done well historically and his choice for CEO, Larry Swets, is young but highly regarded from what I can gather.  There's really no reason the future can't be much better than the past.  This speculative investment may require some patience until the underwriting losses are corrected.

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