Service Corp International (SCI) Q2 2023 Earnings Call Transcript

Good morning, and welcome to the SCI Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to SCI management. Please go ahead.

Thank you, and good morning. This is Debbie Young, Director of Investor Relations. On behalf of the SCI team, thanks for joining us today. We're going to have some prepared remarks from Tom and Eric in just a moment. But before that, let me quickly go over the safe harbor language. Any comments made by our management team that states our plans, beliefs, expectations or projections for the future are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated in such statements. These risks and uncertainties include, but are not limited to, those factors identified in our earnings release and in our filings with the SEC that are available on our website. Today, we will also discuss certain non-GAAP financial measures. A reconciliation of these measures can be found in the tables at the end of our earnings release as well as on our website. I'd like to now turn it over to Tom Ryan, Chairman and CEO.

Thanks, Debbie. Hello everyone, and thank you for joining us on the call today. This morning, I'm going to begin my remarks with some high-level color on our business performance for the quarter and then provide some greater detail around our solid funeral and cemetery results. For the second quarter, we generated adjusted earnings per share of $0.83, which was on par with our results from the prior year quarter. We were able to achieve this result despite absorbing a $19 million or $0.09 per share increase in interest expense resulting from a more than 400 basis point rate increase in our variable rate debt. We continue to see significant earnings per share growth over pre-pandemic results. Compared to a second quarter 2019 of $0.47 per share, we have grown earnings per share at a compounded annual growth rate of 15% over the four-year period. Funeral metrics were strong and performed at or above our expectations. Cemetery preneed sales production increased slightly quarter-over-quarter. However, they fell short of our internal expectations, as we experienced a decline in the number of contracts sold, primarily within the entry-level price-sensitive consumer segment. We believe this is predominantly attributable to a decline in discretionary consumer spending by this entry-level consumer due to the actual and perceived impact of inflation on our preneed cemetery property sales and a variety of other discretionary purchases. Below the line, higher interest expenses incurred from the spike in interest rates on our variable rate debt reduced earnings per share by $0.09 and was partially offset by the $0.04 per share favorable impact of a lower share count. Now let's take a deeper look into the funeral results for the quarter. Total comparable funeral revenues increased by $11 million or about 2% over the prior year quarter, primarily due to an increase in core funeral revenue. Although comparable core funeral volume declined 2% compared to the prior year quarter, volumes were higher than we anticipated and about 9% higher than comparable second quarter 2019 levels. Our core average revenue per service grew over the prior year by an impressive 4%, even after absorbing the negative effects of a 120 basis point increase in the cremation mix. From a profit perspective, funeral gross profit declined slightly by $2 million, while the gross profit percentage remained about 21%, well above our pre-pandemic second quarter margin of 19.5%. Inflationary fixed cost increases slightly outpaced our moderate funeral revenue growth. We incurred slightly higher inflationary staffing and selling costs, which were mitigated in part by lower transportation costs and lower bonus incentive expenses resulting in about a 4% increase in fixed costs. Preneed funeral sales production grew an impressive $12 million or about 4% over the second quarter of 2022. Both the core and the SCI Direct channels experienced sales production growth that was primarily driven by increases in sales contract velocity. We continue to see consumer awareness and openness to preplanning elevated, with continued strength in marketing leads in preneed funeral sales production. Now, shifting to cemetery. Comparable cemetery revenue increased $5 million or just over 1% compared to the prior year second quarter. Core revenue accounted for the preponderance of the increase, as recognized preneed revenue increased by $6 million or 2%, offset slightly by a $1 million decline in atneed revenue. Preneed cemetery sales production increased by $1 million in the second quarter. While we did see a slight growth, it was below our expectations. We saw impressive increases in our large estate property sales, particularly in both the Western and Eastern regions, and we also saw healthy increases in our core average sale across the network. However, we did see a decline in our property sales velocity over the prior year quarter, a trend we also experienced in the first quarter. Again, keep in mind, our second quarter contract velocity is still 15% above our pre-pandemic 2019 second quarter. As we bifurcated the sales data by price tiers, we noticed that our mid- and premium-level property price tiers had increases in velocity, while our more entry-level price-sensitive tiers saw some unanticipated declines. Based on examining a variety of consumer discretionary data sources, and from feedback from our customers as well as from our frontline sales teammates, we believe that a significant reason our sales velocity has been negatively impacted is due to a more cautious consumer, particularly consumers that are more acutely impacted by the effects of accelerated inflation. Additionally, as we get further away from the acute impact of the pandemic, there seems to be a slightly diminished urgency for this specific entry-level consumer to transact at the pace we've experienced over the last three years. The good news is, that we believe these consumers are deferred, not lost. So we're developing selective programs and payment terms to enhance this specific customer's ability to transact with us. Still, to put cemetery preneed sales in its proper perspective, our second quarter preneed cemetery sales production was about 47% above our 2019 second quarter, representing a 10% compounded annual growth rate over the four-year period. Cemetery gross profits in the quarter declined by about $4 million, and the gross profit percentage declined slightly to 33%, still well above our pre-pandemic second quarter gross profit percentage of just above 30%. Expected inflationary increases in our cost structure exceeded our modest revenue growth for the quarter, putting pressure on comparable cemetery profits. Now, let's shift to a discussion about our outlook for the remainder of 2023. As you saw disclosed in our release, we have slightly reduced and narrowed the range of our annual earnings per share guidance while slightly increasing our annual cash flow guidance reflecting both favorable working capital trends and an expected decrease in cash taxes associated with a tax accounting method change. The primary reasons for the earnings per share change was a reduction in our preneed cemetery sales production assumption for the year, as well as the higher interest expense assumption associated with our variable rate debt as the Fed continues to push short-term rates higher and is communicating a willingness to maintain those rates for longer. This updated earnings guidance still reflects impressive growth within our 8% to 12% framework after considering the unique interest headwind this year and removing the beneficial COVID impact from last year. So for the rest of the year in the funeral segment, we would expect to see low to mid-single-digit declines in funeral volume, as the impact of the COVID pull forward slightly outpaces increasing volume trends. We would expect healthy low to mid-single-digit growth in our funeral average, both from atneed cases as well as preneed going atneed cases, as trust fund income increases from recent strength in the financial markets, which should favorably impact our funeral sales average. On the cemetery side, we would expect preneed sales production to range from slightly down to low single-digit growth in the back half of the year. Positive trends in large estate property sales and core averages should be tempered by lower velocity, particularly with our price-sensitive consumers. It is our hope that our pivot to enhance the customer proposition for the entry-level customer through more consumer-friendly payment terms on cemetery property will have a favorable impact on velocity in late 2023 and into 2024. The impact from newly completed construction projects over the next two quarters should create favorable comparisons of recognized cemetery revenue for the third quarter and slightly negative comparisons in the fourth as the 2022 fourth quarter impact from completed construction was quite significant. From an earnings per share perspective, we would expect to deliver year-over-year growth in the back half of the year, particularly in the third quarter as the favorable impact of higher funeral sales averages, higher year-over-year cemetery revenues, and the impact of our share repurchase program will more than offset the negative effects of slight volume declines and significantly higher interest expense associated with our variable rate debt. Finally, I'd like to thank the entire SCI team for all that you continue to do every day for our customers, our communities, and each other. You all are what makes this company great. With that, operator, I'll now turn it over to Eric.

Thank you, Tom, and good morning everyone. I want to begin by extending my heartfelt gratitude to all 25,000 SCI associates. Your commitment to the communities and the families you serve during their most challenging times is incredibly inspiring. I'm thankful for your dedication to going above and beyond. This morning, I'll provide an overview of our cash flow results and capital investments for the second quarter. I will also share insights on our trust fund income and corporate general and administrative expenses, followed by a discussion on our financial position and updated cash flow guidance for 2023. In the second quarter, we generated an impressive adjusted operating cash flow of $157 million, exceeding our expectations by over $16 million compared to the previous year. Several factors contributed to this increase year-over-year. First, we saw an uptick in operating income of about $6 million, as highlighted in our press release. We also experienced lower cash tax payments of approximately $23 million due to reduced book income for the quarter, which more than offset about $20 million in higher interest payments. These increased payments primarily stemmed from elevated floating rates and a slightly larger debt balance. Moreover, favorable working capital changes during the quarter provided a net benefit of about $7 million, mainly linked to timing discrepancies related to payables and receivables. To elaborate on cash interest, our interest payments increased by about $20 million year-over-year, largely due to rising interest rates on our floating rate debt, which slightly exceeded our forecasts. For 2023, we initially anticipated a headwind of around $55 million in interest expense and cash interest, but we now expect this to be between $60 million and $65 million due to floating rates increasing more than we expected. However, we believe we are in a strong position to manage this interest rate risk as we aim to operate at the lower end of our leverage range by reducing the amount of floating rate debt we use. At the end of the quarter, roughly 29% of our total debt was floating, with a rate just above 7%. Regarding our capital investment activities in the quarter, we invested a total of $258 million, which covered our current businesses, new growth opportunities, productive acquisitions, and capital returned to shareholders. We allocated $70 million back into our existing businesses, which included $38 million on cemetery development and $32 million for maintenance capital at our facilities. Additionally, we invested $20 million in digital systems and initiatives. Some of the cemetery development expenditures were accelerated this quarter due to significant projects at our Rose Hills cemetery on the West Coast. We expect maintenance capital spending to moderate during the latter half of the year and remain within our guidance range of $290 million to $310 million for the full year of 2023. We also invested nearly $10 million in growth capital for new funeral home construction in several states, including Virginia, California, and Florida, as well as expansions in Ohio, Louisiana, and Texas. On the acquisition side, we completed three transactions in Illinois, California, and Tennessee for a total of just over $30 million, bringing our acquisition spending to almost $40 million in the first half of the year. We are optimistic about our acquisition momentum, targeting a full-year acquisition investment range of $75 million to $125 million. We returned nearly $127 million to shareholders this quarter, including $41 million in dividends and about $86 million in share repurchases. Now, let me briefly discuss trust fund income and corporate G&A. As noted in our release, trust fund income was positively impacted by favorable market returns over the past year and by trust fund income retained from some unclaimed property handled during the quarter. Corporate G&A was $35 million, which is $11 million lower than the same quarter last year and slightly below our expectations, mainly due to reduced incentive compensation expenses. Looking forward, we anticipate G&A expenses for the remainder of the year will remain within our expected range of approximately $38 million to $40 million per quarter. Turning to our financial position, we maintain a favorable debt maturity profile and have over $1 billion in liquidity at the end of the quarter, which consists of around $170 million in cash and approximately $860 million available on our long-term bank credit facility. Our leverage slightly increased to about 3.6 times net debt-to-EBITDA, and we plan to manage our leverage toward the lower end of our targeted range of 3.5 to four times in the near future. Now, I want to update you on our full-year cash flow outlook, which has remained solid. Due to the net sources of pre-need working capital, we are increasing the lower end of our adjusted cash flow from operations guidance range, excluding special items, from $910 million to $960 million to $920 million to $960 million. Additionally, we now anticipate a significant reduction in cash taxes for 2023 due to a change in our tax accounting method. This change will defer cash taxes into future years, resulting in an estimated $80 million decrease in 2023 cash taxes. Therefore, we are adjusting our full-year cash tax guidance from $160 million to $170 million down to $80 million to $90 million. We are not yet ready to provide specific guidance for 2024, but we expect cash tax payments in that year to be lower before returning to normal levels in 2025 and beyond. Overall, we are raising our 2023 adjusted after-tax operating cash flow guidance by $85 million from the previous range of $740 million to $800 million to the new range of $830 million to $880 million, with a midpoint of $855 million. This also marks a $30 million increase over the $825 million generated in 2022. Our strong cash flow and balance sheet position will enable us to allocate capital wisely to maximize shareholder value. I want to express my gratitude once again to the entire SCI team for their contributions to these strong cash flow and earnings results. Operator, this concludes our prepared remarks, and I will now turn it back to you to open the call for questions.

Thank you. We will now begin the question-and-answer session. The first question comes from Tobey Sommer at Truist Securities.

Thanks. Good morning. I wanted to dig into that change in buying behavior of your more price-sensitive customer. Maybe could you set the stage by describing what it was like in recent years and maybe giving us some color around either the price sensitivity sort of the price points at which this happens or what your field reps are learning in terms of interactions with those prospective customers?

Sure, Tobey. I'll address that. There are a few important points to consider regarding price sensitivity among cemetery consumers. When we look at year-over-year comparisons, we noticed greater volatility in the cemetery segment compared to the funeral segment. This can be attributed to the fact that the average consumer in the cemetery sector is younger and tends to engage with these services earlier. In the context of the COVID impact, younger individuals began to be more aware of these matters, leading to an increase in interest particularly in cemetery products. What we are observing is a more challenging comparison when looking back, especially in relation to funeral customers. This is partly due to our success in comparison. Additionally, we've received valuable feedback based on solid consumer discretionary data. It's worth noting that inflation, particularly in food prices, has placed significant pressure on consumers. As these essential costs rise, people tend to make different spending choices, especially on discretionary purchases like cemetery services. This is a factor affecting the current situation, although we believe it will eventually stabilize. It's also essential to understand that the surge in volume we experienced in the cemetery segment over the past few years presents a tougher benchmark for comparison.

Thank you. As a follow-up, I wanted to know what the total increase has been over the last three years in cemetery sales within this specific customer niche. How long do you anticipate it will take for demand to return to normal levels going forward?

I believe things are normalizing now. If we look back, we've seen more volatility in the cemetery sector compared to the funeral side. However, taking a compounded growth approach to the cemetery, we're seeing about 10% annual growth from pre-pandemic levels, which is consistent with what we experienced in the second quarter. I think we are reaching a stable and normalized state, which is a positive outcome. For the funeral sector, that same figure is around 8%. The key difference here is that the funeral side did not experience the same spikes in 2020 and 2021. If we review our cemetery sales, especially preneed cemetery sales, although I don't have the exact figures at hand, my recollection is that we experienced growth rates of about 15% to 20% over a couple of years. Now, we are starting to normalize in the latter half of 2022 and more significantly in 2023. We feel confident about this stabilization. However, we are also facing inflation, which is a new challenge, yet we remain optimistic. One way to enhance affordability for our customers might be to introduce flexible payment options, as we continue to see interest in our services. While the interest is not as strong as it was three years ago, people are still inclined to address these needs, and we're here to assist them.

Thank you.

The next question is from John Ransom at Raymond James.

Hey good morning, guys. Thanks for the shout out on the research.

You’re probably the last one.

So let's assume that preneed cemetery production is going to decrease by 5% in the second half of the year. What would be the two categories of revenue? I know this is a simplified approach, but if we differentiate between the high end and the low end, what is the decline in the low end that contributes to that 5% decrease compared to any growth or trends observed in the high end?

Well, first, I don't think I ever said it'd be down 5%. So it's hard for me to quantify for you. But we feel a little more excited about the back half of the year than that. But I do think we would expect our high end to continue to grow probably in the low kind of teen double digits, the 10%, 15% type of growth that we would anticipate. And I think, again, it's this lower tier of the things that we're seeing; we'd probably be looking at similar types of declines in the high single digits and 10% to 12% as you think about last year. But remember, you're beginning to compare against periods that experienced some inflation. I think we're going to see some more favorable comparisons if you will as you get to the back half.

So, what's the percentage of sales at the high end compared to the low end on the production side?

I believe the high end is likely around 15%. However, determining where to set the low end for comparison is crucial. The high end, which we categorize as large estate sales over $80,000, represents a small volume but constitutes a solid 15% of our revenue.

And so the low end, it wouldn't be 85%. Would it be something like 20% on the low end or...?

Yes. I would estimate that it's approximately 15% lower than if you consider any contract below $10,000, which would be around 20%.

Okay. So kind of similar numbers then.

Yes. Yes. I think...

At a high level, consider the high end growing, the low end shrinking, and the middle remaining flat, which would align with your guidance.

I think that's right. The middle being flat is you're talking about velocity-wise. But again, you should get some inflationary pricing to it. So think of that growing slightly in the low to mid-single-digit percentage.

Yes. You're highlighting the delayed effects of inflation on behavior. Regarding your second question, the recognition rate you mentioned is still expected to be in the mid-90s this year. Is that accurate for the cemetery?

Yes.

It was a little bit lower in the second quarter. Is there anything to highlight regarding that?

Yes. I think if you remember we talked about particularly on the West Coast with the rains in the first half of the year. We had some kind of delays and damages going on in some of those construction projects, which delayed the completion. We do expect those obviously will get completed probably in the latter part of this year or may push into the first quarter of next year, but that's part of the reason John is just surprisingly there’s some pretty severe damage because of the way the rains have fell. And so we're a little bit behind that, but again that will catch up.

Also can I get to stop thinking about rain, but we got to maybe think about it for one more quarter. That's fine. So, lastly as you know there's been some chatter in the marketplace again about pricing in your funeral and like-for-like. Have you been able to chop any more wood on your relative pricing? And is there anything you could point to that would be quantitative or hard evidence that your prices are in line with your like-for-like competitors?

John, this is Eric. As an update, we are consistently reviewing our pricing strategies and have mechanisms in place, such as starting at pricing and the premium price experience I mentioned last quarter. To recall, about 500 of our 1,500 locations feature starting at prices, and around 400 offer a premium price experience that includes various services, such as cemetery options in combination facilities. Our general price lists range from approximately 1,000 to 1,100. We maintain our market share and receive positive feedback, which I wanted to emphasize. Regarding your second question, when comparing to hotel chains, we've discussed our positioning in the middle and upper tiers. We have SCI Direct at the lower end, but when comparing our homes and combination facilities on a like-for-like basis, we feel comfortable with our pricing. If you compare our higher-end offerings, like Ritz-Carltons and JW Marriotts, to lower-tier brands, you will see a distinction, but we believe that is not an ideal analysis. Proper analysis should be based on like-for-like comparisons, customer satisfaction surveys, and market share. We are confident in our performance and positioning within the market.

So the last one for me just kind of going one more level on that question. So let's just take a typical urban market. And you look at your competitors, how real-time is your competitor pricing data? Are they not putting stuff online, or how do you kind of assess out what your competitors are doing? And what's the lag, if any, if they decide to have a big sale? When do you find out about that?

We find out about it pretty quick. I think, you're thinking about a cemetery in Asheville. There's two-for-one plots right? I'll send you a picture from Wells Funeral Home. They were running a little special. So what do you think of that? But we're pretty real-time with our market leadership and our market management and our general management of the combination facilities and location managers. There are independents that have pricing online and there's a tremendous amount of independents that do not have pricing online, same with some of the consolidators. So it's very market-specific and funeral home-specific as well. But even then we're always understanding where we are in the marketplace. They're using mystery shoppers and we perhaps are using mystery shoppers as well. But that's not an issue at all. We're very comfortable with our market management and how they understand where specifically they are within the markets.

Thank you very much. Good morning. I have a follow-up question regarding the preneed cemetery, which actually has two parts. First, I know that Rose Hills experienced a delay due to the weather. Can you discuss when that was completed? Specifically, how should we consider recognition versus production for that location, given that it has been a significant contributor? The second part of my question is about your confidence in ongoing demand for the high end. How do you manage capacity in situations like Rose Hills, where there might be a temporary surge before new offerings are constructed to attract potential customers? I'm interested in how you maintain that capacity. Thank you.

Okay, Scott it's good to hear from you. So as it relates to production and particularly you mentioned the West Coast Rose Hills. So as you think about the first quarter the thing that was really poor about the timing is Ching Ming. So Ching Ming sales are going to occur typically in March and in April depending on the market. But unfortunately that weather event occurred during those periods. And so you don't necessarily catch up, let's say in June, July, August as you think about production. The good news that I would look at it is if you don't have a rain event next year you ought to have a pretty good first quarter, maybe pretty good second quarter when you think about those particular markets. First capacity goes we're constantly developing new cemetery gardens and we're never going to be in a position where we don't have that available for people. So really no concerns around it. Your last piece I think you talked about was recognition. And I mentioned this a little bit in my comments, but I'll be a little more specific for you. These can be lumpy and Eric talked a little bit about we're not getting the recognition rates where we were. So some projects have been pushed back. As we think about the third quarter, we should see a pretty favorable comparison of recognition rate, because again I think we've got some projects that pushed that will get done in the third quarter. When you get to the fourth quarter, it's still going to be good, but you're comparing back against a pretty monster fourth quarter 2022. We had a lot of projects pushed to the fourth quarter. So the comparison when you think about recognition, it's going to be down year-over-year would be our guess at this point. And again, some of these projects, particularly on the West Coast where we had the damage we might even push into 2024.

Thank you for that information. I want to shift our discussion to the funeral side, as it significantly contributed to this quarter's results, with a volume decline of just low single digits, around 1%. This was slightly better than our expectations. We've noticed a positive trend during what appears to be a reversion period. However, I recall you mentioning earlier that there might be some concerns about this trend potentially declining further. I am interested in your observations regarding excess deaths and how you anticipate this will evolve in the latter half of the year and into next year. Thank you.

I understand your question about the pull-forward effect. It's important to note that many of these insights are based on assumptions, and accurately tracking them is challenging. When we model the pull-forward, we estimate that entering 2023, there could be a decrease of around 15,000 to 20,000 cases, which we expect to diminish over time. While I don't want to provide exact figures, we anticipate an overall volume decline of approximately 4% to 6%. Regarding the death rate, we are observing an upward trend aside from the pull-forward effect, and the average age of deaths is higher than previous years. This shift away from younger deaths could be linked to the baby boomer demographic and health trends, which might also contribute to our market share. These factors appear to be key drivers of the unexpectedly strong performance in the funeral sector. However, the assumptions surrounding the pull-forward are challenging to validate. We can analyze it by age groups and believe our predictions are fairly accurate, though it's difficult to confirm. Looking ahead, I do not foresee a significant decline, but the impact of the pull-forward will be less pronounced in 2024 compared to 2023.

All right. Thanks, Tom. I appreciate that color. Just one more for Eric. It sounds like the new accounting method change with regard that's impacting cash taxes. It sounds discretionary. Why now as opposed to a year ago a year from now? And thank you for the color on the call saying that it should benefit this year, it should probably benefit 2024, but those taxes would be coming up for payable in 2025 and 2026. Is there something you're doing there, Eric, that you wanted to increase cash in the current years? And I guess that's transitioning into a question of what's your view on allocation? Is there something in the pipeline for M&A coming right or want to be aggressive with buybacks? Just curious on that. Thanks.

Yes. I think, if you look at the history of this Scott, we've always been through looking at accounting method changes to simplify our tax accounting methods to be honest with you. We've done this several times over the years. We did have some interaction with the IRS and seen some guidance that allowed us a couple of years ago, to start looking at this. But the truth to it is, is that we have two or three different tax accounting methods for when we recognize for tax purposes, the revenue stream of cemetery property, the one that we are switching to is one that's called the basis recovery method, which really is the method that's going to result in the deferral of cash taxes, but these cash taxes will eventually be paid when installment payments, when cash received from the consumers those installment payments are received. So, I don't know if that just muddied it up or not. But I'm just basically saying two or three accounting methods are going to one. We had a little bit of interaction with some guidance out there that allowed us to do it. We've been working with our advisers. We're going to file our tax return to go from two to three to one, and that's what is going to precipitate this issue where you're going to have a temporary deferral of cash taxes, and you will eventually pay those cash taxes as the installment receipts come in. It's really just good blocking and tackling, and getting better and being strategic, as it relates to your tax accounting methods and how you maximize value in terms of the cash tax scenario. It's nothing more than that.

Understood. Thanks. And it is going to free up some cash. So, just any new considerations we should think about with the use of cash.

No, not at this time.

Since there are no further questions, at this time. I'd like to turn the conference back over to SCI management.

Thank you all for joining us today. We appreciate your time and look forward to speaking with you again in early November for our third quarter update.

Early November.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.