Kingsway Financial Services
A micro-cap compounding engine at a fair price
This is a slightly old writeup on Kingsway from Jan 2024.
Disclaimer: None of what I write is a recommendation to buy or sell a stock. I am an internet stranger writing about random businesses with no successful track record in investing. This is a selfish endeavor to grow as an investor myself and to document my research as I do not have a good memory. Please do your own research before buying a stock.
If you like reading pdfs, here is a pdf link of this writeup.
INTRODUCTION
Kingsway Financial Services, is a holding company, with a collection of small, high quality, recurring revenue businesses(many of them B2B service businesses), that are capital light, in fragmented industries, and have good growth potential.
KFS defines recurring revenue as re-occurring invoicing of services delivered, at a monthly or quarterly basis for at least 18 months. An important metric to look at in recurring revenue businesses is churn. Although management doesn’t report out these numbers in their financial statements, they look at churn as an important metric for acquiring businesses with good economic characteristics. KFS talks about 3 metrics - logo churn, gross revenue churn and net revenue churn. Logo churn is percentage of customers(‘logos’) not extending their contract in any given year, gross revenue churn is the percentage of revenues lost YoY from a customer leaving, net revenue churn is the percentage of revenues lost from an existing customer YoY. We will look at these metrics for some of their businesses in the business segment section below.
BUSINESS SEGMENTS
KFS consists of two business segments - Extended warranty and Search accelerator.
Extended Warranty
This segment is majorly a collection of a few businesses that sell extended warranty policies(Vehicle Service Agreements) to new and used car buyers(IWS, PWI, Geminus) and has an annual revenue of around $72M in 2023(operating margins of 13%). A small portion of this segment’s revenues comes from a business called Trinity, which sells extended warranty for HVAC, standby generators, commercial LED lighting and commercial refrigeration. The extended warranty business is fragmented, growing at HSD%, has some barriers to entry in the form of regulations, has decent margins and recurring revenues(auto extended warranty companies typically have contracts with credit union/auto dealers to carry their products - in some cases exclusively(IWS)).
These extended warranty businesses are good businesses as their policies are usually priced in favor of the warranty provider, with the customer over estimating the risks of product failure. Also, many of the customers that buy their used car extended warranty products belong to a demographic who can’t afford to have losses, hence are willing to buy an extended warranty product at a profitable price for the issuer. Another reason that this segment is attractive is that the frequency of claims in these businesses are very predictable, hence reducing the risks of outsized losses. Just like insurance, the consumer pays for these products upfront, claims only start to happen a few years later and in the meantime, the company gets to use the float for investment gains.
KFS’ extended warranty policies are backstopped by AAA rated insurance companies for a fee. These insurance companies, in turn, require KFS to hold a portion of its policy in a trust and invest it in low risk instruments like government bonds, high quality corporate bonds and match its duration with its claims(avg duration of 2-3 years).
KFS sold ‘PWSC’, a home warranty provider it had acquired recently for a 10x multiple on invested equity(around 5x return on purchase price, half financed by debt) and around 25 times EBITDA.
Other bigger publicly traded warranty companies like Frontdoor(FTDR) and Assurant(AIZ) also typically trade at over 20 times EBITDA. This demonstrates the attractiveness of this segment.
NOTE:
EBITDA is used in many places in this report in place of operating income - all of KFS’ businesses are capital light with very little depreciation and amortization numbers are just purchase accounting numbers. Hence, EBITDA approximates pre tax operating income for KFS. In addition, company has ≈650M of NOLs(Net operating loss) from the previous management’s tenure, which KFS can use to shield future tax payments until 2033(these NOLs start to expire in 2029 with close to $400M expiring in 2029). Therefore, EBITDA today represents after tax operating income as well.
Adjusted EBITDA is another item mentioned in this report and by KFS’ management - this adjusts EBITDA for items like one time revenues/expenses, discontinued operations etc.
IWS
This business forms 30% of the revenues in this segment. IWS sells its extended warranty products through credit unions, mostly for new automobiles(warranty bundled with financing of new automobiles). These credit unions are slow to change, hence these revenues are sticky and they also exclusively sell IWS’ extended warranty products. They currently partner with ≈130 credit unions. This business benefits from a tailwind of customers increasingly taking new auto loans from credit unions than banks as those loans are becoming more attractive(as credit unions’ costs are lower than banks).
Overall customer churn(KFS calls this ‘logo churn’) is very low - they typically have long lasting relationships(15+ years) and in a year, they lose only ≈1% of credit unions because of them being acquired or switching to a competitor. The credit union they lose is usually a very small one, so gross revenue churn is almost nil and they have negative net revenue churn of 8-9%, which means their existing customers are contributing more revenues than the year before.
PWI/Geminus
PWI forms ≈43% of the revenues of this segment and Geminus ≈14%. Here, these businesses partner with used car dealers to sell their extended warranty products. These are not exclusive agreements, so this segment is more competitive. These businesses partner with smaller car dealerships as opposed to big car dealer franchises which possibly lets them capture more of the value they create. PWI and Geminus typically have high logo churn of 30-35% and gross revenue churn of HSD - HDD%(smaller than logo churn as they lose smaller customers). In the current environment with high used car prices and higher interest rates, they have a small positive net revenue churn, which should improve as the environment improves.
Trinity
Trinity forms ≈13% of this segment’s revenues. Trinity sells extended warranty for HVAC, standby generators, commercial LED lighting, commercial refrigeration and also provides repair/breakdown support services for these products(Trinity will provide such repair and breakdown services by contracting with certain HVAC providers). In the warranty side of this business, logo churn is about 14%, gross revenue churn is about 2.5 - 3%(again, the customers they lose are smaller ones) and net revenue churn of negative 8%(existing customers grow revenues by 8%).
Search Accelerator
This is the most interesting segment of KFS and the company is focused on growing this. This segment is based on the search fund model of acquiring companies. Wikipedia defines a search fund as “an investment vehicle through which an entrepreneur raises funds from investors in order to acquire a company in which they wish to take an active, day-to-day leadership role”. According to a study by Stanford, 526 search funds formed in the US and Canada since 1984, generated pre tax returns of ≈35% IRR.
KFS hires what they call as OIRs(Operators in Residence), who along with KFS actively look at acquiring small companies searching for ‘succession capital’ with EBITDA of $1.5M - $3M. The companies acquired are founder led, who are looking to retire and cash out of their businesses. These founders value their employees, their businesses and want to sell their businesses to a long term oriented buyer, hence they prefer a firm like KFS vs PE firms. These kinds of businesses are not attractive to PE firms because of their small sizes and the need to appoint new management altogether. Once such a company is acquired by KFS, the OIR leading the acquisition becomes the CEO of the business, with the founder usually staying on for a year or so, to help with the transition. This fit, according to the management, is the main reason for the success of search funds as an asset class. Also, the fact that KFS is a publicly traded company gives a lot of credibility and trust, as compared to other search funds.
52% of search funds fail to close an acquisition or fail to return 100% of invested capital(inspite of this, search funds as an asset class generated 35% IRR according to the Stanford study). KFS recognizes this and is differentiating itself from other search funds by having a search accelerator platform which among other things, allows them to avoid the “standing start” problem of other search funds, where relationships with brokers, company databases are being built from scratch vs having a search platform with existing broker relationships, databases etc within KFS. KFS also has standard processes in place for investment evaluation, performing due diligence, obtaining financing etc from its experiences in previous acquisitions, which a traditional search fund would not have.
These make KFS’ search platform much more attractive to prospective OIRs as compared to starting a search fund, as it allows them to focus on running the business after acquisition, rather than searching for investors, small businesses from scratch and having to deal with the different steps involved in acquiring a business. To develop this search platform further, in terms of indirect sourcing, lending relationships, program awareness in universities to recruit new OIRs etc, KFS has appointed Charles Joyce as VP of business development. KFS is also trying to avoid losing money in these acquisitions by focusing on acquisitions with attractive industry and company attributes and purchasing them at reasonable prices.
The acquired businesses usually have unexploited opportunities for growth like improving management team quality, operating efficiency, capital allocation, pricing etc. The incentives are aligned for the OIR to grow the business profitably through equity stakes in the business based on earnings growth. The incentives are also aligned on the downside as the OIR doesn’t earn anything unless KFS earns a minimum return on capital - these OIRs are usually business school graduates from prestigious universities like Harvard, hence opportunity costs for these individuals are great.
KFS also demonstrated that this model can work, through their purchase of PWSC(a home warranty provider) for $10M($5M debt + $5M in equity) in late 2017. They had hired Tyler Gordy, an OIR, to run the company and they were able to sell it for $50M in 2022 for a 10x multiple on invested capital, most of that accruing to KFS(and a portion to the OIR).
KFS now has a collection of 6 companies in this segment, all of them being B2B service businesses(capital light), with recurring revenues in favorable industries(with tailwinds), a fragmented market(lots of niches), having room to grow and purchased at very low multiples to trailing EBITDA. Management is looking to acquire 2-3 businesses in this segment per year, by having 4-5 OIRs searching for acquisitions at any given time.
Ravix/CSuite
Ravix is a provider of outsourced accounting and human resources services. Its customers are primarily venture capital funded startups. Ravix has about 20% logo churn, gross revenue churn of 7% and net revenue churn of negative 8%. This company was bought in 2021 for $11M(plus potential earnouts) at a multiple of ≈4x TTM adjusted EBITDA. This business is run by Timi Okah(OIR), a Harvard business school graduate. The company did not historically actively market its services, new business primarily came from referrals of existing clients, which Timi has started to change.
CSuite is a national, financial executive services firm that provides financial management leadership(interim CFO services and CFO placement). This business is complementary to Ravix and run by the same OIR as Ravix. Although Ravix and CSuite have opportunities for cross selling, this acquisition’s purchase price was not justified by taking upcoming synergies into consideration. CSuite was purchased in Nov 2022 for $8.5M(plus potential earnouts) at a multiple of ≈4.5x TTM adjusted EBITDA.
SNS Healthcare
SNS employs highly-skilled medical nurses for assignment in hospitals located in Southern California. SNS places these healthcare professionals in both per diem assignments, and in short-term/long-term travel assignments in a variety of hospitals in southern California. SNS does not market its services, instead relying on word of mouth for new customers. SNS is a seasonal business with more revenues in the flu season. SNS was purchased in Nov 2022 for $10.9M at a multiple of ≈4x TTM adjusted EBITDA. This business is run by another of KFS’ OIRs, Charles Mokuolu.
Digital Diagnostics Imaging(DDI)
DDI provides fully managed outsourced cardiac monitoring telemetry services to long-term acute care(”LTAC”) and inpatient rehabilitation hospitals(”IRHs”) throughout the U.S. The business enables remote access to client hospital telemetry systems from an outsourced monitoring station ensuring that a patient’s ECG is continuously under watch. This acquisition was announced in Oct 2023 for $11M at a 6.1x TTM adjusted EBITDA multiple and this transaction is expected to close in 2024. This business will be run by Peter Dausman(OIR).
System Products International(SPI)
This is a small acquisition(EBITDA of $0.3M) in the vertical market software industry. This company specializes in shared ownership property management.
MANAGEMENT & CAPITAL ALLOCATION
Joseph Stillwell, an activist investor, took a big stake in the company in 2009 and appointed a new CEO named Larry Swets. The company was run poorly by Larry Swets with lots of complex transactions and acquisitions that didn’t work. Larry Swets stepped down as CEO in 2018 and JT Fitzgerald has been CEO since. He joined the company as part of an acquisition by previous management, of a search fund run by JT Fitzgerald. His primary job was to clean up the mess left behind by the previous management.
JT offloaded a lot of underperforming, non-core assets acquired by previous management and started to focus on extended warranty businesses because of its favorable industry economics. With JT also having a background in the search fund space, he was able to demonstrate how lucrative this can be, with the purchase and sale of PWSC, a home warranty provider. He and the present management started to lay down a vision to setup a search accelerator business segment(based on the successful search fund asset class) that would focus on acquiring businesses with good industry and business characteristics(capital light, fragmented, growing at 2x GDP, high recurring revenues, long history of profitability, simple businesses to run etc).
They have also put processes in place for acquisitions and have laid down an operational framework called “Kingsway Business System”(similar to Danaher Business System of Danaher Corporation) to improve efficiency and successfully scale this model/decentralize operations to OIRs. To best achieve their goals, they have appointed Thomas P Joyce and William Thorndike to their strategic advisory board. Thomas P Joyce was president and CEO of Danaher Corporation from 2014 to 2020 and William Thorndike is the author of the famous book on capital allocation, ‘The Outsiders’. Thorndike also manages a search fund and became an investor in KFS recently. Insiders own 60% of the business(CEO owns 7.3%, Joseph Stilwell owns 30%).
KFS targets 20% unlevered returns(IRR) for any potential acquisition/capital allocation(35% IRR on equity). Management has demonstrated that they have been able to allocate capital wisely with an adjusted EBITDA CAGR of 31% from 2018-2023. The company had a real estate segment earlier, which it has now mostly exited, with the sale of a rail yard it owned in Texas for ≈$200M in 2022(to BNSF) and cleared ≈$170M of its associated debt from the balance sheet(still owns a small asset from this segment which has been listed for sale and operations marked as discontinued). They have also been opportunistic buyers of extended warranty businesses when purchase prices were attractive and opportunistic sellers when a great price was offered(sold PWSC at a great price). They redeployed the proceeds from the sale of the rail yard and PWSC into repurchasing trust preferred securities issued by previous management(with interest rates of ≈10% and rising, due in 2033 which is 10 more years of possibly paying high interests) worth ≈$55M, for around 60 cents on the dollar(with a small portion still left) and acquiring other businesses within the search accelerator segment at low purchase multiples(part financed by debt, not exceeding 3 times EBITDA).
The debt used in financing acquisitions are at the portfolio company level(not at the holdco level) and are hence non recourse to KFS. With the acquired companies, being capital light and throwing off a lot of free cash flow, they have been steadily paying down debt on acquired companies - for example, their debt on their extended warranty business segment went down from $25M in 2020 to $12M in Sep 2023. They currently have total debt of $29M in their operating companies(expected to go up to $33M due to the announced acquisitions in Sep/Oct 2023), $12M in the holding company(trust preferred securities left), cash on balance sheet of $20M, for a net debt of $20M(will go up to $25M due to the recent acquisitions). The company’s current annual adjusted EBITDA run rate is around $20M($10M in extended warranty, $10M in search accelerator segment).
There has been some dilution for common stock holders in the past 2 years or so, due to conversion of preferred shares and warrants(issued by previous management) into common stock. However, this is behind the company and no more dilution is expected looking ahead.
CURRENT DIFFICULTIES
KFS is facing a few headwinds in its businesses this year. Their warranty businesses have been affected by higher used car prices, higher interest rate environment and higher claim costs due to part and labor price increases. The warranty business results have already improved QoQ and are showing signs of improving further. Ravix and CSuite have also been impacted, with revenues slightly down but profitability still high. SNS healthcare has seen some temporary tailwinds reverse(which management priced into the acquisition) with demand shifting more towards per diem assignments from travel assignments, still the long term outlook remains favorable.
These headwinds seem to be temporary, nevertheless these businesses were purchased at very attractive prices that they should still do well as investments. In spite of these temporary headwinds, the trailing annual EBITDA run rate mentioned by management is $18M-19M(with warranty businesses already having their strongest quarter this year in Q3 and also includes the recent acquisitions’ trailing results).
PRE-MORTEM
Search Accelerator model turns out to be a one time success with the PWSC sale and many of the subsequently acquired businesses start performing poorly for a consistently long period - for example, business performance and churn metrics deteriorate or mistakes were made in predicting the economics of the businesses. This may still not be detrimental to the investors as the businesses in the search accelerator segment were bought for very low PE multiples.
As the accelerator segment is scaled, oversight by management of individual businesses will reduce and operational problems may start to creep up with scale(problems in integrating acquired businesses) - for example, management becomes lenient in hiring OIRs and hires unethical or incompetent OIRs. Over time, one or two OIRs are bound to be hired who end up as bad fits for running the acquired businesses, but given the simple nature of the businesses KFS acquires, this risk should be manageable by simply replacing those OIRs.
Interest rates rise way beyond comfortable interest coverage ratios(EBIT/interest) that it starts hurting owner earnings.
MARGIN OF SAFETY
Normalized earning power for KFS’ current businesses should be higher than the current trailing run rate mentioned by management when headwinds faced by some businesses subside - normalized EBITDA can easily be $21M-22M for the present collection of businesses. After accounting for the ≈$2M operating costs at the holding company level, owner earnings will be in the $19-20M range.
All these businesses are profitable, mostly B2B service businesses with recurring revenues, in industries with good long term growth outlook. Being capital light, these businesses do not require much capital to grow. The quality of these businesses provide a big margin of safety in itself. Considering the fact that these businesses were acquired for very attractive prices, even assuming no growth, they should provide good investment returns for KFS. For example, if a business is acquired at 5 times PE, KFS will earn 20% returns on capital(30%+ return on equity) assuming no further growth. These attractive purchase prices provide a margin of safety in another dimension(apart from the superior business quality).
The cash flows from these businesses will be plowed back into other acquisitions in the search accelerator segment as well as opportunistic buys in the extended warranty segment if prices return to attractive levels. Management mentions they are looking to buy 2-3 businesses in the search accelerator segment per year with an EBITDA of $1.5M to $3M. This management has shown that they are very good capital allocators in the past and I expect this to continue. They should be able to compound equity at atleast 15-20%(given they also use conservative amounts of debt) going forward.
KFS is now trading at a market cap of ≈$200M(Dec 2023) for a business with owner earnings(of present businesses) of ≈$20M and a net debt of $25M. Without assigning any value to their NOLs, and assuming they have the ability to pay back debt quickly(which they have demonstrated in the past), this business with a high quality management team is trading at a PE of 10(EV/EBITDA multiple of 11.2), which seems very cheap for a possible long term compounder.
Disclosure: Long KFS