Description
Kingsway Financial Services
ticker: KFS
Price: $ 4.55
Market Cap: $ 225m
52 Wk Range: $3.70 - $15.57
Shares Outstanding: 55.07m
Debt at last quarter: $284m
Net Operating Loss Carryforwards: ~$25m
Introduction
Headquartered in a Company owned building on the outskirts of Pearson International Airport in Canada’s largest city, Kingsway Financial Services is one of the largest non-standard auto and trucking insurers in Canada and the US. Along with the rest of its commercial lines, it also offers standard and non-standard auto, as well as motorcycle, property, and liability lines while its specialty coverage includes customs, bail, and surety bonds. The company's eleven subsidiaries include American Country Holdings, American Service Insurance, Jevco Insurance, and Southern United Fire Insurance.
Despite its unique niche, scalable platform and overcapitalized balance sheet, the stock trades for a fraction of its 1995 IPO price and roughly 45% of real book value.
A combination of poor management, bloated SG&A, an overzealous acquisition strategy and a lack of oversight are the cause of this discount. But fear not. Something good is happening at Kingsway, and the gap between intrinsic value and share price has a real shot at closing over the next few years. The shares offer upside of 3-4x their current price.
Background
While the financial markets have been volatile and painful for everybody over the last year, fewer places have faired worse than financial stocks. Banks, insurance companies and mortgage lenders mired in complex derivatives, off balance sheet transactions and a complete lack of access to capital have destroyed shareholder value in ways that were unimaginable just 12 short months ago.
Kingsway Financial Services has no credit default swaps, reinsurance treaty with a hurricane underwriter or exposure to a few Bernie Madoff offshore specials. It is a boring, plain vanilla insurer that writes around $1.9b of premium per year with ¾ of that premium domiciled in the U.S. and the balance in Canada.
Lines of business break down as follows: (2008est)
Non Standard Auto: 42pct
Trucking: 16pct
Property & Liability: 15pct
Motorcycle: 6pct
Other: 6pct
The Company’s Loss Ratio (loss and loss adjustment expense divided by net premium earned) has fluctuated from a low of 68.3% in 2003 to around 78.4% in 2008. The Expense Ratio (underwriting expenses divided by net premiums earned) has fluctuated between 26.9% in 2004 to 33.9% in 2008. Expenses at this Company are way too high, and this write-up will address that later. Adding this all up, the Combined ratio (Loss Ratio + Expense Ratio) has moved between 97.2% in 2005 to a staggering 112.3% in 2008. For the insurance beginner, keep in mind that due to the investment income generated by the float, an insurer can still earn a profit even with a combined ratio in excess of 100%.
Over the years the Company has gone through the typical mid cap insurance company perils, complete with write downs, reserve adjustments, management changes, empire builder-esque acquisition binges and capital raising activities. Despite years of lackluster leadership and sub par returns, it took the greatest financial crisis in a generation to bring the shares to a level where the core underwriting franchise, strong balance sheet, and some key catalysts make it worth a hard look.
Given its previous years of reserve additions, it’s extremely likely that the actuaries have scrubbed Kingsway through and through. The tail on most of Kingsway’s business is short dated stuff, with non standard auto elapsing on a monthly basis in some cases. Kingsway today is overcapitalized with a total debt to capitalization of around 30%. Having paid down its bank debt recently with the sale of a non-core business unit, their next debt maturity isn’t until 2012 (C$100M); then 2014 (US$104M), 2015 (C$78M), 2032 (US$87M).
While we are on the topic of debt it is worth noting that Kingsway has outstanding debt issues that trade at a discount to face value. The Company should be taking steps to retire all or parts of these issues. Kingsway’s Book Value at 9/30/08 was $772m. The total securities portfolio at that time was valued at $2.54b. Out of this $2.54b, $315m was invested in US and Canadian equities. See the illustration below:
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in millions of USD
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'9/30/08
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ASSETS
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cash and equiv
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197
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securities:
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Stocks
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315
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US Canadian and Corp Bonds
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2225
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total securities
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2540
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accrued investment income
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26.2
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financed premiums
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68.3
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accounts receivable
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309
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due from reinsurance
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212
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deferred policy acq costs
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142
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income tax recoverable
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9.2
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future income tax
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150
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capital assets
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119
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Goodwill
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111.4
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TOTAL ASSETS
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3884.1
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LIABILITIES
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Bank Debt
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0
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Loans Payable
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66
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Accounts Payable and Accrued
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131.5
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Unearned Premium
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604.7
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Unpaid Claims
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2032
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Senior Unsecured Debt
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196.8
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Subordinated Debt
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87.3
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TOTAL LIABILITIES
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3118.3
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SHAREHOLDERS EQUITY
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765.8
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94% of the fixed income portfolio is rated A or higher. So let’s calculate tangible book value. If we are to assume that the equity investment portfolio fell by 25% since 9/30/08, this would equate to a loss of $79m, reducing Shareholder’s Equity to $687m. We should also subtract Goodwill of $111, a modest amount given a balance sheet this size and the acquisition history. Eliminating this figure leaves Kingsway with a tangible book value per share of around $10.45 per share. Kingsway trades for 45% of this value at the current level of $4.75 per share. In come the activists to close this gap.
Illustration of Tangible Book Value Per Share
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Starting Shareholders Equity
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765.8
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Stock Losses at 25%
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-78.75
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Less Goodwill
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-111.4
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New Shareholders Equity
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575.65
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Shares Outstanding
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55.07
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Tangible Book Value per share
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10.45
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Current Price
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4.75
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Activists Enter the Picture
On October 29th, 2008 the Stilwell Group filed their first 13-D on Kingsway reporting an ownership stake of 7.67%. For those of you new to activism in financial stocks, the Stilwell Group is led by Joseph Stilwell, a New York City based hedge fund manager whose intense level of activism and value creation for shareholders speaks for itself via the Group’s stellar track record. Stilwell’s brand of activism stands in stark contrast to a Third Point or William Ackman as the Group has been known to hold and grow their investments over a significant period of time. Unlike other activists who use the pageantry and fanfare of the media and sophisticated options strategies to juice quick returns, The Stilwell Group’s approach involves having a real Board Room presence with a focus on the merits of the target’s true business franchise and the ongoing capital allocation of the entity. Recent campaigns in the insurance space include American Physicians Capital (ACAP) where the Group still occupies two Board seats and SCPIE holdings (SKP) which no longer trades as it was bought out by The Doctors Company. The Stilwell Group delivered significant value in each of these situations in addition to a handful of situations involving Mutual Thrift stocks. You can go through the names by looking at any of the Stilwell Group 13-D filings on Kingsway whose links are reproduced below.
Since this is a report on Kingsway and not an analysis of the Group’s past campaigns, I will leave it up to the reader to investigate how successful their past endeavors were. You will find the results encouraging.
What Does the Stilwell Group Intend To Do?
The Stilwell Group plans on building Shareholder value in Kingsway by focusing on the Company’s niche underwriting capabilities, eliminating all expansion plans and capital raising activities, reducing outrageous levels of SG&A, and replacing the current Chairman (Walsh) and CEO (Jackson) with their own Board nominees. The nominees include Spencer Schneider, a New York based attorney and Board Member at American Physicians Capital who helped Stilwell build massive value for shareholders at that medical malpractice insurance firm and Larry Swets, a Chicago based fund manager and former insurance executive and advisor, including former Director of Investments for Kemper Insurance from June 1997 to May 2005. Larry Swets is gaining a reputation in value investing circles for his work on small and mid cap insurance company ideas. Earlier this year, he and Gordon Pratt, whose resume includes a former membership of the operating committee of Conning & Company (highly respected 85 year old insurance focused investment group) launched a SPAC which purchased a solid Florida based property and casualty underwriter for around 4x earnings.
The Group also wants Kingsway to use excess capital to retire stock which is trading way below book value as well as debt which trades below par. A careful look at the Stilwell Group’s filings provides some insight into their actions. I have reproduced the “Purpose of Transaction” sections below. In their first 13-D, filed on October 29, 2008, the Stilwell Group stated:
“Our purpose in acquiring shares of Common Stock of the Issuer is to profit from the appreciation in the market price of the shares of Common Stock through asserting shareholder rights. We do not believe the value of the Issuer's assets is adequately reflected in the current market price of the Issuer's Common Stock.
We have requested a meeting with the Issuer’s executive management and board chairman to discuss ways to maximize shareholder value and minimize both operational and balance sheet risks. We oppose any capital raise by the Issuer. We believe management needs to reduce expense levels. We strongly oppose the Issuer's acquiring other companies or businesses at this time. We hope to work constructively with the existing management and board to help them focus on maximizing value per share. However, we will exercise our shareholder rights to whatever degree necessary in order to achieve our goals. The Group intends to seek at least two board seats.”
At first, Kingsway refused to meet with The Stilwell Group, prompting the Group to file a second 13-D. This, 13-D filed on November 11th, 2008 stated:
“We are filing this First Amendment to report that when Issuer's CEO refused to promptly schedule a meeting with us, we served a requisition for a special shareholders meeting on Tuesday, November 11, 2008, to remove the CEO and chairman from the Issuer's board and replace them with Spencer L. Schneider and Larry G. Swets, Jr.
We still hope that Issuer's management and board will agree to meet with us to discuss ways to maximize shareholder value and minimize both operational and balance sheet risks. We oppose any capital raise by the Issuer. We believe management needs to reduce expense levels. We strongly oppose the Issuer's acquiring other companies or businesses at this time. We hope to work constructively with the existing management and board to help them focus on maximizing value per share. However, we will exercise our shareholder rights to whatever degree necessary in order to achieve our goals.”
After a bit of bickering over meeting times (including an episode where the Group flat out tells CEO Shaun Jackson that he is now not even welcome to the meeting as his replacement is an absolute must (a fourth 13-D was filed on November 17, 2008) the Group filed its final 13-D on November 24th, 2008. It stated:
“We are filing this Third Amendment to report that we met with the Issuer’s officials on Saturday, November 21, 2008 in Toronto, and offered to rescind our requisition for a special shareholders meeting and have Michael Walsh remain on the board if our nominees were promptly added to the board. We also stated our intention to proceed with the special shareholders meeting to remove Messrs. Walsh and Jackson if an agreement is not reached in the near future.
We also declined a request to meet with Shaun Jackson until such time as he resigns from, or is removed from, the board. Michael Walsh, Brian Reeve, Thomas DiGiacomo, Shelly Gobin, Kathleen Howie, and Irwin Greenblatt attended for the Issuer. Joseph Stilwell, Spencer Schneider, and Larry Swets attended for the Stilwell Group.
We expressed our displeasure with the Issuer's expense reductions to date; we stated our belief that the Issuer should immediately reduce overhead expenses in the range of $50 million; and we informed the board and management representatives that the board's current practice to not require timetables for management to reduce expense levels by definite amounts is unacceptable to us.
We expressed our belief that the Issuer should sell and/or run-off non-core lines of business as quickly as possible and use excess capital to retire the Issuer’s debt at a discount and repurchase shares of common stock.
We disagreed with assertions that the Issuer is moving at an appropriate pace to address its problems. We stated that the price of the Issuer's public securities indicates that its owners do not have confidence in the board and management, and that actions need to be taken quickly to address that lack of confidence.
We stated our belief that a date be set to achieve a combined ratio below 100 and that date be communicated to shareholders. We stressed the importance of management accountability to clearly stated corporate goals.
We urge the Chairman and other board members to insist that management maximize value per share and minimize both operational and balance sheet risks. We oppose any capital raise by the Issuer. We believe management needs to reduce expense levels. We strongly oppose the Issuer's acquiring other companies or businesses at this time. We hope to work constructively with the existing management and board to help them focus on maximizing value per share. However, we will exercise our shareholder rights to whatever degree necessary in order to achieve our goals.
Can the Activists Succeed?
A campaign to remove Shaun Jackson from both his CEO post and the Board in addition to one of the other Board members (Walsh) is not particularly easy for a US based investor to pull off given that this is a Canadian company. I have observed quite a few examples over the years of institutional Canadian shareholders mired in bureaucracy who want to keep the status quo and shun the American hedge fund “vigilante”. Stilwell has two things working in his favor with respect to this.
First, the status quo at Kingsway is clearly unacceptable. Jackson has spent the last 13 years at the Company and has done nothing but destroy value. Given his lackluster performance and the current environment for financial stocks, why NOT give Stilwell, who has a proven track record, a chance to reverse the fortunes of the Company?
Secondly, unlike most U.S. Companies, Canadian law gives Stilwell (or any 5% holder) the right to call a special meeting at any time for any legitimate purpose. If the Group does not success in replacing Jackson and his henchmen the first time around, they will simply continue to fight until victory is achieved. Their relentless pursuit of shareholder value is no more evident than in PBIP, a Pennsylvania Mutual that the Group has refused to concede victory to after a fairly long battle.
Kingsway is shaping up to be another fight. On December 2nd, 2008, the Company announced a Special Meeting requisitioned by the Stilwell Group, as the two sides failed to come to terms on a reshuffling of the Board. The vote will now be put to the shareholders on February 10, 2009. The record date for this meeting will be January 6th, 2009. Naturally the Company has taken the position that the meeting will cost it significant time and expense. Shareholders will decide on the future of the Company with what looks to be a pivotal contest.
One of the first orders of business of the activists could be to retire all or part of the Kingsway debt issues that trade below market. Kingsway’s $66m loan payable, for example, was repackaged by the lender into a security which trades for $7.50 on a $25.00 issue price or a third of face. The entire equity portfolio of Kingsway should be liquidated and the proceeds used to buy this issue back. It is also worth noting that the Company’s $196m debt issue is offered in the marketplace at around 70c. This too could be retired in order to increase book value. We will take a look at what retiring at least one of these debt issies does to the Company's valuation below…
Valuation
There are two methods to value a rejuvenated Kingsway. One is on earnings per share and the other is on book value. I consider book value to be much more interesting, but show the earnings power of Kingsway below for illustrative purposes.
Earnings per share
Kingsway should be able to write its book of business at a combined ratio below 100, coupling a niche focused discipline with fewer operating expenses. Investments should throw off a very minimum yield in the current environment. It’s well documented that a properly run non-standard auto book ought to run a combined ratio of 95% in tough times and as high as 65% in great times.
Here is Kingsway’s earnings power per share under different combined underwriting ratio and investment return scenarios, not including any share buybacks or debt retirement. I use a static $35m for interest expense (which would decrease if the debt were to be retired) and a tax rate of 38% to be conservative despite the Company’s NOLs:
Underwrite to 95%, Investments Yield 5% = Earnings of $2.06 per share
Underwrite to 97%, Investments Yield 5% = Earnings of $1.63 per share
Underwrite to 100%, Investments Yield 5% = Earnings of $1.00 per share
Book Value
Even in this awful environment for financial stocks, Kingsway was able to sell its York Fire and Casualty unit in late August for almost 1.8x book value. Comps in Kingsway’s market cap range trade anywhere from 1.1x – 1.3x book.
As established in the previous section, the true book value of Kingsway under some very conservative assumptions should shake out to a current value of $10.45 per share.
Should the activists liquidate the equity portfolio and retire the $66m loan at the market price of say 35-40c on the dollar, tangible book would rise to $11.27 per share. Using only the example of this $66m loan getting retired, just to be conservative, here is what the stock is worth at various multiples of the $11.27 tangible book value:
@ .85x book = $9.58 per KFS share
@ 1.0x book = $11.27 per KFS share
@ 1.1x book = $12.4 per KFS share
@ 1.2x book = $13.5 per KFS share
@ 1.3x book = $14.65 per KFS share
@ 1.4x book = $15.78 per KFS share
@ 1.5x book = $16.9 per KFS share
Each of these scenarios provides excellent upside potential from current levels.
It is also worth noting that Kingsway’s unpaid claims are not discounted ie claims are listed at face on the balance sheet but are not all due on demand like a bank’s deposits would be. This is not just a philosophical point. The reason that an insurance company such as this is a safer investment in uncertain times than a bank is that there could never be a “run” on Kingsway, ie policy holders can’t all show up at once and demand that claims be paid.
The activist group may very well force Kingsway to abandon its business units that are not focused on the core non-standard auto and other niche lines. If this were the case, the balance sheet transformation would be “game changing” ie if these niche activities only represent around $800m in premium, and Kingsway were to write at 2x equity to premium, they would only require $400m in equity. With non-standard auto as the focus, the blessing of a great AM Best rating would be of little importance to the business. Thus, there would be a couple of hundred million dollars in equity that shareholders could pull out of the Company. This is just something to think about.
Risk Factors
The risks to an investment in Kingsway include continued poor execution of management should the activists not prevail, an inability to fully rationalize the business units, and a continued general malaise with respect to financial shares. I think that most of these risks are priced into the current depressed share price.
Notes:
Link to second Stilwell 13-D filing: http://www.sec.gov/Archives/edgar/data/1072627/000089291708000291/stilkfs13da111408.htm
Link to fifth 13-D filing: http://www.sec.gov/Archives/edgar/data/1072627/000089291708000301/stilkfs13da3-112408.htm
Catalyst
Catalyst(s):
Shareholders elect the Stilwell Group to the Board in February and the market regains confidence in Kingsway’s ability to both underwrite profitably and allocate capital properly.
Although their record to date has been far from satisfactory, the Company did announce that it was exploring strategic alternatives on November 21st, 2008 with the help of Scotia Capital and Houlihan Lokey.
On December 17, 2008, the Company announced that they would cut 2009 SG&A costs by $20m by merging some subs and laying off staff. It’s a start, and clearly a response to the Stilwell Group’s demands.