Description

Service Corporation International (SCI)

Service Corp International (SCI) is the largest company in the death-care industry in the world with 1,250 funeral homes and 364 cemeteries located throughout North America in 43 states and 8 Canadian provinces.  We think SCI is a high-quality franchise asset that represents an important part of the economy.  SCI has about a 12% share of the North American death-care market and the next largest competitor has less than 3%.  SCI has used its large size to achieve scale economies while retaining the local brands in each of its markets and there is no other competitor with a network comparable to SCI's.  The industry is fairly fragmented and localized with many small players.  Over the last 8 years SCI has developed a co-branding strategy, retaining local names but co-branding them with the Dignity Memorial brand.

Investment Thesis

SCI generates tremendous amounts of free cash flow and has consistently done this for several years and we expect SCI to use this free cash flow to drive shareholder value.  Over the past five years, SCI has been able to repurchase close to 100 million shares or over 30% of its share base driving total shares outstanding down from 350 million to 250 million.  Moreover, SCI was able to acquire Alderwoods, the #2 industry player, for $1.3 billion (including assumed debt) in November 2006 and realize very substantial cost synergy savings of over $90 million.  SCI retained Alderwoods' strongest properties and sold off the remainder and some residual international properties for over $400 million, resulting in a very successful acquisition.  Over the past four years SCI has generated roughly $1.3 billion of cash from operations or almost two-thirds of its current market cap of $2 billion.  As SCI regains its footing from the dramatic downturn in 2008 and 2009 (its business is recession-resistant but not recession-proof), we expect a similar pattern of cash flow generation and usage to occur over the next three or four years and we think this will be very favorable for shareholders.  We think SCI should continue to hold its own in today's tough economy, especially with the dramatic cost reduction program mgmt undertook, but we believe SCI can also benefit nicely as the economy begins to improve.  Overall, we think SCI provides the type of asymmetrical upside-to-downside relationship we like to see in our investments.

SCI has guided to about $1 per share of free cash flow in 2009 and 80 cents to $1 per share of FCF in 2010.  Based on an $8 share price, SCI is trading at about 8x FCF in 2009 and 9x FCF in 2010.  We expect SCI's free cash flow per share and adjusted EPS (about 50 cents est for 2009 and 2010) to improve over the next few years and we would not be surprised to see SCI trade at $14 per share or higher considering the quality of the business (SCI previously traded in the $14 range prior to the economic downturn).  The differential between SCI's adjusted EPS and FCF per share is largely due to D&A expense which is almost twice as large as maintenance capital expenditures and cash taxes which are much lower than GAAP taxes (cash tax payments are estimated at $20 to $25 million for 2009 and 2010).

Over the next 24 months, we think SCI's leaner cost structure will result in stronger gross profits and operating profits as revenues stabilize.  We expect SCI to use its strong free cash flow and b/s to make carefully selected tuck-in acquisitions in strategic markets, such as two recently announced.  SCI recently agreed to acquire Keystone, the 5^th largest chain in North America (revenues of approx $124 million), as well as Palm Mortuaries, the largest player in the Las Vegas market (revenue of approx $30 million).  We expect both these acquisitions to be quickly accretive to EPS and free cash flow.   Palm closed in Q4 of 2009 and we expect Keystone to close in Q1 of 2010.

SCI's stable business model is enhanced by the substantial amounts of pre-need funeral and cemetery sales (discussed below).  Funds are disbursed funds at the time of need (i.e., death) from either (a) trusts which are regulated but overseen by SCI-chosen managers or (b) insurance contracts.  These pre-need contracts represent almost $6.5 billion of future revenues for SCI and enhance the stability of the business model.

SCI will release Q4 results after the close on 2/24 and we are hopeful to see continued progress on adjusted EPS and free cash flow generation.

Background

We like SCI's management which has been led by CEO Tom Ryan since 2003.  As many VIC members are aware, SCI and the death-care industry went on a debt-fueled acquisition binge in the late 1990's to meet Wall Street's growth expectations.  This did not end well and SCI narrowly avoided bankruptcy.  Since then, SCI and the industry have focused instead on free cash flow and selling off non-strategic assets to repay debt.  Ryan initially sold off international assets to reduce debt and increase focus on North America, and has led a laser-focus on free cash flow generation, upgrading marketing capabilities, strong cost efficiencies, and strategic/accretive acquisitions.  Although top line growth for SCI and the industry is modest (low single digits), we think the combination of SCI's unique network and franchise, strong and recurring free cash flows, and modest leverage create an investment with powerful upside and modest downside.  We think SCI provides a nice call option on an eventually stronger economy which would clearly help with sales volumes and pricing.  We also like that SCI's funeral and cemetery sales prices are generally less price-sensitive than for most retail transactions and their pricing has held up relatively well in the recession.

Strong balance sheet and liquidity position

SCI has leverage but we think it's manageable at 3.3x LTM EBITDA given the stability of SCI's base business, revenues, and cash flows.  SCI had total debt of $1.74 billion at 9/30/09.   SCI has no debt maturities until 2013 when its bank revolver matures (about $150 million outstanding at present).  SCI's debt is rated "BB".

Funeral and Cemetery Segments

SCI's two segments are funerals and cemeteries.  The funeral segment contributes 2/3 to 3/4 of total gross profits and is the major driver of the business.  The funeral segment is also the more stable segment because pre-need sales of funerals do not impact the current income statement, whereas pre-need sales of cemetery properties are included in current earnings.  Because preneed sales are discretionary and at-need sales are not, the cemetery segment gross profits, which include these more discretionary cemetery property purchases are more volatile and were more impacted by the economic downturn in 2008. 

Funerals performed are pretty steady for obvious reasons and SCI has done a good job of driving improved average revenue per funeral service over the past five years through stronger emphasis on service rather than merchandise, improved sales and marketing, and emphasizing the corporate-wide Dignity Memorial brand.  Funeral and cemetery sales are generally less price sensitive purchases than other retail items and their pricing has held up well through the downturn.   The result is a stable business model that has produced stable cash flows over the long period of time, even in a difficult economy.

Funeral services performed have generally been down in the low single digits in recent years but this has been more than offset by steady increases in average revenue per funeral service (average revenue per funeral service increased from $4,410 in 2005 to $5,105 for 9 months of 2009).  Interestingly, funerals performed dropped sharply in Q1 of 2009 (down 11.2%, the most ever), then again in Q2 of 2009 (down 7.1%), and started to stabilize in Q3 of 2009 (down 4.6%).  (Management has stated that October 2009 was down in 4% range.)  A weak flu season in Q1 of 2009 and a secular trend of fewer births in the 1930's are the reasons management cites for this decline.  Funeral volumes are generally expected to be down in the low- to mid-single digits in Q4 of 2009 and 2010.

A major portion of SCI's cost structure is labor-related expenses and the company has been aggressive about reducing both field and headquarters labor costs during the downturn.  The company is starting to add back a modest amount of labor reductions which were designed to deal with a draconian macro-economic scenario which did not materialize.  Consequently, adjusted EPS expected for 2010 of close to 50 cents is relatively flat versus adjusted EPS guided for 2009 as these temporary labor cost reductions are reinstated.  We actually view the add-back of these costs as a positive because we don't think the company would add-back these costs if it didn't have a decent amount of confidence in its business trends for 2010 and beyond.

During the economic downturn in 2008-9 SCI has focused primarily on cost-cutting, reducing capital expenditures, and paying down debt.  As a result, we think SCI is very strongly positioned with a lean cost structure and strong liquidity to do extremely well as the economy begins to improve.  SCI's leaner cost structure helped drive sharply higher gross margins in both the funeral and cemetery segments in Q3 of 2009.  G&A expense is also at reduced levels although management has begun to add back a modest amount of G&A expense as gross profits have started to increase year over year.

Pre-need funeral and cemetery sales and trust investments

SCI sells both funeral and cemetery services on a pre-need basis in addition to the at-need business it generates.  Most of these pre-need sales are deferred until they go at-need but cemetery property sales do run through the income statement on a current basis (as long as 10% deposit is made and the property is completed).  These pre-need cemetery property sales are clearly more discretionary and these slowed sharply with the economy starting in Q4 of 2008 and continuing through 2009.  However, cemetery property sales rebounded nicely in Q3 of 2009 as consumers regained some confidence in discretionary purchases.  Pre-need cemetery property sales were $53 million versus $63 million in Q1 of 2009 (down 16%), $72 million versus $79 million in 2009 Q2 (down 9%), and were $72 million versus $60 million in Q3 of 2009 (up 20%).

One long-term positive for SCI is that pre-need sales of funerals (added to backlog but not included in current earnings) have been at significantly higher prices than at-need funeral sales averages.  For Q3 of 2009 the average pre-need funeral sales price was over $5,600 as compared to about $5,100 for average at-need funeral sales price.  When these pre-need funeral sales become at-need funerals and are recognized through the income statement, this will help increase SCI's average revenue per funeral.  SCI has indicated about 30% to 35% of funeral volumes in a given quarter are from the pre-need backlog so this should help drive higher average revenues per funeral service over time.

A second long-term positive for SCI is the large backlog of pre-need contract which represent future revenues of about $6.5 billion.  There pre-need contracts are supported by investment trusts and insurance contracts which provide funding when pre-need contracts go at-need.  Revenue recognition and receipt of these funds is generally deferred until death.

Competitive Position

We believe SCI has a very strong competitive position with a 12% share of the North American market while its next closest competitor has less than a 3% share.  The funeral and cemetery business is primarily a local oriented business dominated by smaller mom-and-pop players and local competitors with long-established relationships and histories in their respective markets.  For this reason, SCI retains the local market brand names but takes advantage of the support and scale of its large national position.  SCI has also adopted a dual-branding strategy with Dignity Memorial packages across its local brands.  SCI also used modern sales and marketing techniques and data analysis which are less available to local players.  The company has also focused on affinity programs with insurers and other businesses that are involved in death care decisions.  With several local brands in a given market, SCI is able to leverage its cost base (labor is a major cost factor) in a given market.

SCI is strongly focused on growing its pre-need sales in both funeral and cemetery segments.  These pre-need sales basically represent future market share and another source of advantage over smaller, more local competitors.  Furthermore, pricing on pre-need sales is generally more attractive than for at-need sales since the consumer is able to pay over time.

Cash Flow from Operations and Free Cash Flow per Share

SCI's business is not capital intensive.  There are substantial growth-oriented projects which SCI believes can be pursued with limited capital expenditures or working capital required.  Consequently, SCI generates strong cash flow from operations and SCI's cash flow has remained strong through the economic downturn.  Q1 is generally the strongest quarter for earnings and cash flow due largely to the flu season.  Cash from operations (CFO) for Q1 of 2009 was $141 million versus $140 million prior year; CFO for Q2 of 2009 was $70 million versus $70 million prior year; and CFO for Q3 of 2009 was $94 million versus $117 million prior year (down due to timing on some working capital items).  SCI management has guided to CFO of $45 to $60 million for Q4 of 2009 versus $29 million for Q4 of 2008.

SCI management has guided to CFO of $350 to $365 million for 2009 and CFO of $300 to $350 million for 2010 based on working capital being a use of cash in 2010 versus a source of cash in 2009.

SCI management deducts maintenance and cemetery development expenditures from CFO to arrive at free cash flow.  For 2009 maintenance and cemetery dev expenditures are expected to be about $70 million and for 2010 about $90 million.  This results in free cash flow for 2009 of $280 to $295 million or over $1 per share and $205 to $265 million for 2010 or 80 cents to $1 per share.  Based on an $8 share price, SCI has a free cash flow yield of 10% to 13% on reasonably expected 2010 free cash flow.  We believe management's projections for EPS and cash flows are conservative and would not be surprised to see 2010 cash flow from operations come near the high end of the stated range.

We think that SCI's free cash flow per share can continue to grow over time through a combination of: 1) stable funeral services performed, 2) modest increases in average revenue per service, 3) improved gross margins in both the funeral and cemetery segments due to cost reductions, 4) improved revenue from stronger pre-need cemetery property sales, 5) acquisitions that are rapidly accretive to EPS and free cash flow, and 6) significant share repurchase programs.  Lastly, if SCI continues its focus on debt reduction, interest expense could also decline significantly.

SCI repurchased almost $1 billion of stock from 2003 to 2008 and reduced shares outstanding from 350 million to 250 million.  We are confident that if meaningful, accretive acquisitions are not available the company will prudently use free cash flow to retire large amounts of outstanding shares.

Q3 Results

SCI's results have progressively improved during Q1, Q2, and Q3 of 2009 driven largely by 1) cost reductions, 2) improved pre-need selling, and 3) improved trust income through the income statement.  Q1 adjusted EPS was 12 cents versus 20 cents prior year.  Q2 adjusted EPS was 12 cents versus 14 cents prior year, and Q3 adjusted EPS was 13 cents versus 9 cents prior year.

It is worth understanding how SCI is driving these improved results, so we elaborate on the three drivers of improved results below.

The first factor, cost savings, included reactionary reductions which were short-term reactions to the environment and resulted in dramatic cost reductions in the field organization.   (SCI has about 20,000 employees and labor is the largest component of its cost structure).  A second part of cost savings were longer-term, including using technology and metrics to streamline costs.  One example is a funeral staffing metric which allows SCI to share resources within a market.  If one funeral home is not busy, you can bring staff from a sister funeral home two or three miles away.  Another type of cost saving is cemetery maintenance administration, including the maintenance of cemeteries (mowing lawns, setting markers, etc.) where mgmt thinks it's in the third inning of cost savings.   Costs were reduced in field operations and cemetery maintenance and administration, where increased outsourcing improved costs.

Cost savings were also achieved due to insurance reserve reductions including workers comp, etc. where training on safety, etc. has helped reduce costs over time.  Q3 realized a one-time benefit of about $7 million due to adjustment of a long-tail liability.  Mgmt believes this expense will come down further over time.

The second factor was improved pre-need sales, as discussed above.  These pre-need cemetery property sales are clearly more discretionary and these slowed sharply with the economy starting in Q4 of 2008 and continuing through 2009.  However, cemetery property sales rebounded nicely in Q3 of 2009 as consumers regained some confidence in discretionary purchases, and were $72 million versus $60 million in Q3 of 2009 (up 20%).

The third factor was improved trust fund income which represents contracts that go at-need, which happens when someone dies.  Earnings on these trust funds are carried with the contracts.  While SCI was running at about $25 million per quarter prior year from this trust fund income flowing through its income statement, this declined to $13 million in Q1 of 2009 due to the severe declines in the markets in 2008.  For Q2 of 2009 these earnings increased to $17.6 million and for Q3 $17.9 million and SCI expects to be near $20 million in Q4.

Q3 funeral volumes were weak, but much improved from earlier in 2009.  Q3 comparable funeral volumes were down about 4.6% as compared to over 9% during the first six months of 2009.  Average revenue per funeral grew 1.9% in Q3 and 3.9% for 9 months of 2009 excluding currency changes and trust fund impacts.  The increased average revenue per funeral was achieved through strategic pricing initiatives, controlling discounts, and increased take-up rates on Dignity Memorial Packages.  

Q3 funeral gross profit dollars grew almost 17% despite a 4% decline in revenues as funeral gross margin improved 390 basis points to 21.6% vs. 17.7% prior year due to the factors discussed above. 

Q3 cemetery sales increased about 3% which represented the first increase since Q2 of 2008 after reported declines of 8% to 18% in past four quarters.  Q3 cemetery revenue increase was driven by increased willingness of discretionary consumer on pre-need cemetery sales production, which grew over $15 million or 18% versus prior year.  Improved sales counselor productivity also contributed to the improved results.

Q3 cemetery gross profits increased about 44% or $10 million as cemetery gross margin improved almost 560 basis points to 19.4% versus 13.8% prior year as a result of incremental revenue growth, cost savings, and insurance reserve improvement.

Q3 total gross profit increased about 23% to $101 million as compared to $82 million prior year as a result of the funeral and cemetery segment results discussed above.

Q3 general and administration expense increased to $23 million from $16 million as the company gradually reinstated some of the labor expense reductions it initiated when the economic downturn hit in Q4 of 2008.

Q3 operating income before non-recurring items increased over 21% to $80 million as compared to $60 million prior year.

Preneed funeral and cemetery sales also turned in a strong performance during Q3.  Q3 preneed funeral sales were steady at $123 million or down $4 million vs. prior year.  Preneed funeral sales do not impact the income statement but do grow the company's future pipeline of revenues.

Disclaimer

Disclaimer:  We own shares of SCI.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst

Improving adjusted EPS and FCF per share

Share repurchases

Accretive acquisitions

Stronger economy