I had a look at this expecting to reject it quickly, but, after a few months looking at it, I have invested. This is a departure from my usual micro-cap (<£250m) long-term, insider-equity growth investments.
D. is undervalued by at least 30%. There is uncertainty and many unattractive aspects, but little risk of permanent capital loss. My perceived odds are:
- Capital loss: < 10% - even then underpinned by predictable market and crematoria
- 1x to 2x return: 25% - crem value wrong and some negatives greater
- 2x to 3x return: 50% - funeral business is worth more than £360m, some upsides
- more than 3x: 15% - funerals and plans worth materially more, up-sides realised
Predictable with overall demand forecast to gradually increase over next 20 years.
See below re competition in each of group’s three divisions. While barriers to entry are lower than D. presented there are some basic requirements including administering paperwork, handling the deceased and arranging burial or cremation.
In 1960, 35% of deceased were cremated. This increased to 77% by 2017. In 2018, there were 299 crematoria split 190 local authority, 109 private (46 D., 29 Westerleigh, 9 Memoria, 6 London Crem Co). The number of direct cremations (or those without a ceremony) is increasing.
The funeral director usually makes the arrangements in consultation with the client. The cremation usually costs c. £900. With 1,600 per crematoria revenues are c. £1.44m and EBITDA c. 1m. The cost of a crematoria is c. £5m to develop (and assume c. £1m for land and permission) with a 3 or 4 year ramp up to a mature £1m that implies a c. 6 year payback. High up-front, but low ongoing capex suits dividend seeking infrastructure and pension investors.
D. has 46 operational and 6 in planning with 4 of those under construction. 19 of 46 leasehold but long leases with none due to expire before 2031. Often D, leases ground but owns facilities making it difficult for council not to extend lease. In 2013, 9/39 had adjoining cemetaries and c.
14% are from D. funeral directors.
Phoenix recently valued the crematoria at £1.2bn to £1.6bn. My valuation (with no credit for operational improvements or sites without planning) is:
£50m EBITDA plays against EBITA of £43m implying £7m depreciation. Maintenance capex is c. £4m.
Crematoria are unique, quasi monopoly assets. By definition, planning requires a need not served locally. There is potential for regulation but given differing quality and pricing, regulation is unlikely to be unduly onerous.
D. with Westerleigh is one two private operators of scale, so should achieve a premium. Westerleigh has recruited new consumer and operational team. It is owned by pension and infra funds: 2013 Antin Infrastructure and 2016 Ontario Teachers and USS (£53bn AUM).
In the current market, there would be credit for sites with planning, especially as four are well developed and were meant to open in 2019 to 2021. D. bought five (3 freehold and two leasehold) for c. 16x EBITDA in 2015. Channon said Phoenix had access to comparables when presenting their multiple (see 2021 AGM). Operational improvements include catering (2/46 have catering) and increasing chapel capacity (often a peak constraint). These are upsides to the current valuation.
I have taken some of the estimated central costs an allocated them to crematoria based approximately on headcount. The find the lack of cost disclosure irritating in a multi divisional group, where the parts are valued very differently. Costs should be allocated to divisions, operational indirect and genuine central costs. The lack of cost clarity suggests they are not tightly managed.
Funeral directors are required to carry out a complex process with specialist facilities while being sensitive to the deceased. Activities include: transporting and caring for deceased, administration and requisite paper work and carrying out the service. A funeral director will require a mortuary, chapel of rest, hearse, limousines and qualified staff.
There are c. 5.5k FDs in the UK (2013) up from 4.3k in 1998. Dignity has c. 12% share and the Co-op 18%. Most private FDs do c. 100 to 150 funerals pa. This implies annual revenues of c. £500k to £600k. Historically, most customers do not shop around. In 2001 OFT 92% approached one funeral director with location the key factor.
D. operated 108 areas across 10 regions supposedly clustering to maximise vehicle and mortuary efficiency. Most are situated in secondary retails sites (with a reception, shop and chapel of rest) and in London there are four business centres (or hubs for mortuaries and vehicles). In some cases, D. opened smaller satellite operations to gain cluster benefits.
The FD market is in the midst of fundamental change. Historically there was significant price inflation, which led to a CMA investigation in 2019. At the same time, the internet is allowing customers much greater optionality and transparency.
The funeral mix has changed due to Covid and commercial pressures.
2021 interims support my pro-forma; especially quarter 2 with less Covid impact.
Pre-arranged generally cheaper. Full service and simple funeral pricing declined by 12% and 28% respectively between 2017 and 2020. FY20 volumes higher due to Covid. Funeral plans provide c. 30% of funerals. They also provide a significant backlog of c. 20 years at current rates.
Pricing will reduce as customers forsake traditional funerals and price transparency. D aims to win by volume. Competitors will include Beyond (Premium) and Pure (Volume). The current CEO believes funerals are where weddings were over 20 years ago and the industry is undergoing a fundamental shake up that will favour the larger and digitally savvy operators.
It is difficult to value in the midst of flux. I assume that D’s sales will remain flat at c. £200m with volume compensating for price falls. I assume a genuine (fully loaded) 15% EBITA margin, which is consistent with good operators in other “high touch” consumer/care settings. This implies £30m EBITA. However, I have assumed that funerals absorbs c. £10m of overhead that relates to funerals. In that case, the divisional P&L would broadly be:
The assumption is £30m on £200m versus £80m on £215m in 2017. With the overhead adjustment, it is £40m or earnings halving on similar sales. On a like for like basis EBITDA would back to 2004. Gary Channon has ambitious plans to increase to 20% of market, which would be upside.
I value the reformed business at 12x. It still has a strong market position. Size makes it better able to reform to meet consumer needs. Also, backlog underpins earnings and multiple. Therefore, divisional EV of £360m.
The customer either pays into a trust or buys a whole of life policy. These practices were investigated in 1989, 1995 and 2001. D.’s trusts fell within exclusion, so were not regulated. In practice requirements including in trust, written, with half trustees independent, independent fund manager and annual accounts were almost the equivalent to regulation. Regulation favours larger providers and D’s current practices probably comply with any future regulation. About 81% are D funerals, with the others provided by third party (usually outside D area of operations).
In 2019, the trusts’ liabilities were c. £978m with assets of £1bn. Less conservative valuation suggests surplus of c. £160m versus (note 30). Accounting recognises margin on delivery not sale of policy, but I do not understand accounting at p109 and p160 of annual report.
Regulation will close the “cowboy” operators and regulation should favour D. and other reputable operators.
D. trusts are unique asset to secure D. funerals. Difficult to value but 3% of AUM suggests £30m. Currently main benefit is funeral backlog, but if D can use “float” to generate investment profits, they could be very valuable.
D. has c. 20% of the UK funeral plan market. Value based on 5% of AUM and leading compliant scheme in the UK with significant growth potential. Assume c. £50m as “platform”. It also assumes that this valuation absorbs £1m of central overhead.
This is mostly covered above. I have added £100m for opex and capex related to tech, digital and physical improvements required to support the divisional valuations above.
Balance Sheet Liabilities
The two main balance sheet concerns are debt and pensions.
The debt summary is as follows.
As per the latest interim report, group has c. £20m EBITDA headroom versus its hard 1.5:1 EBITDA:Debt Service covenant. Debt service is c. 33.2m so the threshold is c. £50m. Last few tests have been 2.12x, 2.15x and 1.99x with headroom of c. £21m of EBITDA. The CEO rightly worries about covenants driving short term measures that would prevent the sensible execution of long term strategy. There are therefore plans to raise capital by partial disposal of Crematoria. “Every 20 years cheap debt will trip you up.” There is a tougher Free Cash Flow to Debt Service dividends etc…
According to the 2021 interims, the debt market is more optimistic about D’s prospects.
There are redemption premia, that appear to largely relate to compensation for loss of interest on the B tranche (equivalent Treasury instrument plus 0.5%). The premia are not payable on change of law, tax or enforcement. I suspect that on enforcement the premia would be deemed an unfair preference re other creditors. In the case where the security is obviously worth more than the nominal value of the B Loan note, there would be little commercial advantage in enforcement (i.e. loss premia immediately). In that case, there would be a negotiated settlement closer to the nominal value of the debt. See debt document https://ise-prodnr-eu-west-1-data-integration.s3-eu-west-1.amazonaws.com/legacy/Prospectus+-+Standalone_c1bcdb12-0455-440f-bbdb-b25e5a6f3c48.pdf (pp 55, 199 and 205). As a result, I have assumed no premia in my valuation.
D. has a significant defined benefit pension scheme liability. The previous management, who presumably are major beneficiaries, were very slow to reduce or close access to the scheme. Most management teams in the early 2000s knew DB schemes were problematic, but D. did not start to address the issue until 2013, when it was closed the scheme to virtually all new entrants. Further accruals stopped in 2017.
The current position compared to 2012 (note 29 in A/cs) is as follows.
The assets are reality, but the liabilities the result of a range of actuarial assumptions about returns and mortality that change over time. The note does not give the number of beneficiaries but 33% are active, 27% deferred and 40% current pensioners with an expected average duration of 18 years. The current additional contribution is c. £1.5m pa, but will need to be much greater. In my valuation, I have added another £100m to the liability based on a crude estimate on what would be needed to fund the return spread for another 15 years or so. Also, so-called “buyout” valuations are often 2 or 3 times the actuarial deficit.
Gary Channon the Phoenix investment manager, who is CEO, came across well. Broadcasting - Dignity Plc - Annual General Meeting 2021
After the recent “bloodbath,” GC expects the Board to be Code compliant by March 2022.
In general, while the staff are caring and competent, management is not commercially strong nor are operations equivalent to other consumer sectors. Channon recognises too much management and not enough discretion at local level or maximisation of expertise across the group. He will need to blend funeral, care, consumer, property and financial services expertise to deliver the plan (cf recent Westerleigh hires). Channon speaks encouragingly about principles and standards that will be: codified, taught/trained and inspected.
The previous Board was unsuitable for a complex multi-business with too many insiders and accountants. In 2017, the Board of 8 had 5 accountants, 2 insiders and no fully fledged former CEOs. The bonus was 70% based on profit with price the easiest lever. The results were predictable: short term profit increased; long term value fell.
Phoenix and Gary Channon are well covered elsewhere. The only new point is Channon is launching an IT, Castlenau, with Sir Peter Wood, which will take on the activist positions of his other funds.
Artemis Alpha is a £160m market cap investment trust - the only IT in the Artemis stable. It is managed by John Dodd and Khartik Kumar. John Dodd, Artemis’ founder, is the second largest shareholder with c. 7% or £11.2m invested in the fund (of which 8.6% is invested in D. which implies a c. JD £1m indirect investment in Dignity). Dodd and Channon are a similar age and run very similar strategies (e.g. Dignity, low cost airlines, housebuilders and online delivery). Alpha appear to have carried out site visits etc…
John Jakes is a Monaco-based high net worth who sold his stairlift company, Acorn Mobility Services, for hundreds of millions.
Granular Capital Management are a relatively new hedge fund run by Thiago Mordehachvili.
While not acting in concert, it is not difficult to imagine this group that own nearly 60% having a common understanding on strategy and exit horizon etc… In many cases, the current share price at c. £7 is below or just above the current shareholders’ entry prices.
GC’s strategy is to significantly improve the individual divisions and to integrate them. In doing so, he would create a low-cost funeral/end of life services provider with leading transparent funeral services but which would also feed the investment and crematoria businesses. If he did so, he would create a more competitive and compliant group that would dominate the UK end of life market alongside the Co-op. Similar groups have done very well in the US (e.g. CSI and StoneMor).
The crematoria and funeral plan business require specific plans to adapt and maximise the opportunities regulation provides. The funeral business is a significant operational turnaround and repositioning as low-cost multi-service end of life. GC refers to Munger’s lollapolluza effect of multiple small improvements and better integration.
The major challenge is the operational improvement of a such a large and entrenched group. But, the prize of creating a market leader in a predictable and growing market is significant.
Potential errors and risks include:
- Crematoria valuation wrong/too high – but, appears to be based on comparables
- CMA review more onerous – appears relatively clear now. UK regulation generally ineffective (cf: other utilities).
- Underestimate cost, time and operational complexity of turnaround
- Management incapable of executing ambitious plan in challenging market
- Breaches covenant and got debt wrong
- Pensions worse
This is a messy situation, but worth probably twice as much as current value. Operational complexity is high, but, crucially for me, the market is predictable and stable. Gary Channon seems credible and open, if a little idealistic. Currently controlling shareholders should support turnaround on a public market.
Alpha will discuss D. attractions at their AGM in a few weeks. Gary Channon cannot over sell as he is CEO of D, but Alpha will. Share price is not likely to rise until new model is proven in non-Covid times. The results should become clear by end of 2022.