StoneMor Partners (STON) was the latest master limited partnership (MLP) to shock investors with a distribution cut (learn about the main risks of investing in MLPs here).
After increasing its distribution each year since 2005, Stonemor announced last week that its third quarter distribution would be reduced by 50% to 33 cents per share.
Even worse, StoneMor’s stock collapsed 45% on Friday.
Many dividend investors are wondering how this happened, especially after management’s comments about STON’s distribution less than three months ago on August 5th:
“We are encouraged by the positive metrics we’re seeing from our recent sales initiatives and when combined with lower operating expenses, will allow us to continue providing attractive distributions to our unit holders.”
StoneMor’s Chief Financial Officer also noted in August that StoneMor’s cash distribution coverage ratio for the last quarter was a reasonable 1.3 times.
Let’s review some of the warning signs StoneMor gave off prior to announcing its distribution cut and whether or not the stock could provide some value to high income investors going forward.
StoneMor Business Review
Before analyzing the distribution cut, let’s quickly review StoneMor’s operations. StoneMor was formed in 2004 and is the second largest owner and operator of cemeteries (317 locations; 81% of revenue) and funeral homes (105 locations; 19% of revenue) in the United States.
StoneMor’s products and services are sold when someone passes away (“at-need”) or ahead of time (“pre-need”) and include burial lots, caskets, headstones, memorials, and various installation services. The company is an MLP and does not pay any federal income tax (learn more about what MLPs are here).
Many income investors were attracted to StoneMor for several reasons. For one thing, StoneMor’s management team had rewarded investors with distribution increases every year since the company started paying one in 2005 (learn about Dividend Achievers, companies with 10 or more straight years of dividend growth, here).
StoneMor’s line of business was perceived to be very stable. Few new cemeteries are developed these days, capping industry supply. Nobody wants to live next to a new cemetery, and most cemeteries are owned by small companies or families (i.e. not the most aggressive competitors and plenty of acquisition opportunities).
Industry demand trends looked appealing at first glance, too. As the popular James Bond novel is titled, “Nobody Lives for Ever.” When coupling our mortality with America’s aging population, StoneMor seemingly had good visibility into its future revenue.
What went wrong, and could investors have known?
StoneMor’s Distribution Coverage was Fragile to Begin With
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. StoneMor’s dividend and fundamental data charts can all be seen by clicking here.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
StoneMor’s Dividend Safety Score prior to management announcing the distribution cut was 34, suggesting that the company’s distribution was at heightened risk of being cut sometime in the future.
As an MLP, StoneMor distributes almost all of its cash flow as a dividend. However, StoneMor’s business model fails to generate enough GAAP (generally accepted accounting principles) earnings or free cash flow to cover its cash distribution.
Over the last 12 months, StoneMor’s GAAP diluted earnings per share and free cash flow payout ratios are -322% and -1,143%, respectively. As seen below, StoneMor has struggled to generate positive free cash flow per share in recent years.
Since StoneMor doesn’t make nearly enough money to cover its full distribution and invest for growth, it has depended heavily on issuing more units and taking on additional debt.
As seen below, the company’s long-term debt to capital ratio has increased from 44% in fiscal year 2005 to 63% last year. Meanwhile, diluted shares (units) outstanding have more than tripled over that period of time.
Many MLPs have similar looking charts – high leverage and steadily rising share counts. This can work if management’s growth investments earn a return in excess of the company’s cost of capital and are increasing per share cash flow over time.
However, if unexpected business challenges arise or management makes an operational blunder, we have seen that previously dependable MLPs can become volatile nightmares (see Ferrellgas Partners for a recent example).
High debt loads, high payout ratios, and high dependence on capital markets to fund distributions and growth investments reduce an MLP’s margin of safety compared to basic corporations.
There are few MLPs I am comfortable investing in for many of these reasons. Another issue is their complicated accounting and organizational structures. StoneMor’s accounting in particular required a lot of faith in management and was rather controversial.
Accounting for cemeteries is extremely complicated (see here). Even as a CPA, I was ready to “pass” on StoneMor since it quickly fell into the “too hard” bucket for my (limited) circle of competence.
Other investors were willing to dig deeper (no pun intended) on the company. Here is a link to Luma Asset Management’s comprehensive research on StoneMor. The crux of their short thesis centers on complex financial engineering. Investors can watch an informative video with Luma Asset’s analyst talking about StoneMor’s short thesis here.
Essentially, Luma argued that the company does not make any money and never will. One look at StoneMor’s GAAP diluted earnings per share shows that the company has failed to turn a profit every year since fiscal year 2008, although the company’s management has consistently recorded positive operating income on a non-GAAP basis.
How has the company managed to issue higher distributions for more than a decade given the figures above? StoneMor has raised money by selling new units and paying it back to existing investors.
The chart below shows the cumulative amount raised by selling new units (red line) and cumulative distributions paid (green line). Luma’s analyst noted that StoneMor’s cumulative distributions were not from operating the business but rather from financing the business.
Luma’s thesis didn’t necessarily raise any new points for the bear case against StoneMor (in my opinion), but it highlighted some of the big disconnects between the company’s results under GAAP and the non-GAAP figures reported by management.
Essentially, Luma turned out to be correct in believing that StoneMor’s situation would eventually prove