Service Corporation International
NYSE:SCI
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Service Corporation International
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Welcome to the Fourth Quarter 2017 Service Corporation International Earnings Conference Call. My name is Victoria and I will be your operator for today’s call. At this time, all participants are in listen-only mode and later we will conduct a question-and-answer session. Please note that this conference is being recorded. And I will now turn the call over to SCI management. You may begin.
Good morning. This is Debbie Young, Director of Investor Relations at SCI. We want to apologize for the technical difficulties this morning. The webcast provider was not able to get the phone line that we have secured working. So, we apologize for the delay. Sorry for the inconvenience. And we will get started now.
Before I begin with the Safe Harbor language, I did also want to mention to you that many of you have seen we are going to host an Investor Day next week in New York on Tuesday afternoon. If you would like to attend, please reach out to me via phone or e-mail and I can get you registered. So with that, let me just quickly run through our Safe Harbor language.
The comments made by our management team today will include statements that are not historical and are forward-looking. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. These risks and uncertainties include, but are not limited to, those factors identified in our press release and in our filings with the SEC that are available on our website. In today’s comments, we may also refer to certain non-GAAP measurements such as adjusted EPS, adjusted operating cash flow and free cash flow. A reconciliation of these measurements to the appropriate measures calculated in accordance with GAAP is provided on our website and in our press release and 8-K that were filed yesterday.
With that behind us, I will now turn it over to Tom Ryan, SCI’s Chairman and CEO.
Thank you, Debbie. Hello, everyone and happy Valentine’s Day. We appreciate you joining us on the call today and I’d like to start this morning by reflecting on our accomplishments for the year 2017, then I will get into an analysis of the fourth quarter and end with some color on our outlook for 2018.
So, first some observations on the year 2017, it was an exceptional year from a financial performance perspective. And we finished with a solid fourth quarter. From an SCI family perspective, it was an incredibly challenging one considering the catastrophic events that occurred in a number of our communities in which we live and serve. It’s been a year of significant headwinds yet despite the multiple hurricanes, the extensive wildfires, Vegas tragedy and other various challenges our team proved just how much can be accomplished when we all come together. I was so proud to watch how you all reacted by supporting each other and your community. My heartfelt thanks goes out to all of you for continuing to provide compassion to our client families, day in and day out even as you are dealing with your own personal tragedies You guys are real pros and I am so proud to be such be a part of such an extraordinary team.
Now, back to the financial stuff, during the year 2017, we generated an impressive $1.55 of adjusted earnings per share, which exceeded the top end of our adjusted guidance range. This amount included a little more than $0.09 of excess tax benefits from a new accounting standard for share-based compensation that was not reflected in the prior year and had the effect of lowering our tax rate in 2017. Additionally, we also enjoyed an even lower tax rate in 2017 primarily as a result of some nice work from our tax team, which improved earnings per share by an additional $0.05. I am going to offset these $0.05 against the $0.05 of favorable special items in 2016’s earnings per share.
So in trying to simplify and analyze the operating growth rate for 2017, I would use $1.46 for 2017, which is the $1.55 minus the $0.09 of excess tax benefits when we compare it to our adjusted earnings per share of $1.29 reported in 2016. So, this reflects a $0.17 or 13.1% increase in operational earnings per share growth even after absorbing the negative impact from the hurricanes and it’s slightly higher than our long-term guidance range of 8% to 12%. Funeral operating profits improved over $14 million for the year 2017 and we expanded operating margin percentage by 70 basis points to 20.3%. We experienced solid funeral volume growth for the year of almost 1% without a flu impact. While average revenue per case was relatively flat as the 90 basis point increase in cremation mix and the relatively higher volumes from SCI Direct offset slight organic growth in pricing at the customer level. Although small in contribution compared to core revenues SCI Direct continues to grow revenues in the mid to high single-digits in non-funeral home operating revenue as well as recognized pre-need revenue.
Cemetery operating profits improved by over $33 million for the year and we expanded operating margin percentage by 140 basis points to 28.6%. We experienced solid revenue growth of 5.1% for the year which was primarily driven by the success of our pre-need selling efforts. This resulted in property revenues of approximately 5% growth as well as merchandise and service revenues exceeding 6%. This growth was slightly offset by a $5 million reduction in eternal care fund revenues as anticipated due to some special earnings and cash receipts in the prior year. These operating segment improvements when combined with the negative impact of increases in general and administrative expense and interest expense still delivered approximately 7% of the 13% earnings per share growth, slightly above our long-term guidance range of 4% to 6% growth for the base business. The remaining 6% earnings per share growth came from the impact of acquisition contributions and the reduction in share count.
Our adjusted cash flows results were also very strong for the year $554 million and exceeded the high end of our adjusted guidance range. Eric can speak in more detail about our cash flow in just a moment. From a capital allocation standpoint, during the full year of 2017, we returned an impressive $308 million to our shareholders through dividends and share repurchases. This should demonstrate to you our belief in the future strength of our business platform and the cash flow growth we expect to generate in the foreseeable future. Additionally for the year, we invested $98 million in accretive acquisitions and the construction of several new funeral homes. And finally in 2017, our shareholders received an impressive 34% total shareholder return versus the 22% return for the S&P 500, continuing the company’s track record of delivering a significant premium to the S&P 500 return when you look at the 1-year, 3-year, 5-year and 10-year periods ending December 2017.
Now for an overview of the quarter, we reported an adjusted earnings per share of $0.50 for the fourth quarter which is the $0.03 or 6% increase over the prior year quarter. There are a lot of moving parts of this, so I am going to try to break it down as simply as I can. Within the $0.50 is a $0.05 benefit in the quarter related to a non-cash benefit in our tax provision resulting primarily from various discrete items in hurricane tax credits. Excluding the $0.05 impact, our adjusted earnings per share would have been $0.45 which was in line with consensus estimate. This $0.45 is absorbing about a net $0.015 of additional expenses related to the hurricanes that occurred in September. Absent the hurricane costs and the tax savings, we believe from a pure operational perspective, we are generally in line with the prior year quarter of $0.47.
So from an operating perspective solid improvements in our funeral segment were for the most part offset by decreased cemetery profits. Recall, last year we had a couple of big construction projects that were completed in the fourth quarter of 2016 resulting in a significant amount of GAAP revenues and profits being recognized out of deferred revenue. This did not reoccur at those levels in our 2017 fourth quarter. However, cash flows were strong as cash profits from both funeral and cemetery. Remember the cemetery revenue declined as non-cash from constructed revenues. These cash flows were further enhanced by improved working capital performance.
Now, shifting to some more detail around the funeral operating performance during the quarter. Our comparable funeral segment performed very well with revenue growing by almost $10 million or 2.2% compared to the prior year period. Comparable core operating revenue accounted for $5.8 million of that growth as core services performed grew by 0.8%, again without an impact from the flu as far as we can tell and average revenue per case grew by 0.7%, absorbing a 90 basis point increase in the core cremation rate.
Total non-funeral home operating revenue accounted for another $1.1 million of our revenue growth. Comparable services performed as well as average revenue per case equally contributed to the 10% growth in the segment. Recognized preneed revenues were responsible for the remaining funeral revenue growth as it grew by $2.8 billion or 11%, comparable funeral operating profit increased by $8.4 million for the quarter on a $9.9 million revenue increase for about an incremental margin of 85%. This is what we should expect in such a high fixed cost business. This resulted in a 21% funeral operating margin percentage, which increased to 140 basis points over the prior year quarter. Finally, from a preneed funeral sales production perspective, which gets deferred into our backlog, we produced almost $200 million, which was an increase of $2.7 million or 1.4% over the prior year quarter.
Now, moving on to cemetery operations for the quarter. Comparable cemetery revenue declined $6.9 million or 2% during the fourth quarter as compared to the 2016 quarter. This reported decline was primarily caused by an $11.4 million decrease in new construction revenues as compared to the prior year quarter, which included the completion of a few unusually large projects. During the first 9 months of 2017, we experienced a higher recognition rate for cemetery property sales versus 2016 as we had more constructed inventory to sell. During 9 months, our property sales production grew at 7%, while our property revenue recognized grew at 10%. This again is just timing and the fourth quarter regulated the results for the year. For the entire year, cemetery revenue and even more specifically property revenue and preneed property sales production, all grew at about 5%, which was in line with our expectations. Preneed cemetery sales production for the quarter grew by just around $2 million or 1%. While this is not a growth rate we are excited about, the muted growth percentage was due to a strong fourth quarter 2016 comparison as well as the impact from the sales disruption in the markets impacted by the hurricane. For the year, preneed cemetery sales production grew 5.3%, which was in line with our expectations.
Finally, cemetery operating profits in the quarter declined about $7 million or 140 basis points. This decline is primarily a result of the new construction property revenue decrease I just described coupled with normal increases in our high fixed cost structure. From a cash flow perspective, cemetery cash margins actually increased as the revenue shortfall versus the prior year was a non-cash revenue item.
Now, let’s shift to discussion about 2018. Our guidance for adjusted earnings per share in 2018 is $1.72 to $1.90. The midpoint of our guidance of $1.81 represents a 17% increase over adjusted 2017 earnings per share of $1.55. This increase includes the favorable 2018 impacts from a new accounting standard as well as the new tax reform act. It also includes the increased expense of a decision we have taken regarding investing some of the cash savings generated from the new tax reform act by increasing the base pay of certain of our critical customer facing associates.
So first as a result of implementing the new accounting standard related to revenue recognition, we believe our earnings per share will benefit by an estimated $0.04 as we begin deferring some incremental selling costs that are currently expensed when incurred. Second, our tax rate is expected to be reduced to 24% to 26% in 2018 as a result of the tax reform act. This reduction in our provision is a $0.135 benefit slightly offset by an anticipated $0.035 reduction of excess tax benefits related to the expected exercise of stock options during 2018, so on a net basis we had a $0.10 anticipated benefit from a lower tax rate. Finally and in light of the almost $20 million of cash tax savings over 2017 related to the tax reform act, we expect to invest approximately $7 million or $0.025 which will have a negative earnings impact to salary expense during 2018. This is intended to permanently increase not like a one-time bonus the pay of some of our critical field customer facing positions at both our funeral and cemetery operating locations.
Adjusting for all three of these items the midpoint of our guidance reflects an almost 10% increase in adjusted earnings per share which is within our long-term earnings growth framework of 8% to 12%. We believe this increase will come as it historically has with organic business growth contributing 4% to 6% growth in earnings per share, contributions from recently acquired businesses contributing an additional 2% to 3% and the affect of the 2017 and 2018 share buybacks delivering an additional 2% to 3% earnings per share growth.
Allow me to briefly discuss the underlying assumptions regarding our base business growth for 2018. First, funeral revenues should grow in the 1% to 2% range resulting in a stable funeral operating margin percentage of around 20% that generates slightly higher funeral operating profits. Next, cemetery revenues should grow in the 4% to 6% range, led by mid single-digit growth in property revenue and mid single-digit growth in merchandise and services. We also would expect slightly higher interest expense as we will have a higher average debt balance coupled with an anticipated higher rate on the variable rate bank debt that is tied to LIBOR as we expect short-term rates to rise throughout the year.
So to wrap it up, we will continue to focus on driving revenue growth and leveraging our scale which will enhance cash flows that we will then utilize to grow our business and further enhance value for you the shareholder our return in capital back to you. With that, I will turn the call over to Eric.
Thanks Tom and good morning everybody. I want to echo what Debbie started at the beginning of the call and apologize for the technical difficulties that we had this morning and really appreciate everybody being flexible and being able to join us about an hour later than originally planned. So to shift into the remarks, today I am going to begin by addressing our cash flow results during the fourth quarter then followed by our annual cash flow results and capital deployment for all of 2017 and then finally we are going to shift gears and provide some details of our outlook for 2018. But first and more importantly as Tom did, I would like to start by thanking all of our dedicated and talented associates who are able to help our company deliver what we characterize as very strong earnings and cash flow results in the face of a good number of challenges thrown their way during 2017. I am proud that through the hurricanes, wildfires and the other events our associates collectively banded together and we are able to help each other and their communities through this adversity.
So now shifting to the financials and we will start with the cash flow overview for the quarter. We reported an impressive $124 million of adjusted operating cash flow, a $17 million increase over the prior year of $107 million. Now you may recall I have mentioned last quarter that we deferred about $25 million of federal cash tax payments from the third quarter into the fourth quarter of 2017 as allowed by the IRS for businesses affected by Hurricane Harvey. Neutralizing for this impact, our businesses produced nearly $150 million of cash flow during this quarter, which is about $42 million increase over the prior years. The drivers for this increase include higher cash earnings for the quarter that Tom just mentioned, but it mostly resulted from strong execution of our working capital initiatives that primarily related to improved cash collections and down-payments during the quarter in the preneed cemetery and in the atneed funeral areas of our business. As I mentioned in last quarter’s call, we had expected a rebound in the fourth quarter related to working capital from items that we said were temporary in nature and that in fact did occur.
Also included in working capital were some opportunities to withdraw cash from our trust funds in certain states where allowed under the laws. These withdrawals should be considered one-time in nature and they resulted from a multiyear initiative working with existing trust laws that did not have any impact on our quarterly earnings. This initiative generated an incremental $16 million of cash flow in the quarter that you saw in the press release, but also $20 million in total for the entire year.
Maintenance and cemetery development CapEx, which again is the two components that we define as CapEx in our free cash flow calculation came in at about $69 million for the quarter, which is about $12 million higher than the prior year, while about half of this increase relates to the impacts of the hurricanes. We continue to believe an increased investment in maintenance CapEx is a prudent use of our cash flow as we invest more to remain relevant with our customers through updated and more flexible facilities allow us to offer an expanded variety of contemporary services such as caterer receptions and less formal gatherings, where family members actively participate in this service.
Now, let’s talk about an overview of the year in terms of cash flow as well as capital deployment. For the full year, we generated $554 million in adjusted operating cash flows, $46 million over the prior year and surpassing the high-end of our guidance range which was $515 million. As I just mentioned though, cash flow results during 2017 benefited by $20 million of non-recurring cash flow from our trust funds. So adjusting for this, we generated about $534 million in adjusted operating cash flows or about $26 million above the prior year. So, backing out about $0.12 of non-cash earnings growth related to stock option accounting and share repurchases, our cash earnings per share grew about $0.14 per share or about $42 million. And partially offsetting this was about $20 million of higher anticipated cash tax payments that you saw in the press release that occurred during the year. Our liquidity and strong cash generation enabled us to continue our longstanding capital deployment strategy, with a focus on creating long-term value for our shareholders. For the full year, we deployed over $400 million towards acquisitions, new location builds, dividends and share repurchases.
So, let’s talk about the breakdown of this $400 million. We deployed approximately $80 million towards acquisitions in 2017 reflecting an increase from the $75 million invested in the prior year and well within our targeted range of $50 million to $100 million. And remember, acquisitions continue to be our best use of capital as they generally result in a mid-teen after-tax IRR. Additionally, we invested almost $18 million on the new build and expansion of several funeral homes, which we expect will provide positive returns to us going forward into the future. Dividend payments in 2017 totaled $109 million, an increase of 11% over the prior year of $98 million. Further, you also probably saw in our press release yesterday that our Board approved a 13.3% increase in our dividend rate to $0.17 per share this quarter as we benefited from the impacts of recently enacted tax reform that Tom just mentioned.
Finally, we returned an impressive $200 million of capital to investors in 2017 in the form of share repurchases, which has also resulted in the number of shares outstanding being reduced to just under 187 million shares. We repurchased approximately 6.2 million shares during the year at an average price of $32.15. Subsequent to year end, we have continued this repurchase program reducing our outstanding share count by an additional 1.7 million shares for a total investment of about $67 million. Concurrent with the increase in our dividend announced yesterday, our Board also approved an increase in our share repurchase authorization of up to $400 million, which gives us substantial amount of flexibility as we move forward in 2018.
So with that, let’s shift forward now to 2018 in terms of cash flow and capital deployment. In the release, we introduced our 2018 guidance range for adjusted operating cash flow of $540 million to $600 million. Adjusting 2017 cash flow from operations of $555 million for the $20 million of one-time trust withdrawals I just mentioned, our operating cash flow has grown about $35 million at the midpoint of our 2018 guidance, which would be $570 million. This growth is consistent with our adjusted earnings guidance that Tom spoke to earlier as we expect to generate adjusted earnings per share growth or about $35 million during 2018. Additionally, an expected $20 million of lower cash taxes will be offset by about $10 million of higher cash interest and about $10 million of incremental working capital uses.
So let’s talk about that and walk through some details of cash taxes and interest. So remember in 2017, we paid about $135 million of cash taxes with an adjusted cash tax rate of approximately 32%. As a result of the recently passed tax reform, we expect to pay an adjusted cash tax rate of approximately 25% to 27% in 2018 or about $110 million to $120 million, which will result in a $20 million reduction of net adjusted cash tax payments in 2018 versus 2017. And as Tom noted, we expect to use about $7 million of this cash tax benefit to provide wage increases to approximately 10,000 frontline employees in both our funeral and cemetery businesses. The remainder will be returned to shareholders primarily through the increased dividend that we announced yesterday.
Lastly, we continue to challenge ourselves on cash tax planning and believe there is a possible opportunity to ultimately pay less cash taxes than our current range that I just mentioned, but I will update you on this as the year progresses. Our expectations for maintenance and cemetery development capital spending, is about $185 million in 2018. This is somewhat lower than our capital spend in 2017 as we don’t expect much more capital related to the impact of the hurricanes. 2018 capital spend includes approximately $100 million of maintenance capital as we expect to continue our emphasis on updating our facilities as we continue our key focus to remain relevant to our consumers. The remaining estimated $85 million of capital relates to cemetery development spending, which continues to drive superior returns for us as well.
At the midpoint of our adjusted operating cash flow forecast guidance of the $570 million I just mentioned and adjusting for these capital expenditure items, we calculate our forecast 2018 free cash flow to be $385 million at the midpoint or roughly $2.04 per share, which is just under 10% higher than 2017. In addition to these recurring capital expenditures, we expect to deploy $75 million to $100 million in acquisitions and other growth initiatives, including new funeral home construction opportunities, which together drive low to mid-teen after-tax internal rates of returns for us.
Finally, after taking into account the completion of the redemption of our 2018 notes in early January of this year, we have a favorable debt maturity profile and tremendous liquidity of over $1 billion, consistent of about $240 million of cash on hand currently and around $800 million of availability on our long-term bank credit facility. So in conclusion, we ended 2017 really on a high note. We generated strong free cash flow and deployed over $400 million in capital to drive total shareholder return. We continue to identifying opportunities to remain relevant to our customers and drive long-term value for our shareholders. Looking forward to 2018, we really expect the same, robust free cash flow and a focus on the consistent capital deployment philosophy we have been executing successfully over the last several years.
So with that operator, that concludes our prepared remarks and now I will turn the call over to you to open the call up for questions.
Thank you. [Operator Instructions] It looks like our first question is going to come from John Ransom from Raymond James. Please go ahead.
Hi, good morning. I had a bunch of snappy questions about the bridge from ‘17 to ‘18 on the tax rate and the cash tax rate, so you had all those, so thank you. The second line of inquiry I had though was we are hearing, just from the financial community a bit more concern about the pricing transparency issue, particularly what happened with the dignity in the UK and then the potential move as I understand about the FTC and their working papers around transparency, so with that asking a 17-part question, I think you understand the concern, can you just address that and is this something you will give a more detail on your Analyst Day? Thanks.
Yes. John, its Tom, how are you doing? Thanks for calling in.
I am great. I am looking forward to seeing you in March. I am great. Thanks for asking.
I know I can’t wait to see you. So let’s start with the UK and first I want to address kind of some structural issues from their market to ours and then I will get into some maybe decisions they made that in the rearview mirror they wish they wouldn’t have released from our perspective. So first is the UK has no regulation, so as you think about competitors over there you are able to open up there is no licensure requirement, there is nothing. So you can operate out of the garage, you can operate out of a bunch of different places. Here in the States we have a 2-year licensure requirement generally in the States and most of our funeral homes if you visited them are very nice businesses that require capital to put money into. Second thing that’s different about their market, they have a large national competitor called the Co-op, so the Co-op is actually bigger than the UK and has a national presence. When you look at our footprint over here, we are about 15% and our largest competitors aggregate around 1% as they exist. And the third thing again I think is the structural difference. Their funeral homes are very different than what we experienced here in the United States. They are predominantly arrangement offices. So when you think about a funeral over there, you are going to a very small office to make an arrangement and generally you are going to have some form of service outside of their particularly could be in a graveside and the cemetery, which again they do not own. So the difference here, we obviously in the States have a very wide variety of offerings, we are used to having ample square footage in order to have a chapel or have a service or a remembrance or the like. So it’s just a very, very different funeral service offering when you think about theirs versus ours. And again if you wanted to do a graveside at the cemetery over here we own cemetery, so we are going to get that business and dignity wouldn’t have that benefit. So now specifically to them with operating in that I would say a little more difficult environment the things that I have been able to decipher from their disclosure, is they have been raising prices on the funeral side about 5% to 6% per year and particularly over the last 3 years they have seen 6% annual volume declines in their same-store. So, the cumulative 3-year they lost about 20% of their volume of their businesses. And so again compare us, we generally are seeing 1% to 2% type of funeral price increases over the last number of years. And if you look at our same-store volumes, they are actually holding up pretty good, I mean particularly in ‘17 we are up 1%, ‘16 was a little more difficult, but I think ‘15 was up. So we are holding our own as you think about on a national basis.
The other thing that I think is different over there is they sold preneed pretty aggressively just like we would and when they sold preneed, they sold it on a discounted basis. You will notice that a lot of their business that they sold the channel through was it had a substantial discount to what they sell it. And I think when they did that and again their accounting and trusting laws are very different from revenue recognition. So, trust really helped grow their earnings and cash flows. They created expectation that funerals could be provided at that lower cost. So, I think the bad news for them is by creating this lower cost option I think they are bidding down their atneed offering. And then what happened is the co-op came in and competitively priced them and so they did the math. So, if you look at our preneed business, we sell at essentially the same cost. Actually there is about a 3% differential between atneed and preneed reduction, but so I think we are very, very different than them. I don’t want to say that we can’t have issues around pricing from time-to-time, we do in markets and we react to those today and develop plans to be more competitive, but again I don’t see something on a national basis that looks like them.
And as far as the FTC potential ruling, again, I don’t know how likely that really is, but again we are experimenting now with online pricing and it’s not something we are afraid of. I think the one thing that’s challenging again in a very – in a commoditized product online is very easy. This is not a commoditized business. If you walk into a variety of our funeral homes or cemeteries, they are very, very different and so how do you convey that value proposition over the Internet. And we are not afraid of it. We have got the best properties and we will do it, but again I am not so to see how likely that’s going to be. I mean, if you think about funeral home operators today, there is 26,000 in the U.S. and Canada and a lot of these places don’t have websites. So, you begin to get into complication on regulation is how do you evenly apply that across the network. So, hopefully, that addresses it John. And I am sure you will have another question in New York or in March and I will be happy to answer that. Any other questions?
It looks like our next question comes from A.J. Rice from Credit Suisse. Please go ahead.
Hi, everyone. Thanks. Maybe just a couple of quick questions here. First of all, when I look at comparable sales average revenue per service in the funeral side, on the atneed you are down 1% and I think on the preneed matured preneed you are up 3.6%, that’s nice increase obviously on mature preneed. Is that us finally getting to the point where the contracts written 10 and 12 years ago right as we started to get into the ‘08 to 2010 hit to the market or starting to mature and you are going to see that boost your averages for a period of time you think we can look forward to that?
Yes, A.J. I think you are exactly right. I think the differential you are looking at this year though there is a little bit of a difference I just want to point out. We changed our terminally imminent policy if you recall in how we deal with that customer. We used to take that customer through atneed contract and not write them on a preneed. And so what you are seeing now is a little bit of a blip of that imminent flowing through into preneed and out to preneed. So there is a little bit of lift in there related to that although you are right on the preponderance of that increase is exactly what you said, the increased returns from the preneed backlog. So I think the way to think about it is you ought to see a little bit of an improvement year-over-year on the atneed average and maybe a slight detriment on the preneed average and you are absolutely correct in your direction I’d just say I muted a bit for those two taking the imminents into account.
And on the atneed side down 1% that’s pretty much driven by the cremation continuing to uptick, is there I know you guys have put a lot of emphasis on additional services, the catering etcetera. If we were to look at a normalized pricing trend, is that still running in the sort of CPI rate of increase on the atneed piece?
It’s probably a little below the CPI. Again, it’s being muted slightly, A.J., because in last year we had some of those terminally imminent contracts that were higher average. We are in the atneed number. So, I think that will get a little bit better, but the other thing and again, this is more of a Tom’s opinion versus I have great evidence, I think we are competing and we will talk a little bit about this in our Investor Day next week, but I think we are competing more effectively for business that is cremation related that may or may not be a full service cremation through our channel than we have historically. So, we might have a little bit more business than we would have had in prior years and that a little bit more business running through the core channel is cremation. It’s not a super high average. So, again, the right move, but it does put a little bit of it looks like deflation if you will on the atneed walk-in business, but it’s tough, we are not increasing prices very much, we are trying to be very competitive and I’d expect that to continue for the next few years.
Okay. Maybe just switching gears, couple of other quick topics, you mentioned in the prepared remarks that preneed cemetery sales production was impacted in the fourth quarter by hurricanes, can you just explain obviously the hurricane really hitting, I guess in the third quarter, what lingered into the fourth quarter? And is whatever dragged you in the fourth quarter pretty much addressed at this point going into the New Year?
I think so, A.J., because we are talking specifically about cemetery. So, as you think about it, you got a couple of things. You have a lot of cemeteries that have damage and so may or may not be ideal for walking through and so on preneed, probably more importantly a lot of our counselors, sales counselors were personally impacted by this. So, think of 250 employees in Houston that are impacted by the hurricane, I have got water in my house I have got elderly parents that I am dealing with. So, let’s say there was a time distraction as it relates to being back and up and running. And then you have the customer effect, if I have got water in my home or I am dealing with something, it’s probably not the ideal time for me to discuss my cemetery burial options. So, I think we view it as this was a temporary deferral. Some of that business may defer to the back half of the fourth quarter and we captured it anyway, some of it may push into the next year. So, we just highlighted, because we saw numbers that again year-over-year particularly kind of October, I’d say as you look at the back half of the quarter, we saw normalized sales rates returning to those markets.
Okay. And then just the last question for me on when I look at what you are talking about on the tax reform, the $0.14 of benefit, if I have got my math right, which is always dangerous. I think that results in about a 500 to 600 basis point reduction in the tax rate. Obviously, the statutory rate is going down 14%, I know you have got much tax planning stuff you do. Can you maybe just bridge that a little bit for us and then as we think going forward all these tax strategies you have typically done in the last few years to reduce your tax rate as the years progressed, if they have been taken off the table somewhat because of tax reform or is that still a possibility as we go forward?
Hi, A.J., it’s Eric. The way to bridge it is really you are right going from 35% down to 21%, probably gets us about $50 million, about $55 million actually. There is some other tweaks to the tax law which offsets that and makes it about 50 net. So, that’s pretty close to your calculation, but the way you have to think about it is that assumes we are at a 35% rate, which as you know in 2017 we were not. We are not a full cash taxpayer. So, if you come from your perspective what I do is I would say $135 million of what we had in cash taxes in 2017 absent tax reform would go up to about $165 million related to become a full cash taxpayer, then you say tax reform comes in at that net $50 million that I just explained to you. So $165 million comes down to that $115 million and I think I gave you a range in the remarks of about $110 million to $120 million. So, all of that should kind of reconcile if you think of it that way.
Now, the second part of your question is are there other opportunities related to tax planning that were under way that now are moved from that perspective, because of the change in law. I think there were some that fall into that category, but as I alluded to in the remarks qualitatively without quantifying anything, I do think there are some other things that we are doing related to some intercompany and particularly related into some state taxes that could provide some benefit along the way, but I don’t want to quantify that yet, because as you know just like every other company, we are digesting the 1,000 pages or whatnot of this law and figuring it out. But I do think that there is some opportunity that’s left on the table A.J., but nothing that I am willing to quantify at this point in time and I will just keep you informed as we continue to work forward in this area.
Okay, great. Thanks a lot.
And our next question comes from Scott Schneeberger from Oppenheimer. Please go ahead.
Good morning. This is Daniel on for Scott. Can we do a high level question, I am curious on the guidance range, if you can discuss kind of like the swing factors that will put you at the high end and the low end of the 2018 EPS guidance?
Yes, I think on the high-end, low-end question, I would start with the revenue driver. So one thing that could occur is an increase in funeral volume clearly would be a big factor. We have seen as you would expect with the news on the flu, we have seen a definite impact as we look at the January preliminary numbers and again we are not in any position to talk about numbers other than we have been very, very busy in our locations. So again, history tells us that when you have a heavy flu season, generally, you are going to give some of that back as you get into the summer months. So I don’t want to get overexcited, but that’s probably one revenue trigger if you will that would drive to the high side. The second one is going to be preneed cemetery property sales. So again to the extent, we can grow that number, because it gets recognized when we sell it for the most part and the cash flow goes into our coffers, if you will, then those are the two big drivers they are going to push us to the high-end of the guidance range.
Got it. Thank you. Can we talk funeral margins, if you can elaborate a little bit on the expense management you noted and if you kind of think about the outlook for 2018 as well as the impact from the accounting change?
Sure. I will touch on the margins and I will let Eric touch the accounting change difference that you might experience in that line item. But for the most part as you think about funeral, remember revenue recognition is really going to be tied to the event of death. And so to the extent the number of deaths are there you can grow revenues and to extent they are not you cannot. So, until you really see a demographic impact, our expectation is kind of 1% to 2% kind of funeral revenue growth. Then on the variable cost line, again, those are just going to grow kind of commensurate with what’s happening on the revenue line item. There is one unusual item that used to be selling costs and now that we are tying the selling cost to the actual revenue recognition, I think that’s going to correlate very well again with funeral volume, where historically, you could see high levels of selling that actually eroded your margin. It was a good thing we grew the backlog, but – and Eric will tell you that, that will change with the new accounting standard. And then finally, you have a lot of fixed cost as you think about the funeral business and history tells us that those are going to grow in or around 2% year-over-year on those fixed cost increases. This year, we may see a little bit more associated with our plan again to invest in our frontline-facing employee group and enhance their pay packages to be more reflective of again what we can do to continue to drive customer satisfaction and be the best in our industry.
Related to the revenue recognition accounting changes, we have really had two effects at SCI, one hits revenue and one actually hits expenses as Tom just mentioned. The revenue piece is actually pretty small. It’s related to an administrative fee or a processing fee we are charging in certain funeral homes and cemetery locations related to processing contracts and such. That’s about a $3 million amount that now had an effect of $3 million to our revenue line in a negative fashion. As we have to defer that fee until the contract turns that need in the preneed environment, the offset to that is down in expenses. And as Tom just mentioned, prearrange funeral insurance contracts remain the same. Those selling costs will still be expensed, but as it relates to the trust funded prearranged funeral contracts and of course the cemetery preneed contracts are all trust funded that will have an effect where we are deferring selling costs and then recognizing them at the time those services are performed that merchandise has delivered. That’s about a $13 million reduction in expense.
So when you take the $3 million headwind to revenues and the $13 million reduction to expense, it nets to about $10 million to the bottom line in terms of operating profits that the revenue recognition accounting change has with us. Further, it’s about half and half between the two segments. So cemetery think of that as $5 million or $6 million and think of funeral as $5 million or $6 million, but remember it’s the trust contracts for funeral. So, where that is predominately sold, there is some still sold in our core operations as you know. The most of them were sold in the SCI Direct part of our business. So that tailwind reduction in deferred selling costs will affect SCI Direct disproportionately from the core funeral homes within the funeral segment.
Thank you very much.
It looks like our next question comes from Chris Rigg from Deutsche Bank. Please go ahead.
Hi, good morning. Just wanted to ask about the trust funds, I know the inflation there doesn’t directly hit the bottom line, but clearly you had a very good year in 2017 with the overall market, was there any sort of excess earnings generated last year because of the strength in the market and then we think about 2018, is there some sort of reset we should be thinking about? Thanks.
The only excess earnings that we had, Chris was related to the eternal care fund in the cemetery segment and if you remember we reconciled that when we talked about $1.29 in 2016 on a normalized basis was about a $1.24 and that related to both those ECF funds I just mentioned to you as well as the loss of a sale of the archdiocese properties that we discussed in California, but no, there is no real effect that’s making these earnings disproportional. I would tell you that we are excited about the trust backlog growing the way it’s been invested we see the returns when we publicly announce them in the press release and those ultimately will come through both our cash flow statement and our earnings statement as those contracts turn atneed, which is on average 10 to 12 years although much of them will turn prior to that. That’s just an average that 10 to 12. Ultimately though, I think you are going to continue to see, I think A.J., asked the question and Tom answered the question about the difference between the sales average coming out of the backlog versus the lock in atneed sales average and we are going to give you a little bit more color on that and try to quantify it a little bit better next week, next Tuesday at the Investor Day, but I think you get the story. I think you get the trend. We will just try to put some numbers around it for you as well.
Great. And then just on the acquisition environment last 2 years including the 1031 exchanges have been about $75ish million. I know it’s early days in 2018, but when you think about the pipeline for this year, is it going to be in that range again or more or less than that, just any color would be helpful?
Yes. Chris, I think is the difference between doing a 75 and doing something north of that generally is going to be determined by the size of the transaction. So, I would tell you that the activity level is very good. We are seeing a very nice pipeline of businesses come up. And so I would expect this to be able to continue to do something at that level for sure. And I think anything if we were to over-perform that by quite a bit, it will be due to the fact that we got a large one in the boat if you will. And I think that would change the dynamic of getting outside of that range.
Got it. Okay. Thanks a lot.
And then it looks like our last question comes from Joanna Gajuk from BoA. Please go ahead.
Good morning. Thank you. So actually on the last point on acquisition, so the commentary around the guidance details in terms of acquisition, I think 2% to 3%. So is it a little bit higher than in the past when you kind of talk about it or am I just reading it too much? And I guess this is more in line with the 2017 contribution?
Yes, I think two things and you will notice this reflected in our comments. So previously, we used to say that share repurchases would impact us at 3% to 4%, I believe with the range and that was true and our stock price was a lot cheaper and now that the stock price has gone up, I think achieving in the 4% range has not been a realistic target. I think so as we run our models now, it’s probably closer to 2% to 3%. On the acquisition side, as we think about that, Joanna, two things, one, we are seeing a more robust pipeline and that gets us excited. And the second item that you will see us talk about is constructing new funeral homes. We have actually begun to spend in the last couple of years $20 million a year. And as you recall the IRRs on these businesses are a little bit lower, because the first few years of cash flow are very different than an acquisition target, but still a very good deployment of capital in long-term maybe even a better opportunity, because we can build it like where we want it. And so what you will begin to see is that pipeline of new businesses that we have built where that cash payback may take year three to begin to payback to us. So, it’s a reflection of the class of construction homes that we are building each year that begin to contribute positively to the earnings per share growth of the company with a more robust acquisition pipeline.
Okay. That makes sense. So you are saying that when I think about modeling the growth CapEx should be around $20 million, I guess it was ‘18 and ‘17 then you are referring to, correct?
Yes, I think within our slides that we will show you next week, we are attacking the two together and so you probably go from a range now of 75 to 125 when you begin to think about building funeral homes and buying businesses. So yes, I think $20 million to $25 million is a fair number.
Right. And then I want to follow-up on the discussion around tax benefit and the potential upside just over time, because when you talk about a $50 million or the net improvement year-over-year of $20 million that doesn’t include anything around the provision that would allow accelerated depreciation or does it include and I guess if it doesn’t, then is this one of the items you are considering that might create some benefits of this for the next 2, 3 years?
Those numbers do include that benefit.
Okay. And the benefit is what the value of it is for you guys?
I don’t have the…
How much CapEx as a percentage you can apply the accelerated depreciation, some of the companies in the healthcare universe that I cover it ranges from 50% to 80%?
I believe we are somewhere around 50% before. So I think it’s a differential of about 50%, Joanna.
Okay, that makes sense. And then the last point the comment around the flu season, which you said Q4 you haven’t really seen much, but in January, you have seen some increased activity. So, should we assume that guidance also reflects at least the January activity to some degree, but maybe after that you kind of assume that things kind of drop?
Yes, Joanna, I would say that we look at January this way, we are treating January obviously as I think about when I think about the quarters of the year based upon what I have seen, I would expect the first quarter to be pretty good. We are going to see a lot of funeral volume a lot of activity in the cemeteries. I think what history tells us because of a flu season is you are going to get that benefit and then probably you may give back some of that in the middle of the year as you think about Q2 and Q3. So, as we think about it, we are not letting it impact our annual guidance at all, because again we are going to assume probably a more robust first quarter that then give back a preponderance of it rest of the year. Now that may or may not play out, I can’t tell you that, but that’s the way we have addressed our guidance for this year.
There are no further questions at this time. I will now turn the call back over to SCI management for closing remarks.
I want to thank everybody for participating today. We really appreciate you being here and we look forward to speaking to you again, I guess that’s going to be in April. We will see in April. Thank you.
Thank you. Ladies and gentlemen, you may now disconnect.