Service Corporation International: A Deadly Opportunity

With all this talk about another economic depression, it is ironic to find value in an industry that only recently has been feeling the effects of the last depression. During the 1930s, when the unemployment rate reached 25%, it is not surprising that people were less inclined to have children. Less births back then has been one of the reasons the death care industry has recently seen a decrease in customers.

The 30s, however, ushered in the 40s, which saw the beginning of the baby boomer generation. This large shift in demographics could have a profoundly positive impact on the fortunes of the death care industry in a few years. With a 13% share of the industry in North America, Service Corporation International (NYSE: SCI) is best positioned to benefit from this change. Other publicly-traded industry participants include Stewart Enterprises, Inc. (Nasdaq: STEI) and Carriage Services, Inc. (NYSE: CSV).

The implications of a multi-year ramp-up in demand on a high fixed cost business with a healthy amount of financial leverage are fairly clear. What may not be so clear is how SCI has been setting itself up for this opportunity following the debt-driven collapse of the industry last decade.

In the 90s, industry pundits were twenty years premature in pointing to the positive impact of the baby boomer generation. With robust demand and enthusiastic support from the investment community, consolidators in the industry competed fiercely with easy access to debt. This drove up prices for funeral homes and cemeteries to unsustainable levels. When the industry started facing weaker demand, the stocks of these consolidators collapsed.

To recover from the hangover, SCI sold off its international operations to reduce debt and promoted Tom Ryan to run the company. Ryan executed well, selling off non-strategic assets and excess land into a bubbling real estate market. He leveraged the company’s size with the national branding of Dignity Memorial and focused on profitability instead of market share by selectively raising prices. Ryan expanded the products and services associated with each funeral and demonstrated an ability to efficiently allocate capital with the successful acquisition of Alderwoods.

The result has been that SCI has generated significant free cash flow the past few years and has increased earnings to what is expected to be around 55 cents a share this year. The company has paid down debt to an acceptable steady state level of around 3.5 times EBITDA and has been aggressively buying back shares. The company is selling for around $5.50 a share, representing a P/E of 10 and is expected to use its significant anticipated 2009 free cash flow of almost one dollar a share to continue to buy back shares. Although the death care industry is recession-resistant, it is not recession-proof with earnings only expected to remain stable at 55 cents a share in 2009; not bad for this environment. With a dividend yield of 3%, stable cash flow, and significant future upside, SCI should be selling for more.

So what are the main risks?

The main long term risk is the increased popularity of cremations. The number of cremations has consistently increased the past few years and this trend is expected to continue. The company has been trying to compensate for this lower revenue alternative by selling more products and services related to cremation. However, a large upward shift in the cremation rate could be the one damper in a compelling long term demographics story.

On the bright side, the company has no material debt maturities in the near future. It is generating plenty of cash flow and is expected to keep at least 100 million dollars of cash on its balance sheet. It also has 200 million dollars of unused capacity on its revolver facility. Liquidity should not be an issue.

In the short run, the company is expected to continue to fight two headwinds related to today’s economic environment. With home prices and equity portfolios down significantly, the company has seen a pull-back in the purchase of high-end cemetery property. This is not surprising. The equity markets have also impacted revenues from SCI’s pre-need business. When a customer pays years in advance the money is either used to buy an insurance contract or is invested in a trust until the service is performed. This latter method exposes the company to investment risk. This risk is mitigated by the long term nature of the contracts. So, as long as the market doesn’t collapse long term, the company should be okay.

A dominant recession-resistant business with strong cash flows and strong potential future growth should sell well in this market. Customers may be dying to get into this company, but so should investors.

Disclosure: Author holds a long position in SCI

Comments

[Anonimko123:]

You should also discuss the issues with the recent trust portfolio returns on the pre-sale business, as well as the refund risks there. I'd be more worried about it than the cremation trend.

2008 Dec 21 10:10 AM

[reader:]

This company has one way of increasing revenue. Raise prices. That has been the way for years now and if you look in the markets that they are in you will find they are the highest price establishments around. I see their stock buybacks as nothing more than an attempt to keep the stock price up. As I have looked at their revenues year over year any increases are a result of their continued price increases and not as a result of inreased market share. They are literally dispised in markets such as Chicago.

2008 Dec 22 05:17 PM