Funeralcare provider Dignity (LON:DTY) suffered a blow this morning as a lower number of deaths than anticipated in the first half of the year has meant unless there is a recovery in the second half, profits will miss expectations. The share price slipped by a morbid 6.66%:
Bad news has affected Dignity for some time and the share price sits at approximately half of the levels we saw last year, and almost a quarter of the value we saw two years ago. This is an indication that things had gone badly wrong, and indeed they have. In January last year a profit warning came out casting doubt on whether their prices may be maintained, which was a fore-warning to the news that the Competitions and Markets Authority (CMA) were looking into the funeral sector and to whether participants were abusing their market position. An immediate price cut of 25% last year seemingly was not enough.
The industry is a two-edged sword: there will be no lack of demand, since everyone has a requirement for it at some point, but death is a sensitive subject and financial stories surrounding the hard-up will be more compelling for the authorities to prevent excess profits.
This comes in a first-quarter trading update. To be fair to Dignity this is comprehensive, contains lots of numbers rather than bluster and gets to the point.
We start with some points about the first quarter. Deaths lower than expected, and for the first quarter underlying profits were £21.7m, down from £37.5m. Underlying needs to be treated with carefully as we can see later.
We also get some handy data about the average cost. Considering the CMA investigation will continue to bite this shows a worrying trend of the average cost of a funeral slipping downwards from £2883 to £2691.
The profit warning comes in the outlook and reads as follows:
The year has started below the Board’s expectations primarily as a result of the number of deaths so far in 2019. Achievement of full year expectations will rely heavily on the number of deaths in the remainder of the year compared to 2018. Historical data over the last 20 years indicates that the final volume is likely to be within three per cent of the previous year. If deaths were 580,000 (approximately three per cent lower), then all other matters being equal, underlying operating profits for the full year could be approximately £3 million to £4 million lower than originally anticipated. Clearly, this would require a significant increase in the number of deaths compared to last year in the second half of the year and would result in the financial performance for the year being more heavily weighted towards the second half of the year.
Perhaps this is sensible. The last quarter in the last year showed deaths ahead of expectations, so perhaps a good quarter is then followed by a bad as we revert to the mean.
For a long while it was clear that Dignity was a terrific business. With death a certainty, it could be said there would always be a demand for its services. The business has natural network effects: multiple facilities in the same space would consign them all to loss.
Their margins showed evidence of pricing power:
Apart from one year (which accounting adjustments meant a loss) and the last the margins have been incredibly stable over time, which is great considering the product itself has no proprietary barriers to entry (anyone could start a similar business should they wish). The maintaining of margins suggests that Dignity have been able to simply pass on price increases to their customers, which indeed has been happening.
On most other metrics, the business stacked up really well. Operating profits came in at close to £100m for a couple of years, cash conversion was great, and the business paid a very conservative dividend which was well covered by profits.
At the peak, the business carried a £1bn market cap, which definitely would have been deserved in any other industry. It is here where some of the bear points begin. As Dignity admit themselves, most customers have the perception that the funeral care industry is regulated, where in fact it is not. Many would argue that to an extent this approach has not worked out badly so far. Service is good, and like weddings price can be a secondary matter at these times. Some funerals can be equally as lavish as a wedding.
On the other hand, regulation would put down new standards for quality, price and procedures. Dignity could benefit from this as it would provide a new barrier of entry from competition, but at the same time, may suffer because pricing caps may come in , or they may be forced to accept unprofitable business. With this process underway it depends what they can negotiate, but it seems clear that the days of big profits are over and they will be reverting to lower levels.
The biggest bear point for Dignity is that it has been run almost like a utility, and the company has a large amount of debt giving it massive financial gearing. There is no net tangible asset value due to the amount of goodwill and intangible assets. The debt stacks up like this:
This is a rather scary amount: the level of debt is now greater than the market capitalisation. This refinancing of the debt was carried out in 2014, and it does seem that the implicit assumptions in that were that business then was going to carry on as normal indefinitely. It may be the case that to refinance these notes would not achieve as good a rate as beforehand.
The good news is that on current trading these figures do not give immediate threats. Interest costs for the last were £26m which was easily covered, and there are undrawn credit facilities totalling another £100m. With Dignity accounting for a 12% of the market there may be an opportunity for consolidation somewhere. The only real chance of danger is if regulations massively cap prices which reduces the profits required to service the bonds.
Dignity appear in a tough place at the moment, and the prospects of regulation do not appear favourable: greater competition and lower prices would benefit consumers. Even at the lower price points the margins are over 20% which might be deemed excessive looking at other industries.
But then, these regulations would affect all players in the market and given the non-quoted nature of some of them, may lead into other difficulties. Firms such as the Post Office or the Co-Op (who offer funerals) might simply withdraw. It is also fair to say that Dignity have a good position in the market, being perceived as ‘premium’. Their customer ratings are high, which implies that although they may charge a lot, customers are happy with them.
The share price is at a level now where it may be deemed a contrarian bet or a recovery play. Given the levels of underlying profit even at lower levels of pricing, the shares represent extremely good value and there seems to be plenty of upside. However, the underlying profits do not account for debt, and once this is taken into account throws some uncertainty into the mix. Whichever way it is structured, it does seem like significant payments will be needed to service this for the foreseeable future.
Risk and reward are balanced nicely here, enough for me to sit on the fence. 3/5.