Betting on the Inevitable...
Some of the best investments are those able to exploit increased population growth. Many of the companies that have rewarded investors handsomely over the past several decades, including Procter and Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL) and Johnson & Johnson (NYSE:JNJ) will grow with the population as more people using band-aids, brushing their teeth or shaving translates into larger profits over time.
Following this logic, more people living today translates into more people dying several decades down the road. So why not take a look at companies operating in the funeral industry? A small name I have been recently attracted to has been Carriage Services (NYSE:CSV). Carriage operates in two segments, funeral home and cemetery operations. Carriage operates 159 funeral homes across 25 states and 33 cemeteries in 12 states. In addition, the company has been acquiring funeral homes and cemeteries in order to expand its business.
The Numbers on Carriage Services
Currently priced at $18.60 per share against $.07 of cash and $7.75 of book value - investors are paying a premium for the company. The P/E ratio stands at 29. The company has also begun to initiate payments on its common shares however the dividend is low, only yielding half a percent. Insider ownership of the company is high, currently standing at over 20% - something that I believe is encouraging. The company is also friendly to common shareholders, repurchasing 686,208 shares of common in 2012
Revenue from the company's business segments in 2012 stood at 75% from funeral parlors and 25% from cemetery operations. Additionally, 47% of the operating revenue from cemetery operations was generated in advanced through the sales of interment rights, cemetery merchandise and services. As many people plan their internment in advance, I view this as a good way for the company's operators to obtain predictably forecasted future cash flows. The company was also able to harness the current low interest rate environment and refinance its debt, redeeming high interest 7.825% senior notes in exchange for a credit facility indexed to LIBOR plus a margin - current interest rates on the credit facility averaged 3.73% for 2012 - a substantial savings.
A Compelling Proposition for Expansion
The funeral business has historically been highly fragmented and localized, providing high barriers to entry for new competitors. However, as time progresses, because of the grim nature of many of these family owned businesses, the next generation is often not interested in continuing to work in the area. By acquiring local funeral homes and incorporating them into their nationwide network - Carriage is able to retain the localized quality and clientele of individual funeral homes while enjoying operating efficiency afforded by operating at a large scale.
1. Possibility of an REIT Conversion or a Spin-off?
REIT conversions of companies with significant real estate holdings have become increasingly attractive in the past several years. Activist investors and companies themselves often use a REIT conversion to increase the tax efficiency of their operations as regulations for what constitutes an REIT qualifying entity have slackened in recent years. As a result, I believe that Carriage is an excellent candidate for REIT conversion, given the fact that both its funeral home and cemetery segments can be converted or spun off. In addition, this activity has already occurred in the funeral and cemetery sector, with Stonemor Partners (NYSE:STON) operating as a funeral home and cemetery focused REIT - yielding a very healthy 9%.
2. Acquisition Target?
With a market cap slightly north of $300 million - I believe that Carriage Services has the potential to be acquired either in the medium term or the future. As discussed earlier, funeral homes are by nature a very fragmented business that are facing a generational decline in family operators - as a result I believe that in the next decade there is not only large potential for growth of companies like Carriage Services and Stonemor but the potential for consolidation in this sector. The recent purchase of Stewart Enterprises (NASDAQ:STEI) by Services Corp International (NYSE:SCI) at close to a 30% premium also indicates there is potential for future consolidation in the industry.
For a business that is built upon something inevitable - an investor would think that there are few risks that could damage the company's future source of business. While death is inevitable, I have identified several things that merit further consideration before an investor seeks to make a commitment.
As the company employs a large amount of debt to conduct its expansion strategy, it is important to assess the stability of its future cash flows. As medical technology has advanced and human life expectancy has increased, one potential risk factor for the company is that it will suffer from reduced sales volume. Despite the fact that death is inevitable, it is also a very unpleasant subject that many people prefer to put off planning for.
A potential risk factor for the company is the rise in cremations and alternative methods of burial. Though the company does generate revenue from cremations and selling related merchandise (such as urns), a quarter of the company's business comes from cemeteries and as generational attitudes begin to shift regarding physical interment (something that is often governed by cultural and religious beliefs), the company could face a decline in cemetery revenue or less predictable cash flows. Though I believe that these events will happen over a protracted period and can be ably tackled by the management of the company, it is something for investors to be aware of.
Another source of risk is the possibility of a potential decline in spending for end-of-life expenses. I believe that this could be possible for several reasons including the burden of an increasingly high cost of living for those on a fixed income, widespread questions about the viability of unfunded pension liabilities and the increasingly expensive cost of medical care that comes with a prolonged life expectancy, leaving little left over.
I also think that given the fact that there are very few large operators in the field, there could be a potential for Federal antitrust intervention to block further merger activity, and were a catalytic event such as a tender offer or unsolicited takeover bid to occur - I would caution investors to take the windfall and reinvest the proceeds elsewhere.
For investors looking for a stable and inevitable source of business, death care and death services provide a dependable base of revenue in addition to high barriers to future entrants. I believe that Carriage Services is poised to continue to execute its growth strategy and is well positioned, having been able to exploit low interest rates to refinance its existing debt on favorable terms. In addition, as seen with StoneMor Partners, REIT conversion could provide investors with a chance to unlock value and realize high income earning potential. Merger activity in this sector has also occurred and I view Carriage Services as a clear candidate for takeover pending regulatory approval.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSV, STON over the next 72 hours. 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.