Description

Investment Thesis: Very compelling risk/return

Carriage Services (CSV), a leading funeral home and cemetery operator, is a very good business trading far too cheaply because of short-term, self-inflicted operational issues and a temporary vacuum in 2019 guidance.  CSV is run by a strong management team that is well aligned. As a result of the market's over-reaction, CSV is trading at a normalized 10.5% FCF yield. We expect management to release new guidance in January and the stock to trade up 50-80% in 12-18 months.  Significant insider buying in the past week and the Company repurchasing stock supports our thesis.

So what happened?

The opportunity exists because management recently pulled guidance after some disappointing quarters and the market has significantly over-reacted on a solid, cash-generating business that has temporarily stumbled. Management typically guides to expectations for the rolling next twelve months. In 3Q18, because of recently implemented business changes, management unexpectedly declined to provide forward guidance which we believe scared the market into fearing the worst. We believe the decision to pull guidance was the key driver of the stock overraction.

Management expects to pre-announce 4Q results and an update on the efficacy of recent business changes along with updated 2019 guidance.

CSV generated $69mm of EBITDA in 2017 and acquired 7 funeral homes at the end of the year (adding ~$4mm of EBITDA). Management guided to $80-85mm of EBITDA in 2018 but weak operating performance will result in CSV doing ~$71mm in 2018. In 3Q18, CSV acquired four more properties (adding another ~$4mm of EBITDA) and has just announced they will take out $5-6mm of overhead expenses/compensation. Without any benefit from business improvement, CSV should do $78mm of EBITDA in 2019.

In an upside case you could see management hitting its original guide and benefiting from the recent acquisition/lower overhead and generating closer to $90mm of EBITDA in 2019.  

Operational issues: Self-inflicted and fixable

So what are the operational issues that the company has had and what is being done about it?

·       In 2017, CSV disappointed due to (i) operating challenges at a few cemetery locations, (ii) weaker than expected performance from certain 2016 acquisitions and (iii) higher corporate costs

o   Cemetery weakness – after years of growing rev mid-single digits, the cemetery business declined in the first three quarters of 2017 (down 4% revenue and 17% EBITDA). After rebuilding the sales teams, the businesses bottomed in 4Q17 and returned to growth in 2018 (+3% rev and +11% EBITDA YTD).

o   Acquisition-related weakness – CSV acquired a funeral home in 2016 that was overstaffed and under-earning relative to expectations. The integration/down-sizing did not happen quickly enough and became a drag on the business in 2017 but we believe this has recently been addressed.

o   After years of keeping overhead relatively flat, 2017 corporate expenses increased 11%. The management team has commited to reducing corporate overhead by at least $5-6mm in 2019 from current levels.

·       We believe the 2017 issue were fixed by early 2018 based on our analysis.

·       In late 2018, new and unrelated issues arose which caught the management team by surprise that have undermined their credibility but we believe these issues are temporary, fixable and a primary driver of the opportunity - (i) same store funeral weakness and (ii) discontinued business.

o   Same store funeral volumes declined ~3% in 2Q and 3Q. Management has made changes to local pricing strategies and growth incentive structures to realign managers who may be lagging peers.

o   CSV lost a management contract generating ~$2mm of EBITDA. CSV had managed the cemetery properties in Ft Lauderdale for 20 years and the city unexpectedly decided to take back control at the end of 3Q. CSV has one other management contract but is small and not up for renewal through 2020.

Business Description: Stable, growing industry with manageable headwinds

CSV owns and operates 182 funeral homes and 32 cemeteries across the US which perform ~35k funerals annually.

“Same store” represents properties owned for 5 years. Same store volume has been flattish historically though revenue and EBITDA have grown in the low single digits with pricing and operating leverage. By adding tuck-in acquisitions (which have been higher quality/margin) and leveraging fixed overhead, total EBITDA has grown in the high single digits. We expect these trends to continue once management fixes the current operating issues. Over the longer-term, we see upside optionality with positive same store volume growth leading to faster EBITDA growth.

Deathcare industry

Funeral homes and cemeteries can be an attractive business with local franchises that have sticky customer relationships going back multiple generations and pricing power due to high barriers to entry (few funeral homes opening up, even fewer new cemeteries). With relatively high fixed costs and low utilization, even modest volume growth can produce impressive profit flow through (as seen in historic “same store” performance). We estimate funeral revenues have incremental margins of ~60%.

Demographics

Approx. 2.7mm people die in the US every year and this number is expected to increase by 1-2% due to demographics. The average life expectancy today is approx. 79 years, which means the average person dying today was born in 1938, the trough of the Silent Generation. While we hope and expect scientific/medical advancements will continue to push life expectancy out further, we believe historical results the baby boomer demographic will turn the headwinds into a tailwind in the near future with the population of Americans over 65 growing 3% a year.

Cremation

Cremation is a secular headwind facing the industry as cremation tends to come at a much lower average price ($3-4k) vs traditional burials ($8-9k). While cremation generates higher gross margin %, the lower dollars continues to be a minor challenge facing Carriage and the deathcare industry.

Cremations currently account for half of deaths in the US and the mix is expected to increase by approx. 100bps a year reaching approx. 55% in 2020. At Carriage, the company has managed this headwind by increasing prices (on both traditional burials and cremation) and focusing selling memorialization services rather than products. Our diligence with industry participants suggests that the majority of CSV properties are local market leaders with pricing power. Despite increasing cremations, CSV has been able to grow revenue and EBITDA and we do not see a change in their ability to manage this headwind.

Management: Our differentiated view vs the market

CSV was founded in 1991 by Melvin Payne, who remains Chairman/CEO and owns ~8% of the company. Carriage is ‘his baby’ and his ownership is the majority of his wealth, aligning him well with  investors. We spent considerable time doing diligence on the CEO and have concluded that Mel is misunderstood and is in fact a competent CEO. He has a great vision, he is a strong leader and is a disciplined capital allocator. On earnings calls, Mel may come across as abrasive or non-shareholder friendly. We support his long-term focus and revulsion for the focus on individual quarters by sell side analysts and short-term traders.

It should also be noted that in the last few days there has been significant insider buying with the CEO buying $2.5mm shares personally in addition to purchases by the CFO and multiple board members.

Industry: CSV as a unique buyer and undoubtedly cheap on absolute terms and relative to comps

The industry remains highly fragmented with nearly 80% of the industry owned by small independents, with many funeral directors at or near retirement age and lacking a clear succession plan. There are only a few large consolidators remaining and we believe CSV is uniquely positioned to benefit. Carriage’s decentralized model distinguishes it as a consolidator in the deathcare industry. CSV focuses exclusively on acquiring only quality not quantity. CSV looks for entrepreneurial managers who want to stay on and focus growing their local business but may partner with Carriage for succession reasons or to benefit from CSV back office support. Our industry diligence confirms an industry ripe for continued consolidation and Carriage’s reputation as a partner to only partner with the best remaining independent directors.

Carriage has been very selective in the acquisitions they do, focused not only only the right markets (e.g., demographic, cremation trends), but also on the right partners (e.g., market share winners, entrepreneurial spirit). At the end of 2017, CSV acquired 7 new properties that added 1.5k calls (+5%). In 3Q18, CSV acquired another 7 properties that will add another ~1.5k calls. These acquisitions bring Carriage into large new strategic markets and were done at accretive valuations (~6-8x EBITDA).

·       Service Corp (SCI) remains the giant in the industry though only has ~16% market share and is limited in certain markets due to higher local share. While SCI is an excellent company in its own right, it similarly faces same store volume challenges, requires larger acquisitions to move the needle, and trades at a 5% FCF yield.

·       Stonemor (STON) is the other US large public consolidator but we don’t see them as much of a competitor given their track record of overpaying for acquisitions and questionable accounting leading to an overlevered company (30x) needing to be restructured.

·       Park Lawn (PLC) is a relatively new consolidator that has emerged from Canada. The company has been rolling up US assets at 10-13x EBITDA using its own equity (PLC currently trading at 17.5x 2018 EBITDA). While the company does not have the transparency that CSV provides, we estimate the underlying business does not  generate much free cash flow and is not growing organically. Based on bullish street estimates, PLC trades at a 5% 2019 FCF yield and 12x EBITDA.

Pre-Need/Trust

While pre-need is not a huge part of the CSV model, they leave it up to local managing partners to decide on how much pre-need they need to sell to be competitive. That being said, the total pre-need trust is $230mm, with the majority of the trust (~$180mm) well managed internally by the CSV CEO and CFO.

The trust is benchmarked against a 70% high yield and 30% SPY index and has generally outperformed the index (10% CAGR since 2009 vs 9.5% for index). Based on our discussions with management about their trust investments, we believe there is some upside optionality from the performance but we are not including it in our analysis and we do not believe there is substantial risks related to the trust given the conservative positioning of the portfolio.

Valuation

On an absolute valuation, we believe a 10.5% FCF yield numbers for a stable/growing consumer staple business is mispriced and believe Carriage should trade in the 6-7% FCF range or $25-30.

On a relative basis, CSV trades at a significant discount to SCI and PLC and we believe CSV has higher quality assets than PLC and greater growth potential than SCI given its CSV’s relative size and reputation in the industry.

Catalyst

-  Guidance in January 2019 highlights the undervaluation and provides clarity about strong underlying performance and highlights the undervaluation
-  Continued share buybacks