SCI - Service Corporation International: Recent Weakness Provides A Buying Opportunity

2023-12-04 12:08:13 ET

Summary

• Service Corporation International shares fell from their all-time high due to macroeconomic pressures.
• SCI has a very strong history of delivering growth and above-market shareholder returns.
• The company has multiple growth drivers including demographics and strategic M&A.
• SCI trades at a below-market earnings multiple, but has above-market growth potential.
• I am initiating SCI with a buy rating.

Service Corporation International ( SCI ) shares fell sharply from an all-time high level of $74.66 reached on February 2, 2023. Since then, shares have delivered a total return of around -15% compared to a total return of ~11.4% delivered by the S&P 500.

The stock has sold off for a variety of macro related reasons including a slowdown in consumer spending on preneed cemetery planning, rising costs due to inflation, and rising interest costs due to higher rates.

I believe these factors are just short-term headwinds and do not change the long-term story. SCI has a strong history of delivering earnings growth and above market shareholder returns. Despite the relatively mature of the industry, SCI has multiple growth drivers. For these reasons, I believe the recent weakness in the stock provides an attractive buying opportunity.

Company Overview

SCI is the largest player in the deathcare business, with operations in the U.S. and Canada. The company holds ~15%-16% total market share and operates 1,900 funeral homes and cemeteries across 44 states, 8 Canadian provinces, the District of Columbia and Puerto Rico. SCI is well diversified geographically and key markets include California, Florida, and Texas.

SCI reporting segments include Funeral and Cemetery. The Funeral segment accounts for ~57% of revenue, while the Cemetery segment accounts for ~43% of revenue.

Strong Historical Performance and Shareholder Returns

SCI has a strong history of delivering growth. The company has grown revenue at a ~5% CAGR over the past 10 years, while growing EPS at a ~17% CAGR over the same time period. Additionally, while the company experienced an earnings boom due to the Covid-19 pandemic, increases in revenue and earnings have been fairly consistent overtime.

Strong financial performance by the company has helped drive solid shareholder returns. Since becoming a publicly traded company in 1974, SCI has delivered a total return of 12,510%.

SCI has also delivered solid returns over more recent time periods. Over the past 10 years, SCI has delivered a total return of 303% compared to a total return of 204% delivered by the S&P 500.

Multiple Growth Drivers

SCI experienced a sharp increase in earnings for FY 2021 which has created some recent volatility around growth rates. However, the company now expects to return to earnings growth of 8%-12% going forward.

One growth driver is demographics. The U.S. population is aging, and thus the number of reported deaths has been increasing each year. While the number of annual deaths in the U.S. has fallen over the past year, the long-term trend remains higher. For the period 2010-2019, the number of annual deaths in the U.S. increased from ~2.47 million to ~2.85 million, representing a CAGR of ~1.6%.

A more important driver of growth is strategic M&A. SCI has grown to become the largest player in its industry due to a solid growth acquisition strategy. SCI has unique efficiency benefits due to its scale, including cost advantages and marketing efficiencies. The company provides additional color on its acquisition history and strategy in its FY 2022 10-K :

We were incorporated in Texas in July of 1962. Our original business plan was based on efficiencies of scale, specifically reducing overhead costs by sharing resources such as preparation services, back office administration support, transportation, and personnel among funeral service locations in a business “cluster.” After proving the plan’s effectiveness in Houston in the early 1960s, we set out to apply this operating strategy through the acquisition of deathcare businesses in other markets over the next three decades...

In late 2006, having arrived at a position of financial stability and improved operating efficiency, we acquired the then second largest company in the North American deathcare industry, Alderwoods Group. In early 2010, we acquired the then fifth largest company in the North American deathcare industry, Keystone North America. In June 2011, we acquired 70% of the outstanding shares of The Neptune Society, Inc. (Neptune), which is the nation's largest direct cremation organization, now known as SCI Direct. Subsequently, in 2013 and 2014, we acquired the remaining 30% of the outstanding shares of Neptune. In December 2013, we purchased Stewart Enterprises, Inc. (Stewart), the then second largest operator of funeral service locations and cemeteries in North America. We continue to pursue strategic acquisitions and complete divestitures of non-strategic funeral homes and cemeteries.

Currently, consensus estimates call for SCI to report FY 2023 EPS of $3.50 representing a decline of 7.8% vs FY 2024. In 2024, SCI is expected to grow EPS by 4.3% to $3.65. In 2025, SCI is expected to grow EPS by 8% to $3.94.

I view these growth estimates as reasonable. Additionally, I believe there is potential for growth to accelerate above the 8% rate in years after 2025 as the company has a long-term target of 8%-12% earnings growth and has been able to achieve that level of EPS growth historically.

Strong Liquidity and Moderate Leverage

Currently, SCI has $974 million in liquidity and a net leverage ratio of 3.54x. While this degree of leverage is fairly high, SCI is engaged in a somewhat recession resilient business, and thus I feel comfortable with this degree of leverage.

Additionally, SCI's debt maturities are fairly long-term in nature and the company does not have any significant maturities prior to 2027. While the rates that SCI is currently paying on its senior bonds is below what the company would be forced to pay if issued today, it is possible that interest rates fall from here, thereby allowing SCI to refinance at rates only moderately above what it is currently paying.

Alternatively, if rates remain high, SCI could use some of the cash generated by the business over the next few years to retire a portion of its debt.

Recent Dividend & Buyback Increases

On August 2, 2023 SCI raised its quarterly dividend by 7.4% to $0.29 per share from a previous level of $0.27 per share. The company has a very long history of increasing its dividend and has grown the dividend at a 16% CAGR since 2005. Currently, SCI yields ~1.9%.

On November 8, 2023 SCI increased its buyback authorization amount by ~$477 million. When combined with the company's pre-existing remaining authorization of ~$123 million, SCI's total buyback authorization is now ~$600. For context, SCI's current market cap is ~$9 billion. Thus, the current buyback authorization represents ~6.6% of all shares outstanding. I view the increased buyback as an important signal, as it suggests that management may view the stock as undervalued.

Reasonable Valuation

SCI trades at 16.8x consensus FY 2024 earnings and 15.6x consensus FY 2025 earnings. Comparably, the S&P 500 trades at ~18.9x FY 2024 consensus earnings. Thus, SCI is trading cheap vs the broader market. Additionally, I believe SCI has superior growth prospects and can grow long-term earnings at ~10%-12% compared to a historical S&P 500 earnings growth rate of high-single digits.

SCI is trading roughly in line with its long-term historical average P/E ratio and recent average forward P/E ratio. While this may suggest the company is not highly undervalued, the valuation is certainly reasonable relative to the historical norm.

It is difficult to compare SCI to peer valuations as there are no other large publicly traded deathcare companies. However, SCI's valuation compares favorably to both the consumer staples and consumer discretionary sectors. The reason why I believe investors should consider both of these industry classifications is that SCI's business represents a mix of discretionary spending (preneed revenue) and non-discretionary spending (atneed revenue).

Consumer discretionary stocks can be represented by the iShares U.S. Consumer Discretionary ETF ( IYC ) which currently trades at ~25.3x earnings. Consumer staple stocks can be represented by the iShares U.S. Consumer Staples ETF ( IYK ) which trades at ~21.3x earnings. Thus, SCI is trading at a significantly cheaper valuation than both of these sectors.

Risks To Consider

One potential risk investors should be aware of is that economic conditions worsen, leading to lower spend on preneed deathcare. While SCI's atneed business is much more recession resilient, preneed deathcare spending represents a highly discretionary expenditure. Additionally, weaker economic conditions may lead families to choose cremation over burial. Cremation services tend to be cheaper and do not require the purchase of a cemetery plot.

Another risk investors should be aware of is the ongoing increase in cremation as opposed to burial. The National Funeral Directors Association recently released a report calling for the U.S. cremation rate to reach 81.4% by 2045. Currently, the U.S. cremation rate is ~60.5%. While SCI provides cremation services, a shift away from burials is a negative, as cremations tend to be cheaper and thus less profitable. However, SCI has been able to navigate this challenge over the past 15 years, albeit while cremation rates have nearly doubled . That said, investors should be aware of this risk and continue to monitor any changes in SCI's business and profitability related to increasing cremation rates.

Conclusion

The recent weakness in SCI shares provides investors with an attractive buying opportunity.

Historically, SCI has delivered very strong financial performance and shareholder returns. This growth has been fueled by a significant consolidation strategy. While SCI is the industry leader, the deathcare industry remains highly fragmented. Thus, I believe SCI has significant growth opportunities ahead related to further industry consolidation as well as organic growth.

While SCI is moderately levered today, the company has a number of years before it faces significant debt maturities. Moreover, SCI is highly profitable and could use some cash generated by the business to retire debt if rates were to increase from here, making refinancing more challenging.

SCI has a strong history of returning capital to shareholders and recently increased its dividend and buyback authorization. I believe the buyback increase is an important signal, as it suggests management views the stock as undervalued.

SCI trades at a below market multiple but has delivered above market earnings growth historically. SCI is trading at an attractive valuation to both the consumer staples and consumer discretionary sectors as well.

I am initiating SCI with a buy rating and would consider upgrading the stock to a strong buy if the valuation were to become more attractive.

For further details see: