Only two things in life are supposed to be certain: death and taxes. Unfortunately, for investors like us, profiting off of taxes is impossible. Death, however, is an interesting industry to say the least. In many ways, funerals might even be regarded as being an ideal business: there is unending demand, the customers are often too emotionally impaired to shop around and there is a cultural taboo against spending too little. The fact that most people only ever end up organizing one or two funerals in their lifetimes also means that there's a deep asymmetrical information advantage in favour of funeral home directors, who are selling to unsophisticated customers. And yet, funeral homes and cemeteries have been facing declining revenues.
Secular trends are moving against funeral homes
The current situation in the funeral home industry can only be understood by first accounting for the historical perspective. In 1970, virtually all funeral homes and cemeteries in the US were independently owned. Then, the roll-up craze hit the industry like it did so many others. The logic behind it was simple: funeral homes and cemeteries are an inherently local business, so combining hundreds of sites from multiple cities would result in a more diversified location base, stable revenue, and cost savings. The logic was so compelling that today, 20% of all funeral homes are owned by publicly-traded corporations alone. However, despite the substantial cost savings attained by large funeral corporations, they often raise prices, in my opinion, because their customers are emotionally-impaired at the time of sale and have access to much less information than the funeral home director. For example, a report from the Funeral Consumers Alliance and Consumer Federation of America has found that median prices are up to 72 percent higher at Services Corporation International (SCI) funeral homes, which often use the Dignity Memorial brand name, than at independent rivals. SCI is the largest company operating in the space, with over $3 billion in annual revenue, and it is reasonable to expect that other funeral companies would model their operations off of the most successful competitor.
It isn't simply services that are overpriced at most funeral homes. Per the National Funeral Directors' Association (NFDA), median funeral expenses look like this:
- Basic Service Fee - $2,100
- Transporting remains to funeral home - $325
- Embalming - $725
- Preparing the body in other ways, such as makeup and hair styling - $250
- Facilities and staff to manage a viewing - $425
- Facilities and staff to manage a funeral ceremony - $500
- Hearse - $325
- Service Car - $150
- Basic memorial printed package - $160
- Metal casket - $2,400
- Vault - $1,395
- Total: $8,755
The median figure of almost $9,000 looks steep but the most egregious mark-ups are typically in the physical products. For example, while the casket is a substantial portion of the cost of the entire funeral, funeral homes buy them for only a third of what they sell them for.
With such fat margins and steep mark-ups, it was only a matter of time before consumers switched en masse to products with a more compelling value proposition. And that's what appears to be happening. The largest threat to profits in the traditional funeral home industry is the rise of cremation. In 2018, 53.5% of all Americans chose cremation while 40.5% chose burial (source: 2018 NFDA cremation and burial report). The disparity is projected to widen, with over 80 percent projected to choose cremation in 2035. Where the average burial service costs $9,000, the average cremation costs around $3,000 and direct cremations average just $1,100. In some cases, the price can drop even further. For example, DFS Memorials is a nation-wide network of funeral homes which offers direct cremation at unbeatable prices. Cremations start at $650, which is just 7% of a traditional funeral's price tag.
The revenue economics of cremation is a serious threat to the entire funeral home industry. Let's work through the math. If a funeral home has a hundred customers per year, which is pretty close to the 113 annual customers per NFDA funeral home, and it charges $9,000 per customer, it would have annual revenues of $900,000. But if 60% of customers switch to cremation at $3,000 each, then annual revenue drops to $540,000, a 40% decrease in revenue. An 80% conversion rate would leave the hypothetical funeral home with merely $420,000 per year, cutting revenue by more than half. If direct cremations get even more popular, those numbers look even worse. Given that funeral homes' costs are mostly fixed, that bodes ill for the industry.
Cemeteries have problems of their own. By federal law, cemeteries are obliged to maintain endowments to support the cemetery forever. That's a huge liability, and like the pension funds of old, some state laws mandate insufficient minimums. Some don't even mandate a minimum amount set aside. As a result, according to New York's Division of Cemeteries, an average of 8 cemeteries have been abandoned/failed every year in the state alone from 2001-2014.
Now that we've established that the funeral home industry is facing an impending revenue crunch and cemeteries probably have balance sheet problems, let's take a look at how publicly-traded companies measure up.
It's primarily a cemetery company, with an 80/20 split of cemeteries and funeral homes. It's the only stock with a major cemetery focus. Revenues have generally declined over last five years, as you would expect, while the company has tried to mask this with a series of acquisitions. It has only acquired an average of five cemeteries per year over the last 3 years, but it used to be much more active in rolling-up cemeteries and as such as a debt load reflecting that.
The debt load has gotten so onerous that earlier this year StoneMor breached debt covenants. Lenders have waived the breach for now, and are currently negotiating refinancing, but that may merely be delaying the inevitable. Free cash flow is weak, with most of the firm's cash flow going to interest payments. To make matter worse, the acquisitions that StoneMor spent so much on in the first place are underperforming. It hasn't made a profit in eight years and is pretty much a classic case of an over-acquisitive firm that's now overexposed to debt and drowning in interest payments. Some have taken the fact that Axar Capital (the largest equity owner) has injected a $35 million loan into the company as proof that StoneMor is capable of pulling off a turnaround. I would caution against that line of thought. Axar Capital is injecting cash into StoneMor because it is their largest equity holding, per their Form 13-F. I firmly believe that Axar is throwing good money after bad here.
Despite the serious decline in the stock, StoneMor could be going to zero. In late 2018, a Bloomberg story broke about StoneMor burying prepaid customers' graves before they died because doing so would allow the company to tap customers' pre-need trust accounts. Basically, they buried empty graves because it would allow the company to legally siphon off what its customers had paid in advance.
StoneMor is a classic short. It has weak free cash flow that's choked by debt, has had its reputation trashed by its own actions and is on the wrong side of the secular trend towards cremation in the funeral industry. Their bonds reflect this, with the 2021 bond yielding 14.3%. When looking for short sale candidates, experienced stock-pickers look for the most exposed, overleveraged candidates, and StoneMor certainly fits those characteristics.
Carriage Services (CSV)
Carriage Services is the direct opposite of StoneMor in terms of its revenue mix, where StoneMor was an 80/20 mix of cemeteries to funeral homes, Carriage is the same except the mix favours funeral homes.
Now, Carriage is a curious case because all of its growth in revenue and operating profit has come from funeral homes acquired after 2013. Same-store revenue shrunk slightly from $161 million in 2017 to $160 million in 2018 but revenue from acquired funeral homes increased from 30 to 41 million, thus covering for the decline in same-store revenue and giving the illusion of growth. The company seems to have recognized this too, since it's acquired 11 funeral homes over the past two years, representing a 7% increase in total sites. Like every other funeral company, it's pursued a strategy of buying out smaller competitor, a strategy that's been fueled by record-low interest rates. That strategy appears to have been working out well so far, but there are very subtle signs of trouble looming on the horizon.
More specifically, I'm talking about potential signs of distress in the company's bond repurchases. On the 7th of May 2018, Carriage completed an exchange of $115 million worth of convertible notes for 75.2 million in cash and 2.822 million shares. That prices the shares at $14 each, which is very attractive considering that at the time the stock was trading at $26. This would allow those who participated in the exchange to turn around and sell that stock for almost twice what they received it for. This implies to me that the company was desperate to retire debt, maybe to avoid breaching debt covenants like StoneMor. Strengthening this thesis is how Carriage negotiated privately to purchase $22.4 million of its convertibles for $23 million. This was unusual because it represented another above-market purchase as the bonds were trading at slightly under par and are another indicator that the company wanted to quickly retire debt capacity.
As it is, Carriage is perched upon a mountain of debt. At 2018 levels of income, it would take over 30 years for the company to pay off all of its debt, and that's at today's remarkably low rates. Even if net income were to return to its trailing 5-year average (which would be more than twice 2018 net income), it would take 15 years for the company to repay its debt.
It's not hard to see that a single, large unexpected shock or decline in revenue would result in Carriage being unable to meet its interest payments like StoneMor. The company appears healthy for now, but with a large decline in funeral home revenue looming due to cremation trends, that may not be the case forever. Watching for a catalyst before shorting could prove quite profitable.
Services Corporation International
Like its peers, SCI is a serial acquirer. The company spent almost $200 million on acquiring funeral homes in 2018, and a further $140 million was split between 2017 and 2016. It also charges much higher prices than independent funeral homes. As mentioned above, a report by the Funeral Consumers Alliance and Consumer Federation of America has found that median prices are up to 72 percent higher at Services Corporation International funeral homes, which often use the Dignity Memorial brand name, than at independent rivals. But we don't have to take their word for it. The average NFDA member handles 113 funerals a year. SCI has 1491 funeral homes and 481 cemeteries. It had $3.19 billion in 2018 revenues. That turns out to an average of $1.626 million per site in revenue or about $14,000 per funeral, assuming they handle an average number of funerals. That's $5,000 or 56% above median price.
Thus, while it is true that SCI is doing the best out of any public funeral company, its higher price positioning leaves it more exposed than other funeral home chains when it comes to the threat of cremation. Nevertheless, while SCI's business is likely to have limited growth prospects in the future, it has the best record of consolidating acquisitions in the industry and is the best operator in the space. Shorting it would be a fool's errand. There are easier targets to go after.
The funeral home industry is an excellent case study illustrating how even an industry as unchanging as funerals can be affected by evolution in consumer preferences. In such cases, the debt-fueled acquisition binge that companies love to partake in often proves to be their undoing when the hard times come. Shorting the most exposed and worst operators in such an industry is often rather profitable. This lesson might prove quite useful whenever the longest bull market in history ends.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.