Service Corporation International (SCI) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen and welcome to the 2006 fourth quarter Service Corporation International earnings conference call. At this time, all participants are in a listen-only mode. We will conduct an audio question-and-answer session towards the end of today's presentation. [OPERATOR INSTRUCTIONS]

I would now like to turn the call over to the management team of SCI. Please proceed.

Good morning. This is Debbie Young, Director of Investors Relations for SCI. Today we will provide some commentary about our 2006 results, and then open the call up for questions.

As usual, I need to remind you that the conference call today will likely contain some statements that are not historical facts, and that are forward looking. These statements are based on assumptions that we believe are reasonable, however, there are many important factors that could cause our actual results in the future, to differ materially from the forward-looking statements that we will make today.

For more information related to these forward-looking statements, and other important risk factors, please review our periodic filings with the SEC, that are available on our website at SCI-corp.com, in particular our 2006 10-K, which we anticipate filing later today. A replay of this conference call will be available on our website for at least 90 days, and can be accessed by clicking on Webcasts and Presentations in the Investors section.

With that, we will begin with comments from Tom Ryan, our President and Chief Executive Officer.

Thanks, Debbie and thanks everybody for participating today. It seems kind of odd. Last week we spent looking ahead to what was going to drive 2007, and today we will take a step back and talk about what went well in 2006, and maybe some things that didn't go as well as we would like. I think first of all, when you take a financial score card, as we look back at 2006, we are very pleased to report normalized earnings per share at $0.41, versus the prior year of $0.28. This is an approximate 46% improvement, and was beyond our own internal expectations, as well as the analysts that follow SCI.

First of all, I want to say thank you to all of our 22,000 fellow employees who really made this happen. The first contributor that I want to speak to today regarding the earnings per share improvement was our enhanced comparable North American funeral margins, which improved to the tune of about 130 basis points, and brought our gross margin percentage to 20.8% for the year ended 2006. This was really accomplished as we implemented our strategic pricing initiative, moving value from the product side to the service side, as well as introducing our customer segmentation strategy to our entire management structure.

This resulted in comparable at need average growth of 11%, which was partially offset by a somewhat expected reduction in case volume of 5.8% for the year ended 2006. Further contributing to our enhanced funeral margins was the initial success, particularly in the second half of 2006, of the implementation of our staffing measures. This allowed us to lower the cost of service delivery around efficient use of personnel, fleet, and other scalable local market functions.

Another key driver of our earnings per share improvement was improved cemetery margins, which improved to the tune of 320 basis points raising our gross margin percentage in that segment to 19.1%. This does include a $7.9 million contribution from an endowment care income gain that we reported in the second quarter. But even excluding this item, cemetery margins would be at 18%, or a 210 basis point improvement.

This was accomplished on the top line side, with slight production increases, and increased recognition of preneed merchandise and services, as well as improved returns from our preneed trust backlog. Further contributing to our enhanced cemetery margins were efficiencies gained in selling costs and salary expenses, as we increased standardization within the cemetery segment.

In addition to the improvements, we had improvements outside of our core business segment. We benefited for example, from a $10.9 million distribution from our 25% ownership level, in PFG, which is our French operation. This will also contribute to future periods, but probably not to the $10.9 million level we experienced this year.

And finally for the year, we saw enhanced interest income as we accumulated cash throughout the year, both from operations, and as we were divesting of businesses that didn't fit our strategy. When we invested that cash at higher returns, as the Fed moved short-term interest rates up throughout the year. Now this excess cash has been invested in a higher returning investment for our shareholders, as it was a key funding mechanism for the Alderwoods transaction, which was completed in the latter half of November 2006.

If there is one item that sticks out in my mind as disappointing for 2006, it was the level of our sales production for preneed funeral and cemetery, as it fell short of our expectations. I am afraid our focus on strategic pricing and staffing metrics, distracted us from recognizing that we may not have provided the appropriate infrastructure and support necessary to accomplish our sales goals for 2006. We have committed to that investment in 2007, and expect to see results in the coming year.

Now, for a quick review of the quarter by business segment. Our funeral profits for the quarter were up $8.6 million, or 330 basis points, as we we raised the gross margin percentage to 21.3%. Our comparable funeral volumes continue to trend down. They were down to the tune of about 6.7% for the quarter.

As you will recall speaking in previous quarters, we try to measure what is happening with market share by looking back at what's happening within our preneed, going at need business, as well as what's happening in the cemetery interment side of our business, and what we are seeing is preneed going at need volumes trending down to the tune of 3%, and our cemetery interments trimming down to 5%, which we believe is reflective of what is happening within our relative markets.

Our at need volumes for the quarter were down 7%. So while this is not a perfectly accurate statistical conclusion, it tells me we lost about 3% of our at needs business in the fourth quarter, due to reasons other than market share. I'm sorry, reasons other than market trends.

This is about 1,100 calls for the quarter, and therefore when you annualize it, I figure our strategy of strategic pricing and the related segmentation, probably we've lost 4,000 to 4,500 calls on an annualized basis. Once again, we are tracking this on a market-by-market basis. And we see large concentrations occuring in the Pacific Northwest, Florida, as well as the Denver market, that are tied are specific decisions to exit low priced direct cremation businesses, contracts as well as individuals.

The good news is our comparable funeral averages continue to increase. In the fourth quarter, we were up 7.6%, and I believe that is 7% when you exclude the floral reflect that we talk about each quarter. The primary driver of this increase is the effect of our strategic pricing initiative, which recognizes that customers value our services versus the products that we provide. As a reflection of this, you will see on the cremation side, that our average is up 15.1% for the quarter, while our burial average is up 4.6%, again caused by the emphasis on service versus product.

Our cremation mix, which historically continues to trend up, we again experienced a quarter where our cremation mix actually decreased 80 basis points, to 40.3% for the quarter. If you add back the 1,100 calls I talked about before, which were the immediate disposition cremation calls, it would tell you that we were on a trend with comparable businesses for a 41.5% cremation rate, which would tell us that the cremation rate continues to grow in the North American market. We believe to the tune of 40 basis points. So the market hasn't necessarily changed, but our approach to the customer has.

Now turning to the cemetery segment, our cemetery profits were up 13.7 million, or 800 basis points in the fourth quarter, and they achieved a 22.6% margin return. On the revenue side, we were very pleased we saw the sales production for the quarter up 5.3%, and also our preneed production was up almost 8%. We also experienced higher recognition rates, particularly in the merchandise delivery component of our cemetary sales, and generally expenses were very well managed, as metric-driven efficiencies were gained on the selling cost side of the equation.

As we look out to 2007, the keys to our success are going to be as follows. Number one, the Alderwoods' integration. Clearly this is a very strategic acquisition for us, and very, very important. We must achieve the overhead synergies that we have identified. We believe that we will. We must achieve the purchasing power and scale that we have talked about.

Thirdly, as it relates to Alderwoods, we have got to insure that our footprint rationalization takes place. And that means taking assets that don't fit our strategy, and divesting of those assets and converting them to cash, as well as rationalizing our strategic footprints, looking within our strategic markets for what is the appropriate footprint, and taking advantage of real estate opportunities, as we make those markets more efficient.

Lastly, and most importantly, as it relates to the Alderwoods integration, it's creating one team. I can't stress this enough from our side. Our management team is keenly focused on making sure Alderwoods and SCI becomes one team, and we are getting there. Therefore, that allows us to get to Best Practices, to further development our people, to implement our segmentation strategy, and roll out the successful strategies of pricing and staffing metrics that we have seen in the legacy SCI businesses.

The second item that's going to be achieved in 2007 is the continued impact of our strategic pricing initiatives, open funeral and the cemetery segments. The third item I will speak to is continued favorable impact from the utilization of our staffing methods in dissemination of the Best Practices, which should result in greater efficiencies that we have already seen in the legacy SCI business.

And lastly, while we expect no financial impact for 2007, we must develop the appropriate infrastructure, and make appropriate investments in our customer segmentation strategy. What I mean by that is investing in the appropriate people, investing in the appropriate assets, both in showrooms, and the looks and feels of our facility, as well as the appropriate marketing plans that are tied to the customer segmentation strategy, which once in place should begin to bear financial results that shareholders would be very proud of. We expect that financial impact most likely to occur in the latter half of 2008. When we execute on these key initiatives, we believe it should result in differential performance in earnings growth for our shareholders during 2007.

With that, that concludes my prepared comments, and I will turn it over to Eric Tanzberger our CFO, for his comments.

Thanks, Tom. I want to again reiterate the strong financial performance that Tom just discussed, in terms of our guidance from last year. Again, our EPS excluding special items, which excludes things such as losses on businesses, physicians, losses on debt and the Alderwoods transition costs, for the quarter was $0.11, versus $0.06 in the prior year, and on a year-to-date basis, $0.41 versus $0.28.

We said last quarter that we would be on the high end of our guidance range, which was $0.32 to $0.36, or even exceed that guidance range by a couple of pennies. If you follow that math and say our revised guidance range was $0.36 to $0.38, we exceeded that revised range by about $0.03 to $0.05 under the above scenario. So very good performance for us. We are very pleased with that.

I want to reiterate that exceeding of the guidance was an SCI performance, not necessarily from an Alderwoods perspective. The SCI businesses performed at those levels. However with that said, we are very pleased with the Alderwoods performance in the first months that we owned them, excluding the Alderwoods transition costs, the transaction from the EPS perspective is already accretive. In December, the Alderwoods businesses produced about $0.018, where the new interest expense we took on for the financing of Alderwoods was about.0 $0.016, so again just to reemphasize that the synergies are already in progress as we speak.

From a cash flow perspective, our quarter was 59 million, versus 54 million for cash flow from operations. On a year-to-date basis, it was $324 million, versus $313 million. I will get into a little bit more detail in a second. But the $324 million of cash flow from operations for '06, exceeded the upper end of the guidance range, which was $315 million.

Shifting more to the income statement now, again, Tom really explained the general performance of the average, the volume and the other business drivers. Just a couple of items I will point out. General administrative expense was up $8 million, to $31 million for the quarter. That is primarily the result of $7 million of Alderwoods transition and financing costs, as well as about $1 million of stock option expense we had this year and not last year.

Also interest expense for the quarter, interest expense is up about $10 million to $37 million. All of that increase for the quarter relates to the Alderwoods financing activities, and then from a year-to-date basis, the interest expense is up $20 million to about $123 million, and, again, Alderwoods, from the additional debt to the financing is $10 million of that $20 million, and then if you recall in the third quarter, we had $7 million of bridged financing costs that we had to expense, related to our bridge financing for the deal. And then we had penalty interest from our 2017 bonds during the year of about $3 million.

Shifting also to the trust performance for the year. We are very pleased with the performance of our trust funds as well. From the quarter to-date perspective, the funeral trust funds produced 4.6% return, and a year-to-date of 8.8%. On the cemetery side, the quarter to date return was 4.2% and the year-to-date was double that, 8.4%, and then from the ECF side, the Eternal Care funds, the return was 3.4% in the quarter, and 10.8% for the year. So all-in, it was about a 9% return that we had on the trust funds during 2006, and we are very pleased with that.

From the balance sheet perspective, when we file our 10-K later today, you will see that our balance sheet looks significantly different because of the Alderwoods transaction. First of all, we obviously added the Alderwoods balances on to our balance sheet, and then adjusted these balances to fair value, with the remaining balance going to goodwill. Generally, you will see about $600 million of excess purchase price, over and above the Alderwoods historical balances, that came over on to our balance sheet.

To give you some more color on that, property claim equipment and cemetery property was increased about $240 million. And tangible assets, separately identifiable as tangible assets is about 90 million, and that relates to an amortization increase of about $2.5 million per year. I think I said that last week.

We also have an $80 million intangible asset related to the preneed backlog associated with Alderwoods, and that amortization will occur over many, many years, as those contracts turn at need. We also adjusted our deferred taxed assets by $40 million, and other balances by, down by $35 million. All that being said, what it resulted in is $185 million of goodwill being added to our balance sheet at 12/31/06 after the Alderwoods transaction.

Shifting now to cash flows. I have already said cash flows were about $324 million at year end. If you take into account several things that are in that balance, for example, $3 million of Alderwoods' transition costs that were paid, legal payments of about $6 million, and a prior year tax refund that we have disclosed many times at $29 million, the cash flow from operations is up about $50 million. The parts of that are that we had $21 million of capital leases during 2006, where the principal payments were moved out in financed activities in '06, and they were not in financed activities in '05. So that is $21 million of the $50 million increase.

The other are the French dividend that we have talked about before of $11 million, the additional ECF income that we talked about last quarter of $8 million, and then we had a working capital source of about $10 million for 2006. The working capital source resulted from good cash receipts, and cash interest income that Tom discussed, and that was offset primarily by the executive long-term incentive plan cash payment, and increased bonus payments that we discussed early in 2006 in our May conference call.

CapEx was within our expectations on the cash flow statement. It was $36 million for the quarter, and 100 million year-to-date. 32 of the 36 for the quarter was maintenance and cemetery development, and about $4 million worth of growth CapEx. And on a year-to-date basis, $93 million was maintenance and cemetery CapEx, and $7 million was growth, the sum to the $100 million I just mentioned.

Last thing on the cash flow statement, when we file our 10-K later today. I want to let you know that you will see a little different presentation related to preneed funeral and preneed cemetery working capital line items. And as we disclosed and discussed before with you, we were under review with a comment letter with the Securities and Exchange Commission, and we have concluded that review.

And what the result was, is that the net increase and decrease of the preneed funeral line, and the net increase and decrease to the preneed cemetery line, each of those lines will essentially be blown up into three separate lines with a little bit more detail. So instead of a net presentation on the cash flow statement, you will see a gross presentation. And I just want to bring that to your attention when you see the 10-K later today.

Lastly, in summary, I want to reiterate how excited we are looking forward to 2007. As Tom mentioned, most of our energy will be towards the Alderwoods integration, as well as getting traction on our customer's segmentation project.

From a financial perspective, we expect to build cash balances during the year. We will spend that cash on projects that meaningfully exceed our weighted average cost of capital, and we will also expect to spend that cash on share repurchases as well, while of course, we manage to the three capital target ratios that we discussed last week, as the governor, related to how much share repurchases that we do during 2007. And again, to reiterate our authorization is now up to $200 million that we announced last week for share repurchases.

With that, I think we are ready to take questions.

Thank you, sir. [OPERATOR INSTRUCTIONS] Your first question will come from the line of Tom Bacon of Lehman Brothers. Please proceed.

Good morning. Eric, just in terms of the consolidation on the balance sheet, I just wanted to and with regard to the preneed backlog, I mean it looks like most of the balances related to preneed went up, with the exception of the cemetery revenues which actually went down. So I am just kind of wondering why that would go down with a consolidation?

Well, there was other movement obviously, during the quarter is what you are really seeing. The $80 million that I referred to on the backlog is actually on the asset side, Tom, and as intangible assets that would be, that will go through P&L as those contracts turn at need. The theory of the intangible asset is essentially that we cannot take credit or revenues or book the revenues. The component of their preneed backlog that relates to the selling activity, of actually selling that preneed contract.

What we can recognize as revenues going forward, is the actual revenues and margin that relates to the actual performance of the preneed contract when it turns at need. So that $80 million, think of it as kind of a write-down of their backlog, even though it's on the asset side, and that will be amortized over, call it 15 to 20 years. I mean it will be over their entire backlog. So we really don't anticipate having a P&L effect at all.

So is that essentially the difference between what they collected from the customer, and what they actually had to put in trust? So in other words, there is cash they already spent, so you guys can't recognize that revenue?

No, it's not precisely related to the cash. It's a theoretical calculation that we have been through with our accountants and with our audit firms, that essentially says this much of their revenues related to that backlog is really related to the fact that they sold it early, it is a selling profit. It's getting into an accounting theory that we may want to do offline, Tom, but that's really the answer to your question.

Okay. And then just one other quick question. I think in the last quarter's conference call, you mentioned that there was another adjustment to cash flow from operations related to revenues that Kenyon had got that were out of period revenues. And I am just wondering, what happened to that adjustment, wouldn't that still be applicable to the full year?

Yes, I think what it is Tom, this is Tom. I think it is probably immaterial to the full year, but really what occurred is Kenyon's recognition of revenues, really a lot of those are reimbursable costs. So when you go back to the tsunami and you go back to Katrina and some of those events. We fronted the money on behalf of the governments, or on behalf of people that we service, millions and millions of dollars. So we paid those monies out, and the revenue recognition is entitled to cash flow. And the reimbursement from the country of Australia was a piece that lagged for a while. It was really 9 to 12 months after the commencement of the work. What we are seeing the cash flows coming back in from cash flows that we fronted, 9, 12, even 18 months ago in some cases.

But we are beyond the need to adjust for that?

Yes, I think it's immaterial at this point. We really stopped, you know this year we didn't have a lot of incident activity, as you can tell from the Kenyon business.

Okay. And then in terms of the, all right. I guess that's it for me, actually, for now. Oh, when are you going to lap the running off, when you decided not to perform those cremation contracts? Is that the second quarter?

Yes, I think you should see continuing through the second quarter of this year, some differential in the quarter-over-quarter change, and I think as you get to the third and the fourth quarter, it ought to normalize a little bit more, as it relates to the legacy SCI business. What I would forewarn you is as we implement the strategies on the legacy Alderwoods businesses, could you see, again, some call that we may or may not do particularly in those markets where we see a high concentration of price sensitive direct cremation for consumers.

Have there been any new contracts that you decided not to renew, other than the ones you have already mentioned in the Pacific Northwest and Florida, I believe?

I think it is less about contracts now, and as an example, we may have promoted direct cremation out of some of our better properties. We may have had a product that we tried to sell from that property, and what we have done now is said, listen, we don't do low end cremations at our finer facilities. And so that creation that we might have sold for $895, now goes for $1,895 for $2,195, so again if someone really wants an $895, or a $795 direct cremation, they may go somewhere else. We hope they go to one of our direct cremation locations, but that's not always the case. Again with our overall strategy, we think that is the right thing to do. So I don't think you will see a lot of that on the SCI side, but I would expect some of that to occur on the Alderwoods businesses.

Okay. Great. That's it for me. Thank you.

Thanks, Tom.

Your next question will come from the line of John Ransom of Raymond James.

Good morning. Tom, when would we see the revenue work you are going to do on Alderwoods, in terms of the backlog, the pricing, the cremation? At what point in time should that start to be apparent in the financials?

I think, John, you know we have already begun to roll that out, and we prioritized it by the markets that will have the larger impact. It's our belief that it will be done sometime in the third quarter of this year. And so it would be my thought that you would begin to see an impact most likely in the second quarter.

Okay.

And probably see a more run rate type of impact in the third and the fourth quarters of this year as it relates to the pricing.

Okay. And I guess we could look at revenue per call and call volume. Is there anything else we should be looking at externally that would give us a clue as to whether or not you are on track there?

Yes, I think if you go back to my final comments, as we looked at 2007, look for us to deliver the synergies we said we would deliver. Look for that volume probably to continue to trend down at least in the first half of the year. Look for the average to continue to look good.

The other things that I think are important to keep in mind, is that besides the synergies and besides the pricing, and the other things, is the staffing metrics. You know, we talked about how the staffing metrics are going to allow us to trend down as it relates to our costs around personnel and fleet and other things. If those things gel, then you will see a really good 2007.

Great. And my other question relates to rebuild. You mentioned that you were a little disappointed in the preneed activity, and the need to address infrastructure. Again, outside looking in, should we look, was that a part of the working capital source in '06? And would working capital be a little bit of a drag as you start to rebuild that? And what other financial effects should we see as you address the preneed effort?

Well, I think if you bifurcate the two, and let's take preneed funeral for a minute. Clearly preneed funeral has no earnings per share impact in the immediate day. So it's really going to be a bit of, most likely a working capital build on that side of the business.

Okay.

If you look at the cemetery side, it really relates to what products you are selling. If you are selling new customers and you are selling property, you know, property does not need to be trusted. So again, that will generate cash flow to the extent you are selling that, and it will also allow us to recognize earnings. I would look for overall, we would expect that if we get our selling goals, that you would see a slight increase in your earnings, as it relates to the cemetery side of the business, and maybe either flat to slightly negative impact as it relates to working capital. Again, we think it's a good investment in building future business for 2008, 2009 and beyond.

And when you say infrastructure, I mean those are kind of big, fat words. What do you mean specifically? Do you mean that you need to hire some more people? Do you mean more training? Is it a different way of selling? What do you think, what exactly are you doing there?

Infrastructure is a long word, I admit, John. I think that really whatever it relates to is providing the administrative backbone to help better track leads, to provide leads to our sales management, to provide incentives to drive the right products and again, both from a customer perspective and from our perspective. It's kind of the administrative support to help manage, to help the sales management manage the sales force.

Great. Lastly, I know you have talked about goals for asset sales in your guidance, and you have committed your capital to share repos, but what external events, you know could theoretically occur, that could make you either decide to get more back into the acquisition business, or conversely, decide to sell more assets than you have talked about?

Well, I think two things. You know, the type of guidance we have provided so far is specific to the Federal Trade Commission mandated divestitures, as well as legacy SCI businesses that we kind of had in the chute to get rid of for this year.

Okay.

A couple of things are going to occur. We are now going through an asset rationalization process, as we take on the Alderwoods businesses. Now what that will mean is we probably will identify some Alderwoods locations that don't fit our strategy. Maybe in a market that isn't strategically significant to us, and so we will exit those businesses, and sell them as businesses. Those are probably quicker to identify.

The one that will take a little bit longer, as we go to strategic markets and take a Houston or Atlanta, or take a market that is very strategic to us. We are going to look at our footprint and look at the number of locations, and decide, do we need that many locations? Are locations bunched together within a mile of each other? Can we maintain a lot of that business and look for opportunities to convert real estate.

Again, the businesses that may not be performing that well into cash that we can redeploy. That will take a little longer, and therefore it's hard to give you great guidance as to what that number will be, and exactly when it will occur.

Sure.

Second thing, again, that's a variable. As we look at markets, we don't believe there's going to be a lot of great acquisition opportunities out there. What we are seeing occur now in the market place is multiples being paid that are, again, pretty high. That may keep us, at least in the short term from participating in a lot of that.

Having said it, we are going to look within our key strategic markets, looking for opportunities to buy businesses to grow, and/or build businesses. I think that we expect to probably build a lot of new locations within our key strategic markets.

And on the asset sale front, this is my last question, do you have a bias toward funeral versus cemetery at this point?

On asset sales?

Yes, let's say you had an equivalently sub-par location, one was a funeral home, one was cemetery. Are you more interested in being in the funeral business longer term? Do you want to reduce your cemetery presence? Do you want to do more combos? How are you thinking about cemetery as a strategic asset?

I think when you look at strategic, we look at them pretty equally. The difference is with funeral homes is you typically, again within a market place have more leverage than a cemetery does. A cemetery is much more a standalone entity. As we view assets that don't fit our strategy, they equally would be shared.

As we look at ways to rationalize our footprint within strategic markets, we are more likely to divest the funeral homes, again they can be used for alternative purposes, cemeteries really can't. So I think that's the way we view it. We are the world's largest funeral provider, and we are the world's largest cemetery provider, and proud to be both.

Great. Thanks a lot.

Okay.

And your next question will come from the line of Mike Scarangella of Merrill Lynch.

Hey, good morning, guys. I was wondering on the volume number, if you could give us that 6.7% pro forma for the businesses that you exited, so we could see what was death rate and what was related to the exited businesses?

That 6.7% is comparable businesses. What I was trying to say and hard to follow on the call, if you assume we are down to 6.7, our at need calls are down actually just above 7%. So if you are trying to say, and it was probably hard to follow on the call, but if you assume we are down 6.7%, our at need calls are down actually just above 7%, so if you are trying to describe why are we down 7%, our indicators within our markets, that we think are relevant market indicators are cemetery interments, because you don't have as competitive an environment typically around cemeteries. People bury in there from other locations, just as well as SCI.

And the other thing is preneeds going at need. Because people that have a preneed contract, don't necessarily change their mind when they are going to die, and if they are going to provide, go to another service provider. So if you look at those two indicators, it tells us that within our markets, we should be down about 4%. And we are seeing being down by 7%.

So what I was trying to say is within to our at need market place, we think we lost 300 basis points. And if you convert that to calls, it is about 1,100 calls for the quarter, and therefore if you annualize it, you would say maybe we are losing 4,000 to 4,500 calls on an annualized basis.

Again, not statistically relevant from a statisticians point of view. That is kind of the way we view it, and it's how we try to manage our business. Again, you really have to look locally, it's very hard to speak to this on a national level. When we drill down, we see Pacific Northwest, we see Florida, we see Denver, where specific decisions, we are seeing differential levels of volume falling off. They are typically contracted at less than $2,000, and they typically are direct cremation contracts. So again, we think we know why and we think we know where the deterioration of volume is occurring.

Okay. I don't know if this makes sense looking at it in this context, but how do you explain the quarterly trends for '06. The volumes were down kind of 5% in the beginning, and trend up to mid-5s in the middle of the year, and then we end at 6.7 or 7%. I don't know what the right stat is. What drives that trend that way?

Well, I think what you are seeing is different decisions being made at different times. You know, we exited the contract in the Pacific northwest, I think in the second quarter of this year, other decisions that are going to be made. We mentioned Denver. We mentioned Florida, because those, I think what we are seeing now is a full run rate of that occurring as opposed let's say a 70 to 80% run rate that we experienced in the third quarter.

Okay.

Plus I also think you have to take into account the death rate, which could be different from the fourth quarter to the third quarter as well.

Okay. And I think I heard you say that this annualizes in the second quarter, but this is the fourth quarter of this type of phenomenon. Wouldn't we expect this to look a lot better in the first quarter?

What we saw, Mike, and again I know I'm speaking to history, and some people know it and some don't. The first quarter of this year was predominantly in the Northeast, and really we don't believe related to exiting of direct cremation business.

We think it was a very mild winter in the Northeast, and we didn't see these things happening in Florida particularly, as well as the Pacific Northwest. So beginning of the second quarter, we saw the Northeast somewhat stabilize and we began to see kind of these pockets of, you know, low-priced business falling off in these markets. So we think it began in the second quarter of last year, but it only began, and we began to see more of a full run rate going into the third quarter and fourth quarter. Therefore I expect second quarter next year to be a little more normalized, but not completely because you didn't have a big impact, as big an impact in the second quarter of '06.

All right. That makes sense. Maybe just put it into perspective for '07 then. I know you are expecting some softness in volumes and your outlook. Can you be more specific as to what you think the volume trend will be in '07?

Well, I think, again it's hard for me to speak as to what I think will happen as it relates to the general market. If I knew that, I would make a lot more money doing something else. I think the idea, the way to look at it is this, I would expect 300 basis point differential in the first half of the year, relative to the death rate.

So if the death rate is down 2%, I expect us to be down 5 in the first half of the year, and then I would expect in the last half of the year, that that would stabilize and normalize. So I guess that's the way I put it, and again, the relevant number of deaths is going to be driven by, you know, the flu and all the other relevant factors on the healthcare side that people follow.

Okay. That is helpful. Thanks, guys.

Okay.

As a reminder, ladies and gentlemen, [OPERATOR INSTRUCTIONS] Your next question will come from the line of Dana Walker of Kalmar Investments.

Good morning. Great results. Can you describe what type of consistency we might expect from the cemetery side of your business? Q4 was very strong. Q3 was not quite as strong. Are we ever going to get to the point where it consistently delivers at the same level that the funeral business delivers?

I think the way to think about the cemetery business. Unfortunately there is an accounting mechanism that is going to cause a little bit of lumpiness. If you think about it, first of all, the cemetery has seasonality, just like funeral. It's a little bit different. You tend to see higher levels of sales in the summer months, as opposed to the winter months because, again, you don't have bad weather in the Northeast, where people aren't going to stand out in the cold and buy cemetery property, as an example.

But, more importantly, the accounting difference that you have to take into consideration is that when we sell property, we recognize that revenue when it's constructed, and have 10% down. And so, it really is contingent, because we don't recognize it until it's fully constructed, a completed contract method that when that occurs, you will have a lot of revenue.

And if you don't complete a lot of contracts in the quarter, you will have an absence of revenue. I think you will always have a little bit of that, but I think when you look back over a year, there shouldn't be a large differential. On a quarterly basis, you will have some differential.

And you would therefore expect some differential in '07 based on that normal pattern?

I think so by quarter, but as we look at guidance for the year, we don't see a big difference in what we would construct in '07, versus what we would construct in '06. I can tell you again, you may have a contractor, you know, that doesn't have the labor to complete the job. You may have bad weather. There are so many factors that go into the weather, if something doesn't get completed in the second quarter versus the third quarter, it's very difficult to predict.

Are you reasonably convinced, looking at funeral volumes, that the differential that you described of 300 basis points, that that is almost solely derived from the direct cremation, and that you are not seeing any full price business wander off?

Yes. Based upon our analysis, we are seeing the large preponderance of this is the low end, we are actually seeing at the high end increased volume. Again, part of that may be because of our strategic pricing. But if you take contracts above $10,000, we actually see more contracts above 10 than last year. So, again, we are always reviewing this. We are always looking for how to do it better. And again, I point out to people, as we mature in our customer segmentation strategy, we may find better ways to deliver a business to the low end more efficiently, but it is my belief that people have gone too far.

I think you are seeing some of these contracts for $500 and 600, that you can't make money. The rise is too high to be in that business. So I think over time, you will see the low end move up the price range a bit, and stabilize. I think people have changed incremental calls for too long in this industry. It will come home to roost over the next few years.

From a profit standpoint, what are the implications in the markets where you are sluffing the direct cremation business? Are you able to adjust your direct costs sufficiently, that you can offset that, or are those homes touched by that are they going through downed comparisons?

Well, I think if you look at a market, and you are sharing resources. In the markets we identified in that kind of southeast Florida, Fort Ord, as well as the Northwest, we saw our profit margins go up in both of those market places, as we lost significant amounts of calls.

We also have evidence in the Northwest, as an example, where we know where those calls went, and that business performed more poorly with 1,000 extra calls in it. We have very direct evidence that these are not profitable contracts, and we will continue to execute our strategy as we have defined.

So your margins went up in those markets but your profits, that was truly unprofitable business, so your profits didn't go down?

That is correct.

Final question from me is, can you address what you would expect on your at need pricing in the funeral segments, whether it's burial based or cremation based in '07?

Well, I think you have to separate the SCI legacy businesses from the Alderwoods businesses. I think about SCI legacy, we got to have some spillover into the first quarter, and quite potentially a part of the second quarter, where we are seeing differential increases beyond what I would call inflationary increases.

And that again, is because certain markets haven't had a full year's impact of the strategic pricing model. So if you assume inflation is 2 to 3%, then I would expect some differential performance on the SCI side, as relates to the first half of the year. When I think of Alderwoods, it is hard to put a number on it, because again, there are different businesses than our SCI businesses.

But if history tells us something, you could see increases once that is fully in place, you know, somewhere in the high single digit increases, which again is beyond inflationary pricing. That's the way I view it. I wish I could give you more specifics on the Alderwoods. But we are just learning those businesses and just beginning to implement those strategies.

But were you, I'm getting some feedback here. When you adopt the strategic pricing in your SCI core markets, once you fully anniversary that, you are viewing the ongoing pricing benefit as being closer than inflationary, rather than something beyond that?

I think that's the case, and then Dana, I think to look out longer term, we believe when our customer segmentation is more mature, we will do a better job within segments of getting differential pricing improvements. As an example, we believe we are leaving money on the table on the higher end segments. We think we are not offering enough products and services, and so we may be able to go beyond inflationary increases for certain specific items. As you go to the lower end of the spectrum, again, not fully cooked, we may decide that's not the case.

I think I mentioned to you that on the low end, other people have gone too far. We will view it from the customer segmentation standpoint, and so one segment may be inflationary, and another segment may be different from that. And were just not in a position yet to fully understand that within our core businesses.

Thank you very much.

Okay.

You have no further questions at this time. I would like to turn the call over to management for closing comments.

We wanted to thank everybody for participating today, and we will talk to you again on our first quarter conference call later in the year. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation, and you may now disconnect. Have a wonderful day!