Service Corporation International (NYSE:SCI) is the leading funeral home and cemetery services provider in the United States. The COVID-19 pandemic this year has resulted in a unique environment for the company. Even as a surge in deaths has supported the demand for burials and cremation, social distancing requirements have pressured sales for more elaborate memorial services. Favorably, the company just reported its latest quarterly earnings highlighted by better-than-expected results, driven in part through technology initiatives like offering remote video and virtual services. While the company still has some long-term challenges including an evolving “deathcare” market moving towards lower-cost options, we think SCI is well-positioned to maintain its leadership position with overall solid fundamentals.
SCI Q2 Earnings Recap
SCI reported its Q2 earnings on July 27th with non-GAAP EPS of $0.58, which was well above the consensus estimate of $0.24. Similarly, the revenue of $820 million beat expectations by $111.7 million and climbed 0.9% compared to the period last year.
The big surprise here was that the services revenue of $354.8 million in the quarter climbed by 4.6% y/y and was resilient despite the economic disruptions caused by nationwide lockdown orders between April and June. A key operating metric highlighting the increased demand this quarter was that the company performed 90,579 funeral services during the quarter compared to 79,054 in Q2 2019. Still, the average revenue per service declined to $4,733 from $5,150, pressured by a shift in services format.
(Source: Company IR)
A higher gross margin of 27%, compared to 23.5% in the period last year, was driven by a 3.2% y/y reduction in revenue costs supporting a strong increase in the operating income. The company took various steps to cut costs and preserve cash in the early stages of the pandemic given the uncertainty.
Property and merchandise revenue – which includes things like caskets, gravesites, tombstones and memorial items – was about flat on the quarter. This segment still represents the largest business for the company that faces some structural headwinds given a shift in the death care market which has moved towards more cremations. Essentially, compared to traditional burials which require various products, consumers are favoring cremations as a less expensive alternative. In this regard, SCI is doing higher volumes of cremations but seeing fewer burials and related property site sales which are the higher-margin business as a long-term industry trend.
One area of the business that was pressured in the early stages of the pandemic was “preneed” sales. These services are arrangements made by customers for future deaths. The company made efforts to continue sales and consulting through remote video conferencing which helped the preneed business improve as the quarter progressed. Comments by management indicated the business improved through the quarter.
Separately, SCI was able to implement “virtual” services allowing friends and family members to participate in services remotely which became a theme in the industry supporting the demand for the business. News coverage of the phenomenon in virtual funerals highlights the new business opportunity. From the press release:
We’ve found creative ways to serve our customers safely by harnessing technology to hold virtual services and sales seminars, mastering the skills to work remotely, and learning that anything is possible with the solid foundation of our teams. We have continued to add measures to help ensure client families can safely visit our locations and celebrate the life of their loved ones.
Our preneed sales teams have continued to overcome social distancing obstacles in certain areas of the country by leveraging technology with customers who may prefer to purchase cemetery property and merchandise from the safety of their home or setting up outdoor pop-up tents to discuss pre-planning from a safe distance. As local governments began to reopen in the back half of the quarter, we experienced an increase in the velocity of our preneed cemetery sales.
Given the strong financial result and limited capital expenditures during the quarter, SCI was able to generate $140.2 million in free cash flow during Q2, compared to 33.4 million in the period last year. It’s worth noting that the company maintains a high level of long-term debt at $3.6 billion, compared to $222 million in cash and equivalents at the end of the quarter. Part of this is related to the business model which conducted regular acquisitions of smaller deathcare providers across the country for growth. There is also a significant level of preneed receivables at $4.6 billion recognized on the balance sheet. Overall, the balance sheet position remains stable and even improved in the last quarter. From the conference call:
So we entered this crisis from a position of strength, and we continue to be very well positioned. We continue to have a significant amount of liquidity and flexibility to meet all the needs of our businesses as well as invest in growth opportunities. Our liquidity has remained robust, growing to just over $775 million, consisting of about $220 million of cash on hand plus $555 million available today on our long-term bank credit facility. We reduced our leverage from 3.88x at March 31 to 3.79x at the end of June, which is well within our targeted range of net debt-to-EBITDA of 3.5 to 4x.
(Source: company IR)
2020 Management Guidance
According to management, SCI expects to see increased demand for funeral services through the end of the year given the ongoing pandemic and excess deaths. The challenge continues to be that the social distancing measures and large gathering restrictions will limit some of the more premium packages and value-added merchandise sales. From the earnings release:
We anticipate the continued impact of the COVID-19 pandemic will result in increased funeral services performed, particularly early in the third quarter, which will be somewhat offset by declines in our average revenue per service as gathering restrictions and self-isolating measures persist in certain jurisdictions. We expect that cemetery preneed sales will move somewhat in tandem with atneed services due in part to family members who wish to secure cemetery property next to their loved ones.
Management is guiding for full-year EPS in a range between $1.78 and $2.00. At the midpoint, if confirmed the estimate is about flat compared to $1.90 in 2019. The takeaway here is that a higher volume of funeral services performed is expected to be balanced by lower customer spending on higher-margin products and services.
(Source: company IR)
Analysis and Forward-Looking Commentary
Amid all the uncertainties regarding the timetable for when the pandemic can be contained and the strength of the economic recovery, the reality is that death remains a fact of life. We like SCI as the company provides an important service and product that will always be in demand. Long-term, one of the important growth tailwinds for the company is an aging population that will likely require SCI expertise in the future. Across 1,472 funeral service locations and 483 cemeteries, SCI has the national footprint to capture future growth opportunities.
(Source: company IR)
In terms of valuation, SCI with a market cap of $7.7 billion is currently trading at an earnings multiple of 19.6x. Across different valuation ratios like a P/S of 2.5x and EV to EBITDA at 12.8x, the stock is within the range of its average premium over the past 5 years. By this measure, SCI appears fairly-valued, not necessarily cheap or expensive. In our view, a long-term earnings multiple around 20x is fair for this business.
(Source: data by YCharts/ table BOOX Research)
A price to free cash flow multiple of 16x appears attractive but is in the context of the company’s large debt position. Keep in mind that the consensus is for revenue and earnings growth in the low single-digits through 2021.
(Source: Seeking Alpha Premium)
The attraction to the business is more from the stability of the cash flow and the company’s market position. According to SCI, the company holds a 15-16% market share in what remains a fragmented market with the main competitors being Carriage Services (NYSE:CSV) and StoneMor Partners LP (STON) which are less than one-tenth its size.
On a forward earnings basis, SCI trades at a premium to CSV which only has a market cap of $395 million and is more leveraged. The appearance is that investors are placing a premium on SCI given its leadership. Notably, SCI dividend yields 1.7% compared to 1.36% for CSV.
Risks and Monitoring Points
While the economic outlook has been resilient given significant stimulus measures, the potential that economic growth falters going forward could also pressure SCI stock if consumers gravitate towards lower-cost funeral services.
We’d like to see organic growth accelerate and some more progress towards reducing the company’s debt position. Monitoring points to watch for the rest of the year include the evolution of financial margins and trends beyond COVID-19 pandemic demand. There is also the potential that the ongoing shift towards cremations over traditional burials accelerates limiting growth opportunities for SCI in terms of its cemetery business. An underperformance of expectations from current levels could result in earnings estimates being revised lower which could pressure the stock.
Overall, we were impressed by SCI’s positive and better-than-expected Q2 earnings which demonstrated the company was able to quickly navigate an unprecedented situation. The stock rallied by over 10% on the positive results and we think this strong reaction likely captured much of the near-term upside. Recognizing the strengths in the business and operating momentum this year, we rate shares of SCI as a hold with a price target of $45.00 for the year-end.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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