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No. of Recommendations: 28
Peter Lynch's Perfect Stock

Service Corporation International(SVR), SCI, was a golden pick by the silver-haired investing genius, Peter Lynch. The Magellan fund must have owned it sometime in the mid 1980's before it was discovered by analysts and they appear to have done well with it. SCI filled several of the criteria Lynch used to pick equities.

*it was undiscovered and cheap
*it was a local Texas business poised to spread
*it had a nondescript unexciting name
*it was in an unattractive business(funerals/cemeteries)

From 1969 until 1998, SVR did well and rewarded shareholders with around 10-fold appreciation and then in 1998, they acquired Equity Corporation International(an even duller name). ECI owned funeral homes and cemeteries and appears to have been fairly successful--announcing record revenues right before the acquisition. On January 26, 1999, only six days after completing the merger with Equity Corp., Service Corp. announced disappointing fourth quarter and year-end 1998 financial results. The market reacted sharply to the announcement, with Service Corp. stock falling $15.19, or 44% to $19.25 per share, after touching $18.38, the lowest price in 3-1/2 years. SVR common stock had traded above $35 per share. A class action suit followed that has only recently been settled without admission of wrong doing by SVR. They were accused of misleading the public with regard to the effects of adverse trends, market conditions and demographics on business and operations and the misleading positive statements artificially inflated the price of Service Corp.'s stock. It was quite likely an attempt to better the acquisition price since it hinged on SVR's stock price. The chart is spectacular:

Quite a drop.

Well, they might have recovered eventually, but their sorry record of corporate misbehavior was about to take a grave turn. From reading One Up On Wall Street, it is apparent that Magellan saw trouble coming and escaped before the trouble began.

Politics, Embalming, Gravediggers and Disturbing the Dead

The funeral business is notoriously under-regulated. State regulation of funeral homes, cemeteries,crematories and casket makers is inconsistent. Nearly all states regulate funeral homes, but only one-third keep an eye on cemeteries. Federal regulations require only that funeral homes to tell customers what the prices are. This"funeral rule," however, doesn't apply to most cemeteries, crematories, or the selling of caskets and monuments on the Internet.Funeral homes and cemeteries fall under different regulatory agencies. A separate cemetery board and funeral board issue licenses and sanctions, but each board is stacked with industry representatives.This is a setup that invites weak enforcement and soft penalties for wrongdoers. And may partially explain SCI's next major blunders.

Governor Bush and Service Corp.

In Texas, mortuary operations are overseen by the Funeral Commission, an indulgent board appointed by the governor and largely composed of funeral home executives and their lawyers.

In 1996 the Commission's then director, Eliza May, began receiving complaints that SCI funeral homes regarding embalmers, many of them low-paid Mexican immigrants. The Sparkman-Crane mortuary(SCI run) in Dallas overpumped a man's body with embalming fluids. When the body was presented for open viewing, fluid was oozing from its eyes, ears and mouth. After the funeral, the casket was placed in the crypt. Several weeks after the funeral a visitor reported a putrid odor in the crypt. Family members noticed a brown fluid had seeped through the casket into a pool on the floor. The family filed suit against SCI, claiming that the embalming was botched by inexperienced and unlicensed workers and that the casket was cheaply constructed.

Ms. May launched an investigation of SCI, which disclosed numerous violations in embalming practices. May and her investigators recommended that SCI be fined $450,000. SCI was founded by CEO Robert L. Waltrip, a close friend of the Bush family and a generous contributor to the campaign coffers of the Texas governor. May claims she was pressured to bring the investigation to an end after Bush and Walthrip met on the matter. She ignored the directive to desist. The company was fined $450,000 by the commission and the legislature then came under pressure from SCI and the governor's office to shut down the agency. In early 1999, May was fired.

Unfortunately, this whole mess was hushed up quickly and it never became a well-known public disgrace for Bush, Texas and SCI.

Disturbing the Dead in Florida--Gravedigger's Story

A fired gravedigger who worked at Menorah Gardens in Palm Beach County(SCI property) said cracked cement vaults holding buried caskets were an everyday occurrence. He reported times when his backhoe uncovered bones that were taken to a pile used for fill, indicating human remains might end up anywhere.

"In the process of digging up the grave, I saw somebody's skeleton breaking up and bones flying all over the place," he testified. Dirt from the disturbed grave was taken to a wooded "dumping ground" and later was used "to fill other spots in the cemetery."

A videotape and photos taken by private investigators showed a leg bone beside chunks of a concrete vault, Jewish burial shrouds, and a Star of David next to finger bones.
SCI was sued. The plaintiffs alleged that the company failed to exercise reasonable care in handling remains by secretly:

1) dumping remains in a wooded area
2) burying remains in locations other than the ones purchased
3) crushing vaults to make room for other vaults
4) burying remains on top of the other or head to foot rather than
5) moving remains
6) co-mingling remains.

One of the company's officers will see some jail time for his role in one of the most gruesome cases of cemetery malpractice in U.S. history.

Prosecutors dropped all criminal charges against SCI. The company will have to pay more than $4 million to expand the state's regulatory capacity over the cemetery industry and help ensure payments to victims of the company's misconduct. They are also required to bury the poor in Palm Beach and Broward counties for one year at no charge. A separate civil settlement in the amount of $100 million was given to the families of the victimized corpses.

Prosecutors agreed to drop the criminal charges because they said a finding of guilt could have meant SCI's insurance company would refuse to pay the civil settlements.

SCI officials said that they were content with the deal and that the provisions give their company an opportunity to show their "real core beliefs."

"Some very unfortunate things happened," SCI spokesman Don Mathis said. "We need to move on and start showing what we can do."

Service Corporation's Business

In spite of all this, one might consider the company for investment if it seemed that they had cleaned up their act and were financially sound. Loose regulation of burial services still appears to be prevalent. On that score, SCI may be risky. That leaves the financial performance. Is it as compelling an investment as when Peter Lynch first spotted them?

Service Corporation is the world's largest provider of funeral and cemetery services. They operate 2,225 funeral service locations, 417 cemeteries and 183 crematoria located in eight countries. They have recently sold less than profitable holdings in the UK, France and Australia.

Personnel at the funeral service locations provide all professional services relating to funerals, including the use of funeral facilities, motor vehicles, and preparation and embalming services. Funeral related merchandise (including caskets, coffins, burial vaults, cremation receptacles, flowers and other ancillary products and services) is sold at funeral service locations. Certain funeral service locations contain crematoria. They sell prearranged funeral services whereby a customer contractually agrees to the terms of a funeral to be performed in the future(more on this later).Cemeteries provide cemetery property interment rights (including mausoleum spaces, lots and lawn crypts) and they sell cemetery related merchandise (including stone and bronze memorials, burial vaults, casket and cremation memorialization products) and services.

Cremations usually result in lower revenue and gross profit dollars than traditional funeral services. In North America during 2003, 39.0% of all funeral services performed were cremation cases, compared to 37.9% performed in 2002. They have expanded cremation memorialization products and services which has resulted in higher average sales for cremation cases compared to historical levels.

Growth Comes From Where?

The initial business model was to acquire small independent funeral homes. By 1999, the competition for these was fierce and they overpaid for many properties which were later divested due to low returns on capital.They now feel that the best way to grow earnings is to become efficient and cut costs. They don't plan to make lots of acquisitions. Expansion appears to be over. This is one thing I think Lynch might have considered to be attractive in the 70's--lots of room to grow beyond Texas. That part of their business is gone. In this respect, their future is less bright than it was 3 decades ago. Cost cutting only creates a finite amount of growth. The days of high growth are history.

The other growth vehicle they comment on is emphasis on cremation as an alternative to burial and expansion of that part of the business. This may have some potential, but they admit the profits are less attractive.

Finally, they hope to steal market share from other less geographically dispersed businesses and from independent operators.They feel their reputation will help them corner the market. I have to disagree. But then with their bland name and the short memories of the consumer, maybe it can happen.

Some Issues With Revenue Recognitin

The company was forced to restate several years worth of unrecognized revenue and place the revenue in the period the preneed service was rendered. Were they perhaps saving up for a rainy day? Saving revenue in an account to bring out in times of need? It is aggressive accounting when revenue and expense are not recognized in the same period. They also amortize part of the selling costs for these preneed(prepaid funeral expenses) sales. This has the effect of decreasing expenses and making operating income look better. Maybe these would be more appropriately expensed. The argument for these sales as assets is weak. If you amortize an expense, it has to show up as an asset on the balance sheet. Is the cost of soliciting prepaid funeral services really an asset?

What the Company Sees

They characterize the core business as stable, reflective of favorable demographics and relatively predictable revenue and cash flow streams that are further enhanced by more than $5,100 million of deferred revenues associated with North America preneed funeral and cemetery sales.

The Trouble With Prepaid Funeral Costs

Bonds, Surety Bonds

Anyone who aspires to own or owns stock in the funeral industry(Alderwoods, Stewart) should carefully consider the state of prepaid funeral costs--also known euphemistically as preneed.

SCI now places all or a portion of the funds collected from prearranged funeral contracts into trust accounts, pursuant to applicable law. In February 2004, they discontinued the use of surety bonding in Florida. Beginning with contracts written in early 2004, they deposit customer receipts from the sale of preneed contracts into trust funds in accordance with state requirements(change applies to Florida only). As a result of this change(in one state only remember), cash flows from operating activities will decline by $15 to $20 million. This is how much cash flow was generated by using surety bonds rather than trust accounts in Florida alone.

In subsequent periods, the impact to cash flows is expected to be immaterial. Not included in the outlook for 2004 are other potential changes regarding the use of surety bonding. We are currently evaluating our surety bonding program and may elect to discontinue the use of bonding in other states or cancel certain outstanding bonds and replace with funds in trusts in accordance with state regulations.

Translation: Rules may tighten regarding surety bonding and future cash flows might be in jeopardy.

What's the difference between surety bonds and trusts? And why is this important to me as the happy owner of either SCI or Alderwoods stock?

A surety bond as financial assurance for a certain amount of the preneed funeral contract in lieu of placing certain funds in trust accounts.That means that surety companies issue surety bonds to funeral companies guaranteeing payment. Chains have found ways to get their hands on the trust money. Some states let them post a surety bond, essentially an IOU, in lieu of placing prepaid funds in trust. Florida was one of those states. In 2000, for example, regulators let SCI and Stewart Enterprises pull $84 million out of trust in exchange for surety bonds.

From SCI:

When we deposit funds into state-mandated trust funds, however, we are often not required to deposit 100% of the liability amount. Therefore, in the event all of the surety companies canceled or did not renew our outstanding surety bonds, which are generally renewed for twelve-month periods, we would be required to either obtain replacement assurance or fund approximately $242 million, as of December 31, 2003, primarily into state-mandated trust accounts.

At first, the chains viewed prepayment largely as a way to build market share for the future. But increasingly, they have come to rely upon these sales for cash flow. During the 1990s, chains overpaid in a mad dash to acquire mom and pop funeral homes, cemeteries and crematories around the country to gain geographic market share. Most of them paid too much including SCI and Alderwoods. Canadian-based Loewen Group(Alderwoods), filed for bankruptcy protection in 1999. SCI and New Orleans-based Stewart Enterprises, meanwhile, are selling off some of their new properties and badly need prepaid money to help pay down debt. The money and cash flow generated by these surety bond IOUs became important in keeping these floundering businesses afloat.

Funeral companies are spending money today on services they won't have to provide for years. Florida state Representative Mark Weissman likens this to a ponzi scheme. "Where are the dollars going to be down the road when they have to deliver all these services?" he asks. "Sales must continue at the same or greater pace year after year just to cover the cost of delivering what was already obligated."

Is this a time bomb waiting to eat into the funeral business much as underfunded pension plans erode company profits currently. As customers pass away and their funeral bills come due, companies may be forced to cut services and staff. Is bankruptcy a possible outcome?

The chains say these fears are way overblown. The Loewen Group(Alderwoods) came out of bankruptcy without having defaulted on a single funeral. For its part, SCI says it places 90 percent of its prepaid money in trust.

"We've never had a contract we haven't been able to honor," says Dan Garrison, SCI's vice president of North American cemetery operations. "Nor is there any evidence that the backlog of prearranged services will not be honored."

About one in three Americans over age 50 have prepaid some funeral costs, and about $25 billion worth of goods and services have been paid for but not yet delivered.

A Few Financial Facts

Income Statement Ratios Quarterly

Dec 03 SEP 03 June 03 Mar 03
growth revenue 6% -3% 1% 1%
growth gross income 12% -20% -10% 35%
growth EBIT 42% -72% -38% 98%
growth net income 707% -139% 66% 1107%
growth EPS 650% -140% -62% 750%
gross margin 21% 19% 24% 26%
gross operating 4% 3% 10% 16%
gross net 6% -1% 2% 7%
growth COGS 4% 3% 5% -8%
growth SGA 28% 39% 78% -33%
tax rate 4% 40% 32% 37%

Annual Income Statement

2003 2002 2001 2000 1999
gross margins 23% 22% 22% 22% 26%
operating margins 8% 12% 12% 10% 16%
net margins 4% -10% -24% -52% -1%
growth revenue 3% -9% -2% -23%
growth gross 7% -11% 0% -36%
growth EBIT -32% -5% 17% -53%
growth net 137% 61% -55% -4046%
growth COGS 2% -9% -3% -18%
growth SGA 98% 28% -12% -3%
growth EPS diluted 182% 84% -25% -1418%
inventory/COGS 8% 8% 9% 8%
tax rate 26% 28% -11% 18%

Litigation in Florida was classified as SGA

The jump to 98% in 2003 reflects this expense charged to SGA. The increase of $88.3 million is primarily a result of an increase in litigation expenses of $85.2 million. These expenses were primarily associated with litigation matters in Florida. Excluding these litigation related expenses in 2003 and 2002, general and administrative expenses increased $3.1 million. Inventory and COGS remain at even ratios. Inventory not stacking up shows it is appropriately accounted for on balance sheet s shown by a constant ratio of inventory to COGS..

Generally, things are improving for SCI.

The business is increasing sales and net income. Growth in SGA hurt EBIT.

Balance Sheet Annual

2003 2002 2001 2000 1999
current ratio 1.00 1.62 1.16 1.32 0.94
quick ratio 0.35 0.43 0.04 0.06 0.04
AR growth 20% 25% 14% 26%
DSO 36.4 46.8 56.1 64.0 66.4
inventory days 27.5 27.7 31.5 30.8 28.2
payable days
outstanding 91.8 11.5 90.3 90.9 87.6

growth in payables 709% -88% -3% -15%
growth in inventory 1% -20% -1% -11%
CCC -27.7 63.0 -2.5 3.9 7.1
ROE 6% -8% -42% -23% -1%
ROA 1% -1% -5% -4% 0%
ROIC 4% 6% 8% 4% 6%
debt/equity 112.1% 153.5% 176.9% 166.6% 116.2%
debt/capital 53% 61% 64% 62% 54%
book value 5.0 4.3 4.9 7.2 12.8
cash/share $0.79 $0.68 $0.10 $0.18 $0.32
NC WC -52.3 206.7 310.7 351.9 274
change in NC WC 259 104 41.2 77.9 274

decrease in LT debt -355.6 -429.5 -800.5 -521.6 3636.1
total shares +5M +4.8 +9.7M +0.4M +272.1M

Long term debt decreasing yearly is a good sign but it is still at high levels of $1.5 billion.
Number of shares increases every year and now stands at a high level of 303 million.
Returns are terrible(ROA,ROE and ROIC)
Good job on accounts payable, days sales outstanding(DSO) and inventory control. The cash conversion cycle is outstanding.

Annual Cash Flow Statement

2003 2002 2001 2000 1999

growth in operating
cash flow 6% -8% 61% -45%
operating cash/revenue 16% 15% 15% 9% 13%
operating cash/net income 440% -152% -64% -18% -1336%

operating cash/
debt+interest 1.1 1.2 0.8 0.5 0.6
growth capex 16% 35% -13% -73%
capex/operating cash 31% 28% 19% 36% 73%
free cash flow 258.1 252.2 309.1 153.4 118.8
free cash flow/share $0.85 $0.85 $1.06 $0.56 $0.44
increase dividend 0 0 0 96.8 -96.8

Operating cash flow has increased in 2003 and it is sufficient to pay off current debt and interest. Long term debt is high. Operating cash is not being consumed as revenue increases. This is good--shows accounts receivables and inventory are controlled.

Capex is increasing and this is especially important in this business. Properties have to be well-maintained and attractive to appeal to customers and keep families pleased with the choice of a final resting place for loved ones. Even with the increase, it is easily covered by operating cash flow.

Free cash flow is positive(operating cash-capex)
Free cash flow to equity is another matter. Because of debt repayment it is a negative 169.8.

Odds and Ends and Final Thoughts

There are 28,315,220 @ $10.77 options outstanding which is 9% dilution and fairly high for this company that already has a huge number of shares outstanding. They have shown no move to buy back shares in sufficient quantity to decrease dilution. Bad.

Funded status of pension plan is $70,105 million in arrears. This is after a significant contribution in 2003. They expect 9% returns which is over optimistic. Add this to the debt and the company has a lot of overhanging expenses. And, they will have all those preneed services coming due.

If Peter Lynch was looking at them today I like to think he would pass. They have an unsavory history. They are perhaps a modest turnaround story, but are unlikely to quadruple or quintuple your investment. They don't pay dividends. The days of growth by rapid penetration into untapped markets are over. They will find the dollars get harder to come by in the future I fear. Cost cutting and realigning their services to appeal to changing tastes in funerals offer the best hope of a come back. I worry about their handling of surety bonds and trusts for prepaid services. This may be a problem a decade or so down the road. I don't like the debt and the underfunded pension. They return very little to shareholders--no dividends, no meaningful stock repurchases, low ROE, ROA and ROIC and there are too many options on the table.

And Waltrip is still CEO. Bush's friend and campaign funds donor and he was at the helm for all of the company's misdeeds. It does seem like an old boys club.

I pass too.

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