Stewart Enterprises: Succeeding Despite Grave Problems

It’s been an exciting week. Although the SP500 plunged around 5% due to poor earnings, the Best Portfolio gain for the first two weeks is still 5.95%, frankly much better than I expected in such a short time – but the market has been very kind to a number of our positions. The advance in resource stocks, plus the call premium and dividends earned, has enabled the portfolio to outperform the SP500 by a whopping 5.8% in just two weeks, which obviously is an outlier return. The Portfolio collected option premium on nine positions and also seven dividends accrued (went “Ex”) this week. See the Excel spread attached below.

Note – Three positions have earned us ‘doubles’ on the dividend play and also an option score, in just two weeks! MSFT, CLF, BTU all enjoyed a spike last week, and we booked the option premium. Regardless of whether we get taken out of the positions five weeks from now or not, we have that money in our account. If those positions are called away, we will do research and come up with some candidates to replace them in short order.

On Monday, I added 5,000 more shares of HL – Hecla Mining – at $1.77, even though I’m pretty unhappy with recent financial developments, as I opined on in last week’s update. I really don’t like to average down in positions very often, but I just believe that HL is unjustifiably cheap here, and silver is moving up strongly, and I expect will continue to do so. The position was on the smaller side to begin with, so I deployed some of the option premium toward HL.

We also have a grave problem in STEI – Stewart Enterprises, a ‘deathcare’ company I have followed for years. So I have chosen that as the feature stock of the week.

Like all companies, STEI has been challenged by a tough economy to maintain pricing in its core funeral business – but it has done so. Families are naturally being price conscious, and cremation has been a growing trend for years, and now stands at nearly 40% of services. There is also a bad stigma for this industry and its shoddy practices – and there have been numerous financial meltdowns of prominent companies over the past decade, including STEI which plunged from the $47 range in 1997 to under $2 at the end of 2000.

Loewen went bankrupt in the early part of the decade, re-emerged as Alderwoods, and then was acquired in 2006 by Service Corp International (SCI), a larger player in deathcare which itself nearly went BK in 2000. SCI was also involved in a really sleazy embalming scandal in Texas, its home state. The Houston-HQ company was accused of not following legal standards of conduct, but its close ties (and large political contributions) to the Bush family allowed it to thwart (bury?) a State investigation into its business practices. George W. Bush was then Governor of Texas and on his way to the White House. The scandal was dubbed "Funeralgate" or "Formaldegate" by the press, and involved the firing of a State investigator who had (pardon the many puns herein) dug up some dirt on SCI. After a civil lawsuit was filed, SCI and the State of Texas had to pay large damages and fines.

Recently, STEI traded as high as $9.74 on September 19^th, after the Lehman BK, but then quickly sank to under $5 over the next month, along with the market crash. Volume increased sharply as the plunge picked up pace, driven in part by the panic, and also the forced selling by institutions that can’t own stocks under $5, and don’t know what to do anyway in a very volatile market. Stewart was also in the advanced stages of being acquired by SCI, but on 10/7/08 SCI abruptly deep-sixed its offer to buy STEI when financing evaporated in the market melee. The $9.50 all-cash offer had been floated by SCI in late June, and STEI hired advisors and pressed for a bid in the $10.25 to $11.25 range.

The two companies haggled over price but were moving forward with DD right up through early October when the market began collapsing with sudden ferocity. Here is the text of the letter from STEI to SCI -

October 7, 2008

Thomas L. Ryan

President and Chief Executive Officer

Service Corporation International

1929 Allen Parkway

Houston, TX 77019

Dear Tom:

We were surprised and disappointed by the timing and content of your letter.

Your letter comes at a time when we had finished preparing the due diligence information you requested and we were awaiting the mark-up of the confidentiality agreement.

We disagree with how you characterize the current state of our discussions in a number of ways. Throughout our discussions you had consistently communicated to us that you were prepared to consider increasing your offer after receipt of limited due diligence information, that you were comfortable with the anti-trust regulatory risk and that your ability to deliver financing was key to the transaction.

It is disappointing that you are publicly attempting to characterize us as unreasonable when the only thing that seems to have changed since our initial discussions is the state of the financing markets. It has now become apparent to us that either your level of commitment to this transaction or your ability to consummate this transaction is not what it once was. Our Board will continue to assess all of our alternatives to maximize shareholder value and also remains open to an appropriate dialogue with SCI with respect to a transaction.

Sincerely,

Thomas J. Crawford

Stewart also had exposure to Lehman and FNM, AIG, WM, and FRE preferred securities which all collapsed over the summer and early fall. This lethal combination of the merger withdrawal and collapsing investment values understandably put enormous pressure on the stock, which sank to under $3 in mid-December. Given all this, why would I or anyone want to buy STEI in its present state?

First, I would say that despite all the agony, STEI’s business looks halfway decent going forward. It reported a large 39 cent loss per share for the fourth quarter ended 9-30-08, and an overall loss of four cents for FY08 on December 19^th, but the details reveal that the company is far from moribund. Here’s a quote directly from the call, a transcript of which is available here from Seeking Alpha. This is CEO Tom Crawford:

First as disappointed as we are to report a loss, the loss for the quarter and the year was driven by severe declines in the financial markets and in relation to some of our investments.

Additionally the decline in the financial markets plus reduced property sales resulted in a goodwill impairment and the loss that we recorded and reported was not the result of operating performance.

Second while there is always room for improvement for the quarter and the year we are pleased with our operating performance and believe our initiatives are strengthening the business at the rooftop levels and we’re pleased with that. We do think we’re pointed in the right direction. We believe we are doing the right things to make the business stronger and more valuable over the long-term. The third message is that even in today’s economy and the turbulence from financial markets the company’s balance sheet remains strong and we expect to continue generating consistent cash flow over time.

And then later in his introductory remarks:

Investors have felt it on both the equities and in the debt markets and we here at Stewart are not immune nor is our industry. We have felt the effects of the financial meltdown most acutely as the result of the investments we made in preferred equities of Lehman Brothers, Fannie Mae, and Freddie Mac, plus holdings in Washington Mutual and AIG, all of which have little or no value today…

The evidence of the Best in Class initiatives that we put in place also show up in our margin progressions and when you look at our progressions which is one of the things that we measure, our revenue was up 3.2%, our gross profit was up 6%, income up 56%, and EPS up 60%. And you see the same kind of progression for the year, just not as steep and again the margins that I talked about on our progressions for the quarter, we don’t believe those are sustainable at that level but our intent is that we get a multiplying effect as we go from revenue, through gross profit, income and EPS through the year.

In relation to the strength of the balance sheet and cash flow, cash on hand right now is $73 million. Our operating cash flow is $85 million for the year and again Thomas (Kitchen, the CFO) will talk more in detail about this. Our net debt remained constant over the year at $377 million. However, that should be considered in relation to the fact that dividends and share repurchases totaled nearly $60 million in outflow for the company in 2008.

Investors are rightly concerned about the economy and its impact on STEI, and of course it appears that Stewart made some very poor choices in its Trust investments. The company holds over $500 million in Trust to cover perpetual care and maintenance at its various cemeteries. The 10K stated “At October 31, 2008, the fair market value of our total trust investments was $334.6 million less than our original cost basis of $990.5 million. As of November 30, 2008, the fair market value of our total trust investments was $584.8 million.” So the Trust was under water by 34% at the end of the fiscal year, then sank another 10.2% in November. Obviously, STEI needs huge improvement in its asset management, which it apparently farms out to outside firms. This may need to be revisited.

Stewart also booked a $7.4 million deferred tax asset adjustment, or “valuation allowance” pertaining to the capital losses in the company’s cemetery trust investments – that was recorded in Q4-08 per the auditors. This arose due to the uncertainty of generating investment gains in the future, which would utilize the capital loss CFs, before they expire. You will see many companies in the same boat as STEI as they report earnings for a dismal Q408. That is, they lose money from either operations or investments, or both, and then have to take an additional hit for the allowance on the capital loss CFs. Those will reverse in some cases, and not in others. Regardless, it reduces the asset base right now, and therefore makes debt-to-equity ratios look worse than they otherwise would be.

Even with all of this going on, STEI’s book value at 10/31/08 was $3.96 or 35% higher than Friday’s closing price of $2.94. There are numerous details related to operating metrics in the December earnings release and the call – too many to include here – but the basics of the business are really doing OK, so I am a holder despite the problems in the Trust, and will buy more if it dips much lower.

Several other positions suffered last week – notably HNZ (now down 5.6%), CAG (-5.15%), TPP (-4.3%) and Cameco, with the symbol CCJ (-5.43%). None of these are seriously under water yet, and I don’t plan on dumping positions during brief slumps, as the object here is not to try to guess the swings, or jump from name to name. Cameco is an interesting company, and controls some of the largest uranium mines and processing facilities in the world. Cameco’s dismal performance of late can be summed up in one phrase - CIGAR LAKE FIASCO - and I will likely cover it next week as the featured stock. I think uranium has a very bright (glowing?) future, so I’m a holder for the long term on CCJ, which will spike enormously on any U.S. initiative to begin building a lot of nukes, or on any positive news from its tortured development project at Cigar Lake.

Let’s go over a few of the rules which I have established for this model portfolio, in terms of income recognition and tabulation of results as we go forward. First, as our intent is to capture some covered call premium whenever our holdings enjoy an advance, we will do that if the stock is up 12% or more from our basis. This premium income will be recorded immediately (options sold actually pay into your account the following day) and be available for adding to existing positions, or replacement positions, as soon as the option is recorded on the spreadsheet. The total options premium will be recorded in a section below the sheet, and from time to time the detail will be posted.

Dividends that go “Ex” will be recorded as income on that day, and added to the portfolio’s total value, for the sake of easier tracking – most dividends are relatively minor, and it would add a lot of maintenance time (that I don’t have) to track the actual payments received day by day. When dividends go Ex, they are yours, and regardless of when you sell the stock or it gets called away, you have the dividend coming to you as a legal obligation of the company. So in the week they go Ex, they will show up on the sheet, and then when paid they will disappear soon afterward, but the money will stay in the accumulated “cash position” cell until it is spent on another stock.

I will try to keep most of the money invested, with a small cushion to be able to pounce on bargain prices when they occur in this swingy market. Most of the time, the cash will be at 2% or less, to give the portfolio the best chance to bear fruit from the original game plan. A complete history of all option trades and new or added positions will be posted from time to time, just to fully document what the strategy has delivered.

All commissions will be ignored, but I will adjust the cash collected from time to time with a ballpark estimate for actual commissions that would have been paid on purchases or call writes. The benchmark is the S&P 500, without adding in dividends received – those too will be estimated at the end of each quarter and the benchmark figure will be adjusted accordingly to ensure a fair comparison.

One recent trend has been strength in the resource sector, as hopes for a global recovery take shape, at least for some. China has been buying recently, and our three Canadian resource stocks (WTN-met coal, SVM – silver, and QUA- copper & gold) have all produced nice gains so far, with SVM up a whopping 26% despite a very lackluster quarter announced a few days ago.

We have little exposure to the financial sector, which will get a huge bid if mark to market (M2M) accounting is suspended. Personally I am in favor of this move – I believe that the imposition of FASB 157 has led to a vicious downward spiral for the financials, and that many balance sheets have had irrational markdowns forced upon them, which in turn has destroyed confidence in our banking system, and made many lenders very cautious, as well as restricting available funds. We are marking to “market” prices that don’t actually exist in the sense of a normal, healthy and active market. They only exist in a crazy market where nobody really wants to own these things, because of all the fear and lack of a clear picture of what the CDOs hold. Some no doubt are worth little or nothing, but many others can only get ludicrously low bids, despite the current situation in which over 90% of the mortgages contained in the CDO are still paying on time.

This nonsense has got to stop, as we have a panicky, dysfunctional financial market for mortgage securities and bank stocks at the moment, and the only one we own right now is STT. We will await further developments in Washington, and may very well miss an enormous spike in this sector. On the other hand, we may see a wave of bank nationalization that could wipe out a lot of shareholders, so we will content ourselves with an exposure of around 2.5% of portfolio value for the moment. The Portfolio at the close on 2-13-09 is attached below.

(Click to enlarge)

Comments

[User 353755:]

Bill, thank you for very good educational material.

Feb 17 11:38 AM