Description

This idea partially revisits another idea that I wrote up late last year (somewhat prematurely in retrospect).  This time around, the foundation for the cataylst is already in place and the Company, Kingsway Financial Sevices, is taking the appropriate steps to create value. 

The security I am writing up this time around is The Kingsway Linked Return of Capital Trust (LROC), which launched in July of 2005 to provide holders with exposure to a senior note issued by an affiliate of Kingsway Financial Services Inc (KFS.CN or KFS.US).  The Trust will terminate on or about June 15, 2015 subject to an early redemption feature and its net assets will be distributed thereafter to holders of Units.

Holders of the LROC Preferred Units receive primarily tax-deferred quarterly distributions of $0.3125 per LROC Preferred Unit which at the time of issuance represented a yield of 5.00% per annum on the $25.00 per LROC Preferred Unit offering price and the Company has never missed a payment since the IPO.  The units are listed for trading on the TSX under the symbol KSP.UN and appear on Bloomberg as KSP-U CN.  At the current price of $9.85, the Units not only feature a current yield 12.69%, they offer significant appreciation. 

The Units are a 'buy' for a number of reasons which I will talk about below.  However we first need to do a brief recap on the current lay of the land on Kingsway Financial Services.  I encourage you to read my VIC entry on this name which was posted on December 18, 2008 for some more complete thoughts.  An understanding of Kingsway Financial is critical to any analysis of the Kingsway Linked Return of Capital Trust Units.

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.

In the past few years, Kingsway has written around $1.9b of premium per year with ¾ of that premium domiciled in the U.S. and the balance in Canada.  This will shrink.  For now, lines are broken out as folllows:

(2008)
Non Standard Auto: 42pct
Trucking: 16pct
Property & Liability: 15pct
Commercial Auto: 15pct
Motorcycle: 6pct
Other: 6pc

A combination of poor management, bloated SG&A, an overzealous acquisition strategy and a lack of oversight are the cause of Kingways's poor results and discount between its stock price an book value.  Something transformational had to happen fast if Kingsway was to survive amidst Management's complacency and lack of drive...

Consistent with the thesis in my write-up on Kingsway, something did happen.  A highly respected insurance industry activist hedge fund led by Joseph Stilwell successfully removed the CEO and secured two Board Seats at the Company including the Chairman's position.  Stilwell's team has carefully implemented a significant transformation plan which will shed unprofitable lines, streamline the Company's structure, reduce overhead costs and free up excess capital to buy back debt and equity.  As I said in my Kingsway post, "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.

Specifics on the Restructuring Plan

- Exiting the Canadian Cross Border Trucking Unit.

- Run rate headcount was reduced by 445 since the beginning of 2009.

- Submitted plans to put all but the strongest of Lincoln's programs into run-off to the Pennsylvania Insurance Department.  Lincoln is Kingsway's largest U.S. division and has been hampered by poor underwriting.

- Overall target for savings delivered through all initiatives now at a run-rate of $120 million by the end of 2010 from the previously announced $80 million.

- Kingsway's capital ratios exceed regulatory minimums for all subsidiaries except Lincoln.

- The company elected to dispose of virtually all of its common share equities during the March 2009 quarter.

- The Board has delegated to the Capital Committee of the Board the authority to repurchase debt of the Company up to a maximum of $40 million subject to an assessment of liquidity levels.

By the time the restructuring is complete over the next 12-18 months, Kingsway's cap structure and earnings profile will look significantly different from how it looks today.  The goal will be to shrink the Company down to its most profitable units, write disciplined business, and streamline operations.

Balance Sheet / Book Value

Here is a current look at the Balance Sheet following the First Quarter results...

At March 31, 2009

ASSETS

cash and equiv 220

securities:

Stocks 0

US Canadian and Corp Bonds 2090

-------

total securities 2090

accrued investment income 20.8

financed premiums 58.1

accounts receivable 260

due from reinsurance 125

deferred policy acq costs 117

income tax recoverable 27

future income tax 22

capital assets 93

Goodwill 62

TOTAL ASSETS 3099

LIABILITIES

Bank Debt 0

Loans Payable 66

Accounts Payable and Accrued 92

Unearned Premium 495

Unpaid Claims 1804

Senior Unsecured Debt 182

Subordinated Debt 87.3

TOTAL LIABILITIES 2728

SHAREHOLDERS EQUITY 371

 BOOK VALUE PER SHARE

 (using 55.1m fully diluted shares) = $6.73

As of the last Quarter, Kingsway's Senior Debt was trading at 48c on the dollar and the sub debt was trading at 23c on the dollar.  here is the Balance Sheet re-cast for these market values...

At March 31, 2009

ASSETS

cash and equiv 220

securities:

Stocks 0

US Canadian and Corp Bonds 2090

-------

total securities 2090

accrued investment income 20.8

financed premiums 58.1

accounts receivable 260

due from reinsurance 125

deferred policy acq costs 117

income tax recoverable 27

future income tax 22

capital assets 93

Goodwill 62

TOTAL ASSETS 3099

LIABILITIES

Bank Debt 0

Loans Payable 32

Accounts Payable and Accrued 92

Unearned Premium 495

Unpaid Claims 1804

Senior Unsecured Debt 89

Subordinated Debt 20

TOTAL LIABILITIES 2532

SHAREHOLDERS EQUITY 567

BOOK VALUE PER SHARE

(using 55.1m fully diluted shares) = $10.29

Now that you have had a refresher on KFS, and the value embedded in the equity, here is why are the KSP UNITS are an attractive BUY (in addition to the equity)...

4 solid reasons.

1. As demonstrated above, the EQUITY has real value, thus any debt instrument above it has to contain real value as well.  In this case, book value of KFS even if you use 50% of the stated (not market) book, would still be $185m.  In my opinion, all of Kingsway's debt is worth par.  The Units appear in the Balance Sheet under (Loans Payable).

2. Excess Capital:

As at March 31, 2009 Kingsway was adequately capitalized to support the premium volume of the insurance subsidiaries.  The Canadian subsidiaries had $36.2 million in excess of required capital.  In the United States, aggregate capital excluding Lincoln totaled approximately $85.9 million.  The reinsurance subsidiaries had approximately $74.9 million in excess of the regulatory requirements in Barbados and the capital maintained by Kingsway Reinsurance (Bermuda) Limited was approximately $9.6 million in excess of regulatory requirements.  Thus the total excess capital at Kingsway is $206.6m.  Management is SHRINKING THE BUSINESS meaning that excess capital will only rise.  What can Management do with excess capital?  With Senior, Sub and Unit debt all trading well below par, and the equity trading well below book, Management could use excess capital to retire debt or buy back shares.  Which leads to reason number three.

3.  Management has JUST STATED that they intend to buy back $40m worth of debt.  Given the market prices of KFS debt, $40m could retire all of the sub debt and almost half of the Senior Debt.  It could also retire all of the Units at the current market price.  Book value would rise, interest expense would shrink, and KFS would look even more favorable from a liquidity perspective.

4. Get paid while you wait for the restructuring.  12.69% is the current yield.

Catalyst

- Continued execution of the restructuring plan.

- Sale of loss making divisions.

- Debt Paydown.

- Restoration of Investor confidence.

Risks:

- Liquidity: the Units are not super liquid

- Lincoln losses are worse than we think and pose a drain on the excess capital at KFS