Kingsway

Financial Services (KFS)

08/13/15
Stock Price $5.35


Given the high valuation of the market at this time I continue to search for companies whos value
will be discovered regardless of the overall markets movements. Strong hunting grounds for such
stocks are companies that have large NOLs and are in a position to finally monetize those. I have
written about SWKH in the past which is in the process of monetizing such tax assets, and I have a
large position in RELY which is also successfully utilizing its NOLs (Barrons beat me to posting a
write-up on the stock and the price shot up over what I believe is a attractive acquisition price so I
abstained from publishing a post). It seems Im not alone in seeing attraction in such companies;
Bill Ackman recently gave a presentation at the SOHO conference discussing the merits of investing
in such hidden asset companies. The third company Im adding to the portfolio that possesses
large NOLs is Kingsway Financial Services (KFS).

Ill allow Kingsways CEO Larry Swets, Jr. himself briefly explain what they do. Kingsway Financial
Services Inc. is a Canadian holding company with operating subsidiaries located in the United
States. We operate as a merchant bank, as taken from the 2014 shareholder letter. And from their
2015 shareholder letter Kingsways CEO will explain their mission, Kingsway focuses on building
long-term value by compounding capital with investments/acquisition/financings that offer
asymmetric risk/reward potential with a margin of safety supported by private market values
using a merchant banking approach. Bold/underlines are his.

In the annual letter to shareholders dated March 31, 2014 Larry Swets expands further on what he
means by long-term, Terry Kavanah, in trying to convince me to take on the challenge at Kingsway,
shared with me a conversation he had with Joe Stilwell (our largest shareholder and a board
member). In that conversation, Joe mentioned he wouldnt judge the success of Kingsway as a stock
investment for 15 years. Terry said to me I told Joe that was way too short; we wouldnt evaluate it
for 20+ years. He was serious. Our efforts to create and build value are focused on the 15-to-30
year perspective. That doesnt mean we ignore short- and near-term realities, but it is the
perspective by which we set our strategies and judge our results. In todays market were everyone
is tying to out maneuver other investors for the quickest trade down to the nanosecond, its
refreshing to see a CEO take a long-term view of building value, as in my mind, this is the surest way
to create wealth.

In a nutshell, KFSs value is derived from 3 areas, operating businesses, passive investments and
NOLs. KFSs operating business is comprised of 2 warranty businesses in Intercontinental
Warranty Services (IWS) and Trinity Warranty Solutions and a non standard auto insurance
company in Mendota (theres other divisions too but Mendota is the largest). Passive investments
are consists of fixed income, equity, and real estate. I will briefly note KFSs managements thoughts
from annual shareholder letters on each of these areas along with the NOLs below.
IWS IWS has been in business since 1991 serving the credit union sector by providing
vehicle service agreements. Management noted that theres room to grow this business as

credit unions currently hold well over $1 trillion of assets. Contracts sold are the best
indicator of future profits as profits can be easily estimated at time of sale. Long-term
contracts provide years of future earnings. Currently financials show a small loss due to
amortization of the purchase price.
Trinity Trinity provides warranty and dispatch services on HVAC, refridgeration,
generators and commercial equipment that competitors ignore (like large commercial
chillers). Keeping larger than needed sales staff in order to focus on long-term growth.
Management expects strong double-digit margins in the long run. Management expects
Trinity to generate $7 milion in revenue in 2014 and be cash-flow positive in 2015.
As noted in the letter to shareholders dated April 29th 2015, management will be spending some
time in 2015 performing a strategic review on the warranty companies. I expect further
clarification on future plans and profitability in the coming year.
Mendota Mendota is the main division of the companies non-standard automotive
insurance business. Since the new management took over, Mendota moved from
focusing on premium growth and how fast it could add states to focusing solely on
writing profitable premiums regardless of size. This new strategy appears to be paying
off as KFSs insurance underwriting has gone from a large loss to slightly positive
(combined ratio of 99.2% in 2014). This essentially allows the company to be paid for
investing the float provided by its insurance customers. Also of note, the reserves on
the liability side of the ledger for Mendota are to the highest level within the range of
estimates provided by the outside actuarial firm. They seem to be very conservative in
their assumptions.
Passive Investments KFSs passive investment portfolio contains a mix of fixed-
income securities, which supports the insurance reserves, bridge loans, publicly traded
equity, and real estate. Their goal is to find investments that contain asymmetric
risk/reward potential.

Major shareholders
No matter how much an outside investor researches a company they will never have the same level
of knowledge of the operations as an insider. Keeping that in mind, it becomes very important for
the outside investor to become comfortable with the management team and major shareholders
(those a large enough position in the firm to influence).

KFSs largest shareholder is actually the reason I stumbled upon this stock. While listening to a
podcast on community banks the guest mentioned a great way to find investments is to find small
community banks that have an experienced activist as a main shareholder. Joseph Stilwell was one
of the names he brought up as a smart activist investor. This led me to look thru Stilwell Value
Funds 13F and its top holding being KFS (11.6% of fund, approx. 20% of company). Id like to say I
was bright enough to recognize the value in KFS immediately and bought up a large stake to ride
the coattails of Mr. Stilwell as soon as I saw it, however this would be false. I looked at KFS, as I
imagine a lot of other investors do, and saw an insurance company with a poor underwriting
history selling for a few times book. This was about all the time I spent on it as I moved to the next
company on the list. Luckily, after looking into Stilwells success as an activist investor, I decided to

take an evening and give KFS a deeper look (for insight on Stilwells success as an activist, I suggest
reviewing some of his 13-D filings).

Given Stilwells large stake in Kingsway he has a lot of control over the strategy of the firm.
However, more on the day-to-day operations and investments of the firm fall to the CEO (or as he
calls himself the Chief Capital Allocator CCA) Larry G. Swets, Jr. He owns over 8% of the company
and the shares are restricted and subject to a 10-year cliff vesting. These guys truly focus on long-
term value creation.

Valuation
Since Kingsway has numerous parts to value, I will be taking it in a few steps:
1. Insurance Operations
2. Insurance Services Operations
3. NOLs

Insurance
In the past I always struggled with the method to value an insurance company. Some value them at
book if its underwriting is breakeven. Some add the value of the float to this metric. Columbia
University offers an eBook on the insurance industry that provides insight into valuation. However
the best, most rational, method Ive come across was laid out by the fantastic blog The Brooklyn
Investor at brooklyninvestor.blogspot.com. He outlined his method while walking thru the
valuation of Berkshire Hathaway. My method will walk through some of this, but I suggest
searching Brooklyn Investors website for a more comprehensive look if you so should desire.

Basically an insurance company is just an underwriting operation and a basket of investments. A
successful underwriting operation can add to the returns of the basket, and unsuccessful
underwriting operation needs to be supported by the investment returns. In the past the
underwriting operations at Kingsbury have been horrid, to put it mildly. When the current
management took over, Kingsbury was solidly in the red. Since then, management has worked hard
and in 2014 the combined ratio of Mendota was 99.2%, meaning theyve basically back to even.
Their goal is to get to a combined ration of 98%, this would mean theyre being paid to take the
insurance customers money to buy investments. Im going to give no credit to this underwriting
profit and consider the underwriting operations break even.

Now it just comes down to what should I pay for the basket of investments? Its a pile of money
that they allocated to different assets. If I gave a pile of money to someone Id at least require a
10% return. So if KFS is getting 10% return on their investment portfolio, Id be willing to pay
100% of the value of that portfolio. Its important to remember that you also have to subtract any
cost of debt they use too fund these investments.

Currently the majority of Kingsways portfolio is sitting in cash waiting to be invested. They have
allocated the second largest perentage to bonds, which covers the requirements for their insurance
liabilities. The rest is invested in, as they call it, their alternative investments. This covers common
shares, real estate and other business investments. Based on the prorated expected return of each

of these categories, and the assumption that they put half their current cash hoard to work, I expect
KFSs investment portfolio to return around 6% in a normalized environment. If they can put more
of their cash to work, this 6% assumption will prove to be very conservative.

Below is my valuation for the insurance division after finding my expected normalized return for
their basket of investments.

Investments
Proj. % Return
Return
Debt at Par
Cost of Debt
Debt Cost
Underwriting P/L
Return After Debt Cost
Required Return (10%)
% of Required
Value of Investments

$186,000
6.0%
$11,093
$90,000
5.0%
$4,500
$0
$6,593
$18,600.00
35.4%
$65,930

With my assumption of a 6% return for KFSs investments its investment divisions worth is almost
$66 million, or 35% of the portfolio Of note, if Kingsway can put all its excess capital to work my
estimated return for their investments jumps to 8% and the value of the insurance division jumps
to over $100 million. For my valuation Im going to use the more conservative 6% return and value
of $66 million.

Insurance Services
The insurance services division is a bit murky to get a solid valuation for. As of 1Q 2015 they had
revenue of $5.5 million and basically breakeven. The services division used to contain another
company named ARS that was recently sold for $47 million. Backing out the recent quarters
numbers for IWS and Trinity annualized from 2014 numbers means ARS had roughly $30 million in
revenue and $4.9 million in operating profit. Meaning it sold for approx. 1.5x revenue, 10x
operating income, and 14x net income. Annualizing 1Q 2015 numbers would give me $22 million in
revenue times 1.5 means the services division is worth $33 million. However this is a major
assumption given its still not profitable. Management has set up both services companies for
future growth, which should leverage the operating costs and produce profits. Meaning future
revenues will be higher, if management produces as promised. In valuing the services division Im
going to take Warren Buffetts approach of being approximately right rather than exactly wrong.
The value could range from $15 million to $40 million. Im going to value it at 1x revenue for a
valuation of $22 million.

NOLs
Because of the dire situation KFS was in when the current management took over, it posses a
significant tax asset in the form a net operating losses. A lot of unprofitable companies have these
assets, but the ones Im interested in are ones on the balance sheet of a company that has
transitioned management or has moved to a new profitable line of business via acquisition or other
method. Kingsway falls into both categories, and KFS has significant tax assets currently at $286.6
million or $14.54 per share. If all the tax assets could be used today for their full amount, valuation

would be simple, $14.54 per share. However, these tax assets expire at some point, and as of now
Kingsway doesnt posses enough operating income to use much of this asset. In regards to the
expiration, KFS has significant time with the majority expiring in 2029. Currently on the open
market tax credits are selling for about 90 cents on the dollar. Using this method would mean KFSs
tax assets are worth about $250 million. However, because of restrictions Kingsway cant just sell
these and reap that profit. Kingsway will have to earn a profit, either through current operations,
or more likely, an acquisition to realize a benefit from these assets. Because of the time value of
money, I ran a simple discount cash-flow model assuming they would use the $280 million in assets
evenly over the remaining time before expiration in 2029, discounting these back at 7%. You can
play around with the 7% number, but I feel its close to appropriate given the current bond rates,
rates of inflation, and the fact Ill be applying my margin of safety discount to the final valuation of
KFS. Running this discount model gives me a valuation for the deferred tax assets of $175 million.

One way to look at the current markets valuation of KFS is to say were buying $286 million in
NOLs for 40 cents on the dollar in addition to an insurance underwriter, basket of investments, and
two growing insurance services firms thrown in for free. If you believe management will produce
as promised this is a fantastic deal.

Final Valuation
Adding up the individual divisions valuations above gives us:

Value of Insurance Under
$65,930

Value of Insurance Service
$22,000

Value of NOLs
$175,000


Value of KFS
$262,930

Per Share
$12.40


At a current market price of $5.35 KFS is selling for 45% of my valuation of $12.40. Offering a
significant margin of safety should any of my assumptions prove to be too aggressive, or if
management underperforms.

What to Watch
Below are a few of the things Ill be looking out for over the coming quarters/years to make sure
management is on track.
Dilution of Shareholders
o They have recently issued some preferred shares to Stilwell and are authorized to
issue more. As of now I view this as a way to fund the company without
jeopardizing the NOLs. However this will be something I monitor closely moving
forward to make sure they dont pillage the pockets of the minority common
shareholders for the insiders gain.
Underwriting Quality
o Current management has transitioned the insurance division from a growth at any
cost perspective to a profitable underwriting perspective. This has taken the
underwriting from a large loss to breakeven, proof of their vision playing out.
However, should this positive momentum proves to be fleeting the valuation of the
insurance division, and the trust in management, would be cut dramatically.
Investment Returns
o Should the returns from the basket of investments fall short of projections, Ill need
to reassess (lower) the valuation I put on KFSs holdings.

Insider Buys/Sells
o Should Stilwell or the CEO Swets start liquidating their position, I will need to assess
why they are making such a move.
Use of NOLs
o Are they buying cash-flow rich businesses at decent prices to take advantage of their
tax asset?
Direction of Insurance Service Companies
o As the insurance services companies are current breakeven, management has
indicated that 2015 will be a year of review for them. If they dont continue to move
in a positive direction I will need to review the valuation I assigned to them.