Service Corporation International (NYSE:SCI) Raymond James North American Equities Conference Call September 12, 2017 8:55 AM ET
Tom Ryan - CEO
Eric Tanzberger - CFO
Unidentified Company Representative
So, I’m very pleased to have Tom Ryan and Eric Tanzberger from Service Corp here. Tom is CEO and Eric is CFO. And I think Tom is going to present first.
Thank you everybody for being here today, we appreciate it. You’ll notice the forward-looking statements. I won’t reiterate that. And we’re going to start off today -- I’m going to present on the business overview, talk about some of our core strategies. Let me give you some observations as we think about the long-term nature of this business and returns that we ought to be able to achieve.
So, first slide we’ll get into and this gets into the industry itself. You’ll notice the industry is not big; it’s probably about $19 billion and think about the U.S. and Canada where we compete. If you take that share of the pie as big as we are and here that we are, we are still only 16% of the market. Another four consolidators, some public, some private encompass another 5%. And so, you can begin to understand, there is still quite a bit of business that can be consolidated, albeit we probably wouldn’t want to -- there are certain segments we probably wouldn’t want to consolidate into but ample opportunities for us to grow through acquisition or new build. We have got about $3 billion in revenues; you can see the market cap is about $6.6 billion. The all important $320 million of free cash flow, so that’s after CapEx. And we can deploy that in the highest possible returns for our shareholders, and there is a plethora of ways we do that that we’ll get into.
Another important stat, if you see the number of employees, we’re very employee-driven business, 23,000. We’ve got a backlog of $10 billion of business. And every year, we write about $1.6 billion through our 4,000-person strong sales force in preneed sales. Most of that gets deferred into the backlog, all of it on the preneed side.
So, now, you look at the last five years that we will take to take a look back here. And you can see that we’ve been able to grow the business at about 17% CAGR earnings per share. That’s outperforming the guidance that we give people. The primary reason we have been able to outperform, has been our ability to grow preneed cemetery sales at a higher rate than we have guided to in the past. And so, that’s driven a lot of the outperformance, as you think about the drivers of our business, and I’ll break that down for you when we get into long-term guidance that we provide. Remember that number is 17% EPS. That has resulted in I guess over performance from end market perspective from the shareholders’ eyes. And you can see, probably the most important, because any one year could be any one year but if you look at the five-year -- the three-year returns are almost double the S&P, significantly higher on annualized basis on 5 and again approaching doubling the S&P if you think about the 10-year period. So, we are proud of those. But most importantly, as new shareholders and existing shareholders, how does the chart look going forward, that’s going to be -- that’s where we are focused on.
So, how do we do that? It’s through the strategies of the Company. And our strategy is based on this slide. And really everything that we do -- the important thing to take away from this is -- and this is a demographic slide, people choose to buy their cemetery property in their early to mid-60s. So, if you look at the green box, and we dropped 2010 off here, but you would see a big elevation from 2010 to 2015 in the green. And that’s what’s happening now. We have got more customers to sell to on the cemetery side of the business; that trend is going to continue. So, that’s allowing us to grow EPS, to grow cash flow.
Now, preneed funeral, remember that’s going to get deferred on the balance sheet. You will see, we are beginning to enter into the baby boomers. Early 70s people pre arrange their funeral. And we should see similar growth trend as time goes on. And then, finally, the funeral business from an earnings perspective is going to be driven by that red box, which is the primary date that customers are going to pass away. That’s still a ways out but that’s going to have a pretty big effect on the earnings of the funeral side of the business.
So, our strategy is really developed around three core strategies, revenue growth, which is encompassed by remaining relevant in the consumers’ eyes through products and services, driving those preneed business because that’s how we capture share and grow cemetery revenues today. Second, leveraging our scale through enhanced sales organization, network optimization and again the preneed backlog and insurance where we can earn returns beyond our competitors. And then finally, the all-important capital deployment, acquisitions and new builds, a growing revenue and a share repurchase program that’s based upon the relative returns of capital for us. And again, lower share price, we’re going to buy more, accelerate the share repurchase program; as it goes up, we’ll probably decelerate it, is the way the model works.
So, again, the first one, driving revenues, it’s about giving customers what they want. When you think about the traditional American consumer, if you think Christian, Caucasian, that’s a challenging one right now. Because being there for generations, people -- baby boomers don’t want their grandfathers’ funeral; they want something unique. So, how do we get in front of them with unique experiences, product offerings, things that differentiate in their mind. And they need help in understanding what that might be; so, creating the tools to do it.
The second thing that’s happening with the demographic wave, particularly in Asian and Hispanic customers, they are coming in and saying, I know exactly what I want. I want you to adhere to my rituals, my customs, my religious belief, and you better be able to deliver with people that are like me. So, where we’re seeing our biggest growth opportunities is providing exactly what they tell us that they want in the Buddhist community and that may be a three to five-day service, burning incense. We’ve got to have facilities that are conducive to that type of customer want. And then simplifying the arrangement process. People are on a hurry these days. I want to package program; I want to get in and out, I don’t want to spend four hours arranging a funeral of my father. And then, finally, leveraging technology. So utilizing Salesforce.com, our customer relationship management system, HMIS plus which are customer facing, basically taking you through the process pictorially and generating a contract and elevating that into our sales enablement platform and all the while improving our website capabilities which we’re in the process of doing.
The other piece of revenue growth in the future is our preneed business. Think of the green piece, as the piece we sell today and recognize; the blue piece is grow in that funeral backlog. And again, we believe we can grow these in the low to mid single digits on the funeral side and the mid to higher single digits on the cemetery side. And remember, we’ve done actually -- our actual results about 10% to 11% and instead of that mid to high range single digits and that’s what drove the overall performance.
Then using our advantages, again, our scale. We’ve got the premier sales force, premier training; we’ve got customer relationship management. We can deploy capital unlike our any of our competitors towards these tiered cemetery offerings. These are projects that have internal rates of return in the 50%, 60%, 70%, so they’re good deployments of capital. And we can minimize the cash flow impact of preneed funeral because we’re generating high general agency commissions from the insurance companies. We fill $800 million with the insurance product, we get a very high rate and that allows us to sell preneed in a cash neutral format, when our competitor is bleeding from the ears because they are losing cash their selves. So, we like competing in that arena where we have the advantage.
Network optimization, again, we’re always constantly focused on supply chain and our purchasing power, utilizing technology to outsource or standardize what we do. And we do a good job of that. And then, finally, again being large and having large tools and money, we have preeminent money managers, fee structures. And like I mentioned before, we’ve got favorable general agency commissions as it relates to the insurance companies, products that we sell.
So, long-term outlook, we’ve grown 17%, so you might say, why do you put a 8% to 12% slide up here, you’re really dampening my enthusiasm. And it’s not meant to do that. What this really says is we believe 9 out of the next 10 years, we can achieve this, every year. We always have the anomaly year that’s something you can’t imagine right now. But, we believe this is very, very achievable most every year. And what builds this? Obviously, free cash flow, that $320 million we are generating, we are going to deploy capital. We are going to tuck in acquisitions; we are going to repurchase shares. And that’s going to give us the bottom part of the chart pretty easily.
So, the real challenge is, how do you grow the base business of 4% to 6% and how certain are you that you can do it? Well, this slide tried to address that. What that assumption says is it says, can we grow the funeral business revenue 1% to 2%? That assumes we have a generally flat volume, slightly down, we are going to get inflationary pricing of call it 2% in today’s environment. And the mix change is going to be a headwind for us, as you convert to cremation. So, we have seen this, we have experienced this 1% to 2% revenue growth, and that allows you manage your cost and maintain flat gross margin percentages. Now, if you ever give you volume and you get to 3% to 4%, that’s going to add $0.07 per share annually to it, as you get that tiny bit of revenue growth. That will happen; I don’t know when. Demographics are going to push that to that side of the business. But we love funeral, it’s flat but it generates cash and it’s going to grow.
And then, finally, the cemetery side of the business, this is where we are seeing the improvement today. If we can sell preneed at 7%, remember when you sell preneed cemetery property, you recognize it today at 60% of our cemetery revenue. So, if you grow it at 7, 60% of 7 is about 4.2%. That’s we know we can grow that as long as we hit that 7% boggy in our sales. The other part of the cemetery business, the 40% are more like funeral. They are delivering products and merchandise and services on the cemetery side. And so, those are going to be more akin to the funeral business where they’re very predictable. So, our ability to success is, can you grow cemetery sales at 7. And we have done it at 10 for the last five years, and we think we can continue to do it. Demographics is more people to sales to; it’s a very defensible business when you think about pricing power; there is not a lot of new entrants. And our investments in that tiered inventory process where we have got high-end inventory at different tier points, customers are buying up into those improved opportunities for them.
So, now, for deploying capital, I’m turning it over to our CFO, Eric Tanzberger.
Thanks, Tom. I’m going to pick up where Tom left off and talk about our free cash flow and our capital deployment program. So, I’ll start with the free cash flow, as you can see on slide 19. Little complicated slide, primarily because we are transitioning over the past four or five years from not being in a full cash tax payer, I mean U.S. federal cash tax payer when I say that versus where we are today which is pretty close. So, if you look at this by year, on the left part of slide 19, start at the bottom, you would see the red is the cash tax payment themselves. So, we started in 2012 paying $17 million, during that particular year and federal cash tax payments. 2016 was $113 million and the guidance continues to grow where we are going to pay $140 million to $145 million in cash taxes this year. That’s pretty close, not exactly being a full cash tax payer, but getting really up there where that particular cash tax rate would be in the low 30 percentage from an effective rate perspective and getting pretty close to becoming a full cash tax payer, which equals our provision, which is about 36% to 37% from an effective tax rate.
So, the green is the reported adjusted operating cash flow that’s grown from $381 million in 2012, all the way up to $509 million in 2016. You can see again the guidance for 2017 is $480 million to $520 million; $500 million mid-point, which is what Tom was describing before. So, what we do is in that in the navy blue part of the slide is we add back those cash tax payments. So, you can see a nice underlying growth from the funeral and cemetery businesses themselves in terms of operating cash flow, which translates into a 16% CAGR over this particular period. So, very stable cash flow in this business, very strong cash flow in this business. And as we’ve been able to grow from a per share perspective, 8% to 12%, as Tom mentioned, and in fact that’s a guidance, so actually exceeding that over the past five years, we’ve also had commensurate type growth into the mid-teen percentage growth from a CAGR perspective on our adjusted operating cash flow, when you isolate the cash taxes, just to make it clear, as we go through, the transition.
So, what do we do with all that cash flow? We know we have $500 million of cash flow, that’s our midpoint of our year of 2017; we have got a $180 million of CapEx that translates into the $320 million of free cash flow. The first thing before we deploy capital is to make sure that we have substantial liquidity. And this slide on slide 21 pretty much answers that question that we do. The navy blue is the long-term credit facility that expires in 2021 and the availability on that credit facility. The green is the unencumbered cash that we have on hand at any point of time. So, ultimately, in 2017 through mid-year, we believe our liquidity is about $363 million, which you can see in the upper top right side of slide 21. We’re comfortable, anything about $250 million based on our models in terms of deploying capital above that $250 million liquidity amount.
But in addition to liquidity, one thing that we also look for prior to deploying capital is having a very manageable debt maturity profile and slide 22 shows you that we actually do. At the bottom you see how the debt matures over the next, call it 10 years. You can see our first maturity that’s of any size of the $250 million note that’s due in October 2018. So, at any point in time in addition to liquidity, we manage this debt maturity profile to give us maximum flexibility, so that with that liquidity, with that good debt maturity profile, we can go ahead and deploy capital through its highest and best relative use in terms of return on that cash deployed.
Before I leave this slide, I want to talk about the leverage at the very top of slide 22. And you’ll see our target is 3.5 to 4 times and through the second quarter; we’re right in the middle of that mid-year, about 3.7 times in terms of our net-debt-to-EBITDA leverage as defined in the credit facility that I mentioned to you before. We feel very comfortable with that leverage target, when you take into account the business itself, the defensiveness of the business as well as the stability of the cash flow stream that has been proven throughout time.
So, with that backdrop of $320 million of free cash flow, ample liquidity, well above the $250 million that we’re comfortable with as the strategy before coupled with the very manageable debt maturity profile, we’re pretty aggressive on deploying capital for the benefit of our shareholders. And this is kind of how we stack ranked, at least in our head. But again, it’s a relative value opportunity. So, at any point in time we could go heavier on one of these mechanisms, one of these deployment scenarios than another ones.
So starting on slide 23, just kind of stack ranking, acquisitions are usually going to win in our industry. We are usually paying six to seven times, six to eight times maybe on a presynergy EBITDA multiple. We have pretty close to a turn, pretty quick in our acquisitions from a purchasing power standpoint because of the size of our Company. And we actually have other opportunities as well to take more synergies and acquisition. What does that translate to? It translates to after tax unlevered cash IRRs in the range is generally about 12% to 22%. As you can see on this slide, we are calling it pretty much a mid teen type after tax cash IRR related to acquisitions. We believe in 2017, if you look at the upper right of the slide, we are going to deploy about $75 million to $100 million of those acquisition opportunities again with the mid teen after tax IRR that relatively is the best use for our capital to drive shareholder value.
Secondly, we do believe in a dividend. We deploy about 35% to 45% of after tax, recurring income towards the dividend that translates to just over a $100 million, so that $320 million of free cash flow that will be deployed to the dividend during 2017. We would like to see that dividend grow over time, as the Company grows, that’s why we use the percentage of recurring net income and we have a pretty good track record over the past five years of growing that dividend.
Third would be the share repurchases. Absent a better relative return opportunity, we tried to quantify the intrinsic value of the Company versus where we’re trading at and back into what we think a return would be, in terms of deploying that capital towards the shares. So, far during mid-year, during 2017, we have deployed about $130 million of capital towards a share repurchase program. This is something we believe very strongly and that we started in 2005.
And then lastly, our managed debt maturities. We are constantly monitoring the debt maturities to making sure that we have a very manageable debt maturity profile for the reasons I have descried to you earlier.
And how does this all work out for us over the past few years since really 2005? So, you could see this metric that we used on slide 24, which is a dividend per share metric. The green on the graph shows the shares outstanding and the blue on the graph obviously shows the distribution in terms of the dividend rate per share, which compounds to a 21% CAGR over this period of time, which we think is very impressive. You can seen when we started the share repurchase was about 345 million shares outstanding in 2005. 12 years later we have about 185 million shares outstanding, so substantial reduction in the amount of equity outstanding as well coupled with growing cash flow with the growing business, translating to the dividend growing as we grow our business as has created 21% CAGR on a dividend per share that we think continues to drive shareholder value for us.
So, lastly in summary, here is our strategy. Grow revenues and free cash flow, Tom has described that. Continue to leverage our scale. We have 16% market share from a revenue perspective in North America. I think the next largest company would be probably around 1% if not less to 1%, so we have a lot of scale in this business from a local and national perspective. And then deploy capital very effectively. We define effectively as deploying capital to the highest relative return opportunity that will translate into delivering superior total shareholders return at SCI.
So, with that Robert, [ph] I think that concludes the presentation. Tom and I would be happy to answer any questions.
Q - Unidentified Analyst
Well, they are actually very different. One thing about StoneMor is, their structure was a master limited partnership. So, they’re structured that way. To qualify for a master limited partnership treatment, they have done cemetery. So, they are very cemetery based. They’ve bought pretty into cemetery to get their hands on. And the strategy, as you know from an MLP, if you want to be the GP is to grow cash flow under any way that you can. So, what they tended to do was what I call, non-customer friendly thing. They are geared to drill cash flow first. So, for instance, they would take a vault and bury it ahead of time because you can get the money out of trust. Well, that’s a great idea but the customer doesn’t want the vault in the ground until they need it. Right? So, there were just a lot of behaviors that were driven by the model that ultimately -- and so, if you think about it, they increased payouts. And so, they got to a point where they literally were paying out more than they were earning. And the theory being, well, we’ve got the trust funds that are backing that up. So, that’s what ultimately got them in trouble is they grew the dividend way too much and they couldn’t afford it and now here they see it as an MLP having to cut the dividend, no real growth opportunity, a lot of issues.
So, I’d say, the difference for us is we’re managing our payouts within a level that we think is a affordable. We can invest back into the business and truly have a growth model that’s geared around the customer being happy. And so, I don’t think there is any ill intention there. It just -- it probably was a model that didn’t fit the business that then generated behaviors that led to where they are today.
Any other question? Okay, we will see you in breakout session. Thank you.