Double Pain & Doubling down in Dignity

So I have been busy eating  so called humble pie lately. One could also make a joke of being buried by my latest investment. To recap, I invested in Criteo and a few days later the stock dropped -30%. I invested in Dignity and a few days later it dropped -50%. Although the companies are very different, the situation the stocks were in at my time of purchase were somewhat similar. Two pictures says more than thousand words:

In both cases the market had caught on to something that worried it. In both cases I believed it to be short term noise that does not change the long term prospects of the companies. So for me it was buying opportunities in “misunderstood” stocks. As it turned out, it was rather me that had misunderstood the seriousness (at least short term). Right after I bought, in both cases the companies issued profit warnings and the market did not think it had discounted these warning fully, the stocks consequently plummeted. So here were are, looking at two interesting companies that are trading at multi-year lows in the middle of a roaring bull market. The question naturally becomes, what to do now? Take my losses, realize I have been wrong, and move on,  keep my position, or add? After spending some time looking into this my conclusions are: Criteo – Keep, Dignity – Add. Criteo I won’t have time to go into now, I will focus this post on Dignity, the funeral service company:

Dignity – Add back 6% weight

I have really been scratching my head about this company the last week. Although I made significant losses in some companies throughout the years, I actually can’t recall ever owning a stock that lost 50% of its value in a single day, so its really something unprecedented experience wise for myself. The irony of buying into it a few days before it happens really adds some extra salt into the wound. So what to do? Well of course I need to look into the details of the profit warning, pull out the calculator and start to calculate what this means for the company.

To take a step back before we go into the figures, as you can see, Dignity pulled back some -40% from it’s peak already before the -50% drop. Obviously everything was not so rosy outlook wise since the stock had traded down so significantly. So what was it then the market picked up on? Well basically good old competition. Dignity has been acquiring smaller funeral services over the years, streamlined some, but also raised prices significantly over the years. Competition has not raised prices and so Dignity has started to lose some business, especially in the “budget” market if we can call it that. Dignity does about 70 000 funerals in UK every year, the data during 2017 looked like this:

2017 Pricing

Funeral Type	% of Funerals	Income (GBP)
Basic Funeral	7%	2700
Full Funeral Package	60%	3800
Pre Paid Funeral	27%	1650
Low Value Funeral Contributions	6%	500
Ancillary Revenue from Funerals (flowers etc.)	100%	280

What happened in the profit warning was that Dignity has realized they have been losing way too much market share in the “Basic Funeral” segment, as you can see it was only 7% of it sales. Consequently there has been in a reduction in the number of funerals held per venue. Top-line revenue held up for a while through acquisitions, but each funeral venue held less and less funerals (although with larger margins per funeral). Now Dignity has decided to change the trend, fight for market share in the “Basic Funeral” segment by slashing prices for the “Basic Funeral” to 1995 GBP. By that probably cannibalizing some of their own customers as well, who will choose the basic package instead of Full Package. Dignity themselves forecast that for 2018 probably 20% of the customers will choose the “Basic Funeral”, but of course this also gives the company a fighting chance to change the trend of less and less funerals held per venue.

2018 Pricing 

Funeral Type	Forecast % of Funerals	Income (GBP)
Basic Funeral	20%	1995
Full Funeral Package	47%	3800
Pre Paid Funeral	27%	1650
Low Value Funeral Contributions	6%	500
Ancillary Revenue from Funerals (flowers etc.)	100%	280

Since costs will stay the same, this price reduction eats directly into the profit margin. If we use the new Mix of funerals as a estimate for funerals sold for 2018, we can make some rough assumptions. Another assumption would be that number of funerals held will stay more or less flat (meaning no market share will be gained by slashing prices). The calculations give that Operating Profit will be lowered by about 10-15 million GBP for 2018 compared to 2017. The reason why we can’t get an exact figure is that cost of Basic and Full funeral is not presented in annual reports. But 10-15m reduction in Operating Profit I think is a reasonable estimate and that is in my view what the profit warning we are talking about expresses.

Debt and Pre-paid funerals

Anther concern and probably a big reason we see such a stock price drop is the fairly significant amount of debt the company is servicing. The interest expense for the last 5 years has been between 24-28m GBP. This is not likely to increase significantly during 2018 since GBP LIBOR rates are still fairly low.

Another aspect worth looking into is the Pre-paid Funerals, which are a massive liability of ~800 million GBP, but this is funded by all the pre-payments which is invested in the same way as an insurance company invest its assets to meet obligations. Obviously this investment portfolio could go haywire, but no such information has been given, and history do not show any proof of such behavior. The risk I see is that if stock markets crash and the portfolio is way to invested in risky assets, the obligations will be severely underfunded and losses needs to be taken. The other side of the coin is that this is a sure base of funerals that Dignity has locked in, as you can see in the table above, 27% of all funerals held are of the pre-paid type, and Dignity still manages to make profits on these funerals at 1650 GBP. Op margins are lower though for pre-paid at about 30% versus 37% of the mix of Basic and Full funerals.

Conclusion

We are looking at a company that generates for 2017 about 100m GBP in Operating Income. Deduct from that the about 25m GBP interest expense, we are looking at pre-tax income of about 75m GBP. After tax, a Net Income of about 57m GBP.

Now with the estimates above, of about 15m GBP less in Operating Income due to price slash. It translates into Operating Income of about 85m GBP, interest expense and tax rate the same, I see Net Income at about 48m GBP. With 49.9m shares outstanding and trading at 8.9 GBP, the stock is trading at forward 2018 P/E of 9.3. Even if market deteriorates further under serious competition, there is room to slash prices further, since Operating Margins are very healthy for the “Full Funeral Package”. I think a small sell-off might have been warranted given the unclear situation on pricing and volume. Also the debt load is fairly high so there is not room for severe further margin deterioration. But I can’t see how small privately own funeral shops could be able to run more efficiently than a large organisation, so there must be some floor pricing from the competition. There is much else to say, for example how very high the customer satisfaction is from Dignity’s service. But I stop here and conclude that although it feels like a catching the knife moment stock price wise, I’m willing to take possible further short term pain and will today add to my position so I have a 6% weight in Dignity.

At these levels, I would actually classify this as the best Value investment case I have come across over the last years.