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  Digging the funeral industry

BENJ GALLANDER and BEN STADELMANN

Friday, February 24, 2006

Most of us know about the "bait and switch," where a store offers a super special, you arrive, and — lo and behold — they have sold out. "But don't worry, we have another that is even better and for only a few dollars more..."

This recently happened in the political arena, where Liberal supporters ponied up cash to help ensure the election of David Emerson, who won his All-Star spot, but found himself on the losing team. The ruling party flashed a signal, and Mr. Emerson decided to jump ship and clone himself as a Conservative. At least his bait and switch won't cost taxpayers extra.

Another variation of this theme is the "bait, bury and switch," which was almost perfected by a company that we own, Service Corp. International. Essentially what they did at one Florida location was bait clients for their funeral services, bury the bodies, and then when space was lacking, dig up the corpses and switch them to make way for the newbies.

When this unsavoury movement was discovered around Christmas 2001, the stock price dipped, tripping our buy order at $4.51 (U.S). And while we cannot say that it made us proud to have become associated with this type of ghoulish activity, there were lots of reasons to buy into the business.

Death rates at the time were below actuarial predictions, indicating to us that more bodies were in the "pipeline." For, while dying can be postponed, as far as we know, it remains inevitable.

Service had also been getting its debt under control via the sale of assets. Interest rates appeared to be moving lower, which would help reduce debt payments. And after huge losses, the company posted some decent quarterly numbers, marking a net income of $4.3 million with a strong increase in cash flow.

However, a few days after our purchase we turned tail to hide quickly, selling off 62.5 percent of our position at $4.87. While it had originally appeared that a settlement of $35 million would handle the vapid affair, additional lawsuits appeared that threatened potential liability into the hundreds of millions of dollars. A lot more sod would need to be turned to cover that eventuality. Ultimately a settlement was reached with a payout of $100 million and change.

Over the past five years the company has been moving in the right direction. After losing 79 cents a share in 2002, share profit was 28 and 35 cents respectively in the following two years. Though back in the red once more, black ink will likely be the story in 2006 — partly fuelled by the dramatic drop in long-term debt, which has gone from almost $1.9 billion to under $1.2 billion. The dividend was reinstated in 2005 with a yield of more than 1 percent based on the current share price of $8.

Service was not our only purchase in this field. Stewart Enterprises joined the Contra portfolio in 2003 at $3.11. The pattern that this company followed is quite similar to that of its brethren in the sector. The stock price recovered nicely, topping $8; debt was reduced and cash flow improved.

But then, among other problems, the corporation became delinquent in its regulatory filings, partially caused by being forced to evacuate its head office in New Orleans with the arrival of Hurricane Katrina. They are now close to being up to date in their filings and have received an extension from the Nasdaq Stock Market to regain compliance

However, dealing with this problem has been expensive, a restated increase of $157 million in deferred revenue and a decrease of shareholder's equity of $93 million. Couple this with the net loss for the 2005 fiscal year of $143.3 million, or $1.31 per diluted share, and even a corpse might shudder at the ugly numbers. But looking ahead, much of the clean-up work is now done and reasonable profits are likely towards the latter half of fiscal 2006.

The funeral industry remains in recovery mode. Though the heady days when Service was above $40 and Stewart pushed $30 are not on the near term horizon, our initial sell targets of $13.84 and $9.24 are not that distant. And we imagine that neither stock price will be hit by another play on the bait, bury and switch.


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