Description

THESIS

SCI is a cash cow, with a demographic tailwind at its back and a number of potentially game-changing strategic transactions it could pursue in coming years.  I am recommending going LONG SCI, with a target price of $30 (+65%) over the next 12 months, based on its misunderstood and underappreciated (i) FCF potential, (ii) the near-term reinitiation of its share buyback, and (iii) yet-to-be-realized STEI synergies in excess of management's conservative guidance.  Further, SCI could be worth $40 (+120%) if it pursues the trust monetization and REIT conversion transactions discussed herein.

SCI is loosely followed by the Street and its holders are all large vanilla funds.  The market has not yet recognized the trust monetization and REIT opportunities here, and the accounting complexity and morbid nature of the business is a deterrent to analysts doing work.  However, a deep-dive into the business and financials reveals a number of levers SCI management can pull to unlock tremendous value, all not yet priced into the stock.     

Free Cash Flow:  Management has guided to $1.32-1.59/share of FCF in 2014, which reflects conservative guidance around synergies from the STEI acquisition and no share repos.  I see FCF growing to ~$2.00/sh in 2015, implying a yield of ~11% on the current price - this, for a market leader with a stable and growing business and demographic tailwind at its back.  $2/sh does not include the trust monetization or REIT conversion transaction described below, which would be meaningfully accretive to FCF per share above my $2/sh estimate.  

Capital Returns:  In 2011-12, SCI bought back almost 20% of its market cap, while also paying a ~2% dividend yield.  With the STEI acquisition complete, SCI is poised to reinitiate its share repurchase program.  Leverage ticked up to ~4x EBITDA for the STEI transaction, as of YE’13.  Divestiture proceeds will quickly reduce leverage to management’s target near ~3.5x.  Over $250mm (~7% of market cap) of excess FCF is available in 2014 to repurchase shares, and management likely has a strong interest in reinitiating their buyback, especially given the stock’s lackluster performance over the past several months and since the STEI deal closed.  In 2015, share buybacks could be well over $300mm.       

STEI Synergies:  Alderwoods, a closely comparable acquisition by SCI in 2006, illustrates SCI management’s conservatism regarding projected transaction synergies.  Even after FTC-required divestitures, SCI was able to revise up its synergy guidance to $90-100mm from its initial guidance of $60-70mm.  I expect guidance of $60mm in synergies from STEI is equally conservative, and actual realized synergies will be closer to $90mm.  The $60mm of STEI synergies is primarily corporate overhead reduction, and management has specifically called out other significant operating efficiencies that were excluded from this guidance (see discussion herein).            

Trust Monetization:  SCI’s preneed business gives rise to ~$3bn (~75% of market cap) in trusted cash and investments (discussed in more detail herein).  The market and Street gives SCI’s stock zero credit for this asset or the opportunity it offers.  SCI could pursue a monetization of these trust assets, with proceeds used for accelerated share repurchases or other capital returns.  There are a variety of structures/scenarios that could be explored to monetize the trust assets, and the accretiveness and magnitude of this opportunity could be a windfall to SCI’s equity.  As detailed herein, there is upside to over $35/share (+90%) through this trust monetization transaction.    

REIT Conversion:  SCI could pursue a REIT conversion of its funeral home real estate, similar to the transaction PENN Gaming recently completed.  SCI’s NOLs run out in early 2014, and its cash tax rate will move toward the low 30s % in 2015 and thereafter.  Management has discussed tax optimization structures in the past.  A propco/opco spin and REIT conversion could result in substantial tax savings and multiple expansion for SCI.  An SCI REIT would have expansive white space for acquisitions, as SCI comprises just 15% of the death care market, and future acquisitions would be highly accretive as the SCI REIT arbs its >15x multiple against ~8x buyers multiples in the sector.  As detailed herein, there is upside to $32/sh (+75%) through a REIT conversion and $40 (+120%) when taken together with the trust monetization transaction.   

Secular Tailwind:  There are three different age ‘tiers’ of customer: (1) early-60s years old: preneed cemetery, (2) early-70s: preneed funeral, and (3) late-70s/early-80s: at-need cemetery/funeral.  The first baby boomers began hitting tier #1 in 2006; today they are ~67 years old.  The % of the US population exceeding 60 years began to accelerate rapidly over the last several years, and is projected to exceed 20% by 2015.  This demographic inflection point introduces a rapidly expanding customer base, which SCI will serve in coming years, driving topline and FCF growth.

Significant Scale in a Highly Fragmented Industry:  With the acquisition of STEI (the 2^nd largest player), SCI will further enhance its scale as the #1 player in the industry.  However, SCI will still only have ~15% market share.  The death care market is highly fragmented, and tuck-in acquisition opportunities will arise into the future.  SCI’s scale allows for significant cost efficiencies and go-to-market advantages, which will drive margin expansion and share growth into the future.      

Valuation:  SCI’s current 2014 FCF yield trades wide of its historical average of ~8%.  At 12.5x 2015 FCF, SCI should trade at $25, and assuming a ~10x EBITDA multiple and ~15x 2015 FCF I arrive at my one-year target price of $30.  I believe 15x fully taxed FCF is an appropriate multiple given (i) FCF growth, (ii) future tax avoidance through a REIT structure, and (iii) potential FCF accretion through a monetization of SCI’s trust assets.

BUSINESS OVERVIEW

SCI is the largest provider of death care products and services in North America, with a network of 1,595 funeral homes and 477 cemeteries pro forma for the STEI acquisition.  SCI’s revenue is primarily derived from preneed and at-need cemetery and funeral sales, as well as direct cremations through its Neptune subsidiary (acquired in June 2011)

Preneed Cemetery:  Typically in their early 60s, preneed cemetery customers purchase cemetery merchandise and services (internment rights, marker, etc.) in advance of need.  Comp preneed cemetery production has been growing at low/mid double-digit %. 

Preneed Funeral:  Typically in their early 70s, preneed funeral customers purchase funeral merchandise and services (embalming, casket, burial vaults, cremation receptacles and memorial products, flowers, etc.) in advance of need.  Comp preneed funeral production has been growing at high-single/low-double -digit %.    

At-Need:  Cemetery and funeral services are sold at the time of death.  At-need volumes are out of SCI’s control and driven by mortality rate, which has been essentially flat for the past few decades.  Over the short-term, bad flu seasons or adverse weather can impact at-need volumes, but generally they trend flattish.  Over the longer term, aging baby boomers will cause an inflection point of accelerating mortality rate as they approach their late 70s (average life expectancy of ~79 years).        

Neptune:  The cremation rate is growing across the US, and currently stands at ~45%.  SCI provides cremation services, which can include memorial services, receptacles, memorial products, etc.  In addition, SCI acquired the Neptune Society, the largest direct cremation services provider in the US, in June 2011.  The Neptune Society provides direct (no-frills) cremation services, and also sells small memorials, certain insurance policies, and other products.     

STEI ACQUISITION

In 2008, SCI bid to acquire STEI for $11/sh, but the bid was pulled as the credit crisis accelerated later in ’08.  In May 2013, SCI announced that it had reached an agreement to acquire STEI for $13.25.  After several months of negotiations with the FTC over divestitures, the transaction closed in December 2013.  Required divested EBITDA of $53mm exceeded guidance of $35-45mm, but the successful deal close is a positive development, and management has on several occasions reinforced its expectation for sellers multiples of at least 8x (versus STEI acquisition multiple of 7.9x PF for mgmt's synergy guidance).  Interested buyers for SCI’s divested assets include public operators, private equity, and independent operators.  The M&A process is moving well along, and should be wrapped up in 1H’14.  Higher than expected divestiture proceeds will be used to more quickly return SCI’s leverage to its target level, at which point share buybacks will resume in earnest.  Management has guided to $330mm of asset sale proceeds, net of taxes, in 1H'14.   

In April 2006, SCI announced the acquisition of Alderwoods for $1.2 billion, a 7.2x multiple based on estimated synergies of $60-70 million realized over 12-18 months.  The STEI acquisition for $1.4 billion, a 7.9x multiple based on estimated synergies of $60 million realized over 24 months, is strikingly similar to Alderwoods.  In 2006, SCI subsequently revised its guidance of synergies from Alderwoods up to $90-100 million, even after FTC-required divestitures.  Given management’s conservative nature, we will likely see a similar upward revision to synergies from the STEI deal.  In addition, the STEI synergy guidance excludes specific synergies from optimizing operations, which are easily attainable.  SCI’s $60mm of synergy guidance for STEI, largely consisting of corporate overhead cuts, is still fully attainable despite divestitures, and I expect other operating and cost rationalization will drive actual realized synergies well above this figures, as was accomplished in Alderwoods. 

Management speaking at the BAML Lev Fin Conference on December 3^rd: “…we had a similar transaction called Alderwoods in November of 2006 with a similar size company, and we originally thought that those synergies would be about $65 million. They ended up being about $95 million, whereas in the Stewart situation, we are expecting $60 million. Now, past performance is no guarantee for the future as well, but we do think that there's a possibility of additional synergies above the $60 million… We do believe, as I've mentioned to you, there's a possibility of further synergies. For example, in our field operations, if you have an operating team that runs a market and we have an operating team that runs a market, you don't need two operating teams running the same market, so that's a good example of additional synergies that are not baked into the $60 million…”    

The STEI acquisition, net of FTC-required divestitures, will bring SCI to ~15% market share.  Going forward, there are other larger collections of funeral homes that SCI could look at, but I expect M&A activity to be limited to opportunistic tuck-in deals ($25-50mm per year), as management focuses on paying down debt and returning to its share repurchase program.

TRUST MONETIZATION OPPORTUNITY

In a preneed sale, there is naturally a delay in delivery of merchandise and services, as the customer makes the purchase in advance of her time of death.  This deferral of delivery has accounting and cash flow implications for SCI that are somewhat complex.  Despite SCI incurring some selling and other costs at the time of sale, funeral revenues are deferred until the time of death, and preneed cemetery revenues can also be deferred for some period following the initial preneed sale.  In addition, for the protection of customers, most states and provinces require that any cash paid by customers for preneed contracts be deposited directly into trusts or escrow accounts until the services or merchandise are delivered.  These trust assets can be invested in the financial markets to provide a return, which should at least offset cost inflation since the point of the initial sale.  In addition, laws generally require a portion of proceeds of cemetery internment right sales to be deposited into a perpetual care trust, with earnings from this trust utilized for the long-term care of the cemetery grounds.  The following summarizes the general treatment of preneed cemetery and funeral sales:

Preneed Cemetery:  Full revenue recognition once SCI has (i) collected at least 10% of the sale price, and (ii) developed the property purchased.  Cash collected upfront or through installments (paid over period up to five years) is deposited in trust until time of death.

Preneed Funeral:  Full revenue deferment until time of death.  Most (~90%) of cash paid upfront or in installments (paid over period up to five years) is invested into trust until it can be withdrawn by SCI at the time of death.  Alternatively, customers can purchase insurance policies that pay for funeral services at the time of death.  Insurance premiums are paid directly to the underwriter, so nothing hits SCI’s financials until the time of death, except for a sales commission (~19%) paid to SCI from the insurance companies.    

The preneed business and resulting revenue deferrals give rise to a backlog of unfulfilled preneed contracts.  As of September 2013, SCI’s backlog was $7.6 billion (more than 3x its annual revenue).  This revenue and the associated cash flow (held in trust or insurance-funded), will be recognized as services are delivered (at time of death).  The trusted assets associated with SCI’s backlog amount to ~$2.8bn.

SCI could pursue the opportunity to monetize these trust assets, with proceeds potentially used for accelerated buybacks or other capital returns.  There are a variety of different structures/scenarios that could be explored to monetize the trust assets.  For example, SCI could work with a third party financier, perhaps an institution with competency in insurance policy underwriting (e.g., Berkshire Hathaway), who would advance cash immediately, at some discount to the face value of assets held in trust.  At time of death, SCI would pass along to the financier cash liquidated from the trust assets.  Thus, the financier could target an IRR based on its own actuarial assumptions regarding SCI’s customer base.  The below illustrates a scenario where the financier would monetize 50% of SCI’s trust assets for an expected IRR of 8.1%.  If SCI were to use proceeds to buy back its shares at an average price of $27.50, the stock could be worth over $35/share (+90% from current price).  

This is a high-level example of a potential trust monetization transaction that does not fully address the specific issues and complexities involved - but it illustrates the value that can be unlocked by management through successfully structuring such a transaction, with proceeds used for an accelerated share buyback.  In addition, a trust monetization credit facility could monetize future preneed sales on an ongoing basis, meaningfully increasing SCI’s FCF and expanding capital returns.

REIT CONVERSION OPPORTUNITY

SCI, with ~90% of its real estate owned (not leased), has the opportunity to REIT its funeral home real estate, mitigating cash taxes and realizing meaningful multiple expansion.  Despite the market's focus on REIT conversion since 2012, SCI has gone under the radar.  In 2010-12, cash taxes were de minimus.  In 2013, cash taxes will be ~$30mm, and in 2014 they will be ~$70mm (high-teens effective rate and ~19% of pre-tax FCF).  The cash tax rate will likely move toward the low 30’s % in 2015, with tax aspects of the STEI transaction and other minimizing strategies potentially mitigating this increase.  In response to its growing tax liability, SCI has explored tax optimization structures. 

The sellside does not frequently explore these alternatives with management on its earnings calls, but in 2005, SCI management addressed MLPs and Canadian income trusts as alternatives: “The two mechanisms I've seen accomplished in this industry: one is the MLP structure. The MLP structure only allows cemetery income to be treated appropriately in MLP… You could look at an MLP for the cemeteries. It's not an option on the funeral side. There's a Canadian income unit structure that other people have done.”  Given the implications accompanying an MLP structure (yield requirements, aggressive trusting practices, etc.) and SCI’s low composition of cemetery properties relative to funeral, I do not believe SCI will pursue an MLP.  However, a propco/opco split of the funeral homes could allow SCI to REIT its funeral home real estate, mitigating SCI’s cash tax liability.  What’s more, the SCI REIT would have an enormous addressable market of acquisition targets. 

With SCI having only 15% market share, there would be a huge pipeline of funeral home assets owned by independents who may wish to monetize some of their funeral home’s value without relinquishing control of its operations.  An SCI REIT could do this by entering sale-leaseback transactions with the independent operators.  This structure also eliminates hurdles posed by FTC anti-compete concerns, as SCI would only own the real estate of these funeral homes and not the operations.  Finally, there would be enormous opportunities for multiple arbitrage, as the REIT would likely trade >15x EBITDA and its acquisition targets could be purchased at ~8x PF EBITDA.  A good case for this kind of transaction is PENN Gaming, which recently pursued a REIT spin-off of ticker GLPI.  SCI’s addressable market for acquisitions would be even greater than GLPI’s and its tenants would have stronger fundamental drivers than does regional gaming.

I estimate that 2/3 of SCI’s EBITDA is from its funeral home business.  Assuming 50% of funeral EBITDA was spun off into a REIT through a sale-leaseback transaction, the REIT would have EBITDA of ~$266mm, and the remaining Opco and Cemetery business’s EBITDA would be ~$567mm.  Based on net leverage of 5.0x for the REIT and 3.5x for the Opco, and an AFFO multiple of ~14.5x for the REIT and ~8x for the Opco, there is upside to $32/sh (+75%) through this REIT conversion and $40 (+120%) when taken together with the trust monetization transaction

MODEL AND KPIs

Given the complexity around the GAAP P&L, it is necessary to focus on the following key performance indicators that are not obscured by accounting to get a true picture of SCI’s business drivers and return potential:

Free Cash Flow:  Management reports adjusted FCF, which excludes non-recurring capex (maintenance capex and cemetery development capex are included in recurring capex), and also guides to forward FCF.  SCI should do ~$1.50 of FCF in FY’14 and ~$2.00 in FY’15, as it realizes synergies related to STEI, deleverages, and buys back shares.

Comp Preneed Production Growth:  Management reports SCI’s comparable preneed production growth for both funeral and cemetery.  This metric provides a read on SCI’s preneed business, the results of which generally do not flow through current period numbers given the revenue deferrals required by GAAP and discussed herein.  Comparable preneed cemetery and funeral sales have both been generating strong double-digit growth.  Preneed funeral comped up 11%, 14%, and 13% in the past three quarters, respectively, and preneed cemetery comped up 5%, 16%, and 16%. 

Comp Average Revenue Per Contract Growth:  Comp Average Rev/Contract reflects the pricing SCI is getting on its average contract.  SCI has consistently driven low-SD % pricing growth, which offsets anemic mortality rate growth (likely to persist until the Baby Boomers approach their late 70s) and the slowly rising popularity of cremation.

Comparable Volume Growth:  Comp Volumes reflect SCI’s at-need business, and this is driven by mortality rates.  Until the Baby Boomers approach their late 70s, volumes should trend flattish to slightly down, while experiencing some quarterly volatility based on flu seasons and weather.  SCI’s funeral volumes have been comping down low-SD%.  

In summary, pricing power mitigates lower funeral volumes, and preneed production is driving growth.  When baby boomers reach their late 70s, the trend of lower funeral volumes will hit an inflection point and turn markedly higher.  Free cash flow is robust and stable.  The below lays out PF financial (estimates) and PF capitalization for SCI, following the STEI acquisition.          

RISKS

Volumes:  Over the short-term, funeral volumes can fluctuate based on weather, flu season, and other factors.  In addition, growth in demand for creations has taken share from funerals over time.  This trend will persist until baby boomers approach their late 70s.

Macro:  SCI’s preneed business is exposed to consumer discretionary spending, and any macro shock would negatively impact demand for preneed contracts.  In addition, SCI is exposed to equity and debt market valuations through its trust assets.  A selloff in financial assets would negatively impact SCI trust income and asset values. 

Litigation:  The death care sector is no stranger to litigation arising from allegations of mishandling or damage to burial vaults.  In 2009, a class action lawsuit was filed against SCI at its Eden Memorial Park cemetery.  This case is ongoing, and could result in some damages or settlement liability to SCI.  SCI’s largest litigation settlement was for $100 million, a substantial portion of which was covered by insurance, in 2003 for its cemetery property in Menorah, FL.  Since then, the Company has meaningfully enhanced its ethical and operational training and policies to mitigate any behavior that would open it up to liability. 

Catalyst