Description

“Kingsway has undergone a transformation roughly five years in the making. As I write this, we are a dramatically different company than when present management embarked on this journey. Today, we can best be described as a lean, decentralized, tax-advantaged holding company with nine high quality operating businesses housed in two operating segments – Extended Warranty and our Kingsway Search Xcelerator (“KSX”). We have modest leverage, adequate resources and a great platform to execute our organic and acquisition growth strategies. We are energized by the opportunities in front of us.” – Kingsway 2023 Annual Letter to Shareholders

Kingsway (“KFS”) has been written up many times on VIC in the past, though because of the company’s many alterations in both operations and strategy, only two writeups exist that touch upon the present corporate version of KFS (pitched by fiverocks19 in 2020 at $1.75/share and Jumpman23 in 2023 at $8.52/share).

The company deserves a revisit at $8.18/share, down slightly since Jumpman23’s writeup in September. At the current price, KFS trading at 16x underlying run-rate EBITDA (defined as trailing 12 months EBITDA of all subsidiaries, irrespective of whether KFS only owned them for part of the TTM). The valuation does admittedly not provide any discount to the existing operations but it is Kingsway’s incremental investment opportunities that are desirable (20-30% return on invested capital) and why paying 16x EBITDA on current profits – early on in the company’s life cycle – could end up looking very cheap. In essence, I believe that Kingsway can compound free cash flow per share at a high rate (above 20% p.a.) for a long period of time (>5 years) and that, as the company becomes more diversified when it acquires additional businesses in a selected number of core verticals, it’s likely that its valuation multiple will expand as well. However, we do not need to make any such aggressive assumptions to get a good return outcome. Without any heroic assumptions, I think KFS can be worth $20/share in 3-4 years.

Kingsway is particularly attractive here because the company is now at a stage where the management team can fully focus on growing the search platform through acquisitions, having previously gone through a long process of simplifying the corporate entity, getting rid of non-core assets, optimizing the existing businesses like its extended warranty operations as well as building out the basic infrastructure for its new search fund business. 

The share price decline of late (KFS traded at ~$9/share for most of Q1-Q2, until May) is likely partly due to the search fund business having performed worse than expectations on the whole (particularly CSuite and SNS): management noted that run-rate EBITDA of the operating businesses was in the $18-19m range as recently as January this year but most recently, in May, talked of a $16-17m run-rate EBITDA range. Since both run-rate figures include the same set of companies coupled with the fact that we know that DDI has been performing well with stable profitability ($1.7m in TTM adj. EBITDA in Q1 2024 vs $1.8m at close – difference due to investments in employee benefits and new HR systems) and that the recent acquisition of SPI is too small to make a material difference ($0.3m in adj. EBITDA), it implies that CSuite and SNS continue to have challenges. Management noted on the Q2 conference call that CSuite was facing both declining revenues and adj. EBITDA in absolute terms but did not quantify the figures and they decided not to include any year-to-year comparisons when talking about SNS’ performance at all. In addition, there has been selling pressure from Kingsway’s largest owner, Joseph Stillwell, who’s been looking to incrementally reduce his position in KFS as it's an inordinately large portion of his fund. We’ve seen him sell parts of his stake several times whenever the share price has risen to $9-10 per share. Stillwell is likely to continue to sell as/if the share price rises. This will unfortunately be a constant supply of new shares into the market but should be seen as positive for the company long-term since Stillwell is not chiefly in charge of corporate decisions nor has been very successful in his past attempts to make KFS work. KFS in its current form is the brainchild of CEO J.T. Fitzgerald (6.5% ownership), who continues to gradually increase his ownership stake in the company. 

I am disappointed in the performance at CSuite and SNS but I don’t see it as necessarily very important in the grand scheme of things. In the short-term, it depresses cash flow and thus the capital available for future acquisitions, impacting IRR, but this impact is minor. The issues at the two companies looks to be cyclical: the travel nursing industry took a steep downturn following the covid-19 fueled boom in demand, impacting SNS, and the rapid increase in interest rates temporarily put a stop to M&A activity, a core market of CSuite’s services. Positively, the managers of these two businesses have been implementing a lot of new practices to work against the declining sales (see prior KFS commentary on this in the 2023 annual letter and the quarterly results). However, should these headwinds persist for longer (into 2025 and beyond), it puts management’s underwriting into question and I would then begin to be much more concerned.  

Before going into why I believe Kingsway’s search fund platform will be able to complete accretive acquisitions for many years to come, I’ll touch on some basic background information of what’s happened in recent years.

Note: in the VIC interface, I use EBITDA (M) instead of EBIT (M) as the difference between the two numbers is almost entirely non-cash amortization

The Last 5 Years’ Improvements 

A lot has already been written about KFS’ extensive history and its many efforts to grow out of its busted insurance company shell into something tangible that could utilize the company's massive net operating losses (>$600m) that were created by the financial crisis. That history does not require repetition here; it's sufficient to say that the strategies employed by Stillwell and his picked CEO for the job, Larry Swets, strategies which included trying to convert Kingsway into a merchant bank, did not plan out. 

The noteworthy piece of recent history in my eyes begins in 2018 when J.T. Fitzgerald joined as CEO: the corporate structure and web of company interests were overwhelming when J.T. took over, but in the last few years, he has gone on an impressive streak of simplifying the business through re-organizing the business strategy, monetizing non-core assets and streamlining the capital structure. Through these efforts, Kingsway has (i) returned to being cash-flow positive at the corporate level (ii) reduced net debt by ~$270m and (iii) established a clear growth strategy for future capital deployment with KSX (Kingsway’s search accelerator). He also designed a clear incentive structure throughout the organization: managers of the company’s warranty businesses are incentivized on profitability and return on capital metrics, and the cash flow generated by these divisions are deployed into search fund acquisitions, where searchers can receive up to 25% of the acquired company by reaching certain return hurdles (vesting in thirds — one third is received at close of acquisition). J.T. is a large owner of Kingsway shares himself and board members of KFS have purchased their ownership interests in the company on the open market (they only receive cash-based compensation). 

Advantageously Positioned

The investment thesis for KFS can be summarized as, one, search funds being investments with generally good base rates (6x MOC and over 30% pre-tax IRR on average) and, two, Kingsway being structured more thoughtfully than the average search fund, leading to a better-than-average outcome. So that is the main purpose here: to go over why KFS has a good chance of creating a better - and more scalable - product and the ensuing value creation resulting from that effort.

For those unacquainted with search funds, a search fund is an investment vehicle for a single or two searchers to finance the process of finding and acquiring a company. After closing, searchers transition to a CEO role to run the company. For aspiring entrepreneurs who do not have an interest in creating a tech startup, acquiring an existing business from a retiring founder is an attractive choice. There are a few variations of entrepreneurship-through-acquisition / search funds: the single-investor model, where one sponsor (PE, growth, family office, etc.) funds the searcher, provides a salary during the search process, and varying degrees of support and/or network access; a funded model, where a group of similar investors sponsor the searcher and again help with necessary support such as mentorship advice, bank relationships, etc. Kingsway is running one of the newest varieties where there is no fund structure to begin with. Instead, they benefit from permanent capital through their public corporate entity, which allows them to take a longer-term view. This is a structural advantage that Kingsway has, as it’s been shown that the top quartile return outcomes in search funds are sold in year 4 or 5 at 4-5x MOC. They are seldom held for 10 years or more. Why? Despite the initial success, fund structures and search compensation packages incentivise a short-term exit. Kingsway’s open-ended approach is favorable for compounding capital over a longer period of time. Moreover, a public company structure can help to convince old founders to sell – as was the case with DDI, for example – since it is easy for them to verify the financial standing of the company, something they many times care deeply about as they are giving over their life’s work to another business partner. 

The long-term holding model explains why Kingsway has made the strategic choice of methodically building out its search platform, prioritizing the org structure over growth in the short-term. On May 20th this year, Kingsway held an investor day that provided a lot of insight into how the search process works at KSX. The talk centered on the scalability of the platform: The Head of Business Development, Charles Joyce, has spent the last few years building out a structured search process that should enable them to improve the scalability of the KSX platform without sacrificing on quality. Many of the steps that a searcher needs to go through to identify an attractive industry, find a business, and close the deal can be entirely or partly automated to reduce repetitive and redundant tasks and increase a searcher’s productivity. KSX provides searchers with outreach tools, databases of brokerages and other intermediaries, and solves many administrative tasks such as managing accounting, compiling the necessary regulatory requirements for negotiations and financing, and keeping a proper system of records. This directly influences the volume of acquisitions that KSX could realistically complete without it starting to impact due diligence or the price paid. These features are also attractive support systems for searchers and ensure that Kingsway can pick top-tier talent for their operators in-residence “class”. A searcher does not give up any financial terms by joining KSX vs pursuing a traditional search fund (incentive structures are fairly standard across the industry) but they derive many benefits from KSX versus other alternatives. It undoubtedly also helps to attract people by having long-time search fund investor William Thorndike onboard as an investor and advisor.

Over time, KSX’s automated processes and the quality of their searchers will be crucial to maintain returns at scale and it’s encouraging to see that management is doing the work today to ensure that they have sufficient resources in the future. There are many case studies and research papers on serial acquirers that highlight the negative correlation between (i) pace of acquisitions and (ii) the ROIC generated by those acquisitions. It will be important to continue to monitor KSX’s acquisitions and see if they continue to adhere to their acquisition volume standards. Looking further out, aside from new search investments done through the HQ, KFS can not only scale acquisitions through a wider set of searchers but also have existing operators at its companies do tuck-ins within their vertical as they gain more experience and can handle more responsibility. There’s an emerging platform effect where, as the roster of acquired companies expands, there’s an increasing number of internal M&A from tuck-ins that fuels growth for a long period of time. The investor day showed that the basic infrastructure has been fully laid out and that the focus can now be directed on growing the platform.

While some investors have been surprised by the lack of acquisition announcements by Kingsway in 2024, I think that the slow approach is a function of their focus on establishing the platform, in addition to the poor performance of CSuite and SNS which probably has made management more careful of the pace of acquisitions, as time and resources are required to ensure that those divisions get back on track. 

A relevant question to ask here is why returns have persisted in the search fund space despite the increased attention placed on it and will these returns continue in the future? The number of search funds started has risen dramatically in recent years, more than doubling from 2019 levels to close to 400 new launches per year. This sounds ominous at first glance but should be put into context of the small starting number and the massive ‘silver tsunami’ of retiring baby boomers who are looking to hand off their businesses to the next generation. As it relates to Kingsway specifically and why they’ve had success so far, I would say that first, copying KFS is hard to do: it's taken years to build out the operational infrastructure to scale the KSX platform to more than 1-2 operators in-residence. Secondly, high-quality companies can generally still be acquired below 7x EBITDA which translates to high initial returns (even better if the searcher provides value to the company post-close, which is a core assumption). The multiples paid for good businesses have not changed over time which is due to a combination of the large wave of founders looking to retire, their preferences in an acquirer and the lack of cheap debt capital to finance the acquisition of small companies.

Current Profitability

In 2023, the businesses that Kingsway owns generated $16.4m of EBITDA (and similar cash flow figures). This includes the warranty operations, the search fund companies owned coming into 2023 as well as the pro-forma figures of SPI and DDI, the business acquired during the year. Against an enterprise value of $261m, this works out to 16x. However, a ‘normalized’ EBITDA figure should be higher than the 2023 figures, closer to $18-19m, as the warranty businesses have been temporarily under-earning (8.6% EBIT margin in 2023 vs 14-15% EBIT margins in the prior two years). The extended warranty businesses in and of themselves could likely be sold for around $150m ($10-11m of EBITDA and a 14-15x multiple) as the demand for such businesses has been high in recent years. Kingsway has talked about how they are not buying any warranty operations even though they like them very much because of the high prices on the market. This leaves $110m paid for the search fund business, which generated $8m in EBITDA in 2023.

While these businesses command much of Kingsway’s enterprise value on their own, it is not like we are not betting on or paying up for growth: overlaid on these operations are $4-5m of corporate overhead and a few $m’s in other expenses to support the search fund platform. The ongoing costs take a significant cut out of current profitability ($16m in segment-level EBITDA is reduced to $9m at the corporate level). It requires a belief in the attractiveness of the investment opportunities at KSX to see these ongoing costs as worthwhile, which I do.

Future Returns

With $10m in available cash (plus $8m of restricted cash) and positive cash flow, Kingsway has sufficient liquidity to support their stated pace of 2-3 acquisitions per year, and should KSX in an unlikely scenario need more liquidity to pounce on several attractive opportunities all at once, management has noted that they do have the ability to recapitalize their under-leveraged warranty companies. In Q2 2024, J.T. reaffirmed that they are still looking at doing 2-3 acquisitions per year on average. 

To illustrate what returns on future capital deployed may be, we can look at the past. When reviewing the acquisition history, a typically acquired business at KSX has $10m revenue, 20% EBITDA margins, ~5% long-term organic growth, and little capital expenditures to speak of, leading to pre-tax FCF that almost equals EBITDA. These businesses have been acquired at 5x EBITDA on average, financed 50/50 by equity and debt (at ~9% interest rate). In those instances when Kingsway has paid a higher multiple (6-7x EBITDA), it’s been due to the better-than-average quality of the business (e.g. DDI’s 20% organic growth rate, SPI’s high revenue retention). I think the average statistics provide a good measurement stick for future acquisitions. I assume that Kingsway will make 2 acquisitions in 2024 and then slowly scale them up to 3 acquisitions in 2025 and 4 in 2026. By now we are so far into the future that we can’t have a perfect sense of what Kingsway will look like. Will there be a set of vertical industry ‘platforms’ deciding on their own acquisitions/tuck-ins or is it still primarily the recruitment of new operators in-residence fueling the pace of acquisitions? Whatever specific structure KSX eventually decides on, today the structure supports 4-5 acquisitions per year and given the decentralized acquisition structure, I think this could expand further. Hence I’m increasing the volume of acquisitions in the outyear, 2027, relative to 2026, to 6. The output of all of my assumptions on FCF can be seen in the table below: 

Kingsway ends up with $45m in EBITDA in 2027 ($34m in FCF) when following this hypothetical acquisition scenario and I think it may not be far from the eventual truth. Capitalizing EBITDA at 14x EBITDA  (more than two turns lower versus today’s valuation as I expense all corporate costs in the 2027 EBITDA figure), the expected return lands at 24-25% per year. This is unsurprising as the acquisitions are the primary driver of the return and when we approximate the deal IRR generated by the acquisitions by using return on equity and half of organic growth, acquisitions do indeed produce a 24% initial return. The slight margin improvements I assume of the warranty operations and the search business over time work against the valuation headwind. My price target range out to 2027 is $18-22 per share.

Some may view Kingsway with a skeptical lens. It has definitely had its stops and starts. The risk in the investment is reduced by the great people at the helm. J.T. has many characteristics of other very successful CEOs in the past and I’m sure he will work towards a great outcome for all. He has significant skin in the game and made sure others are aligned too by establishing clear incentives across the entire organization and he has a rational mindset, not afraid of selling good assets when the price is right (sold the division PWSC for a 10x equity return after holding it for 4 years). 

KFS released its Annual Shareholder Letter on May 1st. It is a good read, showcasing J.T.'s priorities. Long-term compounding as measured in decades is almost always a function of how shrewdly capital has been invested and reinvested. What a CEO points to as important in letters and interviews gives a lot of clues to their subsequent behavior. A CEO of an operating business is primarily responsible for capital allocation. Warren Buffett in 1987: “after ten years on the job, a CEO whose company retains earnings equal to 10 percent of net worth will have been responsible for the deployment of more than 60 percent of all capital at work in the business.” This becomes even more of an acute skill in a decentralized holding company of capital-light businesses, where all excess is diverted back to ‘headquarters’ to be reinvested in new ventures. If KFS continues on its current pace of acquisitions and slowly increases the number of deals through its structured process but maintains its current transaction size (something KFS was very clear on stating that they desire to do), the rate of compounding can be high for many years. Although we do not know what the company will look like in 5 years time, it has the potential for an open-ended outcome. On top of this Kingsway has over $600m in NOLs that will shield all profits against corporate taxes for most of the remaining decade, further augmenting the rate of growth in FCF per share.

Catalyst

• Acquisition announcements in H2 2024
• Improved performance of and/or sale of extended warranty businesses

Risks:

• Continued dissapointing performance at KSX subsidiaries CSuite and SNS
• An expensive acquisition with subsequent poor performance that reduce KFS' cash flow and diverts attention from the core business
• Loss of key man (J.T.) as he's been instrumental for the success of KFS so far