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SCI > SEC Filings for SCI > Form 10-Q on 25-Apr-2013All Recent SEC Filings

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Form 10-Q for SERVICE CORPORATION INTERNATIONAL


25-Apr-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The Company
We are North America's largest provider of deathcare products and services, with a network of funeral homes and cemeteries unequalled in geographic scale and reach. At March 31, 2013, we operated 1,437 funeral service locations and 374 cemeteries (including 213 combination locations) in North America, which are geographically diversified across 43 states, 8 Canadian provinces, and the District of Columbia. Our funeral segment also includes the operations of 12 funeral homes in Germany that we intend to exit when economic values and conditions are conducive to a sale. Our funeral service and cemetery operations consist of funeral service locations, cemeteries, funeral service/cemetery combination locations, crematoria, and related businesses. We sell cemetery property and funeral and cemetery products and services at the time of need and on a preneed basis.
Our financial position is enhanced by our $7.5 billion backlog of future revenues from both trust and insurance-funded sales at March 31, 2013, which is the result of preneed funeral and cemetery sales. Preneed selling provides us with a current opportunity to lock-in future market share while deterring the customer from going to a competitor in the future. We believe it adds to the stability and predictability of our revenue and cash flows. While revenue on the majority of preneed funeral sales is deferred until the time of need, sales of preneed cemetery property provides opportunities for full current revenue recognition (to the extent we collect 10% from the customer and the property is developed).
We believe we have the financial strength and flexibility to reward shareholders through dividends while maintaining a prudent capital structure and pursuing new opportunities for profitable growth. We currently have approximately $190.1 million authorized to repurchase our common stock.
Factors affecting our operating results include: demographic trends in terms of population growth and average age, which impact death rates and number of deaths; establishing and maintaining leading market share positions supported by strong local heritage and relationships; effectively responding to increasing cremation trends by selling complementary services and merchandise; controlling salary and merchandise costs; and exercising pricing leverage related to our at-need revenues. The average revenue per funeral contract is influenced by the mix of traditional and cremation services because our average cremation service revenue is approximately half of the average revenue earned from a traditional burial service. To further enhance revenue opportunities we are developing memorialization products and services that specifically appeal to cremation customers. We believe that these additional products and services will help drive increases in the average revenue for a cremation in future periods.


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For further discussion of our key operating metrics, see our Results of Operations and Cash Flow sections below.

Financial Condition, Liquidity and Capital Resources
Capital Allocation Considerations
We rely on cash flow from operations as a significant source of liquidity. Our
cash flow from operating activities provided $151.1 million in the three months
ended March 31, 2013. In addition, we have $381.7 million in excess borrowing
capacity under our bank credit facility which expires in March 2016. We
currently have no significant maturities of long-term debt until April 2015.
Our bank credit facility requires us to maintain certain leverage and interest
coverage ratios. As of March 31, 2013, we were in compliance with all of our
debt covenants. Our financial covenant requirements and actual ratios as of
March 31, 2013 are as follows:
                        Per Credit Agreement   Actual
Leverage ratio               4.00 (Max)         2.82
Interest coverage ratio      3.00 (Min)         4.88

We believe the sources of liquidity can be supplemented by our ability to access the capital markets for additional debt or equity securities. We believe that our $188.5 million of cash on hand, future operating cash flows, and the available capacity under our credit facility will give us adequate liquidity to meet our short-term needs as well as our long-term financial obligations. It is our intention to evaluate the best uses of our cash flow that will yield the highest value and return on capital. Our capital deployment strategy is prioritized as follows:
Reinvest in the core business. We expect to continue to focus on funding growth initiatives that generate increased profitability, revenue, and cash flows. Our primary internal growth initiative is to increase our funeral and cemetery preneed backlog to grow the Company over the long-term. We will also invest in the construction of funeral home facilities and in the construction of cemetery property to promote future cemetery sales growth. Lastly, from time to time we may have other smaller capital projects, primarily related to the improvement of processes and systems.
Invest in acquisitions. We intend to make acquisitions of funeral homes and cemeteries when pricing and terms are favorable. We expect an acquisition investment to earn an after-tax cash return that is in excess of our weighted average cost of capital with room for execution risk. We target businesses with favorable consumer segments and/or where we can achieve additional economies of scale.
Repurchase shares. Absent a strategic acquisition opportunity, we believe share repurchases are attractive at the appropriate price. Currently, we have approximately $190.1 million authorized under our share repurchase program. We intend to make purchases from time to time in the open market or through privately negotiated transactions, subject to market conditions, debt covenants, and normal trading restrictions. Our credit agreement contains covenants that limit our ability to repurchase our common stock. There can be no assurance that we will buy our common stock under our share repurchase program in the future. Pay a dividend. Beginning in November 2007, we began to pay quarterly dividends of $0.04 per common share. On February 9, 2011, our Board of Directors approved the payment of a quarterly dividend of $0.05 per common share and on February 13, 2013, approved a quarterly dividend of $0.06 per common share. We intend to continue to grow our cash dividend commensurate with the growth of our free cash flow. While we intend to pay regular quarterly cash dividends for the foreseeable future, all future dividends are subject to limitations in our debt covenants and final determination by our Board of Directors each quarter upon review of our financial performance.
Repurchase debt. While the Company has no significant debt maturities until April 2015, we will seek to make open market debt repurchases when it is opportunistic to do so relative to other capital deployment opportunities in order to manage our near-term debt maturity profile.
Our bank credit facility expires in March 2016 and we believe we will be able to successfully renew this facility at the appropriate time. Our long-term liquidity profile assumes that we will have access to the capital markets to refinance our long term debt if, and when, we choose to do so. The Company has a relatively consistent annual cash flow stream which is generally resistant to down economic cycles. This cash flow stream is available to substantially reduce our long-term debt maturities should we choose to do so. Furthermore, the Company's capital expenditures are generally discretionary in nature and can be managed based on the availability of operating cash flow. Cash Flow


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We believe our ability to generate strong operating cash flow is one of our fundamental financial strengths and provides us with substantial flexibility in meeting operating and investing needs.
Operating Activities
Net cash provided by operating activities increased $55.3 million to $151.1 million in the first quarter of 2013 from $95.8 million in the same period of 2012. This increase was driven by:
a $64.7 million increase in cash receipts from customers as a result of higher atneed and preneed sales;

a $9.6 million increase in net trust fund withdrawals; partially offset by,

a $7.5 million increase in vendor payments;

a $4.6 million increase in payroll;

a $3.9 million increase in cash tax payments; and

a $1.3 million decrease in General Agency (GA) receipts.

Investing Activities
Cash flows from investing activities used $20.4 million in the first quarter of 2013 compared to using $22.7 million in the same period of 2012. This decrease was primarily attributable to an increase of $1.6 million in cash receipts from divestitures and asset sales, a $0.8 million decrease in capital expenditures, and a $0.8 million decrease in cash spent on acquisitions; partially offset by a $0.9 million decrease in net withdrawals of restricted funds. Financing Activities
Financing activities used $34.3 million in the first quarter of 2013 compared to using $89.1 million in the same period of 2012. This decrease was primarily driven by a $73.4 million decrease in the repurchases of company stock, partially offset by an $8.3 million increase in purchases of Neptune Society noncontrolling interest, a $4.5 million increase in debt payments, a $4.4 million increase in bank overdrafts and other, and a $1.6 million increase in payments of dividends.
Financial Assurances
In support of our operations, we have entered into arrangements with certain surety companies whereby such companies agree to issue surety bonds on our behalf as financial assurance and/or as required by existing state and local regulations. The surety bonds are used for various business purposes; however, the majority of the surety bonds issued and outstanding have been used to support our preneed funeral and cemetery sales activities. The obligations underlying these surety bonds are recorded on the unaudited condensed consolidated balance sheet as Deferred preneed funeral revenues and Deferred preneed cemetery revenues. The breakdown of surety bonds between funeral and cemetery preneed arrangements, as well as surety bonds for other activities, is described below.

                                                            March 31, 2013       December 31, 2012
                                                                    (Dollars in millions)
Preneed funeral                                           $          104.5     $             110.1
Preneed cemetery:
 Merchandise and services                                            110.6                   114.6
 Pre-construction                                                      4.2                     7.2
Bonds supporting preneed funeral and cemetery obligations            219.3                   231.9
Bonds supporting preneed business permits                              3.0                     2.9
Other bonds                                                           18.1                    17.2
Total surety bonds outstanding                            $          240.4     $             252.0

When selling preneed funeral and cemetery contracts, we may post surety bonds where allowed by state law. We post the surety bonds in lieu of trusting a certain amount of funds received from the customer. The amount of the bond posted is generally determined by the total amount of the preneed contract that would otherwise be required to be trusted, in accordance with applicable state law. For the three months ended March 31, 2013 and 2012, we had $4.4 million and $4.8 million, respectively, of cash receipts attributable to bonded sales. These amounts do not consider reductions associated with taxes, obtaining costs, or other costs.
Surety bond premiums are paid annually and are automatically renewable until maturity of the underlying preneed contracts, unless we are given prior notice of cancellation. Except for cemetery pre-construction bonds (which are irrevocable), the surety companies generally have the right to cancel the surety bonds at any time with appropriate notice. In the event a surety company


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were to cancel the surety bond, we are required to obtain replacement surety assurance from another surety company or fund a trust for an amount generally less than the posted bond amount. Management does not expect that we will be required to fund material future amounts related to these surety bonds because of lack of surety capacity or surety company non-performance. Preneed Funeral and Cemetery Activities and Backlog of Contracts In addition to selling our products and services to client families at the time of need, we sell price-guaranteed preneed funeral and cemetery contracts, which provide for future funeral or cemetery services and merchandise. Since preneed funeral and cemetery services or merchandise will not be provided until sometime in the future, most states and provinces require that all or a portion of the funds collected from customers on preneed funeral and cemetery contracts be paid into merchandise and service trusts until the merchandise is delivered or the service is performed. These trust funds own investments in equity and debt securities and mutual funds, which are sensitive to current market prices. In certain situations, as described above, where permitted by state or provincial laws, we post a surety bond as financial assurance for a certain amount of the preneed funeral or cemetery contract in lieu of placing funds into trust accounts. Trust-Funded Preneed Funeral and Cemetery Contracts: The funds are deposited into trust and invested by independent trustees in accordance with state and provincial laws. We retain any funds above the amounts required to be deposited into trust accounts and use them for working capital purposes, generally to offset the selling and administrative costs of our preneed programs.
The table below details our results of preneed funeral and cemetery production and maturities, excluding insurance contracts, for the three months ended March 31, 2013 and 2012.

                                                  North America
                                               Three Months Ended
                                                    March 31,
                                                 2013           2012
                                              (Dollars in millions)
Funeral:
Preneed trust-funded (including bonded):
Sales production                           $     46.3         $  37.7
Sales production (number of contracts)         17,253          14,077
Maturities                                 $     50.9         $  56.1
Maturities (number of contracts)               14,636          14,235
Cemetery:
Sales production:
Preneed                                    $    133.2         $ 124.5
Atneed                                           63.3            59.4
Total sales production                     $    196.5         $ 183.9
Sales production deferred to backlog:
Preneed                                    $     49.2         $  55.2
Atneed                                           47.7            45.4
Total sales production deferred to backlog $     96.9         $ 100.6
Revenue recognized from backlog:
Preneed                                    $     35.9         $  32.3
Atneed                                           45.5            44.0
Total revenue recognized from backlog      $     81.4         $  76.3

Insurance-Funded Preneed Funeral Contracts: Where permitted by state or provincial law, customers may arrange their preneed funeral contract by purchasing a life insurance or annuity policy from third-party insurance companies, for which we earn a commission as general sales agent for the insurance company. The policy amount of the insurance contract between the customer and the third-party insurance company generally equals the amount of the preneed funeral contract. As the insurance contract is between the insurance company and the customer, we do not reflect the unfulfilled insurance-funded preneed funeral contract amounts in our unaudited condensed consolidated balance sheet.
The table below details the results of insurance-funded preneed funeral production and maturities for the three months ended March 31, 2013 and 2012, and the number of contracts associated with those transactions.


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                                                  North America
                                               Three Months Ended
                                                    March 31,
                                                 2013           2012
                                              (Dollars in millions)
Preneed funeral insurance-funded:
Sales production (1)                       $    137.9         $ 134.4
Sales production (number of contracts) (1)     24,134          22,776
General Agency revenue                     $     25.2         $  23.3
Maturities                                 $     92.7         $  83.1
Maturities (number of contracts)               16,305          14,672

(1) Amounts are not included in our unaudited condensed consolidated balance sheet.

North America Backlog of Preneed Funeral and Cemetery Contracts: The following table reflects our North America backlog of trust-funded deferred preneed funeral and cemetery contract revenues, including amounts related to Deferred preneed funeral and cemetery receipts held in trust at March 31, 2013 and December 31, 2012. Additionally, the table reflects our backlog of unfulfilled insurance-funded contracts (which are not included in our unaudited condensed consolidated balance sheet) at March 31, 2013 and December 31, 2012. The backlog amounts presented are reduced by an amount that we believe will cancel before maturity based on historical experience.
The table also reflects our preneed funeral and cemetery receivables and trust investments (fair value and cost basis) associated with the backlog of deferred preneed funeral and cemetery contract revenues, net of the estimated cancellation allowance. We believe that the table below is meaningful because it sets forth the aggregate amount of future revenues we expect to recognize as a result of preneed sales, as well as the amount of assets associated with those revenues. Because the future revenues exceed the asset amounts, future revenues will exceed the cash distributions actually received from the associated trusts.

                                                March 31, 2013                 December 31, 2012
                                          Fair Value         Cost          Fair Value        Cost
                                                             (Dollars in billions)
Deferred preneed funeral revenues        $      0.52     $     0.52       $     0.53      $    0.53
Deferred preneed funeral receipts held
in trust                                        1.36           1.30             1.34           1.32
                                         $      1.88     $     1.82       $     1.87      $    1.85
Allowance for cancellation on trust
investments                                    (0.16 )        (0.15 )          (0.15 )        (0.15 )
Backlog of trust-funded preneed funeral
revenues                                 $      1.72     $     1.67       $     1.72      $    1.70
Backlog of insurance-funded preneed
funeral revenues (1)                            3.71           3.71             3.68           3.68
Total backlog of preneed funeral
revenues                                 $      5.43     $     5.38       $     5.40      $    5.38
Preneed funeral receivables, net and
trust investments                        $      1.56     $     1.56       $     1.54      $    1.52
Allowance for cancellation on trust
investments                                    (0.15 )        (0.15 )          (0.14 )        (0.14 )
Assets associated with backlog of
trust-funded deferred preneed funeral
revenues, net of estimated allowance for
cancellation                             $      1.41     $     1.41       $     1.40      $    1.38
Insurance policies associated with
insurance-funded deferred preneed
funeral revenues, net of estimated
allowance for cancellation (1)                  3.71           3.71             3.68           3.68
Total assets associated with backlog of
preneed funeral revenues, net of
estimated allowance for cancellation     $      5.12     $     5.12       $     5.08      $    5.06
Deferred preneed cemetery revenues       $      0.88     $     0.88       $     0.86      $    0.86
Deferred preneed cemetery receipts held
in trust                                        1.35           1.23             1.29           1.23
                                         $      2.23     $     2.11       $     2.15      $    2.09
Allowance for cancellation on trust
investments                                    (0.15 )        (0.15 )          (0.15 )        (0.15 )
Total backlog of deferred cemetery
revenues                                 $      2.08     $     1.96       $     2.00      $    1.94
Preneed cemetery receivables, net and
trust investments                        $      1.89     $     1.77       $     1.82      $    1.76
Allowance for cancellation on trust
investments                                    (0.16 )        (0.16 )          (0.16 )        (0.16 )
Total assets associated with backlog of
deferred cemetery revenues, net of
estimated allowance for cancellation     $      1.73     $     1.61       $     1.66      $    1.60


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(1) Amounts are not included in our unaudited condensed consolidated balance sheet.

The fair value of our funeral and cemetery trust investments was based on a combination of quoted market prices, observable inputs such as interest rates or yield curves, and appraisals. The difference between the backlog and asset amounts represents the contracts for which we have posted surety bonds as financial assurance in lieu of trusting, the amounts collected from customers that were not required to be deposited into trust, and allowable cash distributions from trust assets. The table also reflects the amounts expected to be received from insurance companies through the assignment of policy proceeds related to insurance-funded funeral contracts. Trust Investments
In addition to selling our products and services to client families at the time of need, we sell price-guaranteed preneed funeral and cemetery contracts, which provide for future funeral or cemetery services and merchandise. Since preneed funeral and cemetery services or merchandise will not be provided until sometime in the future, most states and provinces require that all or a portion of the funds collected from customers on preneed funeral and cemetery contracts be paid into trusts and/or preneed escrow accounts until the merchandise is delivered or the service is performed. Investment earnings associated with the trust investments are expected to mitigate the inflationary costs of providing the preneed funeral and cemetery services and merchandise in the future for the prices that were guaranteed at the time of sale.
Also, we are required by state and provincial law to pay a portion of the proceeds from the sale of cemetery property interment rights into perpetual care trusts. For these investments, the original corpus remains in the trust in perpetuity and the net ordinary earnings are intended to offset the expense to maintain the cemetery property. The majority of states require that net gains or losses are retained and added to the corpus, but certain states allow the net realized gains and losses to be included in the income that is distributed. Independent trustees manage and invest all of the funds deposited into the funeral and cemetery merchandise and service trusts as well as the cemetery perpetual care trusts. The trustees are selected based on their respective geographic footprint and qualifications per state and provincial regulations. All of the trustees engage the same independent investment advisor indirectly through SCI's wholly-owned registered investment advisor. The trustees, with input from the investment advisor, establish an investment policy that serves as an operating document to guide the investment activities of the trusts including asset allocation and manager selection. The investments are also governed by state and provincial guidelines. Asset allocation is based on the liability structure of each funeral, cemetery, and perpetual care trust. The investment advisor recommends investment managers to the trustees that are selected on the basis of various criteria set forth in the investment policy. The primary investment objectives for the funeral and cemetery merchandise and service trusts include (1) achieving growth of principal over time sufficient to preserve and increase the purchasing power of the assets, and (2) preserving capital within acceptable levels of volatility. Preneed funeral and cemetery contracts generally take years to mature. Therefore, the funds associated with these contracts are often invested for several market cycles. While cemetery perpetual care trusts share the same investment objectives as listed above, these trusts emphasize providing a steady stream of investment income with some capital appreciation. The trusts seek to control risk and volatility through a combination of asset styles, asset classes, and institutional investment managers.
As of March 31, 2013, 84% of our trusts were under the control and custody of two large financial institutions engaged as preferred trustees. The U.S. trustees primarily use common trust fund structures as the investment vehicle for their trusts. Through the common trust fund structure, each respective trustee manages the allocation of assets through individual managed accounts or institutional mutual funds. In the event a particular state prohibits the use of a common trust fund as a qualified investment, the trustee utilizes institutional mutual funds. The U.S. trusts include a modest allocation to alternative investments, which are comprised primarily of private equity and real estate investments. These investments are structured as limited liability companies (LLCs) and are managed by certain trustees. The trusts that are eligible to allocate a portion of their investments to alternative investments purchase units of the respective LLCs.
Fixed Income Securities
Fixed income investments are intended to preserve principal, provide a source of current income, and reduce overall portfolio volatility. The SCI trusts have direct investments primarily in government fixed income securities. Insurance backed fixed income investments preserve the principal, guarantee annual appreciation, and reduce overall portfolio volatility.
Canadian government fixed income securities are investments in Canadian federal and provincial government instruments. In many cases, regulatory restrictions mandate that the funds from the sales of preneed funeral and cemetery products sold in certain Canadian jurisdictions must be invested in these instruments. Equity Securities
Equity investments have historically provided long-term capital appreciation in excess of inflation. The SCI trusts have direct investments primarily in domestic equity portfolios that include large, mid, and small capitalization companies of different


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