Hillenbrand HI
April 30, 2008 - 1:48pm EST by
coffee1029
2008 2009
Price: 18.18 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,133 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

 
Hillenbrand, Inc. (“Hillenbrand”) was spun-off from (old) Hillenbrand Industries on 2nd April 2008 (simultaneously another division supplying the healthcare industry was also spun-off as the larger Hil-Rom Holdings).  Hillenbrand is a very simple niche business: it sells funeral caskets, cremation urns and remembrances to funeral homes. 
 
It is priced cheaply to earnings, at 6.7x EV/EBIT ’08 (6.3x ave. 03-07 EBIT).  At first glance this valuation, which is cheap on an absolute basis, might appear justified for an uncomplicated manufacturing company which produces a necessary but boring product, for a market which is not growing (unit sales have been flat over the past decade) and for an industry (death care) which is far from glamorous.  But in the same way that Coca Cola is not just a manufacturer of sugared water, Hillenbrand is not just a manufacturer of wooden boxes.
 
Firstly it truly dominates its industry, a good initial sign of barriers to entry and that this is not a commodity manufacturer.  It has grown over the last 100 years to be the world’s largest casket supplier with a dominant 50% US market share in caskets and a 35% US market share in cremation products.  Closest competitors Matthews (ticker MATW) and Aurora (privately held) each have less than 15% market share; below them are 100-200 small players.  Hillenbrand earns more than two thirds of the entire profits of the US casket industry.
 
Secondly its sustained record of high profitability suggests that it is in fact a good business.  Over long periods of time, through various economic cycles, it has delivered remarkably high and stable profits: 40%+ un-leveraged returns on equity, 23%+ operating margins, and 60%+ returns on capital (ROC = ebit/(net working capital plus fixed assets).  How did this manufacturer of what should be a commodity product get to be such a profitable business? 
 
Well there are two plausible answers.  The bearish view is that they have achieved this status through illegal methods, which are currently the subject of an anti-trust lawsuit, on which, more later.  The alternative view is based on several factors:
 
The product is not a commodity, but its cost-base is commodity-like.  Here I do not just mean that Batesville, Hillenbrand’s trading name in caskets, is considered the premium brand, although it is.  More importantly Hillenbrand sells a business-critical product that must be delivered exactly according to individual specifications, normally within 24 hours of order, which the funeral home then marks-up 2.5-3x.  Each of these ingredients contributes to a high quality business.
 
Let’s examine the casket manufacture and distribution business by working backwards from the ultimate point of sale in a funeral home, back to the manufacture of the casket. 
 
Funeral homes find it easier to mark up the essential casket, which is custom built and often personalized, than its other services, which most homes try to itemize at very reasonable rates in order to prevent giving the consumer any sense of gouging or greedy behaviour.  So right from the outset, the casket is a high-margin product in the eyes of Hillenbrand’s customer: the funeral home manager.  Now think about the logistics of delivering “made to order” caskets: the delivery cannot be outsourced (neither funeral home directors nor their future customers, who are almost all local and regularly walk or drive past their local funeral home, would like to see UPS deliveries of the next batch of wooden crates; instead Hillenbrand employees make daily deliveries to each funeral home with dignified, white gloved service).  So, if the front-end of transportation must be company owned and branded, the entire transport fleet must be dedicated to this one activity.  For a small player, they can never get the throughput of orders that would allow them to keep the required fleet size on the road (Hillenbrand’s delivery network uses 650 company owned trailers, making deliveries every day to the majority of its clients).  By logical extension, the biggest delivery network with the highest capacity utilization also becomes the most reliable supplier.  Funerals are stressful times for all involved, so ensuring the right casket gets delivered at the right time is business critical for a funeral home manager.  Hillenbrand’s scale makes it both efficient and reliable (delivering “the right casket at the right time 99.3% of the time”).  Finally, a combination of scale in transport and manufacturing means that instead of having to make a new customized casket for each order, existing inventory can be used to fill the majority of orders.
 
Hillenbrand could therefore be compared to a tailor selling off-the-peg inventory as a made-to-measure suit, with clear implications for pricing power.  Batch production, rather than individual customization, is more efficient and obviously cheaper.  This means that manufacturing processes can be streamlined to the most efficient methods available. Hillenbrand runs manufacturing out of six locations in the US and Mexico, and distributes through 94 distribution centres.  The plant in Batesville, Indianna, for example is run at full capacity from 7 a.m. to 1 a.m. five days a week, employing a total of 675 workers split into two shifts, turning out a thousand caskets a day.  Hillenbrand have based most of their manufacturing methods on Toyota, after extensive operational analysis and study in Japan by senior management.  Various US manufacturing journals have recognized the company’s plants as being among the top 10 in North America for efficiency, worthy of study by other manufacturers.  Each casket therefore makes the remarkable journey from an efficient, but commodity-like factory floor, via the dominant delivery network in the industry, to a shop front where the product is sold as a custom-made rush job.  No wonder they manage to keep margins high.
 
Funeral homes develop an increasingly dependent on Hillenbrand.  The North American funeral home market is remarkably fragmented, small scale and local in nature: 80% of the total 22,000 funeral homes are independent.  (This is unlikely to change soon, after previous attempts to roll-up the industry dramatically failed).  Just as Coca Cola provides free chairs and tables to café start-ups in return for exclusivity, Hillenbrand frequently redecorates funeral homes at its own expense, provides casket displays which relieve the funeral homes from carrying inventory, and trains the overwhelmingly Mom and Pop operators in more sophisticated merchandising and sales techniques.  In short Hillenbrand treats their customers like franchisees, and in return they gain near exclusivity as suppliers. 
 
So it can be seen that Hillenbrand occupies unusual territory: the dominant supplier where scale is critical selling to a highly fragmented, small-scale market.  This must be what suppliers to the retail trade looked like in the 1950’s.
 
Valuation
 
Enterprise Valuation:
 
Price:               $18.18
Shares o/s:       62.3mm
Mkt Cap:         1,133mm
Cash:                  123mm
Total Debt:           250mm
Net Debt:             127mm
EV unadjusted :  1,260mm
Additional investments: 208mm
EV adjusted:      1,053mm
 
The additional investments are legacy investments held by (old) Hillenbrand Industries and transferred at the spin-off:
  • $124mm sellers note issued in July 2004 when (old) Hillenbrand Industries sold the funeral pre-payment plan company Forethought Financials Services to FFS Holdings.  The notes currently accrue at 6%, and beginning in 2010 will pay $10mm annually.
  • FFS warrants valued at $1mm.
  • Private equity Limited Partnerships with a book value of $26mm – these have generated returns of $10-12mm p.a. in recent years.
  • Unimpaired auction rate securities with a book value of $57mm, convertible to cash over the next 12 months.
 
 
EV/EBIT 07:    6.8x
EV/EBIT 08:    6.7x
 
Price/sales: 1.7x
Price/book: 4.4x          (evidence of the high returns on equity the business enjoys, rather than overvaluation).
 
Comps
 
Matthews, is the number two in caskets, and is the closest publicly traded competitor to Hillenbrand.  Its casket business has inferior market position and profitability when compared to Hillenbrand, but its Bronze Division holds a very attractive position in providing bronze memorials for cemetery graves, which is in many ways similar but complementary to Hillenbrand’s position in caskets.  It dominates this smaller bronze niche with an estimated 75% market share.  So Matthews is a very similar business, operating in the same industry.
 
Company
Ticker
EV/EBIT 07
EV/EBIT 08
ROE
07
ROC
07
Operating Margins
Casket market share
Matthews
MATW
14.7x
14.0x
15%
48%
15%
15%
Hillenbrand
HI
  6.8x
  6.7x
77%
77%
23%
50%
 
 
 
Private market value
 
  • Milso Industries (then number 4 player) was bought by Matthews in July 2005 for 11.2x EV/EBIT (’04) for a net purchase price of $96mm.  Compared to Milso, Hillenbrand has a bigger market share and superior competitive position as demonstrated by its much higher profitability (’04 EBIT margins for Milso were 8% vs. 28% for Hillenbrand).
  • York Casket (then number 2 player) was bought by Matthews in May 2001 for 11.1x EBIT (‘02), for a net purchase price of $110 million.  Compared to York, Hillenbrand is again a better business: York had 15% market share vs. Hillenbrand’s 50%; York’s operating margins in ’02 were 9% vs. 28% for Hillenbrand.
  • Several previous attempts to buy York at a lower valuation (e.g. Wilbert Inc.’s offer of 7.9x EV/EBIT in May 2000) did not succeed since York’s management believed, correctly in hindsight, that the business was worth far more than the multiple then being offered.
  • Aurora (number 3 player) has been family run and privately held since 1890.
  • Today’s dominant leader, Hillenbrand was last privately purchased in 1906 when it traded under the name Batesville Coffin Company.  It was family managed until 2000, and formed one part of Hillenbrand Industries since 1971.  It first traded as a public stand alone entity in April 2008.
  • Conclusion: private market valuation for Hillenbrand should be at least 11x EBIT, or a significant premium to current valuation.
 
Capital allocation history
 
  • In the past 15 years the division been very disciplined, focussed, and successful in the few acquisitions that it has done.  It has only spent a total of $27.8mm during that period, all in the same niche as itself, and each acquisition has increased their dominance by a little bit.  The majority of the money has been used to buy 6 regional casket distributors; these are tiny companies, typically family concerns working a small patch of rural funeral homes. 
  • Historically the parent company (old Hillenbrand) made the other capital allocation decisions, which resulted in most of Hillenbrand’s cash flow being directed towards investment in Hill-Rom.
 
Anti-trust litigation
 
  • Two independent casket discounters have filed cases (on behalf of themselves and consumers) alleging that Hillenbrand and three large national funeral homes conspired to exclude them from selling caskets to consumers.  If successful the worst case would appear to be $4.5bn (alleged monetary damages trebled) plus costs.  In addition to the fact that Hillenbrand is joined by three other defendents (funeral homes), there is also a formal judgement sharing agreement between Hillenbrand and the recently spun-off Hill-Rom Holdings, which should help to soften the blow of a negative outcome.
  • This does appear to be the biggest threat to business safety, and could depress valuations until resolution (trial date is expected to be announced in May 2008).  A worst case settlement of $4.5bn (bearing in mind that Visa’s November 2007 $2.1bn settlement of the antitrust lawsuit brought by Amex was believed to be the largest amount ever paid to resolve an antitrust matter) could conceivably push the company close to bankruptcy (back of the envelope calculation: apply an assumed one fifth share, or $0.9bn cost to Hillenbrand, paid immediately with no appeal), although it is interesting to note that assuming the judgement does not materially impair future earnings power, the settlement-adjusted current valuation would be a pricey, but not ridiculous, 13x EV/EBIT multiple even in this dire scenario.
 
 
Additional risks
 
  • US cremation rates, currently 34% of all deaths, will continue to erode casket burials.  Rates have been steadily rising from 19% in 1995; the Cremation Association of North America projects this to reach 57% by 2025.  Countering this trend is the likely increase in the total number of deaths over the next 20 years, the result of an ageing population overall population growth.
 
 
Catalysts
 
  1. End of initial spin-off selling.  Since the spin-off began trading on a WI basis, 33% of the total shares outstanding have traded, which suggests potential for some more spin-off related supply in the short-term.  Current owners are almost all under water on their average entry price, given that before the spin-off, old Hillenbrand was already trading near 5 year lows, and since the spin-off (new) Hillenbrand has traded lower as many shareholders prefer the growth story of Hill-Rom Holdings to a no-growth boring stock like Hillenbrand.  The timing of the spin-off also helps create an opportunity here.  Many spin-offs in recent years have tended to be more “efficiently” priced, with many of the strategic benefits of singular management focus being realized in the first few days after a spin-off is announced (old Hillenbrand stock rallied 10% immediately after the May 2007 announcement), and frustratingly little subsequent cheapening caused by old-style spin-off selling.  However, by spinning-off in April 2008 in the middle of market dislocations elsewhere, Hillenbrand appears to be a neglected good business trading at a temporarily low valuation.
  2. Management now have in place performance-based compensation directly tied to the operational performance of just the business that they run.
  3. Excess cash flows can be returned to shareholders rather than funding the capital-hungry healthcare division of Hill-Rom, pre-spin off.  More than half of 2008 free cash flow is dedicated to being returned to shareholders via dividends.
  4. It appears that just one sell-side analyst covers the stock currently.  One recent in-depth spin-off analysis was negative on Hillenbrand, which potentially discouraged further research, as it concluded that although smaller competitor Matthews is valued at a premium to Hillenbrand of “at least 65%”, this valuation gap is unlikely to close soon due to Hillenbrand’s lack of growth prospects.  Increased exposure should normalize the market valuation.
  5. Insider buying. Ray Hillenbrand (Chairman) spent $3mm of Dakota Charitable Foundation’s money, of which he is a trustee, buying stock in the range $19-$20.

Catalyst

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