Service Corporation International (NYSE:SCI) Wells Fargo Securities Healthcare Conference September 8, 2016 1:10 PM ET
Eric Tanzberger - Chief Financial Officer and Treasurer
Ryan Halsted - Wells Fargo
Happy to be joined by Service Corporation International. And with the company, I have Eric Tanzberger, CFO and Treasurer. We're going to do a Q&A. So, if anyone has any questions, please feel free to raise their hands, but otherwise I will get started.
So, starting with your funeral services business, same-store volumes have been down a few quarters now in a row. Maybe you could talk about what you're seeing there? Are there markets or maybe you are losing some market share?
Okay. The first thing that I would say when you talk about is, you have to first have a inter-year, if you will, discussion on a flu season and this being a healthcare conference as well, would know that. So, last year, very heavy flu season, very strong funeral volumes for us in the first half of 2015. 2016, relatively very weak flu season, so our funeral volumes would decline against that tough comp and ultimately that's part of the reasons why you are seeing this tail of declines in same-store number of events or funeral volume, as we call it, in the industry.
So, very strong first half sequentially, third and fourth quarter down and that's carried through with the tough comp first and second quarter sequentially of this year, and I think you may see that come back up because of the weaker comp that we've in the second half of this year versus second half of 2015.
The point though that I'm really trying to make when you think of it as an annual basis is we really don't see that a strong flu season will affect you on an annual basis. So, in other words, the flu season in 2015, that was so strong early in the year that occurred in the first and then went into the second quarter as well, in our opinion what it really does is accelerate events that you would have provided services to in the third and fourth quarter - into the first and second quarter.
So, for example, after the first quarter, I think we started off last year up 5% in the same-store events or funeral volume, and we knew that that would normalize to what we experience in market place as a general statement, flat to down 2% right now for our same-store funeral volume or funeral events. This year this should be the inverse. This year because we didn't have a flu season in the early part of this year and we are against that very tough comp, we started off out of the whole down 5%.
So, we still believe the annual guidance at the end of the year being flat to slightly down will occur, which therefore being indicative of sequentially growing the back half of the year. So that's the first thing you have to talk about when you think about why are you having these sequential quarters of declines in volume. We hope that, that would normalize, and in fact, potentially even go flat to slightly up to balance the easier comps that you have from the back half of last year through that flu season.
The other point though Ryan that you have to think about is, why does our volume look a little differently than what you'd see in the CDC report for example or some of the other statistics that are out there that are available. The one thing you have to realize when you look at our network is first of all and if you want to talk specific to funeral, we have 16% market share in total as a company, funeral and cemetery, but the funeral segment itself is about 13% market share.
So first you're comparing 13% versus the rest of the geographic country and it can move. This last quarter, it's interesting how the northeastern part of the second quarter had volumes that were down 10% and there's other studies that will offset that as well in other geographic parts of the country. But of that 13% market share, we have very, very institutional type high-end leaning businesses, more in the high-end or high-spend structure, I should say. And when you think about that consumer, and this again being a healthcare conference, you have to start thinking about who has access differentially to healthcare.
And we believe that the type of consumers that we're servicing at the higher spend end of the market differentially has access to healthcare, which is in turn affecting our number of events versus more global picture across the country. Ultimately, as a general statement, there’s always going to be a market where you can find, where you are gaining market share, and there's always a market that you can find that there's been a new entrants and you may be weak in a little market share. But as a general statement, we've been, as far as our statistics, we've been very consistent at that 16% market share now for a couple of years post Stewart acquisition, which was done in December 2013.
Okay. That's helpful. Maybe you could talk about the pricing side of your business. What kind of pricing power do you have? What are some of the key contributors to that? And then maybe want to delve into some of the other - what's the competitive environment or pricing, and then maybe lastly, just if you could talk about the HMIS plus system?
Okay. So let me take the first part of it. In terms of pricing power, generally we've had a few headwinds in our pricing year-over-year in the funeral segment and I'm specifically talking about average revenue per sale or per event, and ultimately that relates to the Canadian dollar that's been a headwind some of the trust fund income, because of the performance of the markets that's obviously now lapping itself and then a great July and et cetera. But when you back that out and look organically at the funeral home itself what does the spend look like, the spend in terms of pricing is very healthy, it's actually up 2.5% to 3%. I think last quarter was kind of the high end of that, right around 3% growth for the second quarter of 2016.
Ultimately that's a function of some inflationary type pricing power that I think exists in this industry. I think you will have parts of your markets that could be price sensitive. We think as a general statement, the price sensitive consumer is probably about 20% of the consumers that are out there. But ultimately, if you had some pricing power and implement as a general statement, the independent competition probably will follow you, so good pricing power. But I think you really got on to something different, which is how we presented the consumers to ultimately increase the average sale by selling higher margin projects - products, but incremental products and services. And you got to look at the history of the industry to come all the way to HMIS plus.
15, 20 years ago you walk into a funeral home, it looked totally different than what it looks today, and the sales approach or the arrangement conferences would be totally different than what you're seeing today. You're really seeing, you'd walk in and there'd be a room full of caskets to choose from, these fast-forward all the way today that room doesn't exist anymore. That room's been converted to some type of visitation facility for families with kitchens and such, going down the path of more of a celebration of life, get together, catered event within the actual funeral homes themselves or at least during visitation as well. That's one of the metamorphoses.
Another one is going from kind of an a la carte price list to package funeral plans, which we started implementing 15 years ago as well and it's all about, again, like any other package concept, selling additional products that have higher incremental margins. And that takes us all the way through today, which is something that we've implemented probably in about half of our markets and are continuing to do that, a new system, which we call HMIS plus. HMIS is just our point-of-sale system, plus is just the new version of it, which is actually a very contemporary way to interact with the family that ultimately provides us products and services a way that also increases customer satisfaction.
It's actually about a 55-inch screen. It's done digitally. There's videos embedded. A lot of it's a touchscreen and the arranger is working with the families and it's so much more visual in terms of what they can select. It really helps us reinforce the training in terms of how we want to present it from a top-down selling technique as well and how the packages, good, better, best package concepts includes these incremental products and services that ultimately add value to the family.
So, we've come a long way over the last 15 years. So, part of that 3% growth relates to pricing power, inflationary in nature, like I described to you. But the other part of it is, we're simply selling more unique products and services to consumers that they show value in, in the way that they're memorializing today, which is much more of a celebration of life than 15 years ago, which is a much more traditional, more mourning exercise with the church service.
Great. I was hoping to dig a little deeper into your backlog. Obviously, very sizable backlog, you know you’ve been very public about. How should we think about the timing of that $9.6 billion backlog? When we could really start to see some maturities of these preneed contracts start to accelerate?
Well, the metric that we use - first of all, the step back at the backlog, the backlog, as Ryan just said, it's about $9.5 billion. It's a unique backlog because it's contractual with the customer, and for the most part, it's either funded or it's being funded through an installment plan that the customer is paying for. When we get those moneys, we either give those moneys to a life insurance company, and we're the ultimate beneficiary of a life insurance policy, little bit more complex than what I just simplified for you, so you get the concept, or we take those moneys and we - or we put it into trust funds, and it's about $4.5 billion roughly in terms of the split between insurance and trust. We don't manage those trust moneys. We outsource that to professional institutional money managers just by 25 to 30 of those across an asset allocation, which is meant to match the underlying investment period, which to answer your question is about 10 years to 12 years.
So generally, the consumer that is pre-arranging their funeral is around 72 years old, and therefore, that contract stays in force all the way to 80 to 84, it's a very general average statement. And so, therefore, when we are managing the trust funds, the asset allocation is meant to match that underlying 10-year to 12-year life. So it's got a pretty high equity component. Its 50% to 60% equity, 30% or so fixed income, which includes some government securities and some of the states that are still very restrictive in terms of how you can invest it, very small piece of alternative investment, and then ultimately some cash as well just for the churns, you're not having your portfolio managers have to liquidate all the time.
The backlog from a net basis continues to grow though, so you're always appealing contracts out of it as they mature. But there is a lot more contracts going in. I think it's about a 1.5 to 1 ratio, right now, in terms of what's going in versus what's coming out on average. So the metric that we use to answer your original question is about one out of every three families that walk-in, that have had an event in their lives and need our products and services, have a pre-arranged funeral contract in their hand.
At some point in time, we hope that 33% growth, and because of this unique organic growth strategy that we have, which is frankly to employ a very large sales force to not only radiate out into communities that we're serving today, but really ultimately out into the independence or our competitions backyard to differentially sign-up their consumers as well. That's the strategy to build the backlog up. Now, the answer to your question is, when will you know it's working, and that is, when things start maturing and in my opinion, more and more than the 33% or the one out of three families that are walking in, have that pre-arranged funeral contract in their hand, then you start seeing that more and more sort of come out of backlog and the strategies they're starting to work and come into fruition. But it's a very long-term strategy. We've always sold preneed in this industry, but in terms of really, really ramping it up differentially from our competition, there's probably more in the 2010 to 2012 time frame. And since the average life is 10 years, there is still some time to go before you really start seeing this differential amount of contracts we are putting in that backlog start to mature and therefore hopefully give you a little bit more market share since you've differentially went out and signed people up.
Your preneed cemetery contracts has been certainly a big part of your growth story more recently, certainly. How do you see that sort of trending into the future? Do you see that as being a big - larger component of your growth?
Well, it's a huge component of our growth right now. Ultimately, our cemetery segment is about one-third of our total company. And when you look at the building blocks of what we think of being able to grow 8% to 12% bottom line, that's an earnings per share figure, and you think about tuck-in acquisitions, which gets you to 1% to 2%, shrinking the share base, will get you to 3% to 4%, but that leads at 4% to 6% of organic growth. As a general statement, we should be able to do, may not do it every year, maybe more, maybe less, but generally, that's what we think the business is going to do.
Ultimately, what's driving that 4% to 6% growth though right now is the cemetery segment, and it all has to do with demographics and has to do where the baby boomer generation is starting to affect our company in the sense of preneed cemetery property sales. And that's driving the growth in our cemetery segment, which is driving the growth organically overall of the company. And the reason is that the first time a consumer touches our company or industry, they're generally in their early to mid-60s, and that's when that consumer decides that I want to start thinking about this and the first thing that they do is go to a cemetery, and for the most part, buy cemetery properties on a preneed basis.
Now that the baby boomers are the oldest part of the generations in their upper 60s, there is obviously a larger group of consumers that want to have that conversation. And so, that has helped to drive growth in our cemetery segment coupled with the way we have tiered our cemeteries. So, 10 or 15 years ago, when you walked into a cemetery, it was a very homogenous experience in terms of what the lots looks like compared to what it looks like today. Today, we've invested capital into creating very high-end inventory. Then you have middle to high-end inventory, middle inventory, and what that does is allow you to tier it almost like a real estate play. And with top down selling techniques, you're also increasing the average sale at your cemetery.
So those two factors increasing the average sale to the tiered pricing concept, coupled with the baby boomer generation wanting to have that conversation in the early to mid-60s has driven our cemetery segment to grow mid-to-high single-digit percentage growth, have some margin expansion as well, which has been successful for us, which is driving the organic growth of the business.
That's great. In the second quarter, your preneed cemetery sales were a little bit weaker than I was expecting. I know comps was certainly a challenge, but anything else in particular that you would point out and how is it trending?
Yes. I would really say two events. The first thing as you said it was a very tough comp. I mean, cemetery, preneed cemetery sales should grow high single-digit percentage growth. In the first half of 2015, it grew 17%. In fact, that was a number specifically I think 16%, 17% for the second quarter of last year. So very tough comp that we're going off of. The other thing was that there is a significant event in the first half of the year, because of the way our cemeteries are made up they are very large, very institutional. A lot of it is headquartered on the West Coast as well, which is geared towards more higher end spend, particularly with the Asian consumer all the way from Vancouver down through California and there is a event that they have culturally called Ching Ming, which involves them going to memorialize again, or annually I should say their loved ones, which involves cemeteries, which brings a high traffic situation, which we radiate off of in terms of sales.
And ultimately there were some timing differences as well, that event primarily occurred more in March of this year versus last year was more of an April event. And so, we had a little bit of a pull from April into March in 2016, which made the comp second quarter over second quarter a little bit tougher. In terms of trending, I think they're trending where we expect them to trend. I think we expect, as I've already said, high-single digits, I should say, in terms of percentage growth. And I think that's what our expectations are for the second half of this year.
Maybe going back to the preneed funeral contracts, one of the questions I asked often is, again as we're maybe anticipating there being an acceleration of these contracts maturing, what’s the capacity side from SCI's perspective? Do you have sort of the capacity to really meet that [indiscernible] of services that might come? And as a follow-on, what's the marginal profitability as that capacity or as you [indiscernible] that capacity?
Well, structurally we feel very strongly we do have a capacity. The funeral home industry for whatever reason grew up where the buildings themselves are very large buildings in terms of square feet, and probably, larger and realistically what they needed to be and what they need to be today. So, ultimately from a structural capacity of the home themselves do we have space, the answer is yes. In no way do we see a large capital expenditure needed to grow the size of the buildings. We certainly put CapEx to change the buildings over the years, and that's what I described you before going from casket rooms to more family, more ovation and catered events and such.
The other thing I'd say is, as the demographics affect the funeral business, it's not going to be a hockey stick type event, it's going to be something that's kind of slow and methodical in terms of growing. The same stores used to be down mid-single digits, then it was 3% to 4%, 2% to 3%, now today, it's basically flat to down 2%. That should methodically slowly continue so that it's eventually flat and hopefully flat to up 2%. So you're going to have time to react to it. The one place where I think you have to think it through is from a human resource component. But again, I think we have adequate employment here at SCI, which we can handle that type of increase. We have the ability to flex up and down with part-time labor as well.
So, just not a lot of capacity concerns ultimately when you think about it that way. The incremental margins are very good in this business. It's a high fixed cost structure business. The funeral segment alone is probably 60% to 70% fixed cost business, which means that, as you put more throughput through it, you should see margin expansion. You see that and the subsets of the quarters, when you have high flu seasons with a lot of throughput, you are going to see margins expand. When you have quarters that don't have a lot of throughput, you're going to see contraction of margins. But over the long-term, as you put more throughput through it, you should kind of see some nice margin expansion.
You've seen that already in our cemetery segment. When you go back decade or several, several years, your cemetery segment may have had low to mid-teen type margins. Today it has 25%, 26% margins. And a lot of that is some of the top down selling where you are increasing the average price dropping to the bottom line that I've already described to you today. But another component of it is, there is more volume going through it because of the demographics as I have already described to you as well, and that also has incremental margins, which is helping to increase the incremental activity and therefore the margins as a whole.
I want to touch on M&A. It seems like you're becoming maybe a little more active with the M&A. Is there anything changing in the marketplace that sort of has you now looking at the high-end of your $50 million to $100 million expected spend?
Well, I think the pipeline is healthy. I think the pipeline was healthy, last year. We ended up in kind of the high $68 million or something like that in terms of spend from the $50 million to $100 million same range as last year. So, not much has changed other than some of the deals have come to fruition. I mean, the way we go about it in terms of the tuck-in acquisition perspective is, we develop proactively very good and in some cases very long-term relationships, with a target list internally of acquisitions that we think are just a great institutional fit for SCI as it exists today in our existing markets or even perhaps in new markets.
Ultimately, though, you can't control whether that deal is going to come this year or next year. I mean, these are third, fourth, fifth generation type families, and every reason is different, whether it's siblings that have differences of opinion or whether it's a patriarch of a family that finally just says, I'm ready to do the slowdown or do something else. But ultimately what you're looking for is that family to raise their hand and say, we're ready for liquidity event and we already have a relationship with you, SCI, the Dignity Memorial network, so we like to talk to you first.
In some cases, Ryan, it gets into an auction scenario and such, but we're very comfortable with that, very comfortable with our ability to create synergies, with our purchasing power and our scale and leveraging our scale, so we're okay with that as well. But ultimately I can't tell you it's going to ebb or flow based on the seller's decision, I guess is my point. Why we're excited is because mid-year we've already spent $53 million, and there's more stuff in the pipeline that we're hoping continues to go down the path that we're expecting, which means it's going to come to fruition, and that we hope will get us into the mid to that higher end of that $50 million to $100 million spend.
Maybe touching on leverage and other uses of capital, assuming the M&A activity goes according to plan. Are you willing to add some more leverage to maybe become aggressive on under-stock and/or your dividend? And what sort of a level of leverage you would be comfortable with, so what's kind of the maximum you'd be willing to be able to release?
Okay. One point, we were talking about early - late 2014, early 2015, 3.25 times to 3.5 times from a net debt to EBITDA perspective. We kind of changed that opinion in 2015, and said, maybe take it up a quarter of return to 3.5 to 3.75, I think our official guidance is 3.5 to 4, that's probably indicative of you don't want to go above 4, you don't want to kind of get up there. Ultimately, we have a track record of going above 4, but only temporarily for a very large major acquisition to get done.
And that's been a successful model for us where we temporarily lever up, have some pre-payable debt in the cap structure related to the acquisition specifically, pay that down and get back into the mid-3s or even the higher end of the 3s. So, we did have an example of 2015 with my point is we levered up a little bit more and we went really heavy into the share repurchase program last year. I think for us to lever up more than we are today, because I'm trying to say we're very comfortable in that 3.5 times to 4 times range, it would have to be a really good accretive, probably larger acquisition with the type of after-tax IRRs that are very healthy into the teen percentages that you've seen us do on large deals before.
Absent that, I think you're going to continue to see us to be very methodical and disciplined in a way we distribute the capital. I don't see a big change one way or the other in terms of the dividend. We have a metric that we could argue about what's right and there's a lot of different opinions, but generally it's around 35% to 45% of after-tax money gets distributed in the form of a dividend. So as the Company grows, the dividend should grow as well. So, I think it's a pretty good healthy dividend. And if you look at it, we've been able to grow a pretty good double-digit percentage rate over the past few years. After that, like I said, I don't think I see us levering up more than that for share repurchase program or one-time event. It would take something, a tremendous opportunity in that space or more importantly or what you've seen us in the past in terms of our track record levering up for a much larger acquisition with the proper return.
Great. Well, thank you very much. I think that's going to do it on time. So, thank you.
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