Credit Crib Note: Service Corp International (SCI)
We frame the financial and operating fundamentals of Service Corp as a solid credit in the BB tier.
Credit quality trend: Stable. High margins, consistent leverage management, high free cash flow, and a heavily discretionary capex program mitigate downside risks despite the low BB tier unsecured composite rating as listed in the BB tier index. The low business risk goes along with the usual punchlines around guaranteed, steady business. We believe SCI’s predictable discretionary free cash flow across cycles and leadership position in its core markets deserve more weighting than is awarded in the current ratings.
SCI has been active in the credit markets from IG to HY for decades and ranks just below the Top 50 issuers in the BB tier bond index. The most recent large bond deal was in 2021 with the $800 million 4% due May 2031. SCI has a minimal maturity schedule until 2027 with $137 million of 7.5% bonds and $550 mn of 4.625% bonds maturing that year. The unsecured revolver and term loan matures in 2028.
The only black mark across SCI’s history of stability was some problems way back in 1999-2001 during a period of industry overexpansion and financial aggression. SCI had to retrench on its global ambitions and dial back its very active M&A program, sell assets, and narrow its focus to North America. After that ordeal, SCI maintained strong relationships with bank lenders (addressed below) as evident in their unsecured revolver and term loans that are guaranteed by key subsidiaries. In contrast the holding company debt is not guaranteed by the key subs.
The tiers of structural subordination for unsecured lenders means structural seniority for the unsecured loans vs. parent company bonds. SCI chose to maintain those strong bank relationships even though they could have cleaned up all that bank debt with unsecured low coupon bonds during the various HY and crossover credit market peaks.
Operating profile: As by far the #1 player in the North American funeral and cemetery services business, SCI has established a highly successful operating strategy. The market confidence in SCI’s low volatility financial risk is supported by consistency across some turbulent capital markets backdrops and two deep economic contractions over the past two decades. Creative branding strategies, development of a very successful sales model with increased digital operations, and ongoing expansion of its diversified services offerings including cremation and increased multicultural and ethnic market penetration (Hispanic, Chinese, etc.) are part of a favorable operating history.
SCI has a 28% to 30% share of the cemetery market based on revenue with almost 500 cemeteries (many quite large) and 12% of the funeral market with almost 1500 funeral homes. With respect to branding, the lead brand is Dignity Memorial, but many people attend funeral homes across all price tiers where the funeral homes carry their own legacy name. Families and those paying their respects at that location may not even be aware of SCI ownership. Branding in funeral homes can be about tradition and family names, and that has been an integral part of the SCI game plan. An example of SCI ownership in Manhattan serving the high price crowd of different faiths is Frank E. Campbell on the Upper East Side and Riverside Memorial on the Upper West Side.
Concentrations by geography across the US reflect the population mix with California, Texas, and Florida leading the ranks in funeral home and cemetery count. In New York, SCI has funeral homes only and no cemeteries. Some states explicitly ban co-ownership or investment across the combined funeral home and cemetery business (MI, WI). Some other states have barriers that essentially prevent such cross-ownership and marketing. If you look at the SCI 10-K for the locations of funeral homes and cemeteries, you can see where that is the case with the tri-state area of NY-NJ-CT seeing a good funeral home market for SCI but no cemeteries. The same is the case for New England and MA (New Hampshire should say “live free but not when you die.”)
Financial trends: SCI has impressive flexibility to pick its own balance sheet leverage by virtue of its discretionary deployment of free cash flow. SCI has room to maneuver in its investment programs above and beyond maintenance and growth capex (land purchases and cemetery development, digital investment). The funeral home business acquisitions are routine and offer exit strategies or liquidity events for legacy funeral home business owners (some family businesses don’t always appeal to “the kids.”). SCI routinely looks at all those opportunities. There are no more big acquisitions in the space to chase since SCI bought the #2 player (Alderwoods, formerly Loewen, was purchased by SCI in 2006). Antitrust watchdogs have always been focused on SCI given the local market risks.
Over the past 10 years, SCI equity has materially outperformed the S&P 500 in total return (using 3-8-24, the 10Y total return was +372% SCI vs. +180% for the S&P 500). Looking back 20 years, SCI posted +1448% vs. the S&P 500 at +358%. That’s why they say, “death and taxes.”
That stock performance is a function of numerous factors across profitability, free cash flow for shareholder enhancement, demonstrated balance sheet stability, leading market share in a business with intrinsically steady, slow growth potential, successful acquisition integration, and a proven ability to adapt products and services to trends such as rising cremation rates and even an unexpected, event-based shock such as a pandemic.
With the shutdowns of public gatherings in many locations, COVID offered a display of the management team’s strategic and operational dexterity through a mix of creativity in event planning and the use of technology while still accelerating its investment in digital operations and its omnichannel approach to marketing with its sales force.
SCI has just navigated a pandemic and related aftereffects that drove record revenues and operating profits in FY 2021 with gross margins crossing into the 30% range before settling back into the upper 20% handles for gross margins and low 20% range for operating margins.
We look at the segment trends below for Funeral and Cemetery operations, but the most recent 4Q23 period showed strength in preneed Cemetery that offset softer Funeral volumes.
The traditional mantra of 8% to 12% growth trends for EPS now has a timeout after the COVID disruptions, and lower single digit increases may be more likely in 2024 before a resumption in promising the traditional long-term target.
SCI presents its long-term plan with overall organic growth of 5% to 7% anchored by preneed Cemetery sales growth combined with more modest growth in Funeral revenues while building up the base of deferred revenue in Funerals.
SCI also cites goals for 3% to 5% capital deployment for reinvesting in the business, growth planning, and managing share buybacks in tandem with “debt management.”
Our favorable view on credit quality and the low volatility of cash flows reflects the revenue and earnings potential of the natural baby boom demographics that show the steady growth in volume with the late 2020s pushing more boomers past the life expectancy line. The oldest baby boomer right now will turn 79 in 2024, and that is slightly above CDC life expectancy (all races). You do the math. We like SCI’s consistent credit quality but not its constant reminders.
In its presentations, SCI makes frequent reference to “pull-forward” sales effects in terms of its ability to forecast volumes on timing to get back to normal cadence on preneed and atneed demand. Visibility is murkier after such a chaotic COVID period. The expectation is that 2025 would be the likely timeline to get back to normal trends.
“Deathcare” combines an unfortunate industry sector moniker with a distinctive set of variables to look at across baby boom demographics, the complexities of product/service mix analysis (e.g., cremation rates, patterns in event planning) and how that flows into demand across the Funerals and Cemetery segments for preneed and atneed.
The accounting issues include some modestly intimidating disclosure items on deferred revenues and some nuances across preneed products in trust-funded vs. insurance backlog numbers. Accounting quality has stood the test of time at this point and is backed up by close regulatory scrutiny of trusts.
The business and financial risk overall is tied into a high fixed cost structure (70% to 80% fixed) with very favorable incremental margins on higher volumes. That dovetails favorably for financial performance with more volume improvements ahead tied to demographics and increased preneed business.
The funeral home business hit record sales in FY 2021 for some obvious reasons with the pandemic fallout and the nuances of the lag times in services that were postponed from COVID lockdowns into later periods.
The timing differences in “death vs. services timing” overlapped with the COVID vaccine launch of Nov 2020 and varied approaches by state in reopening.
In the end, Funerals is “price x volume” business, and the average prices and volumes are detailed in the table above.
SCI has the locations and asset base, the market share, the marketing skills, and the scale of business model that have been proven across multiple economic cycles, the slow and steady force of demographic trends, a range of capital market backdrops (and crises), and now a pandemic.
Theories on what rising cremation rates mean have been tested, and SCI has proven its service packages and the transition to more consumers shifting to a “celebration of life” approach to funerals and cemetery choices.
For FY 2023, the cremation rate was up by +160 bps to 62.9% while overall funeral services decreased by 5.6%, partially offset by a small +2.8% increase in revenue per service.
The cemetery business posted higher revenue as preneed revenue growth exceeded the decline in atneed revenues.
Cemetery gross margins in FY 2023 were almost 5 points below the 2021 peak and a point below FY 2022 but materially ahead of 2019 run rates.
The year 2023 ended on a better note with margins trending up YoY in 4Q23 vs. 4Q22.
Preneed cemetery sales are key drivers of GAAP performance since revenue is recognized at the time of sale of plots while cemetery and merchandise are part of the deferred revenue stream that await delivery of the products and services.
One of the more distinctive aspects of the SCI business line activities is the use of trusts and insurance in the “preneed” revenue mix.
We simplified the table above when in fact there is quite a bit of line-item activity and footnote disclosure in deferred revenue and “preneed receivables, net and trust investments” under the accounting treatment excluding the insurance contracts.
The insurance and trust-funded backlog of funeral and cemetery contracts totaled over $14.8 billion at the end of FY 2023. That backlog is around 3.5 years of revenue at FY 2023 run rates.
Backlog is distinct from deferred revenue and deferred receipts since trust-funded backlog can be in deferred revenue while insurance-funded backlog is not a GAAP deferred revenue item (insurance is a customer-insurance contract).
There are numerous legal and regulatory requirements that vary by state on trusts and how the cash buildup is treated in preneed contracts as well as the asset mix that can be used in the trusts for the long-term deployment to pay for the deathcare services.
The use of trusts can be debated as a risk factor. If one wants to assume mass deaths (i.e. waves of services and merchandise see a spike in immediate delivery demand for funerals and cemeteries) that are accompanied by a securities market crash (i.e., blows up trust assets, shortfall of cash flow to fund the delivery), that scenario still needs to be put in portfolio context across other industries, issuers, and securities.
We have actually had such conversations with investors on the “What if everyone dies and the market crashes?” topic. We usually highlight the need to stress test other holdings under the same scenario. Our punchline is that “atneed volumes would certainly climb! Scheduling would be tough. Used hearse values would soar.”
The main takeaway is that the unusual profile of the long-term preneed revenue flow is one more factor lowering the business risk profile of SCI and reduces prospective volatility. Preneed cemetery is an important line to see growth in GAAP cash flow, but deferred revenue of any type is a positive factor.
The combination of stock buybacks and dividends lead the rankings of the uses of cash, and that is how SCI has generated a strong following on the equity side.
SCI is capex-intensive given the investment in land, cemetery development, and real estate and property investment.
We break out the lines above showing the high investment demands in the Cemetery segment with preneed cemetery revenues an important driver of current revenue recognition.
The SCI segment capex mix for FY 2023 was 59% Cemetery, 35% Funeral Homes, and 6% Corporate.
Investment in digital even gets its own detailed line item in a sign of how SCI has been able to grow its total of digitally generated revenues with a materially smaller sales force coming out of the pandemic. As SCI adapted its operating strategy under demanding COVID conditions, SCI developed an array of productivity-enhancing approaches to sales and marketing.
Capex weighed in at a lofty 8.8% of revenues, but that is still dwarfed by 23% operating margins and over 13% net margins.
The balance sheet history of SCI is remarkably stable as noted in the chart with the outsized earnings move of FY 2021 pushing leverage into a 2-handle.
SCI has the luxury of strong cash flow and highly discretionary acquisition and investment planning to effectively target a balance sheet profile within its current leverage target range of 3.5x to 4.0x.
SCI can boast a 16% CAGR in dividend growth from 2005 to 2023, $6.7 bn returned to shareholders since 2004 set against SCI’s current $11 bn market cap, and a 57% reduction in shares outstanding since mid-2004 (Source: SCI).
SCI is just under a Top 50 position in the BB tier of the HY bond index but would be a Top 50 name with its one non-index bond included at $3.1 bn in fixed rate bonds at FY 2023.
SCI entered into a new credit agreement that extended the maturity to Jan 2028 and expanded the line from $1.65 billion to $2.175 bn, including $1.5 bn bank facility plus the term loan. At 12-31-23, SCI had $658 million outstanding under its term loan and $790 million under its Jan 2028 bank facility.
Beyond high margins and cash flows of its core business lines, SCI is asset-rich with respect to real estate and owned approximately 90% of its real estate and buildings used in its facilities.
On the real estate intensity, SCI was pitched by bankers years ago about breaking off a REIT business (when REIT conversions were the rage for many real estate intensive companies), but that was ruled out at the time on the execution complexity and perceived inability to run a services-dominated business operationally under such a structure and stay in line with tax rules.
Highlights and History
SCI has always been the leading consolidator in Funeral and Cemetery services (vs. equipment such as caskets, etc.). SCI estimates a 16% market share in North America as of 2023 including both Funerals and Cemeteries.
SCI co-brands with local brands using the Dignity Memorial trademark in a strategy that allows SCI to leverage the brand value of local service providers including other brands to broaden the ethnic range of its customer base such as Funeraria del Angel,
SCI is also the leader in cremation with such brands as Neptune Society and National Cremation Society.
The funeral home and cemetery business is much more heavily regulated at the Federal and State level than many in the market may realize from the “Funeral Rule” issued by the Federal Trade Commission back in 1984 (periodically updated).
During the late 1980s, SCI was a rock solid investment grade issuer operating on a global scale, but the 1990s saw industry leaders (SCI, Loewen) expand aggressively by acquisition with Loewen ending up in Chapter 11 (litigation was a big part of the Loewen story). SCI saw its stock crater in early 1999 from a high of $46 in July 1998 to $1.56 in Jan 2002 that also saw pressure on debt ratings and credit spreads during that protracted credit market default cycle and credit market turmoil of 2001-2002.
After the setback of 1999-2001, SCI needed to retrench and retreat from its global strategy, divest assets to reduce debt, narrow its strategy focus to North America, and took an accounting charge of $909 mn in 2000 and $823 mn of restructuring charges in 1999-2000.