In Warren Buffett’s early years as an investor, he looked for cigar butt companies; companies that were thrown out yet had a little bit of value to be extracted. This strategy worked well for him, and is still used today by the man who literally wrote the book on margin of safety, Seth Klarman. Yet as Buffett got older and Berkshire grew larger, it became a necessity to switch gears from investing in cigar butts to great companies at good prices. Think of any Buffett investment and what common factors do you find? Quality management, successful capital allocation strategies, wide moats to protect itself from competition, and (for the most part) a laissez fair approach to actively managing the individual businesses.
Carriage Services might be the Berkshire Hathaway of the Funeral Home & Cemetery business. The company’s business model is to find independent funeral home businesses that are well run, show a history of sustainable revenue growth, and have stellar management in place that would be aligned with the views and goals of Carriage Services. The company sports a 5% 5yr Revenue CAGR, 29.8% 5yr EBITDA Margin, and an 11.5% FCF yield. Gross margins consistently fall in the 30% range, and EBIT / Profit margins are 17% and 14% respectively. Finally, management’s interests are aligned with that of its shareholders. 21% insider ownership that has 7% of total shares outstanding belonging to the CEO, as well as the company buying back nearly 2 million shares since 2015.
Management focuses on putting the right people in the right places. In fact, you’ll see they do some very unconventional things when it comes to how they operate the business from a financial standpoint. I can’t remember a time I’ve been bullish on a company approaching all time highs, but alas, here we are. Let’s get after it.
Founded in 1991 by Mel Payne, Carriage Services set out to achieve their mission statement of “Being the Best” by building a high performance company that excels at allocating capital. Since founding the company, Mel has been the only CEO and Chairman of the Board. The company subscribes to Five Guiding Principles, which are:
- Honesty, integrity and quality in all that we do.
- Hard work, pride of accomplishment, and shared success through employee ownership.
- Belief in the power of people through individual initiative and teamwork.
- Outstanding service and profitability go hand-in-hand.
- Growth of the company is driven by decentralization and partnership.
Although the company stays firm to their principles, they are not against being pragmatic in their approach to finding what works within their company. For example, in 2004 the company got rid of financial budgets. That’s right. You know the everyday thing people use to make sure they don’t overspend what they earn? The company tossed those in favor of a Standards Operating Model. This model allowed the company to more closely re-align their business operations with their principles. In fact, since eliminating budgets, the company says they are now free to focus on leadership, people, and culture.
The company didn’t stop there. In 2006, CSV took Jack Welch’s 4E Leadership Model and applied it to their own business to help find high performing individuals to lead their respective investments. It’s always nice to see management copy from a man who increased the value of GE 4,000% during his tenure.
Finally, in 2015, the company realigned its Strategic Acquisition Model to more appropriately fall in line with best business practices by making sure they partner only with the best independent funeral home operators in the nation.
Business Deep Dive
CSV is a leading operator of funeral and cemetery services and merchandise. The company is one of the largest death care consolidation companies in the US. It currently operates 210 funeral homes and cemeteries across 29 states. So how does the company make money? The company operates two business segments: Funeral home operations and cemetery operations. Funeral home operations accounted for approx. 78% of revenues over the last year, with the remaining 22% coming from cemetery business. When it comes to their funeral home segment, the company makes itself more sticky by offering a variety of services such as consultation, removal and preparation of remains, sale of caskets, and the use of the funeral home facilities for visitation and remembrance services.
Highly Fragmented Industry Presents Substantial Opportunity
At one point in the 1990s there was a funeral home consolidation phase, but since then, nothing to speak of. Even after over 50 years of start-and-stop consolidation, the funeral home industry remains one of the highest fragmented industries in the United States. This will most likely change as succession planning issues for privately owned funeral and cemetery businesses have become more difficult and complex and than ever.
There are three main players in the funeral home consolidation business: Service Corporation International (SCI), StoneMor Partners L.P., (STON) and CSV. Combined, these three companies represent roughly 20% of the funeral and cemetery revenues in the United States. That means 80% of the remaining revenue is driven by independent or privately held funeral home companies. This represents an extraordinary chance at capturing market share as more and more independents roll-up in consolidation. That it will come down to which management team can offer the best deal makes me confident in my choice that CSV will capture most of that market.
A Natural Moat for the Funeral Home Business
Funeral homes are great, sustainable businesses. With consistently high margins, fixed overhead, and a guaranteed line-up of customers, it begs the question why there aren’t as many funeral homes throughout the US. The main reason is because the funeral home business has traditionally been family owned and operated, with companies building local heritages and traditions through successive generations. These successive generational passages of the business create opportunities for established client family relationships and referrals.
Also, because the nature of the business is emotionally sensitive, these relationships take years to develop at the local level, and are a significant driver of market share. So sure, new funeral homes could prop up with entrepreneurs hungry for sustainable high margins, but it would take a tremendous amount of time and energy to develop the long-standing relationships most of these companies took decades to fortify.
As depressing as this sounds, it’s good for the business: The United States is seeing an uptick in deaths. During 2017, the number of deaths in the US increased 2.1%. What’s more appealing to longer-term revenue growth is this: The number of Americans aged 55 – 64 is expected to grow 2% by 2021, making it the second fastest – growing age group. Even better, Americans aged 65 and older represents the fastest growing segment, growing at an average annual rate of 3%, and will on average increase in death count by 2% per year until 2021.
CSV’s Competitive Advantage
Besides being in a moaty industry, CSV digs their moat deeper through management and operational structure. CSV really is a spitting image of Berkshire Hathaway when it comes to how the company acquires businesses to add to the portfolio. Check out this quote from CEO Mel Payne when he was asked to describe how he acquires businesses:
“We want to buy businesses, much like Berkshire Hathaway describes, that will grow and have more opportunity to deploy capital into the future, in their markets” – Most recent earnings report.
In short, CSV tries to find businesses within the funeral home industry that are growing revenues, increasing their EBITDA margins, and are generating sustainable free cash flow. Much like Berkshire and the Oracle of Omaha, Payne recognizes that sometimes its good enough to get a great business for a good price, not just a cheap price:
“We also want to pay a fair price for a good business. That doesn’t mean a low price because if it’s high on the strategic ranking criteria by definition, it’s going to be a higher multiple, higher revenue growth in the future. And if the revenue is growing, the EBITDA margins will be growing faster in compounding and creating value creation for our shareholders. So we know what we’re doing.”
In all honesty, if I didn’t tell you who that quote was from, you might have guessed I pulled it from a Berkshire annual report. CSV is focused on the long – term growth of the companies they buy. In fact, management has said in numerous earnings calls that they don’t even like giving quarterly results because their investments should be measured on a 5 to 10 year basis.
Robust Acquisition & Operating Models
Strategic Acquisition Model
What surprised me the most about these models is the lack of pure numerical financial data that goes in. 85% of the company’s Strategic Acquisition Model deals with qualitative natures of its business. So what makes this model so great? Since development of the model, the company can generate a relatively confident “roughly right” range for long-term revenue growth as well as making sure ROIC is greater than their Cost of Capital in the early years, which then increases over time.
When it comes to acquisitions, the company historically has paid roughly 5 – 7.5x EBITDA for each business. The acquisition model is based on 10 criteria, and management bases their confidence and future growth prospects on how well a business scores on those 10 criteria. Because of this, the score of the model is the largest driver of deciding what multiple to pay for the business. This is an advantage because the model places a huge emphases on qualitative aspects of the business that cannot be quantified per-say, but only known if there are boots on the ground in the industry. Mel Payne said it himself, he doesn’t even have to look at financial statements in order to decide if a business will be a good acquisition to the firm. I love that kind of pulse on an industry from its leader.
Business Operations Model
When it comes to their internal funeral home operations, the company has Funeral Standards, another model. This model is split 50% Qualitative and 50% Quantitative. Within the quality segment of the model, 30% of the value is placed on market share and volume growth, 10% on continuous upgrading of staff (people quality), and 10% Right Quality of Staff (making sure you have the best leaders in the best positions). Switching over to the quantitative side: 15% comes from Average Revenue Per Funeral contract, 12% from Salaries & Benefits as % of revenue, 10% for Gross Margin and EBITDA margin, and 3% from bad debt % of revenue.
Combine these models with the company’s adopted 4E’s from Jack Welch and you create long-term achievements in hitting those Standards for each and every operation. These models are also tweaked depending on the individual Managing Partner, which is another nod to CSV’s dedication in entrepreneurship and decentralized decision-making.
Decentralized Decision Making Style
80% of the industry is still privately held or independently operated. Why is this? In short, if something’s not broke, there’s no need to fix it. But more than that, funeral homes are very local and very specific. What works in Nebraska might not work in Chattanooga. Because of this, CSV’s style of decentralized decision-making makes them the best choice for funeral home operators that are on the fence about whether or not to roll-up and consolidate. The operator would get CSV’s Operating Model (which has shown consistent 30%+ margins), CSV’s support center, and comfort in knowing that when CSV acquires businesses, those businesses show significant improvement in operating performance.
Results That Speak For Themselves
As a result of these models and decentralized decision-making, CSV is able to leverage single digit revenue growth rates into larger increases in EBITDA and EPS. From 2012 to 2017 the company averaged a Revenue CAGR of 5.4%, but EBITDA CAGR came in at 6.3% and EPS growth sported 11.7% CAGR. During that time frame, revenues jumped from $198MM to $258MM, EBITDA from $50.7MM to $68.7MM, and EPS from $0.80 to $1.39.
The company has also proved excellent at sustaining positive free cash flow yields. These yields allow CSV to fund the majority of their acquisitions or investment allocations via FCF instead of debt leverage (such as internal growth expenditures, share repurchases, dividends). Since 2012, FCF grew from $22.0MM to $37.4M.
Finally, the beauty of the funeral home industry shows through relatively fixed overhead cost structures, which for CSV ensures a slower rate of overhead growth compared to its FCF generation. Overhead costs represent a mere 14% of total revenues and have increased roughly 4.2% CAGR over the last five years.
The company is trading at 12.3x earnings, lower than its peer average of 23.3x and its sector average of 19x. P/B ratio of 2.3x is well below its peer average of 3.8x, and slightly above sector average of 2.1x. P/FCF comes in at 17.42, better than 61% of its competitors. The company is trading roughly 8x its EV to EBITDA, which is below the sector average of 10.2, and below its two closest competitors. The company sustains a near 30% EBITDA margin, 30% gross margin, 14.5% Net Profit Margin, and 20% ROE.
Concerns Over Leverage
The company is about 5x leveraged. The funny thing is, it doesn’t need to be 5x leveraged. But there’s a kicker. There’s a difference between being 5x leveraged in a business like funeral homes compared to a business like technology or retail. The sustainability and competitive advantages inherent in the funeral home business make a 5x leverage not as worrisome as it could be. Nevertheless, I wanted to see what management had to say about this leveraging. The answer from CFO Mark Bruce I found was perfect. It follows (emphasis was my own):
“I call myself inside the company as the chief mistake maker. I have earned that over and over, over 27 years. I made a huge mistake allowing that convert to be done. It wasn’t my idea, but I allowed it to be done as my watch, I’m the boss. I regret that more than anyone can possibly no. And so, we will deal with that because it has to be dealt with. I think it’s holding our stock down. We have got a lot of shorts in the stock. We never had shorts before. And the next thing we do from a capital structure point of view will be smart, not dumb.”
There’s nothing as refreshing as extreme ownership in business. Issuing notes to leverage the business was a mistake simply because the business has enough cash to finance its operations without the need to leverage. However, this 5x leveraging isn’t a death sentence, and management made it clear they are working on bringing it down to the low 4x’s by the end of the year.
The Market Narrative
The market has loved CSV since 2012, and rightfully so. This is one of those instances where the market is pricing quantitative information to near perfection. Since 2012, CSV’s gained nearly 400% Total Return, compared to its competitor SCI which returned 317%, and the Russell 3000 which returned 152.5%. Yet the recent leverage situation brought forth shorts out of the woods, hungry for companies with 5x leverage to collapse under their own weight. I attribute this to what could be a simple “Short Screener”, where people screen for companies trading at 5x leverage while disregarding the industry the company is in. So after a near 400% total return, why on Earth do I still think there’s tremendous value?
The company still trades at a mere 13x earnings and sports a FCF yield of 11%+. This company is a virtual Berkshire Hathaway in its own industry, and through principled management, decentralized decision-making, and an emphasis on individual entrepreneurship, the company is extremely well positioned to capture the remaining 80% of the funeral home market.
Using a simple P/E multiple growth rate between 16x and 20x, and multiplying that by its average net income per year, we get an equity value range of $595MM – $744MM. Divided by the number of shares outstanding and you arrive at a fair value between $36 – $46. The company’s “Roughly Right” 5 Year scenario has revenues growing at an 8.4% CAGR clip, significantly higher than the last five years of 4.5%. Adjusted EBITDA growth is anticipated at 11.4% CAGR.
Reading the Tape
Shares are trading near all time highs. In a perfect world I would want the price to head back down towards its 50MA / bottom end of the symmetrical right triangle before I would accumulate shares. However, if price breaks through the upper resistance level around $29 – $30 I would start buying. I would start small, given my natural apprehension for being at the highest highs.
Where Is My Fallibility?
Here are some ways in which I could be wrong on CSV:
- The company fails to reduce its leverage, and even increases leverage into 6 – 7x territory.
- The company deviates from its models and starts poorly allocating capital.
- Mel Payne steps down suddenly and the company is left without a leader for the first time in its history.
- Competitors outbid and gain more market share than CSV with respect to the 80% untapped market.
- The company fails to acquire businesses that provide long – term growth and increased shareholder value.