Keystone is a recession resistant business trading at 6.9x EBITDA and 7.9x unlevered free cash flow and offering a blended dividend yield of 13.6%. The company trades 1.5x to 2.0x cheaper than comparable companies due to misplaced concerns over the Canadian income trust legislation and obscurity per its Canadian listing. This is not a multi-bagger story, but an investment in a stable industry providing a healthy yield with limited downside.

 

Keystone North America (Bloomberg ticker: KNA-U) is the 5^th largest provider of funeral services in the US with 177 funeral homes and 10 cemeteries. The company operates in 27 states and the province of Ontario with no state accounting for more than 15% of total revenue. Much like its deathcare peers, Keystone is a roll-up story. The company completed 65 acquisitions (97 homes) from 1996 to 2000 and has continued to acquire businesses since then, but at a slower rate. Unlike its larger urban-focused publicly-traded competitors, Keystone operates primarily in secondary suburban and rural markets. Its homes are located in the Midwest, Northeast, Southeast and Northwest. These businesses are well-established with an average age of over 50 years.

 

Formerly a portfolio company of GTCR, Keystone was taken public at C$10 per Income Participating Security (IPS) via the Toronto Stock Exchange in February 2005. The offering raised C$188 MM ($154 MM) and was 4x oversubscribed. Approximately C$70 MM (USD $57 MM) of the use of proceeds was used to purchase Hamilton, a collection of 80 homes in suburban, semi-rural markets generating $47.6 MM of revenue and $9.7 MM (5.9x EBITDA multiple). With the exception of Centerplate (CNP), Coinmach (DRY) and B&G Foods (BGF) traded on the AMEX, the bulk of the IPS and income trusts have been issued in Canada.

 

An IPS unit includes a senior subordinated note and an equity security (original allocation is C$5.714 common share and C$4.286 subordinated notes), which can be separated after 45 days. The majority of cash flow is paid in the form of monthly interest and dividends (in Canadian dollars – Keystone hedges its Canadian dollar risk). Generally, a high tax basis and interest deductions provide a tax shield that results in little corporate tax. The individual pays tax on interest (ordinary income tax rates) and dividends received. Canada withholds 15% which results in a foreign tax credit for US investors. Currently, 90% of the dividend receives return of capital treatment. Since Keystone pays very little in the form of corporate taxes, the structure is akin to a Canadian income trust, REIT or an MLP.

 

Unlike Canadian income trusts, US-based IPS companies like Keystone do not reduce Canadian tax collections. Since it is traded in Canada, the 15% withholding mechanism applied to US investors actually results in tax revenues that would not normally be available to Canadian tax authorities. In contrast, the Canadian income trusts eliminate double-taxation and result in lower tax collections as these companies convert from a standard corporation to an income trust. As such, it appears that existing trusts will lose their tax advantaged status in 2011. Despite being a different security and not subject to Canadian taxing authorities, Keystone has traded down in sympathy with income trusts.

 

In contrast to Service Corp., Stewart Enterprises and Carriage Services, Keystone is ~90% funeral home focused, while the others generate 25% to 50% of revenues from cemeteries. The funeral business is more service-related with the obligation completed shortly after death, compared to the real-estate nature of cemeteries, which have ongoing requirements. Additionally, a greater percentage of cemetery revenue is derived from pre-need (before death) sales, which is more discretionary than the largely at-need (at death) funeral home services. These factors lead to greater stability and predictability of cash flow for funeral homes.

 

Deathcare services provided include: consultation with the family, removal of human remains, preparation of the body (embalming), planning and coordinating of funerals and cremations, conducting memorial services, performing cremations, transportation services and cemetery internments. The company sells merchandise, such as caskets, urns and burial vaults and garments.

 

The funeral business is characterized by high fixed costs (maintaining facilities, salaries (25%-30% costs), utilities, property taxes, etc), which represent an estimated 55% of total costs and predictable volumes. Caskets and urns generally represent 15% to 18% of costs of goods sold. Volumes have been fairly stable with US deaths growing at an annual rate of 1% from 1980 to 2000, before slightly declining from 2001 to 2003 and remaining flat in 2004. From 2004 to 2010, the US Census Bureau estimates a 1% annual increase in the mortality rate.

 

Despite the acquisition frenzy of the late 1990s, fewer than 25% of funerals in the US are served by the publicly-traded companies. Mom and pop owners run the vast majority of funeral homes and the business remains localized. There is some seasonality with higher volumes typically seen during the 1^st and 4^th quarters.

 

As the industry is very mature, establishing a new funeral home can be difficult due to the importance of local heritage and tradition. A study completed by the National Association of Funeral Directors indicated that the most important reasons for selecting a funeral home are location, reputation and previous service to the family. Most funeral homes have developed a strong reputation through decades of operation. Approximately 90% of funeral homes were established prior to 1960. As such, market share changes occur very slowly. These characteristics coupled with the necessary capital outlays, local zoning restrictions, regulatory burdens (licensing restrictions) and scarcity of locations make new start-up homes unlikely. The major risk is competition from former funeral home owners who have already sold their family business to a larger operator. To limit this risk, Keystone requires non-compete agreements before purchasing a funeral home. Additionally, 81% of the former owners are actively involved in the business in some manner. Most of the remaining 19% are no longer involved in the daily operations of the business due to death, age, heath or other personal reasons.  

 

One of the most important points in comparing Keystone to its competitors is location and size. As mentioned earlier, Keystone operates in smaller suburban and rural markets. Most of its locations are owned (85%). Its larger competitors focus on urban (SCI/Alderwoods and Stewart) or suburban markets (Carriage Services) markets with higher population densities and annual volumes. The smaller size and lower volumes limits competition as these markets are not targeted by the aforementioned competitors. For example, SCI is divesting some of its smaller territories. The competitors tend to be smaller operators. Keystone’s advantages over these players include: volume discounts for merchandise and supplies, better access to capital and superior information systems.

 

The focus on tradition and reputation creates an environment with less sensitivity to price. As such, the funeral home operators enjoy high EBITDA margins (i.e. 20%-30%) and significant pricing power. Over the last 15 years, prices have increased an average of 4% per year. The high fixed cost nature of the business allows for significant contribution margins and cash generation from any incremental volumes. Given these attributes, the aging of the “Baby Boomer” population offers the potential for cash flow enhancement as the number of cases per funeral home is expected to increase over the next 20 years from 112 in 2004 to an estimated 136 in 2024, a CAGR of 1%.

 

Other than competition with former owners, the major risks are short-term declines in the death rate (Is this really a bad thing?) and an increasing cremation rate. In 1980, cremations accounted for 10% of total US dispositions. Now cremations account for around 30% of the burial market with an expected increase to 36% by 2010. Keystone’s average funeral price is $6,700 with cremations in the $2,500-$2,600 range. Per my discussions with several deathcare executives, the EBITDA margins for cremations are generally 15% to 20% higher than regular burials, but the actual margin dollars decline 35% to 45%. The management teams I have spoken with expect to offset this shift with additional volumes and seek to do a better job of selling memorial and other services along with cremations.

 

Studies have shown that higher rates of cremation are found in the Western US and Florida. However, people residing in smaller towns and rural communities, where migration rates are lower tend to prefer burials over cremations. As a result, Keystone should experience lower growth in cremation rates than its competitors.  

 

The IDS units are very sensitive to interest rates. Furthermore, the IRS may challenge the characterization of the senior subordinated notes as debt or may claim “earnings stripping” due to the high interest rate. The coupon on the notes is 14.5% and there are interest deferral provisions, which make the notes very similar to preferred stock or even equity. If the IRS takes the position that the senior subordinated notes are equity, the interest deduction or a portion of it may not be allowed. Both Kirkland & Ellis LLP and Torys LLP have rendered opinions that the senior subordinated notes should be treated as debt. A portion (“bachelor bond”) of the senior subordinated note is sold separately to investors to further these claims. Similarly, an IRS challenge on the rate of interest paid on the notes could also reduce allowed interest deductions. Even if the interest rate is lowered 4% to 10.5% (remember this is a highly levered capital structure), the tax increase of roughly $1 MM per year will be somewhat offset by lower taxable income for the holder (higher percentage of dividend versus interest income). To offset any adverse tax rulings, the company does maintain some NOLs and currently the IRS is not reviewing these structures.

The capital structure is very debt heavy to minimize taxes.

 

Secured Revolver                                 $20.8

Secured Term Loan                                43.1

Equipment Financing                                 1.0

14.5% Senior Subordinated Note             8.7

IDS Attached Senior Subordinated         74.7

Total Debt                                            148.3

 

Cash + FX Contract                                (9.2)

Equity Market Value                               51.6

Total Enterprise Value                           190.7

 

Financials               2003          2004          2005          PF LTM

Total Revenue         $86            $82            $86            $102

Adj. EBITDA           24              22              24                27

Capex                       (3)              (3)             (3)               (4)

Unlevered FCF         21              19              21                23

 

Historical financials are not perfectly comparable due to some divestitures and recent acquisitions. The decline from 2005 to the LTM period is largely the result of the absence of the anomalously strong 1Q05.

 

Performance in the third quarter was in line with expectations. Total revenues rose 13% from $19.4 MM to $22.0 MM largely as a result of acquisitions. Revenue per service increased 5.6%, while same store funeral volumes fell slightly. General and administrative costs increased due to board approved incentive plans ($0.3 MM) and accounting and legal services rendered in connection with acquisitions, dispositions and operating as a public company ($0.1 MM).

At current prices of C$7.33 (12/15/06), Keystone trades at 6.9x Pro Forma LTM EBITDA and 7.9x unlevered free cash flow (enterprise value nets out Keystone’s in-the-money foreign currency contract of $6.9 MM). The pro forma numbers include adjustments to reflect estimated revenues and EBITDA from already completed and recently announced acquisitions. Based on the current payout of C$1.00, the dividend yield is 13.6%. Since this payment includes both interest on the subordinated note and dividends on the shares, it should probably be tax adjusted to recognize the higher tax rate on interest income versus dividend income. After adjusting for this (excluding the 90% return of capital treatment on the dividends), the yield is closer to 12%.

 

Competitors trade in the 8.5x-9x EBITDA range and do not pay out nearly as much of their free cash flow. The best comparable is Carriage Services, which trades at 8.7x 2006E EBITDA and 10.8x unlevered FCF (adjusted for the value of NOLs).

 

I have met and spoken with Keystone management. Their experience in the business ranges from 18 to 44 years. The CEO, Bob Horn is a former funeral director (which is evident). They run a very lean organization (one secretary for the team), spend a lot of time in the field and have delivered on their promised synergies to date. The team intends to make acquisitions with a focus on buying good assets and not overpaying (5.0x to 6.0x EBITDA). With that said the management team does not have a lot of experience managing a public company and is not the most polished team.

The predicable and stable funeral services demand coupled with other barriers to entry make the Keystone story an attractive one. I think it has gone unnoticed and been unfairly punished by concerns over potential changes in the taxation of Canadian income trusts.