Description

CSV has been written up a few times before with raffles378 writing the most recent one in 2023 surrounding the proposed acquisition of the business. All the past write-ups are great work and provide a very solid overview of the business and its industry. That said, we believe that the business is trading at an attractive entry point right now and are reintroducing it given some of the structural changes that have taken place.

Business Overview

Carriage Services (NYSE: CSV) is one of the largest providers of funeral services as well as cemetery services and merchandise in the United States. Carriage reports operations in two different segments: funeral home operations and cemetery operations. The former segment represents ~70% of the business’ total revenue and the latter ~30%.

Funeral home operations primarily consist of burial services, cremation, and related merchandise including caskets and urns. Funeral services are split into two time-based classifications: “atneed” and “preneed.” Atneed simply refers to services sold at the time of death and preneed is planned. 62% of Carriage’s 2022 contracts are preneed. As a note, Carriage sweeps their preneed cash to their trust funds and earns a return on the capital locked in their bank deposits.

Cemetery operations primarily consist of cemetery interment rights, cemetery merchandise (monuments), and services (installation). These cemetery services and offerings are also split into atneed and preneed categories. As of the end of Q3 2023, Carriage owns 171 funeral homes, 32 cemeteries, and boasts operating margins that hover around 40%.

Thesis 1: Investor Jitter Surrounding Trade-Downs from Burial to Cremation

Over the last decade, cremation has accelerated meaningfully with estimates placing the service to cap out at roughly 80% of interments by 2035. We acknowledge that the shift to cremation is a meaningful risk; however, we believe that fright about this structural decline has distracted investors from what still is a high-quality free cash flow generating machine.

First, while the trade down to cremation is a meaningful trade down, it is still a capped risk. Notably, a funeral home consultant in Arizona noted that the prices of funeral home burial services hover around ~$7800 per contract and ~$7000 for funeral cremations. A 10% decline in revenues is still a 10% decline in revenues, but this is far from an existential threat. Even after modeling in this supposed revenue decline, we arrive at a 12% IRR if management accrues cash reasonably, so we do not view this concern as particularly impactful considering valuation.

Additionally, Carriage has been able to command sizeable margin expansion since 2017, despite the cremation rate increasing 7% since that year. Notably, Carriage has been disciplined in rationalizing prices across its ecosystem and marketed add-on services in the form of memorialization options. While it is difficult to quantitatively measure the success of these add-on offerings, Carriage has successfully grown their ranging from flower shops, pet cremation, and online cremation services quite successfully since their expansion in 2018. Notably, these services have only seen a decline once in 2022, but it’s important to acknowledge this small $0.2m decline in context of a post-COVID era. Additionally, margins on these expansions have grown by 6% (from 21% to 28% EBIT in the last five years). Therefore, while we are unable to pin down the exact adoption metrics of these add-on offerings, we believe that this collection of positive information certainly seems comforting.

What’s more, 30% of people who chose for their loved ones’ ashes to be cremated still had their remains interred at a cemetery, once again allowing for a higher take rate. Finally, although the rate of cremations is accelerated, the only effect is a decrease in ARPR—not a per unit incremental margin decline as our internal research suggests. With these factors in mind and the ease of matching valuation, we believe that the million-dollar important question surrounds the durability of the business, not the secular changes that are occurring around it.

To begin, we believe that Carriage’s demonstrated post-COVID resilience is a testament to their operational strength. Notably, despite a 47% reduction in COVID-19-related fatalities, Carriage’s funeral contracts only declined from 49,249 to 47,498 in 2021 to 2022, a mere 3.6% drop after such an extended period of accelerated growth. Additionally, we believe in Carriage’s continued ability to operate. Carriage has historically differed from peers through their decentralized operating model. We’ll discuss this operating principle later, but the program has allowed Carriage to respond to market dynamics and bolster their local brand identities more quickly. This approach has allowed them to make pricing adjustments in response to volumes and they’ve been able to optimize this service far better than their peers including Service Corporation which has observed significant fluctuations in volume after any price hikes. This operational excellence is evidenced by Carriage’s margins—ones that are higher than Park Lawn despite the size difference and just below Service Corporation despite the even larger size difference. We believe this to be quite impressive given that size is king in this industry.

Additionally, we only need to prove the durability of Carriage’s customer acquisition skills, and we were gladdened to discover Carriage’s best-in-class operations throughout our research process. Alongside product customization, Carriage has built itself into a trusted operator that boasts best-in-class reviews. For those who enjoy reading product reviews, we’d like to refer them to a recommendation left by a former patron who noted that “[My father] was a Vietnam Veteran who loved his country. We sought a memorial reflective of the highest respect and his fervent passion. Karla with Allisons [a Carriage company] … attentively absorbed our family's stories about our beloved. She actualized our every aspiration and vision into reality… even commissioning a bespoke piece of artwork of him in his military attire.” Additionally, in a random sample of Carriage funeral homes that we pulled, nearly 80% boasted 5.0 star google reviews. 

As we turn to future profit drivers and observe trends within the industry, it's clear that the preneed sales program has emerged as a significant frontier for exploration, not only for Carriage but across the sector. In 2021, Carriage reported a revenue increase of $46.4 million from the previous year, propelled by a 20% rise in preneed interment rights sales and a 17% increase in the average price of each interment right. The accumulation of deferred revenue solidifies Carriage’s financial fortitude and offers a bulwark against inflationary pressures. Beyond financials, this strategy also nurtures early client relationships, fostering loyalty and increasing the likelihood of referrals, while simultaneously capturing a younger demographic — a strategic move for long-term client base expansion. Additionally, Carriage's strategic diversification of revenue through the introduction of ancillary services such as flower shops, pet cremation, and comprehensive after-service offerings demonstrate their adaptability and commitment to retaining revenue in-house, even as we consider a slight decrease in 2022 within the broader context of a post-COVID-19 environment.

This logical progression—from acknowledging industry trends and CSV's pricing resilience, to detailing the strength of their business model and looking forward to future growth avenues—solidifies our argument that CSV is not only weathering the trade-down event but is also well-positioned for continued operation and growth, with a valuation that remains compelling.

Thesis 2: Carriage’s Value-Accretive Roll-Up Strategy

We hold a favorable view of long-time CEO Melvin C. Payne and his ability to execute on the M&A roll-up strategy that he has employed at Carriage. To be specific, Payne has had his fair share of missteps at the helm in his early years when he was appointed to the position just after Carriage’s founding in 1991. Payne rose to the CEO seat with very little equity investing or dealmaking experience, so given the acquisition frenzy that dominated Wall Street in the 1990s, it’s difficult to fault him here for some of his early deals. We do recognize that his early dealmaking did contribute to the Carriage’s early inability to generate positive free cash flows; however, he has repeatedly owned up to his mistakes and become a much more sophisticated purchaser of quality businesses.

Over the last decade, Payne has employed what he calls his “No Brainer” strategy, and despite the odd name, his disciplined buying strategy has been highly shareholder accretive. As zbeex mentioned in his past write up in 2018, Carriage typically only purchases high quality funeral homes; reputable funeral homes with top-tier operations and durable brand names as we have also shown in thesis 1. While this means that the purchase multiples are typically higher, Carriage does not need to invest the large amounts of CAPEX required to turn around distressed brands. Post-purchase Carriage makes various operational improvements like building new funeral homes on under-utilized plots of land and recognizing  back-office synergies. Finally, unlike their other large competitors, Carriage gives their funeral home managers significant amounts of autonomy. Funeral home managers are given a specific set of goals to maximize long-term value appreciation, and these managers are handsomely compensated when they achieve these goals. This incentive creates significant skin-in-the-game for Carriage’s managers, and the centralized operating structure that Carriage’s competitors field makes it very difficult for them to replicate this operational edge.

As reductive as this sounds, Carriage’s team members are simply better operators than their peers and its organizational structure and internal talent are worthy of praise. This set of enviable traits has allowed the business to command best-in-industry margins and returns on incremental invested capital. When compared to their publicly traded peers—whose size should give them every advantage because it allows them to play a roll-up strategy more easily and make better use of their operating leverage—Carriage still commands elevated margins.

There have been some concerns surrounding the quality of Carriage’s acquired assets as many of them were Service Corporation’s formerly divested holdings. While this is true, Service Corporation divested many of these holdings due to anti-trust concerns, and it seems unlikely that the DOJ and FTC would allow Service Corp. to only divest their worst holdings.

As a final note, Payne owns 8.1% of the business’ outstanding shares, and alongside his lieutenants, over 90% of the business is owned by insiders who have tied much of their personal wealth to the long-term success of its shares.

Thesis 3: Asymmetric Upside Driven by Potential Acquisition Activity

On June 13^th, 2023, deathcare provider Park Lawn Corporation moved to acquire all shares of Carriage Services for $34.00 a share in cash at a 25% premium. The proposal was backed by large private equity and infrastructure investor Brookfield Asset Management which looked to create an industry titan (or as large of a titan as one can be in such a fragmented space). That bid was withdrawn on October 2^nd, 2023, for unnamed reasons, but we believe this to be a sign of significant M&A interest in the business.

Carriage Services appears to be an obvious target for strategic acquirers. Minimal geographic overlap with many other providers, strong margins, historically efficient operating principles, and quality managers are all attractive green flags. Additionally, in an industry where scale is king, acquiring the ~5^th largest player which has a demonstrated track record of operational success certainly does not seem like a bad deal. That said, we do believe there to be few antitrust concerns. However, even if the industry’s largest player in Service Corporation acquires both Carriage and their competitor in Park Lawn, Service Corporation would still only have a ~20% market share.

For financial sponsors, we believe that the stability of the business and their ability to generate massive amounts of free cash flow with minimal operational risk makes for a good deal. While Carriage is certainly a semi-melting ice cube given the structural trade down from burials to cremation, their strong free cash flow conversion and undemanding valuation suggests that they can be levered up to earn an attractive return. We recognize that the operating leverage within this business does pose a degree of risk for a financial acquirer; however, we believe that the durability of their cash flows alongside the unlikeliness of a structural industry downturn outside of trade downs helps mitigate much of this concern.

Key drivers:

1. Sales Growth

Factors driving sales growth are funeral home/cemetery property counts, contract volume per location, average revenue per contract and ancillary services/preneed insurance trust earnings. With the growth through acquisition strategy and management plans to divest non-core assets, we assume CSV will continue to acquire 3 new and divest 4 funeral homes every year from 2023-2025 with proceeds to pay down long term debt and reduce interest expenses as guided. From 2026-2029, we project net acquisitions at 6 per year, given the liquidity improvement and benchmark to historicals. For cemetery segment, growth is estimated at 1 additional location per year.

For contract volumes, we conservatively estimate pulled forward demand will continue to impact growth until 2025, as suggested in the -5% atneed volume comp growth in Q3 2023. This results in negative volume growth for 2023, 2024 and flat growth in 2025. From 2025 onwards, volume growth is benchmarked to total deaths growth in US, which is estimated to be 1% in base case. On the ARPC/ARPR side, because of expected smoothing inflation into future, we estimate average revenue per contract growth will step down from current 4% to 1.5% by end of projection period, in line with the 2014-21 U.S. funeral costs growth statistics. Contributing to the slowed growth is continued preference for cremation over traditional burial services, which management guided will increase by 1% every year in the contract mix. We estimated contract revenue for cremation services to be 1/3 of traditional burial services and factored in the trade down impact on topline growth. To offset such trade down in funeral forms, CSV has been promoting axillary services to accompany cremation funerals, which has seen significant growth in the pandemic. Due to the emerging and discretionary nature of this segment, we assigned 10% growth to the low base but we expect its development to grow ARPC Cremation overtime.

Additionally, CSV invests its preneed trust for funeral and cemetery services into different insurance, bonds, and mutual funds, generating a capital gain recognized as part of other revenues at 8% and 10% CAGR over the past 10 years.

2. Margin expansion

While we keep cost of service and merchandise as variable to revenue growth and benchmarked to historical levels, we believe the fixed nature of land expenses and lower cost of cremation funerals will provide margin expansion capacity in depreciation items. Operating leverage is factored in on the SG&A level, which we see a reversion back to 2019 levels by end of projection period. D&A expense will converge with CapEx at end of 2029, with growth CapEx stepping down to and maintenance fixed as a % of existing PPE.

3. DSO and Net Debt adjustments

Given the strong cash flow generation capacity and the acquisition driven growth strategy, we allocate free cash flows into continued acquisitions, debt paydown, dividends and share repurchases. As announced in management’s current priority in debt repayment to reduce interest expenses, we use proceeds from divestitures to reduce leverage ratio from current 5.75x to 4.0x in 4 years and resume the dividend distribution and $75M share buyback programs as authorized by management.

These estimates place us at a 13.2% IRR.

Comparables:

The three major publicly traded competitors are SCI and PLC. When we researched SCI, we recognized its business quality but ultimately decided its M&A assets are not attractive given the scale. Pre-pandemic, CSV’s forward EV/EBITDA multiple has been stable around 9.5x, which is consistently 2x below SCI and ~5x below PLC. However, this divergence seems to be closing after emerging out of pandemic, when the industry wide multiple compressed given the investors’ uncertainty over impact of demand pulled forward in COVID,  cremation issues and the timeline for normalization to pre-COVID growth/profitability patterns. Despite the scale SCI and PLC demonstrate, we believe SCI and PLC have much fewer opportunities to grow inorganically. In particular, SCI is already restrained by anti-trust regulations in many states they operate in. Overall, we believe CSV’s multiple should revert to pre-COVID levels, which gives us confidence for an exit multiple at 9.0x EV/EBITDA in 2029.

Note on Strategic Review and Deal Process:

Ongoing strategic review process indicates CSV’s intention to explore a sale. In July, Park Lawn, the publicly-listed Canadian competitor, placed an unsolicited bid for CSV at $34.00 per share, which is a 25% premium to the unaffected share price. This was in response to a failed succession planning at CSV to replace then CEO Melvin Payne aged 79, who is the founder. At 10x EBITDA and 12x FCF, a potential buyout offer provides a benchmark of strategic view on CSV and a substantial upside to our current valuation. While previously investors are concerned with founder succession, now the urgency of sale is very much relieved after the transition of leadership to Carlos Quezada. Given PLC’s recent aggressive acquisition behaviors, we believe the ultimate withdrawal is irrelevant to CSV’s business fundamentals but more due to the buyer’s capital allocation strategy, as evident in its intended joint investment with Brookfield initially. There was significant optimism embedded in the deal, therefore when the deal announced stock price climbed up to ~$33, hoping to capture the merger arbitrage opportunity. However, the market reacted dramatically to the news of offer withdrawal, causing a steep price downfall to ~$21, leading to it trading 20% below its unaffected price preannouncement. Given no material changes to the business, we think the short-term mispricing created an attractive entry point.

Risks:

Americans are increasingly opting for cremation instead of traditional burials. This adversely impacts CSV’s business, particularly in the cemetery segment. Since only 30% of remains are interred at a cemetery post-cremation, any increase in cremations means more customers will not be interacting with CSV’s cemetery’s business. However, as stated in Thesis 1, we believe Carriage Services’ positionality as a primarily funeral home operator insulates it from the worst effects of a shift towards cremation, and the valuation is still viable given an incremental shift to cremation from the 58% to 80% cremation rate, and the effects that shift would have on a portion of CSV’s cemetery business.

The FTC announced in September it had initiated a rulemaking process to update the Funeral Rules enacted in 1984. The original rule requires funeral homes to make prices readily available in person or over the phone and allows consumers to select items a-la-carte, instead of being forced into packages of goods and services. The updated ruleset forces funeral homes to also make the prices available on their websites and via SMS text. We do not believe price transparency adversely affects them since they are already price competitive with other funeral home operators. Compared to SCI, ARPR is similar. In addition, consumers select funeral homes based on location, reputation, and familiarity with the funeral director in addition to price, so CSV, even if they were pricing above market, would not be adversely affected by price transparency. Finally, they already are forced to have price transparency over the phone and in person, and there have been no recent price transparency cases actions brought by the FTC against CSV, suggesting they are complying with the existing regulations.

Most of Carriage Services costs are fixed. Despite their high operating leverage, their fundamental business is durable given population demographics, and they generate substantial free cash flow to pay down debt and make acquisition. While any business with high operating leverage has its risks, Carriage Services is well positioned to manage its high fixed costs.

Catalyst

Further M&A, Continued Operational Success + Margin Maintenance, Potential Future Buy-Out