Service Corp. International (SCI, Financial) is the leading company in the American funeral and cemeteries business, or as they call it in the industry, “deathcare.”
One would think these might be boom times for Service Corp. and the industry given the Covid-19 pandemic. However, it is currently selling for less than its intrinsic value. That, along with an excellent earnings record, has put it on the GuruFocus Undervalued Predictable list.
That seeming contradiction is explained by looking at the other factors that come into play. Yes, the pandemic is generating more deaths, but there is more going on:
- Because of social distancing rules, conventional funerals are being replaced by simpler functions with streaming video rather than large gatherings, thus pulling down the revenue per funeral. As Jay Waring, Service Corp.’s chief operating officer, noted in a press release on April 30, “The rigorous restrictions placed on gatherings and mandated by state, provincial, and local governments has posed a unique challenge for our funeral homes and cemeteries.”
- The economic crisis accompanying the pandemic is making consumers more cautious, leading them to order fewer high-end funerals.
- Many of the funerals are for elderly people who might have died in the next few years; revenue today will be at the cost of funeral revenues that would be earned in the future.
There are other factors as well, including costs and revenues from preneed sales and cemetery operations. While the first two months of the quarter were fine, things took a turn for the worse at the beginning of March. Investors lost confidence in the stock, as illustrated in this 10-year price chart:
The company reported it has ample liquidity and no major debt repayments due until 2024, so it expects to ride out the current crisis without too much difficulty.
With the price falling as it has, enough resources to get through the current troubles and a history of predictable earnings, is this a time to buy SCI?
To assess the company, we use the Macpherson model, an initial screen for competitive advantage (moat), financial strength, profitability and undervaluation.
Moat
To test for a competitive advantage that will protect a company’s margins and earnings, the model looks for a 10-year median of at least 15% for return on capital and return on tangible equity.
- ROC: Over the past 10 years, it has only managed to deliver double-digit returns twice, and only one of those years produced a return of more than 15% (that was 17.54%). Service Corp. does not pass this hurdle.
- ROTE: Quite the opposite for this metric; over the past 10 years, its median ROTE was 147.79%. GuruFocus explains: “Return-on-Tangible-Equity is calculated as Net Income attributable to Common Stockholders divided by its average total shareholder tangible equity. Total shareholder tangible equity equals to Total Stockholders Equity minus Intangible Assets.”
Both metrics considered, let’s give the company a medium-width moat.
Financial strength
As the details below show, Service Corp. gets a low, failing score for financial strength:
Why the low score? The GuruFocus system lists a “Severe Warning” because of the company’s growing debt. Short term, there is no problem since it had cash, cash equivalents and marketable securities worth $186 million, but only $95 million of short-term debt at the end of 2019. Turning to the long-term, though, Service Corp. has $3.556 billion in long-term debt and capital lease obligations (almost all debt in this case).
Still, the company is confident about the current situation. According to Chief Financial Officer Eric Tanzberger, “I think it is important to reiterate that we are well-positioned financially to weather this storm. Our financial position is strong with very robust liquidity. We continue to expect a significant amount of positive operating cash flow during 2020. Additionally, we have no meaningful debt maturities until May 2024.”
From a long-term perspective, I would judge Service Corp. a miss on the financial criteria of a cash-to-debt ratio of 0.05 and a GuruFocus rating of at least 9 out of 10. That’s based on this question: What happens if the presumed current recession turns into a lengthy depression?
Profitability
This is an area of strength for Service Corp. since it meets the model’s criterion of at least a 9 out of 10 score for profitability:
Note, too, that the GuruFocus system gives the company an excellent rating for earnings predictability, a full five out of five stars. GuruFocus reported that stocks with a five-star rating will gain an average of 12.1% per year in the coming decade, and only 3% of five-star companies will be in the red if held for at least 10 years.
Valuation
With the stock trading at $37.79, the discounted cash flow analysis indicates a generous amount of headroom. The calculator shows a fair, or intrinsic, value of $52.85. That would provide a 28.50% margin of safety.
Over the four Macpherson model criteria, we give Service Corp. a pass on its moat, profitability and valuation. We give it a failing mark on financial strength due to its heavy leverage.
Ownership
Only two of the gurus followed by GuruFocus have Service Corp. holdings, a rather low number. Pioneer Investments (Trades, Portfolio) owned 270,412 shares at the end of 2019, while Joel Greenblatt (Trades, Portfolio) of Gotham Asset Management had just 8,700.
Institutional investors owned 56.02%; Vanguard Group has the biggest holding, with more than 16 million shares. BlackRock Inc. is the second-largest investor with more than 15 million shares.
Insiders have a solid stake in the company at just over 3%. CEO Tom Ryan holds 1,143,308 shares, representing 38.5% of insider holdings as of March 4.
Covid-19 response
As noted, the company is finding its margins challenged as it deals with lower spending on funerals. The pressure may ease as social distancing and fears of a serious recession/depression are relaxed.
Still, the company says it has lots of liquidity, has no major debt payments due until 2024 and is trimming expenses where possible.
Conclusion
For those who thought a pandemic would bring boom times for the deathcare industry, there is an unpleasant surprise. Or as the saying about relationships goes, “It’s complicated.”
Investors realized that in early March, cutting or eliminating their holdings in Service Corp. International. That, in turn, made its stock available at a discount and with a solid margin of safety.
However, value investors will likely shy away from the company because of its heavy debt load, which it should be able to handle in the short term. But in the longer term, there will be doubt about its ability to maintain its status as a consistent generator of robust profits.
Disclosure: I do not own shares in any companies named in this article and do not expect to buy any in the next 72 hours.
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