Brian Harper has done an excellent job of detailing a myriad of issues at StoneMor Partners (NYSE:STON) in his two articles about the company, Stonemor Inflated on Dividend Enthusiasm and Stonemor Dividend Unsustainable. Harper highlights the fact that StoneMor generates very little free cash flow and thus relies on both debt and, increasingly, equity capital raises to fund its very high 8.4% dividend; that it’s overvalued relative to its peers; and that its founders cashed out their limited partnership stake.
The true story of StoneMor, however, is even more troubling, going beyond a relatively simple case of a roll-up strategy gone awry (how many times has that happened?!), with the usual poor operating performance, weakening balance sheet, and irrational capital allocation, all of which Harper exposes. This story adds skewed incentives, deception, greed, and unethical behavior by a management team that engaged in precisely such behavior with a prior company, The Loewen Group, which ultimately filed for bankruptcy.
StoneMor reminds me of three previous situations, all of which collapsed: a) Star Gas (NYSE:SGU), also a Master Limited Partnership (MLP) with an unsustainable dividend whose stock declined by more than 90% in eight months from late 2004 through early 2005 when it was finally forced to cut its dividend (don’t miss one of Dan Loeb’s all-time classic letters to the CEO here); b) Allied Capital, another big dividend payer that was cooking its books (see David Einhorn’s fabulous book, Fooling Some of the People All of the Time); and c) Orthodontic Centers of America, which also used bogus accounting to hide the true fundamentals (see: www.valueinvestorsclub.com/value2/Idea/ViewIdea/696).
Misleading non-GAAP accounting
Harper discussed the use of non-GAAP accounting in his article, “Stonemor Inflated on Dividend Enthusiasm”, but let’s really drill into the company’s earnings reports to understand how the company is manipulating its numbers to deceive investors, who are being blinded by the fat dividend and management’s disingenuousness.
In its most recent (Q1) earnings release on May 9, 2012, StoneMor highlights “Distributable free cash flow generated”, a non-GAAP number which it defines as:
- Operating cash flows, plus
- Net cash inflows into the merchandise trust, plus
- Net increase in accounts receivable, plus
- Net decrease in merchandise liabilities, minus
- Net (increase) decrease in accounts payable and accrued expenses, plus
- Other float related changes, minus
- Maintenance capital expenditures, plus
- Growth capital expenditures reclassified as operating expenses and deducted from adjusted operating
Got that? Basically, StoneMor is adding back a bunch of mostly favorable line items from its cash flow statement, while mostly ignoring many cash consuming items, to arrive at a figure, “Distributable free cash flow generated”, that – surprise! – (slightly) exceeds the amount StoneMor pays out each quarter in dividends (for MLPs like StoneMor, they’re called “distributions”). For example, in Q1 2012, “Distributable free cash flow generated” was $13.82 million and the dividend payout was $11.78 million.
The problem is that “Distributable free cash flow generated” is a completely bogus number that doesn’t reflect true cash flows. The company even admits this in the fine print of the earnings release:
“…our calculation of distributable free cash flow may not be consistent with calculations of free cash flow, distributable cash flow or other similarly titled measures of other companies. Distributable Free Cash Flow is not a measure of financial performance and should not be considered as an alternative to cash flows from operating, investing, or financing activities.”
True Free Cash Flow
StoneMor is using a very old trick that has been used by countless nefarious and/or promotional companies in the past, but any knowledgeable investor can see right through it by going directly to the cash flow statement rather than relying on management’s misrepresentations. This table, which goes back 13 quarters to the beginning of 2009, shows the key line items from StoneMor’s cash flow statement, with my calculations of free cash flow (OCF-cap ex) and the dividend deficit (FCF-dividends paid):
(click to enlarge)
This chart shows the last three lines of the table:
Now we can see the true, extremely ugly, picture at StoneMor: in the last 13 quarters, the company has only once generated enough true free cash flow to cover the dividend – and even then, only by a smidge. Over this period, the company has averaged a mere $1.4 million in free cash flow per quarter, yet has paid a dividend averaging $8.9 million per quarter (and nearly $12 million in each of the last four quarters), resulting in a cash burn that has averaged $7.5 million per quarter. This is clearly absurd and unsustainable.
But wait, it gets worse!
Under cash flows from investing activities in StoneMor’s cash flow statement, in addition to cap ex, there are two line items, “Cash paid for cemetery property” and “Purchase of subsidiaries”, both of which reflect StoneMor’s ongoing acquisition strategy. Here’s the data by quarter:
Here’s the same data graphically:
We can see that, above and beyond the cash burn that has averaged $7.5 million per quarter to pay the dividend, StoneMor spends an additional $5.9 million per quarter, on average, doing acquisitions to keep the growth story afloat.
Funding the Deficit
So if StoneMor is really burning through an average of $13.4 million per quarter ($7.5+$5.9), how come it’s not bankrupt? There are two reasons, as the table below shows: first, StoneMor has been increasing its debt by an average of $2.6 million per quarter since Q1 2009 (resulting in a recent downgrade by S&P of the company’s corporate rating from a weak B to an even weaker B-); and second, more importantly, StoneMor has done three big equity offerings in Q4 ‘09 ($23.7 million), Q3 ‘10 ($39.5 million), and the biggest of all in Q1 ‘11 ($103.6 million):
This game can continue as long as the stock price remains elevated since issuing stock above book value – and StoneMor currently trades at the absurd price of three times book – is highly accretive. But look out below if the markets close to new equity issuances…
Management’s questionable past
The background of the management team raises all sorts of red flags. Five senior managers – CEO, President, and Chairman of the board Lawrence Miller; Senior VP and COO Michael Stache; Senior VP of Sales Robert Stache; VP of Business Development Gregg Strom; and VP of Finance Paul Waimberg – all worked at The Loewen Group, a business in the same industry that filed for bankruptcy in June 1999. A two-year investigation by the State Auditor of Minnesota on two cemeteries owned by The Loewen Group resulted in a Special Investigative Report released in October 2001 (pdf), which found that The Loewen Group failed to: adequately fund preneed trust accounts, deposit proceeds into separate trust accounts, notify consumers of trust account information, properly disburse trust funds, properly file reports with the Commissioner of Health, create and maintain preneed consumer records, and provide preneed price information.
This sordid history, with the direct involvement of most of StoneMor’s current management team, raises serious questions whether StoneMor might be engaged in similar shenanigans.
Complicated structure and perverse incentives for management and the General Partner
The Company’s structure is a bit complicated, and is best detailed in the chart below from StoneMor’s amended S-1:
However, the structure of the limited partnership percentages has changed due to equity raises and a disposal of the limited partnership shares by the General Partner (a miniscule 5,000 shares are still held by a member of McCown De Leeuw, Robert Hellman).
The structure of the firm leads to a disproportionate share of the distributions being sent to the General Partner, which owns 2% of the equity in the firm and is entitled to 2% of the dividends up until $0.5125 (per quarter). Between $0.5125 and $0.5875, the GP receives 15%, between $0.5875 to $0.7125, 25%, and above $0.7125, half of the incremental dividends (see page 32 of the 2011 10-K).
With the dividend currently at $0.58 per quarter, the GP is above the threshold to start receiving a disproportionate share of the distributions. Further, according to the partnership agreement, the GP can force StoneMor to borrow funds or sell assets in order to make the quarterly cash distributions. The company raises capital in order to pay distributions above $0.5125 in order to provide the GP with gains disproportionate to their investment. Further, the GP controls the board, allowing it to milk the company for cash despite its limited equity stake, even if this impairs long-term unit holders. This provides incentive for management malfeasance.
StoneMor has a management team with a highly questionable past, weak financials, and doesn’t come anywhere close to funding its dividend, which it cleverly covers up. It’s a house of cards that will soon collapse when the fundamentals catch up with it.
Bulls argue that the MLP structure of StoneMor should lead one to ignore all of these troubling facts, but this is a specious argument. The company’s structure offers tax benefits (distributions are tax free) to partners and allows limited partners to write off the depreciation of the company on a pro-rata basis, but does nothing to warrant such an egregiously high valuation for a barely profitable company with an unsustainable dividend.
Paradoxically, the MLP structure that bulls argue justifies a higher valuation for StoneMor will in fact lead to its downfall, as it gives management and the GP strong incentive to inflate the dividend in every way possible, even if it’s simply by round-tripping shareholders’ capital by doing equity raises and then paying out the capital in the form of a dividend to a diluted shareholder base.
Disclosure: Long STON Puts.