Boring Portfolio

Death: It's Serious "Business"
Don't believe the mortality hype

By Alex Schay (TMF Nexus6)

ALEXANDRIA, VA (April 9, 1999) -- Some contributors to the Boring message board have recently broached the question of whether or not there is some value in the deathcare segment -- or to use the currently accepted euphemism, "post-life services." Ever since Service Corp. made the startling announcement about its earnings difficulties, almost the entire group has gotten, um... killed. So, is an investment in this sector just "dead money" for a while (sorry, I know, I know, it's just way too easy), or can we look for it to be reanimated over the next year? Here are a couple thoughts:

First, don't believe the mortality hype. Yes, over the last three years or so deaths as a percentage of the overall population have been in a trough. However, the absolute number of deaths have been steady and rising (depending on your source, 2.3 million a year, plus or minus 50,000), which is really the germane number to the industry. Joseph Henican, the CEO of Stewart Enterprises, noted in a recent Wall Street Transcript Interview, "What is significant to us is not the percentage, but the absolute number of deaths that occur in the U.S. That's what could impact our business, not the percentage."

It's important to note that one big problem with the segment as a whole is the lack of reliable data. As it turns out, in 1998 the Center for Disease Control (CDC) reported a drop in the number of deaths, but the National Center for Health Statistics actually reported higher volume. Incidentally, I've had Stewart (Nasdaq: STEI), the third largest deathcare firm in North America, on my watch list for a while and it looks interesting below $15 -- it was up $1 1/16 to $15 5/8 today though.

Deathcare is the quintessential high fixed-cost business, where incremental volume is essential for stimulating growth and incremental margins are enormous when the business can grab 'em. Therefore, either the mortality rate needs to pick up out of the trough (deaths accelerate), or the companies in the business need to adjust their infrastructure costs to match the lower volume. That's why a lot of investors are still hanging out on the sidelines with respect to Service Corp. (NYSE: SRV). They're waiting to see how management reacts on the cost side (as well as probably differing on the numbers for breakeven volume and what incremental volume will bring down to the bottom line). Stewart addressed costs and the problem of unified backoffice management a number of years ago with its "Shared Services Center" initiative. Support service functions had run at about 2.9% of domestic revenues a couple of years ago. In 1998 they were down to 1.8%, and in 1999 projections are for 1.3%.

Perhaps the most intriguing element of the segment in valuation terms is the guaranteed cash flow from pre-need (cemetery sales) and pre-arrangement contracts (funeral sales). While Stewart had return on invested capital of about 6% in 1998, the firm sold nearly three prearranged funeral services for every one it delivered from its backlog (the average ratio for the last five years). Therefore, you can look at the "real" net operating profit after tax in a number of ways. You could discount the cumulative "pre" pool of funds (about $1.3 billion) to present value in a DCF model, or simply look at what the firm is really taking in based on the capital it has deployed. For example, in 1998 Stewart only recognized the revenue from services that it actually performed, but meanwhile it's signing contracts at roughly three times the amount of revenues reported. Is it proper to only use 1998 after tax operating earnings to indicate what the company made off of the capital it has employed?

If the company is always going to have a backlog -- sorry, you have to buy into the notion that people will always die -- then the answer has to be no. And at current levels it looks like the present value of those pre-need, pre-arrangement cash flows are not even in the equation. The accounting for these things can get pretty arcane, but here's a little overview:

Pre-need funeral sales are facilitated by deposits to a trust or purchase of a third party insurance product (at whole or in a part). Since companies do not have access to the trust fund principal, the related assets and liabilities are not reflected on the firm's balance sheet. Although the marketing costs associated with getting these contracts come out of cash flow, the actual expenses are deferred and amortized over an industry average of twelve years (approximating the expected time of service). Accounting standards dictate that a revenue cannot be recorded until it is earned, and deferrals such as unearned revenue accounts need to be recorded as liabilities until they perform the service. However, with the typical company's average number of pre-need funeral contracts standing at 20,000, most are loathe to distort their balance sheet numbers with huge deferrals. Yet for valuation purposes the amount of pre-need contracts are an important consideration as we discussed.

Under most state laws, companies are required to make deposits into a merchandise and service trust for cemetery merchandise and services sold on a pre-need basis as well. The related trust fund income is recognized in current revenues as trust earnings. These earnings are offset by any current period inflation costs accrued related to the merchandise that has not been actually purchased. Liabilities for undelivered cemetery merchandise and services, including accruals for inflation increases, are reflected in the balance sheet numbers (unlike funeral services) net of the merchandise and service trust balance.

Anyway, before everyone starts completely glazing over, we'll bring this to an end. Don't worry, we'll revisit this topic again. Enjoy your weekend, and come visit us on the Boring board if you have the chance.

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        Rec'd   #  Security     In At     Value    Change
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