Rising Star Trade: Buy StoneMor Partners

This article is part of our Rising Star Portfolios series. Follow all of Alex's trades on Twitter.

Markets are pretty efficient. That's why, when investors see a stock yielding a well-above-average 8.2%, you can't blame them for assuming that there's something wrong with the company. Usually, that's an accurate assumption.

But not this time.

Today I offer you StoneMor Partners (Nasdaq: STON  ) , a stock so brazenly befuddling to investors that the market assigns it a whopping 8.2% yield out of raw confusion.

The business
StoneMor's business is actually quite simple. The second-largest cemetery owner in the country, the company owns and operates 263 cemeteries and 62 funeral homes in 27 U.S. states and Puerto Rico. The company sells burial plots (either plots of land or cremation niches), merchandise (think burial vaults, caskets, and grave markers), and services (installation of the merchandise).

About 80% of cemeteries are still local mom-and-pop operations, and these small properties are the plankton on which the StoneMor whale is constantly feeding. While StoneMor is in no danger of running out of space on its existing cemeteries -- its average cemetery will take about another 260 years to fill up -- the company grows by tucking additional properties into its fold.

There are four other consolidators that do similar cemetery roll-ups, but StoneMor has a defined edge over them in its pre-need sales program. Most cemeteries simply sell burial plots and merchandise when needed -- at the time of death. StoneMor, on the other hand, makes 60% of its cemetery-related sales in advance of the time of need, called "pre-need" sales in industry parlance. This strategy, which StoneMor has bastioned with an 800-person national sales team, is unique to the company and offers a compelling advantage. Not only are pre-need sales more profitable than at-need sales, but the pre-need program allows StoneMor to acquire and operate even the smallest of cemeteries profitably, thanks to reliance on regional salespeople instead of expensive, dedicated staff at each and every cemetery.

What's so confusing?
This is a straightforward business. It's highly predictable, profitable, and recession-proof. What exactly is so confusing here?

Let me show you some numbers.

USD $000 2008 2009 2010
Net Income 4,556 (4,388) (1,417)
CFO 21,144 14,729 3,106
Distributions 25,658 27,253 32,443

At first glance, this looks scary. After all, how can an unprofitable company with shrinking cash flow support such a massive -- and growing! -- distribution?

Easily, it turns out. The most important thing to know about investing in StoneMor is that the numbers in its financial statements don't reflect reality. They're practically meaningless.

StoneMor is subject to a series of bizarre accounting requirements that on paper thoroughly distort the underlying reality of the business. The source of the problem is trust requirements. When StoneMor books a sale, it has to put 15% of the sale price of the burial plot into a trust. If the sale was a pre-need sale (and remember that 60% of StoneMor's sales are pre-need), the company also has to put 75% of the merchandise and service revenue into a trust. These are legal requirements intended to make sure StoneMor is able actually deliver the stuff it sold when the customer eventually dies. Until then, the cash is managed in trusts by third-party investment managers. And none of the cash diverted to the trusts is counted as revenue -- so a bulk of the revenue StoneMor is generating never makes it to the income statement.

But here is the outlandish but critical point: StoneMor can basically pull that money out of the trusts whenever it wants simply by delivering what it sold. In other words, if it sold a casket, all it needs to do is own a casket. If it sold a burial-vault installation, it just needs to install the burial vault (the casket is later placed inside it).

StoneMor is run by four key executives who know this business inside and out. They know the accounting distorts their results, but they remain focused on the underlying strength of the business. That said, as deft capital allocators, they play within the accounting rules to withdraw cash from the trusts when they decide to make a new acquisition or increase the company's distribution.

Financials and valuation
Even though the financials are practically meaningless, the balance sheet is strong and the company's payout -- which is largely what I'm after by buying shares -- is secure. To illustrate just how secure, consider this: If StoneMor were to not book another sale ever again, I calculate that the company still has the financial resources to maintain its current distribution for another 12 quarters.

Of course, I don't expect StoneMor's highly predictable business to suffer. Assuming that future cemetery acquisitions perform similarly to past ones (and after 137 acquisitions, management has this down to a science) and that the company spends $20 million to $25 million a year on them, shares are worth $30 to $38. Although shares are undervalued, I'm buying them more for yield than appreciation.

The Foolish bottom line
StoneMor is a well-run, defensive business unfairly punished by a perplexed market. I'm taking advantage of Mr. Market's blundering to lock in the outsized yield these shares offer.

Note: StoneMor Partners is a master limited partnership. Before investing, you should review the tax implications for your personal situation.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Alex Pape owns no shares of any company mentioned. The Motley Fool owns shares of StoneMor Partners. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 19, 2011, at 5:56 PM, NerfBall wrote:

    Great article. The death-care sector, of which STON is the champ. Certainly unglamorous and maybe even a little ghoulish (if that type of thing bothers you), but tons of money to be made in that sector and unless we somehow achieve human immortality, never a lack of business. I've done really well with StoneMor.

  • Report this Comment On December 03, 2011, at 12:19 AM, etihwttam wrote:

    Sounds too good to be true, but I'm in. The fact that it is an MLP explains the fat dividend. I'm no expert, but it seems to me that:

    1) Because of the tax implications of "unrelated business taxable income" that MLPs produce, individual MLPs aren't suitable for tax-deferred accounts, i.e., keep it out of your IRA.

    2) Most MLP distributions are comprised of about 20% net income and 80% return of capital (which is really just an allowance for depreciation). The income portion is generally taxed at your ordinary income tax rate.

You don't pay taxes on the return-of-capital portion until you sell the security, i.e., try to make it a long-term investment.

    3) Return-of-capital distributions lead to a reduction in your cost basis. If you pay $50 a share for an MLP, for example, and receive a $5 return-of-capital distribution this year, then the cost basis of your shares declines to $45. If you sell the shares next year for $55 a share, you will have to pay taxes on your $10 gain (investors will get mailed a K-1 tax form), i.e. as your cost basis decreases, you are deferring taxes 'til a later date. Best time to sell is never?

    Anyway, MLP or no, same play as always: buy on dips (sell puts if you can); inch your way in in 25% chunks (no need to rush); hold for the long term (see previous).

  • Report this Comment On December 07, 2011, at 7:15 PM, rockymtn9 wrote:

    If management are such deft capital allocators and shares are undervalued, why are they issuing stock at the current price, year after year? They issued $39 million in 2010, $24 million in 2009, and $104 million so far in 2011. It's an important point that their trusts are growing and are a source of future value, but they've clearly needed the cash to fund the massive payouts to shareholders. Despite the offerings in 09 and 10, shareholders equity was actually down during that time.

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