For the core of my portfolio I want to focus on businesses that are stable and predictable. One business that doesn’t get much attention is Service Corporation International (NYSE:SCI).
Service Corporation is the largest funeral home operator in the world. Service Corporation has 1,471 funeral homes and 488 cemeteries across 44 states domestically as well as 8 Canadian provinces.
Dividend growth investing is a straight-forward investment philosophy that focuses on the dividends that a business will be able to pay out to shareholders. Intuitively it makes sense as it helps to narrow down the investment candidates to ones that are likely high quality if they have a lengthy history of dividend growth.
Service Corporation has increased their annual dividend payment for 11 consecutive years which gives them the title of Dividend Contender. Service Corporation’s dividend growth got off to an inauspicious start by stalling just 2 years into its journey during the Great Financial Crisis. However dividend growth resumed in 2011 with several years showing multiple raises.
Dating back to 2007 Service Corporation’s year over year dividend growth has ranged from 0.0% to 33.3% with an average of 15.6% and a median of 15.8%.
Over that same period there’s been 11 rolling 5-year periods with annualized dividend growth ranging from 11.0% to 22.4% with an average of 16.1% and a median of 16.2%.
During that same timeframe there’s been 6 rolling 10-year periods with annualized dividend growth ranging from 15.6% to 17.2% with an average and median of 16.5%.
Back in February Service Corporation announced a raise to $0.25 from $0.23 which was an excellent 8.7% increase over the prior payment and a 19.0% increase for the same payment in 2021.
The rolling 1-, 3-, 5- and 10-year dividend growth rates since 2007 for Service Corporation can be found in the following table.
|Year||Annual Dividend||1 Year||3 Year||5 Year||10 Year|
*Assumes 2 additional payments at $0.25 per share.
Source: Author; Data Source: Service Corporation International Investor Relations
The dividend payout ratio gives a quick glimpse into the safety of the dividend, and the potential for it to continue to be raised in the future, by comparing the annual payout versus either profits or cash flow. All else being equal I prefer to see a lower payout ratio as that gives more room for the inevitable fluctuations in the business without jeopardizing the dividend.
Despite the rapid growth in the dividend over time, Service Corporation’s payout ratios has remained quite conservative. The 10-year average net income payout ratio is 34% with the 5-year average at 26%. Meanwhile the average free cash flow payout ratios are 30% and 31%, respectively.
When employing a dividend growth strategy the focus is centered around the dividend; however, the fundamentals of the business are what will fuel dividend growth over time. In the process of determining whether the business is one I can be confident will still be around and paying out higher dividends in the future, I want to examine how the business has performed across a variety of financial metrics over time.
For a rather mundane industry, Service Corporation has shown solid revenue growth through both rising prices, upselling services, and acquisitions. Over the last decade revenues increased 71.9% or 6.2% annualized. Gross profits improved an impressive 149.3% or 10.7% annualized over that time as well.
Operating profits rose 190.8% or 12.6% annualized with operating cash flow increasing 149.3% or 10.7% annualized. Similarly, Service Corporation’s free cash flow improved by 143.0% or 10.4% annualized.
The following chart shows the rolling 5-year CAGRs for Service Corporations revenues, gross and operating profits, and operating and free cash flow.
My expectation is that good businesses will be able to have stable or increasing margins over time as the business flexes its proverbial strengths. I prefer to see free cash flow margins greater than 10% and take that as a sign that the business is able to convert an adequate amount of revenue into excess cash flow.
Service Corporation’s gross margins have been stable at greater than 20% every year of the last decade. The 10-year average is 24.1% with the 5-year average coming in at 26.0%.
Similarly, their free cash flow margins have routinely been better than 10% and shown solid improvement over time. The 10-year average is 11.1% while the 5-year average is 12.9%.
My preferred profitability metric is the free cash flow return on invested capital, FCF ROIC. The FCF ROIC is a measure of how efficient the business is at generating excess cash flow in comparison to the capital invested in the business. I prefer to see FCF ROIC that are improving over time.
Service Corporation’s FCF ROIC’s aren’t quite where I’d like to see them; however, they have consistently been in the mid-to-upper single digits. The 10-year average FCF ROIC for Service Corporation is 7.1% with the 5-year average at 8.1%.
To understand how Service Corporation uses its free cash flows I calculate three variations of the metric, defined below:
- Free Cash Flow, FCF: Operating cash flow less capital expenditures
- Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
- Free Cash Flow after Dividend and Buybacks, FCFaD: FCFaD less net cash used on share repurchases
Service Corporation has generated a total of $3.5 B in FCF which is quite remarkable considering their market cap stood around $3.2 B 10 years ago. Service Corporation has paid out a total of $1.0 B to shareholders in dividends putting the cumulative FCFaD at $2.5 B.
Service Corporation has also spent a net total of $2.4 B on share repurchases during that time which puts the 10-year FCFaDB at $0.1 B.
Share repurchases can be a great way for businesses to return additional cash to shareholders provided they are done at reasonable valuations. Service Corporation has pretty clearly committed to returning the bulk of FCF to shareholders.
Service Corporation’s shares outstanding declined from 219.1 M in FY 2012 to 170.1 M for FY 2021. That’s a total reduction of 22.4% or roughly 2.8% annually.
I aim to invest in businesses with holding periods measured in years. As such I want to make sure that the balance sheet is in good shape and is not overly leveraged and potentially endangering my equity stake.
I want to see stable or improving levels with significant deviations being more closely examined. Service Corporation has maintained a stable debt-to-capitalization ratio over time. The 10- and 5-year average level is 69%.
I also like to examine the net debt levels versus a variety of cash flow metrics to see how much leverage is piled onto the underlying business. I believe the net debt ratios give a better indication of how much leverage the business carries.
Service Corporation’s 10-year average net debt-to-EBITDA, net debt-to-operating income, and net debt-to-FCF ratios are 3.8x, 5.4x, and 9.8x, respectively. The 5-year averages are 3.5x, 4.8x, and 8.3x accordingly.
Given the stable nature of the underlying business of Service Corporation they can afford to carry higher leverage than other businesses that experience wider swings.
When valuing potential investments I like to employ several valuation methods to home in on what I believe the fair value could be. The valuation methods that I use are the minimum acceptable rate of return, MARR, analysis, dividend yield theory, the dividend discount model, and a reverse discounted cash flow analysis.
The MARR analysis requires you to estimate the future earnings and dividends that a business will generate over a given timeframe. You then apply a reasonable, yet conservative, expected terminal multiple to determine the future potential market price that shares could be valued at. If the expected return is greater than your hurdle rate for investment, then you can feel free to invest in the business.
Analysts expect Service Corporation to have FY 2022 EPS of $3.00 and FY 2023 EPS of $3.29. Analysts also expect Service Corporation to be able to grow EPS at a 7.0% CAGR over the next 5 years. I then assumed that Service Corporation would grow EPS at a 5.0% CAGR for the following 5 years. Dividends are assumed to target a 33% payout ratio.
For the reasonable terminal multiple I like to see how investors, collectively, have valued Service Corporation over time. As we can see in the following YCharts, Service Corporation has typically been valued between ~12x and ~30x TTM EPS.
The following table shows the potential internal rates of return that an investment in Service Corporation could provide if the assumptions laid out above prove to be reasonably close to how the future plays out. Returns assume that dividends are taken in cash and that shares are purchased at $63.40, Wednesday’s closing price.
|P/E Level||5 Year||10 Year|
Additionally I use the MARR analysis framework to arrive at the price I could pay today to generate the returns that I desire from my investments. My standard hurdle rate is a 10% IRR and for Service Corporation I’ll also examine 8% and 9% hurdle rates.
|Purchase Price Targets|
|10% Return Target||9% Return Target||8% Return Target|
|P/E Level||5 Year||10 Year||5 Year||10 Year||5 Year||10 Year|
Dividend yield theory is a simple and straight-forward valuation method based on the idea that investors will value a business around a “normal” dividend yield level over time. For Service Corporation I’ll use the 5-year average forward dividend yield as a proxy for the fair value.
Service Corporation currently offers a forward dividend yield of 1.58% compared to the 5-year average forward yield of 1.66%.
The dividend discount model is another valuation method that’s focused on the dividend stream from a business. The DDM is a dividend oriented version of the Gordon Constant Growth Valuation Model. For Service Corporation I’ll use an 8% assumed long term dividend growth rate and a 10% discount rate.
With a current forward dividend of $1.00 per share, an 8% dividend growth rate and a 10% discount rate, Service Corporation is worth around $54.
A reverse discounted cash flow analysis can be used to figure out what the growth, margin, and cash flow assumptions are embedded in the current valuation. In other words you can use the model to determine what you need to believe a business can achieve in order for the current valuation to make sense.
I use a simplified DCF model based on revenue growth, an initial FCF margin of 12.9% that increases to 15.0% during the forecast period, and a terminal growth rate of 4.5%.
Based on those assumptions Service Corporation needs to grow revenues at an 11.5% rate annually during the forecast period in order to generate the cash flows necessary to support the current market valuation. Reducing the required return to 8.0% lowers the necessary revenue growth rate to just 3.8% annually. Alternatively, using the required revenue growth rate from the 8.0% discount rate scenario of 3.8%, the terminal FCF margin would need to rise to 25.9% in order to give 10% returns.
Service Corporation is one of those under the radar businesses that just keeps compounding over time. The sector that it operates in, funeral homes, isn’t exactly glamorous; however, with the right strategy and capital allocation those types of boring businesses can do well for patient investors.
Service Corporation’s revenue growth has been steady over the last decade although that has been aided by acquisitions rather than pure organic growth. Their free cash flow margins have routinely been around 10% to 12% meaning they are able to translate a solid amount of sales into excess cash flow. However, their free cash flow returns on invested capital are only in the mid-to-upper single digits although they have been improving.
Dividend yield theory suggests a fair value range between $55 and $67, while the dividend discount model gives a fair price around $54. The MARR analysis with a terminal multiple between 15x and 20x 5 years out puts the fair value range between $46 and $59 based on 10% required returns. Reducing the hurdle rate to 8% increases the fair value range to between $49 and $64.
The reverse DCF shows that 10% returns are unlikely from the current valuation unless you believe that Service Corporation can hit the lofty revenue growth assumptions or improve margins significantly. That being said 8% returns have a very low bar in terms of revenue growth and margin expansion.
Service Corporation was a beneficiary of the pandemic and was likely overearning in both 2020 and 2021. While that will sting in the short-term, as evidenced by the expected sales and earnings decline for FY 2022 vs FY 2021, the business is still on solid footing. My baseline expectation would be for Service Corporation to be able to have sales growth in the 2-4% range over time which leads to earnings or free cash flow growth in the 4-6% area.
Keep in mind that’s before accounting for the likely share repurchases in the future which if done at roughly the same pace as the previous decade could reduce the share count around 2-4% annually.
Add that all up and you’re looking at potential earnings or free cash flow to grow somewhere in the order of 6-10% before including additional M&A opportunities which should be plentiful.
According to the National Funeral Directors Association it’s estimated that 89% of funeral homes in the United States are still privately owned.
I’m really impressed that management took advantage of the overearning from the pandemic to aggressively reduce the share count. Shares outstanding declined 8.3% from FY 2019 through FY 2021.
The valuation at this time appears to be on the upper end of fair value. That’s not necessarily a bad spot to buy a business that will surely be around decades from now. Typically I would look towards the options market; however, Service Corporation doesn’t offer much liquidity in that area. That being said I’ll hold out for opportunities to purchase additional shares in the mid-to-upper-$50s.