Future demand is guaranteed for funeral provider Dignity, says Phil Oakley.
Dignity (LSE: DTY)is the largest independent provider of funeral services in the UK and the largest owner of crematoria. It has around a 12% share of the funeral market. The company was created in 1994 and bought by current chairman Peter Hindley and chief executive Mike McCollum in 2002 with the help of a private-equity partner.
The shares have delivered spectacular returns since the company was listed in 2004. A shareholder who invested at the flotation would have had more than their initial stake returned to them, and would still be holding a share that has more than tripled in value. However, this ability to churn out consistently good results means Dignity’s shares are sought-after and are not particularly cheap. Can the shares keep delivering the goods or will future returns disappoint?
Prospects for the business
Benjamin Franklin said that in this world nothing can be said to be certain, except death and taxes. We might not like contemplating our mortality, but as far as investors in Dignity are concerned, it makes for a very steady and predictable business that is easy to understand.
The company makes money by selling funeral services, cremations, and from the growing trend for people to pay for their funeral in advance – so-called pre-paid funeral plans. It’s an extremely profitable business. Its funeral services business has profit margins of 42%, while those from cremations are even higher at over 58%.
Returns on the money invested in the business (return on capital employed, or ROCE) were a very healthy 22.6% last year. Based on its financial performance and steady growth, Dignity has the hallmarks of one of the most outstanding companies listed on the stock exchange.
Usually a company making big profits will attract the attention of competitors and see its profits forced down. That’s one of the building blocks of capitalism. But although the funeral industry is competitive, Dignity’s profits have not come under threat yet.
The main reason for this is that it is quite difficult for new businesses to get into this market. The primary ‘barrier to entry’ is the critical importance of having a good reputation, which is something that takes years to build. Planning restrictions also make it difficult for competitors to build new crematoria. That means that even though land prices have been quite favourable recently, there aren’t many new facilities opening up.
There has also been talk of regulating the funeral services industry. You might think that would be bad for Dignity’s profits, but that’s by no means certain. In fact, regulation may act as yet another barrier to entry and protect it from competition. So at the moment it’s hard to see the company’s profits coming under serious pressure in the short term.
That’s not to say that Dignity doesn’t face any challenges. The death rate has been slowly falling in recent decades as people are living longer, which has altered the demand for funerals. To counter this, Dignity has been hoovering up lots of smaller businesses. The funeral services market remains very fragmented, with lots of small family businesses that are ripe for take over, which Dignity can integrate into its existing network and so boost profits.
A glance through its accounts also suggests that Dignity has the ability to raise prices to cover costs – another good sign. Revenues have grown faster than overall demand for funerals and cremations, which has helped profit margins to continue to grow.
While the death rate may be falling, broad demand for funerals is still relatively easy to predict, which means Dignity’s cash flows are very reliable. It also has the equivalent of four and half years of its current funeral workload pre-booked. So while investors would normally see Dignity’s high levels of debt as a danger sign, the predictable nature of the business enables it to support quite a high level of debt comfortably.
Should you buy the shares?
In fact, Dignity’s shareholders have done nicely out of this debt, and will probably keep doing so. That’s because Dignity has used loans to buy back shares on a regular basis. On top of that the debt has enhanced (geared) shareholder returns, with steady increases in trading profits being magnified into bigger increases in earnings per share. In many ways Dignity has similar characteristics to a water or electricity grid company, where the risks of big profit falls seem small and where debt doesn’t make the shares too risky, but instead boosts returns.
All in all, Dignity has a lot going for it. In fact, for me the most worrying aspect is that it’s hard to see what could go wrong. A disruptive competitor seems unlikely at the moment. It’s possible that increased regulation of funerals or pre-paid funeral plans may knock sentiment towards the shares if it was announced, but as I already said, this could well be a benefit in the longer run.
The shares are not cheap, trading on over 18 times this year’s earnings with a negligible dividend yield – but they look worth every penny. The high quality of the business and the expectation of further strong earnings growth means they look a good long-term investment.
Stockmarket code: LSE: DTY
Share price: 1,328p
Market cap: £706m
Net assets (June 2013): £85.3m
Net debt (June 2013): £312.0m
P/e (prospective): 18.4 times
Yield (prospective): 1.1%
Dividend cover: 4.9 times
Interest cover: 3.5 times
M McCollum (CEO): 200,001
S Whittern (CFO): 21,367
P Hindley (Chair): 175,305
What the analysts say
Target price: 1,575p