Description

Service Corp. (SCI) has benefited from an abnormal surge in earnings that seems likely to prove transitory. As a result of elevated deaths and increased preneed cemetery buying, SCI saw EBIT jump 84% from FY19 to FY21 - for a business that saw little-to-no growth pre-COVID. On more normalized earnings, I suspect the stock may trade closer to $45-$50 (down 30-38%).

The thesis is as follows:

1. Earnings appear unsustainable due to a significant pull forward of deaths during COVID in combination with elevated preneed cemetery sales that are economically sensitive. 

2. While aware that deaths will moderate, Street seems to underestimate the true extent of the pull-forward impact and expects preneed growth to continue.

3. SCI is an otherwise low growth, low margin biz with LT structural headwinds and potential regulatory risk from a new FTC rule.

For those unacquainted, SCI is the leader in the death care industry with 10-15% share. It is the largest provider of funeral homes and cemetery services. By revenue, the business is split ~60% funeral and ~40% cemetery. The funeral segment used to account for the majority of the profits (71% of GP in FY10); however, that changed as cemetery became more profitable thanks to steady growth in preneed. As of the most recent quarter, Cemetery now accounts for the majority of profits at 56% of GP.

Like it sounds, preneed is when a consumer pre-pays for a funeral service service or cemetery spot to be used in the future. Since a cemetery plot is considered a real estate sale, SCI is able to recognize this Cemetery preneed revenue upfront at the time of purchase. Funeral preneed, on the other hand, needs to be deferred until the time of service. This accounting quirk is an important point and we’ll come back to it later.

Prior to COVID, SCI was a low growth, low margin business. The 5 year revenue CAGR pre-COVID was +1.5%. That growth rate was roughly in-line with the annual number of deaths in the US, which normally increase by a small percentage each year.  

In addition to being low growth, SCI also faced longer-term structural headwinds pre-COVID due to the increasing preference for cremations. Cremations represented ~30% of the mix in 2005 but that had grown to just over 50% by 2019. Industry projections call for cremations to reach nearly 80% share by 2030. This is problematic for SCI because cremations are much less profitable: every 1% change in mix results in a $10m EBITDA headwind. As such, if cremation mix increases to 80% it could represent a $300m headwind (or 34% of FY19 EBITDA).

The other longer-term headwind that gave investors pause pre-COVID was the risk of increased FTC regulation. At the beginning of 2020, the FTC announced that they were going to formally review the “funeral rule”, which was enacted in 1984 and is still somewhat antiquated. The main risk for SCI is that it is required to start posting prices online as this NYT article highlights.  

While these risks have not abated, investors have instead decided to focus on SCI’s exceptional results on the heels of the COVID-19 pandemic and Street estimates assume such results are sustainable going forward.

As we all know, deaths sadly spiked as a result of COVID. There were 2.9m deaths in the US in 2019 and that total was growing ~1% per year. Deaths spiked to 3.4m in 2020 (+18%) and have remained elevated since with 3.5m deaths in 2021 and 3.3m in 2022. Assuming a normalized 1% growth rate, the cumulative number of “excess deaths” since the start of the pandemic totals 1.3m. This is a staggering number when you consider that it’s 46% of all of the deaths that occurred in 2019.

It seems possible that these excess deaths may represent a pull-forward of deaths that otherwise would have occurred over the coming few years. To that point, most of the excess deaths that occurred during the pandemic were individuals 75+ with existing comorbidities.

It is indeed puzzling that death rates have remained elevated into 2H’22 (given that COVID-related deaths have subsided). While down YoY, deaths are still running ~10% ahead of 2019 levels. SCI management has asserted that deaths will remain elevated going forward due to unhealthy lifestyles. As management noted on the Q3’22 call, “And that would be from mental health issues as well as physical health issues, going to doctor screenings, diabetes, so many things are dragging. And again, I'd love to believe that we're all going to get a Jane Fonda tape and go workout tomorrow and everybody is mentally healthy. But the truth is, it takes time and these things are long-term issues. So that is having an impact.”

I will not speculate as to why deaths are still high but I suspect (and hope) that deaths will return to normal in the near future. Afterall, you can only die once so there’s a limited pool of candidates.

Should the aforementioned excess deaths represent pull-forward, the results could be much more dramatic. The normalized death rate for 2023 (assuming 1-1.5% growth since 2019) is ~3m deaths. If we further assume that the 1.3m excess deaths serve as a headwind over the next 3 years, it would represent a drag of ~440k deaths per year. This would point to reported deaths closer to 2.6m and SCI funeral segment services of ~285k (11% share), or ~20% below Street estimates for FY24.

In addition to increased deaths, SCI also benefited from a jump in preneed cemetery sales. This is important because the cemetery segment accounts for ~60% of total profits and preneed sales account for ~70% of cemetery segment revenue.

A preneed cemetery spot is typically a $5k to $6k purchase (largely financed) made to someone 65 or older to be used in the future at their time of death. Since it is considered a real estate transaction, SCI is able to book the revenue upfront at the time of sale.

Prior to the pandemic, SCI’s preneed cemetery sales production grew at a 4% CAGR in the three year prior to the pandemic with 2019 slowing to just 2% growth. Over the years, SCI increasingly relied on its salesforce to generate preneed sales as an additional revenue stream not directly tied to the numbers of deaths.

The COVID environment of increased deaths, heightened awareness of mortality and ample consumer stimulus, created a perfect storm for preneed cemetery sales production, which jumped +15% in 2020 and another +28% in 2021. As SCI continues to work through its backlog, preneed sales have remained elevated with 2022 results still running ~60% ahead of pre-pandemic levels.

SCI expects to continue growing cemetery preneed property sales going forward thanks to vague salesforce “efficiencies” cited by management (CRM, new website, etc). The problem with this assumption is that 1) the most reliable predictor of preneed sales historically was the overall number of deaths, which seems likely to revert and 2) preneed property sales are an economically sensitive, consumer discretionary expense. The below quote was from SCI’s investor day in May 2022:

The correlation between high-end cemetery and housing is amazing today. If you go around and say, where is the best cemetery inventory in the country? It's going to be where housing prices are the highest. And so you've got the money to spend on a high-level product. So you tend to see us really ringing the bell in those markets where you've got high correlated home prices and people feel confident. So if home prices are going up, I would tell you that we're a high propensity to be able to sell to the high-end customer. If the stock market is up, everybody feels really good, and they're buying. And what happens, if you look back at 2009 as my one glaring example of a tough time, we started to see cemetery -- high-end cemetery sales fall off in the fall of 2008. And it was really bad in the first 3 months of 2009…So what it taught me is, on a very short-term basis, cemetery can be very reactive to recessions.

Similar to the funeral segment, it seems probable that a portion of the elevated preneed cemetery sales during the pandemic could represent a pull-forward of sales from future years. If we imagine that preneed sales grew at 4% from FY20-FY22 it would total $3b in cumulative sales. The actual cumulative number was $3.8b, suggesting that there could be a headwind of ~$800m over the coming years (this is relative to ~$1.4b in preneed cemetery sales production in 2023). Street estimates, meanwhile, have recognized preneed property sales growing +3% in 2023 and +5% in 2024.

The final piece of the thesis that is worth noting is that SCI has also benefited from an increase in high margin trust income. This is largely due to preneed funeral contracts, which are placed in trusts and SCI then recognizes the appreciated (or depreciated) value as revenue at the time of service. Given the confluence of spiking deaths and stock market highs, SCI saw a significant increase in trust income in 2021, up 40% vs 2019 levels. Trust income has started to normalize and could pose a headwind going forward.

SCI has guided to FY22 EPS of $3.60-$3.80 and set an initial range for FY23 of $3.45-$3.75. At the midpoint, guidance implies that FY23 EPS is relatively flat YoY and Street has EPS growing to almost $4 by FY24.

Given the concerns noted about a possible pull-forward of deaths and preneed cemetery sales, I think Street estimates may prove too high. Normalizing the death rate and moderating preneed cemetery sales, points me to earnings closer to $2.35-$2.50. A 19-20x multiple would suggest the stock could trade closer to $45-$50 as results revert to more normal levels. 

This report (the “Report”) with respect to Service Corporation International (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.

As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a short position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.

Nothing in this Report constitutes investment advice. Readers should conduct their own due diligence and research and make their own investment decisions.

Catalyst

• Negative earnings revisions.
• Lower deaths.
• Reduced preneed cemetery sales.
• Funeral rule changes.