Why Do Insiders Love Kingsway Financial Services?

| About: Kingsway Financial (KFS)
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Kingsway Financial Services (NYSE:KFS) shareholders have had a rough ride over the past five years as insurance underwriting losses have proved far greater than the company had previously estimated. That said there are reasons to believe that the worst is behind the company, and that it might have a future as a cash generative, disciplined acquirer. If this is the case shares are far too cheap - trading at book value but at a material discount to adjusted book value (more on that later). With KFS having lost over $350 million in the past 4 ½ years, what reason do shareholders have to be optimistic? The company is controlled by a highly successful activist investor Joseph Stillwell who invested additional capital into the business via a rights issuance in September 2013. Besides increasing his investment last month, while operating losses have piled up and shares have languished, Stillwell and other insiders have been steadily increasing their stake in the business:

Trading Period

Insider Buying

Insider Sales

Option Exercises

year-month

Shares

Value

Shares

Value

Shares

Value

2013-08

54,500

$167,426

0

$0

0

$0

2013-06

691,768

$2,512,098

0

$0

0

$0

2013-01

56,450

$219,858

0

$0

0

$0

2012-12

199,800

$569,590

0

$0

0

$0

2012-11

28,957

$66,724

0

$0

0

$0

2012-10

58,478

$191,519

0

$0

0

$0

2012-09

139,926

$286,988

0

$0

0

$0

2012-08

3,700

$7,670

0

$0

0

$0

2012-07

60,879

$147,988

0

$0

0

$0

2012-06

15,000

$8,645

0

$0

0

$0

2012-05

12,000

$7,662

0

$0

0

$0

2012-04

3,000

$2,145

0

$0

0

$0

For a more detailed breakout (by insider/transaction see http://www.insider-monitor.com/trading/cik1072627.html).

Note that insider buying was actually greater than indicated in the above chart - KFS did a rights issuance in September whereby insiders invested another $4-5 million into the company. Interestingly the transaction was structured in a way where the shares were purchased at a premium ($4/share vs. $3 share price) and came with out of the money warrants attached (7 year warrant with a $4.50 strike which is callable at $6 and a 10 year warrant with a $5 strike which is not callable). This is a convoluted deal structure (usually rights issuances are done at a discount) which enabled insiders to further increase their stakes in the company while shoring up the capital position (which had been hurt by losses).

Insider buying is great but it is particularly exciting when the insider purchasing is done by well-respected industry experts with successful track records. The key insider involved in KFS is activist Joseph Stillwell who now owns 19.3% of outstanding shares. Stillwell has a remarkable track record of investing in banks and insurance companies - he is best known for investing in thrift demutualizations but has successfully invested in a couple of insurance turnarounds including American Physicians Capital group which was an absolute basket case that he turned into a homerun (he was involved for about 6 years). Stillwell occupies a seat on the board and was responsible for selecting the CEO Larry Swets, who has a background as an insurance consultant. Swets, 38, owns 2.9% of the outstanding shares. Other board members own an additional 9.3% of outstanding shares making total insider ownership 31.5%.

What do these guys see that isn't evident in the financials? Firstly, because of the large losses the company has incurred in the past several years, KFS will be able to defer taxation on nearly $900 million in pretax income (so has a nearly $300 million tax asset). The company has a valuation allowance for the full amount of the asset (so this is not included in book value) because its poor operating performance precludes the company from recognizing it as an asset. Over the past two years, KFS has been acquiring capital-light insurance services businesses for a total of $22 million (the largest of which is a brokerage). When combined with its existing insurance services business, revenues from this line of business total nearly $50 million on an annualized basis. Operating income has been bumpy but looking at publicly traded insurance brokers, it is very plausible that this business could earn an operating margin of 15-20% which would translate to $7.5-10 million.

Secondly, while the company has experienced losses and recently raised capital, it is in the midst of winding down (running off) its most troublesome business, Florida-based Amigo. As Amigo is run off, it will release capital (insurance regulations require a minimum amount of capital to be kept in the insurance subsidiary) which will eventually be up-streamed to the holding company. Similarly, while pricing for its other two insurance businesses has improved, if these businesses don't produce acceptable returns on capital I would expect that they too would be exited (either by selling or running off). So while insurance has sucked capital (to shore up reserves) in recent years, going forward I expect it will be a source of capital. I think there is something like $35-40 million of capital which can be freed up over the next 2-3 years.

The release of capital (coupled with putting the $13 million raised in recent rights issuance & $16 million from sale of Atlas preferred shares) will give Kingsway some options. I expect that $27 million will be used to pay an upcoming maturity in 2014. The remainder will likely be used to make acquisitions (and help KFS make use of those NOLs). Assuming that it spends $40 million to buy a business for 8x EBIT, this would add another $5 million in operating income. Here is what the financials could look like:

Kingsway Services

9

assumed operating profit from existing services business

+Acquired Operating profit

5

assumed to pay 8x operating profit

-Interest Expense

-2.38

34 million in debt @ 7%

Pre-tax profit

11.62

 

-Taxes

0

losses sufficient to shield $900 million in taxes

After-tax income

11.62

 
     

Shares outstanding

16.5

pre-warrants

+Dilution from Warrants

6

 
Total Shares o/s

22.5

including warrants
     

EPS

0.52

 
     

P/E multiple

   

10

5.16

 

12

6.20

 

13

6.71

 

14

7.23

 

16

8.26

 

I don't think it is unrealistic to expect 130%+ appreciation looking out a couple of years. Actually, this could be conservative - given the NOL position described above, KFS is likely to use the free cash flow generated by the business to make more acquisitions which would facilitate EPS growth of 10-15%. At some point this could be considered sexy - a cash generative services business with a shrewd activist allocating capital toward tuck in acquisitions. A story like this could attract some interest in the market and warrant a multiple closer to the higher end of my range indicating +180% upside. While this is certainly a messy situation, I've decided to follow the insiders and have taken a long position in Kingsway.

Disclosure: I am long KFS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.