Service Corporation International

Service Corporation International

Service Corporation International (SCI) has experienced tremendous growth through

numerous acquisitions. The concern is whether or not the market understands SCI’s acquisition
strategy and whether or not they believe in a “high-growth company in a low-growth industry”.
Additionally, there is some concern surrounding how SCI plans to continue funding their growth,
whether it is through issuing long-term debt or equity. Ultimately, SCI must find a balance
between maintaining their growth and managing the risk of financial distress.

Regarding how SCI makes money in the death care industry, their main strategy is “cluster”
strategy. This strategy was implemented through acquisitions of its competitors. Under the
cluster strategy, funeral homes in single location could share the costs of cremation,
transportation, personnel, and inventory, which leads to reduction of fixed costs. In addition,
through sharing resources by cluster strategy, SCI succeeded to enhance purchasing power.
Consequently, it also reduced variable costs of caskets and hearses. SCI also succeeded to
enhance revenue by providing a wide variety of products and services than its competitors could
provide. For example, SCI provided higher grade merchandise such as upgraded casket room
with attractive displays. Overall, the net effect of cluster strategy brought a dramatic change in
cost structure and an increase of revenue. In order to dig into its profitability, we calculated
ROA. Here we used operating profit and total assets for calculating ROA in order to eliminate
the impact of debt amount. From ROA perspective, as you can see in Exhibit B, SCI’s strategy
did not work efficiently to improve its profitability and its ROA deteriorated each year.
Consequently, its ROA was below the competitors’ weighted average ROA as of the end of
1994. Therefore, from profitability perspective, we are slightly doubtful that this strategy worked
well. In addition, speaking of sustainability, we are also doubtful of the statement that cluster
strategy is sustainable. Of course, as the case mentions, there were acquisition opportunities
around the world as of 1995, so we can say that SCI can continue its existing strategy for a
while. However, there would be limitations for finding attractive targets of acquisition in the end.
Thus, we would conclude that sustainability of cluster strategy is doubtful.

SCI’s acquisition strategy needs to be placed under a value creation microscope as well.
Through its various purchases, SCI managed to increase international revenues from 0% to 40%
in a very short period of time, while also managing to post large revenue growth domestically.
However, this expansion was being achieved at a great cost; mainly arising from the feasibility
of being able to sustain double digit growth while attempting to limit debt financing. Other
factors also played a significant role when trying to assess the prospects of value creation from
acquisitions in the long run as several trends were beginning to shift dramatically in the funeral
home business. Among these, the rise of another extremely popular alternative for body disposal;
cremations. This shift not only limited the expansion for SCI as the population grew in size and
age, but it also limited revenue streams from casket, flowers, urns, embalming, transportation
and visitation services that traditional funeral homes were used to selling. Moreover, as more
funeral homes were being built, competition on price was becoming fiercer as more of these
establishments realized that customers were more price sensitive than they had anticipated. The
combination of all these elements make it very hard to justify, from a value creation standpoint,
that SCI’s acquisition strategy creates any value domestically or internationally. It is near
impossible for any firm to sustain a 20% YoY growth in an industry with shifting trends away
from the underlying business model and strategy. Additionally, the costs incurred from all the
business lines acquired during the vertical integration stage of SCI (i.e. flower shops and
manufacturers of caskets, embalming fluids, burial clothing and funeral home furniture), that will
no longer be used at capacity due to industry shifts, will continue to apply downward pressure on
revenues growing at a decreasing rate. Furthermore, taking into account the high costs of capital
due to the firm’s high leverage ratio makes it extremely difficult to conclude that the firm is
creating any value by continuing to devour more assets in their quest to become “the Walmart of
funeral homes”.

When assessing how much debt SCI should have in its capital structure, we must examine
how effectively they are able to service those debt payments with the income from their
operations. Per Exhibit 11 in the case, at the end of 1994, SCI has an interest coverage ratio of
3.61, which is the second highest compared to their competition. This ratio bodes well at putting
potential lenders at ease as SCI has demonstrated that they are capable of servicing the debt that
they currently have. Considering that the nature of their business has been able to generate them
stable and significant cash flows, SCI could in fact increase the amount of debt held within their
capital structure. By the end of 1994, the average long-term debt to total capital for death care
consolidators was 39%. Comparing this average to SCI’s long-term debt to total capital ratio of
53%, SCI is certainly more levered than their competition. On the other hand, SCI has enormous
scale compared to even the closest competing company. With early results of the recent
acquisitions flashing positive growth, we can assume that SCI can successfully manage a capital
structure of 65-70% given that they can maintain a debt rating of BBB. If SCI’s debt rating is
downgraded, the resulting cost of debt may be too high and SCI would stand to face significant
financial distress risk. This would suggest that SCI should begin to pick and choose acquisition
targets with extreme caution and not just acquire additional companies for the sake of
acquisition.

While the risks of financial distress increases as SCI continues to add additional debt, if they
continue to utilize acquisitions as their method of growth, issuance of debt would be the best way
to fund the future investments. With the death rate growing at less than 1% per year, issuing
equity to fund acquisitions may cause the market to respond adversely as they become skeptical
about the potential returns that SCI can realistically obtain. With stable and sizable earnings, SCI
should be able to service any additional debt they decide to issue while maintaining their ability
to growth given that they choose future acquisitions carefully.

As the corporate manager of SCI, I would look at profitability as a way to measure the value
driven from this growth strategy. Profitable firms should maintain a higher Market/Book ratio
and, as a corporate manager, I can convince investors that this strategy is driving profitability by
selling the high returns given the current amount of equity. To find the Market/Book ratio, I
compare the Return-on-Equity (ROE) and the Cost of Equity (Ke) to find the growth ratio. I find
ROE by taking the current Net Income ($131,045) over Total Equity ($1,196,622) which can be
found on Exhibits 8 and 7. The ROE is 19.18%. I find Ke by first finding the Equity Beta for SCI
(see Exhibit A). I then use CAPM to find Ke at 16.09%. The ROE/Ke ratio is 1.19. Since the
Market/Book ratio is greater than 1, I would convince investors that the firm is currently
generating higher returns per dollar of equity which shows that the current growth strategy is
working.

As an investor, I would acknowledge the assumption that this growth strategy carries an
impending expiration that the company cannot sustain this strategy because other firms will see
the success and begin to mimic the same strategy. I would use the assumption that there exists an
advantage horizon for this firm and the cash flows should be looked at as an annuity rather than a
perpetuity. To do this, I take the Market/Book ratio with an advantage horizon of “n” years.
According to Fruhan’s research found from the “Note on Value Drivers” article, firms typically
enjoyed the highest ROE in 5-10 years so we’ll use 5 years as our most conservative estimate
(Etsy p.4). Using the same ROE and Ke as in the current assessment of the Market/Book ratio,
we plug those numbers into the following equation:

Market/Book =

= 1.055

Note, the Market/Book ratio is much lower with the advantage taken into account and shows
that the firm is generating less normal returns than projected from a profitability standing. And
this is only assuming that the firm can maintain this advantage for the next 5 years. An estimate
of 2 years puts the Market/Book ratio at .99 which implies that the firm will generate negative
abnormal returns during this period. Overall, the decision to buy into this strategy will depend on
how long the investor assumes that SCI will maintain this competitive advantage.

For question 1 regarding how SCI makes money in the death care industry, their main strategy is
“cluster” strategy. This strategy was implemented through acquisitions of its competitors. Under
the cluster strategy, funeral homes in single location could share the costs of cremation,
transportation, personnel, and inventory, which leads to reduction of fixed costs. In addition,
through sharing resources by cluster strategy, SCI succeeded to enhance purchasing power.
Consequently, it also reduced variable costs of caskets and hearses. SCI also succeeded to
enhance revenue by providing a wide variety of products and services than its competitors could
provide. For example, SCI provided higher grade merchandise such as upgraded casket room
with attractive displays. Overall, the net effect of cluster strategy brought a dramatic change in
cost structure and an increase of revenue. In order to dig into its profitability, we calculated
ROA. Here we used operating profit and total assets for calculating ROA in order to eliminate
the impact of debt amount. From ROA perspective, as you can see in Exhibit B, SCI’s strategy
did not work efficiently to improve its profitability and its ROA deteriorated each year.
Consequently, its ROA was below the competitors’ weighted average ROA as of the end of
1994. Therefore, from profitability perspective, we are slightly doubtful that this strategy worked
well. In addition, speaking of sustainability, we are also doubtful the statement that cluster
strategy is sustainable. Of course, as the case mentions, there were acquisition opportunities
around the world as of 1995, so we can say that SCI can continue its existing strategy for a
while. However, there would be limitations for finding attractive target of acquisition in the end.
Thus, we would conclude that sustainability of cluster strategy is doubtful.

Exhibit A:

Exhibit B: SCI’S ROA (1992, 1993, 1994) relative to competitors’ weighted average ROA in 1994

Reference

Esty, Benjamin C. "Note on Value Drivers." Harvard Business School Background Note 297-082, April
1997.