Returns on capital invested

As always, I am looking at Dignity's returns on the money it has invested including any hidden debts (known as lease-adjusted returns).

Starting with its free cash flow returns (CROCI) below, we can see that the company does consistently produce free cash flow which is always a good sign. Lease-adjusted CROCI over the last ten years has usually been above 10% which is the minimum level I set for a good business. Its current CROCI is 13.2%. So on this measure, Dignity looks like a pretty decent business.

This is also confirmed by looking at its return on capital employed (ROCE) figures. In many cases, you should usually expect ROCE to be higher than CROCI as ROCE only takes away depreciation (an estimate for how much money a company needs to spend to maintain its assets) rather than the total amount of money spent on new assets in the CROCI calculation. ROCE tends to be higher than CROCI when a company is spending more than its annual depreciation expense on new assets - i.e. the capex to depreciation ratio is more than 100%.

It is also worth noting that ROCE is calculated before tax whereas CROCI is an after tax measure. This should also see CROCI lower than ROCE when a company pays tax.

As you can also see in the chart, Dignity's ROCE (the second or red bar) has been very stable which is a good sign. It has trended downwards during the last couple of years but is still running at a very respectable 14.4% adjusted for leases.

Cash conversion

How good is Dignity at turning its profits into cash flow? Given that ROCE and CROCI are fairly similar numbers the initial signs are good. Dignity passes the first test of cash conversion as operating cash flow is consistently more than operating profit as shown in the chart below.

But if we look at the profits and cash flow for shareholders, the track record is a little bit more patchy - a large chunk of earnings per share hasn't always been turned into free cash flow per share.

That said, things haven't been too bad on this score, especially as Dignity has been spending quite heavily on new assets as shown by a few years when capex was significantly higher than depreciation. As capex has come down in recent years, free cash flow per share has been increasing significantly which is encouraging to see.

A closer look under the bonnet - Funerals

Dignity's core funeral business appears to be in rude health and is very profitable as shown by its high and rising margins. In 2015, it has been helped by a spike in the UK death rate during the first six months of year which means that profit growth rates will slow in 2016.

The company doesn't disclose a separate figure for capex but lumps it in with money spent on buying other businesses. Maintenance capex is disclosed in the annual report at just under £12m in 2014 which is only just higher than depreciation indicating that the company's profits are believable.

High profit margins are very desirable but they can be competed away if they attract new competition wanting a slice of the pie. The number of funeral directors is increasing in the UK but this doesn't seem to be hurting Dignity as its estimated share of the market is broadly stable. Reputation and local presence count for a lot in this business and this can deter new entrants.

That said, it is spending reasonable amounts of money buying up other funeral companies and so it is buying some market share to defend itself from competition.

What is encouraging is that Dignity does seem to have some pricing power as the revenue per funeral keeps going up. This is despite the fact that nearly a quarter of Dignity's funeral sales come from pre-paid funeral plans which tend to have a lower price.

Funeral plans

Dignity has been selling a lot more pre-paid funeral plans in recent years. This gives its funeral business a lot of visibility on future sales as the plans are making up a bigger chunk of its total funerals. Dignity currently has five years annual funeral volumes in pre-paid plans.

This business needs to be watched closely. The sale of funeral plans is not currently regulated and there has been some concern that it might be in the future which might increase costs and reduce profits.

Profits here are small and are made up from administering and marketing the plans sold through partner companies. The monies paid for the funerals are held in independent trusts - where they are invested - or are backed by insurance policies and are not handed over to Dignity until a funeral needs to be paid for.

The amount of money in trusts was £678m at the end of 2014 and was sufficient to meet the anticipated costs of future funerals. However, the trusts have recently changed their investment policies and moved more money into shares and overseas markets. A stock market crash might see the value of the funds fall and leave Dignity with a hole to fill to cover the cost of the funerals it is obliged to provide.

To sum up

1. Dignity seems to be a high quality business with decent returns on capital and high profit margins.
2. Cash flow performance is reasonable and has been improving.
3. Debt levels are not too high given the stability of profits and cash flows.
4. Dignity seems to have pricing power in both funerals and cremations which has helped preserve high profit margins.
5. Pre-paid funeral plans give lots of visibility on future sales.
6. The funding of funeral trusts needs to be watched.
7. Profits and cash flows have benefitted from a spike in the death rate in 2015.
8. The shares have high valuations attached to them.