Sunday, December 30, 2007

Is Kingsway Financial a "cigar butt" stock despite its reserving problems?

In my previous article on the Canadian non-standard auto insurer Kingsway Financial(KFS-TO ; KFS NYSE)I discussed that there may have been potential warning signs at Kingsway's subsidiary, Lincoln General, prior to its announcing big reserve increases both recently and during the last year.

Furthermore management's strategy with Lincoln of employing external claims assessors likely contributed to these reserving problems.

Despite the reservations I have expressed over management's stewardship of Lincoln, as investors we have to ask the question...is Kingsway's stock now priced for a worst case scenario and does it have a "cigar butt" quality.

Lets run over the numbers (in US $s)

KFS's current market cap is $690 million or $12.30 per share, $1.90 or $125 million is the high end estimate for reserve increases at Lincoln so my current book value estimate for December 2007 is $17.40 ($18.80 less $1.90 reserve increase plus $0.50 in earnings). Kingsway's debt to equity ratio also looks reasonble at 50%.

Kingsway's current share price is around 2/3 of book value or net assets. This appears cheap and fears of future reserve problems are beng priced into the stock.

Lets look at Kingsway's 5 year performance from 2002 - 2006. Looking at the 2006 Annual report, its combined ratio was 99% , return on equiy 15% and growth in book value 18%(note this includes Canadian dollar appreciation).

So Kingsway has a history of growing book value and achieving decent returns on equity. Furthermore, Kingsway's other US operations are operating at break even. So if we can view Lincoln's problems as isolated and its future reserve increases as manageable then a buy thesis could be made for Kingsway's stock.

If Kingsway can break even on their underwriting in 2008 and do a conservative 4% after tax return on their $63 a share in cash and invested assets, then thats around $2.50 a share. So at $12.30 a share the shares are priced at 5x 2008 earnings or a 20% return. If Kingsway is successful in restoring investor confidence in management and fixing the bleeding at Lincoln General, then Kingsway should at least trade for its book value, that would mean around 50% upside for the stock from its current price.

In conclusion, Kingsway's insurance business is not a high quality auto insurance franchise like Progressive or Geico, nevertheless Kingsway's stock at its current price of 2/3 book value looks like a "cigar butt" buy despite the problems of reserving at Lincoln. Concerns over management and reserving appear compensated in the current stock price.

Disclaimer: The opinions expressed in this article by the author represent the authors own point of view and are not intended as investment advice and should not be relied upon as such.

Disclosure: I have no position in the securities discussed.

4 comments:

alejandro said...
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alejandro said...
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