Service Corporation International - 10-Q quarterly report FY

 

(Exact name of registrant as specified in its charter)

713-522-5141
(Registrant’s telephone number, including area code)

None
(Former name, former address, or former fiscal year, if changed since last report)

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 May 5, 2007 was 293,976,436 (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. We also own a minority interest in funeral operations of an entity in France. Additionally, we own Kenyon International Emergency Services (Kenyon), a subsidiary that specializes in providing disaster management services in mass fatality incidents as well as training, planning, and crisis-communications consulting services. 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 for which we have entered into a definitive agreement to sell. The operations of this business are presented as discontinued operations in our condensed consolidated statement of operations and as assets and liabilities of discontinued operations on our condensed consolidated balance sheet.

     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 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.

     The Company has 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 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 would impact our effective tax rate, if recognized.

     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 various state and foreign jurisdictions are auditing years through 2004. It is reasonably possible that one or more of these multi-jurisdictional audits will be settled in 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 historical financial reporting, we recognize potential accrued interest and penalties related to unrecognized tax benefits within our income tax expense account. We have 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 months ended March 31, 2007, we recognized an additional $2.4 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.

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

     The condensed statement of operations for the three months ended March 31, 2007 includes the results of operations of Alderwoods. For the three months ended March 31, 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 $18.0 million and $19.1 million into trusts during the three months ended March 31, 2007 and 2006, respectively. We withdrew $35.0 million and $30.5 million from trusts during the three months ended March 31, 2007 and 2006, respectively. Cash flows from 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 March 31, 2007 and December 31, 2006 are as follows:

     The cost and market values associated with funeral trust investments at March 31, 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 103% of the related cost basis of such investments as of March 31, 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. Any impairment charges taken as a result of other-than-temporary declines in fair value 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 reviews at March 31, 2007 and December 31, 2006, we recorded no impairment charges or adjustments for unrealized losses. See Note 8 to the condensed consolidated financial statements for further information related to 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 March 31, 2007 are estimated as follows:

     During the three months ended March 31, 2007, purchases and sales of available-for-sale securities included in trust investments were $227.4 million and $68.0 million, respectively. These sale transactions resulted in $9.5 million and $6.4 million of realized gains and realized losses, respectively, for the three months ended March 31, 2007. During the three months ended March 31, 2006, purchases and sales of available-for-sale securities included in trust investments were $97.1 million and $95.8 million, respectively. These sale transactions resulted in $18.4 million and $5.4 million of realized gains and realized losses, respectively for the three months ended March 31, 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 amount we are entitled to retain. Recognized earnings (realized and unrealized) related to these trust investments were $11.3 million and $10.0 million for the three months ended March 31, 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 $28.6 million and $32.2 million into and withdrew $37.0 million and $21.1 million from the trusts during the three months ended March 31, 2007 and 2006, respectively. Cash flows from 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 March 31, 2007 and December 31, 2006 are as follows:

     The cost and market values associated with the cemetery merchandise and service trust investments at March 31, 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 106% of the related cost basis of such investments as of March 31, 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. Any impairment charges taken as a result of other-than-temporary declines in fair value are recognized as investment losses and offset by interest income related to non-controlling interest in cemetery trust investments inOther (expense) income, net in our condensed consolidated statements of operations. As a result of our reviews at March 31, 2007 and December 31, 2006, we recorded no impairment charges or

adjustments for unrealized losses. See Note 8 to the condensed consolidated financial statements for further information related to 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 March 31, 2007 are estimated as follows:

     During the three months ended March 31, 2007, purchases and sales of available-for-sale securities included in trust investments were $244.3 million and $108.8 million, respectively. These sale transactions resulted in $13.3 million and $6.9 million of realized gains and realized losses, respectively, for the three months ended March 31, 2007. During the three months ended March 31, 2006, purchases and sales of available-for-sale securities included in trust investments were $106.7 million and $95.3 million, respectively. These sale transactions resulted in $16.8 million and $6.5 million of realized gains and realized losses, respectively for the three months ended March 31, 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 amount we are entitled to retain. Recognized earnings (realized and unrealized) related to these trust investments were $4.6 million and $3.4 million for the three months ended March 31, 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 $4.1 million and $5.3 million into trusts and withdrew $8.4 million and $7.9 million from trusts during the three months ended March 31, 2007 and 2006, respectively. Cash flows from 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 March 31, 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 104% and 105% of the related cost basis of such investments as of March 31, 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. Any impairment charges taken as a result of other-than-temporary declines in fair value 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 reviews at March 31, 2007 and December 31, 2006, we recorded no impairment charges or adjustments for unrealized losses. See Note 8 to the condensed consolidated financial statements for further information related to 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 March 31, 2007 are estimated as follows:

     During the three months ended March 31, 2007, purchases and sales of available-for-sale securities in the perpetual care trusts were $168.7 million and $42.4 million, respectively. These sale transactions resulted in $5.5 million and $1.2 million of realized gains and realized losses, respectively. During the three months ended March 31, 2006, purchases and sales of available-for-sale securities in the perpetual care trusts were $188.5 million and $165.2 million, respectively. These sales transactions resulted in $9.0 million and $3.1 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 $12.3 million and $8.4 million for the three months ended March 31, 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 March 31, 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 months ended March 31, 2007 and 2006 are detailed below. See Notes 5 through 7 to the condensed consolidated financial statements for further discussion of the amounts related to the funeral, cemetery and perpetual care trusts.

     Debt as of March 31, 2007 and December 31, 2006 was as follows:

     Current maturities of debt at March 31, 2007 were comprised primarily of the untendered portion of our 6.5% notes due March 2008 (see further discussion below in Debt Extinguishments and Reductions), our 6.875% notes due October 2007, convertible debentures, and capital leases. Our consolidated debt had a weighted average interest rate of 7.13% at March 31, 2007 and 7.30% at December 31, 2006. Approximately 85% and 82% of the total debt had a fixed interest rate at March 31, 2007 and December 31, 2006, respectively.

     We entered into a new five-year $450 million bank credit facility in November 2006 with a syndicate of financial institutions, comprised of a $300 million revolving credit facility and a $150 million term loan facility, including a sublimit of $175 million for letters of credit. The term loan was funded under the credit facility. We repaid $50 million of the term loan in December 2006 and the remaining $100 million in the first quarter of 2007. The $300 million revolving credit facility remains unfunded.

     The bank credit facility matures in November 2011. As of March 31, 2007, we have used the facility to support $59.1 million of letters of credit. The credit facility provides us with flexibility for working capital cash, if needed and is guaranteed by our domestic subsidiaries. The subsidiary guaranty is a guaranty of payment of the outstanding amount of the total lending commitment. It covers the term of the credit facility, including extensions, and totaled a maximum potential amount of $59.1 million at March 31, 2007. The credit facility contains certain financial covenants, including a minimum interest coverage ratio, a maximum leverage ratio, maximum capital expenditure limitations, and certain cash distribution and share repurchase restrictions. As of March 31, 2007, we were in compliance with all of our debt covenants. We also pay a quarterly fee on the unused commitment, which ranges from 0.25% to 0.50%.

     Subsequent to March 31, 2007, we completed a private offering of $400 million aggregate principal unsecured senior notes, consisting of $200 million aggregate principal amount of 6.75% Senior Notes due 2015 and $200.0 million aggregate principal amount of 7.50% Senior Notes due 2027. We are entitled to redeem the notes at any time by paying a make-whole premium. The notes are subject to the provisions of our Senior Indenture dated as of February 1, 1993, as amended, which includes covenants limiting, among other things, the creation of liens securing indebtedness and sale-leaseback transactions. We used the net proceeds from the offering to fund the closing of the tender offers for our 6.50% Notes due 2008 and 7.70% Notes due 2009 as further discussed below and for general corporate purposes. Under the terms of the registration rights agreement entered into in connection with the offerings of the notes, we

are required to file a registration statement with the SEC with respect to an offer to exchange the notes for a series of registered notes with substantially identical terms.

     In the first quarter of 2007, we repaid $100 million aggregate principal amount of our term loan. As a result of this transaction, we recognized a loss of $2.4 million recorded in Loss on early extinguishment of debt, net in our consolidated statement of operations which represents the write-off of unamortized deferred loan costs of $1.7 million and a $0.7 million premium to early extinguish the debt.

     On March 23, 2007, we commenced a cash tender offer for any and all of our 6.50% Notes due 2008 (total outstanding principal amount of $195 million) and our 7.70% Notes due 2009 (total outstanding principal amount of $202.6 million). At the end of the early participation period, we had received tenders from holders of approximately $149.1 million aggregate principal amount of our 6.50% Notes and approximately $173.8 million aggregate principal amount of our 7.70% Notes. We received additional tenders of approximately $0.7 million at the end of the offer period. The offer expired on April 20, 2007. In connection with the settlement of these instruments, we will record a Loss on early extinguishment, net of approximately $12.2 million in the second quarter of 2007.

     In the first quarter of 2007, we acquired $17.4 million of transportation vehicles using capital leases.

     The components of net periodic pension plan benefit cost for the three months ended March 31 were as follows:

     During the third quarter of 2006, we initiated the process to terminate our cash balance plan.

     We utilize the Black-Scholes valuation model for estimating the fair value of our stock options. This model allows the use of a range of assumptions related to volatility, the risk-free interest rate, the expected life, and the dividend yield. The fair values of our stock options are calculated using the following weighted average assumptions for the three months ended March 31, 2007:

     The following table sets forth stock option activity for the three months ended March 31, 2007:

     Restricted share activity for the three months ended March 31, 2007 was as follows:

     Our components of Accumulated other comprehensive income are as follows: