QUALIPORT
A Franchise In Funerals

By Maynard Paton (TMFMayn)
April 19, 2004

Peter Lynch would love Dignity (LSE: DTY). The company, Britain's largest provider of funeral-related services, fits many of the legendary fund manager's investment guidelines: there's something depressing about it, it's in a no-growth industry, it's got a niche and, having floated earlier this month and sporting a £186m market value, few analysts follow it.

Following this preliminary investigation, Dignity could well make the Qualiport's own watch list. Taken from Dignity's flotation document, here are the facts and figures that may attract long-term 'franchise' investors:

Favourable funeral facts

* Britain has experienced a stable death rate of approximately 600,000 deaths each year since 1950. The Government Actuary Department projects the rate to continue for the next twenty years.

* There are 4,200 funeral outlets in the UK of which 65% are independently owned businesses. There are only three large providers of funeral services: the Co-operative Group, Dignity and United North-West Co-op. There are very few others with a market share greater than 1%.

* The average price of a funeral in Britain has increased at more than twice the compound rate of inflation over the past ten years. In 1994, the average price of a Dignity funeral was £856 whereas, in 2003, the average price was £1,425 (representing a compound annual growth rate of 6%).

* There are just 245 crematoria in Britain of which 193 are currently operated by local authorities. Since 1980, the ratio of cremations to burials has remained stable at approximately 70% in favour of cremation. In 1988, the average price of a cremation was £67, increasing to £205 in 1998 and £288 in 2003 (representing a compound annual growth rate of 10%).

* There are just three sizeable providers of pre-arranged funeral plans in Britain -- Dignity, the Co-operative and Golden Charter -- which in aggregate account for approximately 80% of the market.

Business quality

The following extracts highlight the barriers to entry Dignity enjoys:

"The [2001] Office of Fair Trading (OFT) report states that in choosing a funeral service provider, more than 70% of people base their decision on a personal recommendation. The OFT report also states that in 92% of cases customers approach a single funeral director... The need for an established local reputation, coupled with infrequency of purchase, makes it difficult for new entrants to gain market share."

"The Group's surveys show that, after reputation and previous experience, location is the next most important factor (approximately 10%). Funeral directors are likely to be chosen for the proximity of their funeral home to the deceased's family."

"The OFT's 2001 report found that the price of a funeral was 'generally a secondary' consideration when selecting a funeral director."

"Crematoria are located throughout Britain, with the distance between these facilities making proximity the key determinant of customer choice."

"There are numerous obstacles before construction of a new crematorium can begin. Proof of the need for the crematorium has to be established with the local planning authority and subsequent planning approval must be obtained. Generally there is considerable public resistance to new build plans due to environmental and perception concerns. The relatively high cost of building a new crematorium (approximately £2-3m) further limits the number of potential new entrants. These barriers to entry have meant that only one new crematorium has been built in Britain in the last three years."

"The Directors believe that large national and multi-national life assurance and insurance providers are interested in forming alliances with funeral service providers with a national presence and a high quality service. The Directors believe that, apart from the Co-operative Group, no other individual funeral service provider has the national coverage in their funeral home network to be able to take advantage of this form of opportunity."

Dignity division details

Dignity has three divisions:

* Funeral services: Dignity operates 507 funeral homes throughout Britain, which operate under more than 350 established local trading names. The firm conducted 69,012 funerals in 2003 (representing 12% of all registered deaths), which generated sales of £103m and an operating profit of £30m. The Co-op conducted 14% of all funerals in 2003, while the United North West Co-op did 4%.

* Cremations: Dignity owns 21 crematoria and is Britain's leading cremator. The next largest private operator owns seven crematoria. In 2003, Dignity performed 39,342 cremations, representing 7% of all registered deaths. Cremations produced sales of £20m and a £9m operating profit in 2003.

* Pre-arranged funeral plans: Dignity is the market leader in the pre-arranged funeral plan market, having sold over 280,000 plans since inception in 1985 and with more than 160,000 still outstanding. In 2003, Dignity sold 26,578 plans and performed 7,884 funerals for plan holders, which created sales of £6m and a £1m operating profit.

For 2003 then, Dignity reported group sales of £129m and a £32m operating profit after central costs. Operating margins are therefore a very attractive 25%, which go some way to support the 'franchise' theory. A cursory inspection of the accounts reveals light working capital requirements coupled with some relatively low capital expenditure. However, debt is a significant accounting downer. Dignity presently carries net borrowings of £210m, which will create a £15m annual interest bill and mean gross interest cover of less than three times in 2004.

Profit growth will largely come from two areas. Dignity aims to consolidate the funeral services market by purchasing some of its smaller rivals. There are, according to the company, many funeral directors wishing to sell their business. In addition, Dignity hopes to add to its list of 'affinity partners' that sell pre-arranged funeral plans (current partners are Age Concern, AXA and Royal London). For the record, current trading in all of Dignity's three divisions is ahead of levels witnessed last year.

Valuation and summary

Assuming operating profits keep steady at £32m and a standard 30% tax charge is applied, earnings per share of about 14.9p can be expected in 2004. At a 234p share price, the estimated price to earnings ratio is 15.7. If earnings are a genuine proxy for free cash, the free cash flow yield would come to 6.4%. Forecasts in the flotation document outline a 2004 £4.5m dividend payment, equating to a dividend yield of 2.4%. Earnings estimates from brokers have yet to be issued.

Is Dignity portfolio watch list material? Probably. Funeral services is as steady industry as they come and Dignity would appear to have a good competitive position within it. That said, the company has a complicated financial history (involving a management buy-out in 2002 and trust funds for pre-arranged payments) and there's always the risk that its progress over recent years may have been achieved with the flotation in mind. Though the early signs are generally good, further investigation and deliberation needs to be done before any formal watch list decision.

Where next? Dignity website | A Grave Investment | UK Funerals Online | Peter Lynch