The markets have taken a turn for the worse over the last few weeks, primarily due to concerns about interest rates remaining higher for longer.
It’s been a rollercoaster over the last year or so regarding when rates will be coming down. A year ago, most pundits would have agreed that late 2023/early 2024 would have been when we see policy rates reduced. However, that seems like a long shot, in fact, nearly impossible, considering the circumstances today.
With the battle against inflation far from over, it is becoming increasingly likely we will see “higher for longer” in policy rates.
This is why utility, telecom, and financial companies continue to struggle. In fact, the majority of the TSX is struggling as a whole
There is also one segment of the market, both here in Canada and south of the border, that is also struggling: small-cap stocks.
Today, I’d like to review Park Lawn Corporation (TSE:PLC).
Park Lawn is a stock I’ve owned since 2016, maintains relatively low coverage by analysts, and before the upcoming market selloff, had been producing market-beating returns, even when compared to the S&P 500.
However, high rates and lower mortality rates coming out of COVID-19 have sunk this one down to nearly its March 2020 crash levels.
Let’s dig into the company in-depth this week. I’ll highlight why I continued accumulating shares this past week and will continue to do so in the future.
An in-depth analysis of Park Lawn (TSE:PLC)
As you know, here at Stocktrades, we love companies with straightforward business models that virtually anyone can understand. Park Lawn provides precisely that: Crematoria, cemetery, and funeral services.
It’s a business that, for the most part, clients will not cheap out on, and it’s a business that tends to collect a lot of pre-need sales, meaning people are paying for plots and services before their death. This means that Park Lawn can take capital from pre-need sales and invest it into the business before executing any service.
This type of business model benefits directly from the concept of the time value of money. A dollar received today is worth more than a dollar received in the future because of one’s ability to invest that money today.
The heavily fragmented industry is why Park Lawn’s strategy works so well
Despite large-scale companies like Park Lawn and Service Corporation existing, the industry is still fragmented. Individual owners and operators comprise most funeral home operations in the United States.
In fact, according to the National Funeral Directors Association, over 80% of the funeral homes in the United States are still privately owned.
This is the bread and butter of Park Lawn’s overall strategy. Buy up smaller funeral homes for attractive prices and merge them into the fold. It does this so often that it’s nearly impossible for us to keep up with the level of acquisitions it makes.
Overall, it attempts to deploy anywhere from $75-$125M per year in acquisitions. It aims to fuel 70% of its growth through acquisitions and the other 30% through growing those acquisitions organically.
The downfalls of Park Lawn’s strategy
Regarding margins, the funeral business could be seen as the middle of the pack. Park Lawn has operating margins of around 13%, which are margins that factor in the costs of production, like wages or materials.
In terms of the funeral homes, cemeteries, and whatever other businesses it acquires, they’ll generally come with low margins as well.
In a low-rate environment, the interest costs of supporting these acquisitions are relatively low. A company can generally realize higher returns from an acquisition when debt is cheap.
However, when interest rates rise, interest costs eat away at the profitability of an acquisition, particularly in Park Lawn’s case.
Why? Because it finances most of its acquisitions through debt and the occasional share offering.
When we look to the first 6 months of the year, the company has paid $6.9M USD in interest expenses. At this point last year? Just $2.86M USD.
With financing costs more than doubling, investors have a right to be concerned. But in our opinion, the selloff is extensive and a bit over the top.
The headwinds the company faces
As mentioned above, ultimately, a company that chooses to finance a lot of acquisitions via debt will not only realize smaller returns on future acquisitions if rates stay elevated but financing costs on previous debts can eat away at earnings.
In addition to this, there is the somewhat harsh reality that the company relies on people dying to operate its business. And with the COVID-19 pandemic being behind us, mortality rates are lowering.
Furthermore, small-cap stocks are certainly not at the top of investors’ buy lists in this uncertain environment. However, there is strong historical evidence suggesting that coming out of a recession, small-cap stocks outperform their large-cap counterparts most of the time.
The difficulty with this is identifying whether this will be the worst of it or if there is more economic pain to come.
With all the headwinds associated with the company, however, in our opinion, this provides a strong accumulation period for long-term investors.
Park Lawn is in a position where higher rates will ultimately eat into the company’s earnings. But this is not an unprofitable company that is drowning in interest payments. In fact, despite rising financing costs, the company is still generating strong cash flows.
Free cash flow
When we think of ballooning financing costs, we often think of companies struggling to pay their bills and on the cusp of financial ruin. We’re engineered to think like this. However, Park Lawn is still generating significant cash flows despite rising financing costs and is now providing the highest level of free cash flow yield in over 12 years.
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In the simplest terms, free cash flow yield is the inverse of the price-to-free cash flow ratio. If a company generates $1.50 per share in free cash flow and its share price is $10, its free cash flow yield would be 1.50/10, or 15%.
Generally, when I see free cash flow yields creep above 7%, I’m inclined to dig deeper into a company as it typically signals undervaluation. With Park Lawn sitting at 9.76% (see the chart above), it has certainly caught my eye.
A note with this ratio, however. FCF yields are based on trailing cash flows. It would not be out of the question to see free cash flows dip in the back half of 2023 simply because of the economic environment. However, we don’t expect the dip to be material, and it is still likely that Park Lawn’s FCF yield will remain attractive unless a significant price recovery happens from now until the end of the year.
At this point in time, if the company completely ceased its acquisition-based strategy and went into full-on debt reduction mode, it would generate enough cash that it could pay off the entirety of its debt in just 5 and a half years.
This would likely be cut down by a reasonable margin as well, as it would still have recently made acquisitions brought into the fold, increasing cash flow.
Cash flow in relation to the dividend
Many investors typically don’t think of Park Lawn as a viable dividend stock, primarily because the company does not focus on dividend growth at all, nor has it historically provided much of an attractive yield.
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However, due to this recent drawdown, the company is now yielding around 2.4%. It could be a solid company to look into for investors looking for income and a little touch of growth.
The company will look frustrating for many dividend growth investors, primarily because of some exceptional coverage ratios that have investors wondering why the company does not grow the dividend. Through the first 6 months of 2023, the company has generated $0.755 per share in free cash flow and has paid out $0.18 in dividends.
This works out to be around 24% of the company’s free cash flow, which provides ample room for the company to pay the dividend, reduce debt, satisfy its interest obligations, and buy back shares aggressively.
Park Lawn will likely never be a reliable dividend growth company. This is primarily because it spends most of its cash fueling new growth via acquisition. Until it identifies that it has potentially exhausted all of its acquisition efforts, this will likely be the strategy for the company moving forward. And with how fragmented the industry is, we can’t see that happening soon.
Valuation
It would seem like there is a severe disconnect between the market’s valuation of Park Lawn and its future growth prospects. We must consider that despite exceptional sales and earnings from the COVID-19 pandemic years (2020 and 2021), the company is still growing sales at a double-digit pace.
Although higher interest rates will no doubt impact the profitability of the company’s strategy over the short term, the market seems to be pricing in a material impact to the company’s operations due to rising rates and a slowing economy.
The company is now trading at only 0.87x its book value. Besides a brief 1 or 2-day stint in November of 2022, this is the first time that the company has traded under book value in the last decade.
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In addition, the company is trading at only 12 times its expected earnings and a hefty 34% discount to historical averages.
On a price-to-free cash flow basis, it hit the lowest levels it has traded at in over a decade, at just 10 times trailing cash flows.
Does Park Lawn warrant the valuations it has gotten in the past today, especially in a much higher rate environment? No, definitely not. Interest expenses are no doubt going to hit the bottom line.
However, we feel trading 34% off those valuations is short-sighted, and the market seems to be pricing in much higher interest rates for much longer.
Overall, short-term speculators will likely avoid Park Lawn, but long-term investors could be rewarded
From a charting standpoint, Park Lawn certainly looks ugly. There’s no sugarcoating that. The stock has shattered through any support levels and has been in freefall in 2023, falling more than 27% as I write this.
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However, while there is no doubt that price action determines the narrative over the short term, business operations determine the profitability of an investment over the long term.
Park Lawn is earning about 42% less than in the first 6 months of 2022. However, a whopping 74% of the decline in net income can be attributed solely to financing costs.
The company is actively working to pay down debt, repaying just under $9.5M through the first 6 months of the year, and holds one of the better balance sheets in the industry, especially when looking at its main competitors, Service Corp and Carriage Services.
While escalated interest rates will continue to put pressure on margins and the business and are being reflected in the valuation today, we have a hard time imagining interest rates will remain this high for any considerable amount of time. For this reason, we do believe the stock is attractive at this time.
I (Dan) added to the stock last week and will continue to add moving forward.
Below, we have a report of Park Lawn Corporation after its most recent quarterly filing.
You can view our Park Lawn report here, which is updated as of their latest quarter.
