Stonemor Dividend Unsustainable

Dec.28.11 | About: StoneMor Partners (STON)

"What compelling argument would you make to invest in your company?" -Analyst

"Dividends." -Bill Walton, 2002 Allied Capital Conference call

Ask any Stonemor (NASDAQ:STON) bull about the appeal of owning the stock, you'll be given a simple answer: dividends.The alluring dividend. Indeed shares yield a whopping 9% at the recent price of $26. Pretty attractive when the 10-year U.S. treasury yields 2%.

Having gone public in 2004, Stonemor has paid consistent and substantial dividends since then. Through 2007 the dividend was mostly covered with cash flow. Since 2008, however, that has changed:

Stonemor Cash Flow and Distributions

(all numbers in mils) 2011E 2010 2009 2008 2007 2006
Cash Flow from Ops $12.0 3.1 14.7 21.1 19.0 18.3
Dividends $44.0 32.4 27.3 25.6 18.7 17.3
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The company and Stonemor bulls will note that cash flows are obscured by the company's aggressive pre-need sales program. Stonemor has been aggressive in acquiring additional cemeteries in the past 7 years. Most of these cemeteries did not have pre-need sales programs, which Stonemor subsequently initiated, and which then began consuming working capital. Stonemor is required to set aside much of the proceeds from pre-need sales into a merchandise trust. These funds are released largely at management's discretion, mostly when the vault is installed (which is often decades before it is filled).

The trust issue is fairly complicated, and the company isn't shy about noting that. But we find much of what Stonemor presents to be misleading. In a presentation made on December 8th (slide 28), the company displays "the cash flows associated with a typical (pre-need) contract". We were surprised to see the 15% selling commission omitted from the presentation. This commission is cash and is paid as soon as enough funds are received from the customer. It's directly related to a specific contract. When we asked the company about this, their contact replied "we have been using this same example in our presentations since we went public, and you are the first to ask this question." The cash flows implied on the slide also seem to correspond to what we would define as "gross margin" rather than actual cash flows. It bears no resemblance to the actual cash flows of the business.

Stonemor has also increasingly highlighted non-GAAP accounting over time in their presentations. The company had a period of significant acquisition and growth from the time of their IPO through 2007. Owned funeral homes rose from 7 to 57, and owned cemeteries rose 69% to 232 total. It's interesting that since that time, GAAP results have deteriorated dramatically:

STON Op Inc and Interest Expense

all # in millions 2011E 2010 2009 2008 2007
Op Income $13.0 3.3 12.6 17.4 12.6
Interest Expense $19.1 22.0 14.4 12.7 9.1
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And the company has watered down their definition of "distributable cash flow" over time. In the 3rd quarter of 2007, it was operating cash flow before (loss) reserves, minus maintenance capex and non-operating expenses (i.e. debt refi costs, which have become a regular item, or acquisition related expenses). Two quarters later they had expanded the definition to include all working capital changes, particularly those "to fund pre-need growth" during the period.

Neither the rating agencies nor Stonemor's secured lenders have watered down their definitions, although the latter keep relaxing debt coverage covenants. The most recent amendment, of which there have been two just since May, lowered Stonemor's 3rd and 4th quarter debt coverage ratio to a razor thin 1.05x. The required ratio jumps back to 1.2x in 2012. If STON falls below the 1.05x in the 4th quarter, the lender has the right to restrict dividend payments.

Standard and Poors recently highlighted the growing risks of Stonemor when they downgraded STON's unsecured debt to CCC+ on 11/29/11. S&P noted that Stonemor's free cash flow has not met expectations, and that STON has been highly reliant on outside financing to fund distributions to unit holders. STON's unsecured notes due 2017 recently traded at 97, or a yield to maturity of 10.5%. Bulls who like the shares should love the bonds. S&P estimates a less than 10% recovery in the event of a default.

So what sort of "outside financing" has Stonemor used to fill the cash flow gap? They've issued more stock. Stock issuance by year since 2007:

Stonemor stock issuance

in mils 2011 2010 2009 2008 2007
Stock issued $103.2 38.9 23.7 0.09 50.8
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This explains the huge rise in annual dividend payments, to $45 million at present. It's also notable that STON did no secondary offerings in 2005 or 2006, prior to their rapid growth. Did we mention that the original organizers of STON completely cashed out their stake in the huge February secondary?

It's also notable that the SEC has issued multiple inquiries to Stonemor regarding their accounting. Stonemor's earnings quality has deteriorated, with the company attempting to write up the value of a $14 million, 1Q10 purchase of nine cemeteries in Michigan by $23.3 million upon acquisition. Most of the gain was later reversed after the company agreed to restate results, which the SEC appeared to challenge but wasn't disclosed until March 30, 2011. STON ended reporting a $7.2 million gain on acquisition for 2010.

We'll close by comparing STON with their other publicly traded peers on some metrics. The astute observer will note that STON has a higher dividend yield.

STON versus comps, ttm 9/30/11

SCI 7.57 1.75 15.3% 19.4 1.8%
STON 35.82 2.84 1.4% 83.4 9.0%
CSV 8.07 1.67 18.1% 10.7 1.7%
STEI 8.06 1.53 12.5% 13.8 2.4%
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Disclosure: I am short STON.

Additional disclosure: previously long SCI