Hello, and welcome to week 2 of my new year’s resolution to bring consistency to this blog by posting every Monday.

Just 50 weeks to go!

I’ve been very active on the stock market as of late and as such I’m very pleased to present you with my latest buy.

I recently purchased a small position in UK Funeral and Crematoria operator Dignity PLC.

I bought 12 shares of Dignity Plc for a total of £222.00 – meaning one share cost me £18.50 or 1,850p including fees.

Dignity PLC slots nicely into the ‘auxillary’ or ‘roof’ of my dividend growth portfolio – This represents the relatively high risk of this addition.

Links;

1. Business Overview
2. Share History
3. Why I Invested
4. The Dividend
5. The Industry
6. The Risks
7. Valuation
8. Summary

Overview

Dignity PLC is a UK-based funeral operator that operates in three main segments;

1. Funeral Services

2. Crematoria

3. Pre-arranged funeral plans

Funeral services

Funeral services represent 63 percent of the Group’s revenues and relate to the provision of funerals and ancillary items such as memorials and floral tributes. Dignity operates a network of more than 792 funeral locations throughout the UK trading under established local trading names.

Crematoria

Crematoria represent 30 percent of the Group’s revenues and arise from cremation services and the sale of memorials and burial plots at crematoria and cemeteries.

Funeral plans

Pre-arranged funeral plans represent 7 percent of the Group’s revenues. Income represents amounts to cover the costs of marketing and administering the sale of plans. Pre-arranged funeral plans allow people to plan and pay for their funeral in advance.

A brief history of Dignity shares & Why did Dignity shares drop so much?

Since Dignity debuted on the stock market in 2004 it has earned a reputation as a recession-proof cash machine.

The company has easily grown revenue through acquisitions and yearly price hikes of 6-8%.

But what was seen as a recession-proof machine is now somewhat out of favour.

Dignity’s success and high rate of return on capital has enticed competition and as a result, in November, Dignity slumped over 20% to a low of a touch under 1,600p a share after their Chief Executive warned of intense competition in the funeral sector due to an increase in local start-ups.

As most of Dignity’s profit and revenue growth has come from yearly 6-8% price hikes, the market is now spooked that intense competition will strangle margins and lead to slowing or, worse still, declining earnings momentum in the coming years.

There’s no doubt, any need to cut prices and aggressively compete for market share will put significant pressure on the stock.

Regardless of these fears, I swooped in at 1,850p a share.

Dignity’s fall from grace.

So, why did I invest?

Dignity has been on the periphery of my stock radar for a while now but has always been trading at a pretty rich valuation.

But the huge November drop presented me with the opportunity to buy this still growing stock at just 15 times earnings.

Although the funeral care industry is set to become very competitive I am confident Dignity can leverage its scale and its strong cash generation to come out on top when the dust settles and that the current collapse in share price is an over-reaction.

About that cash flow….

One of the main reasons I like Dignity is its ability to generate large amounts of cash.

£58m in 2016 and £73m in 2015.

Such strong cash generation has meant that Dignity has been able to continually expand its operations through purchasing of crematoria (June 2016: 39, June 2017: 45) and acquiring new locations for its Funeral services segment (June 2016: 777, June 2017: 811).

This strong cash flow will enable Dignity to continue acquiring new funeral locations and crematoria to grow its revenue in the short and medium term even if new-entrants succeed in eroding company margins in the short term.

Better than this, such strong cash flow has meant that shareholders have been rewarded handsomely via dividends.

The Dividend

As a dividend investor, a company’s dividend is of utmost importance. This is because a regular dividend helps reduce risk through instant returns and allows me to compound my wealth.

So, what does Dignity’s dividend look like, and is it safe?

Dignity has paid a dividend since 2006 and has increased the dividend by an impressive and inflation smashing 10% a year ever since.

Dignity’s dividend growth.

But is this kind of growth sustainable?

Taking a look at the company’s cash flow for 2016 we can see that the £58m generated in free cash easily covered the £11m paid out in dividends. This results in a FCF payout ratio of just 19%! (11/58 x 100).

As a result of this very low FCF payout ratio – I am very confident that Dignity can continue to grow its dividend at an above-inflation pace for the foreseeable future even if the company faces adversity as a result of competition.

But, a downside to this low payout ratio is that the stock is sitting at a dividend yield of just 1.36%, as a result, investors will need to rely on continued double-digit dividend growth in the far future.

The industry

Funeral services and crematoria are highly specialized industries and one would think that this would provide dignity with a medium, economic moat.

It has spooked investors, therefore, that management is becoming increasingly bearish given the emergence of competition.

I’d even go as far as to say that management took their eye off the ball and took eye-watering price hikes for granted.

But…

As Benjamin Franklin said – ‘In this world, nothing can be said to be certain, except death and taxes.”

thus, the inevitability of death provides Dignity with a somewhat steady flow of business and ensures that the company’s offering isn’t going out of fashion anytime soon!

Better still, the UK’s population is booming and the ONS doesn’t expect that to slow down, projecting continued growth.

It doesn’t look like the services that Dignity offer are going out of fashion anytime soon and such a predicatble and steady flow of business makes Dignity a solid recession-proof play.

The Risks

Having gone so heavily into Card Factory and Next after significant drops in their stock price, readers will be forgiven for wondering why I have invested a mere £222 into these shares.

Well, the answer is that I consider Dignity as a much riskier investment, mostly due to its high debt leverage and the tiny dividend yield.

Dignity’s debt is probably my largest worry.

Dignity is currently holding total debt of £590m with assets standing at just £715m.

This gives a debt to asset ratio of 83% meaning that Dignity is highly leveraged and may find it difficult to access cash if the debt to asset ratio continues to head northwards.

Dignity’s debt pile.

With such strong cash generation, this isn’t a worry, that’s until one considers the direction that Dingity’s management is moving the company.

As competition in the high-margin funeral services sector heats up, Dignity’s management has indicated that it will increase its focus on the acquisition and ramping up of thinner-margin operations in order to fuel revenue growth in future. But – if margins in funeral services get cut significantly due to competition (as management is predicting), the company may become reliant on debt in order to fund these acquisitions.

In the worst case scenario Dignity may face a perfect storm of declining FCF due to tighter margins and the inability to raise revenue through acquisitions due to being highly leveraged although the sheer scale of current cash generation leads me to think that this would be unlikely.

More likely though is that this squeezing of FCF could cause a slowing in the company’s dividend growth leaving me with a low yielding dud!

Valuation

Over the past five years, Dignity has been able to achieve EPS growth (5years) of 9.29%.

BUT – the years of ‘lazy’ growth is over and it’s very unclear as to what EPS growth we could see in the future.

It is therefore VERY difficult to accurately analyze what shares in Dignity are worth today.

If things turn out as I think they will (remember – I have no crystal ball), Dignity will struggle to grow EPS in the short term as competition heats up but will succeed in overcoming the competition and return to higher growth in the medium term.

In order to reflect this scenario, I used the Discounted Cash Flow fair value calculation model to try to put a value on Dignity shares.

I factored in 8 years of EPS growth at 3% and 5% EPS growth thereafter.

This gave me a fair value of 2119p a share.

Summary

Dignity’s management has their work cut out. They can no longer sit back and raise prices by 6-8% a year to smoothly grow earnings.

Increased competition now means they’ll have to work for growth in the future.

The uncertainty in management’s ability to successfully compete and thrive has created a buying opportunity but significant risks remain.

I’m rolling the dice on this one.

Dignity PLC: Speculative auxiliary buy.