StoneMor’s Rights Offering

This week, StoneMor Partners, L.P. (STON) announced that it has set a record date of September 26, 2019 for its upcoming rights offering. Soon thereafter, once the SEC declares the registration statement to be effective, the partnership will mail a joint proxy/prospectus to unitholders. STON anticipates that the rights offering will be completed early in the 2019 fourth quarter.

The completion of the rights offering will mark another step in the transformation of the partnership – a transformation that sprung from its inability to issue financial statements on a timely basis beginning with its 2017 10-K as a result of deficiencies in its accounting and financial reporting practices. STON did not become current on its SEC financial reporting requirements until the 2019 first quarter. As a result of the delays and misstatements, it has reported material weaknesses in its internal controls which are continuing. Its recent financial statements show accelerating losses which raises questions about its ability to continue as a going concern.

Nevertheless, StoneMor has made considerable progress over the past two years. It is proceeding with a recapitalization of the partnership that has so far seen the issuance of $385 million of senior secured debt and $57.5 million of Series A preferred partnership units. Proceeds were used to (1) retire all of the debt outstanding under the partnership’s revolving credit facility and its 7.875% Senior Notes due 2021; (2) fund losses incurred in the 2019 first half and (3) build a modest cash cushion of $62 million, up from $18 million at the end of 2018. (For now, $20 million of the $62 million is restricted because it is being held to cash collateralize certain letters of credit that were outstanding under the partnership’s revolving credit facilities.)

The next phase of the recapitalization includes the rights offering to existing shareholders, under which the partnership will issue up to 33.5 million limited partnership units at a price of $1.20 for a total of $40.2 million. Eligible shareholders will receive the right to purchase 1.24 units for every unit that they currently hold. Under that formula, 27.04 million existing units (out of the total 39.6 million outstanding units) will be eligible to participate. Proceeds will be used to retire outstanding preferred partnership units at their liquidation value, also equal to $1.20 per unit. If all the rights are exercised, that will leave 18.6 million preferred units outstanding with a total book value of $20.5 million.

The final phase of the recapitalization will occur when the partnership converts to a C-corporation (StoneMor, Inc.), which is expected to be completed by the end of the 2020 first quarter. At that time, the remaining preferred units will convert into common stock of the corporation on a share-for-share basis.

Although the recapitalization has covered the repayment of all outstanding debt and shored up liquidity, it has not come without significant potential costs to the partnership and its existing unit holders. The new senior secured notes carry a high interest rate. Interest is payable in cash at the rate of 9.75% in cash. The company also has the option through June 30, 2022 of paying part of the interest in kind, but at the higher combined rate of 11.00% (7.00% in cash and 4.00% in kind). The “in-kind” interest is added to principal.

The recapitalization will also result in significant dilution to the unit holders. By my estimates, the number of outstanding units (or common shares, after the C-Corp. conversion) will increase from 39.6 million to 93.0 million.

That dilution raises the hurdle for StoneMor’s future shareholders to realize a positive and sustainable return on their investment. The partnership has not generated net income since 2008. Its annual net loss has increased in recent years from less than $20 million in 2013 and 2014 to over $70 million in 2017 and 2018. In the first half of this year, its net loss increased to $56.3 million or $1.44 per unit from $34.6 million or $0.91 per unit in 2018. A meaningful portion of the 2019 losses, however, were due to one-time costs associated with the restructuring of operations and the recapitalization.

Similarly, StoneMor’s EBITDA declined from an average of $29.2 million from 2013 to 2016 to $17.3 million in 2017 and then to $6.7 million in 2018. So far this year, its EBITDA has declined to negative $2.7 million from negative $0.3 million in 2018. (However, EBITDA was slightly positive at $0.3 million in the 2019 second quarter, an improvement over the negative $3.0 million recorded in the 2019 first quarter).

StoneMor’s problems appear to be structural. Its profitability in both cemeteries and funeral homes is well below its publicly-traded peers (Carriage Services (CSV) and Service Corporation International (SCI)). In recent years, its two business segments – cemeteries and funeral homes – have not generated sufficient combined operating profit to cover corporate overhead.

Yet, StoneMor’s new management team believes that the partnership can significantly improve its profitability. Besides the recapitalization transactions and the conversion to a C-Corporation, the partnership is pursuing an operational turnaround through strategic initiatives that are intended to get the best possible results as quickly as possible. It has instituted a regional management structure to decentralize control and improve operating focus. It has categorized its operating units into tiers by class and by relative contribution. “Top tier” business units with the greatest profit improvement potential are getting additional resources (e.g. more sales staff); while lower tier units are cutting costs and may be divested.

Management also sees significant opportunities to reduce costs: unit-by-unit and through projects and industry benchmarking. The partnership has already achieved or is in the process of achieving $30 million in cost savings, including two workforce reductions. Phase two of its cost reduction program will bring additional savings, but these are related more to improvements in work flow and StoneMor may have to spend some money to achieve them, for example by replacing manual processes with automated systems.

Given the historical record, it is difficult to project improvement in the partnership results, but the covenants under the new senior secured notes provide some clues about StoneMor’s future performance. The covenants require that the partnership generate operating cash flow of at least $20 million in the final six months of 2019. (Under the indenture, operating cash flow is defined as net cash from operating activities.) By that measure, the partnership used (i.e. had negative net cash of) $31.6 million from operating activities in the first six months of the year. The $20 million operating cash flow target obviously represents a substantial improvement in a short period of time. Consequently, it would be shocking if management agreed to accept this covenant (in June, when the partnership issued the senior secured notes) without being confident in its ability to meet it.

Of course, net cash from operating activities is not the same as net income or even EBITDA. The measure includes changes in operating assets and liabilities that could conceivably prove to be temporary (for example, by letting accounts payable increase). In fact, the debt service covenant on the senior secured notes effectively walks this requirement back by allowing StoneMor to generate negative operating cash flow in early 2020. Still, the minimum $20 million in operating cash flow requires a meaningful improvement in profitability that will also result in positive EBITDA and possibly net income in the second half.

By my back-of-the envelope numbers, in order to generate a meaningful investment return for unitholders (shareholders) over the next two years, StoneMor has to get to around $50 million of sustainable annual EBITDA and it may also have to reduce its debt burden significantly through asset sales. It also will probably have to refinance the new senior secured notes at a lower rate.

$50 million in sustainable EBITDA certainly looks like a stretch given the partnership’s historical performance, but $30 million (or more) in cost savings combined with a rebound in sales back to around $330 million should allow it to get there. Alternatively, StoneMor could eventually pursue acquisitions, especially of funeral homes which require a smaller capital outlay, to help it achieve its performance targets.

The past two years have been difficult for unitholders because of the steep drop in the share price, which was assisted by the partnership’s going dark. Now that it has caught up on its financial reporting, StoneMor has begun communicating with shareholders again by reinstituting quarterly conference calls and also by promising to expand its disclosures of key operating metrics over time. Along with bona fide improvement in performance, this should facilitate an eventual recovery in shares.

At this point, existing shareholders will soon have to decide whether to participate in the upcoming rights offering. Although it is difficult to support participation on the basis of the historical record, there were some modest improvements in certain key line items in its 2019 second quarter results which together with the resumption of shareholder communications suggests that we will see performance improvement in the coming quarters. In my mind, that makes an (additional) investment in StoneMor a reasonable speculative bet. Those existing shareholders who skip the rights offering will see greater dilution of their stakes, making it harder to recover a portion of the value that they have lost over the past few years.

Post script: As I was finishing up my editing of this post, StoneMor disclosed that its CFO Garry Herdler and COO James Ford were leaving the partnership. Mr. Herdler will be replaced by Jeffrey DiGiovanni, who has been StoneMor’s Chief Accounting Officer since September 2018. The departures are a surprise because Mr. Herdler has been CFO for only five months, while Mr. Ford has been COO since March 2018.

Mr. Herdler, who spearheaded StoneMor’s recapitalization, will stay on as a consultant under a 14-week contract to focus on cost cutting and productivity improvements. Given his background as a turnaround specialist for Alvarez & Marsal, I did not expect Mr. Herdler to stay very long at StoneMor; but then again, I did not expect him to leave after only five months. By my count, Mr. DiGiovanni will be StoneMor’s fourth CFO since 2017.

Mr. Ford is leaving to pursue other interests. His position is being eliminated in a cost cutting move. With his departure, the three division presidents will report directly to CEO Joseph Redling.

In the press release announcing the personnel changes, Mr. Redling praised the contributions that both Mr. Herdler and Mr. Ford have made to StoneMor’s turnaround efforts. StoneMor also announced that it had hired Johnson Consulting, a leading firm in the funeral and cemetery industry, to assist with asset sales.

With these latest developments, StoneMor continues its now well established tradition of keeping investors (and analysts) on their toes.

September 19, 2019

Stephen P. Percoco
Lark Research
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