Interactive Investor

Stockwatch: should you buy this small-cap share before it’s too late?

16th December 2022 11:13

by Edmond Jackson from interactive investor

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Sentiment may have run too far on the downside here, as often happens with financial markets. Analyst Edmond Jackson gives his view on prospects for this fallen giant.

What might Monaco-based John Jakes, see in Dignity (LSE:DTY)? The founder of Acorn Stairlifts, the world’s largest such supplier, persists to accumulate shares in the troubled funeral services provider near to prices not seen since 2020.

From 2012 to 2016, the share price trebled amid vigorous acquisitions and operating margins over 30%. But competition and regulation eroded any advantage, and Dignity has pretty much “returned to go”. A newish CEO waxes at opportunities ahead, partly because Financial Conduct Authority (FCA) regulation has prompted some operators to leave the market, although it is early days in a turnaround and this sub-£200 million company supports around £500 million of debt. 

Jakes, however, clearly believes now is the time to accumulate before the worm turns. After taking his holding to 10% in June, as of 9 December he was up to 16.3% – a conviction bet which will be hard to unwind if Dignity’s performance does not improve. 

He is not the first to take a bold stance: Phoenix Asset Management acquired a 5% stake in early 2018 and kept buying up to 29% by April 2019. This was premature and Phoenix had to dig in – calling a shareholder vote to change the chairman.  

Industry regulation and a confusing UK death rate 

Many investors lost interest, as an industry investigation by the Competition and Markets Authority (CMA) rumbled on from mid-2018 to end-2020. 

The CMA found people pay high funeral prices because they are not in a good position to choose – and get exploited by an industry with three main firms and a long tail of one-branch operators. By various means, competition was restricted and high prices reflected market power. Better transparency of pricing and services were required. 

Dignity therefore got overvalued in its boom years and has necessarily mean-reverted, but has sentiment run too far on the downside, like markets are apt to do? 

Recalling the proverb “You never step in the same river twice”, a dilemma is the changing environment. 

I feel Dignity may be blaming fluctuations in the death rate to part-excuse its performance, but where the long-term trend could now be rising.   

It peaked in the late 1970s (peak booze and fags?) then declined consistently to 2013 (better healthcare?) and has since risen. Covid caused a jump from around 531,000 in 2019 to 608,000 in 2020, hence an inevitable slip back. Yet the United Nations projects deaths to continue rising – justifiably, it would appear, for an ageing population.   

Given there also seems no solution to an overwhelmed NHS, however much public money is thrown at it, a cynical view may back the UN’s thinking. 

Change of CEO heralds a new approach? 

A new boss is frequently a catalyst for a successful recovery stock. Take your view on Kate Davidson, who is lauded by the “end of life” industry having spent eight years in various management/strategic roles at Dignity, then left for rival Westerleigh – the UK’s leader in crematoria and cemeteries. She returned to Dignity in June 2021 as its chief operating officer, becoming CEO a year later. 

She is therefore “of the industry” and indeed very much Dignity, but perhaps this is necessary rather than bringing in a turnaround generalist. 

Davidson explained a drop in first-half 2022 revenue and profit as part-reflecting increased competitiveness (quite whether the implied price reductions stay low is unclear) as well as staff shortages compromising early signs of growth in market share. 

Interim results showed 2021 underlying pre-tax profit of £36 million wiped down to £600,000 on underlying revenue down 17% to £141 million. This was characterised as “an initial adverse impact” from a new strategy. 

Dignity’s market share has edged up to near 13% both for funerals and cremations. 

Dignity - financial summary
Year end 31 Dec

Turnover (£ million)269305314324354339358354
Operating margin (%)-15.631.
Operating profit (£m)-41.994.997.197.675.944.815.917.8
Net profit (£m)-55.056.957.257.8-17.034.9-25.512.1
EPS - reported (p)-113115115116-34.069.8-51.024.2
EPS - normalised (p)94.9115120126-27.699.618.983.8
Operating cashflow/share (p)13818616315013564.463.044.7
Capital expenditure/share (p)35.540.045.754.050.036.622.241.9
Free cashflow/share (p)10314611796.085.027.840.82.8
Dividends per share (p)19.521.523.624.424.
Covered by earnings (x)-
Cash (£m)86.581.966.849.080.773.495.275.7
Net debt (£m)524521524517481479535535
Net assets (£m)-92.5-43.9-3.546.4-164-137-174-151
Net assets per share (p)-205-88.8-7.092.9-328-274-358-302

Source: historic company REFS and company accounts

Potential testing of debt covenants is a concern 

Forecasting is currently hazardous, but for illustration, with around 50 million shares issue, a recovery say to £15 million underlying net profit implies earnings per share (EPS) of 30p, hence with the stock currently around 370p a price/earnings (PE) multiple just over 12x.  

Quite whether Dignity can avert dilution to reduce balance sheet risk should recession grind on is not clear, hence tough competition on funeral prices. The primary debt covenant requires EBITDA (close to operating profit) over 1.5x and it had declined from 2.1x last December to 1.6x last March. 

The 1 July balance sheet had £513 million long-term debt and £12 million near-term, also £80.5 million leases – relative to a net assets’ deficit of £274 million. This, however, follows from £1,233 million contract liabilities i.e. pre-paid funerals. There was £49 million cash, down 54% on June 2021, albeit £229 million goodwill/intangibles from past acquisitions. 

Interim finance costs were a fairly consistent £14 million, but there was also £26 million deferred revenue financing costs and a £68 million re-measurement of financial assets held by trusts.  

One has to hope that Dignity kitchen-sinked such exceptional charges, given they resulted in a £156 million interim pre-tax loss.  

Management appears to entertain a sale-and-leaseback initiative when it speaks of:  “Addressing the capital structure by use of the crematoria portfolio without undermining the integrated nature of the group.” 

If you examine the interim results statement, there is a section under “Capital structure” where bondholders have agreed to such asset sales. 

This could help de-risk Dignity without incurring dilution – hence likely trigger a stock re-rating – so is worth investigating further. It does appear the board has well-rehearsed such an initiative that the two big shareholders would encourage. 

Projections for this are tricky but to entertain the initiative the board must reckon proceeds can slash debt. 

Third-quarter update offered little inspiration 

“Promising early signs of increases in market share” was headlined in the latest trading update, as staff shortages were gradually mitigated. Yet there was further pressure on revenue and profit – seemingly from competition and as Dignity re-formulates selling cremations. 

Numbers were presented on a 39-week basis rather than comparing third quarters, but a 68% fall in underlying operating profit to £14.1 million was lower than the £14.4 million cited at interims for 26 weeks, implying a loss. Like-for-like revenue for 39 weeks fell 14% on the first three months of 2021. 

It is a bit poor attempt to cover a recent underlying loss, obviously a concern versus the debt covenant. Dignity still generated over £24 million cash from operations, even if down 57% like-for-like. 

Despite a 4% year-on-year rise in the average cost to deliver a funeral to £1,925, average funeral revenue fell 16% to £2,095.  

I draw your attention to another “Capital structure” note, low down this release. It is complex to convey but essentially, the free cash flow to total debt service ratio declined from 1.72x last June, to 0.88x last September. This was below a 1.4x threshold which is not a covenant but restricts flexibility of cash transfers. 

A strict contrarian approach would say Wait

If recession compromises Dignity’s revenues, it might not also be a great time to sell/lease-back its crematoria. On the other hand, a flu epidemic combined with NHS chaos could raise the death rate. A gallows mindset is required here.  

Disciplined investors should leave it alone for now, given the debt. Yet as a gamble, there is scope to get lucky: a fresh approach from the newish CEO, crematoria sales to de-risk the balance sheet, and rising deaths. According to your risk appetite: Buy.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.


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