Last week, I wrote about farmland and farmland stocks. But land can also be used for other purposes. While being asked about land, the most common answers will be farmland or land for housebuilding. Maybe also forestry. However, there is another sector that could prove to be a more valuable investment opportunity due to being less followed, but obvious in hindsight.
Summary and key takeaways from today’s Weekly
– Service Corporation International (SCI) is another interesting business with land possessions and the market leader of the North American deathcare industry
– the business has attractive economics and management shows good capital allocation skills
– the debt levels and the share price are a bit too high for me, however, the company is worth watching
Due to some readers asking me for a short summary at the beginning of a Weekly, I decided to implement this info box. Feedback is appreciated the same as other suggestions.
After writing about farmland stocks last week (see here) and having published a research report about a company where the value of its land holdings already covers most of its equity market cap (see here), today we close this unofficial trilogy of land investments with a look at an industry that isn’t in everyone’s mouth.
We are talking about the funereal business that is also called the “deathcare industry”.
Land can actually also be used for cemeteries.
Many will know the famous saying that the only things being sure in life are taxes and death. Benjamin Franklin is said to be the one these words came from originally.
No one likes thinking or talking about death.
What might seam scary at first sight, is a very reliable, profitable, high-margin business that is not dependent on the common business cycle of the economy. At least not that much, because it is unlikely that people will wait for better economical times to pay the last respects to the close ones and honor the lives of those they just lost.
Is it morally justifiable to invest in death? For me, personally, the answer is: First, you do not invest directly in death or something leading to the death of others per se and second, I see no difference than investing in Coca-Cola (ISIN: US1912161007, Ticker: KO) or Nestlé (ISIN: CH0038863350, Ticker: NESN) that obviously are not favoring a healthy lifestyle, but are core holdings in many portfolios.
Putting emotions aside, death is a natural occurrence. We get born, live and finally die at some point. Why should it be questionable? No one gets harmed with such an investment. It cannot be said about many other companies.
Today, we will look at the leader of a fragmented market in North America as a stock idea that may not be on everyone’s watchlist. Therein lies the opportunity! This business is a big land owner that perfectly fits into the recent unofficial series of land investments. It is worth watching, however, not a screaming buy at this point.
Being prepared in advance and then striking when appropriate, is the way to go.
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An overview of the deathcare business
The field of funeral services is all about organizing the final ceremony and paying the last respects to the beloved relatives and friends. Many wish for and accordingly organize a well planned and unique funeral for their loved ones they just lost.
For this, they not only need the burial itself. One has to choose between a traditional funeral or a cremation, a property option (how exactly the gravesite in the cemetery should look like), proper merchandise and services like flower arrangements, special rituals (often in connection with religious traditions), the coffin, transportation or the final funeral ceremony.
Also, one can plan and book the grave maintenance in advance.
A funeral is not only a very personal thing. It is also one where trust into the service provider is essential. Size, breadth of the offerings, image and also costs matter a lot. There is no excuse and no second chance for mishaps on such an important day.
Here is a first overview of this industry in North America, spanning the USA (+ Puerto Rico) as well as Canada:
In total, it is a large sector with 22 billion USD in yearly revenues. This industry is pretty fragmented, as there are often local operators and many “mom and pop” service providers. Many of these smaller businesses are handed over to the next generations. Others close their operations for good or get acquired.
But still around 90% of funeral homes are in private ownership (see here).
The single biggest player has only a market share of around 15%, according to revenue numbers. The next ones are two thirds smaller, already.
Consolidation is the keyword.
The biggest player in this field is Service Corporation International (ISIN: US8175651046, Ticker: SCI). It is a business that was founded in Texas already in the 1960s and which relatively quickly expanded by acquiring nearby competitors.
First focussing just on the South of the US, SCI until now expanded into 44 states plus D.C. and Puerto Rico. Its formerly international expansion (including Europe) was sold again later on, due to too much competition and fragmentation. Also, SCI had to deleverage its balance sheet. The only foreign market left today is Canada.
But more on SCI in the next section.
What an investor should also know about this two-fold business model, is summed up on the following chart:
The funeral contains the final ceremony and is sort of a personal one-time event. Revenues mainly get recognized by the provider around the ceremony. The barriers to entry are lower, because (in theory) many people or companies could offer these services. Due to its one-time nature, new “customers” need to be found. It gets easier with a good reputation and convincing offerings out of one hand.
Quite the opposite with the cemetery business which is the real estate, i.e. land-part. The barriers to entry are high, because besides needed capital an operator also must get regulatory permissions and ownership of special-purpose properties. You cannot just dig a hole in the backyard. Revenue is usually recognized partly beforehand, but a big chunk follows after the funeral for the ongoing use of the property.
The tailwinds for this business are also quickly explained.
Besides percentage-wise bigger parts of society being represented by older generations (“baby-boomers”), also bad nutrition and lifestyles paired with growing chronic diseases as well as limited amounts of space for this special-purpose properties facing an at least stable, predictable demand are the key arguments.
As already shortly teased in the intro section on this Weekly, the business is non-cyclical and has relatively inelastic demand. The only slightly negative thing for the providers is the growing trend from traditional funerals to more cremations, obviously due to costs. The former has higher-margins and also higher total sales, because more services need to be booked.
Now, let’s have a deeper look at the market leader SCI.
Introducing Service Corporation International
Service Corporation International, or in short SCI, is the market leader of the North American death care industry with a market share of ca. 15% in terms of revenues.
Out of the industry’s revenue of 21 billion USD, SCI generated 4.1 billion USD in 2021. It served around 750.000 customers in that year and seems to have even gained some market share due to takeovers, being a reliable contact during the very sad and difficult last two years, as well as internal optimizations with its website, sales personel and offering innovative services digitally.
Keep in mind that this is traditionally an analog-only business.
What is interesting and a sign of still strong demand for its services, is the order backlog for its future services which amounts to more than 13 billion USD (as per their last quarterly report) – that is more than 3x yearly revenue!
Needless to say, the operations are strong on margins and capital returns.
Here are two screenshots from TIKR.com showing returns on capital and equity as well as operating earnings margins and free cash flow margins over the last ten years:
The main building block of SCI’s business strategy is takeovers. From time to time, they buy relatively big competitors like in the past, when they swallowed the industry’s number 2 and 5 by size. Or they just gobble up smaller and most often family-run private businesses that struggle to find reliable successors.
Often, the acquired businesses are allowed to keep their former name or brand, but get labelled as “a dignity memorial brand” which is the main brand of SCI.
The other two pillars of its strategy are keeping the debt level manageable and offering attractive shareholder returns.
At the turn of the last century, SCI was also active in Europe. However, this was a costly and not really successful adventure, hence they left that market later on and reduced debt levels over the next years. Currently, the company is at the lower boundary of its own debt target range. The level of this range, however, is not very low, but you get a reliable business. More on debt later.
In the graphic above from SCI’s investor presentation, you see shareholder returns since 2004. That was about the time, when they left the European market. Due to continuous share buybacks, the total share count could be reduced by very strong 52%.
Repurchases will continue and, at current share prices, represent approximately 5–6% of the outstanding shares to be withdrawn from circulation each year. That is a relatively good number, however, not jaw-dropping.
The yearly raised dividend had an average growth of 17% p.a. in the past. However, I wouldn’t bank on that for the future to continue in this order of magnitude. Also, the current dividend yield is not attractive for me personally, just sitting at 1.5%.
To make two arguments in favor of the dividend: The payout ratio is just around 25–30%. A few weeks ago, the dividend got raised by nearly 10%. That’s a strong sign of confidence and commitment!
What is also worth highlighting, is the total return performance of SCI. You would think of a sleeping and boring stock that barely moves due to being a slow-grower.
If you thought so, I must disappoint you – or better surprise you:
Whether you look at one year, five years or the last rolling ten years – SCI in every case has beaten the S&P 500 by a wide margin!
Year to date, the stock hovers around the zero (without the small dividend).
It is another reliable, under-followed possible crisis investment that shows you that you don’t need to find the “next Amazon“ (ISIN: US0231351067, Ticker: AMZN) or the likes – you seldom will find anyhow – in order to have successful stock picks.
By the way, one of my favorite plain language speaking investor-idols, Peter Lynch, already covered this stock in his highly recommended first book “One up on Wall Street” form 1989 (the year of my birth). He wrote:
If during 1969 you found yourself having to pay for a traditional burial ($980) of a loved one from one of the many funeral outlets owned by Service Corporation International, and somehow in spite of your grief you managed to invest another $980 in SCI stock, your 70 shares would have been worth $14,352.19 in 1987. A $10,000 investment in SCI would have resulted in a $137,000 gain.Peter Lynch, One up on Wall Street (1989)
It was already a controversial investment back then during his active time as a fund manager. But he made a good pick on this one.
A few words on their land holdings. SCI has total land ownership of 35,500 acres as per the last annual report. To compare this to last week’s two farmland companies:
- Gladstone has 115,000 acres
- Farmland Partners has 160,000 acres of own land (plus some under management)
Of these total 35,500 acres, SCI has around one third being unused. But how much land is this? Management estimates, that the remaining 12,000 acres are enough to accommodate enough people for the next 110 years (!) who seek their final peace.
From time to time, they also sell some land, but this is not of further interest for today’s overview.
The next two points I want to touch on, are growth and debt.
Usually, growth should be slow, but predictable. Or as the CEO said during the last conference call:
If you go back in this industry and particularly with SCI, year-to-year you would see the numbers of deaths — probably in one year you may be down 1% or 2%, in the next year you’re up 1% or 2% which you could predict was pretty good accuracy over a year […]CEO Tom Ryan, SCI – Q3 2022 Conference Call
Together with their frequent acquisitions and stock buybacks, you could expect a yearly growth rate in the ballpark of 8–12%. Of course, with time these numbers become more difficult to achieve, because with more size the net effect or overall contribution of both become less meaningful.
However, all in all, a stable business with not much volume growth.
You also must know that the last two years were somewhat of a special situation for SCI where management expected demand to have been pulled forward. In the next chart you see the strong uptake in earnings during 2020 and 2021:
And here you see their predictions of earnings development over the next years:
You see, the original expectation was for pulled-forward demand in 2020 and 2021 with correspondingly much higher earnings. Then, already beginning in this year 2022, earnings were expected to drop and then grow again in line with historical rates. Back to usual business. Even until 2025 management didn’t expect to reach the 2021 highs in earnings.
But the recent Q3 results were way better than expected.
Not only that. Management raised this year’s guidance and also expects higher results for next year. The results were so good that the relatively honestly and openly communicating management seemed afraid of how good the business is currently running.
Here are some more highlights from the earnings call:
What we would have expected is, why wouldn’t we go back towards, let’s say, a 2019 level, maybe you get a percent or so growth of 2019, I would expect that. So that would be a reasonable level that we think would stabilize.
What we’re telling you is, the third quarter of this year, we did 15% more calls than we did in the third quarter of 2019. That is not what anybody would have anticipated and that has just a very de minimis amount of Covid deaths in it.CEO Tom Ryan, SCI – Q3 2022 Conference Call
If you just scanned through the last section of the quote, please read it again slowly.
I will leave it with that.
As to debt levels, the business is a stable one and as such is capable of handling more debt than other types of businesses. Strong and predictable cash flows allow for that. The target ratio for SCI’s management is around 3.5–4x net debt to EBITDA. Currently, the debt level is sitting at around 3.5x, as per 30 September 2022.
Personally, this ratio is too high for me. I would have liked to see rather 2.5–3x max.
The good thing is, however, that debt maturities are stretched far into the future. And with the exception of some bank loans (due in 2024), all outstanding bonds have a fixed coupon to them. Interest rates on the bank loans are unfortunately variable so that in the rising rate environment also debt servicing costs from this part rise.
This should be the case until 2024.
But you see that the next bigger chunk of bond repayments is only due from 2027 on.
And here is a big chance for a home run.
At this point, I must praise the management team for their understanding of effective capital allocation. Not because of the long durations of their bonds. But for their already started buybacks of bonds. And they openly stated that they will continue to repurchase their bonds, if market conditions allow so. This will save them interest costs, but also principal repayments.
Here is the quote from their annual report 2021:
We continue to focus on maintaining optimal levels of liquidity and financial flexibility. Our flexible capital strategy allows us to manage our debt maturity profile by making open market debt repurchases when it is opportunistic to do so.SCI Annual Report 2021, p. 11
The longer the maturity of the bonds, the better, because the higher they get discounted with higher interest rates.
For example here is the bond due in 2027:
The bond could be bought back 6.5% under par, currently.
This means that for every 100 USD you borrowed, you have to only repay 93.5 USD, currently. A free lunch so to speak, if you know how to use capital properly.
Should we have another liquidity crisis like in 2020, such bonds can rapidly fall under 90% or even 80%, depending on the severity of the panic.
Doesn’t seem realistic?
Bonds were supposed to be stable? Keep this in mind, we are in a new interest rate environment. What we had in the last decade was an artificially too low (read: manipulated) level. Now bonds adjust to the new reality that actually is not new, but only got forgotten (or simply never experienced) by many.
Now, let’s jump into the valuation of this business in the next section.
How is SCI currently valued?
The equity market cap currently is around 11 billion USD. Add to that 4 billion USD in net debt and we arrive at an enterprise value of 15 billion USD.
Management is expecting operating cash flows of slightly more than 800 million USD. After investments, free cash flow should come in at around 500–600 million USD.
That gives us an EV / FCF multiple of 25–30x.
The historical growth rate and also the target going forward before the Q3 results was 8–12% of growth in earnings per share.
That would be somewhat too high for me. Even if SCI managed to grow by 10–15% p.a., I would like to see a discount from current prices.
You see in the next chart that although being a stable business, the share price can fluctuate pretty much from high to low:
Before the published Q3 results, the stock was under 60 USD which corresponds to a market cap of 9 billion USD (EV = 13 billion USD).
At that level, the EV / FCF multiple would be a more reasonable 21.6x using the higher FCF target of 600 million USD. Ideally, the stock should be bought in the mid- to low-50s, for my taste.
There is seldom a need to hurry, when there is no panic selling in the markets. The best chances for discounts only come once or twice a year. In such a scenario when nearly everything gets sold off, I would suggest to start accumulating, if this business model is of interest.
Also, at 55 USD the dividend yield would be a slightly more attractive 2%. The last time this stock offered at least 2% was during the 2020 selloff.
The patient get rewarded in the end. It is always the same.
However, one could also play another card. SCI has valued its cemeteries properties at around 2 billion USD on its balance sheet. You could also argue that subtracting this hard asset – that is rather increasing in real value with time – could give you a discount of around 20% on the company’s operating activities.
In such a case, you would pay about 16–18x for the operations, knowing that you have bought also land with its own value.
Even with this, I would like to see a drop of the stock price, first. At least under the 60’s mark.
Service Corporation International is another interesting business with land possessions. The use case and whole investment is a totally different one, however.
SCI is the market leader of the North American deathcare industry. It is a slow growing, but not uninteresting niche sector that even Peter Lynch was invested in.
The economics are attractive. Management does a good job and shows respectable capital allocation skills. Only the debt level is a bit too high for me. The good thing is that it has long maturities and management committed to buying back debt on the open market. This makes sense especially now that bonds are priced under par.
At this equity price, however, I would pass and wait for a better margin of safety.
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