Description

We believe KFS is a timely and catalyst-rich long with 3-4x upside under a rebuilt management team.

Catalysts in the next 60-90 days include:

• Clean-Up of Forced Seller.  We understand shareholder Long Meadow Investors LLC is liquidating its investment vehicle.  As a result, it has been a “forced seller” of 980,000 KFS shares over the last 3-4 weeks – at one point causing KFS shares to fall more than -40%.  This seller appears to either be done or very close to cleaned-up.

• Dark, but Soon Current.  KFS has been dark on its financial statements for over a year, but the company started catching up in March and we believe KFS is likely to come current in the next six weeks.

• Refreshed Equity Story.  KFS has done zero outbound investor relations for 2.5 years.  Once the company is current, we anticipate KFS will re-introduce its far more straightforward equity story to investors.

As detailed below, we see fair value of $6-7/share vs. a current depressed share price of $1.75.  This represents upside of 3-4x to our estimate of intrinsic value.

Background

Kingsway Financial Services (“KFS”) was formed in 1989 as a niche Canadian insurer.  For the next 18 years, the company pursued a “growth at any cost” strategy (total written premium compounded at +60% per year from 1995 to 2003).  The peak was 2006 when KFS’s market cap reached $1.3 billion.  In 2007/2008 the company imploded as poor underwriting standards were exposed heading into the financial crisis.

KFS’s market cap collapsed by 95%+.  This attracted well-known financials activist Joe Stilwell, who launched a campaign to oust management.  He successfully took over the company in 2009. 

Stilwell named Larry Swets as CEO.  Swets’s vision was to remake KFS as a mini-Berkshire Hathaway (with a billion-dollar NOL asset attached).  In the years that followed, Swets pitched investors with buzzword-heavy paeans to value investing.  At the same time, he allocated capital to a series of increasingly complex and opaque transactions that were often rife with conflicts-of-interest.

In 2018, as an increasing number of Swets’s deals soured and the conflicts-of-interest came to light, Stilwell (the Board Chairman and largest shareholder) ran out of patience.  He fired Swets and replaced him with JT Fitzgerald, the company’s then-President, who had been brought on a short time earlier to drive operational improvements.

A Sensible Strategy

Fitzgerald cleaned house.  Swets’s cronies were sent packing.  The entire leadership team turned over.

His approach has been to shift the company's model to an operating business (not an investment holdco).  The centerpiece is KFS’s best business: its growing, asset-light, cash-generative warranty operation.  In a nutshell, the strategy is to monetize KFS’s non-strategic investments and re-allocate the capital to scale up warranty.

Over the last eighteen months, Fitzgerald has (1) simplified the corporate structure by changing the company’s jurisdiction of incorporation to the US and exiting the Canadian dual-listing, (2) completed the sale of KFS’s money-losing, albatross non-standard auto insurance business, (3) cut central costs by a third, (4) made significant headway unwinding the non-core investments/transactions made by Swets, and (5) redeployed capital to the purchase of growing, profitable, asset-light warranty businesses at reasonable valuation multiples.

The significant progress has been masked by a restatement.  Kingsway hired RSM as its auditor prior to the 2018 audit.  During the audit, RSM decided (contrary to the determination of the prior auditor) that many KFS investments needed to be consolidated onto KFS’s financial statements.  This had essentially no impact to KFS’s valuation, earnings, or cash.  However, it required a lengthy process by which each newly-consolidated investment entity (many of which have since been sold) needed to pass RSM’s audit review.

KFS went dark in April 2019, just prior to issuing its 2018 10-K.  Two months ago, KFS finally caught up and filed the 2018 10-K.  KFS has since issued 10-Q’s for the first three quarters of 2019.  Our expectation is the 2019 10-K will be filed within weeks and KFS has a reasonable chance to be current before the end of Q2 2020 (i.e., in the next six weeks).

Valuation

KFS’s financial statements are messy and not yet current.  That said, we believe it possible to do a sum-of-the-parts valuation of the business.

Assets

First, there is KFS’s warranty business.  In 2018, this business produced nearly $8M in operating cash flow.  The company has disclosed that the Geminus warranty business (purchased in early-2019) was done at a 5x EBITDA multiple and the purchase price was $8.4M.  Accounting for growth in the interim, we believe KFS’s warranty vertical in total is likely a $10-11M cash EBITDA business.  The closest public warranty comp, FTDR, trades at 14x EBITDA.  If we value KFS’s warranty business at 10x EBITDA, this represents value of $100-110M.

Second, there is KFS’s railroad asset called CMC.  CMC owns a mission-critical, 190-acre railyard in Dayton, Texas leased by BNSF.  At the end of the lease (in 2034), BNSF will pay $150M to CMC for ownership of the property, in which KFS has an 81% interest.  After deducting its portion of the $68M then-remaining to pay off the mortgage, KFS will receive $67M.  In addition, KFS is to be paid $25M total cash in equal installments by BNSF through 2034.  Total cash received by KFS from CMC is expected to be $92M.

Third, KFS owns a portfolio of passive investments it is currently monetizing.  This portfolio includes public and private securities as well as significant real estate holdings.  The most important assets are three triple-net leases – one is a food distribution facility, one is a hearing aid manufacturer, and one is a lubricants facility (i.e., no retail) – that are likely worth $3-4M each.  Public equity stakes and other assets can also be readily valued.  We estimate the passive investment portfolio is worth $20-30M.

Fourth, KFS has net operating loss carryforwards that totaled $846M as of the end of 2018.  These NOL’s expire between 2027 and 2037.

Liabilities

First, KFS has outstanding liabilities in the form of Trust Preferred Instruments (“TRUP’s).  The TRUP’s are really sh**ty paper (for the lenders…great for KFS).  They are long-dated, with maturities between 2032 and 2034.  The coupons are cheap at LIBOR + 400bps.  And KFS has the ability to turn interest payments on or off at will.  If traded, they would probably be worth 50-60c on the dollar.  KFS values the liability at $50.5M on its balance sheet.  But we value this liability at par, which is $90.5M face value, plus a few million dollars of accrued coupon payments.

Second, KFS has asset-level debt against its warranty businesses in the single-digit millions.

Third, central overhead costs for KFS, which primarily consist of public company costs, run at roughly $4M per year.

Sum-of-Parts

KFS has approximately 21.9M fully-diluted shares outstanding.

The pay-out from CMC lines up closely with the maturity of the TRUP’s.  To keep things simple, we net the $92M CMC value against the $90.5M TRUP’s liability at par plus accrued coupons and call it (more-or-less) a wash.

That leaves us with the warranty business, the passive investments, and the NOL’s.  We conservatively apply all central costs to the warranty business and value it at 10x fully-costed EBITDA of $6.5M, less the asset-level debt, for a value of around $60M.  An acquirer might pay the full $100M and cut the public company expenses (so we could be understating true value).  That said, we don’t see KFS selling the warranty business, so we take a more punitive approach.  We know other investors who value this business at $80-90M.

Using our valuation, we see the warranty business worth $3/share.  The passive investments are worth a little more than $1/share.  We value the NOL’s at $2/share.  We estimate total value at $6-7/share vs. a current share price of $1.75/share.

COVID-19

We think the COVID-19 pandemic has had a neutral impact on KFS’s financial statements.  KFS sells prepaid warranties (primarily commercial HVAC and personal auto) that it books over a multi-year period.  With many restaurants closed and lower miles driven, claims are likely down materially – boosting KFS’s bottom-line.  This is modestly offset by fewer new warranties written.  As KFS’s warranties are anywhere from four years to ten years, we do not expect a meaningful change in profitability due to either slightly fewer policies or slightly fewer claims.

Risks & Uncertainties

There are a number of unusual risks to an investment in KFS.  Its past financial statements are messy.  The company is dark.  For the thesis to play out, KFS will need to successfully (1) sell passive investments and (2) purchase warranty businesses at reasonable prices.  Some investors have a bitter taste in their mouths when they hear “KFS” if they remember the Larry Swets experience.

That said, we think the opportunity is compelling.  Even valuing the NOL’s at zero leaves a fair value above $4/share.  That’s 150% upside.  A less-punitive mark of the TRUP’s liability (could it be repurchased below par?) or central costs (is it right to value them at a warranty business multiple?) could add $2-4/share of incremental value.  And if fully utilized (unlikely), the NOL’s could be worth as much as $8/share.

Conclusion

KFS insiders own close to 50% of the company.  Just prior to KFS going dark, Stilwell was an aggressive buyer up to $3/share.  This is the second-largest disclosed position in his portfolio.  Stilwell (and other insiders) are highly motivated to have the shares trade closer to fair value – and to make the business a success.

We believe KFS has already turned the corner operationally.  Now it needs to turn the corner in the financial markets.  As the forced seller is cleaned up, the company comes current with its reporting, and KFS reintroduces itself to the investor community via an analyst day and proactive shareholder communication, we see a clear and timely path for that to happen.

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds a long position in this security. Author may purchase additional shares, or sell some or all of Author's shares, at any time. Author has no obligation to inform anyone of any changes to Author's view of KFS US. Please consult your financial, legal, and/or tax advisors before making any investment decisions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in KFS US. READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE. As with all investments, caveat emptor.

Catalyst

-Share overhang cleared.

-Company becomes current on its filings.

-Investor relations re-started.

-Additional monetization of passive investments & tuck-in purchases of warranty operations.