Description

Invest in the inevitable

Fu Shou Yuan (FSY) is China’s largest burial services (87% revenue and 89% gross profit) and funeral services (13% revenue and 11% gross profit) provider. The distinct operating model (described below), allows FSY to consistently gain market share and produce returns that are the largest in an industry that is filled with inefficient state-owned enterprises. Shares trade in HKD but the financials are in CNY.

Death care providers are generally dismissed because they operate in an unpleasant industry with few recurring revenues (transaction-based sales like real estate developers). However, FSY’s distinct strategy and superior operating capabilities have helped the company develop favorable relationships with governments that position it well to open/acquire new cemeteries/funeral facilities and further consolidate the death care industry. FSY operates 28 cemeteries (burial services) and 10 funeral services facilities in 13 cities. For burial services, FSY develops raw land into cemeteries and sells small plots to families (current land reserves can last 20+ years); primary costs are land use rights, development, material and selling costs. For funeral services, FSY provides ritual and ceremony services to families; primary costs are labor and facility costs.

Two of the most important factors to the company's success have been:

Premium strategy: FSY is a frontrunner in innovation, offering well designed and landscaped cemeteries, as well as improving the overall service quality in the industry. FSY will systematically solicit celebrity clients and build museums to commemorate historical figures in order to form a premium brand locally. FSY offers customized services and a richer selection to customers than its peers. The premium positioning and limited supply of land for use by cemeteries coupled with growing demand for ground burial sites have underscored historical pricing power (mid-teens% annually). Gross margins have averaged ~80% in the past five years and operating margins at ~39%.

Superior operating practices: CEO Jisheng Wang revolutionized this poorly run industry by continuously observing and borrowing industry best practices from foreign peers and steadily improving the operations at FSY. The company has developed a comprehensive training program for its employees that has been used as an industry benchmark. Training employees well has allowed FSY to increase retention (decrease hiring costs) in an industry that generally lacks experienced professionals (due to social stigma). Furthermore, FSY has a dedicated marketing and sales force that organizes various field trips and activities for local seniors to promote its brand and services. FSY relies much less on brokers for referral (30-40% vs. 50%+ industry) and pays much lower commission rate (5-10% vs. 20%+ industry). As a pioneer in the industry, FSY, often times, provides workshops to peers free of charge.

There are additional aspects that make the company an attractive investment:

Abundant land reserves: FSY will supply an estimated 45,000+ sq. m of land in 2016 and has a total saleable area of approximately 1.59mn sq. m as of first half of 2016 with land use rights certificate to support development for at least another 20 years.

High ROIC: the low capex nature of the business (less than 5% of sales) and the low working capital requirements (FSY collects payments upfront) coupled with consistent pricing power allow FSY to produce high returns on invested capital: 23.4% in 2015, and five-year average of 35.7%. FSY has also been able to earn superior returns on acquisitions or partnerships. For example, FSY acquired Henan FSY for RMB 73mn in 2008/2012 and in 2015 the cemetery generated around RMB 13mn in net income (17% cash-on-cash return). Similarly, the Jinzhou Maoshan Anlin acquisition from 2012 has generated a 15% return.

Brand equity and the go-to-consolidator: FSY continues to acquire local players or enter into partnerships with government-affiliated entities. Several factors have contributed to an industry fertile with consolidation targets for FSY. 1) Some owners (especially those who have inherited the business) tend to cash out because the business is regarded as socially distasteful; 2) some players (especially real-estate companies) who entered the space to make quick money, later become cash-strapped as cemetery cash flow patterns are completely different from those of typical real-estate projects (5-7 years vs. 1-2 years); 3) FSY is by far the most efficient operator and is able to increase operating margins by 10-20% from its acquisitions.

Long industry runway: although the death care services industry is still not a fully open market, private sector companies have emerged over the last two decades to operate cemeteries and funeral facilities. These private death care services providers bring competition into the industry and drive government-affiliated entities to improve the quality of their services. The industry is highly fragmented on a nationwide scale with the vast majority of services providers being relatively small in size and having very limited brand recognition. FSY has capitalized on this opportunity to strike smart deals and partnerships with local governments in order to gain market share. Despite being the largest player in the death care market, FSY controls only a 1.5-2% revenue market share (RMB 1.4bn out of RMB ~84bn market), far lower volume market share (17,322 plot sales, compared with ~10mn deaths per year).

High barriers to entry: the death care services industry remains a highly-regulated industry. The provision of funeral services is still primarily dominated by government-affiliated entities, and while the cemetery business has been commercialized, there are many government-imposed restrictions and rules that set entry barriers. The approval and incorporation process is much more complicated for private sector companies attempting to enter the death care services industry than for government-affiliated entities.

Death care services are a basic necessity: people are going to continue to pass away and therefore need death care services. Death rates in China are expected to continue to trend upward from the current 7.7 deaths/1,000 population driven by aging population. Presently there are ~10mn death per year with a ~50% cremation rate. Euromonitor expects the death care market value to grow at a 17% CAGR from 2013-2017 driven by urbanization and an increase in consumption power.

Aligned management: CEO Jisheng Wang owns 4.6% of shares outstanding. On a combined basis, management and the board own more than 10% of the company.

Valuation: At the January 13, 2017 closing price of HK$4.37 per share, FSY trades at 21x NTM PE. DCF valuation (10% discount rate, 3% terminal growth rate) based on conservative LSD-MSD% growth in volume and MSD% growth in pricing coupled with LSD% growth contribution from acquisitions/JVs yields a 50%+ upside to current price of HK$4.37 per share. IRR analysis shows a 10-year 14.2% annualized return based on exit multiple of 18x forward PE.

Risks

·       Change in regulation that decrease the barriers to entry

·       Failed acquisition strategy resulting from quality of assets or price paid

·       Departure of key members of management team

Catalyst

·       Continued market share gains and new acquisitions/JVs in 1^st/2^nd tier cities

·       Cremation machines market opportunity

·       Shenzhen-Hong Kong Stock Connect opens access to HK shares for mainland investors