(Editor's Note Regarding Author's Disclosure: The author disclosed holding a long position in STON when publishing the article. Due to editorial oversight, we did not check with the author regarding the discrepancy between the disclosure of a long position while publishing a bearish/short report. The author has since elaborated on the details of his position - please see the amended disclosure.)
We owe a great deal of gratitude to the lawmakers dating back to the early 1960s who made it a legal obligation for cemeteries and funeral homes alike to deposit pre-paid funds into a restricted trust. These are called pre-need sales, which allow consumers to prepay for their cemetery and funeral services in advance of the time of need. The trusting requirement was put in place to avoid the misappropriation of funds and to ensure the money will be there for its intended purpose, regardless of the financial position of the cemetery or funeral home. Few members of the deathcare industry argue the trusting requirement is an unfair regulation, but for now, that is the law of the land and the reality of the business - no exceptions. Well, maybe one - StoneMor Partners (NASDAQ:STON).
StoneMor follows the MLP playbook by preparing a distributable cash flow reconciliation (Fig.1 below) to net income to show where its distributions (i.e. dividends) are coming from. This non-GAAP metric is subjective and a poor measure of cash flow at best. StoneMor showcases its distributable cash flow like most MLPs, but STON is unlike most MLPs. StoneMor is the only cemetery structured as a MLP. This has afforded StoneMor one extra line item on its distributable cash flow reconciliation and that is "net operating profit deferral from non-delivered merchandise and services".
This is future profit which management estimates it will generate a 75% EBITDA margin on. Not too bad for a cemetery. The deferred profit is primarily generated from pre-need sales which have not been delivered yet and therefore have not been earned yet to be recognized as revenue. Until the service or product is delivered, these funds are held in a restricted trust and not accessible to StoneMor for any corporate purpose. StoneMor is therefore unable to distribute these future profits today. Deposits into the trust do not represent discretionary cash flow in the hands of StoneMor.
This estimated, un-distributable future profit from un-earned sales makes up nearly 100% of StoneMor's distributable cash flow. See table below:
Source: Please see page. 8 of the StoneMor full-year 2015 earnings press release on February 29, 2016, here
The deferred profits above represent nearly 100% of distributable cash flow. These deferred profits require an equity commitment from new investors to be distributed. It would seem investors are financing 100% of a distribution to themselves for income.
Pre-Need Sales Cash Flow
StoneMor's pre-need sales are generally made with a 10% down-payment and paid over 36 months. As StoneMor collects money from its customers, it deposits these funds into a restricted trust. The deferred profits, which StoneMor recognizes in the current period, have not been paid in full and will be collected over a three-year period. StoneMor recognizes and distributes 100% of the profit from these sales, but has not collected 100% of the cash from these sales. It is difficult for StoneMor to payout cash which it has not received. STON also runs a risk that it will not be able to generate a 75% EBITDA margin on its pre-need sales as estimated.
Note: "Profit deferral from non-delivered merchandise and services" has been more appropriately re-named as "Estimated, Intangible, Un-earned Profits" in the table above
Without the inclusion of estimated intangible unearned profits in distributable cash flow, StoneMor comes up nearly 100% short to meet its distribution requirements. See table above. This more accurately depicts the financial reality of StoneMor. As mentioned, the deferred profits do not represent a cash flow to StoneMor, the cash has not been collected yet, and therefore, cannot be distributed.
Click to enlarge As displayed in the bar chart above, there is a large discrepancy between the cash StoneMor is taking in and the cash it is paying out. The cash flow which StoneMor does generate must first be used for growth capital expenditures and debt service requirements. This effectively leaves zero dollars for distributions and even a shortfall in 2014 and 2015 to meet its growth capital expenditure requirements. These should be clear red flags to investors StoneMor is unable to pay these large distributions to shareholders.
Balance Sheet Item
The inclusion of deferred profits on the distributable cash flow calculation is an unusual practice because it involves taking estimated future profits from the merchandise trust on the balance sheet and putting them onto the income statement as if they were earned in the current period. This is not common practice by MLPs or other deathcare businesses.
The deferred profits held on the balance sheet will flow to the income statement once the service and product has been delivered. These pre-need sales will then become earned income and flow to the income statement. StoneMor recognizes the profits from these pre-need sales once when the contract is executed in the current period and again when it becomes earned income. This has been caused by mixing production-based financials for measuring performance and GAAP financials.
How to Pre-Maturely Distribute Profits Held in a Restricted Trust
Raise cash by issuing new shares. StoneMor finances the distribution of the estimated profits it will accumulate in the trust from the pre-need sales contracts produced in the quarter by issuing stock. StoneMor's distributions of deferred profits require an equity commitment from new investors.
As StoneMor noted on page 4 of its Q2'16 press release, the company sells stock to raise money to deposit into the trust. This however is only theoretical. The cash from issuing equity is not deposited into the trust. Theoretically, it could have taken this cash and deposited it into the trust and taken its deferred profits out. This is not an efficient use of cash since StoneMor will have to pay a 10% distribution in perpetuity on this source of funding to pay a 10% distribution today.
StoneMor attempts to explain it as:
We have -- for cemetery pre-need, we have a 60% margin… So we are -- what we're doing with that working capital need, we are funding that with capital market activity…That period, so that sale that we put the cash in, okay, we are funding that working capital need and then we're using that to generate distributable cash flow and pay cash distribution. - StoneMor Management 2015 Analyst Day
Clear as mud? This is a clever tactic to refer to deposits into the trust as a "working capital need" which must be financed through "capital market activity". This explanation seems to generate empathy from investors and analysts for the cruel regulations they have to endure as a cemetery. This is not the case though.
The deposits into the trust are allowed to be made pro-rata as StoneMor receives the cash from the consumer, so there is no pre-funding requirement on behalf of STON. There is only a "working capital need" when StoneMor attempts to distribute cash in the same period it deposits it into the trust.
As displayed in the 2015 unconsolidated cash flow statement below; money is raised at the parent level and distributed back out as earned income at the parent level. This is a clear illustration of the circle of cash from new investors to old investors.
This is a form of financial jiujitsu.
Source: StoneMor 2015 10-k page. 84
Distributable Coverage Ratio
StoneMor publishes a distribution coverage ratio which shows the safety of its distributions. MLP investors seek to have a coverage ratio above 1.0x for obvious reasons. StoneMor's coverage ratio has fallen below the 1.0x threshold as of the trailing last 12-month period of Q1'16 and Q2'16. Given the decline in EBITDA and increasing share count, it is likely this gap will continue to increase through year end.
The coverage ratio is based on available cash flow for distributions. This includes 100% of the beginning cash balance and 100% of the un-earned, un-collected deferred profits. A coverage ratio of 1.0x in multiple periods assumes StoneMor distributes 100% of its cash balance multiple times. This fails the basic litmus test of addition and subtraction - you can't spend the same dollar twice.
Production "Adjusted EBITDA" and Distributions Per Share
As StoneMor increases its shares outstanding faster than it increases its "Adjusted EBITDA", "Adjusted EBITDA" will decline on a per share basis. Over the last 12 months ("LTM"), StoneMor's total "Adjusted EBITDA" has declined and its shares outstanding has increased 11% YTD. This has accelerated the decline of "Adjusted EBITDA" per share, which is a production-based measure and not a comparable metric to other public companies' "Adjusted EBITDA".
It is very burdensome for a business to distribute more than its "Adjusted EBITDA" which is before $22 million of interest expense and $15 million of capital expenditure requirements.
StoneMor Distribution Gravy Train
StoneMor's distributable cash flow calculation calls for the company to raise cash annually by issuing dilutive equity to new shareholders. StoneMor will not be able to issue new stock indefinitely. StoneMor needs to issue approximately $100 million of new shares annually for distributions and additional shares for debt service obligations. The question will be if StoneMor can issue more equity than its current market capitalization and what effect that will have on the share price.
20 Reasons Why "Deferred Profits" Should Not be Included in Distributable Cash Flow
1. They have not been earned yet.
2. They are only estimates.
3. Insult to injury: Management estimates them at a 75% EBITDA/EBIT/Net Income margin.
4. They are not tangible cash flow to the business or discretionary funds.
5. They are un-distributable until the service is performed by state law.
6. StoneMor is not the legal beneficiary of the cash in the trust until the service has been performed. It cannot distribute cash which is not legally theirs.
7. They were not earned in the current period.
8. They will flow from the balance sheet to the income statement and once again be included in distributable cash flow as net income. This is double counting of profits. They are included once when the sale is made and a second time when the service is performed.
9. Include revenue from certain at-need sales which have yet to be performed, but will be in the next quarters' earnings, another double counting of earnings.
10. The requirement to finance profits makes StoneMor highly susceptible to its own share price. Lower the share price, the more new shares STON has to issue.
11. Require StoneMor to sell equity finance future profits which don't exist yet.
12. In StoneMor's 15 years of operating performance, the 75% EBITDA margins from these sales have yet to show up on the income statement.
13. Consumers may be unwilling to purchase pre-need deathcare services from StoneMor if they believed STON was going to distribute 75% of the principal paid to it.
14. StoneMor does not provide sufficient disclosures on how management is estimating future profits.
15. Distributing out profits before they become taxable income creates future tax liability for unit holders.
16. StoneMor may not have received a sufficient down-payment to ensure collectability.
17. Certain sales are still subject to a federally regulated "Cooling off Period" where consumers are entitled to a refund.
18. Pre-need sales are paid off on 36 months installment plans yet StoneMor assumes it can distribute 100% of the profits before it collects the cash.
19. Consumers concerned with deathcare planning may be better off saving the money then allowing StoneMor to distribute 75% of the principal to shareholders and management.
20. Depositing and holding cash from pre-need sales into the merchandise trust is not optional, it's mandatory.
If StoneMor doesn't sell equity to pay distributions, it does sell equity to finance 100% of the profits it distributes in the distributable cash flow. StoneMor will unlikely be able to raise new equity indefinitely to pay out its distributable cash flow. This creates an inherit conflict with the company's distribution policy. This also makes StoneMor prone to fluctuations in its own share price, which is an unusual dynamic. The decline in production-based Adjusted EBITDA coverage ratio below 1.0x and increasing distribution requirements should raise concerns for investors.
Sustainable dividends mostly come from a renewable source of income, such as the earnings the business generates through operations. StoneMor does not generate earnings.
Disclosure: I am/we are long STON.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have an immaterial position of StoneMor Partners (STON) shares. Based on my stated research in this article I believe shares of StoneMor will decrease in value in the future. I have not traded in StoneMor securities in the past 60 days and do not have plans to take a material position in the next 72 hours.