Description

Matthews International is a highly profitable manufacturer that derives the majority of its revenue and profits from the deathcare industry (70% of sales and 78% of profits). Its business is characterized by low economic sensitivity, significant barriers to entry (Matthews has 75% of the Bronze Memorial Market) and enviable pricing power (20% operating margin within the Bronze Division). Matthews is run by an honest and capable management team that have rewarded shareholders with a 26% annualized return since its IPO in 1994 despite no major Wall Street coverage. Management has delivered this return through a three-pronged growth strategy of acquisitions, share repurchases, and internal growth. Prospective shareholders should expect a bond like 7% free cash flow yield that should grow 12-15% annually in the coming years. Matthews currently trades in line with its historical average P/E multiple of 19 (2003 multiple is 16) lending little support for multiple expansion related returns. While I’m personally comfortable with a predictable and defensive “single”, those of you who are looking for a “home run” idea should stop reading.

Financials:

Price: 22
Shares Outstanding: 32mm
Market Cap: $704mm
Debt-Cash: $26mm
EV: $730mm


ROE: 21%
ROIC: 16%
OM: 15%

2002:
P/E: 18.3x
P/CF: 15.6x
P/S: 1.6x

2003E:
P/E: 16x
P/CF: 13x
P/S: 1.5x


1Q03 2002 2001 2000
NI 9.2 35.0 31.6 27.9
CFO 18.9 55.5 39.0 39.0
PPE 2.8 10.0 7.2 7.7

Revenue Breakout: 2002 %
Bronze 197 46
York Casket 108 25
Graphics Imaging 95 22
Marking Products 29 7

Operating Profit Breakout:2002 %
Bronze 45 66
York Casket 10 15
Graphics Imaging 10 14
Marking Products 4 5


Background:

Matthews International was founded in 1850 and went public in 1994 to provide liquidity to insiders. The company today operates in five different business segments: Bronze, York Casket, Cremation, Graphics Imaging, and Marking Products. The first three represent Matthew’s exposure to the deathcare industry and collectively represent over 70% of sales and 78% of profits based on the companies latest 1Q2003 results. As a supplier to the death care industry, Matthew’s customers are wholesalers (cemeteries, memorial parks, funeral firms etc.) who in turn sell the Company’s products to the consumer. The industry is well consolidated between Matthews and Hillenbrand (HB). The last two segments are more cyclical and less profitable than the death care segments. While I intend to focus on the death care segments, I will briefly touch on these segments as well.

Bronze Division:

The crown jewel of Matthews is the Bronze division, which accounted for 39% of overall sales and 56% of profits in the first quarter of 2003. This segment includes bronze memorials for cemetery graves, mausoleum construction, cremation equipment, and bronze plaques for architectural use. Matthew’s boosted its bronze memorial market share to 75% with the acquisition in May 2001 of York Group’s commemorative product division. Matthews, which paid $45 mm for the division (1.1x revenue, 5.6x EBIT), was able to get under the FTC’s $50 mm scrutiny threshold by separately buying York’s bronze division after it had bought York’s main casket business. Matthew’s next biggest competitor in this area is a private company in Minnesota that holds 15% of the market. The remaining balance of market share is held by smaller local manufactures around the country.

Due to significant barriers of entry, this division enjoys operating margins north of 20%. Arguably the biggest barrier to entry is the upfront cost associated with building out a new metal foundry. Relationships with cemeteries (which Matthews has built up over the past 100 years and maintains with over 4,000), pricing ability and product availability, and a skilled workforce are additional forces that contribute to make the competitive barrier dynamics here appealing.

While the barriers to entry here are strong, the potential for high organic revenue growth is weak.
Growth is limited to the total number of yearly deaths, the percentage of people who choose bronze over other alternatives (Granite etc.), and the percentage of people who choose to be buried versus cremated. Further information can be found at http://www.cremationassociation.org/html/statistics.html

# Cremated % # Buried % Total Deaths
1995 487,323 21 1,822,264 79 2,309,587
2000 629,362 26 1,773,989 74 2,403,351

Of the 74% buried in 2000, approximately 1/3 opted for bronze memorial products (alternative being an upright granite monument). Using an average memorial price of $270, this translates into a total U.S. bronze memorial burial market of $158 mm. While the aging population suggests likely market expansion growth going forward, this will partly be offset by the trend toward cremation over burial (CANA projects 47% of all deaths resulting in cremation by 2025). Fortunately, Matthews Bronze is also used in cremation for memorials and urns and the company fully expects to take advantage of this trend with other product offerings (they are the leading North American manufacture of cremation equipment and cremation related products).

In the last three years, Matthews’s total bronze sales have grown at a compounded annual rate of 17% while operating income has grown at 12%. I expect operating profits going forward to be in the mid single digits (Matthew’s latest 1Q03 shows operating profits in this division rose by 7.5%) as the company is forced to focus on organic growth versus acquisition related growth. This growth should disproportionately come from pricing increases versus unit sales increases. Matthews has historically been successful in increasing prices and retaining business.



Casket Division:

The casket division accounted for 28% of sales and 20% of profits in 1Q03 with operating margins at 15.3%. Matthews entered the casket business following its acquisition of York Casket in December 2001. York had been the target of a hostile takeover and Matthews was able to pick up the division for $80 mm (net of cash). Matthews picked up the division with the expectation that they could take a mismanaged business with operating margins in the 8-10% range, and improve them to the mid-to high teens with productivity enhancements (Hillenbrand has operating margins here of 20%+). Currently, Hillenbrand holds an estimated 50% of the market, York Casket 15%, and a private company in Iowa maintains a 15% share of the market. Future success for Matthews in this division will depend on management’s margin execution and the willingness of the other players to act as disciplined competitors versus “market share at any cost” mentality (Hillenbrand’s focus on the medical equipment business suggests the former).

Cremation Division:

The cremation division is a newly formed segment for Matthews and represented 5% of sales and 3% of profits in 1Q03. This division is comprised of cremation equipment from the Bronze division and cremation caskets from the Casket division.

Graphics Imaging and Marking Products Division:

Matthews Cyclical Businesses (Graphics Imaging and Marking Products division) accounted for 28% of sales and 21% of profits in 1Q2003. Graphics had operating margins of 11.2% and the marking products segment had margins of 13.2% Management expects mid-teen operating margins at Graphics Imaging through diligent business improvement. The marking products group future results, which remain Matthew’s most economically sensitive business (sells goods to manufacturing companies), will be largely beholden to the business cycle and therefore difficult to accurately predict.


Matthews Customer Note:

It is important to note that Matthews has achieved its results while some of its largest customers have struggled financially. The publicly traded funeral service companies (Loewen Group etc.) have experienced severe financial difficulties since 1999 when the industry roll-up “theme” began to unwind. While these companies tried to work together to lower prices on funeral products, Hillebrand, York, and Matthews held enough market share to hold pricing together. Today, these consolidators hold less than 20% of the U.S. market and that percentage will likely go lower.



A Bet on Management:

Since David Kelly took the helm of Matthews in 1995, the company has successfully completed 22 acquisitions to help drive growth. During this same period, management retired 10% of the shares outstanding, consistently delivered double-digit earnings growth, and improved the company’s overall profitability, all while maintaining an enviable debt to equity ratio that stands at just 13% today. These results reflect both managements ability to execute on the integration side and, perhaps more importantly, allocate capital efficiently. I recently spoke with Ed Boyle, Matthew’s CFO, who indicated that they plan on reducing their debt with their generous free cash flow and will focus on improving the recently acquired York business before making anymore acquisitions.

DCF Valuation:

The following table presents the intrinsic value for Matthew’s International using a 10% WACC (CAPM suggests a 6.25% rate given the company’s beta of .52). Management expects long-term earnings growth of 12-15% going forward. The operating margin as of 1Q2003 was 15.5%.

Operating Margin Growth Rate
10% 12% 14%

12% 19.5 22.3 25.3

15% 25.0 28.5 32.5

18% 30.2 34.6 39.6

Catalyst

York Group acquisition improvements
Continued intelligent capital allocation
Aging population
Continued investor shift to defensive stocks