StoneMor Partners (STON) was the latest master limited partnership (MLP) to shock investors with a distribution cut (learn about the main risks of investing in MLPs here).
After increasing its distribution each year since 2005, Stonemor announced last week that its third quarter distribution would be reduced by 50% to 33 cents per share.
Even worse, StoneMor’s stock collapsed 45% on Friday.
Many dividend investors are wondering how this happened, especially after management’s comments about STON’s distribution less than three months ago on August 5th:
“We are encouraged by the positive metrics we’re seeing from our recent sales initiatives and when combined with lower operating expenses, will allow us to continue providing attractive distributions to our unit holders.”
StoneMor’s Chief Financial Officer also noted in August that StoneMor’s cash distribution coverage ratio for the last quarter was a reasonable 1.3 times.
Let’s review some of the warning signs StoneMor gave off prior to announcing its distribution cut and whether or not the stock could provide some value to high income investors going forward.
StoneMor Business Review
Before analyzing the distribution cut, let’s quickly review StoneMor’s operations. StoneMor was formed in 2004 and is the second largest owner and operator of cemeteries (317 locations; 81% of revenue) and funeral homes (105 locations; 19% of revenue) in the United States.
StoneMor’s products and services are sold when someone passes away (“at-need”) or ahead of time (“pre-need”) and include burial lots, caskets, headstones, memorials, and various installation services. The company is an MLP and does not pay any federal income tax (learn more about what MLPs are here).
Many income investors were attracted to StoneMor for several reasons. For one thing, StoneMor’s management team had rewarded investors with distribution increases every year since the company started paying one in 2005 (learn about Dividend Achievers, companies with 10 or more straight years of dividend growth, here).
StoneMor’s line of business was perceived to be very stable. Few new cemeteries are developed these days, capping industry supply. Nobody wants to live next to a new cemetery, and most cemeteries are owned by small companies or families (i.e. not the most aggressive competitors and plenty of acquisition opportunities).
Industry demand trends looked appealing at first glance, too. As the popular James Bond novel is titled, “Nobody Lives for Ever.” When coupling our mortality with America’s aging population, StoneMor seemingly had good visibility into its future revenue.
What went wrong, and could investors have known?
StoneMor’s Distribution Coverage was Fragile to Begin With
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. StoneMor’s dividend and fundamental data charts can all be seen by clicking here.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
StoneMor’s Dividend Safety Score prior to management announcing the distribution cut was 34, suggesting that the company’s distribution was at heightened risk of being cut sometime in the future.
As an MLP, StoneMor distributes almost all of its cash flow as a dividend. However, StoneMor’s business model fails to generate enough GAAP (generally accepted accounting principles) earnings or free cash flow to cover its cash distribution.
Over the last 12 months, StoneMor’s GAAP diluted earnings per share and free cash flow payout ratios are -322% and -1,143%, respectively. As seen below, StoneMor has struggled to generate positive free cash flow per share in recent years.
Since StoneMor doesn’t make nearly enough money to cover its full distribution and invest for growth, it has depended heavily on issuing more units and taking on additional debt.
As seen below, the company’s long-term debt to capital ratio has increased from 44% in fiscal year 2005 to 63% last year. Meanwhile, diluted shares (units) outstanding have more than tripled over that period of time.
Many MLPs have similar looking charts – high leverage and steadily rising share counts. This can work if management’s growth investments earn a return in excess of the company’s cost of capital and are increasing per share cash flow over time.
However, if unexpected business challenges arise or management makes an operational blunder, we have seen that previously dependable MLPs can become volatile nightmares (see Ferrellgas Partners for a recent example).
High debt loads, high payout ratios, and high dependence on capital markets to fund distributions and growth investments reduce an MLP’s margin of safety compared to basic corporations.
There are few MLPs I am comfortable investing in for many of these reasons. Another issue is their complicated accounting and organizational structures. StoneMor’s accounting in particular required a lot of faith in management and was rather controversial.
Accounting for cemeteries is extremely complicated (see here). Even as a CPA, I was ready to “pass” on StoneMor since it quickly fell into the “too hard” bucket for my (limited) circle of competence.
Other investors were willing to dig deeper (no pun intended) on the company. Here is a link to Luma Asset Management’s comprehensive research on StoneMor. The crux of their short thesis centers on complex financial engineering. Investors can watch an informative video with Luma Asset’s analyst talking about StoneMor’s short thesis here.
Essentially, Luma argued that the company does not make any money and never will. One look at StoneMor’s GAAP diluted earnings per share shows that the company has failed to turn a profit every year since fiscal year 2008, although the company’s management has consistently recorded positive operating income on a non-GAAP basis.
How has the company managed to issue higher distributions for more than a decade given the figures above? StoneMor has raised money by selling new units and paying it back to existing investors.
The chart below shows the cumulative amount raised by selling new units (red line) and cumulative distributions paid (green line). Luma’s analyst noted that StoneMor’s cumulative distributions were not from operating the business but rather from financing the business.
Luma’s thesis didn’t necessarily raise any new points for the bear case against StoneMor (in my opinion), but it highlighted some of the big disconnects between the company’s results under GAAP and the non-GAAP figures reported by management.
Essentially, Luma turned out to be correct in believing that StoneMor’s situation would eventually prove to be unsustainable, although no one knew exactly when or how.
What Caused StoneMor’s Distribution Cut
The company’s struggle for sales growth turned out to be the pin that pricked the balloon. Luma’s report observed that StoneMor’s organic growth of burial spaces was, on average, declining in areas that the company had not made any recent acquisitions.
Why has organic growth been such a struggle? My theory is that StoneMor is facing a secular headwind caused by changing burial preferences. More specifically, the rise of cremation is making growth difficult. Cremation services generate much less revenue and carry lower margins.
In June 2016, the National Funeral Directors Association reported that the rate of cremation likely exceeded that of burial in 2015 for the first time. As seen below, this trend is expected to continue accelerating over the next 15 years.
I could be wrong, but the figures presented by the National Funeral Directors Association are alarming for a company such as StoneMor that generates the bulk of its revenue from traditional cemetery and burial offerings.
StoneMor last reported quarterly results on August 5, 2016, and management noted that recent sales performance had been below acceptable levels.
The company had made a decision last year to “improve the overall quality” of its sales force, which involved an effort to replace the bottom third of the sales team (approximately 180 people).
StoneMor teamed up with a national consulting firm and began implementing a revised compensation structure focused more on commission to improve sales performance accountability on October 1.
This resulted in far more sales people immediately resigning than management expected. Over 125 sales people (out of around 525-550) quickly left the company in light of the change in compensation plans. While many of these people might have been bad apples that StoneMor didn’t want in the long term anyway, the short-term impact was painful.
Revenue missed expectations last quarter because of the lower headcount and StoneMor’s inability to quickly revamp its sales force. Here’s what management said during the company’s earnings call on August 5, 2016:
“In hindsight it appears that the significant changes we made last year were put in place in too short period of time. We underestimated the number of sales individuals that would leave and we have been too slow in replacing them. We know what went wrong and how to fix it. It requires a commitment to recruiting. Our current problems lie solely with our pre-need sales and specifically and specifically with the number of sales individuals we have. The remaining 60% of our revenue sources are performing well.”
Source: Seeking Alpha
It takes time to replace employees, especially when stronger emphasis is put on bringing in much higher quality sales people than those who departed the company. While StoneMor is only looking to add around 100 people to its sales team, I can’t imagine it is easy to find people with both strong sales skills and a desire to put their talents to work in the cemetery industry.
It’s hard to say how long it will take StoneMor to recover from this blunder. Right now, the short-term outlook remains ugly.
StoneMor’s third quarter results are even worse than management expected, which prompted the distribution cut. Efforts to regrow the sales team have proved to be very difficult, hurting revenue and creating plenty of uncertainty for investors.
Here are some comments issued by management in StoneMor’s recent press release:
“However, previous efforts to accomplish our salesforce goals have meaningfully lagged our expectations, resulting in a negative impact on our revenue. While 3rd quarter 2016 results are not yet final, preliminary data has led the General Partner and the Board of Directors to temporarily reduce the quarterly cash distribution to $0.33 per unit. This distribution level, along with previously announced cost savings measures totaling $7 million annually, will enhance StoneMor’s liquidity by approximately $12 million in quarterly cash savings…
“While we are striving to accelerate the timeline of hiring and training additional sales talent, we estimate that this could take up to an additional six to nine months to attain the level of productivity we expect. We intend to provide monthly updates on the sales team expansion for greater visibility on our progress to the levels we are targeting. At that time, we will reassess the distribution and will look to reset it at the appropriate level.”
It’s hard to believe that a company paying steadily rising distributions for 10+ years could hurt itself so badly and so quickly to slash its distribution by 50% with such little warning. This is especially true in light of the company’s total liquidity of $90 million (compared to $77.5 million of distributions paid last year), cash distribution coverage ratio of 1.3 times last quarter, and ongoing cost improvement initiatives.
Regardless, many investors are now grappling with management’s last remark that they will “reassess the distribution and will look to reset it at the appropriate level” within the next 6-12 months.
It seems like fixing the sales team will eventually happen, and the market is notorious for overreacting to short-term events that don’t impact a company’s long-term earnings power. Might StoneMor be a high yield bargain?
Is StoneMor Now a Compelling Value Play for High Income?
Simply put, I would say no. I would be surprised if StoneMor is able to restore its distribution within the next year (if ever). If anything, another cut might be even more likely. We are talking about a company that has failed to turn a profit under GAAP every year since 2008 and uses very complex accounting.
If I can’t understand how management is turning big GAAP losses into non-GAAP profits, I will not invest. There are too many other good companies with better transparency in the market. I’m not going to try and be a hero.
Furthermore, I think StoneMor’s lack of organic growth is a big deal to consider for the long term. If the rate of cremation exceeds the forecast issued by the National Funeral Directors Association, the majority of StoneMor’s revenue could be obsolete within 15 years. How much would you be willing to pay for a company with that type of outlook?
Overall, something just doesn’t smell right to me. Between the company’s complicated non-GAAP accounting, struggle to grow organic sales, numerous roll-up acquisitions, knee-jerk reaction to revamp its sales practices to force better growth, and the cremation trend, there are enough reasons for me to move on – especially for holdings in our Conservative Retirees dividend portfolio, which focuses on Dividend Safety and capital preservation.
StoneMor has already been badly burned, but there could be more to come. The company no longer has the luxury of issuing new units at an attractive cost of capital to fund its business and distribution. If the company is truly unable to make money under GAAP, this is a real problem.
If management is unable to hire qualified sales people and/or organic growth remains weak due to secular issues (e.g. cremation), StoneMor’s balance sheet could prove to be an even greater strain on the business as well (StoneMor holds just $9 million in cash compared to $283 million in total book debt).
When there is smoke, sometimes there really is a fire.
Lessons Learned from StoneMor’s Distribution Cut
Hindsight is 20/20, but examining painful events such as StoneMor’s distribution cut is critical to helping us avoid similar situations in the future (learn seven other habits of effective dividend investors here).
I took away several lessons from this event. First of all, it’s critical that investors familiarize themselves with the top 10 most important financial metrics for dividend investing. With even a basic understanding of these metrics, a number of red flags would have been raised when looking over StoneMor’s key financials. Investors shouldn’t take management’s non-GAAP reporting for granted either. If something appears too complicated or confusing, it’s best to move on. That’s one of Warren Buffett’s top pieces of investment advice.
StoneMor possessed a number of characteristics that made it a risky dividend stock – even despite its 10+ year dividend growth streak, which shouldn’t be blindly trusted as a comprehensive indicator of dividend safety. The combination of negative earnings and cash flow, high financial leverage, declining revenue, and dependence on capital markets was dangerous. StoneMor’s recent growth struggles and poor sales team management were enough to bring its distribution into the danger zone. When some MLPs begin to show cracks, such as StoneMor’s sales team issues that cropped up last quarter, things can get ugly in a hurry.
Small cap companies are more volatile in general as well. Their businesses tend to be more concentrated by product, service, customer, and end market, and management’s major capital allocation decisions can make or break their businesses. Accessing capital markets can also be relatively more challenging for smaller companies.
There’s nothing wrong with selectively investing in certain quality MLPs, but investors should never buy any high-yielding, seemingly stable business without conducting some due diligence and remaining well aware of the risks involved. MLPs possess several unique qualities that can make them much more dangerous investments if management makes a big misstep, the macro environment unexpectedly deteriorates, and/or capital market conditions turn unfavorable.