We believe that Dignity is currently valued based upon a view that EPS will continue to grow through a predictable increase in revenue and profits. We do not believe that this will be the case going forward and set out our argument as follows.
Between 2005 and 2016 (“the historical period”) the Company delivered:
- Revenue growth from £143 to £314 million (7.4% cagr)
- Operating profit growth from £42 to £98 million (8.1% cagr)
- EPS growth from 22.4p to 119.8p (16.5% cagr)
There have been two drivers of this historical performance:
- a 53% increase in the number of branches (3.9% cagr); and
- an 81% increase in pricing (5.6% cagr)
The former is well publicised and reported on by Management. The latter, however, is not discussed publicly or reported on in annual reports. There are no KPIs reported relating to pricing. To fully understand historical performance, and form a view on future prospects, it is necessary to analyse how both branch expansion and pricing have played their respective parts in Dignity’s growth story.
Our view on the historical contributions of these two drivers is that:
Branch expansion has functioned to keep the number of funerals performed steady, offsetting a +30% collapse in branch productivity
- Dignity’s market share has been static at c.12% between 2005-16
- Branch productivity (funerals performed per location) has collapsed by more than 30% from 129/year in 2005 to 87/year at H1 2017
- Newly acquired locations typically provide around 150 funerals per year initially, offsetting customer losses elsewhere in the portfolio.
Pricing has been used to provide constant top-line growth
- With customer numbers flat over the historical period, pricing has been used as a lever to provide revenue growth
- Prices increased every year between 2005 and H1 2017 from £1,699 to £3,153 (cagr 5.6%)
Effectively, Management have driven top-line growth through large price increases across the existing portfolio, whilst offsetting decreasing customer numbers in the existing portfolio by acquiring new locations. The net result is that Dignity serves roughly the same number of customers each year but charges each of them a higher price.
We believe this strategy will no longer be available to Management and that both branch expansion and price increases are now unsustainable.
Branch expansion must logically end at some point. The ability to ever expand branches without cannibalising existing locations or falling foul of competition concerns is not guaranteed. Already, Dignity has twice chosen not to purchase the entirety of a target’s portfolio, citing competition concerns.
The method of expansion is also unsustainable. Dignity’s historic strategy has been to acquire small, family-owned businesses and operate them under the family name. Frequently, the owners and employees of these businesses then establish a new funeral business of their own post-acquisition. There are practically no barriers to entry on a local level for a funeral business and local competition, in part driven by these former owners/employees, helps explain the collapse in productivity.
It is our view that Dignity should not continue acquiring further businesses without finding a way to compete effectively on a local level. We question the worth of the £350 million of goodwill and intangibles (50% of total assets of £715 million) held in relation to these acquisitions when the businesses acquired simply spring up again.
However, of more pressing concern for Dignity is whether it will be able to continue increasing prices as it has done historically. After all, price increases are the only thing that has provided revenue growth with customers numbers flat.
Dignity has historically operated in an opaque market where customers have had little knowledge of what a fair price is. This is now changing rapidly with the advent of price comparison websites, such as ours, for the funeral industry. Within just a few clicks people can now see what funeral directors will charge them for a funeral before choosing who to use.
Just as with air travel, insurance and hotels, the internet is democratising information and shifting power to the consumer. With consumers shifting their research and purchasing online, funeral directors will have to increasingly compete to win their business.
Within the industry, Dignity is the most exposed provider to any shift to price transparency and increased competition. This is because, following a decade of unremitting price increases, Dignity now operates at a totally disconnected pricing level to the rest of the UK market.
Based on customers through our site in the last year, a Dignity funeral costs 83% more than a funeral arranged through Funeralbooker. Other estimates of this premium can be gained from Royal London research (45%), Ipsos Mori 2010 research (36%) and Sun Life research (32%).
With increasing transparency, investors need to consider whether customers will continue to pay a premium for a Dignity funeral. People are typically only willing to pay a premium for a service when it comes from a recognised brand with a demonstrable advantage.
We do not view Dignity as being a premium provider owing to:
- The collapse in branch productivity. Why would a company with strong a strong product see a 30% collapse in branch productivity?
- Dignity does not operate as a national brand. If the product offered is really at the premium end, why does the Company use over 500 different trading names across the country?
The most obvious, and simple, explanation is that Dignity has only been able to charge a large premium because of market opacity. As this opacity erodes, Dignity’s premium recedes.
Based on this view, we have provided a financial model showing how a pricing reduction of 3.0% per annum between 2018 to 2021 impacts forecast EPS. This model produces a downside to analyst consensus estimates of EPS in 2018 and 2019 of 7.3% and 14.3% respectively.
Disclosure: I am/we are short DGNTY.