Stockwatch: funeral firm shares spike thanks to timid regulator

Dignity is now blossoming as the competition watchdog’s investigation turns out to be more ‘silk glove’ than ‘iron fist’. Our analyst reports.

Shelving the prospect of regulatory price controls has prompted a near-doubling of the shares of funeral provider Dignity (LSE:DTY).

It is also substantially de-risked due to a transformation plan, while upside exists now the NHS struggles to detect and treat heart disease and cancer. This could sadly mean deaths from these illnesses increase in the medium term. 

Cynical view could be more realistic

Last March I suggested a share price of around 275p – having slumped from over 2,800p four years ago. My thoughts were that Dignity offered a chance for gamblers “to get lucky buying in now, potentially at a point of maximum uncertainty”. 

A Competition & Markets Authority (CMA) report had hung over the industry for over a year, supposedly to tackle near 70% inflation in funeral prices over the last decade that have helped Dignity’s operating profit margins rise over 30% during 2015 to 2017 (see table). 

During Covid-19 funeral service providers were able to thrive through the uncertainty afflicting most other businesses, hence be well positioned to meet regulatory demands.  

The talk was of price controls, although as a middle-aged consumer I have wearied of ineffective regulation – be it in financial services, energy or telecoms. 

Regulators seem chiefly to bump up costs, even constrain the service, as a result of the red tape they strap on, while their bosses certainly do well by way of salaries.

I therefore concluded in March to wait for the CMA report, yet saw reasons for shareholders to be positive about Dignity, hence believing an overall ‘hold’ stance was fair. 

Yesterday the CMA parked its plans for a price cap.

It said Covid-19 had disrupted its investigation, which it had no legal power to extend (by statute expiring in March 2021).

Instead it offered a sop to consumers by suggesting more transparent pricing by funeral providers, while price controls are shelved as they “could not safely be introduced in the middle of a national emergency”.  

• Betting on one of life’s certainties
• G4S and Dignity shares plunge
• The Week Ahead: three FTSE 100 stocks to watch
• Stockwatch: Can you trust Shell’s 15% dividend yield?

This week Dignity shares doubled from 331p last Monday to a high of 634p, currently 625p.

I find myself in the odd dilemma of reinforcing my stance on a stock, significantly due to regulatory failure, if not untypical of the UK.

Regulatory risk has not wholly gone away but manifestly the CMA is shown to be wearing kid gloves.

Context of underlying improvements

The 29 July interim results were quite varied both in ‘underlying’ definitions of profit versus ‘reported’ figures, although Dignity’s stock rating had got low enough – on cash flow and earnings – not to have to quibble. 

Broadly, the first half-year showed an 11% advance in underlying pre-tax profit to £26.5 million, on underlying revenue up 9% to £169.1 million. Significantly, underlying cash generated from operations soared 33% to £54.9 million.

The underlying operating margin was plenty strong at 23.1% despite the necessity of simpler funerals due to Covid-19. Hence revenue/profit undershot deaths 23% higher during the period, and funerals 27% higher. 

Market share has risen from 11.9% to 12.4%, still relatively low if the group can reduce its £466 million net debt and resume acquisitions prudently.

Do not confuse (as people regularly do, including commentators) £1,209 million ‘contract liabilities’ on the balance sheet as financial debt, as if Dignity is insolvent. 

These are future service obligations linked to pre-paid funerals, i.e. very long-term and granular, nothing like a debt redemption date or covenant.

For an alternative balance sheet view: if you set aside these contract liabilities and deduct £370.8 million goodwill/intangibles (from past acquisitions) then end-June net tangible assets were £684.1 million or £13.68 a share. 

This is helped by a modest 50 million shares issued, this will help earnings per share (EPS), and in due course dividends per share are similarly likely to spruce up.

However, I suspect the board will want to tread quite cautiously, with a narrative of continuing to improve its balance sheet than restore dividends.

It probably cannot believe its luck escaping the CMA’s claws, but will not want to tempt fate with a quick resumption of dividends. Payouts were suspended after the 2019 interim dividend in support of a transformation plan “to build a distinctive and powerful market offer”.

Relative to a primary debt covenant of earnings before interest, tax, depreciation and amortisation (EBITDA) being 1.5x total debt service cost, the end-June ratio was 2.15x up from 2.13x at end-December and with £22 million headroom. 

An internal restructuring completed 25 July should enhance this further. There is a business rates relief benefit of £5.5 million in the current rateable year, although Dignity’s resilience during Covid-19 has been shown by not having to furlough any staff. 

Valuation currently skewed towards earnings hopes 

For what they are worth, consensus forecasts look for EPS around 42p this year and 18.5p in 2021, based on revenue down 13% to £295 million, slipping further to £289 million. 

However, one such broker has had a ‘sell’ stance targeting 300p, which probably aided the stock’s capitulation. 

At around 625p this implies a price-to-earnings multiple in the high teens, in which case the stock is vulnerable to profit-taking given there is no dividend. Fools will continue to misrepresent the contract liabilities, and price caps are diminished if not wholly banished. 

• Stockwatch: Can you trust Shell’s 15% dividend yield?
• Take control of your retirement planning with our award-winning, low-cost Self-Invested Personal Pension (SIPP)

Yet the modest 50 million shares issued will keep EPS quite sensitive to earnings scenarios that can change. 

A cautious view respects figures for end-June showing the number of UK-registered deaths over one week having fallen below the five-year average for the first time since mid-March, as Covid-19 related deaths subsided.

Management still plans for “localised second Covid-19 peaks later in the third quarter”. I think we are well over the hump of UK deaths unless children back at school boost family infections that reach older vulnerable people. 

Yet there looks to be a real risk of rising fatalities on a one to two-year view from the traditional major killers such as diabetes, heart disease and cancer, given people are not being sufficiently tested or getting early treatment during Covid-19. 

This is a chief reason I do not share an outright ‘sell’ stance on Dignity as there is a fair chance such a scenario coincides with management creating a more efficient business and the regulator having retreated.

Operating margins over 20% seem likely to be enjoyed. EPS and cash flow can thus easily bump up, and dividends be restored, if cautiously.  

Short positions unwinding may also lend support

This morning, the stock remains well-bid as if buyers comfortably outweigh sellers. Its technical position is likely bolstered by Blackrock and Lombard Odier asset managers having trimmed short positions this week, with a total 3.5% disclosed stock still on loan.

The CMA’s retreat may be a trigger for such traders to further unwind unless they hope for price controls, however many years ahead. Short sellers of Dignity will be disappointed. 

Events are confirming Dignity as an essential service business on attractive margins, in time potentially resuming market share growth by acquisition. ‘Hold’. 

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