Stockwatch: what to make of this small-cap firm’s reshuffle?

Share price drops as finance director leaves, but investors should not panic.

How much notice should we take of a sudden departure by a finance director? At the very least it should trigger consideration whether your reasons for holding a stock might have changed.

Yesterday the funeral services group Dignity (LSE:DTY) saw a near 7% share price drop to 690p after “strategic update and directorate changes”.

The London Stock Exchange news service said its finance director is leaving the company on 31 December to pursue other interests. Investors will naturally wonder why. The corporate services director is likewise leaving on 31 December.

We are not being given any explanation, hence many are now profit-taking after a fabulous run from 226p last April to 736p earlier this month. 

A non-executive director (since last March) is to become ‘interim chief financial officer’, while a search for a longer-term finance director is undertaken. 

The current director of funeral operations is also joining the main board and a chief operating officer role will also be appointed. Last year Dignity had been searching for a new chief executive, although an executive chairman suffices for a relatively small company (circa £360 million capitalisation).

Rising chart, but questionable valuation

Even if you respect the consensus forecast for net profit of about £20 million in the current year to end-December (and a tad lower in 2021) the earnings per share (EPS) upshot would be in a mid/late 30p area, hence a prospective price-to-earnings (PE) ratio in the order of 20x. 

That can be justified for a business where the market is confident of earnings recovery, and it is looking increasingly likely the pandemic and its aftermath mean the Competition and Markets Authority (CMA) will avoid price controls of funerals, as previously feared.  

But Dignity is avoiding any guidance for 2020 and beyond, simply saying its strategic review intends to leave the business able to respond to whatever challenges are presented. 

Accepting the group’s normalised presentation of earnings, in the first half of 2020 it achieved EPS of 41.8p, suggesting we could see 30p in the less-buoyant second half, after the maximum impact of Covid-19. 

That would imply a modest PE around 9x, and the cash flow multiple from operations even lower.  

The chief distorter is ‘deferred revenue significant financing’, where services are provided in respect of pre-paid funerals. This hits the income statement to the tune of about £27 million every six months. In the first half of 2020, there was also £15 million re-measurement of financial assets held by trusts, tipping Dignity into a £14 million pre-tax loss at the reported level. 

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There is a similarly contrasting view of net assets according to what view you take of £1.2 billion long-term contract liabilities. Also, with £537 million debt to keep servicing it would be wise to temper hopes for any dividend restoration in the short term. 

All this makes it impossible to set a benchmark intrinsic value target for the stock, it being prone to chartist interpretation.  

Dignity still an interesting speculative play

All considered, I do not think this finance director departure implies a hidden can of worms. Moreover, a well-managed funeral services provider should be a sound investment as an essential service.

Even as competition and more regulatory oversight clip operating margins that topped 30% in past years (see table), this remains a strongly cash-generative business. Free cash flow per share has often exceeded EPS. 

Over time, this should help cut liabilities and restore a meaningful payout.

Last March, I drew attention to Dignity as a gamble for risk-lovers at 275p, after its price had tumbled from about 600p earlier that month with the Covid-19 sell-off. 

I reckoned on a medium-term rise in deaths due both to the virus and other hospital treatments being postponed or not sought; also, due to fears over a CMA investigation.

The CMA still needs to ensure the industry can capably provide funerals i.e. earn meaningful profits in order to invest in facilities. 

The stock failed to join the wider springtime rally, but Dignity’s end-July interim results eased concerns. Then on 13 August the CMA shelved the prospect of price controls which “could not safely be introduced in the middle of a national emergency”. 

This triggered a re-rating to 640p, which then gained a second breath with the November market rally, up to 736p earlier this month.

‘Funeral pricing presents different strategic options’

Currently a chief aspect of change at Dignity is its root and branch review, leading to different options on funeral pricing: i.e. whether to pursue long-term market share at the cost of near-term profit. 

The 14 December ‘strategic update and directorate changes’ regulatory news story cited discussions with Dignity’s largest shareholder, presumably on whether they were content to accept this. 

A restructure of operating assets is said to benefit operating profit by about £10 million by mid-2021. Also, more than £8 million of operating efficiencies will all be implemented by March 2021. The review should then be concluded, which might then provide something of a coda on the past, with those directors also departed. 

UK death rate levelled off 

Dignity’s 9 November update for the year to 25 November showed an 8% like-for-like fall in underlying operating profit to £44.2 million on revenue up 4% to £234.5 million. The context is a 15% rise in the number of deaths to 498,000.

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Within this, however, the death rate had more than levelled off by the third quarter, by 2%. The company said: “It is possible that the tragic events of 2020 may mean 2021 and 2022 could experience a lower number of deaths than in 2019.” This partly explains the lack of financial guidance. 

Meanwhile, market share has increased from 11.9% to 12.2% due to growth in pre-arranged funeral plans, and there was £64 million cash – of which £51 million was “free for use”. 

Up to £417 million unrecognised book value? 

Another positive upshot on 9 November was an independent valuation commissioned to help with the CMA inquiry, that estimated the replacement cost of land and buildings at 41 crematoria to be some £461 million. Furthermore, it found the alternative land use value (presumably housing) for these sites is about £374 million, compared with a net book value of some £44 million. While this may only get triggered by way of a takeover defence, or to exact a good price, it offers a measure of comfort. 

A final summation from the CMA is due by 27 May 2021, although I would not fret. Another aspect of regulatory change is government intention to bring funeral plans under the wing of the Financial Conduct Authority, which I would not view as material to earnings.  

The executive chairman's initiatives should bear long-term fruit. At around 690p support has kicked in broadly around the upward trend-line, if steep. ‘Hold’. 

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