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SCI > SEC Filings for SCI > Form 10-Q on 1-Aug-2014All Recent SEC Filings

Show all filings for SERVICE CORPORATION INTERNATIONAL

Form 10-Q for SERVICE CORPORATION INTERNATIONAL


1-Aug-2014

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 unequaled in geographic scale and reach. At June 30, 2014, we operated 1,614 funeral service locations and 489 cemeteries (including 272 combination locations) in North America, which are geographically diversified across 44 states, 8 Canadian provinces, the District of Columbia, and Puerto Rico. 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 $9.3 billion backlog of future revenues from both trust and insurance-funded sales at June 30, 2014, 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 provide opportunities for full current revenue recognition (to the extent we collect 10% from the customer and the property is developed).


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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 also currently have approximately $130.8 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 cremation revenue in future periods.
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 from continuing operations provided $171.8
million in the six months ended June 30, 2014. We have $233.4 million in excess
borrowing capacity under our bank credit facility. We currently have no
significant maturities of long-term debt until April 2016.
Our bank credit facility requires us to maintain certain leverage and interest
coverage ratios. As of June 30, 2014, we were in compliance with all of our debt
covenants. Our financial covenant requirements and actual ratios as of June 30,
2014 are as follows:
                        Per Credit Agreement   Actual
Leverage ratio               5.00 (Max)         3.81
Interest coverage ratio      3.00 (Min)         5.31

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 $140.5 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.
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. During the six months ended June 30, 2014, we repurchased 3,078,954 shares of common stock at an aggregate cost of $59.4 million, which is an average cost per share of $19.29. After these repurchases, the remaining dollar value of shares authorized to be purchased under our share repurchase program was approximately $130.8 million at June 30, 2014. 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. The quarterly dividend has steadily increased over the past few years with the latest increase to $0.08 per common share approved by the Board of Directors on February 12, 2014. 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.


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Repurchase debt. We will seek to make open market debt repurchases when it is opportunistic to do so relative to other capital deployment opportunities to manage our near-term debt maturity profile. During the second quarter of 2014, in accordance with our credit agreement, we paid $127.5 million to reduce the outstanding balance on our term loan.
The Company has a relatively consistent annual cash flow stream that is generally resistant to down economic cycles. This cash flow stream and our significant liquidity 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.
We have executed a consent order with the staff of the Federal Trade Commission (FTC) in connection with the acquisition, which identifies certain properties the FTC has required us to divest as a result of the acquisition. We are currently negotiating agreements to sell these properties. These agreements are subject to review and approval by the FTC. In 2014, we divested a portion of the properties, generating after tax proceeds of $120.0 million. We believe that divestiture of the remaining properties will generate after tax of $215.0 to $240.0 million in the second half of 2014, which we expect to use to partially repay an additional $80.0 million outstanding under the term loan due July 2018 in accordance with our credit agreement with the remaining proceeds used in a manner consistent with our capital deployment approach. There can be no assurance that the divestitures will generate the proceeds described above. On an annual basis, the FTC properties generate approximately $47.0 million in gross profits, which we will continue to receive until the divestitures occur. Cash Flow
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 decreased $56.1 million to $170.8 million in the first half of 2014 from $226.9 million in the first half of 2013. Included in 2014 are an increase of acquisition costs, related to the Stewart acquisition, of $45.5 million, a $24.8 million premium paid on early extinguishment of debt, a $12.5 million increase in excess tax benefits from share based awards, and a $8.1 million increase in legal defense fees, partially offset by a $1.4 million decrease in system and process transition costs. Excluding the above items, cash flow from operations increased $33.4 million as a result of the following. The increases and decreases described below primarily resulted from the increase in the Company's size due to the Stewart acquisition.
a $203.1 million increase in cash receipts from customers;

a $8.0 million increase in General Agency (GA) receipts; partially offset by

a $81.0 million increase in vendor payments;

a $44.0 million increase in employee compensation;

a $25.3 million increase in cash interest paid;

a $12.3 million increase in net trust fund deposits; and

a $15.8 million increase in cash tax payments.

Investing Activities
Cash flows from investing activities provided $77.4 million in the first half of 2014 compared to using $48.5 million in the same period of 2013. This increase was primarily attributable to a $149.3 million increase in cash receipts from divestitures and asset sales partially offset by a $12.6 million increase in net deposits of restricted funds, a $6.6 million increase in capital expenditures, and a increase of $4.0 million in cash spent on acquisitions. Financing Activities
Financing activities used $250.2 million in the first half of 2014 compared to using $48.5 million in the same period of 2013. This increase was primarily driven by the increase in debt and capital lease payments and early extinguishments of $895.7 million and a $58.7 million increase in repurchases of Company common stock, partially offset by debt issuances net of costs of $744.5 million.
We repurchased 3.2 million shares in the first half of 2014 for $60.4 million and 0.1 million shares in the same period of 2013 for $1.7 million. We paid cash dividends of $34.0 million in the first half of 2014 and $27.6 million in the same period of 2013.


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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.

                                                                               December 31,
                                                            June 30, 2014          2013
                                                                     (In millions)
Preneed funeral                                           $         114.8     $       120.3
Preneed cemetery:
 Merchandise and services                                           129.9             131.3
 Pre-construction                                                     5.7               2.9
Bonds supporting preneed funeral and cemetery obligations           250.4             254.5
Bonds supporting preneed business permits                             4.4               2.8
Other bonds                                                          18.4              17.9
Total surety bonds outstanding                            $         273.2     $       275.2

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 June 30, 2014 and 2013, we had $5.2 million and $4.8 million, respectively, of cash receipts attributable to bonded sales. For the six months ended June 30, 2014 and 2013, we had $9.6 million and $9.2 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 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 tables below detail our results of preneed funeral and cemetery production and maturities, excluding insurance contracts, for the three and six months ended June 30, 2014 and 2013.


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                                                                      North America
                                                      Three Months Ended            Six Months Ended
                                                           June 30,                     June 30,
                                                       2014           2013          2014         2013
                                                                      (In millions)
Funeral:
Preneed trust-funded (including bonded):
Sales production                                 $     55.1         $  44.4     $    114.4     $  90.7
Sales production (number of contracts)               24,147          16,043         44,547      33,296
Maturities                                       $     52.7         $  47.0     $    110.8     $  97.9
Maturities (number of contracts)                     14,142          13,253         29,506      27,889
Cemetery:
Sales production:
Preneed                                          $    195.2         $ 147.8     $    346.9     $ 281.0
Atneed                                                 81.2            61.0          162.2       124.3
Total sales production                           $    276.4         $ 208.8     $    509.1     $ 405.3
Sales production deferred to backlog:
Preneed                                          $     78.7         $  61.4     $    139.6     $ 110.6
Atneed                                                 58.9            45.5          121.6        93.2
Total sales production deferred to backlog       $    137.6         $ 106.9     $    261.2     $ 203.8
Revenue recognized from backlog:
Preneed                                          $     45.8         $  39.4     $     88.1     $  75.3
Atneed                                                 56.8            45.8          116.7        91.3
Total revenue recognized from backlog            $    102.6         $  85.2     $    204.8     $ 166.6

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 and six months ended June 30, 2014 and 2013, and the number of contracts associated with those transactions.

                                                                      North America
                                                      Three Months Ended            Six Months Ended
                                                           June 30,                     June 30,
                                                       2014           2013          2014         2013
                                                                      (In millions)
Preneed funeral insurance-funded:
Sales production (1)                             $    163.0         $ 147.6     $    318.1     $ 285.5
Sales production (number of contracts) (1)           22,152          25,349         48,483      49,483
General Agency revenue                           $     30.5         $  26.8     $     59.9     $  52.0
Maturities                                       $     93.8         $  80.7     $    194.9     $ 173.4
Maturities (number of contracts)                     15,454          13,969         33,974      30,274

(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


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and cemetery receipts held in trust at June 30, 2014 and December 31, 2013. Additionally, the table reflects our backlog of unfulfilled insurance-funded contracts (which are not included in our unaudited condensed consolidated balance sheet) at June 30, 2014 and December 31, 2013. 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 bases) 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. The following table does not include backlog associated with businesses held for sale.

                                               June 30, 2014               December 31, 2013
                                          Fair Value       Cost        Fair Value        Cost
                                                               (In billions)
Deferred preneed funeral revenues        $     0.60     $    0.60     $     0.61      $    0.61
Deferred preneed funeral receipts held
in trust                                       1.68          1.57           1.65           1.57
                                         $     2.28     $    2.17     $     2.26      $    2.18
Allowance for cancellation on trust
investments                                   (0.17 )       (0.17 )        (0.21 )        (0.21 )
Backlog of trust-funded preneed funeral
revenues                                 $     2.11     $    2.00     $     2.05      $    1.97
Backlog of insurance-funded preneed
funeral revenues (1)                           4.58          4.58           4.45           4.45
Total backlog of preneed funeral
revenues                                 $     6.69     $    6.58     $     6.50      $    6.42
Preneed funeral receivables, net and
trust investments                        $     1.88     $    1.78     $     1.85      $    1.77
Allowance for cancellation on trust
investments                                   (0.16 )       (0.16 )        (0.17 )        (0.17 )
Assets associated with backlog of
trust-funded deferred preneed funeral
revenues, net of estimated allowance for
cancellation                             $     1.72     $    1.62     $     1.68      $    1.60
Insurance policies associated with
insurance-funded deferred preneed
funeral revenues, net of estimated
allowance for cancellation (1)                 4.58          4.58           4.45           4.45
Total assets associated with backlog of
preneed funeral revenues, net of
estimated allowance for cancellation     $     6.30     $    6.20     $     6.13      $    6.05
Deferred preneed cemetery revenues       $     1.02     $    1.02     $     0.98      $    0.98
Deferred preneed cemetery receipts held
in trust                                       1.65          1.45           1.58           1.41
                                         $     2.67     $    2.47     $     2.56      $    2.39
Allowance for cancellation on trust
investments                                   (0.12 )       (0.12 )        (0.19 )        (0.19 )
Total backlog of deferred cemetery
revenues                                 $     2.55     $    2.35     $     2.37      $    2.20
Preneed cemetery receivables, net and
trust investments                        $     2.40     $    2.21     $     2.30      $    2.13
Allowance for cancellation on trust
investments                                   (0.14 )       (0.14 )        (0.19 )        (0.19 )
Total assets associated with backlog of
deferred cemetery revenues, net of
estimated allowance for cancellation     $     2.26     $    2.07     $     2.11      $    1.94

(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


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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. While some of the states require that net gains or losses be retained and added to the corpus, 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 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 for the funeral and cemetery merchandise and service trusts is generally based on matching the time period that we expect the funeral or cemetery preneed contract to be outstanding. Since net ordinary earnings are distributed monthly from the cemetery perpetual care trusts to . . .

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