Stewart Enterprises, INC. (NASDAQ: STEI)

 

Price:  $6.95 (7/29/2011)

Market Capitalization: $632.8MM

Advocate: Short

 

Company:  Stewart Enterprises (“STEI” or the “Company”), is a provider of funeral and cemetery products and services in the United States and Puerto Rico.  STEI has three operating and reportable segments: a funeral segment; cemetery segment; and corporate trust management segment.  As of April 30, 2011, STEI owned and operated 217 funeral homes and 140 cemeteries in 24 states in the United States and Puerto Rico.   

 

Investment Thesis:              The death care industry faces major structural headwinds due to the rising popularity of cremation.  Changing demographics, evolving consumer preferences and a difficult economic environment have collectively propelled the cremation rate in the United States from 25.5% in 2000, to 36.6% in 2010.  The rate is expected to grow to 46% by 2015.  The increasing popularity of cremation has disrupted the traditional death care business model as companies sell less high-margin funeral and cemetery products and services.  Localized competitive advantages, characterized by reputation, inventory of high-quality cemetery property, a well-trained preneed sales force, and long-standing relationships with families are increasingly taking a back-seat to price, convenience and customization. 

Over the last several years, this paradigm shift has gradually been reflected in STEI’s operating profit and returns on capital.  The recent economic crisis has also exposed vulnerabilities in STEI’s deferred revenue model as its preened trust assets, funds that the Company receives and invests when customers prepay for services, have suffered serious losses.  STEI is currently sitting on significant unrealized losses relative to the size of the business.   

A granular examination of the balance sheet reveals suspect asset quality.  Conversely, the stated liabilities are solid, and the off-balance sheet liabilities are material.  Despite the industry headwinds, diminished earnings powers and low quality balance sheet, STEI currently trades at 20x TTM Operating Earnings, 15x EBITDA and almost 7x tangible book value.  The current valuation is decoupled from the deteriorating fundamentals of the business.  I estimate that the stock currently trades at a 30%-60% premium to intrinsic value.

 

Before I outline the short thesis, I will try to detail what the “long” buyer may be thinking. 

 

Consistency and Deployment of Free Cash Flow

Traditionally, death care companies have been touted as predictable, recession-resistant, cash flow generators firmly entrenched in an industry impervious to change.  A veritable annuity on death:

 

Operating Cash Flows:

TTM:                           $72.5MM      (FCF yield: 9%; Dividend Yield: 1.9%)     

2010:                           $63.35MM     (FCF yield: 9.9%; Dividend Yield: 2.2%) *

2009:                           $84.89MM     (FCF yield: 16.8%; Dividend Yield: 2.3%)*

2008:                           $84.52MM     (FCF yield: 14.1%; Dividend Yield: 1.9%)*

2007:                           $81.94MM     (FCF yield: 7.1%; Dividend Yield: 1.1%)*

2006:                           $90.1MM        (FCF yield: 10.7%; Dividend Yield: 1.6%)*

                                   

source: Investor Presentation, May 26, 2011

 

At first blush, healthy operating cash flows have yielded a respectable cash-on-cash return for the equity.  Without any adjustments, the current FCF yield is 9%; nothing to scoff at in this environment (Below, I will challenge the quality of the cash flows).           

Management has used the free cash flow to aggressively buyback stock.  As of May 2011, the Company had repurchased nearly 22MM shares of its common stock since it initiated its share buyback program in 2007.  The share repurchases have reduced the float by approximately 20%.  The Company currently has $36.9MM still available under its stock repurchase program.  On June 28, 2011, the Company increased the cash dividend by 14%, to .14/cents per share. 

The Company has also deleveraged the balance sheet.  During fiscal years 2009 and 2010, STEI repurchased $82.6MM and $35.9MM, respectively, principal amount of its outstanding senior convertible notes at a discount to par value.  The Company recently refinanced senior debt at 6.5% percent due in 2019.  Provided that one believes that the shares are undervalued, the buybacks and deleveraging have been an effective use of cash. 

 

Land

As Mark Twain once remarked, “buy land, they’re not making it anymore.” Twain’s aphorism explains another critical facet of the bullish thesis for STEI: cemetery property.  STEI owns and operates 140 cemeteries covering approximately 9900 acres of land.  Critically, 38% of the total acreage (≈3,762 acres) is still available for future cemetery development.  Many of these cemeteries are located in major metropolitan locations, including Orlando, San Diego and Dallas.  Owning cemetery property, and undeveloped cemetery property in particular, traditionally afforded the company several competitive advantages.  Given the zoning restrictions and lack of available land in metropolitan areas, the barriers to entry are significant for a company looking to acquire cemetery property or open a competing business.

 More importantly, cemetery property is the stem off which all other services and merchandise sales can blossom.  After a plot of cemetery land is sold, the Company can upsell funeral services and other merchandise, including caskets, flowers and memorials.  Additionally, selling the first cemetery plot has the potential to catalyze a host of other sales to the same family because families often choose to be buried together.  Further sweetening the proposition is the Company’s ability to sell these services on a “preneed” basis, or before the actual death.  STEI cites the experience and quality of its preneed staff as a major advantage of its business model.  In 2010, cemetery operations accounted for approximately 45% of STEI’s revenues, a substantially larger percentage of revenue than either of its two primary competitors.  Likely, many long-biased investors view the quality and breadth of the land holdings as a valuable strategic asset (a contention that I will challenge below).

 

July 2008 Buyout Offer

In July 2008, Service Corporation International (“SCI”), the largest publicly traded death care company, offered to buy STEI for $11.00 per share.  One could logically argue that the price placed on STEI by a large, informed strategic buyer is presumptively representative of business value.  However, the veracity of this argument is called into question when the relative operating performance, and loss position on trusts assets, in 2008 is compared to today.  See below:

 

                                                            July 2008 (TTM)                                    April 2011 (TTM)

 

Revenue:                                                                           $521.8MM                                    $506.1MM                  down: 3%

 

 

Operating Earnings:                                                         $79.3MM                                      $72.5MM                    down: 8.5%

 

 

Net Earnings:                                                                    $36.4MM                                      $32.7MM                    down: 10%

 

 

Aggregate Unrealized Losses, All Trusts:                        $59.2MM                                                      $163MM                up: 174%

                                              (9% Market Cap)                 (24.6% Market Cap)

 

 

Preneed Sales:                                                                  $158.3MM                                  $143.5MM                down: 9.3%

                                                                                          (2007)                                         (2010)

 

 

Backlog:                                                                            $2B                                               $1.7B                          down 15%

                                                                                          (2007)                                         (2010)

 

 

            Operating earnings and net earnings have declined 8.5% and 10%, respectively, from the comparable period when the buyout offer was made.  These are certainly not earth shattering declines, but when viewed in the context of the overall deterioration of STEI’s business, they highlight the continued downward trend of the operating performance since the 2008 offer. 

STEI’s net unrealized loss positions held in trust accounts have jumped by over 170%, a deterrent for any potential acquiror for reasons outlined below.  And the Company’s backlog, a purported indicator of future revenue to be recognized from preneed sales, has declined a meaningful 15% since the SCI bid.  In and of themselves, these figures do not present a compelling short argument.  But at a minimum, they do refute an assertion that the Company deserves the same valuation placed on the business by SCI in 2008.  

 

 

The Short Case

The short thesis is predicated on five fundamental concerns: 1) significant unrealized losses in the trust portfolios; 2) a highly leveraged balance sheet supported by little tangible asset value; 3) the quality of the cash flows; 4) deteriorating operating metrics caused by worsening industry fundamentals; and 5) a current valuation unreflective of the prior four concerns.  I will address each in turn.

 

1) Trust Assets

            If managed well, large death care companies can have favorable economics due to the deferred revenue business model.  Many customers buy funeral and cemetery merchandise and services from STEI before their actual funeral.  These preneed sales allow STEI to collect cash from customers well in advance of the time that the Company is expected to deliver services or merchandise pursuant to the customer’s contract.  

Customer payments received in advance are placed in trust accounts managed by STEI’s wholly-owned subsidiary, Investors Trust, Inc. (“ITI”). The Company manages three separate trusts: 1) Funeral Preened Services and Merchandise Activities; 2) Cemetery Preneed Services and Merchandise Activities; and 3) Cemetery Internment Rights and Perpetual Care Trust.  ITI invests the money on behalf of STEI.  Earnings generated on trusts assets are recognized as revenue by STEI at the time the merchandise or services are delivered.  

Earnings on trust assets are a critical component of profitability and revenue growth.  When a customer purchases services or merchandise, the contract priced in fixed at the time of purchase.  So, when Granny White agrees to prepay $5000 for funeral services, STEI locks in $5000 in revenue (assuming that Granny White pays her bills) that it will eventually recognize when the old woman is laid to rest. 

However, the labor, maintenance and other costs associated with delivering the services and merchandise for Granny White’s funeral are not fixed.  Labor market conditions, inflation, and the general economic climate all affect the attendant costs of delivering the services.  If the Company can correctly anticipate what these costs are likely to be, then it can bake the correct margin into the contract price.  But as an added layer of profit insulation, the Company gets to keep any earnings generated on trust assets, as well as collect a management fee for managing the trusts. This is an extremely profitable part of the business because the incremental cost associated with generating trust earnings and management fees on the extra dollar of preneed sales is virtually nothing.  Importantly, these earnings are included as a component of cemetery and funeral revenue in the operating results.   See the tables below deconstructing gross margins:

 

                                    Funeral Segment Gross Margins

 

Including Trust Earnings / Asset Management Fee                        Excluding Trust Earnings/Asset Management Fee        

 

2003:                           21%                                                                                   16.5%                          450bps of gross margin

 

 

 

 

2004:                           25%                                                                                   20%                             500bps of gross margin

 

 

 

 

2005:                           22%                                                                                   17%                             500bps of gross margin

 

 

 

2006:                           23%                                                                                   18%                             500bps  of gross margin

 

 

 

2007:                           23%                                                                                   17%                             600bps of gross margin

 

 

 

 

2008:                           23%                                                                                   19%                             400bps of gross margin

 

 

 

2009:                           24%                                                                                   20%                             400bps of gross margin

 

 

 

2010:                           23%                                                                                   19%                             400bps gross margin

 

 

 

 

                                                                   Cemetery Segment Gross Margins

 

Including Trust Earnings / Asset Management Fee                        Excluding Trust Earnings/Asset Management Fee

 

2003:                           19%                                                                                   15%                             400bps of gross margin

 

 

2004:                           20%                                                                                   17%                             300bps of gross margin

 

 

2005:                           26%                                                                                   14%                             1200bps gross margin

 

 

 

2006:                           21%                                                                                   18%                             300bps of gross margin

 

 

 

2007:                           20%                                                                                   17%                             300bps of gross margin

 

 

 

2008:                           13%                                                                                   10%                             300bps of gross margin

 

 

 

2009:                           11%                                                                                   8%                               300bps of gross margin

 

 

2010:                           14%                                                                                   11%                             300 bps gross margin

 

 

 

 

 

 

                                                      Corporate Trust Earnings/Asset Management Fee

 

                                    Percentage of Total Revenue                                         Percentage of Gross Profit

                 

 

2003:                           6%                                                                                     27%                                                                                  

 

 

2004:                           6%                                                                                     24%

 

 

2005:                           6%                                                                                     28%

 

 

2006:                           5%                                                                                     23%

 

 

2007:                           5%                                                                                     24%

 

 

2008:                           5%                                                                                     25%

 

 

2009:                           6%                                                                                     31%

 

 

2010:                           6%                                                                                     30%

 

 

                  Corporate Trust Management Segment Gross Profit Margins

 

2005:                                             96%

 

 

2006:                                             96%

 

 

 

2007:                                             95%

 

 

 

2008:                                             94%

 

 

2009:                                             91%

 

 

 

2010:                                             92%

 

 

The tables above illustrate that STEI is an asset management company as much as it is a death care company.  The asset management business consistently contributes between 300-500 bps of gross margin each year.  Stripping out the gross margins on the asset management business reveals rather lackluster gross margins for the funeral and cemetery operations.  How many investors get excited about mid-high teens gross margins in businesses with flat/declining revenues in an industry facing commodity-like pricing pressure.  Suffice it to say, the performance of the corporate trust management segment is critical to profitability.

 

            Where the Trouble Starts…

            As of April 30, 2011, net of all unrealized gains, the total unrealized losses in common stocks, preferred stocks and equity mutual funds held for longer than one year in STEI’s three trusts combined approximates $130MM (≈$1.43/share).  This is equal to about 20% of the market capitalization of the Company and gives the equity investor a current loss yield of 20% ($1.43/$6.95).  To contextualize the size of the losses, SCI, the largest publicly traded death care company, is sitting on $120MM (exclusive of any gains) in unrealized losses, compared to a market capitalization of $2.7B.  SCI is over four times larger than STEI, yet has smaller losses on an absolute basis and in proportion to the size of the business. 

             

Drilling down on the composition of the trust assets further muddies the

waters:  See below:

 

                        -as of April, 2011, $6.12MM of preened funeral trust assets were classified as

Level 3 investments with significant unobservable inputs;

 

-as of April, 2011, $178MM out of $841MM in fair market value of trusts assets were classified as Level 2 investments i.e. “mark-to-model”

 

                  Level 3 assets values are inherently subjective and dependent on management’s judgment.  Even though $6.12MM represents a relatively small percentage of total trust assets, it still equates to about 1% of the Company’s market capitalization.  With 21% of the fair market value of the trust assets characterized as “Level 2,” investors should hope that the mark-to-model inputs are accurate. 

            Given the recent economic crisis, it is expected that STEI would suffer some significant losses on its investments.  And if the Company had aggressively weaned its trust portfolios to cut the dead weight and take some pain upfront, then the losses would be less of an albatross.  However, several pieces of evidence lead one to believe that the Company is doing the opposite. 

For the six months ended April 30, 2011, STEI sold $70.62MM worth of investments in the Preneed Funeral Trust, $47.77MM in the Cemetery Merchandise Trust, and $52.53MM in the Cemetery Perpetual Care Trust for a total of $170.9MM in securities sold. 

Yet, during the same period, the company only realized  $1.67MM in losses.  In the words of Peter Lynch, perhaps STEI is “cutting the flowers and watering the weeds.” Management has expressed its “intent to hold” some of the unrecognized losses through the “forecasted recovery period.” I am sure many investors are anxious to know when this “forecasted recovery period” begins and ends, so they too can patiently wait for the their losers to snap back in the black.  It is also worth considering that from 2008-2010, STEI realized a combined $87MM in losses on   sales of trust assets ($53.3MM-2008; $24.4MM-2009; $9.4MM-2010).  So, the $157MM in unrealized loss positions held for longer than one year stands even after accounting for sales made since the financial crisis began.    

            A significant percentage of STEI’s unrealized losses are concentrated in financial sector securities.  As of April 2011, individual issuer investments in the financial sector represented 17% ($101.2MM) of the fair market value of the Preneed Funeral And Cemetery Trust Portfolios, compared to 20% ($115.7MM) in October 2010.  In the Cemetery Perpetual Care Trust, individual issuer financial sector investments represented 21% ($51.7MM) of the fair market value of the portfolio assets, compared to 30% ($69MM) in October 2010.  Curiously, the reduced exposure from October 2010 to April 2011 has not translated into realized losses.  This invariably gives rise to the possibility that the Company established positions in financial sector securities at inflated valuations and is sitting on its hands hoping a sunnier day is just around the corner.  As of April 30, 2011, the combined losses in individual issuer financial sector securities for all three trusts combined was $43.5MM ($.47/share; a 6.7% loss yield).

 

            To recap:

 

As of April 30, 2011:

 

Total Fair Market Value of all Trust Portfolios:  $843.8MM

 

Total Unrealized Losses in all Trust Portfolios:  $163.4MM                

 

 

Total Unrealized Losses in all Trusts Portfolios held for > 1 year (common stocks, preferred stocks, equity mutual fund):   $157.2MM

 

 

Total Unrealized Losses in all Trusts Portfolios held for > 1 year, net of all unrealized gains:  $130MM

 

 

Total Unrealized Losses in Individual Issuer Financial Sector Securities: $43.5MM

 

 

Market Capitalization:  $632.8MM

 

At a current share price of $6.95, the equity investor is assuming $1.42/share in net unrealized losses in common stocks, preferred stocks and equity mutual fund positions held for over one year (20% loss yield)

 

Incentive-Caused Bias

There is a compelling array of disincentives for STEI to realize losses.  STEI recognizes earnings on trust assets when the underlying contract associated with the specific trust asset is performed.  Because realized losses have to be netted against realized gains, taking losses will permanently offset the amount of revenue that can be realized in the future on any given contract.  The implicit choice for management thus becomes either a) realize the loss and staunch future revenue growth or b) adopt a “wait and see” approach and hope that the securities in a loss position eventually recoup some of their value.  In the mean time, the Company can sell the winners, realize the gains, and release them into revenue when the contracts are performed.  

In the most recent 10-Q, the Company states that it “believes” that its investments will recover in value.  As Mr. Buffet has so aptly stated, “a stock doesn’t know you own it.”  It would behoove management to elaborate, a least a little, as to why they “believe” that their investments have not suffered permanent capital impairments. 

Realizing losses also permanently depletes the value of trust assets under management, which reduces the fees that the ITI subsidiary receives for managing the assets.  Given that the earnings on trust assets and asset management fees flow almost entirely to gross profit, management may be reluctant to induce gross margin compression by recognizing losses. 

Realized losses also flow through Other Comprehensive Income and reduce shareholders’ equity, which is already on fragile footing.  Realized losses may also compel a write-down of capital loss carryforward deferred tax assets.  Previously realized capital losses on trust assets create deferred tax assets that can be used to offset future capital gains on trust assets.  If the Company realizes losses in the trusts, the carrying value of the capital loss carryforwards may have to be written-down as it becomes less likely that there will be future capital gains against which to utilize the capital loss carryforwards.  Concomitantly, the valuation allowance must be increased, resulting in a charge against income.  As of October 2010, the Company carried $18.8MM in unrealized capital loss carryforwards.  And to top it off, if realizing losses puts any of the preneed contracts in a loss position, the Company is required to book a liability, take a charge against earnings and fund the shortfall. 

Any of these of these accounting fireworks in isolation may not have a material effect on the Company’s performance or its long-term earnings power.  But, collectively, the impact of realizing a significant loss has the potential to reverberate through the financial statements and cause large, unexpected earnings miss. 

Perhaps more importantly, examining the negative ramifications of recognizing losses illuminates why the proverbial “invisible hand” may be nudging management against doing it.  If financial market conditions deteriorate further, or at a minimum, continue to putter along, the Company’s current posture may prove penny-wise and pound-foolish.

 

2) Asset Quality

A close inspection of the Company’s balance sheet reveals a distributing incongruity between the quality of the assets compared to the liabilities.  First, it is important to highlight several critical off-balance sheet liabilities:

 

            Off-Balance Sheet Liabilities

            Preneed Insurance Funded Contracts---$530MM

            Currently, 43% of STEI’s preneed funeral contracts are funded by life insurance or annuity contracts issued by third-party insurance companies.  When the insured dies, the insurance proceeds fund the costs of the services or merchandise.  The net amount of insurance contracts that have not been fulfilled as of October, 2010, was $530.4MM.  Because insurance policy proceeds may be used by customers for other purposes and are portable to other funeral service providers, the Company is not required to put the asset on the balance sheet.  However, the Company does include the $530MM in preneed insurance contracts in its backlog, a metric that purports to convey “anticipated future revenue.” With anticipated future revenues come the costs associated with delivering those revenues.  Because the economic substance of the preneed insurance contracts is the same as the preneed trust assets, it is proper to include the $530MM on the balance sheet. 

 

                 Florida Bond---$24.8MM

            The Company is required to maintain a $24.8MM bond to guarantee funding obligations related to funds withdrawn in fiscal year 2001 from a preened funeral trust in Florida.   

           

            Book Value

            Stated book value is equal to $431MM, or $4.73/share; tangible book value (ex. non-current deferred tax assets and goodwill) is equal to $92.4MM, or  $1/share.  Non-current deferred tax assets and goodwill comprise $339MM (15%) of stated asset value; is it worth examining them.   

 

            Deferred Tax Assets

            Non-current deferred tax assets are carried at $92.1MM, and represent about 5% of the stated asset value.  Deferred tax assets are not often scrutinized, but given that they comprise a significant portion of the intangible asset value, it is worth putting them under the microscope.  Deferred tax assets and liabilities are not created equal.  Many deferred tax liabilities result from different depreciation schedules and thus the temporary differences are almost certain to reverse.  Conversely, deferred tax assets often come in the form of net operating losses or other carryforwards that are less certain to be realized.  The risk and timing associated with utilizing these assets is uncertain, thereby making the non-discounted balance sheet carrying value misleading.   

            Such is the case with STEI, which as of October 30, 2010, held $197MM (≈72% of the total deferred tax asset account) in deferred tax assets termed “deferred preneed sales and expenses.”  In many states where the Company operates, it pays cash taxes on preened sales at the time of sale even though revenue is not recognized until the service or merchandise is actually delivered.  The mismatch creates a deferred tax asset that is reversed only when the contract is delivered and revenue is recognized. 

Two shrouds of uncertainty abound: 1) whether the customer will actually pay and 2) when the customer is going to die.  Even Nostradamus would have difficultly nailing both of those.  To gain a more accurate picture of the true asset value associated with deferred tax assets, the future tax benefits should be risk-adjusted and discounted to present value.  Of course, GAAP does not require this, nor would it necessarily be feasible.  But at a minimum, it raises questions about asset quality; long-term deferred tax assets are not cash equivalents.      

 

                        Goodwill

            The goodwill account ($247MM) represents ≈11% of stated asset value.  I am suspicious of large goodwill balances when the company posses no discernible competitive advantage as evidenced by underwhelming returns on capital-See below:

 

            Return on Invested Tangible Capital                              

(Operating Earnings/ Net Working Capital +Net Fixed Assets+ Cemetery Property)

2010: 9%

2009: 7.5%

2008: 9%

2007: 10%

2006: 11%          

2005: 11%          

2004: 16%

2003: 13%

 

As Mr. Buffet so lucidly explained with his See’s Candy case study, a company is logically worth more than the value of its tangible assets when it generates above market rates of return on those assets.  The figures above show that STEI has consistently generated modest, declining returns on its tangible assets.  The Company cites it reputation, long-standing relationships with customers and a quality preneed sales force as sources of competitive advantages in it business model.  However, these intangibles are of little economic value to the investor if they don’t translate into high returns on capital.  Tangible Book Value (excluding non-current deferred tax assets and goodwill) is equal to $92.4MM, or ≈ $1.00/share.  At the current share price, STEI trades at almost 7x tangible book.  The equity investor is paying a substantial premium to tangible asset value to own intangible assets that create few discernible competitive advantages for the business. 

 

Liabilities

Unlike the nebulous asset value, the liabilities are solid.   See Selected Liabilities Below:

 

Liabilities

Current Liabilities:                                                                                               $89MM

 

Deferred Preneed Funeral Revenue:                                                                   $242MM

 

Deferred Preneed Cemetery Revenue:                                                              $256MM

 

 

Deferred Preneed Funeral and Cemetery Receipts held in Trust:  $591MM

 

Perpetual Care Trust Corpus:                                                                             $242MM

 

Preneed Insurance Contracts:                                                                              $530MM

 

3.125 Senior Convertible Notes, due 2014:                                       $77.4MM

 

3.375% Senior Convertible Notes Due 2016:                                                      $38.5MM

 

 

6.5% Senior Notes due 2019                                                                                $200MM

 

                 

Total Liabilities (certain liabilities omitted)(adjusted):                                       $2.32BB

 

                 

                   Total Debt/Equity:  5.3x

 

                  Long-Term Debt/Equity:  2x                                         

 

Assets/Equity:  6.3x

 

Tangible Assets/Equity:  5.5x       

 

STEI has a highly leveraged balanced sheet.  Any asset deflation in the value of the trust assets brought on by worsening financial market conditions would further erode the equity.  On the other hand, the liabilities related to the deferred preneed obligations will rise if the costs of delivering those services increases, which it almost certainly will due to the natural pull of inflation.  A scenario in which the Company experiences gross margin compression, declining revenues and asset deflation would prove to be a very potent cocktail.   

           

            One more word of caution word about the balance sheet….

 

Cemetery Perpetual Care Trust Investments

            The Cemetery Perpetual Care Trust account is carried at $242.5MM on the balance sheet.  However, this “asset” is different than the Preneed Funeral Trust Investments or the Preneed Cemetery Trust Investments.  Perpetual care laws mandate that death care companies maintain a cemetery perpetual care trust to ensure that their cemeteries are properly maintained.  Generally, between 10%-15% of the proceeds from cemetery property sales (“interment rights”) are deposited into perpetual care trust; the income from this trust is used to defray cemetery maintenance costs.  But, the principal of the trust must be kept in perpetuity.  The Company has compared this trust account to an “endowment.”

Theoretically, this asset benefits equity holders because the earnings on the trust assets are used to keep the cemeteries in good condition, which will then attract customers and drive sales.  But unlike inventory or high quality real estate, these trusts assets can never be monetized in a way that returns cash to the equity.   The Company does not even a have a legal claim on the assets in the Cemetery Perpetual Care Trust.  If this asset is excluded from the calculation of tangible book value, Tangible Net Worth is Negative $173MM.

 

3) Quality of the Cash Flows

Management depicts STEI as a consistent, healthy cash flow generator.  But a careful examination STEI’s operating cash flows reveals a significant amount of one-time, non-recurring cash inflows that raise questions about the quality and sustainability of the Company’s cash flows going forward.  See the adjusted free cash flow figures below:

           

 

            TTM:

                  Operating Cash Flow: $69.9 (adjusted for share-based compensation expense in 2010; 2011)

                  Less: maintenance capital expenditures: $14.2MM (annualized):

=Free Cash Flow to the Equity: $55.7MM

 

2010:

                  Operating Cash Flow: $63.4MM

                  Less:  $2.45MM share-based compensation expense

                  Less:  $12.7MM maintenance capital expenditures

=Free Cash Flow to the Equity: $48.2MM

 

 

2009:

Operating Cash Flow: $84.9MM

Plus: $1.7MM due to Hurricane Katrina related payments

Less: $31.6MM reduction in income tax payments due to tax refunds and tax reductions from “tax planning strategies”

Less: $2.2MM share-based compensation expense

Less: $13.1MM maintenance capital expenditures

                  =Free Cash Flow to the Equity:   $39.7MM

 

                  2008:

                  Operating Cash Flow: $84.5MM

                                    Less: $21.8MM tax refunds

                                    Less: $2.81MM share-based compensation expense

                                    Less: $17.4MM maintenance capital expenditures

                  =Free Cash Flow to the Equity: $42.4MM

 

 

 

                  2007:

                  Operating Cash Flow: $81.9MM

Less: $2.1MM “unusual trust withdrawals”

Less: $2.1MM payment from execution of lease for mineral rights on cemetery property

Less: $3.2MM business interruption insurance proceeds due to Hurricane Katrina

                                    Less: $1.3MM other insurance proceeds related to Hurricane Katrina

                                    Less: $5.8MM tax refunds

                                    Less: $1.57MM share-based compensation expense

                                    Less: $18.9MM maintenance capital expenditures

                  =Free Cash Flow to the Equity: $46.93MM

                 

 

                  2006:

                  Operating Cash Flow:   $90.1MM

                                    Plus: $3.8MM Katrina related payments

                                    Less: $14.8MM “unusual trust withdrawals”

                                    Less: $2.14MM share-based compensation expense

                                    Less: $20.7MM maintenance capital expenditures

                  =Free Cash Flow to the Equity: $56.26MM

 

A series of tax refunds, “unusual” trust withdrawals, and Hurricane Katrina (STEI is headquartered in New Orleans) related insurance receipts have obscured the true picture of sustainable, recurring cash flow.  Averaging the last five years of adjusted operating cash flow (substituting TTM for 2010) yields a normalized figure of $48MM of free cash flow to the equity versus $65.3MM, unadjusted.

 Looking forward, equity investors must consider the appropriate yield to demand on their investment given the highly leveraged capital structure and deteriorating fundamentals of the business.  Based on the current market capitalization, the free cash flow yield to the equity is ≈8.8%.  For reference, the senior secured debt just refinanced due in 2019 is getting paid 6.5% to sit at the top at the capital structure.  On pg. 35 of the 2010 10-K, the Company notes that it used a 9% Weighted Average Cost of Capital (“WACC”) to discount its projected cash flows for the goodwill calculation.  Given that the after-tax cost of debt will pull the WACC down relative to the cost of equity, and this Company is highly levered, STEI is implicitly signaling to equity holders that its internally calculated cost of equity is greater than 9% (whether WACC is an analytically robust metric is a debate for another day).  Equity holders are getting a raw deal if they are providing funds at a steep discount to the rate that the Company expects to pay them for the use of those funds.                   

 

4) Deteriorating Industry Fundamentals

The continued growth of cremation coupled with a static U.S. death rate will likely weigh heavily on STEI’s operating performance going-forward. 

 

            The 2 Major Headwinds:

 

            1) Cremation

            In 2001, cremation represented 27% of the burial market in the United States.  In 2010, the figure stood at 36%; this percentage is forecasted to grow to 46% by 2015. 

The growing immigrant population in the United States has helped fuel the rise of cremation as many immigrant groups (i.e. Japanese, Hispanics) opt for cremation over burials.  The difficult economic environment has also been a large factor as consumers are increasingly unwilling or unable to purchase expensive funeral services.  According to the National Funeral Directors Association, the average cost of a funeral in 2009 was $6,560.  A funeral is the third costliest expenditure that most people make, behind a house and a car.  In contrast, the average cost of a cremation runs anywhere from $500-$3,000, depending on the services.  Greater environmental awareness and a push to be “green” have propelled cremation rates higher in states on the coasts.  

The cremation trend is borne out in STEI’s operating results. See below:

 

                                    Cremation as a Percentage of Funeral Services

2004                            37%

2005                            37%

2006                            39%

2007                            39%

2008                            40%

2009                            41%

2010                            42%

 

 

*In the 2005 10-K, cremation was mentioned 52 times; In the 2010 10-K it was mentioned 88 times

 

To its credit, the Company has responded to the trend by building cremation gardens, expanding its cremation services and merchandise, and hiring a vice president of cremation.  But, one critical statistic encapsulates the stiff headwinds facing the company:

 

                        Percentage of STEI’s Cremations characterized as  “Direct Cremations”

2004:  49%

2005:  54%

2006:  56%

2007:  56%

2008:  56%

2009:  56%

2010:  64%

 

STEI classifies cremations as either “full service” or “direct.” A full service cremation may include a funeral service, merchandise and memorialization or burial of the remains.  A full service cremation can result in funeral and cemetery revenue and profit margins similar to those of a traditional funeral service.  Conversely, a direct cremation generally does not include a funeral service, casket, or memorialization of the remains.  Direct cremations produce no revenue for cemetery operations and lower revenues and profit margins for funeral operations when delivered through a traditional funeral home.  Direct cremations are effectively a commodity with commodity-like pricing ($450-$950).  

 

The increased commoditization of the industry has adversely affected STEI’s cemetery segment profitability.  See below

 

                                    Gross Profit per Cemetery Location

                 

                                    Gross Profit per Cemetery Location             # of Locations

TTM:                           $122,207                                                         140

 

 

2010:                           $174,740                                                         140

 

 

 

2009:                           $116,00                                                           140

 

 

 

2008:                           $174,237                                                         139

 

 

 

 

2007:                           $289,187                                                         139

 

 

 

 

2006:                           $283,622                                                         143

 

 

2005:                           $205,201                                                         144

 

 

2004:                           $246,421                                                         147

 

 

2003:                           $201, 317                                                        148                                                                 

 

As more customers opt for cremation, STEI will sell less high-margin cemetery services and merchandise.  This phenomenon strikes at the heart of one of the Company’s proclaimed competitive advantages; a large inventory of cemetery property.  With less cemetery plots being sold, fewer long-term relationships with families are being forged.  This ultimately results in a diminution in the customer base.  It seems unlikely that families will establish the same emotional connection to a crematorium as they do a cemetery.  As long as cremation continues to gnaw at cemetery profitability, a large inventory of undeveloped cemetery property becomes an increasingly less desirable asset.       

 

            2) Flat Death Rate

            Approximately two-thirds of STEI’s business is termed “at-need;” customers seek merchandise and services at the time of death, not before (preneed).  Thus, it becomes increasingly difficult to grow the top-line when your customers are not dying.  See the statistics below:

 

            -In 2009, the age-adjusted death rate in the United State reached a record low of 741.0 per

100,000  (CDC)

 

                  -In 2009, life expectancy was the highest in recorded history, reaching 78.2 years  (CDC)

 

-Since 2000, life expectancy has increased by 1.8% (or approximately 17 months for the general population (76.8 to 78.2 years) (CDC)

 

                  -U.S. death rate has been in overall decline for the last 20 years (U.S. Census Bureau)

 

                  -U.S. death rate is expected to stay constant at 8.3 (8.3 deaths per 1000 people) for the next

ten years (US Census Bureau)  

 

                  -An increase in the death rate in not predicted until 2020 (U.S. Census Bureau)

 

                  An attenuation in the death rate makes it difficult for the Company to organically grow the top-line.  As a corollary, the U.S. Census Bureau estimates that the population over the age of 50 is expected to increase from 76.8MM in 2001 to 118.1MM in 2020.  With people living longer, STEI’s preened business becomes even more critical to its success.  Yet, the preneed sales figures have been steadily declining for the last five years.  See below:

 

                                                Preneed Sales

           

                                    Funeral                Cemetery                               Total

 

Q2 2011 v. Q2 2010:                     -6.8% YOY                  +7.9% YOY                                                    

 

2010:                                             $95MM                       $48.2MM                            $143MM           

 

2009:                                             $99MM                       $48.7MM                            $147MM

 

2008:                                             $97MM                       $53.6MM                               $150MM

 

2007:                                             $102.6MM                  $55MM                               $158.3MM

 

2006:                                             $103.7MM                  $59.8                                    $163.5MM

 

                                                                                                                                                                                            

The almost 20% decline in cemetery preneed sales from 2006 levels to 2010 levels is particularly troubling given that preneed cemetery sales sow the seeds for a host of potential future sales.  Undoubtedly, the economic crisis was a significant drag on preened sales as pinched consumers avoided/postponed expensive purchases.  And the 2011 Q2 preneed cemetery sales were up almost 8% from Q2 2010.

However, the table indicates that sales volumes began to decline before the recession started and are still well-below pre-recession levels.  If one accepts that the economic crisis had an indelible impact on consumer spending habits, at least in the short-to medium term, then it is unlikely that preneed sales will return to pre-crisis highs any time soon.  

 

5) Valuation:

 

Share Price (7/29/10): $6.95

Shares Outstanding: 91,064,109

=Market Capitalization: $632.89MM

                  +$321.7MM in long-term debt

                  +$591.7MM deferred preneed funeral and cemetery receipts held in trusts*

                  +$24.8MM Florida Bond

                  -$79MM in cash and cash equivalents

                  =Enterprise Value:  $1.49B

 

*A quick comment on the debt included in the Enterprise Value Calculation.  When a trust-funded preneed funeral or cemetery contract is entered into, STEI records an asset on the balance sheet termed either “preneed funeral receivables and trust investments” or “preneed cemetery receivables and trust investments.”  Correspondingly, the Company records a liability termed “deferred preneed funeral revenues” or “deferred preneed cemetery revenues.” Principal amounts deposited in the trust accounts generally range from 70%-90% of each installment received (depending on state law).  As the customer makes payments on the contract prior to performance by the Company, the Company deposits into the related trust the required portion of the payment based on applicable state law and reclassifies the corresponding amount from deferred preneed funeral revenues into “deferred preneed and cemetery receipts held in trust.”  Effectively, the “deferred preneed funeral and cemetery receipts held in trust” (a liability on the balance sheet) represents actual cash received in exchange for future services.  Moreover, there is an implicit interest cost on this liability because the cost of delivering future services will almost certainly increase due to inflation.  The economic consequence to the buyer of the entire business is the assumption of an interest bearing liability to provide future services and merchandise in exchange for cash received in advance.     

 

TTM (April 30, 2011):

EV/EBITDA: 15x

EV/Operating Earnings: 20x

EV/Unlevered Free Cash Flow: 19x

FCF Yield to the Equity: 8.8%

 

Trailing P/E (earning from continuing operations): 19.3x

Price/ Book Value: 1.46x

Price/ Tangible Book Value (excluding non-current deferred tax assets & goodwill): 6.8x

 

Forward P/E ($.41/share analysts estimates): 17x

 

5-yr. Normalized Operating Margin: 14%

5-yr. Normalized EBITDA Margin: 20%

 

The market is paying a high multiple of trailing earnings for a business that has exhibited deteriorating fundamentals as evidenced by declines in revenues, operating earnings and returns on capital over the last several years.  The structural challenges facing the industry make it difficult to envision how STEI can increase sales and defend margins in a manner that squares with Mr. Market’s current handicapping.  The unrealized loss positions in the trusts and balance sheet quality alone should weigh more heavily on the valuation.  

 

 

5% YOY Top-Line Growth:

 

                                                                        2012(E)                    

 

Revenue:                                                         $551MM

 

 

EBITDA (20% Margin):                                 $110MM

 

                                                                                                           

                                                                            10x                                                              12x

Enterprise Value:                                           $1.1BB                                                            $1.32MM                                                                         

 

 

Implied Equity Value:                                    $240MM                                                         $459.8MM

 

                 

 

Price Per Share:*                                           $2.63 (62% downside)                             $5.00 (28% downside)

 

*assumes no dilution

                                                                                                           

Management stated on a recent conference call that it does not like to pay more than 9x EBITDA for potential acquisition targets.  Assuming that STEI’s brand, cemetery property and scale deserve a premium multiple to the industry, the table above implies 28%-62% downside to the current price based on 5% top-line growth and normalized 20% EBITDA margins.  Assuming 2% sales growth, in line with the pro forma figures, puts greater pressure on the share price: 

 

2% YOY Top-Line Growth:

                                               

                                                2012(E)

 

Revenue:                                                         $520MM

 

EBITDA (20% Margin)                                  $104MM  

 

 

 

                                                                        10x                                                12x

 

 

 

Enterprise Value:                                           $1.04B                                           $1.24B

 

 

Implied Equity Value                   :                    $179.8MM                                    $379.8MM                                   

 

 

 

Share Price:                                                    $1.97 (71% downside)           $4.17 (40% downside)

 

 

Another way to think about valuation is to put an 10x multiple on the $48MM adjusted normalized free cash flow figure, assuming that equity will require a 10% yield on the investment given the attendant risks (which doesn’t seem unreasonable).  This results in an implied equity value of $480MM, or a share price of $5.95 (24% downside)--significant loss position in trusts should weigh this down further    

 

 

Market Dislocation/Catalysts:

-Larger than expected losses in trusts portfolios compel STEI to realize significant losses causing unforeseen earnings miss;

 

-Continued deterioration in business fundamentals induce multiple re-rating to reflect diminished growth prospects  

 

Due to the small-market capitalization and nature of the industry, STEI does not receive much coverage from the analyst community.  The analysts that do follow the stock are generally bullish, with Bank of America Merrill Lynch being the most prominent.  Currently, STEI is one of Bank of America Merrill Lynch’s proclaimed best small cap ideas.  In a note written to clients in June, Bank of America Merrill Lynch wrote “…with cash reserves of $79MM, the company should be adequately financed to drive EPS growth in the absence of higher trust returns.”  This seems somewhat analogous to telling passengers in a slowly sinking ship not to worry because there is enough material on board to plug the holes, even though the shore is nowhere in sight. 

While the Company’s cash position does make an imminent funding shortfall unlikely, investors should be weary of the prospect of the Company depleting its cash reserves to “drive EPS growth.”  Further, the Company can always divert its cash flows to cover losses, but this results in less cash available for the equity.  STEI and the analysts seem content to ignore the large unrealized losses in hopes that the market will eventually spring back.  And maybe it will.  If the trust portfolios go on a tear in the next year, then this thesis will certainly be weakened.  But, with the S&P up nearly 90% from its 2009 March lows, and several headwinds facing the broader economy, another rip-roaring rally seems to be a low probability.  In the mean time, STEI continues to nurture significant losses in the trust portfolios.       

            Additionally, the bullish outlook from the analyst community evinces a myopic focus on the short-tern (i.e. quarterly earnings).  The Company’s operating results have deteriorated over a multi-year period and the industry faces major obstacles.  Yet, the current valuation seems to reflect all of the short-term bullish sentiment but none of the longer-term challenges.  As the new realities facing the Company reveal themselves through depressed results, the market should exhibit less willingness to pay high multiples for future earnings.             

 

-Realization of large losses in the trust portfolios

 

-continued deterioration in operating metrics result in multiple re-rating