Service Corporation International (SCI)
Valuation (continued)
Football Field Analysis
*SCI peers are Carriage Services Inc., Matthews Intl., and StoneMor Partners LP.
**EV/EBITDA Multiples used in peer group are forward looking.
***P/S is 5 year historical range for SCI.
Investment Drivers
(1) Pivotal Locations for the Aging Baby Boomers
SCI dominates the North American deathcare industry with a strong footprint across every major market;see Figure 1 – North American Footprint. The properties are strategically placed in five States, i.e. Texas, California, Florida, New York, and North Carolina, because they represent the highest demographic of 65 years and over. Currently, these five States have over 35% (16.3M out of 46.2M), see Table 1- Five Key States,of the 65 years and over demographicwhich make them pivotal States for current and future success of SCI. With the expected rise in U.S. deaths, see Figure 2 – U.S. Deaths, over the next decade this shows potential growth that SCI has in the market.
Figure 1 – North American Footprint
(2) Obesity Does Not Discriminate Against Age
In the report,“An Aging Nation: The Older Population in the United States”, obesity was documented as a large problem for the continued enhancementof the average life expectancy in the United States. They state that, “The incidence of obesity increased dramatically between 1980 and 2008, doubling for adults and tripling for children…Obesity increases the risk of a number of health conditions including hypertension, adverse lipid concentrations, and type 2 diabetes.”Thissuggests that even if baby boomers are living longer, other factors such as obesity, which does not discriminate against age, can negate the impact from the advancements in medicine on the mortality rate in the United States. The number of obese United States citizens is alarming since over 91M Americans fall into this category – 78.6M adults and 12.7M children (aged 2-19 years old). According to a February 2014 article written in the Journal of the American Medical Association (JAMA) the research concluded that, “…the prevalence of obesity in the United States is high, with one-third of adults and 17% of children obese…” - article is titled “Prevalence of Childhood and Adult Obesity in the United States, 2011-2012”. In a study published in 2012 by the Centers for Disease Control and Prevention (CDC) one of the key findings by Dr. Donna Hoyert was that, “Heart disease, cancer, and stroke were among the five leading causes every year between 1935 and 2010.” In summary, obesity hasand appears will continue to play a leading role in the mortality rates within theUnited States.
(3) Leveraging the System
Some of thedeal making that SCI have completed, e.g. Alderwoods ($1.2Bn), Keystone ($265MM), and Stewart ($1.5Bn), over the past ten years have given them cumulative bargaining power when negotiating with suppliers. They have been able to realize immediate success through these acquisitions mainly due to the synergies created with leveraging technology and economies of scale. For example, in order to streamline and simplify the supply chain SCI has a centralized purchasing team. In the past SCI used 187 different suppliers for funeral caskets which created unnecessary drag on the network. It now only handles with 9 funeral casket suppliers. The same aggressive approach has been applied to the cemetery granite suppliers segment. Before there were 200 cemetery granite suppliers used and now only 8 are actively doing business with SCI. It is not only in the supply chain that SCI has found synergies to exploit but the use of functional technology to drive front and back office performance. SCI has been able to improve their processes through the use of salesforce to manage new sales leads and contacts, workday to control human capital and payroll, and carepoint to track and schedule personal care centers. Other areas that SCI has leveragedis the cemetery land care (over $3M saved) and accounting and IT services – Infosys, Tata Consultancy Services, and West (over $8M saved).
Investment Risks
(1) Baby Boomers are Living Longer
The improvements in medicine and technology have helped not only save countless number of lives but also prolong the lives of many more. In 1960 the average life expectancy in Canada was 71 years old and in the United States was 70 years old. Forward to the modern age and we have escalated the average life expectancy for both countries, i.e. Canada is 82 years old and the United States is 80 years old. Another strong contributing factor to the added life expectancy is mainly due to the drop in smoking. In a report called“An Aging Nation: The Older Population in the United States” the results show that one of the leading causes for mortality is directly related to smoking, “In 1970, 45 percent of the population aged 25 to 44 smoked (this is the population aged 67 to 86 in 2012). In 2011, only 22.1 percent of those aged 25 to 44 smoked (this will be the population aged 64 to 83 in 2050)... Reduction in smoking at younger ages is expected to improve survivorship for these cohorts when they reach the older ages.”
(2) Balancing Debt and Interest Payments
The significant portion of the debt on the Company’s balance sheet is related to deals that closed in the pastdecade, e.g. Alderwoods ($1.2Bn) in 2006, Keystone ($265MM) in 2009, and Stewart ($1.5Bn) in 2013. The coverage ratios such as EBITDA/ Interest Expense at 4.6X and EBIT/ Interest Expense at 3.1X show that SCI is capable to service the debt. When compared against its peer group,Carriage Services Inc., StoneMor Partners LP, and Matthews International, in Net Debt/ EBITDA and Total Debt/ EBITDA SCI has the lowest ratio at 3.8X and 4X. This means that based on EBITDA cash flows SCI is most proficient to pay off the existing debt on the balance sheet.
SCI has a credit rating of BB+ and a one year default probably of 0.0977% according to Bloomberg; see Graph1 – Bloomberg 1-Year Default Probability. This is backed by about $3.2Bn of debt on the balance sheet with a weighted average interest rate of 5.2% and 76% of the debt issued at a fixed rate. The fixed interest rate gives SCI an opportunity to strategize its interest and principal payments without the volatility of the markets. Also, the majority of the debt 53% or $1.66Bn is backend loaded, debt maturity due 2021 or later, which gives them time to maneuver its cash flows to meet the maturity of the debt; see Table 2 – Debt Maturity.
Graph 1 – Bloomberg 1-Year Default Probability
Table 2 – Debt Maturity
Key Facts
Industry Overview
The deathcare industry is highly fragmented with several independent operators across North America (Canada and the US). The top 5 operators, SCI being the leader at 16% market share, control approximately 21% of the market. The other notable competitors in the industry are Arbor (private company), Carriage, Northstar (private company), and Stonemor. The industry has traditionally and continues to be dominated by independently owned and operated local entrepreneurs. In North America the deathecare industry is estimated to be $19Bn with 22,000 funeral homes and 4,000 cemeteries. The funeral segment is estimated at $15Bn and is motivated by a caregiver attitude. This means catering to specific ethnic and religious cultures with appropriate arrangements. There are also relatively low barriers to entry, except in the high-end market. The cemetery segment is estimated at $4Bn and is mainly driven by a sales mindset. In the cemetery segment there are high barriers to entry due to government zoning restrictions and capital investments. According to the National Funeral Directors Association(NFDA) in the United States there were 19,391 funeral homesin 2015, which is down from 21,528 funeral homes in 2004. The median cost of a funeral with burial has gone up from $6,580 in 2004 to $8,508 in 2014, representing a 29.3% increase.
Revenues
The growth of preneed backlog has grown to $9.5Bn, which are contracts that customers have signed but revenue cannot be fully recognized until service and/ or merchandise have been provided. The cumulative preneed backlog is divided between funeral services of $7Bn over 2.8MM contracts, and cemetery services of $2.5Bn over 1.7MM contracts. The average total annual preneed sales from funeral services represent $800MM (~174k customers) and cemetery services represent $765MM (~135k customers). Therefore, the average funeral service is ~$4,600 and cemetery service is ~$5,700. The preneed sales provides several positive attributes for SCI; first, it helps create a brand awareness within the community; second, it helps drive future market share; third, it provides a competitive advantage when negotiating contracts with suppliers.
Eric Tanzberger, SVP, CFO, and Treasurer, mentioned in a recent Raymond James Institutional Investor Conference that, “…, we think about one out of every four contracts…of pre-arranged funeral sales, is actually going to our branded home...” If this is indeed correct than SCI is capturing market share in the highly fragmented deathcare space. This will most likely continue as Steve Tidwell, SVP of Sales & Merchandising, leads the largest sales team, i.e. ~5,000 sales counselors, in the deathcare market. The penetration of 1,800 Pre-Planning Advisors and 2,300 Family Service Counselors to reach local communities is unparallel to its closest competitor StoneMor Partners, which has ~800 total sales counselors.The recent introduction of saleforce’s CRM platform will only contribute to a stronger and more effective sales team.
The bulk of total revenues are driven by the funeral segment, representing 63% or $1.9Bn of Sales, and the remaining portion is directed by the cemetery segment, representing 37% or $1.1Bn of Sales; see Graph 2 – 2015 Revenue Distribution. The Canadian operations delivered $181MM, or 6% of total sales, to the Company’s top line in 2015. Over the past ten years, revenues in Canada have stayed relatively stable representing 8% of total sales.
In order to attractive a greater and more diverse market SCI has used a tiered product and pricing offering toaccommodate the local communities that have ethnic traditions and customs; see Graph 3 – Ethnic and Religious Needs. This has been and will continue to be part of the growth strategy in the cemetery segment.
Fifty six percent of the cemeteries (262 out of 469) are considered “combination locations” which means that the funeral service is connected to the cemetery. The combination locations are a win-win for the customers and SCI because it creates cost efficiencies and synergies between the funeral service and the cemetery, leading to higher margins, and allows the customer, both atneed and preneed, added comfort and value as a one stop shop.
In the future, revenues should continue to be strong and stable with the support of the $9.5Bn preneed backlog. The sales team will continue to contribute to increasing sales with the efforts of its new salesforce CRM platform, tiered product and pricing schedule, and robust combination locations; see Graph 4 – Tiered Product & Pricing.
Graph 2 – 2015 Revenue Distribution
Dividend & Share Repurchases
Since 2011 over $1.2Bn of value has been returned to shareholders through dividends and share repurchases.Based on the capital deployment strategy it is expected that additional value will continue to be returned to shareholders in the future. This message is further echoed by the increased dividend payout ratio, which was previously 25%-35% but hassince been increased to 30%-40% of recurring net income.
Based on the recent historical patterns of dividend payments it is forecast that an annual distribution of $0.51/ per share is expected. Since the reinstatement of the dividend in 2005 it has steadily climbed to an annual $0.44/ per share in 2015. Typically the dividend increase is not reflected until Q2 or Q3.
Graph 5 – Historical and Estimated Quarterly Dividend
The share repurchase program has decreased shares from 222M in 2011 to195M in 2015, representing a 12% or 27M share drop. It is expected that SCI will utilize the available $278.8M in the share repurchase program to extend the share repurchase. It is anticipated that shares will stabilize around 190M shares in 2016, thus illustrating a 14% or 32M share downtick from 2011. The acquisition of Stewart Enterprises for $1.5Bn in 2013 was the only year, since 2011, that did not see a contraction in the share count.
Graph 6 – Historical and Estimated Annual Share Count
Share Performance
Since 2011 the S&P 500 has seen a rise of 61% compared to SCI which has advanced 185%. When compared to its peer group, SCI is ranked second only behind Carriage Services Inc. (CSV) as the top performer.
Graph 7 – Five Year Stock Performance of SCI vs. S&P 500 vs. Peers
Leadership Team
Chairman/CEO – Thomas L. Ryan
Mr. Ryan was most recently elected Chairman of the Board of SCI effective January 2016 and has been CEO since early 2005. He initially joined the Company in 1996 and has served in a number of diverse financial leadership roles. Prior to joining SCI, Mr. Ryan was a CPA for Coopers & Lybrand LLP. He attended the University of Texas at Austin.
Senior VP/CFO/Treasurer – Eric D. Tanzberger
Mr. Tanzberger was appointed Senior VP and CFO in the summer of 2006 and later in the following summerwas named Treasurer. He initially joined the Company in August of 1996 and retained several management roles prior to his promotion in August of 2002 to Corporate Controller. Prior to joining SCI, Mr. Tanzberger was the Assistant Corporate Controller at Kirby Marine Transportation Corp., an inland waterway barge and tanker company. He graduated from the University of Notre Dame with a bachelor’s in business administration.
Senior VP of Sales & Merchandising – Steven A. Tidwell
Mr. Tidwell was appointed to Senior VP of Sales and Merchandising in 2012. He originally joined the Company as a VP early in 2010. Mr. Tidwell was a co-founder of Keystone North America, where he served as President and CEO from May 2007 until it was acquired by SCI. At the start of Mr. Tidwell’s career he was a licensed Funeral Director and Embalmer in Nashville, Tennessee. He graduated from John A. Gupton College with an AA degree and has since completed Executive Management and Leadership programs at Harvard Business School.
Table 3 – Executive Officers of the Company
Ratios
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Vincent Ng, Analyst
Service Corporation International (SCI)
Appendix
Table 1 – Five Key States
Figure 2 – U.S. Deaths
Graph 3 – Ethnic and Religious Needs
Graph 4 – Tiered Product & Pricing
Key Variables
Data Table Analysis Scenario Comparison
Free Cash Flow
Terminal EBITDA Multiples
Income Statement
Income Statement Continued
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Vincent Ng, Analyst