Service Corporation International (SCI) Q2 2013 Earnings Report, Transcript and Summary

Welcome to the Second Quarter 2013 Service Corporation International Earnings Conference Call. My name is Chris, and I will be your operator for today’s call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note, that this conference is being recorded. I would now like to turn the call over to SCI management. You may begin.

Good morning. This is Debbie Young, Director of Investor Relations at SCI. Thanks for joining us today as we discuss our second quarter results. Before I turn the call over to Tom, let me remind you that comments made by our management today will include statements that are not historical and are forward-looking. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. These risks and uncertainties include, but are not limited to, those factors identified in our press release and in our filings with the SEC that are available on our website. Today’s comments may also include certain non-GAAP measurements such as normalized EPS, adjusted operating cash flow and free cash flow. Reconciliations of these measurements to be appropriate measures calculated in accordance with GAAP is provided on our website and in our press release and 8-K that were filed yesterday. With that out of the way I would like to now turn the call over to Tom Ryan, SCI’s President and CEO.

Thanks, Debbie, and good morning everyone, and thanks for joining us today. We’re pleased to report our second quarter earnings and cash flow results that exceeded our internal expectations and the prior year quarter. Normalized earnings per share in the second quarter grew to $0.19 which was a penny ahead of the prior year. Based on these results for the quarter, and for the first half of the year, we’re raising our earnings per share and cash flow guidance for 2013. Before I get into more details about the quarter, I wanted to give you a brief update on our Stewart transaction. But before I do that, I want to recognize the fact that we lost one of our great members. Jim McGilley from Kansas City with 85 years old. And our thoughts and prayers are with Mark McGilley and his family today. Jim joined us in 1987. He was truly an inspiration to us all, and really left his mark on our Kansas City marketplace and team. He will be missed. Now back to Stewart. As you know in late May, we announced our expected acquisition of Stewart Enterprises. In early stages of planning through the integration process are underway and we’ve been pleased with the progress so far. We remain confident in the value this transaction creates for us including our synergy testament [ph]. The transaction closing is primarily pending two items. One, approval by Stewart’s Class A shareholders, for which their shareholder meeting is scheduled for August 13. And secondly, the Federal Trade Commission review which is ongoing. As noted in our press release last week, we did receive an expected second request from the FTC and we still anticipate closing in December of this year or early 2014. Now for an overview of funeral operations. Comparable…

Thank you. Good morning to everybody. To echo Tom’s comments, I want to say we’re excited to have exceeded our internal expectations again this quarter. This morning I am going to walk you through the details of our cash flow for the quarter like I usually do, and I’m also going to discuss our 2013 cash flow expectations for the remainder of the year. Then I’ll provide you an update on the financing for our expected Stewart acquisition. So let’s start with cash flow this morning. And as you saw in yesterday’s press release, adjusted operating cash flow in the quarter grew $8.6 million over the prior year to $78.2 million. And this exceeded our internal expectations. So this growth was predominantly related to the timing of cash receipts associated with preneed sales of cemetery property that were deferred as Tom just explained. So we expect most of these sales to be recognized into revenue during the third quarter of this year. Additionally, we had better collections this quarter which was primarily driven by the hard work of our field folks, but created a decrease in our days sales outstanding. This was somewhat offset by the timing of cash outflows related to vendor payments, but this was in line with our expectations. Maintenance CapEx and cemetery development CapEx, and again these are the two components that we consider are recurring CapEx. For the quarter, it came in at approximately $26 million and this was also in line with our expectations. So when you do the math, and deduct in these recurring capital spending items, from our adjusted cash flow, we calculate our free cash flow for the second quarter to be $53 million which is approximately $11 million higher than the prior year and above our internal expectation. So mid-year…

Thank you. (Operator Instructions) Our first question comes from A.J. Rice. A.J. your line is open. A.J. Rice – UBS: Thanks. Hi everybody. A couple of questions if I could ask. The first one is just to clarify what you were just going over there, Eric. The $55 million, does that include the Stewart debt or does that not include that?

That does include that, because we anticipate absorbing those notes and reading them outstanding for a period of time. A.J. Rice – UBS: Right, okay. Obviously the one thing operationally jumped off this quarter was the pickup, particularly in the preneed funeral sales production of 11%. It’s one of the best numbers you’ve had in quite a while. Is that the underlying brisk [ph] activity of customers that’s driving that or is that – I know you have some mobility to drive that by just directing resources and incentives and so forth. Can you just give us a flavor for what’s behind that, and is that with the investment in the news – the incremental sales people is that, sort of the new – do you think the new novel is going to be something closer to higher single digits, low double digits on the funeral side for a while?

A.J., this is Tom. And yes, we’re very, very pleased with the funeral production as you mentioned. I would tell you that the investments in the sales, infrastructure, and people, really hasn’t begun to pay off yet. As you well remember when we talked about this, we’ve seen growth over the last three or four years predominantly from increased production amongst productivity within our sales force. Our counselors are getting better, our managers are getting better. And this was really an attempt to say let’s begin to bring more people under the tent, and grow this against the aging demographic that we could sell to. So we really haven’t experienced that yet. I would chop this up to again just great performance by our sales organization. We’re more effective at following up our leads, from what we can tell. And that’s what it’s resulted in. We’re guiding in the mid to high single digits, I think that’s what I’d expect over kind of longer periods of time. You may have a quarter where you jump up and grab low double digits like we did here. But a lot of that’s going to be a function of which quarter you compare it back to. So that’s the way I think about it is kind of mid to high single digits. We believe we can do that over longer periods of time. A.J. Rice – UBS: Okay. And then maybe just to talk for a minute about Neptune and the cremation rate overall. First of all, on the 160 basis points year-on-year jump in cremation rate. Is that include the Neptune – is that being impacted by what’s going on in the Neptune. And in Neptune specifically, seems like you are seeing very good growth there, 22% revenue growth, 10% revenue for contract. Any interest things to call out there?

Yes, I think first of all Neptune is in both numbers, so you’re seeing that in the cremation rate. And so because it’s now comparable, you notice that our cremation rates kind of went up for both periods over the last couple of quarters, because it includes Neptune. A.J. Rice – UBS: Okay.

160 points, again we think it’s kind of over three months you got to look at anomaly, if you look at it over a year, it could be bigger and we’ve had some quarters that are almost flat. So I don’t think we read much into that. With regard to Neptune and success, we’re very, very pleased. It’s a function of better performance at the operations. We’ve also opened new offices. We opened six new offices this year and in the second half of years we’ve got another two that are coming online. And at that time point it will be at 59 locations. We believe we’re on pace for probably close to 60,000 preneed sales contracts in 2013. So very, very excited about that, and I’d tell you again this is one of those that when you talk about two great companies come together you learn from one another. And this is a perfect example. And one of the things that’s happened with Neptune is that we took our NCS businesses and put them under Neptune’s management. And in doing so we learnt from them a bit about preneed marketing. We weren’t selling travel protection plans at the same velocity as they were. And so with those and all the NCS businesses Neptune taught us how to sell travel protection and that’s increased the average sale as it relates to those NCS businesses. From the flip side, we’ve added to management talent to Neptune by bringing somebody in that’s SCI and that person was responsible in getting the team together and looking at the way Neptune’s felt. We sell in the homes as you can imagine discounting was one of the techniques that we utilized quite a bit. And I think our recognition that, hey, we can sell more of a value and less about the discount. And what we’ve seen is that discount coming down overtime which resulted in a higher average sale because of the quality of what we’re selling. So both sides have probably come together under market as leadership and we’ve seen again average revenue growth approaches 10% like you recommend. A.J. Rice – UBS: Okay, all right. Great, thanks Tom.

Our next question comes from Chris Rigg. Chris your line is open. Chris Rigg – Susquehanna Financial: Good morning. Thanks for taking my question. Just wanted to come back to the selling cost commentary to make sure I fully understand the message. Clearly your on-boarding new representatives but is this sort of the same store or same representative cost going up as well. Are you paying the people more for the same service than you were in last quarter or last year?

Okay. The way to think about it Chris – it’s a great question. The answer really is no, the short answer. There is a little bit of mix and we didn’t get into this on the call as much, but particularly on the cemetery side, one of the things that occurs is funerals probably about the same and you really wouldn’t notice anything. On the cemetery side of the business, there is two factors that would impact it. What you are seeing, and who sells it. We have – if we sell a property, property has a higher cost of sale, they had merchandized our service. So as our major property goes up, your percentage of selling costs should go up and that is a bit of a factor in the quarter, not a big one, but that’s one of the reason why cemetery costs were up. The other thing is who sells it? We have – what you guys would refer to as inside sales and outside sales. If an inside seller sells it, generally that’s an easier sale and the cost associated with it is lower. If more of the production goes to outside sales, and again I’m using this as a generic analogy, the cost of sales tends to be higher. And so what we’ve seen is within our outside sales force is a higher productivity relative to the overall sales. So you do get a little bit of mix shift. It’s not that you’re paying more necessarily by inflationary terms. It’s really how the business comes into the company. Chris Rigg – Susquehanna Financial: Okay. And then on the cemetery margins more generally, I mean sometimes the profits are delayed because of the timing of developments when things are completed. It looks like you are alluding to that a little bit in the commentary, definitely in the press release. Is there anything that would suggest that maybe we would see a decent a sequential change in the profits in the business?

Yes. I think what you’ve always seen – it’s kind of a weird thing, Chris, because you’re hitting on something that is probably the most confusing part of what we do. If you look at this quarter, two things happened. One is in the second quarter of 2012, we constructed a lot of stuff. And when we did that, we recognized the profits. So there is $5 million more profits last year from construction that’s in this year’s quarters than it’s in this year’s quarter. The second thing that’s weird is this 10% down think. We’ve sold almost $4 million more of stuff with less than 10% down. So again we’ve got the selling costs in this year and we haven’t recognized the revenue yet. So two things got to converged on this quarter, and make it dampen a bit. Now on the cash flow side, this is where it gets even trickier. When you construct something, you get the profits but the cash probably is already been collected. So when you look at the cash flow stream, like look at this quarter, profits were relatively flat, cash is up. Cash is up because we didn’t have earnings that weren’t attached to cash like we did last quarter. So it’s going to have inflow and so logically you’d say next year – next quarter ought to be a little bit profitable in the cemetery side, but it may not result in more cash. If that makes good sense. Chris Rigg – Susquehanna Financial: It does. Thanks a lot.

Okay.

And our next question comes from Robert Willoughby. Robert your line is open. Robert Willoughby – Bank of America: Actually two quick ones. Eric, have you mentioned there are (inaudible) what part of the funding of the Stewart deal will actually be cash? Is there any ranges you could throw out there?

We really haven’t talked about it throwing a range out there, Rob. I’ll try to help you. I mean it really depends on in terms of how much cash will be absorbed in the Stewart deal from their cash counts obviously. Roughly that could be somewhere around $100 million or so. And then it just really depends on how much cash we have versus what the liquidity profile that we want to keep. So we look at our liquidity profile with a capacity we have on the new revolver which is a full $500 million at this point. It is brand new. We paid off $87 million off versus our cash balance. But we may be able to use another $100 million as well. So when I said a $600 million term loan and a $500 million revolver, I certainly wasn’t trying to say in the comments that we were fully draw upon that. Robert Willoughby – Bank of America: Right.

It’s probably a couple of hundred million less than that. And that’s how I calculated the extra $55 million of cash interest on an annual basis at the end of the day. Robert Willoughby – Bank of America: Perfect. And do you have an estimate to the kind of Stewart related deal costs this quarter be around the same as what we just saw on second quarter?

I think I would say that it would be somewhat equal. I mean this quarter we have a lot of legal fees that were more front-ended. Although, we have a lot of legal costs related to what we’re going through with the FTC. But what will ramp up a more some transition costs as we have started in June have an access to working with the really high quality folks that are over in New Orleans in the Stewart corporate office. So we’ll see some costs there, but yes, I mean generally it’s going to be somewhere in the ballpark. Robert Willoughby – Bank of America: Okay. That’s great. Thank you.

And our next question comes from Nicholas Jansen. Nicholas your line is open. Nicholas Jansen – Raymond James: Hi guys, two more from me. How is the dialog been thus far with the FTC in kind of any changed expectations relative to the May call regarding potential for divestitures at this stage of the game?

No change in assumptions Nick, at all. I think it’s gone – progressed well as we would anticipate. Few conversations but really early in the process still, but – so we still anticipate basically the guidance we gave in before hadn’t changed. Nicholas Jansen – Raymond James: Okay. And then maybe just looking at the year-over-year improvement in the capital markets, how is that contributed to EBITDA this year in kind of your expectations for the back half of the year? Thanks.

I mean I think the capital markets obviously have performed well, a little above expectations, but as you know the way our trust funds work in revenue recognition is only about 10% of the impact from the trust funds reverts to us in any given year, so not a material impact, but favorable nonetheless.

And generally Nick, the trust funds as you saw are up just under 5%. And to answer your questions, typically for the back half of the year, we’ve pretty much assumed flat performance. So we stay up where we are right now through June 30. So if you are specifically asking a model question, that’s how we model it. Nicholas Jansen – Raymond James: And then maybe just lastly in terms of given the better financing costs that you got from the Stewart deal relative to our expectation maybe your thoughts surrounding when you could maybe perhaps return to the buybacks longer term. Is that more of a 2015 dynamic or how should we think about the de-leveraging post transaction?

Well we’ve filed the credit agreement that I just described to you in early July. And so there are some obviously some limitations above four times leverage as to find in that agreement you go look at that. You are concluded from doing it below that, you could start doing it. And it really depends on when the transaction closes when you’re talking to calendar and when the divestitures occur, but generally I don’t think it’s that late as you mentioned. I would hope it’d be somewhere in maybe the back half of 2014 somewhere in that area, but again there is a lot of variables in that timing in terms of when divestiture proceeds come in. Nicholas Jansen – Raymond James: Thanks guy. Great quarter.

Thanks, Nick.

Our next question comes from Duncan Brown. Duncan, your line is open. Duncan Brown – Wells Fargo: Good morning. Maybe going back to the cemetery preneed. Did I hear you right that you said you sold $4 million more cemetery preneed but that had less than the necessary 10% down payments to recognize it as revenue?

That is correct, Duncan. Duncan Brown – Wells Fargo: Are there – sorry to interrupt you there. I guess my question is can you give us some comfort regarding maybe cancellation rates or something like that that the quality of those sales that you’re comfort regarding that you’re going to get those payments going forward?

We’re very comfortable with it. We monitor it every month and every quarter, and I would characterize our cancellation rates to be right around where we expected and there is no material movement one way or the other as it relates to our cancellation rates, Duncan. Duncan Brown – Wells Fargo: Has there been a – thank you for that. Has there been a change in terms of what you all are offering in terms of offering lower initial down payments or different financing terms?

I’d say lot of that’s driven regionally about market Duncan, and so we have that campaigns that again as you radiate outside of the cemeteries and begin to get the people to probably more thinking about that at the moment, and having save duckboard, didn’t have the money. Those were the type of the business that we’re writing, but I think again you will find historically because of the sensitivity what we fell, people are very loyal about this is the decision they don’t take very lightly. And so our experience has been the collection rates remain in this general area, and we’ve seen quarters like this before, and we generally collect them and they are good customers. So again we’re comfortable. I think you’re going to see more of that as we have more success because again they think about cemetery and the radius around it. As you expand that radius, you’re going to begin to get customers that, one, who were thinking about it, and two might not come into your cemetery. And that’s going to probably require little more financing, but again I can’t think of a better sale because we own the property and it’s pretty easy to repossess if somebody doesn’t like. Duncan Brown – Wells Fargo: Sure. That’s fair enough. Last one for me and maybe not something you care to address, but anything you can comment on regarding the situation in Illinois and the Teamsters Union?

Well again I think I would say, number one, we’re open for business and we continue to serve client families. You mentioned it in Chicago. We’ve got 16 more patients that are affected by the set of our total 1,800. We’ve about 60 employees. And we have adequate staffing in place to continue to serve our families to the levels of service or professionalism that they would expect. Again we don’t like these types of things. These are employees we care about. We want them back to work. We think we’ve offered some very fair increases over the coming years, and we’re really concerned about this under-funded pension plan that we’re going to paid into. And we think it’s very important again to resolve these issues and we look forward to welcome them back at the appropriate time. Duncan Brown – Wells Fargo: Great. Thanks for taking the questions.

You bet.

(Operator Instructions) Now I’d like to turn the call back over to SCI management.

We want to thank everybody for participating in the call today. We look forward to talking to you again. I guess that would be in late October for our third quarter earnings call. Have a great week.

Thank you ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may now disconnect.