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  A takeover bid that may end up six feet under

BENJ GALLANDER and BEN STADELMANN

Friday, August 8, 2008

In February 2006, we wrote about the two funeral-services providers in the Contra portfolio, Service Corp. International and Stewart Enterprises. At that point, both were trading in the $8 (U.S.) range, nice gains from our purchase prices of $4.51 and $3.11 respectively. Since then, there has been a fair bit of up and down motion, but overall, nothing to write home about. That is, until recently, when Service decided to try to buy Stewart.

Our portfolio, which normally contains from 15 to 25 stocks, has put together a statistically astounding streak of 16 years in a row in which a company was taken over. In 1999, we had six. Yet never before has one enterprise in our lineup attempted to hunt down another. Given that these buyouts almost always happen at a premium price to the trading level before the offer was made, sometimes a very substantial one, this is virtually always good news. However, with one of our companies chasing another, it is a bit of a mixed blessing.

Service has already raised its offer once, from $9.50 to $11. Being recipients of this extra $1.50 does please us as Stewart shareholders, but on the Service side, it simply means paying more. Effectively, it is akin to taking money out of one of our pockets and placing it in another. An overall advantage, however, could come courtesy of two factors.

The first is that a cash premium will be received immediately for our Stewart shares if the deal passes muster. This effectively means we are being paid "up front" for a portion of the potential growth in profitability that this combination represents.

The second is that the deal will cement Service's position as America's pre-eminent funeral service provider. It should be able to wring out some savings by cutting overhead, while strengthening its market clout and ability to raise prices.

Still, this is anything but a done deal. Stewart is trading at a lowly $9.14 relative to the $11 offer price. Frank Stewart, who holds about 33 percent of the company, has indicated that he is not interested in selling. Yet, if more dinero were placed on the table, his position might quickly change. The company dismissed the initial Service overtures out of hand, but decided to explore strategic alternatives when the better bid was forthcoming.

Nevertheless, even if the companies can agree on a deal, another stumbling block could be the U.S. Federal Trade Commission. Only a couple of years ago, Service picked up No. 2 chain Alderwoods, radically diminishing competition in the field. Taking out another major player might not be deemed palatable for consumers. After all, one is already dealing with enough turmoil when a loved one dies; the double whammy of a steep bill that pads corporate profits might be too much even for the FTC, which can be pretty laissez-faire about these things.

Service continues to be profitable, as the quarterly results announced this week demonstrate. While revenues were down 3 percent, primarily because of the divesture of 400 funeral homes, profitability increased to 14 cents a share as compared to 11 cents a year ago. The bottom line worked out to $31.4 million. Cash flow from operating activities was $70 million.

The company also has more than $100 million in the till. While this is all well and good, the offer will cost more than a billion dollars. This will certainly sully the balance sheet. Back in the '90s, both of these companies bulked up on excessive debt with rampant takeovers of small funeral homes. In each case, the end result was a drop in the stock price from over $50 to the brink of bankruptcy.

Ultimately, the probability of this marriage falling apart is akin to that of a May-December romance. And if the deal is not concluded, Stewart's price will likely drop like a heart attack victim. Even with this possible jeopardy, our evaluation is to sit and wait, while hoping for a positive conclusion.


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