Description

Alderwoods Group at current levels represents a stable business with good margins and a strong long-term outlook that can be bought for less than 8x recurring free cash flow. This opportunity exists due to the checkered history of both the industry and company along with macro and industry factors that have the made the current business environment for these companies difficult. Despite these concerns, however, AWGI has done an admirable job the last few years of selling off non-core assets, dramatically paying down debt and positioning the company for continued cash flow generation.

History
For a history of the story from 2001, see Blue320’s prior write-up. The short version, however, is that AWGI (former Loewen Group) and its peers went on an acquisition binge in the late 1990s buying funeral homes for huge (and unjustified) prices at a voracious pace to fuel their growth stories. Additionally, the companies manipulated their growth rates by aggressively selling pre-need funerals (effectively insurance policies for customers to secure future funerals and cemetery plots). These sales juiced growth because the companies booked much or all of the revenue up front despite the fact that the cash received, often only a down payment anyhow, would be held in trust until the actual service was performed. Making matters worse, the companies were forced to pay high teens % commissions to their sales force to sell such policies creating a net cash drain despite the sizeable “growth” that the companies touted at the time. Eventually, these factors and a general lack of growth in the business left AWGI with a hugely over-leveraged balance sheet and condemned to bankruptcy.

Current Accounting Situation
Investors no longer need worry about the aforementioned accounting issues. SAB 101, actually intended to curb practices in the software industry, disallowed the companies the ability to book revenues at the time of pre-need sale. In fact, Alderwoods actually took the accounting changes a step further and is the only public company that also expenses 100% of pre-need funeral commissions up front. It should be noted, that this practice is quite conservative and causes AWGI’s financials (EBITDA margins, etc.) to look weaker compared to certain peers as the company grows its pre-need business.

Balance Sheet Repositioning
AWGI management has done a very effective job of reorganizing the company since its emergence from bankruptcy in January 2002. Since that time, Alderwoods has utilized cash flow from operations and asset sales to pay down over $330mm of debt while refinancing and extending maturities on much of what remains. The company’s leverage has been reduced to a now comfortable sub 4x trailing net debt / EBITDA. Strategic actions taken include the sale of all 39 locations in the UK and over 150 funeral homes, cemeteries and combined locations in the US. In addition, the company recently sold its life insurance operations (unrelated to the core business) for $85mm and continues to hold some $20-25mm of additional properties for sale that AWGI expects to close on by the end of 2004. As a result of these actions, interest expense has gone from $85mm in 2002 to a current pro forma company estimate of $28mm.

What’s Left?
Alderwoods is now poised to generate earnings of around $33m for 2004 exluding various non-recurring items (there are quite a few), and adjusted recurring FCF of nearly $55mm off a fully diluted market cap of $432mm. This cash flow estimate assumes a full company estimated tax rate of 37%, $28mm of interest expense and the high end of the company’s $16-19mm maintenance capex estimate. The implied FCF multiple is thus around 7.9x.

Of course, given the valuation, there still are additional issues that will challenge the company going forward. Recent volumes have been affected by an increasing trend towards cremation, a moderate demographic lull in deaths, and general geographic shifts in the population. The percentage of Americans choosing cremation has increased steadily since the 1950s at about 100 bps per year from approximately 3.6% in 1959 to 28.6% in 2003. For the public funeral companies, the trend has been even more dramatic as many, including Alderwoods, have cremation levels in to the mid – high 40% range. The effects of this are clear when considering that the average funeral service with burial is some $2,500 more expensive than a service involving cremation.

These operational issues are clearly significant but one is getting paid to endure them at the current valuation. In addition, it is reasonable to assume that cremation rates will have to level off at some point given that rates among certain religious groups including Catholics and Jews are very low and that many others still view burials as an important tradition. Also, with regard to demographics, there should be a very significant increase in deaths in the next 5 – 15 years as the eldest baby boomers begin to reach their late 60s and 70s (sorry for the morbid note!).

Alderwoods and the other public companies are also fighting back to offset some of the current operations challenges. Moderate pricing increases in funeral services have enabled the company to generally continue to show low – mid single digit revenue increases. AWGI is also attempting to further segment pricing for caskets and other products by installing “Alderwoods Rooms” in many of its sites where traditional retail concepts can be better employed to maximize sales and profits. In addition, the industry remains highly fragmented with the top public companies still representing less than 20% of funeral services. The large public companies should better be able to handle some of the challenges of the business given their scale and purchasing power (significant numbers caskets are now being made in China and elsewhere), more flexible capital access and the ability to do disciplined acquisitions in the future.

Summary
AWGI currently represents a good value at around $10 / share. Continued cash flow generation / debt paydown and eventual dividends and share buybacks should drive the stock higher in the intermediate term. The business does face lingering issues but the company continues to generate double digit cash flow margins and should be able to take advantage of this still highly fragmented industry going forward.

Catalyst

Continued FCF Generation
Continued debt pay down and future dividends, buybacks
Eventual pickup in volumes