2024-01-03 07:07:19 ET
Summary
- Carriage Services is a funeral and cemetery services company operating in the death care industry.
- The industry is facing a decline due to the increasing preference for cremation over burial.
- This decline presents an opportunity for consolidation, benefiting larger competitors like Carriage Services.
- The company trades at 7x Free Cash Flow, making it an attractive opportunity.
Investment Thesis
Carriage Services (CSV) operates in the highly stable and recurring death care business. However, its stock market performance in recent years has not been favorable, primarily due to the current challenging macroeconomic environment characterized by high inflation followed by a rapid increase in interest rates.
This article aims to delve deeper into Carriage Services and its two main competitors. We will analyze the promising prospects that the death care industry offers for leading companies, review potential risks, and provide a valuation to justify why I believe it deserves a ' buy ' rating at the current price.
business Overview
Carriage Services is a company specializing in funeral and cemetery services within the death care industry. Engaging in various aspects of funeral and memorialization services, it may not be the first choice that comes to mind when considering business ownership. However, given the inevitable nature of death, businesses related to death care play a crucial role and often have a consistent clientele , despite the somewhat grim reality.
A notable illustration of the resilience of such businesses is evident in the performance of Carriage Services and Service Corporation (SCI) during the significant crisis of 2008. Despite a 5% annual decrease in SCI's revenue between 2008 and 2009, the company managed to maintain its profit margins. In the case of Carriage Services, not only did its revenue not experience a decline in any year during this period, But its profit margins also remained relatively stable, with the exception of 2008. This underscores the industry's relative resilience and the consistent demand for death care services even during challenging economic times.
As of December 2022, the company had 203 locations in the United States, making it the third largest in North America after Park Lawn ( PLC:CA ) with its 293 locations and the absolutely undisputed leader Service Corporation International with 1,964 locations. In this article I will focus on Carriage Services, but I will constantly be comparing it with these two, since the idea is always to invest in the best company in the sector or the cheapest if there is no clear justification for it to deserve an undervaluation.
Industry in Decline: Trend Towards Cremations
Now, although I have just commented that the industry is quite stable, there is a risk in all funeral homes that has caused the number of businesses dedicated to this to decrease each year, indicating that we are facing an industry that is increasingly becoming more complicated to operate . Part of this decline is due to the increasing preference for cremation over burial. In 2015, there was a notable shift as more Americans started favoring cremation over burial, and projections for 2030 indicate that nearly 70% of the population may opt for cremation. Cremation offers several advantages, including flexibility, not requiring dedicated funeral spaces (which are becoming scarce in highly urbanized areas), and, notably, being more cost-effective compared to burial.
Cremation tends to be more economical than traditional burial, as it eliminates the need for expenses such as a burial plot, casket, burial vault, and other associated costs. This affordability makes it a more accessible choice for many families. In the United States, the average cost of burial is approximately $7,600, while cremation averages around $6,700.
Opportunity for Consolidation
This shift in consumer preference would be a contributing factor for smaller funeral homes to be seriously affected, and the reduced demand may lead some to either close or sell their businesses to larger consolidators. We can see this reflected in the annual decrease of 0.7% since 2004 in the number of funeral homes in North America, which is currently estimated to be close to 19,000.
All this negativity and difficulty in operating in the sector end up benefiting the largest competitors in the sector, which will have greater ease in finding acquisition targets, improving their market share each year, and the unattractive prospects will keep new competitors away. A breeding ground for the sustained growth of companies like Carriage Services
This phenomenon elucidates why acquisitions frequently constitute a pivotal element in the growth strategies of SCI, PLC, and CSV. Over the past five years, Carriage Services has directed $246 million toward cash acquisitions, accounting for 77% of the cash from operations generated during the same period. Similarly, Service Corporation has allocated $500 million to cash acquisitions, constituting 14% of cash from operations. This allocation aligns with their substantial scale in the industry. On the other hand, Park Lawn emerges as the company with the most substantial commitment to acquiring other businesses, having devoted over $700 million, nearly four times its cash from operations generated. In fact, Park Lawn's dedication to inorganic growth was evident in June 2023 when they publicly disclosed their intention to acquire Carriage Services . However, despite the initial announcement, negotiations ultimately fell through , and the deal did not progress.
Key Ratios and Competitors
When examining the total revenue of these companies, the substantial scale of SCI becomes apparent. This is further reflected in the EBITDA margins, which are notably higher due to the operational efficiency achievable at such a scale.
In contrast, Park Lawn exhibits the lowest margins and revenue. A potential factor contributing to these lower margins could be the company's nearly equal distribution of Funeral Homes and Cemeteries, unlike SCI and CSV, where a higher percentage of locations are Funeral Homes. It would be insightful for Park Lawn to provide a detailed breakdown of revenue and margins for each segment to confirm whether the difference in margins is indeed linked to the revenue mix.
Considering the estimated size of the death care market between $22 and $24 billion, we could infer that SCI commands almost 18% of the market share, while CSV and PLC trail behind with 1.6% and 1.5%, respectively. An important observation is that in 2007, Carriage Services' revenue represented 9.5% of Service Corporation's revenue ($167 million / $1750 million) and in the last twelve months, this figure stands at 9.3%. This suggests that CSV may not be losing market share , but SCI has maintained its substantial scale advantage for over 16 years, allowing them both to preserve its market share and continue growing.
Considering that these companies usually grow through acquisitions, it seems important to me to analyze the return on invested capital of each one to evaluate how much value they are generating with the acquisitions. In this ratio, Carriage Services stands out from the rest, as its ROCE is 6% compared to SCI's 5.3%. If we adjust the goodwill in this metric, the ratio would be around 10%. This goodwill adjustment allows us to eliminate the distortion that is generated by making so many acquisitions and to have an idea of the return that the business would obtain once it stopped acquiring so much.
As can be seen, this is an industry with low returns . There are numerous factors that could influence this, such as the fact that funeral services require significant infrastructure and facilities. This capital-intensive nature can result in lower returns compared to industries with lower capital requirements. Furthermore, the death care industry is often considered mature, with relatively stable demand. In mature markets, opportunities for rapid growth and high returns may be limited compared to emerging industries. Although this seems negative at first glance, it also prevents new competitors from entering , attracted by extraordinary returns on capital.
The first negative aspect I would attribute to the company is its status as the most leveraged among the three. It presently holds approximately $600 million in debt, constituting 6x the EBITDA generated in the last twelve months. While this is a drawback, it's worth noting that $400 million is in Senior Notes with maturities extending beyond 2028, and they carry an average fixed interest rate of 4%. This suggests a sustainable debt profile, although it would certainly be beneficial for the company to initiate a reduction.
To provide an understanding of why scale is crucial in the sector, I'd like to share a graph illustrating the Cash Conversion Cycle of CSV and SCI. This metric reveals the number of days it takes the company to collect cash from its customers after paying its suppliers.
For Carriage Services, this ratio stands at 16 days, a notable improvement from the 22 days recorded in 2014. However, Service Corporation exhibits an even more impressive ratio of -72 days, implying that it collects payments from customers sooner than it pays its suppliers. Achieving such negative days is possible when a company has sufficient scale to negotiate more favorable conditions, as suppliers are inclined to agree to terms that retain such a significant customer.
This underscores the essential role of scale in the death care sector.
Valuation
To gain insight into the potential return on investment in Carriage Services, I plan to project revenue growth and margins for the next five years. For FY2023, I will consider management's guidance, indicating a 2% growth this year, which appears reasonable given the challenging macroeconomic environment.
First, we have tightened our guidance range for total revenue to $375 million to $380 million to reflect the decrease in contract volume as a result of the COVID pull-forward effect, which has been partially offset by our increase in average revenue per contract.
Second, we have updated guidance for adjusted consolidated EBITDA to $105 million to $110 million to reflect the general inflationary cost environment we have continued to experience across both the funeral home and cemetery businesses.
For the subsequent years, I estimate that the company can sustain a growth rate of 4% annually. This projection is based on the company's historical performance over the last decade, where revenue grew at an average annual rate of 6%, achieved through a combination of organic and inorganic growth. I believe there is room for growth on both fronts, given the fragmented and declining nature of the market, coupled with the increasing aging of American society.
In addition to this, a slight expansion of margins is factored in, and applying an EV/EBITDA multiple of 10x, the expected annual return would range between 12% and 13% , supplemented by the 1.8% dividend.
The choice of the valuation multiple is based on the historical performance of Carriage Services and SCI. Park Lawn, having been priced significantly higher in previous years, influenced this decision. If the multiple were to increase to 12x EV/EBITDA, which is still reasonably conservative, the expected return would be closer to 20% , augmented by dividends of 1.8%.
Risks
- The first risk is related to the industry's shift towards cremation over traditional burial , as mentioned earlier. If Carriage Services is unable to adapt to this trend, it could impact their business.
- Additionally, since Carriage Services grows through acquisitions, integration risks are significant. Challenges in integrating new businesses, achieving synergies, or dealing with cultural mismatches could affect margins and returns on capital.
- Carriage Services' current debt levels , especially if not managed prudently, could pose financial risks.
- Finally, it seems that Carriage Services' competitive position is significantly weaker than that of its competitor, Service Corporation. As seen earlier in the article, scale is fundamental, and in this aspect, SCI is ahead. In the future, this competitive disadvantage could hinder the growth of CSV or even lead to a potential acquisition by SCI.
Final Thoughts
It appears there are a couple of risks to consider before contemplating an investment in the company. However, it is also true that the industry holds promising prospects for the three leading companies, including CSV.
Moreover, the current trading multiples of 10x EBITDA and 7x Free Cash Flow lead me to the conclusion that the potential risks are more than compensated by the benefits that could be realized. Therefore, I believe the company is a ' buy ' at the current price.
For further details see:
Carriage Services: A Fragmented Market Provides Great Opportunities For This Industry Consolidator