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StoneMor Inc. (NYSE:STON) is yet another business in the death industry on which we’ve been expanding our coverage. It is more focused on cemetery operations than some of its peers, and that presents a little bit of a problem for them in the current market.
Since returns on investments from selling interment rights are important for the long-term revenues of the business, and cemetery revenues are exposed to inflation pressure, we worry about StoneMor’s debt situation. They are in talks with a financial sponsor for some sort of transaction, but nothing has been decided yet and all parties could walk away. Shareholders appear to be in a position where a deal must happen otherwise the equity in this business could suffer a lot due to debt pressure, and indeed at maturity in 2029 collapse entirely.
STON has excellent economics in theory, and can probably turn the ship around. It is discounted with respect to some closer comps, so there is an upside here, but the risks are absolute. While mitigating factors are saving them, the situation is really ambiguous, and with an abyss below, we don’t walk these tightropes.
The Challenges
Let’s first discuss economics. StoneMor’s primarily business is in cemetery operations. There’s about a 4:3:3 split between selling interment rights, services and merchandise. There are two dynamics which are saving StoneMor right now. Services and merchandise are often sold on a preneed basis, i.e., before a death has occurred. That cash flow is essential for servicing debt, and is why the operating cash flow figures are just about positive while net income is in the deep negative. Deferred revenues save them here. The other element is that when selling interment rights, the cost of servicing those interred remains are not payable immediately, as the plot is maintained on an ongoing basis. Therefore, selling interment rights provides an excellent upfront cash flow that helps service debt.
Indeed, the debt situation is very severe. They have about $400 million in gross debt, and the interest expense is about $40 million a year, implying the 10% rate that would honestly be consistent with the risks from leverage here. Net debt is a bit lower at $320 million, but the problem still remains.
We mentioned earlier that a lot of cash comes upfront for StoneMor. Especially for interment sales, this means that a lot of cash ends up in trusts that need to invest the money so that there’s more to distribute back into the working capital of the businesses, and indeed the pockets of shareholders over time. If investment performance is weak, then there’s less distributions in the long-term for the company from those interment sales, which are partially deferred using these trusts and all that associated accounting. The economics aren’t so different from pension plans with defined benefits.
The problem is that performance is probably going to be pretty weak.
2022 revenues were $70.5 million for the second quarter of 2022, compared with $72.1 million for the second quarter of 2021, a 2.3% decline, which was primarily driven by the decrease in investment and other income.
And if it’s really weak, there’s even a risk that the company has to pay into the trust to cover the statutory obligations for covering interred remains. State laws play into this, and it creates some hidden leverage that is contingent on poor investment performance.
You might see how things could be complicated…
Also, there’s the issue of inflation. Labor is inflating, materials like steel, lumber and copper are inflating, and all this is shrinking gross margins and increasing SG&A and other below-COGS OPEX. Thankfully STON has lots of pricing power, and as preneed sales are digested and new deals are made at more favorable prices, hopefully that inflationary pressure will be mitigated. Still, every dollar counts and this puts them behind in the process of covering debt. The debt is all due in 2029, which is a bit of a saving grace, because refinancing is likely not very economical either given rate hikes.
Conclusions
STON is in talks with Axar Capital over some sort of deal. Makes sense. This is a business in a fragmented industry and there is scope for roll-ups and other activity that could be very value accretive. Also, STON badly needs strategic options. At least private markets are flush with cash, there could be other potential buyers out there together with Axar, and the economics of STON are attractive for PE and other financial sponsors, as well as for strategic that those financial sponsors might be selling to or involving down the line.
At the moment, the business is not only indebted but also poorly run, and the increment looks to be on the negative side, even if horizons in the death care business are thankfully quite reliable and long. Competitors are very profitable, with EBIT margins often in excess of 20%. STON trades at a 1.3x P/S while Service Corporation (SCI) trades at 2.5x. Carriage Services (CSV), which is well-run like SCI, trades at a 1.6x. SCI is closer to STON in terms of business mix than CSV, so it seems the market are tempering their expectations relative to the closer, well-run peer. The implication is that markets believe STON can become half as profitable as SCI, thus justifying the multiple. Expenses would have to be cut 25% for that to happen. 14% came from supply chain and inflationary uptick YoY, and that could be reversed with pricing action to compensate. Trimming more fat after that seems doable. We can see why sponsors are interested.
Nonetheless, we don’t see the need to play this game. In addition to debt, which is one of the ways equity investors can really lose a lot of money, poor market conditions and other ad hoc challenges for STON related to supply chain and inflation do worry us. Also, some part of their business is discretionary, on the merchandise and funeral side especially. It’s not a clean situation, and we don’t ever take these kinds of risks, although upside here could be argued. Overall, a pass.
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