Service Corporation International - 10-Q quarterly report FY

 

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act (check one).

Large Accelerated Filer þ      Accelerated Filer o      Non-accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). YES o NO þ

The number of shares outstanding of the registrant’s common stock as of November 1, 2007 was 278,672,176 (net of treasury shares).

The following terms are common to the deathcare industry, are used throughout this report, and have the following meanings:

Atneed — Funeral and cemetery arrangements after the death has occurred.

Burial Vaults — A reinforced outer burial container intended to protect the casket against the weight of the earth.

Cash Overrides — Funds received based on achieving certain dollar volume sales or production targets of life insurance policies.

Cremation — The reduction of human remains to bone fragments by intense heat.

General Agency (GA) Revenues — Commissions paid to the General Agency (GA) for life insurance policies or annuities sold to preneed customers for the purpose of funding preneed funeral arrangements. The commission rate paid is determined based on the product type sold, the length of payment terms, and the age of the insured/annuitant. The commission rate is applied to the face amount of the policy purchased to determine the commission amount payable to the GA. GA revenues are recognized as funeral revenues when the insurance purchase transaction between the customer and third party insurance provider is completed.

Interment — The burial or final placement of human remains in the ground.

Lawn Crypt — An outer burial receptacle constructed of concrete and reinforced steel, which is usually pre-installed in predetermined designated areas.

Marker — A method of identifying the remains in a particular burial space, crypt, or niche. Permanent burial markers are usually made of bronze, granite, or stone.

Maturity — At the time of death. This is the point at which preneed contracts are converted to atneed contracts.

Mausoleum — An above ground structure that is designed to house caskets and cremation urns.

Perpetual Care or Endowment Care Fund — A trust fund used for the maintenance and upkeep of burial spaces within a cemetery in perpetuity.

Preneed — Funeral and cemetery arrangements made prior to the time of death.

Preneed Backlog — Future revenues from unfulfilled preneed funeral and cemetery contractual arrangements.

Production — Sales of preneed funeral and preneed or atneed cemetery contracts.

As used herein, “SCI”, “Company”, “we”, “our”, and “us” refer to Service Corporation International and companies owned directly or indirectly by Service Corporation International, unless the context requires otherwise.

(See notes to unaudited condensed consolidated financial statements)

(See notes to unaudited condensed consolidated financial statements)

(See notes to unaudited condensed consolidated financial statements)

(See notes to unaudited condensed consolidated financial statements)

     We are a provider of deathcare products and services, with a network of funeral service locations and cemeteries primarily operating in the United States and Canada. At September 30, 2007, we also owned a minority interest in funeral operations of an entity in France, which we divested in the fourth quarter of 2007. Additionally, at September 30, 2007, we owned Kenyon International Emergency Services (Kenyon), a wholly-owned subsidiary that specializes in providing disaster management services in mass fatality incidents as well as training, planning, and crisis-communications consulting services. We divested 70% of our Kenyon investment in the fourth quarter of 2007. Kenyon’s results are included in our funeral operations segment. As part of the Alderwoods transaction, we acquired Mayflower National Life Insurance Company, an insurance business that we sold in July 2007. The operations of this business through the date of sale are presented as discontinued operations in our condensed consolidated statement of operations.

     Our funeral and cemetery operations consist of funeral service locations, cemeteries, funeral service/cemetery combination locations, crematoria, and related businesses. Funeral service locations provide all professional services relating to funerals and cremations, including the use of funeral facilities and motor vehicles and preparation and embalming services. Funeral related merchandise, including caskets, burial vaults, cremation receptacles, flowers, and other ancillary products and services, is sold at funeral service locations. Cemeteries provide cemetery property interment rights, including mausoleum spaces, lots, and lawn crypts, and sell cemetery related merchandise and services, including stone and bronze memorials, markers, casket and cremation memorialization products, merchandise installations, and burial openings and closings. We also sell preneed funeral and cemetery products and services whereby a customer contractually agrees to the terms of certain products and services to be provided in the future.

     Our condensed consolidated financial statements include the accounts of Service Corporation International and all majority-owned subsidiaries. These statements also include the accounts of the funeral trusts, cemetery merchandise and services trusts, and perpetual care trusts in which we have a variable interest and are the primary beneficiary. The interim condensed consolidated financial statements are unaudited but include all adjustments, consisting of normal recurring accruals and any other adjustments, which management considers necessary for a fair presentation of the results for these periods. These condensed consolidated financial statements have been prepared in a manner consistent with the accounting policies described in our annual report on Form 10-K for the year ended December 31, 2006, unless otherwise disclosed herein, and should be read in conjunction therewith. The accompanying year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year period.

     We have reclassified certain prior period amounts to conform to the current period financial statement presentation with no effect on previously reported results of operations, financial condition, or cash flows.

     The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions as described in our Form 10-K that may affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of expenses during the reporting period. As a result, actual results could differ from these estimates.

     In March 2007, the Financial Accounting Standards Board (FASB) ratified Emerging Issues Task Force Issue No. 06-10 “Accounting for Collateral Assignment Split-Dollar Life Insurance Agreements” (EITF 06-10). EITF 06-10 provides guidance for determining a liability for the postretirement benefit obligation as well as recognition and measurement of the associated asset on the basis of the terms of a collateral assignment agreement. EITF 06-10 is effective for us beginning January 1, 2008. We are currently evaluating the impact of EITF 06-10 on our consolidated financial statements.

     In February 2007, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). This Statement permits entities to choose to measure various financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for us beginning January 1, 2008. We are currently evaluating the impact of SFAS 159 on our consolidated financial statements.

     In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective beginning January 1, 2008 for us. We are currently evaluating the impact of SFAS 157 on our consolidated financial statements.

     In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertain income tax positions recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. This interpretation requires companies to use a prescribed model for assessing the financial statement recognition and measurement of all tax positions taken or expected to be taken in its tax returns. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     We adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we recorded a $12.0 million net increase in our liability for unrecognized tax benefits, which was recorded as a $24.0 million increase to goodwill (related to uncertain tax positions acquired in the recent Alderwoods transaction) and a $12.0 million reduction in our accumulated deficit as of January 1, 2007. As of the date of adoption and after considering the impact of recognizing the net liability increase noted above, our unrecognized tax benefits totaled $257.1 million, of which $156.3 million would impact our effective tax rate, if recognized.

     In the third quarter of 2007, we recorded a net decrease in our liability for uncertain tax positions of approximately $24.5 million relating to uncertain positions taken in prior years, as a result of expiring federal, state, and foreign statute of limitations, and the sale of assets. Of the $24.5 million, $20.9 million was recorded as an adjustment of goodwill related to uncertain tax positions acquired in our Alderwoods transaction. We also recorded a $0.4 million increase in the liability for unrecognized tax benefits related to our recent Alderwoods transaction, which was recorded as a purchase price allocation adjustment. In the second quarter of 2007, we recorded a $1.3 million increase in the liability for unrecognized tax benefits due to a change in estimate, which was recorded as a purchase price allocation adjustment.

     We file numerous consolidated and separate income tax returns in the United States federal jurisdiction and in many state and foreign jurisdictions. A number of years may elapse before particular tax matters, for which we have unrecognized tax benefits, are audited and finally settled. In the United States, the Internal Revenue Service has recently completed its field work for tax years 1999 through 2002 and is currently auditing tax years 2003 through 2005. Various state and foreign jurisdictions are auditing years through

2005. It is reasonably possible that one or more of these multi-jurisdictional audits will be settled in the fourth quarter of 2007 or 2008, as some are in the final approval stage, and if favorably resolved such settlements could result in a significant reduction in the amount of our unrecognized tax benefits.

     Consistent with our historical financial reporting, we recognize potential accrued interest and penalties related to unrecognized tax benefits within our income tax expense account. We had recognized approximately $51.3 million for the payment of interest and penalties at January 1, 2007, which is included in the $257.1 million in unrecognized tax benefits noted above. During the three and nine months ended September 30, 2007, we recognized an additional $2.5 million and $7.5 million in potential interest and penalties associated with uncertain tax positions. To the extent interest and penalties are not assessed with respect to uncertain tax positions in the future, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision.

     The effective tax rates for the three and nine months ended September 30, 2007 were 32.8% and 46.5%, respectively, compared to 63.1% and 39.5% for the same periods in 2006. The lower effective tax rate for the three months ended September 30, 2007 was impacted by a net decrease in our liability for uncertain tax positions, an adjustment for tax returns filed, and state tax law changes.

     The effective tax rate for the nine months ended September 30, 2007 was impacted by permanent differences between the book and tax bases of asset dispositions, state income taxes, and newly required interest and penalties accrued on existing uncertain tax positions.

     On November 28, 2006 we completed our acquisition of Alderwoods Group, Inc. (Alderwoods). In the first nine months of 2007, we adjusted our goodwill for various purchase price allocation adjustments as follows (in thousands):

     During the three and nine months ended September 30, 2007, we recorded adjustments to our acquired Alderwoods goodwill related to our ongoing verification of the contract status and fair values of preneed cemetery and funeral deferred revenues and related trust and intangible assets. In addition, during the second quarter of 2007, we adjusted the fair values of certain assets and liabilities sold during the quarter, in relation to certain Alderwoods locations mandated for divestment pursuant to our recent FTC decree. Although we previously disclosed our finalization of fair value adjustments related to the acquired Alderwoods preneed contracts as of the end of the second quarter, we now expect to conclude our remaining analysis and record any required adjustments in the fourth quarter of 2007, due to on-going work related to the preparation and review of certain Alderwoods account reconciliations.

     Certain pre-acquisition contingencies primarily relating to legal matters existed at the date of the merger, and our final assessment required us to gather and analyze a significant amount of additional information and in so doing, to seek third party assistance. We expect to complete this assessment during the fourth quarter of 2007.

     The condensed consolidated statement of operations for the three and nine months ended September 30, 2007 includes the results of operations of Alderwoods. For the three and nine months ended September 30, 2006, the following unaudited pro forma information presents information as if the merger occurred on January 1, 2006:

     Preneed funeral receivables and trust investments, net of allowance for cancellation, represent trust investments, including investment earnings and customer receivables related to unperformed, price-guaranteed preneed funeral contracts. When we, as the primary beneficiary, receive payments from the customer, we deposit the amount required by law into the trust and reclassify the corresponding amount from Deferred preneed funeral revenues into Non-controlling interest in funeral and cemetery trusts. Amounts are withdrawn from the trusts after the contract is performed. We deposited $20.7 million and $20.1 million into and withdrew $37.8 million and $26.1 million from the trusts during the three months ended September 30, 2007 and 2006, respectively. We deposited $66.1 million and $62.0 million into and withdrew $112.0 million and $82.6 million from the trusts during the nine months ended September 30, 2007 and 2006, respectively. Cash flows related to preneed funeral contracts are presented as operating cash flows in our condensed consolidated statement of cash flows.

     The components of Preneed funeral receivables and trust investments in our condensed consolidated balance sheet at September 30, 2007 and December 31, 2006 are as follows:

     The cost and market values associated with funeral trust investments at September 30, 2007 and December 31, 2006 are detailed below. Cost reflects the investment (net of redemptions) of control holders in common trust funds, mutual funds, and private equity investments. Fair market value represents the value of the underlying securities or cash held by the common trust funds, mutual funds at published values and the estimated market value of private equity investments (including debt as well as the estimated fair value related to the contract holders’ equity in majority-owned real estate investments). The fair market value of funeral trust investments, which in the aggregate represented 102% and 103% of the related cost basis of such investments as of September 30, 2007 and December 31, 2006, respectively, was based primarily on quoted market prices at the balance sheet date. We assess our trust investments for other-than-temporary declines in fair value on a quarterly basis. As a result of our review at June 30, 2007, we recorded a $3.6 million impairment charge as a result of other-than-temporary declines in fair value related to unrealized losses on certain private equity and other investments. The impairment charges are recognized as investment losses and offset by interest income related to non-controlling interest in funeral trust investments in Other (expense) income, net in our condensed consolidated statement of operations. As a result of our most recent review at September 30, 2007, we recorded no additional impairment charges. See Note 9 to the condensed consolidated financial statements for further information related to our non-controlling interest in funeral trust investments.

     Maturity dates of the fixed income securities range from 2007 to 2038. Maturities of fixed income securities at September 30, 2007 are estimated as follows:

     During the three months ended September 30, 2007, purchases and sales of available-for-sale securities included in trust investments were $342.0 million and $379.6 million, respectively. These sale transactions resulted in $54.9 million and $10.7 million of realized gains and realized losses, respectively, for the three months ended September 30, 2007. During the three months ended September 30, 2006, purchases and sales of available-for-sale securities included in trust investments were $171.1 million and $197.5 million, respectively. These sale transactions resulted in $15.3 million and $13.7 million of realized gains and realized losses, respectively for the three months ended September 30, 2006.

     During the nine months ended September 30, 2007, purchases and sales of available-for-sale securities included in trust investments were $653.9 million and $575.1 million, respectively. These sale transactions resulted in $87.7 million and $22.8 million of realized gains and realized losses, respectively, for the nine months ended September 30, 2007. During the nine months ended September 30, 2006, purchases and sales of available-for-sale securities included in trust investments were $325.8 million and $357.2 million, respectively. These sale transactions resulted in $49.1 million and $25.5 million of realized gains and realized losses, respectively for the nine months ended September 30, 2006.

     Earnings from all trust investments are recognized in current funeral revenues when the service is performed, merchandise is delivered, or upon cancellation of the funeral contract. Only the amount we are entitled to retain is recognized when a contract is cancelled. Recognized earnings (realized and unrealized) related to these trust investments were $11.2 million and $7.6 million for the three months ended September 30, 2007 and 2006, respectively. Recognized earnings (realized and unrealized) related to these trust investments were $33.3 million and $26.6 million for the nine months ended September 30, 2007 and 2006, respectively.

     Preneed cemetery receivables and trust investments, net of allowance for cancellation, represent trust investments, including investment earnings, and customer receivables, net of unearned finance charges, for contracts sold in advance of when the property interment rights, merchandise, or services are needed. When we, as the primary beneficiary, receive payments from the customer, we deposit the amount required by law into the trust, remove the corresponding amount from Deferred preneed cemetery revenues, and record the amount into Non-controlling interest in funeral and cemetery trusts. Amounts are withdrawn from the trusts when the contract is performed. We deposited $30.1 million and $27.4 million into and withdrew $40.1 million and $27.5 million from the trusts during the three months ended September 30, 2007 and 2006, respectively. We deposited $89.3 million and $91.7 million into and withdrew $121.3 million and $68.7 million from the trusts during the nine months ended September 30, 2007 and 2006, respectively. Cash flows related to preneed cemetery contracts are presented as operating cash flows in our condensed consolidated statement of cash flows.

     The components of Preneed cemetery receivables and trust investments in the condensed consolidated balance sheet at September 30, 2007 and December 31, 2006 are as follows:

     The cost and market values associated with the cemetery merchandise and service trust investments at September 30, 2007 and December 31, 2006 are detailed below. Cost reflects the investment (net of redemptions) of control holders in common trust funds, mutual funds, and private equity investments. Fair market value represents the value of the underlying securities or cash held by the common trust funds, mutual funds at published values, and the estimated market value of private equity investments (including debt as well as the estimated fair value related to the contract holders’ equity in majority-owned real estate alternative investments). The fair market value of cemetery trust investments, which in the aggregate represented 105% and 106% of the related cost basis of such investments as of September 30, 2007 and December 31, 2006, was based primarily on quoted market prices at the balance sheet date. We assess our trust investments for other-than-temporary declines in fair value on a quarterly basis. As a result of our review at June 30, 2007, we recorded a $3.2 million impairment charge as a result of other than temporary declines in fair value related to unrealized losses on certain private equity and other investments. The impairment charges are recognized as investment losses and offset by interest income related to non-controlling interest in cemetery trust investments in Other (expense) income, net in our condensed consolidated statements of operations. As a result of our most recent review at September 30, 2007, we recorded no additional impairment charges. See Note 9 to the condensed consolidated financial statements for further information related to our non-controlling interest in cemetery trust investments.

     Maturity dates of the fixed income securities range from 2007 to 2038. Maturities of fixed income securities at September 30, 2007 are estimated as follows:

     During the three months ended September 30, 2007, purchases and sales of available-for-sale securities included in trust investments were $448.4 million and $461.2 million, respectively. These sale transactions resulted in $66.0 million and $10.9 million of realized gains and realized losses, respectively, for the three months ended September 30, 2007. During the three months ended September 30, 2006, purchases and sales of available-for-sale securities included in trust investments were $321.6 million and $344.9 million, respectively. These sale transactions resulted in $24.5 million and $25.4 million of realized gains and realized losses, respectively for the three months ended September 30, 2006.

     During the nine months ended September 30, 2007, purchases and sales of available-for-sale securities included in trust investments were $805.4 million and $664.8 million, respectively. These sale transactions resulted in $102.3 million and $23.3 million of realized gains and realized losses, respectively, for the nine months ended September 30, 2007. During the nine months ended September 30, 2006, purchases and sales of available-for-sale securities included in trust investments were $509.0 million and $542.3 million, respectively. These sale transactions resulted in $59.0 million and $39.2 million of realized gains and realized losses, respectively for the nine months ended September 30, 2006.

     Earnings from all trust investments are recognized in current cemetery revenues when the service is performed or the merchandise is delivered, or upon cancellation of the cemetery contract. Only the amount we are entitled to retain is recognized when a contract is cancelled. Recognized earnings (realized and unrealized) related to these trust investments were $8.9 million and $3.5 million for the three months ended September 30, 2007 and 2006, respectively. Recognized earnings (realized and unrealized) related to these trust investments were $18.7 million and $10.2 million for the nine months ended September 30, 2007 and 2006, respectively.

     We are required by state or provincial law to pay into perpetual care trusts a portion of the proceeds from the sale of cemetery property interment rights. As the primary beneficiary of the trusts, we consolidate the perpetual care trust investments with a corresponding amount recorded asNon-controlling interest in perpetual care trusts. We deposited $5.7 million and $7.0 million into the trusts and withdrew $4.2 million and $9.2 million from the trusts during the three months ended September 30, 2007 and 2006,

respectively. We deposited $20.3 million and $18.2 million into the trusts and withdrew $22.9 million and $38.5 million from the trusts during the nine months ended September 30, 2007 and 2006, respectively. Cash flows related to cemetery perpetual care contracts are presented as operating cash flows in our condensed consolidated statement of cash flows.

     The cost and market values associated with trust investments held in perpetual care trusts at September 30, 2007 and December 31, 2006 are detailed below. Cost reflects the investment (net of redemptions) of control holders in common trust funds, mutual funds, and private equity investments. Fair market value represents the value of the underlying securities or cash held by the common trust funds, mutual funds at published values, and the estimated market value of private equity investments (including debt as well as the estimated fair value related to the contract holders’ equity in majority-owned real estate investments). The fair market value of perpetual care trusts, which in the aggregate represented 102% and 105% of the related cost basis of such investments as of September 30, 2007 and December 31, 2006, respectively, was based primarily on quoted market prices at the balance sheet date. We assess our trust investments for other-than-temporary declines in fair value on a quarterly basis. As a result of our review at June 30, 2007, we recorded a $1.2 million impairment charge as a result of other than temporary declines in fair value related to unrealized losses on certain private equity and other investments. The impairment charges are recognized as investment losses and offset by interest income related to non-controlling interest in perpetual care trust investments in Other (expense) income, net in our condensed consolidated statements of operations. As a result of our most recent review at September 30, 2007, we recorded no additional impairment charges. See Note 9 to the condensed consolidated financial statements for further information related to our non-controlling interest in perpetual care trust investments.

     Maturity dates of the fixed income securities range from 2007 to 2038. Maturities of fixed income securities at September 30, 2007 are estimated as follows:

     During the three months ended September 30, 2007, purchases and sales of available-for-sale securities in the perpetual care trusts were $405.6 million and $247.3 million, respectively. These sale transactions resulted in $6.6 million and $5.7 million of realized gains and realized losses, respectively. During the three months ended September 30, 2006, purchases and sales of available-for-sale securities in the perpetual care trusts were $395.4 million and $421.4 million, respectively. These sales transactions resulted in $20.8 million and $17.4 million of realized gains and realized losses, respectively.

     During the nine months ended September 30, 2007, purchases and sales of available-for-sale securities in the perpetual care trusts were $632.9 million and $341.4 million, respectively. These sale transactions resulted in $31.0 million and $11.9 million of realized gains and realized losses, respectively. During the nine months ended September 30, 2006, purchases and sales of available-for-sale securities in the perpetual care trusts were $729.8 million and $736.9 million, respectively. These sales transactions resulted in $32.2 million and $25.2 million of realized gains and realized losses, respectively.

     Distributable earnings from these perpetual care trust investments are recognized in current cemetery revenues to the extent of qualifying cemetery maintenance costs. Recognized earnings related to these perpetual care trust investments were $10.3 million and $9.1 million for the three months ended September 30, 2007 and 2006, respectively. Recognized earnings related to these perpetual care trust investments were $35.6 million and $32.7 million for the nine months ended September 30, 2007 and 2006, respectively.

     We consolidate the merchandise and service trusts associated with our preneed funeral and cemetery activities as a result of the implementation of FIN 46R. Although FIN 46R requires the consolidation of the merchandise and service trusts, it does not change the legal relationships among the trusts, our customers or us. The customers are the legal beneficiaries of these merchandise and service trusts, and therefore, their interests in these trusts represent a non-controlling interest in subsidiaries.

     The components of Non-controlling interest in funeral and cemetery trusts and Non-controlling interest in perpetual care trusts in our condensed consolidated balance sheet at September 30, 2007 and December 31, 2006 are detailed below.

     The components of Other (expense) income, net in our condensed consolidated statement of operations for the three and nine months ended September 30, 2007 and 2006 are detailed below. See Notes 6 through 8 to the condensed consolidated financial statements for further discussion of the amounts related to the funeral, cemetery and perpetual care trusts.