Although the “deathcare” industry is usually predictable and unexciting, the pending merger between funeral services provider Service Corporation International (NYSE:SCI) and rival deathcare provider Stewart Enterprises, Inc. (NASDAQ:STEI) has the potential to be very profitable for rank-and-file investors. At the moment, the merger offers a significant arbitrage premium and could create long-term synergies that turn the combined entity into a major player in the space, similar to other recent mergers. Indeed, this deal should be attractive to short-term traders who seek quick profits, as well as longer-term investors who seek yield and growth.
Although the funeral services industry is among the most predictable businesses in existence, it is not completely static. As such, this deal is not without its risks. As tastes change, certain high-margin products and services could lose out to less expensive options that reduce the profitability of the deathcare firms that offer them. As such, investors would do well to take a closer look at these companies as well as the current state of the industry at large.
How the Deal Is Structured
According to the outline of the deal, Service Corporation International (NYSE:SCI) will provide current Stewart Enterprises, Inc. (NASDAQ:STEI) shareholders with cash payments of $13.25 per share on a yet-to-be-determined closing date. Including the debt obligations that Service Corporation International (NYSE:SCI) has agreed to assume, the deal’s total value will come in at about $1.4 billion. Relative to Stewart Enterprises, Inc. (NASDAQ:STEI)’s current per-share price of $13.05, this transaction offers a small premium of about 1.5 percent. Nevertheless, this could prove profitable for nimble-footed investors.
Legal Issues and Potential Complications
Much of this deal’s arbitrage premium may be the result of the legal and regulatory uncertainty that surrounds it. A number of law firms have opened preliminary investigations into the pre-deal “shopping” process as well as the mechanics of the merger’s pricing. If these investigations uncover evidence of shoddy or rushed bid solicitation, shareholder-rights lawsuits and other actions could follow. In the worst case, Stewart Enterprises, Inc. (NASDAQ:STEI)’s shareholders could reject the proposed terms of the merger and force Service Corporation International (NYSE:SCI) to come back with a higher bid.
Although this might not be a terrible outcome for Stewart Enterprises, Inc. (NASDAQ:STEI)’s shareholders, it would create an unseemly amount of volatility and unnecessarily delay a potentially lucrative merger. While it is true that Service Corporation International (NYSE:SCI)’s offer for Stewart did not provide an excellent premium to its pre-announcement share price, it seems to be in line with market-watchers’ opinions of Stewart Enterprises, Inc. (NASDAQ:STEI)’s valuation. As such, investors should be cautious about actively betting against the timely completion of this deal. If all goes according to plan, the merger should close by the end of the second quarter of 2014.
A Closer Look at Service, Stewart and the Competition
Service Corporation International (NYSE:SCI) and Stewart Enterprises adhere to very similar business models. They operate funeral homes, cremation facilities and cemeteries throughout the United States, and they sell a wide range of products and services that deceased individuals and bereaved family members might require. By contrast, close competitor StoneMor Partners L.P. (NYSE:STON) focuses more narrowly on the operation and development of cemetery properties. However, Stonemor does provide funeral home services as well.
Service Corporation is the largest of the three firms by a substantial margin. Its market capitalization comes in at just under $3.8 billion and exceeds that of Stewart by a factor of three. Meanwhile, StoneMor Partners L.P. (NYSE:STON) has a smaller footprint that amounts to about $580 million. In 2012, Service Corporation pulled out a profit of $162 million on revenues of just under $2.5 billion. This compares to Stewart’s profit of about $44 million on revenues of $527 million and StoneMor Partners L.P. (NYSE:STON)’s loss of $7 million on revenues of $243 million. Surprisingly, StoneMor Partners L.P. (NYSE:STON) is more expensive than its two competitors. Its price-to-book ratio of 3.3 exceeds Stewart’s by about 25 percent and surpasses Service Corporation’s by about 20 percent.
These firms all use significant amounts of leverage. StoneMor Partners L.P. (NYSE:STON) is in the worst shape: its debt load of nearly $240 million positively dwarfs its cash-on-hand figure of less than $9 million. Service Corporation has about $2 billion in debt to offset cash reserves of around $190 million, and Stewart has obligations of $323 million in debt against a cash hoard of $78 million.
Long-Term Outlook, Synergies and Possible Plays
Given the redundancies inherent in the two companies’ physical footprints and operational structures, it seems clear that this merger will produce significant synergies within a relatively short period of time. The combined company will enjoy better pricing power, less competition, and new opportunities to pursue growth through new-cemetery and new-crematorium construction. According to Service Corporation’s management team, this should produce revenues of at least $3 billion and cost savings of about $60 million.
In sum, this deal offers a rare opportunity for investors to notch fairly quick gains in an otherwise boring sector. In addition to a small arbitrage premium, it provides substantial synergies that could create long-term value. Although some legal hurdles remain, these should be cleared in due time. Investors who take long positions in Stewart and pocket an immediate premium could be handsomely rewarded.
The article This Play Could Be Profitable for Investors originally appeared on Fool.com and is written by Mike Thiessen.
Mike Thiessen has no position in any stocks mentioned. The Motley Fool recommends StoneMor Partners. The Motley Fool owns shares of StoneMor Partners. Mike is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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