Description

StoneMor Partners LP (“STON”) is a master limited partnership which owns and operates cemeteries and funeral homes throughout the United States. As an MLP, the company doesn’t pay dividends. Instead it pays distributions. Currently its distribution yield is 9%, and it has attracted income-seeking investors who are chasing yield.

My short thesis is that STON is hemorrhaging cash and cannot maintain its current quarterly distribution of $12MM ($48MM annual). Since 2009, ALL of the company’s distributions have come from money from new investors either through stock offerings or increased borrowing. For the reasons explained below, this transfer scheme is not sustainable.

I recommend shorting the stock. That said, because STON is an expensive stock to short, I would also recommend—if you can do it—buying the bonds and shorting the stock as a pair trade.

THE BUSINESS

STON consists of three operating segments: pre-need cemetery, at-need cemetery and funeral home. In the pre-need and at-need cemetery segments, STON sells interment rights (burial lots, crypts, cremation niches), merchandise (vaults, caskets) and services (installation of vaults and caskets). The funeral home segment performs standard funeral home functions.

The at-need cemetery segment and the funeral home segment are fairly straightforward. However, the pre-need segment, which comprises 40% of sales, complicates STON’s accounting and obscures the economic reality of this business. When a pre-need sale is made, the customer is paying for the burial lot, the casket and installation of the casket before he has died. STON therefore cannot perform 100% under the contract and book all revenue because it hasn’t substantially performed yet. Instead it recognizes revenue piecemeal. The company actually provides the timing of revenue recognition for a standard contract.

Year                         0         1         2         3         Time of death

% recognized           19%    6%      73%    1%      1%

As you can see, most of the revenue is typically recognized in Year 2. This is when the company performs a “closing.” It installs the vault into the customer’s burial lot, and it delivers the casket to a third-party (among other things). And once it’s done this, it can book most of the revenue and also release proceeds which pursuant to state law have been held in STON’s Merchandise Trust.

This second part is very important. Because of the trust requirements, booking revenue is not just an accounting action. It also increases STON’s cash flow—because booking revenue releases the funds from the Merchandise Trust.

The trust, incidentally, is mandated by law because of the unique nature of buying a coffin and burial lot before you die. In essence STON is getting cash upfront in exchange for the promise to perform mostly in a couple years and completely at some undetermined future date (the customer’s death). Trusting requirements help prevent the exact behavior STON is engaging in—which is collecting cash up-front and immediately distributing it out to unit holders. Or in STON’s case, not getting the cash up-front and then distributing it out to unit holders.

FINANCIALS

Stock Price: $25

Market cap: $500MM

Cash: $8MM

LT Debt: $255MM

EV: $747MM

[Note: EV doesn't include General Partner's interest which has book value of $386k but is likely worth significantly more under current market conditions.]

Revenue (ttm): $240MM

Operating Income: $14MM

Net income: ($3MM)

Operating Cash Flow: $30MM

Free Cash Flow: $20MM

VALUATION

EV/Operating Income: 53

EV/Free Cash Flow: 37

EV/Book: 5.5

Interest Coverage Ratio: 0.75

THE BULL CASE

• Equity Risk Premium is 5%. However, with the market’s Schiller P/E at 22, there is a high likelihood we’re in for a protracted sideways market. So if capital appreciation is out, why not make money on the income side?

• STON’s acquisitions and balance sheet growth obscure a strong company which will become profitable when the economy turns around.

• Market misunderstands STON because of complicated accounting used for pre-need segment which artificially depresses traditional valuation metrics like EBIT and FCF.

THE BULL CASE IS “BULL”

• Dividends may be a good marker of quality. However, STON’s distributions are not a sign of strength but a way to mask the absence of it. Cumulative FCF (net of acquisitions) since 2007 is about -$130MM. Which is just stunning for a company with $130MM in book value.

• So where has the money for distributions come from? New investors. Since 2007, STON has raised $215MM in new equity and $100MM in debt. New investors pay old. STON isn’t paying dividends. It’s liquidating.

• STON has a cookie jar reserve of deferred revenue as well as the ability to “manage” when cash is released from its Merchandise Trust. These two factors allow STON to potentially manipulate its numbers. So as bad as things seem, they may be worse.

REQUIRED RATE OF RETURN IS UNSUSTAINABLE

As you can see, STON’s cash flows don’t even come close to funding the interest payments on its debt and the distributions STON needs to make to unit holders to maintain its sky-high stock price. STON has been running a massive deficit for six years now and shows no sign that it will ever be able to climb out of the hole it has dug for itself.

One other thing to keep in mind: we’re being unrealistically generous when we use operating cash flow to calculate the deficit. Really free cash flow should be used. In 2012, the company had CAPEX of $14MM and made acquisitions of $28MM. Even if operating cash flow weren’t already likely inflated (I’ll get to that), these two other numbers bring the free cash flow number crashing down into negative territory. You might say deducting acquisitions from FCF is harsh, but it’s necessary when you’re dealing with a serial acquirer like STON.

Below you can see how bad FCF has been for some time:

                   2007          2008              2009              2010              2011              2012

Op Cash     18,973          21,144           14,729            3,107               5,466             31,896

Capex        (5,640)         (9,185)           (7,294)        (10,078)           (13,166)          (11,972)

Acquis      (78,907)         (5,621)                -            (39,127)           (16,142)          (27,976)

FCF          (65,574)           6,338            7,435          (46,098)           (23,842)           (8,052)

AGGRESSIVE REVENUE RECOGNITION

STON’s operating cash flow seemed to have improved substantially in 2012—though it’s still far, far below where it needs to be in order to fund distributions to unit holders. But when we look closely at the improvement, much of it comes from the fact that STON has been drastically cutting the amount of money it sticks in the Merchandise Trust. Remember: when STON makes a sale, it must stick 40-70% of the proceeds in the Merchandise Trust and can only take the money out once it’s performed a closing (which typically takes place 2 years after the sale).

This arrangement is very easily gamed. In 2010, there were $14 million in net cash inflows into the Merchandise Trust. In 2011, there were $24 million. However, in 2012, according to the footnotes, there was only $3 million in net cash inflows. This is just strange. STON’s sales increased 6% and yet it stuck far less money into the Merchandise Trust than it has in previous years.

When we look at deferred revenue, we see the same thing. STON has $500MM in deferred revenue on its balance sheet. This can be used as a cookie jar reserve out of which STON can pull and book revenue. Below is the increase in deferred revenue as shown on STON’s cash flow statement. 

2007              2008              2009              2010              2011              2012

15,668           22,414           32,225           46,060           47,598           47,548

STON’s sales have had a double digit CAGR over this time, and deferred revenue has of course also been growing—until 2010. At that point deferred revenue stops increasing. Why?

2010 was when STON’s cash flow numbers started to completely tank. What’s likely happening is that STON is getting aggressive about booking revenue, so it can take the money out of the trust and pump up its operating cash flow. This number is especially important to STON because it can only make distributions out of “distributable free cash flow” (of which operating cash flow is a major component).

DISTRIBUTABLE FREE CASH FLOW IS A NONSENSE NUMBER

As an MLP, STON must distribute most of its cash in order to maintain its tax status. Below is the formula STON uses to determine how much of its cash flow it can distribute.

Operating Cash Flow

(+) Merchandise Trust inflows

(+) Increase Accts Receivable

(+) Decrease Merchandise liabilities

(+) Decrease in Accts Payable

(+) Other float related changes

(-) Maintenance CapEx

(+) Growth CapEx reclassified as OpEx

(+) Cash on hand

= Distributable Free Cash Flow

Why on earth are merchandise trust inflows counted as present-day cash flow? STON doesn’t get most of the money it puts into the Merchandise Trust until two years in the future! Even by STON’s own admission, it can’t take the money out until it has “earned” the revenue, and the company itself states that it earns the bulk of the revenue on a typical contract in Year 2.

This is just complete nonsense. STON treats its trusting requirements as some sort of meaningless technicality they must comply with. But the reality is they haven’t even halfway performed on most customer contracts until Year 2. The state-mandated trusting requirement actually makes sense!

STON’s attitude reminds you of the Seinfeld episode where Jerry goes to pick up his rental car and finds out the rental company has TAKEN his reservation but it hasn’t HELD his reservation. “Anyone can just take [a reservation]!” he says. Well, anyone can promise to sell you a burial lot, a vault and a coffin, but it takes some sort of actual effort on the part of the company to “earn” the revenue it’s just made on you.

But STON not only hasn’t earned its Merchandise Trust inflows, it hasn’t even collected them yet. They simply do not represent cash on hand. It won’t be getting the vast majority of the money for 2 years on average. The amounts of money we’re talking about here are significant—$12-$24MM yearly—particularly in light of the fact that operating cash flow was $3MM, $5MM and $32MM in the last three years respectively.

The absurdity of this aggressive accounting treatment is exacerbated by the fact that STON pays 10% interest on its debt. When you’re as indebted as STON is, the timing of cash flows becomes especially important. And having to wait 2 years for cash to come out of a trust is especially damaging. If STON had the cash now, it could pay down the debt today and stop additional interest from accruing. But of course STON can’t do that, and besides it earns closer to 4% on the assets it keeps in the trust. That isn’t close to keeping up with the 10% it has to pay on its debt.

RELIANCE ON NEW INVESTOR MONEY

STON is spending cash that its operations simply cannot even come close to providing. So how does it keep going? With new investors’ money.

For the past four years, ALL of the money used to pay unit holders has come from new investors. This can’t go on forever. STON only has about $40MM more it can borrow under its existing revolving credit facility, which keeps getting amended over and over and over (with attendant fees). And if STON does another capital raise, since it now only has $8MM in cash, the stock price would plunge.

Also its interest coverage ratio is well below 1, which in a company with aggressive accounting and serial acquisitions is about as scary as a Bernie Ebbers Halloween mask. Even worse, the coverage ratio has been below 1 since 2009. In other words, for the past four years, this company has been unable to pay even the interest on its debt out of its operational results. Meanwhile it continues to go further into debt in order to make acquisitions and sustain an unsustainable quarterly distribution. 

WHY WOULD MANAGEMENT DO THIS?

• Management is not aligned with shareholders. Specifically, they have a dangerous incentive to keep distributions nosebleed high because the higher the distribution, the higher the percentage of it management keeps.

• The general partner keeps 15% of any distributions above $.5125 per unit but below $.5875 per unit. This explains why management pays out $.58 per unit per quarter. It keeps 15% of the distribution (above .5125).

• Original founders cashed out their stake in February 2012 in a secondary offering. Note: some of the founders were involved in The Loewen Group, a cemetery business which filed for bankruptcy in 1999.

ORGANIC GROWTH

STON is a serial acquirer, and as the company states in its filings, most of its revenue growth has come from acquisitions. Based on its disclosures and pro forma figures, STON has paid between 1.8x and 2.2x revenue for the cemeteries and funeral homes it has acquired. Multiplying the inverse of these multiples to the purchase price gives us the amount of revenue each acquisition contributes to STON’s top line (assuming zero growth).

Over the past three years, STON has made $80 million in acquisitions. Let’s be conservative and say it paid 1.8x revenue for each company it purchased. That means STON’s acquisitions have contributed $44 million to its top line. During the same period, revenue has increased by $61 million. $61 million minus $44 million = $17 million in organic growth. Spread over three years, that gives us 3% average organic growth per year.

Over the same time, STON’s competitors have had different results. CSV, which is a little smaller than STON, has had negative organic growth. STEI had 1.3% compound average growth, and SCI had 1.7%. (Note: I made a hugely simplifying assumption that all three of these companies also paid about 1.8x revenue for the companies they acquired.)

In 2011, the results were vastly different. STON had about 10% in organic growth. Meanwhile SCI and STEI had less than 3% organic growth, and CSV had 0.6% organic growth.

STON has performed better than the rest of the industry. For a company which has an incentive to recognize revenue aggressively because doing so is a matter of survival, 3% organic growth simply isn’t good enough. It’s also worth noting that these competitors haven’t had the same financial or cash flow problems STON has faced over the past three years.

Even if STON truly is actually growing organically at 3%, that isn’t enough to get itself out of the hole it’s in.

VALUATION

Let’s assume that STON’s debt, which is $250MM and almost double book value, is forgiven. Let’s also assume STON pays no taxes going forward. Below is a simple valuation model for the company (note: I use 1.5x the growth rate instead of 2x the growth rate as Graham did. When Graham used 2x, it was to show how absurd the premium was on growth).

If STON didn’t have any debt to pay interest on and it didn’t have to pay taxes, it would be worth at most $9.20. And even that price is based on a 3% organic growth rate that is suspect.

Currently the stock price is $25—more than double $9.20/share. An $9.20 stock price would give it a $180MM market cap. But of course STON has to pay taxes and it has $250MM in debt—which would swallow a sensible equity valuation of the company ex debt.

In terms of intrinsic value, it doesn’t seem there’s much here at all. People who have bought STON for the income yield are in for a shock when the music (the outside financing) stops.

Catalyst