SCI

Business Context and Reporting Period

Company: Service Corporation International (SCI)
Filing Type: Form 10-Q (Unaudited)
Period Ended: September 30, 2004
Business Overview: SCI is the world's largest provider of funeral and cemetery services, operating 1,244 funeral service locations and 412 cemeteries across seven countries. The company also owns Kenyon International Emergency Services. North America operations represented approximately 97% of consolidated revenues in the third quarter of 2004.

Key Financial Metrics

Note: Net Debt calculated as Total Debt ($1,294,716) minus Cash and Cash Equivalents ($318,045).

Material Changes vs. Prior Period

• Revenue Decline: Consolidated revenues decreased $163.1 million (28.8%) in the third quarter and $307.8 million (17.8%) in the nine months compared to 2003. This is primarily attributable to the divestiture of French funeral operations via a joint venture completed in March 2004.
• Profitability Improvement: Despite revenue declines, gross profits remained relatively stable in the quarter (down only $0.7 million) and operating income increased significantly ($24.97 million in the quarter; $22.58 million in the nine months). This was driven by cost reductions in North America and gains on dispositions.
• Accounting Changes: The company implemented FASB Interpretation No. 46R (FIN 46R) effective March 31, 2004, consolidating preneed funeral and cemetery trusts. Additionally, a change in pension accounting resulted in a cumulative effect charge of $48.1 million (net of tax) in the nine-month period.
• Debt Reduction: Total debt decreased by over $400 million in the first nine months of 2004 due to debt extinguishments, including the conversion of $221.6 million of convertible notes to equity and the retirement of other notes.

Guidance, Outlook, and Risks

• Outlook: Management expects full-year 2004 operating cash flows (excluding non-recurring items) to be in the range of $270 million to $310 million. The effective tax rate for the full year is expected to be 11% to 15%.
• Share Repurchase: In August 2004, the company authorized a $100 million share repurchase program. As of late October 2004, approximately $59.4 million had been spent to repurchase 9.5 million shares.
• Strategic Focus: The company is focusing on the "Dignity Memorial" national brand, cost reduction, and increasing average revenue per funeral service. Cremation rates are increasing (approx. 40% of services), which historically generates lower revenue than traditional burials.
• Legal Risks: Significant litigation remains, including a securities class action lawsuit (Consolidated Lawsuit) settled for $65 million (with $30 million funded by insurance) and a consumer lawsuit in Florida settled for approximately $100 million. The company faces potential liability from opt-out plaintiffs.
• Internal Controls: The company identified deficiencies in internal controls over financial reporting related to revenue recognition and preneed activities. While remediation is underway, there is a risk that the company may not complete its Sarbanes-Oxley Section 404 compliance by December 31, 2004, or that deficiencies could be deemed material weaknesses.

Investor Verification Checklist

• Divestiture Impact: Verify the long-term impact of the French joint venture on revenue streams and the realization of the $287.9 million in proceeds.
• Trust Consolidation: Review the impact of FIN 46R on the balance sheet, specifically the classification of non-controlling interests in funeral and cemetery trusts ($1.98 billion).
• Legal Reserves: Monitor the status of the $35 million escrow for the securities class action and the $100 million escrow for the Florida consumer lawsuit, including potential insurance recoveries.
• Internal Controls: Track the remediation of identified internal control deficiencies regarding preneed revenue recognition and the timeline for SOX 404 compliance.
• Debt Maturity: Confirm the schedule for remaining debt maturities, noting less than $140 million is due in the remainder of 2004 and 2005.