Double Pain & Doubling down in Dignity

So I have been busy eating  so called humble pie lately. One could also make a joke of being buried by my latest investment. To recap, I invested in Criteo and a few days later the stock dropped -30%. I invested in Dignity and a few days later it dropped -50%. Although the companies are very different, the situation the stocks were in at my time of purchase were somewhat similar. Two pictures says more than thousand words:

Criteo_buy_timingDignity_buy_timing

In both cases the market had caught on to something that worried it. In both cases I believed it to be short term noise that does not change the long term prospects of the companies. So for me it was buying opportunities in “misunderstood” stocks. As it turned out, it was rather me that had misunderstood the seriousness (at least short term). Right after I bought, in both cases the companies issued profit warnings and the market did not think it had discounted these warning fully, the stocks consequently plummeted. So here were are, looking at two interesting companies that are trading at multi-year lows in the middle of a roaring bull market. The question naturally becomes, what to do now? Take my losses, realize I have been wrong, and move on,  keep my position, or add? After spending some time looking into this my conclusions are: Criteo – Keep, Dignity – Add. Criteo I won’t have time to go into now, I will focus this post on Dignity, the funeral service company:

Dignity – Add back 6% weight

I have really been scratching my head about this company the last week. Although I made significant losses in some companies throughout the years, I actually can’t recall ever owning a stock that lost 50% of its value in a single day, so its really something unprecedented experience wise for myself. The irony of buying into it a few days before it happens really adds some extra salt into the wound. So what to do? Well of course I need to look into the details of the profit warning, pull out the calculator and start to calculate what this means for the company.

To take a step back before we go into the figures, as you can see, Dignity pulled back some -40% from it’s peak already before the -50% drop. Obviously everything was not so rosy outlook wise since the stock had traded down so significantly. So what was it then the market picked up on? Well basically good old competition. Dignity has been acquiring smaller funeral services over the years, streamlined some, but also raised prices significantly over the years. Competition has not raised prices and so Dignity has started to lose some business, especially in the “budget” market if we can call it that. Dignity does about 70 000 funerals in UK every year, the data during 2017 looked like this:

2017 Pricing

Funeral Type % of Funerals Income (GBP)
Basic Funeral 7% 2700
Full Funeral Package 60% 3800
Pre Paid Funeral 27% 1650
Low Value Funeral Contributions 6% 500
Ancillary Revenue from Funerals (flowers etc.) 100% 280

What happened in the profit warning was that Dignity has realized they have been losing way too much market share in the “Basic Funeral” segment, as you can see it was only 7% of it sales. Consequently there has been in a reduction in the number of funerals held per venue. Top-line revenue held up for a while through acquisitions, but each funeral venue held less and less funerals (although with larger margins per funeral). Now Dignity has decided to change the trend, fight for market share in the “Basic Funeral” segment by slashing prices for the “Basic Funeral” to 1995 GBP. By that probably cannibalizing some of their own customers as well, who will choose the basic package instead of Full Package. Dignity themselves forecast that for 2018 probably 20% of the customers will choose the “Basic Funeral”, but of course this also gives the company a fighting chance to change the trend of less and less funerals held per venue.

2018 Pricing 

Funeral Type Forecast % of Funerals Income (GBP)
Basic Funeral 20% 1995
Full Funeral Package 47% 3800
Pre Paid Funeral 27% 1650
Low Value Funeral Contributions 6% 500
Ancillary Revenue from Funerals (flowers etc.) 100% 280

Since costs will stay the same, this price reduction eats directly into the profit margin. If we use the new Mix of funerals as a estimate for funerals sold for 2018, we can make some rough assumptions. Another assumption would be that number of funerals held will stay more or less flat (meaning no market share will be gained by slashing prices). The calculations give that Operating Profit will be lowered by about 10-15 million GBP for 2018 compared to 2017. The reason why we can’t get an exact figure is that cost of Basic and Full funeral is not presented in annual reports. But 10-15m reduction in Operating Profit I think is a reasonable estimate and that is in my view what the profit warning we are talking about expresses.

Debt and Pre-paid funerals

Anther concern and probably a big reason we see such a stock price drop is the fairly significant amount of debt the company is servicing. The interest expense for the last 5 years has been between 24-28m GBP. This is not likely to increase significantly during 2018 since GBP LIBOR rates are still fairly low.

Another aspect worth looking into is the Pre-paid Funerals, which are a massive liability of ~800 million GBP, but this is funded by all the pre-payments which is invested in the same way as an insurance company invest its assets to meet obligations. Obviously this investment portfolio could go haywire, but no such information has been given, and history do not show any proof of such behavior. The risk I see is that if stock markets crash and the portfolio is way to invested in risky assets, the obligations will be severely underfunded and losses needs to be taken. The other side of the coin is that this is a sure base of funerals that Dignity has locked in, as you can see in the table above, 27% of all funerals held are of the pre-paid type, and Dignity still manages to make profits on these funerals at 1650 GBP. Op margins are lower though for pre-paid at about 30% versus 37% of the mix of Basic and Full funerals.

Conclusion

We are looking at a company that generates for 2017 about 100m GBP in Operating Income. Deduct from that the about 25m GBP interest expense, we are looking at pre-tax income of about 75m GBP. After tax, a Net Income of about 57m GBP.

Now with the estimates above, of about 15m GBP less in Operating Income due to price slash. It translates into Operating Income of about 85m GBP, interest expense and tax rate the same, I see Net Income at about 48m GBP. With 49.9m shares outstanding and trading at 8.9 GBP, the stock is trading at forward 2018 P/E of 9.3. Even if market deteriorates further under serious competition, there is room to slash prices further, since Operating Margins are very healthy for the “Full Funeral Package”. I think a small sell-off might have been warranted given the unclear situation on pricing and volume. Also the debt load is fairly high so there is not room for severe further margin deterioration. But I can’t see how small privately own funeral shops could be able to run more efficiently than a large organisation, so there must be some floor pricing from the competition. There is much else to say, for example how very high the customer satisfaction is from Dignity’s service. But I stop here and conclude that although it feels like a catching the knife moment stock price wise, I’m willing to take possible further short term pain and will today add to my position so I have a 6% weight in Dignity.

At these levels, I would actually classify this as the best Value investment case I have come across over the last years.

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Portfolio Changes – larger reshuffle – Part 1

Thoughts on investment philosophy

I have recently had quite a lot of time to contemplate my investment style and philosophy. I think I reached some conclusions. After all that is what this blog is about for me, learning from and seeing my mistakes more clearly and then adjusting accordingly.

Before I started this blog I have during periods followed the market and specific stocks very closely. I have used technicals and fundamentals to swing-trading holdings (3-12 month horizon) with fairly decent results. Meaning that I see the stock as fairly/undervalued with a chart that looks good for a move up. I then later sell when the stock is more close to fully valued. To some degree I have implemented such a strategy also for my blog (for example Avanza, Ericsson, YY, Shanghai Fosun etc). But this is very different from believing in a company truly long-term, even if the stock gets ahead of itself valuation wise. Given that I do have a full time job and this is a hobby, the time I can spend on updating myself on holdings vary widely. From another perspective baby-sitting such swing trade positions takes away valuable time from researching new interesting companies and sectors/niches.

All in all the conclusion for my future investment strategy is stop looking at these companies that trade cheaply currently and then start to swing them in/out of the portfolio as they get cheap/expensive. If all stocks in the world would be drifting sideways forever with some volatility this might be a successful strategy, but that’s not a very likely scenario. Instead I will focus on what makes more sense, finding great companies. Preferably currently cheap, but anyhow companies that in 5 years time in my view has a high probability of trading significantly higher. I should also at all times be comfortable turning to stop following my holdings and be happy to own them for the coming 5 years. Currently I do not hold such a portfolio and I intend to spend the coming months to do just that. This means that I am tilting my portfolio more towards Quality, which in general is expensive now. But I intend to find my own type of Quality, not necessarily Nestle and the likes (nothing wrong with Nestle though)

In terms of Portfolio management I will still allow myself to trim holdings that grow very large or add in holdings that have under-performed but I still believe in. And of course I will still make mistakes and mis-judge companies, meaning they will not sit in the portfolio for 5+ years, but till be sold when my view has changed. But preferably the investments should be such so I won’t be easily swayed in my judgement of the future prospects of the company. For example an oil company with great management and execution might be dead in the water if oil production cost is around US$60/barrel and oil drop to US$40, so before I have a very clear and sure long-term view on the oil price, it would be a silly investment to add to this portfolio. I take this as an example because currently outside the blog holdings I do have a swing-trade position in a what I think is a very decent oil company (Tethys Oil).

Reshuffle of Portfolio – Part 1

Not only have i contemplated my strategy, but another reason why I have written so little lately is that I have been very busy re-searching a larger number of companies. Most of these investment ideas will materialize in new holdings over the coming months. It probably won’t be perfect, since I change so much at the same time. Minor adjustment might come later. But all in all it’s holdings more in line with a more long-term investment strategy. The holdings are in general also more defensive than what I currently hold. This I also very much what I seek in such a late stage bull-market. I’m not sure if I should call it new Themes, but I chose to allocate significant capital to two industries below, 1. Funeral Services and 2. Alcohol and Beverage related companies. In due course I will try to expand on my thoughts behind these investments.

Dignity – Add at 5% weight

Funeral service business in the UK. I had my eyes on for some years now and lately a very good buying opportunity arose. I heard about it for the first time from a long only manager and have since understood what a wonderful business segment funeral service is. Firstly from a margin perspective. but also how fragmented the business is and the possibilities for a cash flow generating company to buy these small companies at attractive multiples.

Fu Shou Yuan – Add at 4% weight

Basically the same story as Dignity above, funeral services, this time in China. This stock I’m perhaps not buying at the right moment short term, as it has traded up and is actually very expensive at the moment, but from a long term perspective I’m very comfortable holding this.

Diageo – Add at 4% weight

Has a portfolio of high quality liquor brands. Also has a minority holding in Moet Hennessy which I find interesting. Overall the thesis here is that they will continue to leverage their strong brands and their tremendous track-record of shareholder returns. For example the portfolio of whiskey brands probably is 50% of all top quality brands available.

Olvi – Add at 4% weight

I have searched for quite some time for a way invest in line with my positive view on the three small Baltic countries, I think this might be one good way. I also have fairly bullish view on Finland, finally coming out of some economically challenging years. This is a family owned (through voting strong shares) beer and beverage company with exposure to the above mentioned countries. They have also shown a tremendous track-record of execution. Overall, smaller listed beer and beverages companies start to be as common as unicorns. I will expand on this later, but not many are listed anymore. As uncommon they are, its seems to be a fantastic business to be in. Since almost all companies shows great returns (until they are bought out) with very strong cash flows. Previously I held Royal Unibrew for mostly the same reasons (I should have kept it), but overall I find Olvi more attractive, with a stronger track-record.

Tokmanni – Sell Full Holding

This was also a play on Finlands recovery and that the company felt cheap with a good dividend. But they continue to under-deliver and the last straw was the mess with the new CEO not being allowed to start due to a non-compete clause. Felt very unprofessional. Also nothing I’m very confident to hold in 5+ years, with what currently goes on in Retail. I’m happy coming out of this one with a small profit.

Microsoft – Sell Full Holding

A great company of course, but current Tech-hype is just too much for me. If/when Tech companies re-price downwards I will definitely be looking at adding 1-2 Tech holdings again. I’m happy for the returns I got and unfortunately I cut my position in half way too early, the part I kept returned almost 80%.

Catena Media – Sell Full Holding

This became the latest of my “swing trades”, with over 40% return in less than 4 months one of the better ones as well. I was a bit torn about this holding, since I do see some good long-term prospects. The online gaming business will grow, and these sites really need channels which supply them with customers. But it’s a way to unstable business case for me to comfortably hold for many years. It is definitely in the “baby-sitting” category, where I felt a need to keep myself updated on a frequent basis. So with a bit of a heavy heart I sell this holding. This could for sure keep performing very well for a long time, but I categorize it in the “too difficult” pile.

 

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