Can Service Corp. Still Deliver Long-Term Value?

Jul.29.14 | About: Service Corporation (SCI)


It makes more sense to buy the best in the sector with better upside potential than the second or third best that present less risk.

With synergies from the Stewart deal, Service Corp. should be able to exceed this year's earnings estimates of $1.07 and surpass 2015 estimates of $1.22.

The $53 million in required divestitures should spur earnings by 4.5% to 5%, which should value the shares at around $23, or 15% above current value.

Over the past five years, very few companies have performed as well as Service Corp. International (NYSE:SCI). We hear all the time that the only guarantees in life are death and taxes. Well, during that span, Service Corp. has made a killing on the former. And the stock has been anything but dormant, soaring 600% since bottoming out at $2.91 in March 2009.

You can't take it with you

For that matter, the entire death service industry has done well. In a bit of irony, it is one of the only sectors that has brought investors the safety and stability needed during an environment where business conditions impacted everything from technology, food/beverage and energy. The fact is, people and corporations may stop spending money. But everybody dies.

Despite advances in the healthcare industry and breakthroughs with innovation and blockbuster drugs that prolong human life, there's nothing to battle old. And as innovative as drug companies and biotechs have become through their research and developments programs, cancer, HIV and deceases such as hepatitis take millions of lives each year. And that is to say nothing about random accidents and natural disasters that contribute to the death toll.

The best of the best

Families and survived loved ones will do everything in their power to come up with the thousands of dollars it costs to fund funerals for things like cemetery plots and the caskets that will house their loved ones. Honoring and remembering the dead is one of the qualities that separates humans from other species. And no other company does this as well as Service Corp.

Similar arguments have been made for smaller rival Carriage Services Inc. (NYSE:CSV). Like Service Corp., shares of Carriage have shot up 490% over the past five years. Both, in my opinion, are worthwhile investments. Carriage, in fact, outperforms Service Corp. by 14% in terms of gross margin (35% vs. 21%). But that's expected given that Service Corp., which has a market cap to $4.2 billion, is 12-times larger than Carriage, which has a market cap of $340 million.

However, what's not expected in that situation is that Service Corp is still growing revenue at a 14% clip, significantly outperforming Carriage, which has seen 3% decline in the most recent quarter. And even if we were to compare Service Corp. to StoneMor Partners (STON), which has a market cap of $563 million, Service Corp still surpasses StoneMor's growth of 8%, while outperforming in operating profit of 16% to StoneMor's 3%.

The future remains bright

As well as Service Corp. has performed, there are plenty of reasons to remain upbeat about the company's future. While the stock is certainly not cheap at this point, trading at a price-to-earnings ratio of 34, that multiple drops to 16 on fiscal 2015 earnings estimates. Plus, going forward, Service Corp. should deliver higher revenue and margin expansion that should de-risk some of the valuation. Combined, these events have the potential to deliver 10% to 15% returns to investors in the next 6 to 12 months to outperform the S&P 500.

The first catalyst is the acquisition of Stewart Enterprises, which was completed in December 2013. At the time, Stewart was the second-largest funeral and cemetery services company in the U.S. Combined, Service Corp, which already had a 15% share of the market, has positioned itself as unshakable force in the death care industry, benefiting investors of both companies.

Near-term and long-term benefits of the deal

With the deal having been completed, Service Corp.'s market share should grow towards the 20% range by 2015 as the U.S. population continues to age. Unlike Carriage and Stonemor, Service Corp has what I believe to be a strong salesforce that understands the importance of pre-needs services upon the aging baby boomers.

Pre-need is the industry term used to describe prepayment of funeral and cemetery plot services before the death occurs. Management has stressed opportunities to leverage what they consider "best practices" at both Service Corp and Stewart to drive pre-need selling. All told, investors should expect multi-year tailwinds from the Stewart deal.

The other key investment point is the potential for $60 million to $70 million in potential synergies by the deal's second-year anniversary. At that point, investors should expect Service Corp.'s to generate robust free cash flow from several years of backlog that currently sits on the company's balance sheet, which should only get bigger as volumes from at-need begin to accelerate. This growth is not yet priced into the stock.

A third catalyst seems like a negative, but should provide long-term benefits. As part of the Stewart deal being approved by the FTC, Service Corp. signed a consent decree with the FTC to divest 53 funeral homes and 38 cemeteries of the combined company. In total, this represented $53 million in 2012 EBITDA. Note that management had only guided for $35 million-$45 million in required divestitures.

While initially disappointing, Service Corp. will still capitalize on the expected return from the deal when compared to the cost of capital. Not to mention, growth should accelerate in 2015 and beyond. Because of these asset sales, management will get a cash infusion, which it will use to grow the business. When you combine this with incremental field synergies and pre-need sales strategies, Service Corp. wins either way.

The other thing is, the required divestitures should free up significant capital to de-lever the business. Once this is achieved, investors should expect management to reinstitute a buyback program sometime in the second half of this year. All told, the company will be able to deliver better-than $300 million in free-cash-flow to be used to deliver value to shareholders.

Potential Risks

As much as I like Service Corp.'s business, there are some risks. For instance, last year the company benefited from a robust flu season. This year, the comps are not as strong. As noted, this is a product for advanced medicine, which continues to make breakthroughs each year. Gross margin has also contracted due to weak at-need volumes. As much as I like the potential benefits of the Stewart acquisition, there's also the chance that management may not realize the synergies that I've suggested.

And even if they do, the synergies may not yield the sort of value to make the stock a worthwhile gamble here at a P/E of 34. Last but not least, Service Corp. is also dealing with some outstanding legal liabilities that may pose a challenge to matching 2013's strong performance. In that regard, both Carriage and StoneMor present less risk. But Service Corp. has faced these challenges before.

What's more, the benefits of the Stewart acquisition are too much to ignore. I'm not suggesting investors are going to make a killing on this stock. But Service Corp. provides an important service to society that will always be in need. And it makes more sense to buy the best in the sector with better upside potential than the second or third best that present less risk.

Bottom Line

On the basis of strong synergies with the Stewart deal and management's projection of $60 million to $70 million in potential cost savings in two years, Service Corp. should be able to exceed this year's earnings estimates of $1.07 and surpass 2015 estimates of $1.22. Assuming the company can reach $1.10 this year and $1.25 to $1.30 in 2015, that, combined with the $53 million in required divestitures, should spur earnings by 4.5% to 5%, which should value the shares at around $23, or 15% above current value.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's healthcare sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.