KFS - Kingsway Financial: An Undervalued Compounder With An 'Outsiders' CEO

Summary

• Kingsway is an undiscovered long-term compounder.
• EBITDA has grown at a 40%+ CAGR since 2018.
• Catalyst No. 1: Kingsway's financial statements are going from "complex" to "simple."
• Catalyst No. 2: Kingsway is poised to be added to the Russell 2000 Index this spring.
• Kingsway's shareholder-aligned board of directors, "Outsiders" CEO, and compelling business model position KFS to create significant value in the years ahead.

In 2021, insiders at Chicago-based Kingsway Financial Services Inc. (KFS) purchased shares on the open market on 96 occasions. Apparently that wasn't enough: In 2022, KFS insiders purchased shares on the open market on 103 occasions. The insider purchases continued right through year end. In December 2022, Board Director Charles Frischer made four separate insider buys to increase his stake by $159,000 at more than $7/share.

And then at the end of December 2022, William Thorndike purchased a $6 million stake in Kingsway through his family office, Sun Mountain Partners, by buying a block of warrants on the open market and exercising them. Though technically not an "insider," Thorndike is a strategic advisor to Kingsway and a famed investor whose book , The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success , is the go-to blueprint for how companies can build shareholder value via smart capital allocation.

When 2021 began, members of Kingsway's board of directors owned roughly half the company. Today, Kingsway Directors (including the CEO) own over 62% of the company.

Where there's smoke, there's usually fire . Why are Kingsway insiders and advisors, who already have tremendous "skin in the game," so desperate to add even more to their ownership stakes?

In this article, we explore the remarkable story of Kingsway - a hidden gem of a business with a compelling business model, an aligned board of directors motivated to grow shareholder value, an "Outsiders" CEO, and a stock that is yet to reflect all these wonderful characteristics.

Company History

Kingsway was founded in the late-1980s as a Canadian insurance company. Successful insurance companies generally grow at a moderate pace, carefully underwriting new business to properly price any new risk taken on.

KFS pursued the opposite strategy. In a race for growth, the company expanded rapidly with gross written premium doubling every two years. This was clearly unsustainable - and as the financial crisis hit, Kingsway's insurance contracts were exposed as having been disastrously mis-underwritten.

The company racked up more than a billion dollars of losses. Kingsway's market capitalization, which had once stood at $1.3 billion, fell to the tens of millions.

In the aftermath of the blow-up, a respected NYC-based activist investor named Joseph Stilwell, who specializes in small-cap financials, saw value in the wreckage and launched a successful activist campaign to take control of the company. In 2009, he installed a CEO to 1) stanch the bleeding, and 2) develop a strategy to monetize the company's $1 billion of net operating loss carryforwards (NOLs), a valuable tax asset that would shield the company from paying cash taxes for years to come.

The new CEO successfully stabilized the business and tied-off pockets of risk. Unfortunately, the new CEO's strategy to monetize the NOL's was to turn Kingsway into a "merchant bank" with an investment holding company structure. This approach, which involved investing in wholly owned businesses, minority investments, and real estate (both wholly owned and minority), was needlessly complex and impossible for public market investors to understand and value.

In 2018, when certain conflicts of interest surfaced regarding the CEO and some of his investments went bad, it became clear new leadership was needed. Kingsway's Board removed the CEO and replaced him with JT Fitzgerald, who we see as a classic "Outsiders" CEO.

An "Outsiders" CEO

What is an "Outsiders" CEO? An "Outsiders" CEO is a leader who in addition to operational excellence (i.e., the ability to successfully run a business) creates value via smart capital allocation. The vast majority of CEO's are either operators or capital allocators. It's rare to find both in a single person. When an investor does find an "Outsiders" CEO, it's worth grabbing on with both hands - because the value creation potential over time can be tremendous.

Fortunately for Kingsway shareholders, we believe JT fits the definition of an "Outsiders" CEO.

On the one hand, he is a strong operator. Trained in the Danaher Business System , widely recognized as among the best continuous-improvement frameworks for business management , JT has a track record of operational excellence.

After joining Kingsway, JT methodically engaged with each business unit one by one, leading to repeated step changes in operating profit (including taking some units from losses to sustained profits). In addition, he exited loss-making and non-core businesses, and sharply curtailed central overhead costs. Kingsway today is a more efficient, more profitable, and more focused business.

On the other hand, JT is a strong capital allocator. Since 2018, Kingsway's operating EBITDA has grown at a 40%+ CAGR. Kingsway has repeatedly purchased businesses for 4-5x EBITDA. In 2022, Kingsway sold one of these businesses for 12x EBITDA, representing a 10x cash-on-cash return over 4.5 years. This demonstrated "proof of concept" that Kingsway's model works.

JT and his team are tightly focused on maximizing return on capital via buying the right kinds of businesses, at the right prices, with the right combinations of equity and debt, to achieve the best-possible return on every dollar deployed.

Kingsway's Strategy

Kingsway's board of directors worked closely with JT to develop a clear and compelling strategy to maximize shareholder value:

1. Focus on operating businesses.
2. Operating businesses must be high quality.
3. Create a repeatable structure for sourcing, buying, and growing great operating businesses.

To understand Kingsway, it's important to consider each of these strategy points one by one.

Strategy Point No. 1: Focus on Operating Businesses

The public markets rarely award full value to investment holding companies, which tend to be complex and difficult to understand. This is particularly true under new accounting rules that require companies to consolidate real estate debt onto the holding company's balance sheet (even if that debt is non-recourse), making the company look more indebted than it is in practice.

Kingsway has resolved to simplify its business by exiting its minority and real estate investments. In recent quarters, the progress against this objective has accelerated.

Kingsway is rapidly becoming a more-focused, cleaner equity story centered solely on its operating businesses and its tax asset.

Strategy Point No. 2: High-Quality Businesses

To maximize utilization of the company's nearly $1 billion of NOLs, it's critical for Kingsway to grow operating profits. Every dollar is precious in this effort.

Kingsway has clearly defined the qualities it's looking for in its operating businesses. Every business must have three specific characteristics: 1) it must be "capital-light," 2) it must be capable of including both equity and debt in its capital structure, and 3) it must be a growth business.

• Each business must be asset-light and not require significant capital to grow (either due to capital expenditures or working capital).
• Each business must have significant cash flow, recurring revenues, a fragmented customer base, etc., such that it is resilient and can sustain interest payments/debt paydown in a variety of market conditions.
• Each business must be in an industry growing at least 2-3x GDP with company-specific opportunities to grow quicker, such that the business can more readily increase profits over time with a growth tailwind.

In short, Kingsway's operating businesses are carefully selected and of extremely high quality.

And this is exactly what Kingsway has done. More than half KFS's EBITDA comes from high-quality, non-cyclical warranty businesses. Other businesses are in B2B services, including outsourced HR, executive placement, and nursing businesses. Each of these companies are of exceptional quality: asset-light, growing, resilient, with recurring revenues and cash flow.

Strategy Point No. 3: The "Search Fund" Model

How does Kingsway find such wonderful businesses and purchase them at attractive prices? The answer is by employing Kingsway's own version of the "Search Fund" model.

Search Funds have been one of the top-performing investment strategies of recent decades. According to the most comprehensive/authoritative study of Search Funds , completed by Stanford University's Graduate School of Business, the aggregate IRR of Search Funds is a remarkable +32.6%.

In the Search Fund model, an early-mid career entrepreneur (often fresh out of business school) raises capital to acquire and then operate a small business. The seller tends to be an about-to-retire small business owner who is proud of the business he or she has built, but has no clear successor (making the business unpalatable to private equity, which prefers to have an operator in place) and the business owner does not wish to sell to a competitor or another firm that would lay off many of the employees.

The Search Fund model solves this dilemma by providing an exit strategy and a successor - with no mass layoffs and a credible plan to continue growing the business.

It also works for the Searcher, who is able to acquire a business at a reasonable price (due to a lack of other buyer options). In addition, many of these businesses are operated as "lifestyle" businesses. A motivated, entrepreneurial younger leader will choose to spend weekends working to grow the business, not taking the family skiing in Lake Tahoe. This presents numerous pathways for the Searcher to enhance profits.

Kingsway's model is to employ the Search Fund structure, but tilt the odds in its favor to drive even better returns.

Kingsway can be selective about its Searchers, which it calls "Operators in Residence" (OIRs), and only select the best talent to join the Kingsway team. Kingsway contributes the capital for the purchase, removing the obstacle of raising outside capital to complete transactions. Kingsway's banking relationships facilitate cheaper debt capital. Kingsway also provides training, mentors, infrastructure, and expertise to maximize the odds of a successful transaction and subsequent profit growth.

The Search Fund model is fantastic. Kingsway seeks to take it to another level.

Operating Profits Can Grow at a High Rate for Many Years

Since 2018, Kingsway's operating EBITDA has increased from $4.8M to $18-19M (run-rate Q3 2022, adjusted for acquisitions). This represents a +40.1% CAGR over four years.

We believe this growth is sustainable. We point to two reasons why.

The first is organic growth. Kingsway's asset-light growth businesses can increase profits over time without requiring incremental capital. There is significant upside in taking "lifestyle" businesses purchased from retiring 70-year-old baby boomers, and putting in charge motivated, well-trained, and incentivized 40-year-old CEOs with the strong support system of Kingsway's advisors and infrastructure.

Ravix, one of Kingsway's recent acquisitions, is a good example. At the time of purchase, trailing EBITDA was $2.35M. One year later, Ravix's trailing EBITDA is $3.14M. This implies run-rate EBITDA is likely $3.5-$3.6M, representing a +50% organic increase in EBITDA in one year - with no extra capital required.

A similar opportunity exists, in our view, for each of the businesses Kingsway acquires. Kingsway could easily see +20% annual organic EBITDA growth from its operating businesses.

The second reason is inorganic growth. If we assume each OIR can transact within 12-18 months, and each existing business can execute a tuck-in acquisition every two to three years (like Ravix did with recently acquired CSuite Partners), then a clear path is presented to acquire an incremental +20-40% EBITDA each year. There could be two acquisitions in 2023, three to four acquisitions in 2024, and five to seven acquisitions in 2025 - with each acquisition representing $2-3M EBITDA.

Put these together, and EBITDA can grow +20% per year organically and +20% or more per year inorganically. The +40% EBITDA CAGR achieved to date could continue for years to come.

Valuation

Kingsway's stock currently trades for $8/share. We believe fair value for Kingsway today is $15-$20 per share. However, given continued operating EBITDA growth in the years ahead, we believe Kingsway could be a $1+ billion company within the next five years ($40+/share).

We approach Kingsway's valuation in two different ways: 1) free cash flow multiple, and 2) sum of the parts.

First, let's consider KFS's value using a free cash flow multiple.

We believe run-rate EBITDA for Kingsway's operating businesses in early 2023 is a bit more than $20M. The businesses are capital-light, so "D&A" is de minimis. The "T" is also de minimis as taxes are offset by the company's NOL's. This leaves only the "I," which is likely only $1M per year, depending on borrowing levels and interest rates. In other words - free cash flow is nearly the same as EBITDA.

A company sustainably growing free cash flow at 40%+ per year could easily command a 20-25x FCF multiple (or higher). That would value Kingsway at $400-$500M, or $16-$20 per share.

Going forward, each incremental $1M of EBITDA would be worth $0.80-$1.00 of per share value. In a few years, if EBITDA reaches $50M+, KFS's stock could easily trade at $40-$50/share.

Second, let's consider KFS's value using a sum-of-the-parts value. To do so, we break the business into three buckets.

The first bucket is Kingsway's collection of wonderful operating businesses. More than half the profits of this segment come from warranty businesses. A few months ago, Kingsway sold one of its warranty businesses for 12x EBITDA . Given that Kingsway's entire portfolio of operating companies shares similar high-quality characteristics (capital-light, growing, recurring revenue, fragmented customer base, etc.), a 12x EBITDA multiple seems appropriate for the group as a whole. Assuming $20M run-rate EBITDA in early 2023 and a 12x valuation multiple, the operating businesses are worth $240M, or close to $10/share.

The second bucket is Kingsway's tax assets of roughly $1 billion of NOL's (including close to $200M of NOLs, against which there is currently a valuation allowance). While these tax assets fully utilized could be worth as much as $9-$10 per share, we apply a haircut and value them at $5-$7 per share.

The third bucket is Kingsway's other assets and liabilities. These include 1) close to $70M cash, 2) two real estate assets, 3) other illiquid investments valued at $10-$20M, 4) debt in the form of trust preferred securities (TRUPs) with a headline obligation of $113.7M, but that Kingsway has entered into an agreement to repurchase five of six tranches for $59.4M, or 63 cents on the dollar, 5) subordinated debt of $5.9M, and 6) non-recourse business level debt of a little more than $20M. When we add these assets and liabilities together, we see about $20M of net cash, or about $1 per share of value.

This sum-of-the-parts approach yields a per share value in the high teens (roughly double the current price of $8/share), a similar output to the free cash flow calculation.

But, like before, the real magic is in the compounding. As Kingsway continues to grow its EBITDA - while paying no taxes due to the NOLs - profits can compound at an extremely high rate. If Kingsway reaches $50M+ EBITDA in a few years with a similar valuation multiple (12x) plus the value of the tax asset and cash flows in the interim, Kingsway would be worth about $40 per share.

We view Kingsway much like an undiscovered Constellation Software (CNSWF) (CSU:CA). KFS is a compounding machine that can be owned for many years to come.

From "Complex" to "Simple"

Why is Kingsway so undervalued? We believe this is largely due to the complexity of Kingsway's balance sheet and financial statements.

At the end of Q3 2022, Kingsway's balance sheet showed $284M of gross debt and $6M of subordinated debt. This "screens" poorly to investors - a $200M market cap business with nearly $300M of gross debt looks like a risky and levered business.

Within the next one to two quarters, however, we expect Kingsway's real estate to be sold, at least five of its six tranches of TRUPs to be retired, and its subordinated debt to be paid off. As a result, gross debt on the balance sheet will fall from $290M to just $40M (most of this step-down will come from selling real estate assets - non-recourse mortgage debt consolidated onto Kingsway's balance sheet totaled $199M in the most recent quarter). Net debt will fall to less than $20M. Suddenly, Kingsway will no longer screen as a levered company at all.

Importantly, Kingsway has already made significant progress. Just in the last quarter, Kingsway sold its two important real estate assets (its Flower Foods portfolio and BNSF rail yard ) for total net cash proceeds of $27M. When Kingsway reports its year-end 2022 results, $183M of gross debt (the mortgages on those properties) will already have disappeared from Kingsway's balance sheet.

In addition, Kingsway has entered into option agreements to purchase five of the six tranches of its TRUPs by May 2023 at 63 cents on the dollar. Shortly after these options are exercised, we expect the $5.9M of subordinated debt to be paid down as well. Kingsway has roughly $70M cash on its balance sheet today, so these payments can be entirely financed from cash on hand.

This continues a trend of "simplification" driven by Kingsway's board and management team in recent years. The company's corporate structure has been simplified (the company redomiciled to the U.S. from Canada - there are no more Canadian operations or presence). Kingsway exited its insurance operation, upgraded its auditor, cleaned up its reporting, and is taking numerous other steps to streamline the business.

By the end of 2023, we believe substantially all the "complexity" in the company will be resolved. Kingsway will have a clean capital structure, little debt, and an easy-to-understand equity story. This can prove to be a major catalyst for the stock. Once the company screens well - and demonstrates its capacity to grow EBITDA at a healthy rate - we believe investors will be increasingly attracted to Kingsway's potential.

And there's one more bit that does have a real-world effect on the stock price. For years, Kingsway has not proactively reached out to institutional investors via an intentional and formalized investor relations program.

Over the last two months, this has changed. In December 2022, the company released its first investor presentation in years, followed by an updated investor presentation in January. Many institutional investors are now hearing from Kingsway for the first time.

In the months ahead, we believe this undervalued and under-the-radar company will finally begin to have a spotlight shown on its wonderful business and potential.

Risks

As with all investments, there are risks to an investment in Kingsway.

• The company is small, with a market cap of just $200M.
• The company must continue to execute on its strategy of buying quality businesses at reasonable prices, and growing profits over time both organically and inorganically.
• The company might not be able to utilize its NOLs before they begin to expire.
• The company may not be able to sell its remaining real estate assets, purchase additional TRUPs, or deliver on its strategy to simplify the business.
• The company's float and trading liquidity are less than might otherwise be expected of a $200M market cap company, given 62% insider ownership. Average daily liquidity is about $250,000 with some days reaching $1M.

The insider ownership, however, cuts both ways. Yes, it does mean the float is smaller. But it also means every shareholder can sleep well at night knowing the board is long term and highly motivated to grow business value, and that it will do all it can to protect shareholders' interests.

Conclusion

According to a recent analysis by Keefe, Bruyette & Woods, the likely cut-off for the Russell 2000 Index will be about $190M market cap.

With 25.4M shares and an $8/share stock price ($204M market cap), there is every possibility Kingsway makes it in.

A rule of thumb is that inclusion in the Russell 2000 Index leads to stock purchases of roughly 10% of a company's market cap by passive buyers and other investors who track or benchmark against the Russell 2000 Index. With 62%+ of shares owned by insiders, this buying would represent a substantial portion of Kingsway's available float.

But the Kingsway equity story is not really about this near-term stock catalyst, impactful as it might be. It's a long-term story about meaningful shareholder value creation.

It's the story of a company going from "complex" to "simple."

It's the story of a board of directors with "skin in the game" who are highly motivated to build franchise value.

It's the story of an "Outsiders" CEO building a wonderful company through operational excellence and sensible capital allocation.

It's the story of a group of young, hungry, entrepreneurial leaders focused on acquiring great businesses and taking them to the next level.

It's the story of a business model that can create shareholder value for years to come.

And it's the story of a remarkable company that is not well understood by investors today - but in the not-so-distant future, will be.

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