Dignity's relief looks temporary

Shares in listed undertaker Dignity (DTY) had new life breathed into them in the summer. In August, the Competition and Markets Authority (CMA) delayed the introduction of long-mooted price controls on an industry that has been accused of over-charging vulnerable customers for its services. Price caps would prove especially punitive to Dignity, which along with the Co-operative Group is described by the regulator as “often significantly more expensive than many of the small, typically family-owned, businesses that operate the majority of branches in the UK”. The company's high debts, built up at a time when this looked a very stable end-market, makes the regulatory heat a particular concern for shareholders.

We think the recovery of Dignity’s shares is an overreaction to the watchdog’s announcement. The regulator intends to revisit price caps once the coronavirus pandemic has subsided. Meanwhile, the crisis has hastened a trend towards cheaper funerals, hitting Dignity’s margins, which the CMA singled out as "well-above" international peers in its original March 2019 market study.

The CMA is also promoting practices that will aid price discrimination. And the investigation has forced Dignity, which is currently without a chief executive, to drag out a turnaround strategy introduced in 2018 to manage increased competition. Indeed, even prior to the investigation, several years of falling prices had begun to push down margins. This is likely to continue. Meanwhile, the high death rates associated with the Covid-19 pandemic are expected to reverse once the crisis is over.

Losing the price war

Dignity is the UK’s second-biggest funeral provider. It generates over three-quarters of its turnover from funerals, earning the rest of its revenues from cremation services. For most of its existence, Dignity has grown by acquiring practices and lifting prices.

Dignity was forced into a strategic rethink in 2016 when Co-op, its main competitor, slashed the price of its basic funeral by 7 per cent from £2,135 to £1,995 nationwide. Excluding acquisitions, Dignity’s funeral market share dropped from 10.9 per cent in 2016 to 10.1 per cent the following year and stayed around that level until the first half of 2020. 

It wasn’t until the start of January 2018 that Dignity responded to the market leader’s price cuts, slashing the price of its simple funeral by around a quarter to match Co-op in England and Wales. Since then, Dignity and Co-op have engaged in a tit-for-tat on prices, while basic funerals as a percentage of Dignity’s services have more than doubled (see table). The shift towards lower-margin funerals has driven down Dignity’s underlying operating profit margin from 32 per cent in 2017 to 19 per cent last year. 

Source: Company

Dignity launched a turnaround plan in 2018 to help navigate this new era, pledging to reduce overlaps between branches in its network while conducting pricing trials. It isn’t currently looking to acquire any more funeral practices. But parts of this strategy were paused after the CMA launched its investigation into the sector in June that year. Added to the strategic confusion, Dignity lost its chief executive, Mike McCollum, abruptly in April this year. Non-executive chairman Clive Whiley is holding the fort until a replacement is found. 

No price caps – for now

The CMA has closely monitored providers for the last two years and has laid out a number of proposals to help protect consumers, most of which wrongly believe the sector is regulated. Proposals include forcing providers to publish prices. 

The CMA’s most contentious idea, which had been to introduce price caps, was temporarily shelved in August due to the impact of coronavirus. Dignity's shares jumped by nearly two-thirds upon this announcement. The watchdog maintains, however, that it will reconsider price controls when the funeral industry has stabilised.

Even while the threat of price caps is stalled, the watchdog’s push for greater price transparency may still give premium provider Dignity a headache. Less than a fifth of consumers compare the services of two or more funeral directors before selecting one. And while less than half of Dignity’s customers find it online, a big rise in online comparison is expected over the next five years. This will expose price differences between Dignity and cheaper rivals.

More funerals has not meant more profit

If Dignity can’t conduct price increases and won’t acquire more practices, higher funeral volumes might offer the potential for growth. But while the coronavirus pandemic has dramatically increased the UK’s death rate, this has not translated into greater profits. Dignity has had to adapt to new requirements while customers have moved towards simpler funerals.

The virus has also effectively brought forward deaths from future years, depriving Dignity of future full-service custom, while it expects lower volumes for years to come. Dignity will therefore have to make cutbacks in order to shore up profits and cash flows. It has already targeted £8m in annual savings, mostly achievable through staff cuts.

Another major issue for earnings is the need to service high levels of debt. As of June, Dignity had debt secured against its assets of £547m, spread across two notes expiring in 2034 and 2049. The group reported an underlying interest charge of £25.6m last year, equivalent to two-fifths of its underlying operating profit (profit before interest). Factoring in lease liabilities, Dignity’s net debt of £570m sits at a lofty 1.7 times its market cap.

For shareholders, concern about borrowings does not stop with the potential for debt costs to magnify the impact of declining operating profits. The debt structure requires that significant amounts of the company's cash flows are fed into its debt "securitisation" vehicles. This cash is only released to the operating business if certain conditions are met. Earlier in the year Digity had warned it may not meet its so-called ‘Restricted Payment Condition (RPC)’ due to the pandemic. This was avoided, but free cash flow (FCF) to debt servicing costs nevertheless diminished towards the trigger point of 1.4 times, falling from a multiple of 1.72 in June to 1.6 in September.

Dignity is also constrained in not being able to issue any more debt. The company's ‘B’ note must be rated at least ‘BBB’ quality by the Fitch and S&P agencies to borrow more. But in July, this prospect grew more distant after S&P downgraded the B note from a BB- rating (which was already below the threshold) to B+, citing the threat posed by new regulation.

Despite falling profitability, Dignity's underlying operating margins continue to look high enough to attract competition and regulatory scrutiny. The level of debt means further travails are likely to prove painful for equity holders as the interests of lenders have priority. The shares, which have doubled since the parking of price caps, currently trade at 16 times Peel Hunt’s 2022 earnings estimates (in what will hopefully be a more normalised period for Dignity). We appreciate that the easing of Covid-19 restrictions will make life easier from an operational standpoint and earnings are very sensitive to positive as well as negative developments. All the same, we struggle to see the brighter long-term outlook needed to support the shares after their strong rally over recent months.

Last IC View: Sell, 548p, 13 Aug 2020