Description

Around the beginning of the new year, The Loewen Group will emerge from chapter 11 bankruptcy protection ending a 2 ½ year odyssey that transformed the company’s balance sheet and business practices. The Delaware bankruptcy court confirmed the company’s 4th amended plan of reorganization on 12/4/01. The company will be renamed “Alderwoods Group” and will be listed under the ticker AWGI on the NASDAQ exchange.

Loewen is North America’s second largest funeral services provider with approximately 920 funeral homes and 275 cemeteries in the United States, Canada and the United Kingdom. Loewen is an attractive cash generating company that should gather greater interest from the broader investment community upon the exit from bankruptcy. The combination of this increased awareness and the valuation disparity (on a multiple basis, Loewen is cheap relative to its peers) that exists between Loewen and some of its major peers creates an attractive investment opportunity at the present time.

Loewen originally filed for bankruptcy in June 1999 seeking protection from creditors as it faced liquidity problems amid a debt load that did not fit with its operations. Beginning on 1996, Loewen began its aggressive growth strategy acquiring approximately 138 funeral homes, 171 cemeteries and one insurance company for aggregate consideration of approximately $546 million. Much of these acquisitions were financed with debt and purchased from small mom and pop type operations. In light of negative cash flow from its businesses and increasing difficulty meeting its debt obligations, Loewen suspended its acquisition program and began selling assets to raise cash. By this time it was too late, though, and Loewen’s only choice was Chapter 11. The bankruptcy dragged on for such a long time due in large part to the case’s complexity stemming from a set of very complex intercreditor issues that are really not important for the current discussion.

Loewen really got into trouble with its sales of pre-need funeral and cemetery services. The company employs salespeople who sell cemetery plots and funeral services to people before they die. The transaction usually requires an upfront payment to a trust fund as mandated by law. In addition, some percentage was also paid to the salesperson as commission. The net effect was that in most cases when a pre-need service was sold a cash outflow was created. Despite this, accounting rules allowed generous booking of revenues. Management operated the business for EPS and not cash flow. This focus on the accounting income and not cash income created the liquidity crunch. The whole industry fell prey to this accounting slight of hand so the SEC issued SAB 101 in attempt to better match up revenues with expenses. Companies, especially Loewen, have started to manage the business for cash and not earnings.

Valuation:

Current Stock Price: $14.00
Shares Outstanding: 40 million
Equity Market Cap.: $560 million
Total Reorganized Debt: $807.5 million
Total Enterprise Value: $1,367.5 million

2002 SAB 101 EBITDA: $180.2 million
2002 Adj. SAB 101 EBITDA: $235.2 million
EV / 2002 SAB 101 EBITDA: 7.6x
EV / Adj. 2002 SAB 101 EBITDA: 5.8x
Debt / 2002 SAB 101 EBITDA: 4.5x
Debt / Adj. 2002 SAB 101 EBITDA: 3.4x

Loewen’s peers have also incorporated the new SAB 101 accounting practices in their financial statements.

Comparable Company Valuation:
Service Corp.:
TEV / 2002E EBITDA: 7.6x
Debt / 2002 EBITDA: 5.1x

Stewart Enterprises:
TEV / 2002E EBITDA: 6.0x
Debt / 2002 EBITDA: 3.3x

Carriage Services.:
TEV / LTM EBITDA: 6.8x
Debt / LTM EBITDA: 4.0x

While Loewen and it’s major competitors have changed their accounting to conform to SAB 101 accounting to create EBITDA as a better measure of cash flow, Loewen has implemented certain measures that are even more conservative that create operating statistics that are lower on a comparable basis. In addition, certain fresh start accounting rules make Loewen’s projected EBITDA even lower compared to it peers. The combination of these two issues makes Loewen’s projected 2002 EBITDA of $180.2 incomparable to its peers operating statistics. Adjusting for the fresh start accounting changes would add roughly $55 million to 2002E EBITDA. This was presented in the bankruptcy court through an analysis done by Wasserstein (the company’s restructuring advisor).

Other adjustments could be made due to the more conservative nature of Loewen’s accounting of pre-need sales. Unlike the other public death care companies, Loewen does not recognize revenues associated with the sale of preneed interment rights until title is transferred (typically 100% of the contract paid). Additionally, Loewen recognizes all selling costs associated with preneed sales at the point in time they occur in contrast to peers who defer the costs and recognize them with the corresponding revenues. Adjustments for this may also be quantified by management in the road show process and investigated by research analysts. Whether you agree with the way Loewen is doing it or the way its peer’s are doing it, the net effect us that Loewen’s is more conservative relative to its peers. This is also the case with respect to the fresh start adjustments.

Applying a more comparable 6.5x multiple to Loewen’s Adj. SAB 101 2002E would result in an equity valuation of $17.90 per share. Applying a 7.0x multiple would result in a $20.83 per share valuation. These represent 28% and 49% increases in value from the current stock price of $14. The higher end valuation is still below the 7.6x where Service Corp. is currently trading.

I believe that there is also additional upside as investors make certain other adjustments to Loewen’s EBITDA to account for its more conservative accounting practices relative to its peers in the booking of preneed sales as discussed above. This could result in an additional $10-$20 million of increased EBITDA as compared to its comps.

Loewen’s underlying business is stable. People always die. While the average life expectancy has been increasing the total number of deaths is still projected to grow about 2-4% a year. Based on the company’s plan projections, Loewen will produce $62.9 million in free cash flow in 2003 before any debt paydown on reported sales of ~$900 million. This excess cash will be used to de-lever the balance sheet. And this cashflow is independent of SAB101 or fresh start adjustments since those are just accounting issues.

I believe that the stability of the cashflows along with the high margins that the company generates deserves a multiple in at least the 6.5x – 7.5x range. The $180.2 in projected 2002 EBITDA represents a 21% margin. The company is projected to spend only about $28.5 in annual capex. Much of the excess cash flow will go to pay interest expense and to pay down debt. Over the next few years, some of Loewen’s debt could be refinanced to lock in lower rates since some of the debt has a 12.25% rate and is trading at 109%-110% on a WI basis. While such pre-payments could be expensive, they may prove to be positive NPV investments depending on the rates Loewen can lock in.

The industry is still highly fragmented and provides further consolidation opportunities for Loewen and its public peers.

Management’s options are priced based on the average of the first 30 days following the effective date. As a result, management, I believe, is not incented to promote the stock until a month following the effective date. This may produce a favorable time to purchase before the more intricate valuation and accounting issued are widely distributed to the investment community.

Catalyst

The emergence from bankruptcy protection and increased coverage by research analysts and the equity investment community.