DEATH: The new growth industry
Posted on February 12, 2008 by Richard Beddard
Filed Under Companies |
Unfortunately it’s not quietly bumping people off. What a great scoop that would be!
Neither is Dignity (DTY) on my ‘approved list‘ of companies with low debt and uncomplicated looking accounting but I’m attracted by investors’ apparent perception that growth is pretty much guaranteed.
That’s because Dignity is in the funeral business, and the UK’s death rate is consistently around 560,000 people a year. It’s also big, second only to the Co-op in funeral services, and competing against small local firms.
Because of its strong position in a stable market investors, bondholders and directors have confidently loaded the company up with debt, which it has used to buy up smaller competitors and buy back its own shares. Since its flotation in 2004, it’s trounced the stockmarket, though it’s tracked the market down since October, perhaps giving investors an opportunity to buy.
Understand the debt and you understand Dignity’s growth story. Before Dignity floated in 2004 the whole business was ‘securitised‘, a horrible term which means it was refinanced by loans secured on its future cash flows. Think of it like a mortgage. Dignity issued loan notes repayable in annual instalments over the following twenty-six years, but instead of being secured on physical assets, they’re secured on the money Dignity will make in future from burying and cremating people.
Any extra cash belongs to shareholders who receive dividends and expect to gain from a rising share price in the normal way. It’s not much different from any listed company with debts, except for the size of the debt. In a typical year Dignity’s operating profit is only about twice its interest payments. It’s interest cover is two.
Going back to my approved list, I tend to screen out companies with interest cover (operating profit divided by interest payments) of less than four. That’s because, as a rule, debt ridden companies are more risky. If Dignity’s operating profit halved there would be none left for shareholders (it would make a loss) after the company paid its bondholders. It might even struggle to pay the bondholders, which would be catastrophic.
That’s why stability is critical to any investor in Dignity.
But why take on so much debt? That’s where the growth comes in. Dignity is growing revenues, slowly, almost metronomically at about 5% a year. It’s buying local rivals, and it’s bidding for local authority contracts to run crematoria. Profits are growing marginally faster than revenues, but there’s nothing much to get excited about:
That is, until you look at earnings per share, perhaps the most important number for shareholders.
The fewer shares there are, the more profit is attributable to each one and, other things being equal, the more valuable your shareholding. The extra growth in earnings the company reported in 2006, and should report for 2007 (in March), was because it bought back £80m of shares with money it borrowed in 2006. Here’s the spreadsheet:
So, although the business is only growing slowly, its earnings are growing faster. The question is, how long can Dignity keep this up? The answer seems to be for as long as it can slowly grow and raise new funds. As it makes more money and repays its debt it can afford to borrow again, and again. And it can use that money to buy back more shares.
It sounds a bit like perpetual motion to me and I’ve had fun writing an iBall script on Dignity imagining reasons it might stop: a cure for aging, Stelios flying in and launching easycoffin. Not very likely. Perhaps the biggest threat is from inside. That in their efforts to feed the buy back machine, Dignity’s managers borrow too much or make unprofitable acquisitions. But that’s just speculation.
And here’s some more. What if interest rates were to rise? Dignity’s appetite for debt fuelled buy-backs would probably fall. What if investors’ appetite for lending remained low? Dignity’s loan notes aren’t the kind of toxic debt that caused the credit crunch but future issues could prove difficult to sell, simply because in jittery markets there are fewer buyers.
The business wouldn’t be in trouble, but the share price could be as investors lowered their expectations of earnings growth.
Fears about debt then might explain the undignified kink in the tail of Dignity’s hitherto unidirectional (that’s up) share price. Investors still rate it though. It’s trading at 28 times earnings in 2006 although, much as I’m loathed to use analysts’ eps forecasts, they might be a better guide on this occasion because:
- The results are for March, a relatively short period to forecast!
- In November Dignity said it was on target to meet forecasts.
- Dignity’s results should be predictable, after all revenues and cashflows are stable.
So the PE is probably more like 23, still well above average. A high PE is, of course, a turn off from a value investor’s point of view. But it’s also a sign that investors on the whole are confident.
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