Some thoughts on Dignity PLC after its 70% share price fall

Dignity PLC is an interesting stock.

It runs the UK’s only national network of funeral directors and crematoria, and only Co-op Funeralcare operates on anything like the same scale.

In terms of performance, Dignity has a long history of rapid and consistent revenue, earnings and dividend growth and its share price tripled between 2010 and 2017.

However, in recent months the share price has collapsed and is now about 70% below its peak. More shockingly (at least for shareholders), in January Dignity’s share price declined by 50% in a single day.

For me, this share price collapse raises two questions: 1) What went wrong and 2) is this an opportunity to pick up a good company at a bargain price?

Problem #1: You pay a high price for a rosy consensus

There is no doubt that Dignity’s headline financial performance has been impressive:

Dignity’s earnings have been increasing by an average of 17% per year over the last decade. And although dividend growth of 12% per year is not quite as impressive, it is still a long way above the 3% to 4% dividend growth you might reasonably expect from the FTSE 100 or All-Share.

Averaged across revenues, earnings and dividends, Dignity’s ten-year growth rate has been just over 12%.

So the company has been growing rapidly for years and of course that’s usually a good thing. However, it looks as if investors thought Dignity’s rapid growth would go on forever.

That optimism shows up in the price investors were willing to pay to own a slice of this company.

For example, Dignity’s share price peaked at around 2800p in 2016. If the shares returned to that price today then investors would be paying 32 times the company’s ten-year average earnings, otherwise known as its PE10 ratio.

Compare that to the median PE10 ratio for stocks on my stock screen, which currently stands at 19, and you can see that Dignity was trading at a very premium price.

To be fair, PE10 ratios of 30 or more are justifiable for a few very rare companies, but most of the time they’re not.

And thanks to Dignity’s policy of only paying out a small portion of profits as a dividend, its dividend yield and PD10 ratios (price to ten-year average dividend) at 2800p were almost laughable.

In terms of dividend yield, a share price of 2800p reduces it to about 1%.

In 2016 that left investors almost totally reliant on rapid future growth to produce the sort of 7% to 10% annual returns they might reasonably expect from their equity investments.

As for the PD10 ratio, the median across my stock screen is 42. With a share price of 2800p Dignity’s PD10 ratio would be a jaw-dropping 165.

That may be acceptable to some investors, but if you have any interest in obtaining a reasonable dividend income then that sort of extreme price to dividend ratio is an obvious turn-off.

Again, a high price-to-dividend ratio could be justifiable if a company can rapidly grow its dividend over the long term, but thanks to the highly competitive nature of relatively free markets, most companies can’t.

So is Dignity one of those rare companies with the ability to rapidly grow revenues, earnings and dividends decade after decade?

Well, as Grampa Simpson once said, “Like all true stories, this one has a crappy ending…”

Contrary to what many investors thought, it turns out that Dignity is not a guaranteed profit growth machine after all. That became clear in January when the company announced price cuts and price freezes in order to retain market share as the funeral market became significantly more price competitive.

The company also announced that its 2018 results would be substantially below current market expectations.

I’m not going to speculate on how Dignity’s future pans out from here, or whether its impressive dividend cover will be enough to protect the dividend if the company’s profits and cash flows fall off a cliff, but one thing is clear:

If something can go wrong it probably will, so don’t buy shares when the price implies an improbably rosy future.

Problem 2: Borrow, acquire and grow is a risky strategy

So how has Dignity managed to grow so quickly, despite operating in what could easily be described as a mature and even stodgy market?

The answer is that it:

1. Borrows money in order to acquire lots of smaller funeral directors and crematoria
2. Raises prices, which (at least until recently) was possible because most people a) don’t want to feel like a skinflint when it comes to burying a loved one and b) aren’t in the mood for doing lots of price comparisons
3. Lowers costs through economies of scale and efficient operating procedures
4. (possibly) improves service quality

There’s a lot more to it than that and, if you’re interested, you can read about it in a research report titled “We’re shorting Dignity” (it’s written by a funeral price comparison website so there are conflicts of interest… but it’s still an interesting report if you have the time to read it, although that doesn’t mean I agree with everything it says).

What I don’t like is the “borrows money” part of the strategy (and I’m not especially keen on the “acquire” bit either).

Yes, the funeral business is a very defensive one. After all, people don’t stop dying just because there’s a recession and relatives still bury their dead even when times are tough.

And the number of UK deaths per year is pretty steady as well, so as you can see from Dignity’s rock-steady revenues, funerals are a very stable source of income.

However, if a company loads itself up to the eyeballs with debt then even the most defensive business in the world can become a fragile time-bomb with a pressure-sensitive detonator.

So is Dignity up to its eyeballs in debt? As far as I’m concerned, yes.

It has borrowings of more than £550m compared to five-year average post-tax profits of £60m, giving it a debt ratio of more than 9.

That’s almost triple the average debt ratio of stocks on my stock screen, where the median value is 3.7.

For defensive stocks, I have an upper limit for the debt ratio of five, so Dignity’s is almost double that as well.

This isn’t a new situation for the company either. Ever since it was bought by management in 2002 with backing from a private equity company, debt has been central to Dignity’s strategy.

And a very successful strategy it has been too. But in my experience, this sort of debt-fuelled acquisition-driven growth strategy is more trouble than it’s worth, at least most of the time.

There’s no doubt it can work for many years, but constantly bolting on new businesses can hide a multitude of sins (including declining performance from earlier acquisitions), and the end result can be the business equivalent of spaghetti code.

Add a mountain of secured debt to that potentially unstable base and Dignity’s future suddenly becomes a lot more uncertain than you might expect, especially given the inherent defensiveness of the funeral market.

So although none of this has had a negative effect on Dignity (yet), and the expectations for underperformance in 2018 are still just expectations, I think another takeaway from Dignity’s demise is this:

Growing a company through debt-fuelled acquisitions is like driving to work at 200 miles per hour. In both cases progress is rapid, but if you hit a bump in the road the results can be catastrophic.

Clearly, I’m not a huge fan of Dignity’s borrow-to-acquire-to-grow strategy. Its combination of high debts and extensive acquisitions means I wouldn’t invest at any price.

So referring back to the second of my two opening questions, is this an opportunity to pick up a good company at a bargain price?

No, I don’t think it is, primarily because Dignity’s does not meet my definition of a “good” company.

However, perhaps you’re made of hardier stuff than I am and it takes a lot more than sky-high debts and an endless string of acquisitions to put you off.

If that’s the case then you might like to know that Dignity currently ranks 34th out of more than 200 stocks on my stock screen, based on a combination of its growth, income, consistency and valuation ratios, and I would definitely be interested if it wasn’t for those debt and acquisition issues.

If you are still interested in Dignity then you might also want to look at some of these articles and reports:

• Shorting Dignity PLC stock (beyond.life)
• Doubling down in Dignity (globalstockpicking.com)
• 10 Important things to understand about Dignity PLC (Walbrock Research)