Equity Valuation: Propel Funeral Partners (ASX: PFP)
Undervalued
SUMMARY
Propel Funeral Partners (ASX:PFP) is the second largest death care services provider in Australia, an industry which is led by the conglomerate InvoCare (ASX:IVC) whose funeral volumes dwarf those of PFP. The company’s core business is operating funeral homes, cemeteries, crematoria and related facilities across Australian and New Zealand.
Through a diversified acquisition campaign which began in 2013, the company has grown from operating only 1 facility in Queensland to either owning or leasing 130 locations throughout Australia and New Zealand as at June 2020. With the assistance of favourable market demographics, the company has proven the scalability of the death care business model and how an aggressive acquisition strategy can be highly lucrative to the company and its shareholders.
A Fragmented Industry
The death care services industry is highly fragmented, with most operations run by small or family-owned enterprises. In the last five years PFP has seen tremendous growth in its portfolio and with it, a sizeable expansion of its market share compared to that of key competitor, IVC. With around 70% of the death care industry market made up of smaller operators, PFP has the potential to fuel the way for further industry consolidation and grow into a death care conglomerate.
Scale, Scale, Scale
Through its growth to 130 locations across Australia and New Zealand, PFP has proven the scalability of the death care model. The business has also become vertically integrated through its acquisition of ancillary services such as coffin manufacturers, warehouses, chapels and shop fronts.
Through greater scale and continued success in seeking out profitable acquisitions, shareholders stand to gain from PFP’s consolidation of the highly fragmented death care industry which is supported by a favourable demographic profile.
Favourable Demographics
The demographic composition of advanced economies such as Australia and New Zealand are highly favourable to PFP’s market. As the Baby Boomer generation continues to age, the pool of future clients will also continue to increase. PFP has noted its focus on acquiring businesses which are located in areas of demographic significance.
Returning Value to Shareholders
The company has historically returned significant value to shareholders through dividends, with the payout ratio for FY20 being 91% of NPAT. At the time of writing, PFP’s dividend yields approximately 3.6% per annum.
INVESTMENT THESIS
The company was developed and is managed by Propel Investments Pty Ltd (the Manager) which has a number of years’ experience in the death care business. In FY2006, the Manager acquired a controlling interest in Bledisloe Holdings (the second largest death care services provider in Australia at the time) and eventually sold the business to IVC for $114 million in FY2011. Shortly after, the Manager established PFP in FY2012 which has since grown from 1 to 130 locations across Australia and New Zealand.
The Manager’s investment strategy focuses on expanding into locations with favourable demographic structures through organic and inorganic growth, acquiring or establishing funeral homes, cemeteries, crematoria and other related properties/infrastructure.
It is clear that PFP’s aggressive acquisition strategy has delivered strong returns to the company and its shareholders for a number of years. The death care model has shown to be relatively scaleable, especially in areas which exhibit favourable market conditions (such as an ageing demographic). As most operators are smaller, there is also significant diversification advantage as PFP acquires these organisations.
As shown in the graph below, PFP’s acquisition strategy has seen the organisation grow from an ASX minnow to a formidable competitor of the previously hegemonic IVC.
Graph: Market Share Estimate (Funeral Volumes)
This analysis has aimed to value PFP on the assumption that the company will continue its aggressive acquisition strategy for at least the next five years, followed by steady-state operations where acquisitions will continue but at a slower rate.
Financial Projection Methodology
Core revenue growth projections have utilised historical revenue figures on a per funeral and per facility basis. Although the model assumes small uplifts in these averages over time, revenue is largely driven by the number of operational facilities. Costs of providing services has been derived from a constant gross profit margin of 71%, which is consistent with historical figures.
Selling, General & Administrative (SG&A) expenditures have been developed based on a combination of PFP’s historical margins as well as IVC’s cost structure (representing a more mature organisation in the space). These assumptions assert a long term operating margin of between 16% and 17%, which is in line with past performance.
As the composition of properties and infrastructure in PFP’s portfolio is not entirely clear, a number of assumptions have been made regarding the properties owned and their composition of funeral homes, cemeteries, crematoria and/or memorial gardens. For simplicity, it has been assumed that future property acquisitions will feature co-located opportunities only (i.e. funeral homes co-located with cemeteries). The same is true for leasehold properties.
Debt will be the primary source of financing for the acquisition of future properties. As outlined in the risk section of this analysis, there are some limitations to this assumption.
FINANCIAL DATA
VALUATION
A Discounted Cash Flow (DCF) valuation methodology has been used to value shares in PFP and to highlight the financial impact of an aggressive acquisition strategy in the near term.
Time Horizon and Stages
The analysis has been conducted over a 10-year timeframe, with FY2030 being the terminal year.
Stage I represents the aggressive acquisition stage, whereby PFP will aim to acquire around 24 businesses/sites per year (relatively in line with its track record) as well as some leasehold properties.
Stage II is the maturity stage of the projection horizon. In this stage, it is assumed that consolidation undertaken by market leaders such as IVC and PFP will begin to slow as acquisition opportunities become less prevalent. At this stage, PFP will continue to acquire around 10 businesses/sites per year as well as some leasehold properties.
Finally, Stage III is the terminal value applied to the valuation based on FCF for FY2030 operations. Further details on the terminal growth rate are provided below.
At the terminal year of operations, the company is forecast to operate 360 facilities, made up of 242 freehold and 118 leasehold facilities (currently 72 and 58, respectively).
Terminal Growth Rate
Selecting an appropriate terminal growth rate has been difficult. There are limited resources which project the long term growth of the death industry, with short term forecasts estimating around 5–6% growth.
With limited industry growth projections available, the model has adopted Australian Bureau of Statistics (ABS) death statistics. The ABS forecasts a CAGR of deaths in Australia of approximately 2.0% in the 2030s and 2040s, followed by approximately 1.0% following that point. A midpoint of these projections (1.5%) has been adopted as the terminal growth rate, reflecting the demographic shift in Australia’s population moving into the future.
Cost of Capital
A Weighted Average Cost of Capital (WACC) has been formulated based on the capital structure of PFP and existing market rates.
A cost of equity of 6.4% has been adopted based on the current 0.98% yield of Australian 10-year Government Bonds at the time of writing. A risk premium of 5.13% and an Equity Beta of 1.05 have also been adopted.
Post-tax cost of debt is considerably lower than industry standards, although this is reflective of the company’s relatively low weighted average borrowing rate of 2.64%.
Finally, a D/EV ratio of 33.9% has been adopted, reflecting the current capital structure of the organisation which considers the current value of the organisation’s debt and equity.
Based on the above, a post-tax WACC of 4.83% has been assumed.
RISKS
Key downside risks to the valuation include:
Debt Availability
Given the capital-intensive nature of the industry, the model assumes a very aggressive use of debt throughout the projection period. On average, the model assumes majority of the acquisition costs will be funded through debt financing.
As at 30 June 2020, the company had approximately $67 million of undrawn facilities remaining from its $150 million debt facility with Westpac. The financial model forecasts net borrowings of more than $60 million by FY 2022, meaning the company will either have to expand its debt availability further or approach shareholders for additional funds.
New Entrants
The Australian death care industry is highly fragmented, with IVC and PFP being the dominant operators amongst what are generally family-run businesses. The larger operators have proven the scalability of their acquisition strategies, and this suggests there is vulnerability to new entrants (such as overseas operators) enacting similar consolidation campaigns.
COVID-19
As with all valuations at this time, COVID-19 will continue to play a big part in the company’s success over the short term. Government-imposed restrictions on funeral attendance in Australia and New Zealand in the second half of FY2020 had a significant impact on the organisation’s ability to offer its full range of funeral services, thus hampering average revenue per funeral.
With the continued threat of a re-emergence of COVID-19 in Australia, the threat of declining revenues (as is likely being experienced by PFP’s Victorian portfolio) will continue to be a threat.
Disclaimer: This analysis is not advice and is not intended for investment purposes. It is based on my own research and opinions, and you should form your own opinions before considering investing. I currently hold a position in PFP and may add to this position over time.
