Propel Funeral Partners: the new black?

The funeral industry doesn't seem like one to get the blood pumping. It certainly won't for the unfortunate person in need of its services. But InvoCare (ASX: IVC) – Australia's largest funeral company – has produced spectacular returns for investors.

Since floating on the ASX in 2003 at $1.85 a share, the stock has risen almost tenfold. In Peter Lynch's terminology, InvoCare is close to being a ‘tenbagger'.

These days, however, InvoCare has a problem: making acquisitions is difficult. With a market share exceeding 40% in several Australian cities, the ACCC is unlikely to allow the company to buy much.

Daylight second

Despite InvoCare's dominance, the long tail of the funeral industry remains fragmented. There are more than 1,000 funeral locations in Australia, with InvoCare accounting for close to 250. No other Australian competitor has more than 4% of the market.

Enter the oddly-named Propel Funeral Partners (ASX: PFP). Propel holds this 4% share of the Australian market as well as a little less than 7% in New Zealand. InvoCare's the market leader across the Tasman as well but it's not quite as dominant as in Australia.

Propel floated on the ASX last month and, at the initial public offering price of $2.70, looked like reasonable buying. But as members of the public can rarely obtain stock in new floats we decided not to devote time to a pre-float review.

So what's the investment case at Propel's current price of $3.40, up 26% from the issue price?

Admittedly the stock doesn't look cheap on a forecast enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 15.4. But there's a great deal of potential growth at Propel which means the multiple isn't as off-putting as it might appear.

In the short term the company has around $50m in cash for acquisitions. Once deployed, that capital might produce perhaps $5m in EBITDA. Annualised, that would reduce the forecast EV/EBITDA multiple to 14.2.

Buyer of choice

But the best opportunity is long-term industry consolidation. With InvoCare unable to compete for most acquisitions, Propel could become the funeral industry's buyer of choice. Family-owned funeral businesses wanting to sell now have the option of ringing a cashed-up Propel and saying ‘buy us out'.

With many Australian industries having consolidated to two main players, it's reasonable to expect the same thing might occur in the funeral industry. InvoCare might end up with, say, 45% of the industry in ten years, while Propel ends up with 20%. Both players could grow but Propel could quintuple in size.

Buying rather than building is the foundation of Propel's investment strategy, which is ‘to acquire assets in the death care industry in Australia and New Zealand'. For family-owned businesses, having the option of selling out to Propel helps with succession planning.

Several issues give us pause for thought, though. Propel has an unusual external management agreement in place. The manager will receive performance fees based on total shareholder return, so there's an incentive to boost the share price.

The art of the deal

Also, what's often forgotten in the race to make acquisitions is that the deal is only part of the art. Afterwards management must run the acquired businesses day-to-day. Time will tell whether Propel can manage assets as well as buy them.

Finally, shareholders should review exactly what Propel buys in future. So far the company has concentrated on buying funeral businesses in regional areas, whereas InvoCare is much stronger in metropolitan locations. If the two companies start butting heads in cities, competition might become less than gentlemanly.

As a recent float, and a stock with little obvious margin of safety, Propel isn't a company we intend to recommend or cover. We'll certainly keep an eye on it, though, given it's a competitor to first-ranked InvoCare.

But the industry consolidation theme that Propel has been designed to deliver makes some sense. If you're interested in doing your own research – and are happy to pay up for potential – Propel Funeral Partners could be your second chance in this attractive industry.

Disclosure: The author owns shares in InvoCare.