StoneMor’s Distribution Rate is Too High

StoneMor Partners, L.P. (STON) is the second largest owner/operator of cemeteries and funeral homes in the United States.  The company controls 307 cemeteries in 27 states and Puerto Rico.  Of those, 276 are owned and 31 are operated under contract.  StoneMor also owns 107 funeral homes in 19 states and Puerto Rico.

Business.  Death care is a $20 billion industry with growth potential because of the aging of the baby boomers.  Annual death rates are expected to grow by nearly 2% annually, faster than population growth, over the next 20 years.

Demand for death care services is mostly stable and predictable.  Sales in certain segments, like “pre-need” (where arrangements are made in advance of a death) can fluctuate with economic trends (since pre-need purchases can be postponed).  The rest, including “at-need” sales and funeral home “calls” are largely determined by demographics.

Besides the expected rise in the death rate, there has been a clear trend in favor of cremations.  According to the Census Bureau, cremations as a percent of total deaths increased from 37% in 2005 to 42% in 2015.  They are expected cross the 50% threshold by 2020.  Although non-cremations as a percent of total deaths are projected to decline steadily, the actual number of non-cremations is expected to remain stable.  Thus, cremations will likely capture all of the increase in the death rate in future years.

StoneMor offers a complete range of cremation services and memorials, such as niches, urns and cremation gardens.  Profit margin percentages are higher with cremations, but the dollar amount of profit per cremation is lower than with traditional burials.

Both the cemetery and funeral home businesses are highly fragmented.  Two-thirds of U.S. cemeteries and more than 80% of funeral homes are independently owned.  StoneMor focuses mostly on cemeteries, where barriers to entry are especially high.  The supply of cemeteries is limited due to land constraints, zoning restrictions and high capital requirements.  Barriers to entry in the funeral home business are also high, primarily because of licensing requirements and long standing local relationships; but capital requirements are lower.

Stonemor aims to gain market share through acquisitions and leverage growth by bringing its service offering to newly-acquired operations and streamlining costs.  The company offers a full range of death care products, including lots, caskets, vaults, mausoleums, lawn crypts, grave markers, cremation niches and memorials, and services such as grave openings and closings and cremations.  With this strategy, StoneMor has nearly tripled in size since it first went public in 2004.

To illustrate how it adds value:  In May 2014, StoneMor signed a lease and management contract with the Archdiocese of Philadelphia to operate the Archdiocese’s 13 cemeteries for 60 years.  The company paid $53 million in rent in advance and agreed to pay another $36 million over a thirty year period (from 2020 to 2049).  When StoneMor assumed operations, these 13 cemeteries did not offer pre-need contracts.  All sales were at-need.  Over time, Stonemor plans to grow the pre-need business at these cemeteries.

Organization.  StoneMor is the only company in its peer group organized as a master limited partnership (MLP).  Its partnership agreement requires that it pay out 100% of its available cash to its common unitholders and general partners within 45 days of the end of each quarter, subject to the discretion of the general partner to establish reserves to cover future operating expenses, debt service, maintenance capital expenditures and future dividends (up to one year).

Financials.  The company’s definition of distributable cash flow is a non-GAAP measure that I assume gives immediate and full credit for pre-need sales and related expenses well in advance of when these transactions are recognized as revenues under GAAP.  Although Stonemor collects payments from its pre-need customers typically over a 30-month period and well in advance of their deaths, GAAP only allows recognition of revenues on these transactions when services are rendered, such as the installation of a vault or interment.  As a result, the difference between GAAP and non-GAAP revenues and profits can be quite large, but the difference should be most significant during periods of rapid growth.  Over the course of StoneMor’s multi-year (i.e. 30 month) sales cycle for pre-need sales, there should be no difference between GAAP and non-GAAP results when the business is flat.

In recent years, however, the difference between StoneMor’s GAAP and non-GAAP results has been significant.  In 2015, the company reported GAAP revenues of $305.6 million, but non-GAAP revenues were $398 million.  Similarly, I calculate 2015 EBITDA on the GAAP financials at $14.1 million; but StoneMor reported adjusted EBITDA of $98.2 million.

The difference between GAAP and non-GAAP would not be so important, as long as the cash received by StoneMor was sufficient to pay its dividend.  In this case, however, StoneMor is restricted by state laws from utilizing most of the cash that it receives from pre-need sales until the key events that also result in recognition of revenues under GAAP take place.  The company must keep pre-need customers’ funds in merchandise trusts until it installs a vault on the lot or places the customer at rest.  Besides making the accounting for pre-need sales complex, the merchandise trusts limit the amount of cash available to pay dividends.  As a result, when GAAP and non-GAAP results differ, StoneMor must borrow the funds or sell additional equity to meet its unitholder distribution payments.

I assess StoneMor’s historical ability to meet its distribution in two ways.  The first is using the company’s own non-GAAP calculation.  That shows that its distributable cash flow has fallen short of the distribution payout by modest amounts – about $5 million – in each of 2013 and 2015.  There was a modest surplus of about $5 million in distributable cash flow in 2014.  The DCF deficit has widened so far in 2016 to about $14 million, compared with just $2 million in the first half of 2015.

(It should be noted that StoneMor adds its available cash-on-hand to its distributable cash flow to arrive at “distributable available cash” for purposes of determining its ability to meet its distribution payments.  This measure has exceeded the distribution during all of the periods included in my analysis, from 2013 to the 2016 first half.)

My second approach is to calculate distributable cash flow using the GAAP numbers but with adjustments.  (This, too, is a non-GAAP measure, but it is more closely related to GAAP results than StoneMor’s definition of distributable cash flow).  Here, I define distributable cash flow as cash flow from operating and investing activities excluding growth capital expenditures and acquisition costs.

Under my non-GAAP definition, StoneMor’s distributable cash flow has fallen well short of its distribution payouts.  According to my estimates, the company has had a distributable cash flow deficit that has averaged $55.8 million annually from 2013 to the 2016 first half.

Consequently, by both measures, my non-GAAP and the company’s non-GAAP, StoneMor has not generated sufficient distributable cash flow to cover its distribution.  According to the company’s definition, the deficit is low and manageable, but under my non-GAAP definition, its distribution is clearly too high.  Based upon my analysis, it is unlikely that Stonemor can grow its cash flow sufficiently and quickly enough to avoid a cut in the distribution rate.

According to my analysis, StoneMor has been able to overcome its distributable cash flow deficit over the past several years by issuing new equity units.  The company has generated an estimated $41.7 million from operating and investing activities (before growth capital expenditures and acquisitions) and raised $361.5 million from the issuance of new equity units during this period, while its distribution payments have totaled $237.1 million.  The excess equity issuance of $166.1 million (i.e. that portion of equity issuance that has not been devoted to paying the distribution) combined with about $25 million in additional borrowings has helped StoneMor to pay for $143.8 million in acquisitions and $22.6 million of growth capital expenditures.

Part of the recent increase in the shortfall in distributable cash flow may be due to investment losses that the company has sustained in its merchandise trusts and perpetual care trusts.  Losses primarily on MLP investments forced the company to book $83.6 million of other than temporary impairments and $65.7 million of unrealized fair value losses on its trusts’ investment portfolios in 2015.  About $28 million in fair value gains were booked during the first half of 2016, offsetting some of these losses.

Due to trust accounting standards, those write-downs and fair value charges have not appeared directly in StoneMor’s profit-and-loss statements.  Instead, they have been booked against the deferred revenue and perpetual care trust corpus liability accounts on Stonemor’s balance sheet.  Unless StoneMor is able to record investment gains to make up these losses in the future, however, it will record lower revenues and higher expenses over time, as lower deferred revenues are recognized and its generates less income from the perpetual care trust to cover cemetery operating expenses.  In fact, these investment losses may be pressuring the company’s 2016 financial performance and be a contributing factor in the recent increase in shortfall in its distributable cash flow.

Valuation.  Given recent and future expected net losses, it is difficult to value StoneMor using traditional price-to-earnings multiples.  Its ratio of enterprise value-to-(rolling 12 month) adjusted EBITDA (company definition) is 12.4 times, which is high.  On the other hand, its EV-to-EBITDA multiple (my definition) is nearly four times higher.

As a multiple of cash flow, STON trades at 12.4 times trailing 12-month distributable cash flow (company definition) per share of $2.10.  Under my definition, I calculate StoneMor’s distributable or free cash flow (i.e. cash flow from operating and investing activities before acquisitions and growth capital expenditures) at $0.04 per share on a rolling 12 month basis.  Thus, its free cash flow multiple, under my definition, is not meaningful, but its valuation is nevertheless high.

The stock’s high valuation is driven by the company’s annual distribution (i.e. dividend), which is currently equal to $2.64 per share.  This translates into a dividend yield of 10.5% at yesterday’s (9/22) closing price of $25.28.  That very high yield reflects obvious concerns about the company’s ability to sustain the distribution.

As it has over the past several years, StoneMor has been able to sustain its high distribution by issuing equity.  Although there probably will be a limit to how much equity the company can raise without a clear improvement in its financial performance, it is uncertain when that limit will be reached.

Nevertheless, this financing strategy comes at a cost.  Each unit issued increases the company’s future distribution requirements.  Financing at a 10.5% annual rate is obviously expensive.

Strategy.  Here are a few of my recommendations for the company (which it undoubtedly has already considered):

  1. Cut the distribution by 80%. This would immediately reduce financing requirements and give the company greater ability to pay down debt over time.
  2. Consider focusing more on acquiring funeral homes. Funeral homes have a lower profit margin than cemeteries, but they also require a substantially lower investment.  Thus, returns on assets are typically at least 50% higher for funeral homes than for cemeteries.
  3. Consider acquiring Carriage Services, Inc. (CSV) (perhaps on a pullback). CSV properties are more heavily weighted towards funeral homes.  It generates about 70% of the revenues of STON and is profitable.  Yet, its enterprise value is less than half STON’s.  The combination of StoneMor and Carriage Services would still be significantly smaller than industry leader Service Corp International (SCI), so it is unlikely that the combination would face any anti-trust issues.

Investment Decision.  Given the current shortfall that the company faces in covering its distribution, I would prefer to wait before making an investment in the StoneMor equity units.  Instead, I would focus on the company’s 7 7/8% Senior Notes due June 1, 2021.  These Notes recently traded at 98 5/8 to yield 8.23%, which represents a spread of 714 basis points over the comparable maturity Treasury security.  They are rated B3/B-.  I calculate GAAP EBITDA coverage of cash interest at 1.3 times on a rolling 12 month basis.  The yield is lower than on the equity units, but the coupon is contractual (vs. discretionary).  If the company’s performance improves, there is good upside potential on these Senior Notes.  On the other hand, should StoneMor’s performance deteriorate to the point where it has to restructure its obligations, this security would probably end up with most of the new equity.

September 23, 2016

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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