Equity Research. KMG America Corp. (KMA-NYSE) OUTLOOK SUMMARY DATA ZACKS ESTIMATES. Buy Prior Recommendation. Current Recommendation

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1 Equity Research July 10, 2006 Ann Northrop, CFA North Wacker Drive Chicago, IL KMG America Corp. (KMA-NYSE) Current Recommendation Buy Prior Recommendation Hold Date of Last Change 04/09/2006 Current Price (07/07/06) $8.49 Six- Month Target Price $9.75 SUMMARY DATA 52-Week High $ Week Low $7.74 One-Year Return (%) Beta N/A Average Daily Volume (sh) 173,815 Shares Outstanding (mil) 22 Market Capitalization ($mil) $188 Short Interest Ratio (days) Institutional Ownership (%) 99 Insider Ownership (%) 2 Annual Cash Dividend $0.00 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) Earnings Per Share (%) Dividend (%) N/A N/A N/A P/E using TTM EPS 40.4 P/E using 2006 Estimate 24.9 P/E using 2007 Estimate 14.7 Zacks Rank 3 OUTLOOK KMG is well positioned to expand its ROE from a sub-standard 2.3% in 2005 to the mid-single digits (4-5%) in 2006, and continue expanding it throughout the next several years. We expect the company to achieve this goal by rapidly growing premiums as it expands geographically, and by expanding margins through operating leverage as it achieves scale economies. Trading at about 1.0x book value, we think the stock has significant upside potential and will gradually be afforded a higher multiple if, as we anticipate, the company gains traction in its group life and disability sales, which should in turn boost margins and ROE. Risk Level High Type of Stock Small-Value Industry Ins-Acc & Hlth Zacks Rank in Industry 6 of 8 ZACKS ESTIMATES Revenue (in millions of $) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) A 39 A 41 A 39 A 154 A A 38 A 39 A 39 A 153 A A 45 E 48 E 53 E 189 E E Earnings per Share (EPS is operating earnings before non recurring items) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2004 $0.08 A $0.49 A 2005 $0.05 A $0.03 A $0.06 A $0.07 A $0.20 A 2006 $0.06 A $0.09 E $0.09 E $0.10 E $0.34 E 2007 $0.58 E Zacks Projected EPS Growth Rate - Next 5 Years % 15 Copyright 2006, Zacks Investment Research. All Rights Reserved.

2 KEY POINTS Potential ROE expansion: KMG is well positioned to expand its ROE from a sub-standard 2.3% in 2005 to the mid-single digits (4-5%) in 2006, and continue expanding it throughout the next several years. We expect the company to achieve this goal by rapidly growing premiums as it expands geographically, and by expanding margins through operating leverage as it achieves scale economies. Inexpensive valuation: KMA shares have partially rebounded (up 10%) since the company lowered its 2006 earnings outlook, citing longer-than-expected time for its new sales reps to gain traction in its group life and disability sales a big growth area for KMG. The delay does not surprise us, given that the operation is a start-up. KMA shares currently trade at 1.00x book value, a multiple we believe will gradually expand if, as we anticipate, the company gains traction in its group life and disability sales, which should in turn boost margins and ROE. OVERVIEW KMG America was formed in 2004 to acquire Kanawha Insurance, which was completed in December 2004, funded by an IPO. Headquartered in South Carolina, Kanawha Insurance was started in 1958 and offers policies through the worksite, both voluntary and employer-paid, including life (individual and group), supplemental health and disability (short and long-term) insurance, annuities and claims administration services. In December 2005, KMG sold its agency office in Florida that focused on the senior citizen market, distributing and underwriting long-term care insurance and distributing Medicare supplement coverage. The sale marked the company s exit from the long-term care market, although KMG retains the underwriting risk for the block of business sold prior KMG continues to sell Medicare supplement coverage, which has been underwritten by Mutual of Omaha since Kanawha stopped underwriting it in The company also provides third-party administration services, such as claims handling and product administration. Prior to its acquisition by KMG, Kanawha historically focused on selling voluntary individual products through independent agents (see Worksite Insurance below) to the small employer market (less than 200 employees) in the southeastern United States, predominantly Florida, South Carolina and North Carolina. KMG intends to expand Kanawha s business nationwide and build an internal sales force to target large corporations (up to 10,000 employees) with both group and voluntary products. Kanawha holds a financial strength rating of A- ( excellent) by A.M. Best Co, the second highest of the rating agency s rankings. The company operates through three business segments: Worksite insurance 51% of KMG s $131 million in revenue in Most of KMG s offerings are voluntary individual products, where the employer offers the products to its employees as part of an array of insurance and health benefits from which the employee may choose, but the employee pays the premiums. Premiums are often deducted from the employee s pay and submitted to the insurance company by the employer. KMG also offers group products, where the employer pays the employee s insurance premium. Senior market insurance 38% of revenue in 2005 after the company exited the long-term care market in October 2005 and stopped underwriting Medicare supplement insurance in Zacks Investment Research Page 2

3 2003, this segment primarily offers Medicare supplement insurance that is underwritten by Mutual of Omaha. Third party administration 11% of revenue in 2005 handles claims, determines policyholder eligibility for coverage, and operates call centers. Currently, this KMG division administers insurance plans offered primarily by its own worksite insurance and in-force block of senior market insurance business. However, KMG also administers plans for third parties. Its customers include MetLife, AXA Financial and Blue Cross & Blue Shield affiliates. Based on 2004 revenues, Kanawha ranked in the top 18% of the 386 third-party plan administrators that are members of the Society of Professional Benefit Administrators. An ROE expansion story KMG is well positioned to expand its ROE from a sub-standard 2.3% in 2005 to the mid-single digits (4-5%) in 2006, and continue expanding it throughout the next several years. The company is currently targeting a mid-teens ROE in mid We expect the company to achieve this goal by rapidly growing premiums as it expands geographically, and by expanding margins through operating leverage as it achieves scale economies. To grow premiums, management intends to repeat performance at previous shop Led by CEO Ken Kuk and CFO Scott DeLong, KMG s management is trying to repeat its success at ReliaStar, which was purchased by ING in The management duo began working together in the 1980 s at Northwestern National Life, which was purchased in the 1990 s by ReliaStar, where Ken Kuk ran the worksite marketing business - one of ReliaStar s fastest growing and most profitable divisions. Using ReliaStar as a prototype, KMG s management plans to use Kanawha s worksite insurance business as a platform and expand it from a regional southeastern United States carrier, focused on employers with less than 200 employees, to a nationwide marketing organization servicing both small and larger employers with up to 10,000 employees. Key to the company s success will be its ability to hire experienced sales reps. A successful sales rep will have connections with brokers, who will in turn have solid relationships with the companies that buy KMG s products. Aiding the company in its recruitment efforts is its relatively attractive compensation package, which includes performance-based equity options most of the company s competitors do not offer broad-based equity incentive awards. At the end of 2005, KMG had 19 sales reps, up from just one that was hired in December Management hopes to hire another six reps in Also attractive to potential sales reps are the company s strong financial strength ratings (Kanawha holds the second highest A.M. Best rating). Voluntary Worksite marketing segment growing faster than overall industry The worksite marketing business is an attractive segment of the overall insurance industry, with the voluntary worksite marketing segment (ie. employee pays premiums see Worksite Marketing in the Overview section, above) growing faster than the overall industry. Voluntary worksite premiums accounted for 21% of KMG s predecessor s (Kanawha s) total premiums, while group worksite premium were just 4%. We note that 75% of Kanawha s premiums were from long-term care products, which the company stopped writing in October Group premiums (employer pays benefits) totaled more than $100 billion in , while voluntary premiums (KMG s primary market at present) totaled more than $14 billion. The voluntary segment is growing rapidly annual growth over the last six years 1 averaged 14% -- as employers seek to shift a portion of their rising healthcare costs to employees, and employees, in turn, are opting for a broader mix of products, including supplement policies. 1 The last period for which we have data. Source: Eastbridge Consulting Group, Inc. Zacks Investment Research Page 3

4 Operating leverage should boost margins as the company achieves scale Another potential boost to ROE, in our opinion, is the potential for rising operating margins. KMG s pretax operating margin was just 1.3% in 2005, a level that we think it could nearly double as the company achieves scale economies. The company s new effort to build an internal sales force that targets larger employers may ultimately enable it to spread its sales and overhead costs over a larger premium base. In the interim, however, the company is incurring start-up costs after opening several offices across the country and adding 19 sales reps from December 2004 through today. We expect administrative costs per premium dollar to plateau this year as new sales reps gain traction introducing KMG s products to brokers and eventually ramp-up business. KMG is targeting a ratio of expenses to premiums earned of 25% to 30%, which leaves room for lots of improvement operating expenses accounted for 46% of premiums in the fourth quarter. In addition, KMG s third-party administration business, which accounted for 11% of 2005 revenue, has potential to boost margins as the company currently has excess capacity in this business and management believes that moderate growth would require minimal additional capital investment. The company s excess capacity is evidenced by KMG sales of third-party administration services to other insurers. Increases in group life sales could raise margins KMG has regulatory approvals to sell stop-loss products in 44 of its 46 states but has approvals for group life products in just 35 states. Stop-loss products currently represent more than two-thirds of new business (as of the fourth quarter). The company reinsures a portion of its stop-loss portfolio. However, reinsurance costs for stop-loss products have been rising, squeezing KMG s margins. We expect that as group life sales increase and stop-loss products shrink as a proportion of the company s premiums, KMG s margins will likely rise. INDUSTRY OUTLOOK INDUSTRY OUTLOOK NEUTRAL Our outlook for the insurance industry is neutral. In the property/casualty insurance segment, sharp premium rate increases in the past few years have translated into strong increases in premiums and underwriting income, which we are now witnessing in the companies' results. However, with higher profitability due to higher premiums and benign losses, the industry's capital has built up. This should lead to increasing pricing competition going forward, particularly with the moderate loss trends on both the commercial and personal sides. Slower premium growth will eventually translate into slower earnings growth for the industry. Our outlook for the life insurance segment is slightly more positive, especially for the companies that sell variable life and annuity products. A rising equity market should lead to increasing sales of variable products. The relatively low interest rates and steep yield curve are also favorable for the margins of fixed income products. Last but not least, an improving economy should lead to better credit quality for the bond portfolios that life insurance companies own. INDUSTRY POSITION Worksite insurance Zacks Investment Research Page 4

5 Competition in the worksite insurance market is based primarily on product mix, service and pricing, and tends to focus more on the distribution channel. KMG views the worksite marketing segment of the life and health insurance business as being composed of three different types of companies: (1) companies selling primarily group insurance products, (2) companies selling primarily voluntary insurance products and (3) companies offering both group and voluntary insurance products, but through separate distribution channels. Most insurers in the worksite market tend to focus on either the group market or the voluntary market, with very few competitors focused on offering both group and voluntary products through the same sales organization, which is how it operates. We believe the fastest growth in the worksite insurance market in the future will be achieved by those insurers offering both group and voluntary products where cross-selling and product packaging opportunities are significant. KMG s competitors that offer both group and voluntary insurance products to the worksite insurance market through the same sales force are limited and include John Hancock Financial Services, Inc., Mutual of Omaha, and State Farm Life Insurance Company. Other competitors in the worksite insurance market that provide either group or voluntary products, or provide both but through the same distribution channel include AFLAC, Inc., StanCorp Financial Group, Inc., UnumProvident Corp., Transamerica Corporation, Metropolitan Life Insurance Company, American Fidelity Life Insurance Company, Prudential Financial, Inc., Assurity Life Insurance Company, ING Groep N.V., Jefferson-Pilot Corporation and Allstate Financial. RECENT NEWS First Quarter Financial Results On May 8, 2006, the company reported first quarter financial results. Operating income was $1.2 million or $0.06 per diluted share, compared to operating income of $1.5 million or $0.07 per diluted share in the fourth quarter of 2005, and $1.0 million or $0.05 per diluted share in the first quarter of The quarterover-quarter decrease was primarily due to the introduction of option expensing and a one-time refund of premiums resulting from a mass cancellation of an older Kanawha policy form. The year-over-year increase was primarily due to improved results in the Kanawha legacy business, particularly the senior segment, which was driven by higher investment income that more than offset increased expenses associated with the new KMG America sales activity. Investment income in the reported quarter was $7.2 million, in-line with that of the prior-year quarter in spite of an improvement in the investment portfolio yield. The investment portfolio yield in the reported quarter improved to 4.95% from 4.88% in the prior quarter. Book value per share, excluding unrealized losses of $12.9 million, grew 4.6% to $8.74 from $8.70 at the end of Reported book value per share fell 4% to $8.16 from $8.47 at year-end Premium income for the reported quarter increased to $29.8 million, compared to $27.5 million in the fourth quarter of The increase was primarily due to incremental premiums related to the new KMG America sales distribution channel that produced $6.2 million of new direct earned premiums ($4.5 million net of reinsurance), compared to $2.3 million of new direct earned premiums ($1.8 million net of reinsurance) in the prior quarter. The Company s benefit ratio worsened to 78.3% in the first quarter of 2006 compared to 77.7% in the fourth quarter of Worksite Insurance business Worksite premium was $15.6 million, compared to $15.6 million in the prior quarter and $16.5 million in the year-ago quarter. The benefit ratio in the legacy worksite segment worsened to 75.3% from 67.3% in the prior quarter, reflecting primarily the effect of the unusual one-time premium refund and other special policy reserve adjustments. The benefit ratio associated with the new KMG America worksite activity increased to 67.7%, compared to 62.3% in the prior quarter. Zacks Investment Research Page 5

6 Senior Market Insurance business Premium for the reported quarter was $10.7 million, compared to $10.1 million in the prior quarter and $10.6 in the prior-year quarter. The benefit ratio in the senior segment improved to 80.0% in the reported quarter, compared to 88.7% in the prior quarter, reflecting lower open claims and favorable dispositions of earlier claims. Third party administration Business Commissions and fees for the reported quarter was $4.1 million, compared to $3.5 million in the priorquarter and $3.5 in the prior-year quarter. Acquired Business Premium for the reported quarter was $0.6 million, compared to $1.6 million in the prior quarter and $0.9 in the prior-year quarter. The benefit ratio worsened to 194.4%, from 115.8% reported in the prior quarter, due largely to higher claims in three acquired blocks Outlook The Company anticipates that its 2006 operating income per share will lie in the range of $0.35 to $0.40. VALUATION KMG America s shares have rebounded (up 10%) since falling 21% (to $7.91) after the company lowered 2006 earnings outlook (to $0.40 from $0.78) and pushed-out its target year to reach a mid-teens ROE to 2008 from The primary reason for the revised outlook is that the company is taking longer than it initially expected to gain traction in its group life and group disability sales (not surprising for a start-up operation) missed out on the annual renewal season, which occurred in the fourth quarter. We believe that management can replicate its success at ReliaStar in KMG out it will take longer than expected. KMA shares currently trade a 1.04x reported book value (0.96x book value excluding AOCI, accumulated other comprehensive income, eg. unrealized investment losses), a multiple we believe will gradually expand if, as we anticipate, the company gains traction in its group life and disability sales, which should in turn boost margins and ROE. Our six-month price target is $9.75, which incorporates a multiple of 1.09 times our book value estimate, excluding AOCI, at September 30, 2005, and equates to a 30% annualized return. However, we think the stock is a longer-term story and will likely have additional upside potential if the company executes on its business plan. Industry Comparables EPS Price/ ROE Curr Pr Range P/E ROE Growth Book 5-Yr Pr. 52-wk. (2006E) (TTM) 5Yr Est (MRQ) Avg KMG America Corp (KMA) $ N/A Peer Group Mean NM NM Peer Group Median NM NM S&P 500 (SPAL) Aflac Inc. (AFL) $ Delphi Finl Grp (DFG) $ Healthextras (HLEX) $ Stancorp Fnl Cp (SFG) $ UnumProvident (UNM) $ Zacks Investment Research Page 6

7 RISKS KMG may not meet its goals for sales of group life and disability products. Ramping sales of these group products is a major part of KMG s growth strategy. The company has recently hired sales reps and opened offices to grow nationally, in part through sales of group products. KMG s is lagging its initial projections for group sales. If group sales do not gain traction in 2006, KMG s earnings and stock price will likely suffer. Benefit claims could exceed management s projections. An insurance company prices polices targeting an estimate of future benefit claims from policyholders. If these claims exceed KMG management s initial estimate, earnings will suffer. A ratings downgrade could hurt sales and earnings. The financial strength of Kanawha, KMG s insurance subsidiary, is rated by A.M. Best and S&P, and a decline in these ratings could affect our standing in the insurance industry and cause our sales and earnings to decrease. Kanawha currently holds financial strength ratings by A.M. Best of A- (excellent), the second highest of ten categories and the lowest within the category based on modifier (ie. A and A- are excellent), and by S&P of A- (strong), the third highest category and lowest within the category (ie. A+, A and A- are all strong). INSIDER TRADING AND OWNERSHIP Institutions hold 97% of KMG s stock. The three largest holders as of March 1, 2006 are Wells Capital Management (10.1%), Becker Capital Management (7.4%) and Hotchkis & Wiley Capital Management (7.6%). Together, all the directors and officers of KMG America own 2.9% of the outstanding shares, including CEO Ken Kuk s 1.5% stake. Zacks Investment Research Page 7

8 HISTORICAL ZACKS RECOMMENDATIONS DISCLOSURES The analysts contributing to this report do not hold any shares of KMA. Zacks EPS and revenue forecasts are not consensus forecasts. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Buy- Zacks expects that the subject company will outperform the broader U.S. equity market over the next one to two quarters. Hold- Zacks expects that the company will perform in line with the broader U.S. equity market over the next one to two quarters. Sell- Zacks expects the company will under perform the broader U.S. Equity market over the next one to two quarters. The current distribution of Zacks Ratings is as follows on the 1122 companies covered: Buy- 19.8%, Hold- 75.8%, Sell 4.5%. Data is as of midnight on the business day immediately prior to this publication. Zacks Investment Research Page 8

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