To err is human and humans learn by "erring." This is a case study on picking an investment based on high free cash flow and what we can learn from it. This is a mistake that value investors frequently make.
The suject of this study is Park Lawn Corp. (TSX:PLC, Financial) (PRRWF, Financial), which is in the death care services business. Based in Toronto, the company operates cemeteries, funeral homes and crematoria in Canada and the United States. With 90% of its business coming from the U.S., the company's operations span across various regions, offering a range of funeral and cemetery products and services.
Further, it is known for acquiring smaller operators. This roll-up strategy is a useful way to reduce operational costs, increase revenue and consolidate resources for improved efficiency as long as the acquisitions are done in a disciplined manner and the acquirer does not over-pay. In addition, the acquirer should have a well developed method of absorbing the operations of the acquired business into its own operating model.
This growth by acquisition strategy has caused both debt and operating cash flow to increase rapidly. However, the company seems to have been creating value, as seen in the trajectory of the intrinsic value of its projected free cash flow in the chart below. The GuruFocus metric was created to deal with situations where FCF is erratic or where using earnings for valuation is inappropriate because of high depreciation and amortization expenses (as is the case here). Essentially, the metric takes 80% of the book value and adds it to the present value of free cash flow over six years. It is clear the death care industry is highly cash generative and consists of a only a few large players and a large number of small players. Thus, the industry is ripe for consolidation.
The vital statistics of Park Lawn and some of its major publicly listed competitors are below. The comapny is among the smaller of the publicly listed cohort.
Company | Exchange | Symbol | Current Price | Market Cap ($M) | Forward PE Ratio | Price-to-Operating-Cash-Flow | Dividend Yield % | Price-to-Free-Cash-Flow | ROIC % | Debt-to-EBITDA | Debt-to-Equity |
| Park Lawn Corp. | OTCPK | PRRWF | 13.30 | 462.75 | 11.58 | 6.28 | 2.57 | 9.45 | 2.15 | 5.07 | 0.49 |
| Matthews International Corp. | NAS | MATW | 37.77 | 1150.76 | 0.00 | 9.98 | 2.48 | 19.51 | 4.26 | 10.69 | 1.63 |
| Hillenbrand Inc. | NYSE | HI | 42.12 | 2944.83 | 0.00 | 8.89 | 2.09 | 11.21 | 7.35 | 2.69 | 0.86 |
| Carriage Services Inc. | NYSE | CSV | 25.20 | 377.14 | 9.19 | 5.63 | 1.79 | 8.11 | 4.74 | 6.35 | 4.01 |
| Service Corp. International | NYSE | SCI | 54.95 | 8289.61 | 14.40 | 11.91 | 1.99 | 26.64 | 4.25 | 3.93 | 2.74 |
Note: Park Lawn's primarily trades on the Toronto Stock Exchange (TSX). The over-the-counter ticker is used in this table to keep the currency (for market cap) consistent in U.S. dollars.
Park Lawn has a high net debt-to-equity ratio, standing at 42.1%. This ratio has seen a significant increase from 12.9% to 47.7% over the course of the past five years. Despite this elevated debt level, the company maintains strong debt coverage, with operating cash flow covering its debt at a ratio of 27.1%. Moreover, the company exhibits robust interest coverage, with earnings before interest and taxes providing a substantial 7.1 times coverage of its interest payments on debt.
A closer examination of the balance sheet diagram below shows long-term debt is actually only about 15% of the total liabilities. Most of the non-debt liabilities are non-interest bearing and relate to pre-paid funeral arrangements and funds for maintenance of cemeteries which are required to be held for regulatory reasons.
These customer advances result in operating cash flow and free cash flow that are consistently more than GAAP earnings. This means there is risk that the intrinsic value provided by the projected FCF method may be too optimistic. This cash gets held up on the balance sheet (as investments and advances) with a concurrent liability for regulatory reasons. However, much of this cash equivalent is unproductive and is slowly released to the income statement when services are performed. This also depresses the return on equity and return on invested capital.
A better method, in my view, than using free cash flow is to use Warren Buffett (Trades, Portfolio)'s owner earnings method. Owner earnings is a cash flow concept introduced by the guru in his 1986 Berkshire Hathaway (BRK.A) (BRK.B) letter to shareholders. For investors, it was an unfamiliar concept at that time as companies were not required to produce a cash flow statement, nor was stock-based compensation to insiders such a big concern. Buffett's formulation of owner earnings removes non-cash distortions from earnings to focus investors' attention on how much cash they are getting as partial owners of the company at the end of the period.
Buffett explained owner earnings as net income plus depreciation, depletion, amortization and other non-cash charges minus average annual maintenance capital expenditures. Owner earnings is similar to free cash flow, but I think a superior metric because it starts from net earnings, so takes stock-based compensation as well as maintenance capex into account. Unlike free cash flow, owner earnings includes stock-based compensation, which can be a significant expense for some companies, but excludes capex spent on growth initiatives.
The following chart compares earnings per share, free cash flow per share and owner earnings per share over the last five years. The price-to-owner earnings ratio is about 21.5, which is not all that cheap. The growth trajectory of owner earnings per share is erratic, which gives me pause. As we can see free cash flow is much higher than net earnings or owner earnings in most years.
Conclusion
While I bought Park Lawn a couple of years ago for my portfolio, seduced by the high free cash flow and pandemic-induced boom in revenue, I have not been happy with the purchase. I should have questioned, why is the free cash so high and why is their a consistent gap between free cash and net earnings? These questions should have triggered second level thinking rather than taking free cash at face value.
The stock has performed poorly. Further, the GF Value Line is now showing it as a possible value trap. Given the high and persistent gap between free cash flow and net income, I have come to the conclusion this may be correct, though for the wrong reason.
GuruFocus triggers a value trap warning if there is a very large discrepancy between the GF Value and stock price. Therefore, I do not recommend adding to a position or starting a new position. Though I don't plan to sell it as the stock may have over corrected. This experience is a good lesson for me to look beyond just high free cash flow and consider the reason for discrepancy between cash flow and income as well as owner earnings. Ideally, all three metrics should be reasonably consistent.
Recent news reports indicate Park Lawn has approached competitor Carriage Services Inc. (CSV, Financial) with a buyout offer. Given the low ROIC for both companies, I do not think that is a good idea as it will mean taking on new debt or new equity. This reinforces my belief to stay away for now. Overall, the death care industry does not seem to be attractive at this time.
