Item 1. Business
General
Founded in 1910, Stewart Enterprises, Inc. is the third largest provider of funeral and cemetery products and services in the death care industry in the United States. Through our subsidiaries, we provide a complete range of funeral merchandise and services, along with cemetery property, merchandise and services, both at the time of need and on a preneed basis. As of October 31, 2005, our operations included 231 funeral homes and 144 cemeteries in 26 states within the United States and in Puerto Rico.
For fiscal year 2005, funeral operations accounted for approximately 55 percent of our total revenues, and cemetery operations accounted for the remaining 45 percent. Our funeral homes offer a wide range of services and products including funeral services, cremation, transportation services, removal and preparation of remains, caskets and flowers. Our cemetery operations sell cemetery property, merchandise and services. Cemetery property includes lots, lawn crypts and family and community mausoleums. Cemetery merchandise includes vaults, monuments and markers. Cemetery services include burial site openings and closings and inscriptions.
We believe that we operate one or more of the premier death care facilities in each of our principal markets. Our funeral homes and cemeteries are located primarily in the Southern, Western, Mid-Atlantic and Mid-Western states, generally in large metropolitan areas such as Miami, Orlando, Tampa and St. Petersburg, Florida; Dallas, Fort Worth and Houston, Texas; Los Angeles, San Diego and San Francisco, California; New Orleans, Louisiana; Baltimore, Maryland and the District of Columbia. According to the United States Bureau of the Census, many of these areas have a large population over age 65, which represents a principal target market for our preneed sales program as well as at-need sales. We believe that we are an industry leader in marketing preneed cemetery property and preneed funeral and cemetery merchandise and services, and we consider preneed sales to be an integral part of our long-term business strategy.
Cemetery operations account for a significantly larger percentage of our total revenues than those of our three largest public competitors. We believe cemeteries provide the best foundation for securing long-term market share in our industry. The sale of cemetery property to a family creates a relationship that builds heritage over time, as family members are buried in a plot or mausoleum and as other family members purchase additional cemetery
property in order to be buried in the same cemetery. Our relationships with our cemetery property customers allow us to offer related products and services, such as cemetery merchandise and funeral services, at one of our businesses located on the cemetery grounds or nearby.
We believe that our combination operations help to increase market share. By building new funeral homes on existing cemetery property, we are able to offer families the convenience of complete funeral home and cemetery planning, services and merchandise from a single location at a competitive price at the time of need or on a preneed basis. Approximately 48 percent of our cemeteries have a funeral home onsite that we operate in conjunction with the cemetery. In addition to our combination operations, approximately 37 percent of our cemeteries are located within the same market as, and operated in conjunction with, one or more of our nearby funeral homes. We frequently organize our operating units in “clusters,” which are geographically integrated groups of funeral homes and cemeteries, allowing us to cost-effectively pool resources, such as assets, personnel and services, and generate higher margins.
On Monday, August 29, 2005, Hurricane Katrina struck the New Orleans metropolitan area and the Mississippi and Alabama Gulf Coasts. Of our 231 funeral homes and 144 cemeteries, three funeral homes and five cemeteries, which represent approximately 4 percent of our annual revenues and approximately five percent of our annual gross profit, are located in the New Orleans metropolitan area, suffered substantial damage and are conducting business in temporary facilities until repairs are completed. Our mausoleum construction and sales business, Acme Mausoleum, which primarily operates in southwest Louisiana and Texas, was also negatively impacted by Hurricanes Katrina and Rita. As of October 31, 2005, we had incurred approximately $20.9 million in expenses related to Hurricane Katrina including the write-off of damaged buildings, equipment and inventory, demolition costs, debris removal, record restoration, general cleanup, temporary living facilities for employees, relocation expenses and other costs. We expect insurance proceeds of at least $11.5 million currently based on the status of our insurance review, $0.5 million of which had been received as of October 31, 2005. We believe that a significant portion of the remainder of the loss we experienced may be covered by insurance. For additional information about the effects of Hurricane Katrina, and Hurricanes Rita and Wilma, on our business, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and Note 24 to the consolidated financial statements included in Item 8.
In July 2005, as part of our strategic planning process, we announced the reorganization of our geographic operating divisions from four to two. For additional information, see “Business Strategy” and “Operations” below and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7. Effective in the fourth quarter of 2005, our business had five operating segments consisting of a corporate trust management segment and a funeral and cemetery segment for each of two geographic areas: Western and Eastern. Additional information on our segments can be found in Note 22 to the consolidated financial statements included in Item 8.
Our business was founded by the Stewart family in 1910, and was incorporated as a Louisiana corporation in 1970. Our principal executive offices are located at 1333 South Clearview Parkway, Jefferson, Louisiana 70121, and our telephone number is 504-729-1400. Our website address is www.stewartenterprises.com, where all of our public filings are available free of charge on the same day they are filed with the Securities and Exchange Commission (“SEC”). The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The SEC’s website address is www.sec.gov.
The Death Care Industry
Industry consolidation. Death care businesses in the United States have traditionally been relatively small, family-owned enterprises that have passed through successive generations within the family. The decade of the 1990s witnessed a trend of family-owned firms consolidating with larger organizations, but this trend slowed dramatically in 1999. As the number of consolidators participating in the acquisition market declined, those that remained generally applied significantly tighter pricing criteria, and many potential sellers withdrew their businesses from the market rather than pursuing transactions at lower prices.
During 1999, Service Corporation International, one of our primary competitors for acquisitions, announced plans to significantly reduce the level of its acquisition activity. The Loewen Group, Inc., now reorganized as Alderwoods Group, Inc., previously a primary competitor for acquisitions, entered into bankruptcy proceedings during 1999, after announcing that it had terminated its acquisition activity and was offering a number
of its own properties for sale. In addition, Equity Corporation International, previously the fourth largest public death care company and another of our competitors for acquisitions, merged with Service Corporation International in 1999.
Throughout fiscal year 1999, we continually reduced our acquisition pricing multiples. In the third quarter of fiscal year 1999, our acquisition activity began to decrease substantially from prior quarters as many potential sellers were not willing to sell their businesses at the lower prices. As the business model shifted, death care consolidators experienced diminishing access to capital. In response to these changes, we ceased our acquisition activity and developed strategies for improving our cash flow and reducing and restructuring debt. During fiscal year 2000 through fiscal year 2003, we completed our transitional strategies of improving our cash flow, restructuring and reducing our debt and selling our foreign assets. During fiscal years 2004 and 2005, we sold underperforming assets, refinanced and further reduced our debt and implemented new strategies to improve operations.
We estimate that our industry, which consists of approximately 22,000 funeral homes and 10,500 cemeteries in the United States, collectively generates approximately $15 billion in annual revenue. Our industry continues to be characterized by a large number of locally-owned, independent operations, with approximately 80 percent of industry revenue being generated by independently-owned operations. At current stock prices, the use of our cash to pay dividends, repurchase stock, reduce debt and construct funeral homes on our cemeteries or those of unaffiliated third parties continues to be more attractive than acquisitions. However, if acquisition pricing improves, we believe that growing our organization through acquisitions can again be a good business strategy, as it will enable us to enjoy the important synergies and economies of scale from our infrastructure.
Importance of tradition; barriers to entry. We believe it is difficult for new competitors to enter existing markets successfully by opening new cemeteries and funeral homes. Entry into the cemetery market can be difficult due to several factors. Because families tend to return to the same cemetery for multiple generations to bury family members, it is difficult for new cemeteries to attract families. Additionally, mature markets, including many of the metropolitan areas where our cemeteries are located, are often served by an adequate number of existing cemeteries with sufficient land for additional plots, whereas land for new cemetery development is often scarce and expensive. Regulatory complexities and zoning restrictions also make entry into the cemetery market difficult. Finally, development of a new cemetery usually requires a significant capital investment that takes several years to produce a return. Entry into the funeral home market can be difficult for many of the same reasons. Families are often willing to move from an existing funeral home to a newer facility developed on the grounds of their preferred cemetery; however, absent that connection, families tend to choose the funeral home that previously served their family. Families also choose a funeral home because of its reputation, which can only be developed over time.
Continuing need for products and services; increasing number of deaths. There is an inevitable need for our products and services. Although the number of deaths in the United States will reflect short-term fluctuations, deaths in the United States are expected to increase at a steady, moderate pace over the long-term. According to the United States Bureau of the Census, the number of deaths in the United States is expected to increase by approximately 1 percent per year, from 2.4 million in 2003 to 2.6 million in 2010. Furthermore, the average age of the population in the United States is increasing. According to the United States Bureau of the Census, the United States population over 50 years of age is expected to increase by approximately 2 percent per year, from 76.8 million in 2000 to 98.6 million in 2010. We believe the aging of the population is particularly important because it expands our target market for preneed sales, as persons over the age of 50 are the most likely group to make preneed funeral and cemetery arrangements.
Growing demand for cremation. Consumer preferences in the death care industry tend to change slowly. One significant trend in the United States is an increasing preference of consumers for cremations. Industry research indicates that the percentage of cremations has increased steadily and that cremations will represent approximately 36 percent of deaths in the United States by the year 2010, compared to 29 percent in 2003. The trend toward cremations has been a significant concern for traditional funeral home and cemetery operators because cremations have typically included few, if any, additional products or services other than the cremation itself. However, industry research has shown that consumers most commonly choose cremation over traditional funerals for reasons other than cost, and we believe that cremations also provide our company with an opportunity to offer families an array of additional products and services with an emphasis on customization.
Growing demand for customization. Our market research and operational experience indicate a growing demand for increased personalization of death care products and services, presenting us with an opportunity for enhancing our customers’ satisfaction and increasing our revenue per sale through our custom funeral planning program. For additional information, see below under the heading “Competitive Strengths - Emphasis on customization and personalization.”
Competitive Strengths
Leading market positions. We are the third largest provider of funeral and cemetery products and services in the United States and have been in business for more than 90 years. We believe that we operate one or more of the premier death care facilities in each of our principal markets, which are primarily in larger metropolitan areas in the Southern, Western, Mid-Atlantic and Mid-Western states. In our view, a “premier” facility is one that is among the most highly regarded facilities in its market area in terms of a number of factors such as tradition, heritage, reputation, physical size, volume of business, available inventory, name recognition, aesthetics and/or potential for development or expansion. While funeral homes and cemeteries in the United States perform an average of approximately 100 funerals and 165 burials per year, our facilities perform an average of approximately 265 funerals and 370 burials per year. In addition, approximately 40 percent of our properties are located in California, Florida and Texas, which are three of the four states with the highest populations over age 65, an age group that represents a large portion of our target market.
Strong cemetery operations. Our cemetery operations account for approximately 45 percent of our total revenues, which is a significantly larger percentage than any of our three largest competitors. We believe this is a competitive advantage because families generally return to the same cemetery for multiple generations to bury family members. Cemetery property often becomes an important part of a family’s heritage, and family members who relocate are often returned to their home cemetery to be buried. We build on our relationships with our cemetery customers by offering additional cemetery property to related family members and by offering related products and services such as cemetery merchandise and funeral services at one of our funeral homes located on the cemetery grounds or nearby. Approximately 39 percent of our total cemetery acreage is available for future development.
Emphasis on combination operations. Approximately 48 percent of our cemeteries have a funeral home onsite that is operated in conjunction with the cemetery, which we refer to as a combination operation. This is a higher percentage of combination operations than any of our three largest competitors. We believe combination operations represent a competitive advantage because they offer families the convenience of complete death care services at a single location. A family that is planning a burial in one of our cemeteries often perceives our onsite funeral home to be a more desirable location for funeral services than an unaffiliated offsite funeral home. Thus, the call volume of the funeral home is enhanced by the heritage of the cemetery, and, over time, the volume of cemetery events increases as well. In addition, combination operations enhance our purchasing power, enable us to employ more sophisticated management systems and allow us to share facilities, equipment, personnel and a preneed sales force, resulting in lower average operating costs and expanded marketing and sales opportunities. As a result, our combination operations usually generate higher operating margins compared to our stand-alone funeral homes and cemeteries. In addition to our combination operations, approximately 37 percent of our cemeteries are located within the same market as, and operated in conjunction with, one or more of our nearby funeral homes.
Expertise in preneed sales; strong backlog. We believe that we are distinguished from our competitors by our strong emphasis on, and more than 60-year history of experience with, preneed sales. Preneed plans enable families to specify in advance and prepay for cemetery property and funeral and cemetery services and products. We market our preneed properties, services and products domestically through a full-time staff of approximately 1,100 commissioned sales counselors. We estimate that as of October 31, 2005, the future value of our preneed backlog of funeral and cemetery products and services (including estimated future earnings on funds held in trust and build-up in the face value of third-party insurance contracts, in each case using projected returns) represented approximately $2.0 billion of revenue to be recognized in the future as these prepaid products and services are delivered, calculated as discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7. Our expertise in preneed sales has historically developed out of, and now complements, our strong cemetery operations. This is because cemetery property, such as a burial plot, is usually the first purchase a family will make when considering preneed arrangements. We build on our relationships with our preneed cemetery property customers by offering them additional preneed products and services such as cemetery merchandise and funeral services. Our focus on preneed cemetery property sales is also important because
these sales generate current revenues and higher current cash flows than other types of preneed sales.
Emphasis on customization and personalization. During 1999 we took steps to gain a competitive advantage by placing our company at the forefront of product offerings based on consumer preferences. We hired a major consulting firm to assist us in conducting an extensive market study evaluating changing trends in consumer preferences. With more than 2,400 interviews conducted, we believe this to be the most exhaustive recent study of consumer preferences in our industry. This project provided us with the consumer’s perspective on our operations and facilities. We gained valuable insight into how our employees, business practices and facilities can better meet consumer preferences. Our implementation of new products and services based on the findings of this project continue to be positive drivers for our funeral business.
Among other important findings, our market research indicated that consumer preferences are shifting towards more personalized memorial services and merchandise in the context of both traditional burials and cremations. We responded to these changing preferences by, among other things, training our funeral arrangers to offer our customers a broad range of options, such as designing a funeral service to reflect the special interests or accomplishments of the deceased. We developed a custom funeral planning program and have implemented this program in over 140 of our funeral homes through the end of fiscal year 2005. By the end of fiscal year 2006, we expect to have implemented this program in an additional 30 of our funeral homes. We are also changing the way our product offerings are displayed at our locations, making it easier for our customers to appreciate our wider selection. In our markets where these new business practices have been implemented, we believe that our product and service offerings have enhanced the experiences provided to families at our funeral homes and have contributed to increased revenues per sale.
Expertise in enhanced cremation and alternative service offerings. Our alternative service firms are generally located in leased premises and have lower overhead than traditional funeral homes. Although death care arrangements at these locations are typically more cost-effective for the consumer than services at a traditional funeral home, it is not our goal to be the low-price leader in these markets. While the average revenue for a cremation service is generally lower than that of a traditional full-service funeral, we have found that these revenues can be substantially enhanced by our emphasis on customization. For example, in addition to a personalized memorial service to celebrate the life of the deceased, an enhanced cremation may include a casket, an urn and a niche in a mausoleum or columbarium in which to place the remains. We continue to market our products and services to address the rising demand for cremations.
Centralized support services; cost controls. Our Shared Services Center, which we opened in 1997, was developed for the standardization and centralization of all of our facilities’ administrative and support processes such as accounting, management reporting, payroll, trust administration, contract processing, accounts receivable collection and other services. It allows us to decrease our costs without diminishing service by creating significant savings on items such as trust administration fees, travel expenses, office supplies, overnight delivery and long distance telephone services. As we look at our opportunities for growth, we expect to leverage the efficiencies that we have achieved through our Shared Services Center and expect to manage much of our growth with our existing infrastructure. Additionally, at the beginning of fiscal year 2000 we developed our centralized formal training strategy and began implementation of standardized marketing programs to enhance sales effectiveness. While our centralization of resources and standardization of processes represent a competitive advantage, our management structure is designed to allow local funeral home directors and cemetery managers substantial flexibility in their operations and service to families in an effort to maintain the traditional structure and culture of an individually-owned operation. We believe that this is important in order to maintain the level of caring, personalized service expected by the families we serve.
Experienced management. We have an experienced management team, many of whom owned and operated their own funeral homes and cemeteries and joined us when we acquired their businesses. Our seven top executives have an average of 27 years of experience in the death care industry and have served our company for an average of 12 years.
Business Strategy
Implement strategic plan. In July 2005, management began to implement a new strategic plan designed to transform our culture and grow our business organically, with a focus on increasing the number of funeral calls, the average revenue per funeral call and the number of preneed sales. One part of the plan focuses on putting people
first - customers and employees. In 2005, we hired an independent research firm to conduct market research with customers, prospective customers and front-line employees as a means of gaining a clearer understanding of customer service expectations. From that research we have implemented ways to increase customer satisfaction. We also conducted employee satisfaction surveys. In response to the surveys, we have emphasized the career ownership concept and enhanced our focus on advancement, development and awareness of opportunities within our organization. Additionally, through new employee orientation, an employee suggestion campaign and enhanced communication from senior management, communication throughout the company will improve as employees have better knowledge of changes that directly affect them. Another part of the strategic plan focuses on growing our business through several initiatives that include expanding our product and service offerings to the cremation consumer, forging additional third-party affiliations and marketing additional products and services to our existing customer-base.
In order to more effectively communicate within our organization and execute this strategic plan, in July 2005 we promoted Everett N. Kendrick to Chief Operating Officer and announced a reorganization of our operating divisions from four to two. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.
Continue to implement 2003 operating initiatives. In fiscal year 2003, our executive management team identified several key strategies that we believe will improve the future growth of our business. This led to our announcement in September 2003 of a set of operating initiatives, which resulted in the creation of four task forces to address the following key areas: increased cemetery property sales volume, growth in the number of funeral events performed, cost improvements and employee development initiatives. We continued to implement these initiatives in fiscal years 2004 and 2005 and plan to continue them in 2006.
Our preneed cemetery property task force identified locations with maximum growth potential and developed specific plans to increase preneed property sales and attract new customers at each of those locations. We view preneed property sales as the catalyst for growth in our cemetery segment as they create a customer base for all our businesses. These sales also result in high margins and produce positive cash flow. We have transitioned to personalized selling, and in addition to responding to requests generated by our media campaigns, our salespeople have been successful in obtaining referrals from their existing customer base, allowing them to assist new customers with their cemetery and funeral needs.
We continue to develop and implement strategies to drive at-need and preneed funeral growth throughout our organization. We developed an at-need task force and a cremation task force, implemented a funeral call incentive compensation program and continue to proceed with full implementation of our custom funeral planning program, additional advertising and employee training. Our funeral call volume task force also used the most successful tactics of our top performing funeral homes to develop strategies to drive funeral call growth throughout our organization with an increased focus on preneed funeral sales. We believe that the continuous addition of preneed funeral contracts to our backlog is a primary driver of sustainable long-term growth in the number of families served by our funeral homes.
To improve margins and reduce costs, our task force identified opportunities where we could reduce costs without sacrificing long-term results. These individuals conducted in-depth reviews of cost centers outside of their areas of responsibility to assure effective utilization of all resources. In December 2003, we restructured certain management functions and reduced our employee headcount by approximately 300 throughout the organization. In the markets in which we operate, declining deaths in recent years have resulted in reduced activity in many of our businesses, requiring fewer employees. Additionally, we restructured for a flatter organization to bring leadership closer to those individuals who have the greatest potential to improve the performance of each location. There were no reductions in the number of commissioned sales counselors. We believe the workforce reduction and other cost reductions did not reduce the quality, service and value consistently provided to families through our funeral homes and cemeteries. While we intend to continue controlling costs and growing revenues, we do not anticipate further significant cost cuts (see “Forward-Looking Statements” included in Item 7 and “Cautionary Statements” included in Item 1A.
Item 1A. “Risk Factors”).
The fourth initiative was to enhance employee satisfaction through professional growth, which includes the implementation of a mentoring program and succession plan for all key employee positions. We continue to invest in the professional growth of our employees through numerous programs including those adopted in connection with our 2005 strategic plan.
Maintain backlog through preneed marketing. As part of the 2003 operating initiatives described above, we have increased our focus on preneed sales. We consider maintaining our backlog through preneed marketing to be an integral part of our long-term business strategy. Our primary objective is to balance our preneed sales levels and our cash investment while maintaining a sustainable and predictable level of growth in our backlog. The aging of the population represents a significant opportunity for us to expand our customer base through preneed marketing, as persons over 50 years of age are most likely to make these purchases.
Focus on cash flow. In addition to controlling our costs, we plan to continue to focus on our cash flow through initiatives begun in fiscal year 2000. In fiscal year 2000, we restructured our preneed sales program to focus on increasing cash flow. We improved the quality of our preneed sales and the associated receivables by increasing finance charges, requiring larger down payments and shortening installment payment terms, although this resulted in a decrease in the overall level of preneed sales. Also in 2000, we suspended dividends and implemented a more rigorous internal process for reviewing capital expenditures. With a more solid cash flow position, on March 28, 2005, we announced that our Board of Directors approved the initiation of a quarterly cash dividend, paying approximately $8 million in dividends during the fiscal year. We plan to continue our focus on improving our cash flow and continue controlling our costs by, among other things, obtaining volume discounts from suppliers and leveraging our operating costs through clustering and combination operations. Additionally, we have been incentivizing local managers to control costs by tying their compensation more closely to the profitability of the locations they manage.
Deploy cash flow. We plan to continue to evaluate our options for deployment of cash flow as opportunities arise. On March 28, 2005, we announced a new stock repurchase program, having completed our initial program initiated in June 2003, and announced that our Board of Directors approved the initiation of a quarterly cash dividend of two and one-half cents per share of common stock. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7. At current stock prices, the use of our cash to pay dividends, repurchase stock, reduce debt and construct funeral homes on our cemeteries or those of unaffiliated third parties continues to be more attractive than acquisitions. However, if acquisition pricing improves, we believe that growing our organization through acquisitions can again be a good business strategy, as it will enable us to enjoy the important synergies and economies of scale from our infrastructure.
Increase enhanced cremation products and services. In fiscal years 2005, 2004 and 2003, 38 percent, 37 percent and 36 percent, respectively, of the funeral services we performed in our continuing operations were cremations. The cremation rate in the United States has been increasing. According to industry estimates, 29 percent of deaths in the United States during 2003 resulted in cremations, and cremations are expected to represent 36 percent of deaths in the United States by the year 2010. As described above in “Competitive Strengths - Expertise in enhanced cremation and alternative service offerings,” we have been addressing this trend by providing enhanced cremation products and services at all of our funeral homes.
Operations
General. We believe that we operate one or more of the premier death care facilities in each of our principal markets. In our view, a “premier” facility is one that is among the most highly regarded facilities in its market area in terms of a number of factors such as tradition, heritage, reputation, physical size, volume of business, available inventory, name recognition, aesthetics and/or potential for development or expansion.
We operate most of our funeral homes and cemeteries in “clusters.” Clusters are groups of funeral homes and cemeteries located close enough to one another that their operations can be integrated to achieve economies of scale. For example, clustered facilities can share vehicles, embalming services, inventories of caskets and other merchandise and, most significantly, personnel, including prearrangement sales personnel; thus, we are able to decrease our costs and expand our sales and marketing effectiveness at each location. By virtue of their proximity to one another, clustered facilities also create opportunities for more integrated and sophisticated management of operations.
Funeral operations. Funeral operations accounted for approximately 55 percent of our revenues for fiscal year 2005. Our funeral homes offer a complete range of funeral services and products both at the time of need and on a preneed basis. Our services and products include family consultation, removal and preparation of remains, the
use of funeral home facilities for visitation, worship and funeral services, transportation services, flowers and caskets. In addition to traditional funeral services, all of our funeral homes offer cremation products and services. Most of our funeral homes have a non-denominational chapel on the premises, which allows family visitation and religious services to take place at the same location. As of October 31, 2005, we operated 231 funeral homes.
Cemetery operations. Cemetery operations accounted for approximately 45 percent of our revenues for fiscal year 2005. Our cemetery operations sell cemetery property and related merchandise, including lots, lawn crypts, family and community mausoleums, monuments, markers and burial vaults, and also provide burial site openings and closings and inscriptions. Cemetery property and merchandise sales are made both at the time of need and on a preneed basis. We also maintain cemetery grounds under cemetery perpetual care contracts and local laws. As of October 31, 2005, we operated 144 cemeteries.
Combination funeral home and cemetery operations. Approximately 48 percent of our cemeteries have a funeral home onsite that is operated in conjunction with the cemetery, which is a higher percentage of combination operations than any of our three largest competitors. Many of these facilities are in our key markets, including New Orleans, Louisiana; Dallas, Fort Worth and Houston, Texas; Miami, Orlando, Tampa and St. Petersburg, Florida; and Los Angeles and San Diego, California.
Combination operations help to increase market share by allowing us to offer families the convenience of complete funeral and cemetery planning and services from a single location at a competitive price at the time of need or on a preneed basis. Our experience demonstrates that a family planning a burial in our cemetery often views our associated funeral home as a more desirable location for funeral services than an unaffiliated offsite funeral home. Thus, the funeral home’s sales benefit from the heritage of the cemetery, and over time, the cemetery’s activity increases as well. In addition, combination operations enhance our purchasing power, enable us to employ more sophisticated management systems and allow us to share facilities, equipment, personnel and a preneed sales force, resulting in lower average operating costs and expanded sales and marketing opportunities. Although it generally takes several years before a newly constructed funeral home becomes profitable, our experience with combination operations has demonstrated that the combination of a funeral home with a cemetery can significantly increase the market share and profitability of both.
We have three primary strategies for growth through the use of combination operations. One strategy is to create combination operations by constructing funeral homes on the grounds of our cemeteries. Another is to enter into agreements in which we construct funeral homes on the grounds of unaffiliated cemeteries, which allows us to enjoy many of the benefits of a combination operation without the capital investment of purchasing the cemetery. The cemetery revenue of the unaffiliated cemetery is enhanced as it benefits by being able to compete more effectively with other cemeteries or combination operations in the market and by providing a better service to their parishioners or other constituencies. The third strategy is to acquire combination operations.
In 1987, we entered into an agreement with the Catholic Archdiocese of New Orleans pursuant to which we constructed and own a mausoleum on one of our cemeteries, and the Archdiocese of New Orleans assists in the promotion of the sale of crypts in the mausoleum to Catholic parishioners of the Archdiocese of New Orleans. The Company pays the Archdiocese of New Orleans a percentage of the revenue from the sale of all crypts in the mausoleum. Additionally, in fiscal year 1994, we constructed a funeral home and mausoleum on the grounds of the New Orleans Cemetery of the Firemen’s Charitable and Benevolent Association, a non-profit organization. We own and operate the funeral home and mausoleum.
In 1997, we entered into lease agreements with the Archdiocese of Los Angeles whereby we have the right to construct and operate funeral homes on the sites of up to nine cemeteries owned and operated by the Archdiocese. As of October 31, 2005, five of these funeral homes were operating, and construction had begun on the sixth funeral home. The leases expire in 2039, and we do not have an option to renew. We account for these leases as operating leases.
Over the last 50 years, through our mausoleum construction business, we have developed relationships with the Catholic Church in approximately 70 dioceses in 39 states. We plan to pursue more of these agreements with the Catholic Church, other faith-based organizations and non-profit entities. We also plan to develop additional combination operations on our own cemetery properties as well as pursuing the acquisition of privately-owned combination operations.
Cremation. In fiscal year 2005, 38 percent of the funeral services we performed in our continuing operations were cremations. The increasing preference of consumers for cremations is a significant trend in the United States. Industry research indicates that the percentage of cremations has steadily increased and that cremations will represent approximately 36 percent of deaths in the United States by the year 2010, compared to 29 percent in 2003. We have been addressing this trend by providing enhanced cremation products and services at all of our funeral homes, including funeral services and memorialization for families choosing cremation. We are also addressing this trend through our alternative service firm strategy as discussed above in “Competitive Strengths - Expertise in enhanced cremation and alternative service offerings.”
Preneed arrangements. We market death care products and services domestically on a preneed basis through a full-time staff of approximately 1,100 commissioned sales counselors. Preneed plans enable families to specify in advance and prepay for funeral and cemetery arrangements. Prearrangements spare families the emotional strain of making death care decisions at the time of need. The products and services included in preneed contracts are set at prices prevailing at the time the agreement is signed rather than when the products and services are delivered. As described in Note 3 to the consolidated financial statements included in Item 8, customer payments related to these contracts are generally placed in trusts and invested or are used to purchase insurance policies to cover the cost of the future delivery of products and services. When the service or merchandise is delivered, we realize the full contract amount plus all accumulated trust earnings associated with that contract or the buildup in the face value of the insurance contract, generally offsetting increases in our costs due to inflation.
We estimate that as of October 31, 2005, the future value of our preneed backlog (including estimated earnings on funds held in trust and build-up in the face value of third-party insurance contracts, in each case using projected returns) represented approximately $2.0 billion of revenue to be recognized in the future as these prepaid products and services are delivered, calculated as discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7.
Trusts and escrow accounts. We maintain three types of trusts and escrow accounts: (1) preneed funeral merchandise and services, (2) preneed cemetery merchandise and services and (3) cemetery perpetual care. For further discussion of these trusts and escrow accounts, see Notes 5, 6 and 7 to the consolidated financial statements included in Item 8 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7. As of October 31, 2005, the market value of our preneed funeral merchandise and services trust and escrow accounts totaled approximately $444.2 million, the market value of our preneed cemetery merchandise and services trust and escrow accounts totaled approximately $190.4 million, and the market value of our cemetery perpetual care trusts totaled approximately $212.1 million.
We believe that the balances in our trusts and escrow accounts, along with insurance proceeds, installment payments due under contracts and future earnings on the balances, will be sufficient to cover our estimated cost of providing the related preneed services and products in the future (see Item 1A. “Risk Factors”).
Generally, our wholly-owned subsidiary, Investors Trust, Inc. (“ITI”), a Texas corporation with trust powers, serves as investment advisor on our investment portfolio and our prearranged funeral, merchandise and cemetery perpetual care trusts and escrow accounts. ITI provides investment advisory services exclusively to our trusts for a fee. Under state trust laws, we are allowed to charge the trusts a fee for managing the investment of the trust assets. We have elected to perform these services in-house, and the fees are recognized as income as the services are performed. For additional information, see Note 22 to the consolidated financial statements included in Item 8. ITI is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. As of October 31, 2005, ITI managed assets with a market value of approximately $812.6 million. Lawrence B. Hawkins, one of our executive officers and a professional investment manager, serves as President of ITI. ITI operates within the guidelines of a formal investment policy established by the Investment Committee of our Board of Directors. The policy emphasizes conservation, diversification and preservation of principal while seeking appropriate levels of current income and capital appreciation.
Management. We have an experienced management team, many of whom joined us through acquisitions. Our management structure is designed to allow local funeral home directors and cemetery managers substantial flexibility in deciding how their businesses will be managed and how their products and services will be priced and merchandised. At the same time, financial and strategic goals are established by management at the corporate level. We provide business support services primarily through our Shared Services Center, which opened in 1997 and provides centralized and standardized accounting, management reporting, payroll, contract processing, accounts
receivable collection and other services for all of our facilities. In December 2003, we restructured certain management functions and reduced our employee headcount by approximately 300 employees throughout the organization. In July 2005, we announced that we were reorganizing our operating divisions from four to two, effective for the fourth quarter of fiscal year 2005.
As of October 31, 2005, we were divided into two geographic operating divisions in the United States, each of which was managed by a division president and chief financial officer. Our operating divisions are further divided into regions, each of which is managed by a regional vice president. We also have a Corporate Division, which manages our corporate services, accounting, financial operations and strategic planning and a Sales and Marketing Division responsible for sales teams in all operating divisions. From time to time, we may increase, reduce or realign our divisions and regions.
In December 2004, Thomas M. Kitchen, a member of our Board of Directors, was named Executive Vice President and Chief Financial Officer. In July 2005, Everett N. Kendrick, Senior Vice President and President of the Sales and Marketing Division, was named Executive Vice President and Chief Operating Officer. John P. Laborde, an independent member of the Board of Directors since 1995, was appointed Chairman of the Board in April 2005.
Financial information about industry and geographic segments. For financial information about our industry and geographic segments for fiscal years 2005, 2004 and 2003, see Note 22 to our consolidated financial statements included in Item 8.
Competition
Our funeral home and cemetery operations generally face intense competition in local markets that typically are served by numerous funeral home and cemetery firms. We also compete with monument dealers, casket retailers, low-cost funeral providers and crematories, and other non-traditional providers of limited services or products. Discount retailers have begun marketing caskets at prices sometimes lower than what we offer. Consumers can now buy caskets in funeral supply stores and directly from manufacturers, as well as over the Internet, and recently, the first large general merchandise company has entered the market for low-cost caskets. Market share for funeral services and cemetery property is largely a function of goodwill, family heritage and tradition, although competitive pricing, professional service and attractive, well-maintained and conveniently-located facilities are also important, and price can be especially important for funeral and cemetery merchandise. Because of the significant role of goodwill and tradition, market share increases for funeral services and cemetery property are usually gained over a long period of time. Extensive marketing through media advertising, direct mailings and personal sales calls has increased in recent years, especially with respect to the sales of preneed funeral services. Information about our sales and marketing approach can be found above under the heading “Business Strategy.” Traditional cemetery and funeral service operators face competition from the increasing number of cremations in the United States. Additional information about the trend toward cremation and our strategies to address that trend can be found under the headings “The Death Care Industry,” “Competitive Strengths” and “Business Strategy.”
Regulation
Our funeral home operations are regulated by the Federal Trade Commission (the “FTC”) under the FTC’s Trade Regulation Rule on Funeral Industry Practices, 16 CFR Part 453 (the “Funeral Rule”), which went into effect on April 30, 1984, and was revised effective July 19, 1994. The FTC began reviewing the Funeral Rule in 1999 at which time it conducted hearings to receive input from industry and consumer groups. At this time, the FTC has not issued any proposed changes to the regulation nor are any anticipated in the immediate future.
The Funeral Rule defines certain acts or practices as unfair or deceptive and contains certain requirements to prevent these acts or practices. The preventive measures require a funeral provider to give consumers accurate, itemized price information and various other disclosures about funeral goods and services and prohibit a funeral provider from: (1) misrepresenting legal, crematory and cemetery requirements; (2) embalming for a fee without permission; (3) requiring the purchase of a casket for direct cremation; and (4) requiring consumers to buy certain funeral goods or services as a condition for furnishing other funeral goods or services.
Our operations are also subject to extensive regulation, supervision and licensing under numerous federal, state and local laws and regulations. For example, state laws impose licensing requirements for funeral homes and
funeral directors and regulate preneed sales. Our embalming facilities are subject to stringent environmental and health regulations. We have a department that monitors compliance, and we believe that we are in substantial compliance with the Funeral Rule and all such laws and regulations. Federal, state and local legislative bodies and regulatory agencies frequently propose new laws and regulations, some of which could have a material effect on our operations and on the death care industry in general. We cannot predict the outcome of any proposed legislation or regulation or the effect that any such legislation or regulation might have on us.
Employees
As of October 31, 2005, we employed approximately 5,400 persons, and we believe that we maintain a good relationship with our employees. Approximately 133 of our employees are represented by labor unions or collective bargaining units.
Item 1A. Risk Factors
Cautionary Statements
Our business is subject to significant risks. We caution readers that the following important factors, among others, in some cases have affected, and in the future, could affect, our actual consolidated results and could cause our actual consolidated results in the future to differ materially from the goals and expectations expressed in the forward-looking statements above and in any other forward-looking statements made by us or on our behalf.
Risks Related to Our Business
We have recently been required to restate previously issued financial statements and have discovered material weaknesses in our internal controls over financial reporting, which caused us to be unable to timely file our Form 10-Q for the quarter ended July 31, 2005 and our Form 10-K for the fiscal year ended October 31, 2005 with the Securities and Exchange Commission.
As a result of our restatement discussed in Note 2 to the consolidated financial statements included in Item 8, we missed filing deadlines for our Form 10-Q for the quarter ended July 31, 2005 (the “2005 Third Quarter Report”) and our Form 10-K for the fiscal year ended October 31, 2005 (the “2005 Form 10-K”). We also have been unable to complete an amendment to our Form 10-K for the fiscal year ended October 31, 2004 (the “2004 Form 10-K/A”). We plan to file a completed 2005 Third Quarter Report by February 22, 2006 and a completed 2004 Form 10-K/A by April 7, 2006. During any period when we are not current with our SEC reports, neither our affiliates nor any person that purchased shares in a private offering during the preceding two years will be able to sell their shares in public markets pursuant to Rule 144 under the Securities Act of 1933. Also our registration statements on Form S-8 regarding sales of our securities through our employee benefit plans will not be available, and we have suspended sales under these registration statements until we are current in our SEC filings.
As discussed in Item 9A, we are in the process of remediating the material weaknesses in our internal controls, and we can give no assurances as to when the remediation will be completed.
We are subject to a delisting proceeding by The Nasdaq Stock Market.
We have received notifications from Nasdaq that our incomplete 2005 Third Quarter Report, the delay in filing our 2005 Form 10-K and our incomplete 2004 Form 10-K/A are not in compliance with the continued listing requirements of Nasdaq Marketplace Rule 4310(c)(14). The Nasdaq Listing Qualifications Panel granted our request for an extension of time to file the complete 2005 Third Quarter Report and the 2005 Form 10-K to February 15, 2006. On February 14, 2006, we requested an additional extension of time to February 22, 2006 in which to file the 2005 Form 10-K and 2005 Third Quarter Report. We also requested an extension of time in which to file the 2004 Form 10-K/A until April 7, 2006. Nasdaq has granted these extensions. Delisting of our Class A common stock could have a material adverse effect on the trading price of and market for our Class A common stock and on our ability to raise capital.
The delay in filing our SEC reports has also resulted in an increase in the interest rate payable on our 6.25 percent senior notes, and we cannot predict when the increase will be reduced.
In connection with the issuance of our 6.25 percent senior notes in February 2005, we entered into a registration rights agreement requiring us to conduct a registered exchange offer to allow holders of the unregistered notes to exchange them for similar registered notes, all with specified times. Due to accounting matters referenced above, we were unable to comply with the agreement within the specified time frames, and have so far not been able to cause the required registration statement to become effective. As a result, we have incurred additional interest on the notes which will continue until the registration statement is effective and the exchange offer completed. The additional interest is currently accruing at the rate of 1.50 percent, which is the maximum additional interest rate under the agreement. See Note 16 to our consolidated financial statements included in Item 8. Before the exchange offer can occur, we must complete and file an amended Form 10-K for the fiscal year ended 2004, file amended Form 10-Qs for the quarters ended January 31, 2005, April 30, 2005 and July 31, 2005, complete a registration statement for the exchange offer and have the registration statement declared effective by the SEC. We cannot currently predict when we will be able to file the registration statement and have it declared effective by the SEC. Although we believe we have resolved all issues raised by the SEC Staff, we can give no assurances regarding how and when the SEC will complete its review.
Failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on the market price of our common stock and our access to capital.
Section 404 of the Sarbanes-Oxley Act requires management’s assessment of the effectiveness of internal controls over financial reporting and a report by our independent registered public accounting firm addressing management’s assessment and the effectiveness of the internal controls over financial reporting. During the course of testing, we identified deficiencies and material weaknesses which caused management to conclude that our internal controls over financial reporting were not effective as of the end of fiscal year 2005, and our auditors also concluded that these controls were not effective as of the end of fiscal year 2005. This could have a material adverse effect on the market price of our common stock and on our access to capital. If we are unable to achieve and maintain effective internal controls over financial reporting, such adverse effects may continue. See Management’s Report on Internal Control over Financial Reporting in Item 9A and the Report of Independent Registered Public Accounting Firm in Item 8.
From fiscal years 1994 to 2004, we have experienced a decline in funeral call volume due to many factors, such as the number of deaths and competition in our markets, our ability to identify changing consumer preferences and various other factors, some of which are beyond our control.
We have experienced declines in same-store funeral call volumes for a number of years due to many factors described elsewhere herein including the number of deaths, intense competition and our ability to identify changing consumer preferences. From fiscal years 2001 to 2002 and 2002 to 2003, same-store funeral call volumes decreased 1.5 percent and 2.6 percent, respectively. One of the operating initiatives announced in 2003 was the creation of a funeral call volume task force, which is using the most successful tactics of our top performing funeral homes to develop strategies to drive funeral call growth throughout our organization with an increased focus on preneed funeral sales. Nevertheless, we experienced a decline in same-store funeral call volumes from fiscal year 2003 to 2004 of 1.0 percent. We did experience an increase of 0.3 percent in same-store funeral call volumes for the year ended October 31, 2005, as compared to the prior year, which includes the impact of the Louisiana funeral homes affected by Hurricane Katrina. We believe the increase in funeral call volume is attributable to the implementation of the operating initiatives described above. However, we can give no assurance that we will be able to sustain such increases in the long term or that we will succeed in stopping or reversing the long-term trend in declining same-store funeral call volumes.
Our business is subject to the risk of losses due to hurricanes.
Our company is headquartered in the New Orleans metropolitan area, and approximately 75 of our funeral homes and 45 of our cemeteries, along with our mausoleum construction and sales business, Acme Mausoleum, are located near the Gulf Coast in southern Texas, Louisiana, Mississippi, Alabama and Florida, along the eastern coasts of Florida, and North and South Carolina and in Puerto Rico. These areas are periodically threatened by hurricanes, which can damage our properties, interrupt our business and disrupt the lives of our customers and employees.
In fiscal year 2005 our business was adversely affected by Hurricanes Katrina, Wilma and Rita. We believe that a significant portion of the loss we experienced due to Hurricane Katrina should be covered by insurance, but we cannot predict the long-term effects on our operations of the following factors: the economic conditions currently existing in the New Orleans metropolitan area; the success and timing of repairs and reconstruction of the New Orleans metropolitan area and of our facilities following the effects of Hurricane Katrina; and the timing and amount of collection of insurance recoveries.
We may experience declines in preneed sales due to numerous factors, including a weakening economy. Declines in preneed property sales would reduce current revenue. Declines in preneed funeral and cemetery service and merchandise sales would reduce our backlog and could reduce our future revenues and market share.
A weakening economy that causes customers to reduce discretionary spending could cause, and we believe has caused in the past, a decline in preneed sales. Geopolitical concerns could lower consumer confidence, which could also result in a decline in preneed sales. Declines in preneed cemetery property sales would reduce current revenue, and declines in other preneed sales would reduce our backlog and future revenue and could reduce future market share.
Price competition could reduce market share or cause us to reduce prices to retain or recapture market share, either of which could reduce revenues and margins.
Our funeral home and cemetery operations generally face intense competition in local markets that typically are served by numerous funeral homes and cemetery firms. We have historically experienced price competition primarily from independent funeral home and cemetery operators, and from monument dealers, casket retailers, low-cost funeral providers and other non-traditional providers of services or products including, in recent years, Internet providers. From time to time, this price competition has caused us to lose market share in some markets. In other markets, we have had to reduce prices thereby reducing profit margins in order to retain or recapture market share. Increased price competition in the future could further reduce revenues, profit margins and backlog and potentially impact our annual goodwill impairment analysis.
Discount retailers sell caskets at prices substantially lower than prices we offer. Consumers can now buy caskets in funeral supply stores and directly from manufacturers, as well as over the Internet, and the first large general merchandise company recently entered the market for low-cost caskets. Competition from these sources could reduce our casket sales, which could adversely affect funeral revenues and margins.
Increased advertising and better marketing by competitors, as well as increased offering of products or services over the Internet, could cause us to lose market share and revenues or cause us to incur increased costs in order to retain or recapture market share.
In recent years, the marketing of preneed funeral services through television, radio and print advertising, direct mailings and personal sales calls has increased. Extensive advertising or effective marketing by competitors in local markets could cause us to lose market share and revenues or cause us to incur increased marketing costs. In addition, competitors may change the types or mix of products or services offered. These changes may attract customers, causing us to lose market share and revenue or to incur costs necessary to respond to competition by varying the types or mix of products or services offered by us. Also, increased use of the Internet by customers to research and/or purchase products and services could cause us to lose market share to competitors offering to sell products or services over the Internet. We do not currently sell products or services over the Internet.
If we are not able to respond effectively to changing consumer preferences, our market share, revenues and profitability could decrease.
Future market share, revenues and profits will depend in part on our ability to anticipate, identify and respond to changing consumer preferences. During fiscal year 2000, we began to implement strategies based on an extensive proprietary study of consumer preferences we commissioned in 1999. However, we may not correctly anticipate or identify trends in consumer preferences, or we may identify them later than our competitors do. In
addition, any strategies we may implement to address these trends may prove incorrect or ineffective.
Earnings from and principal of trusts and escrow accounts could be reduced by changes in stock and bond prices and interest and dividend rates.
We maintain three types of trusts and escrow accounts: (1) preneed funeral merchandise and services, (2) preneed cemetery merchandise and services and (3) cemetery perpetual care. Earnings and investment gains and losses on trusts and escrow accounts are affected by financial market conditions that are not within our control. Earnings are also affected by the mix of fixed-income and equity securities that we choose to maintain in the trusts, and we may not choose the optimal mix for any particular market condition. The size of the trusts depends upon the level of preneed sales and maturities, the amount of ordinary income and investment gains or losses and funds added through acquisitions, if any. Declines in earnings from cemetery perpetual care trusts would cause a decline in current revenues, while declines in earnings from other trusts and escrow accounts could cause a decline in future cash flows and revenues. In addition, any significant or sustained investment losses could result in there being insufficient funds in the trusts to cover the cost of delivering services and merchandise or maintaining cemeteries in the future. Any such deficiency would have to be covered by cash flow, which could have a material adverse effect on our financial position and results of operations.
Unrealized gains and losses in the preneed funeral and cemetery merchandise and services trusts have no immediate impact on our revenues, margins, earnings or cash flow, unless the fair market value of the trusts were to decline below the estimated costs to deliver the underlying products and services. If that were to occur, we would record a charge to earnings to record a liability for the expected losses on the delivery of the associated contract. Over time, gains and losses realized in the trusts are allocated to underlying preneed contracts and affect the amount of the trust earnings we record when we deliver the underlying products or services. Accordingly, if current market conditions do not improve, the trusts may eventually realize losses, and our revenues, margins, earnings and cash flow would be negatively affected by the reduced revenue when we deliver the underlying products and services. Unrealized gains and losses in the cemetery perpetual care trusts do not affect earnings but could limit the capital gains available to us and could result in lower returns and lower current revenues than we have historically achieved.
Increased preneed sales may have a negative impact on cash flow and earnings.
Preneed sales of cemetery property and funeral and cemetery products and services are generally cash flow negative initially, primarily due to the commissions and other costs to acquire the sale, the portion of the sales proceeds required to be placed into trusts or escrow accounts and the terms of the particular contract, such as the size of the down payment required and the length of the contract. We will continue to invest a significant portion of cash flow in preneed acquisition costs, which reduces cash flow available for other activities, and, to the extent preneed activities are increased, cash flow would be further reduced, and our ability to service debt could be adversely affected.
Increased costs may have a negative impact on earnings and cash flows.
During fiscal year 2004, we reduced funeral, cemetery and corporate general and administrative expenses, primarily through a reduction in our workforce. While we intend to continue to control costs, we do not anticipate any further significant cost cuts. We may not be successful in maintaining our margins and may incur additional costs. For example, we are experiencing increased costs, at least in the near term, as a result of Hurricane Katrina. We have also incurred significant legal costs to defend unanticipated class action litigation and significant costs in connection with Sarbanes-Oxley compliance, our deferred revenue project and restatement of our financial statements. We may incur additional costs in fiscal year 2006 in conjunction with improving our systems and remediating control deficiencies noted as part of our Sarbanes-Oxley Section 404 assessment.
Insurance costs, in particular, have increased substantially in recent years. The terrorist attacks in the United States on September 11, 2001 and related subsequent events have resulted in higher insurance premiums. The volume of claims made in such a short span of time resulted in liquidity challenges that many insurers have passed on to their policyholders. Insurers have increased premiums to offset losses in equity markets due to recent economic conditions. Insurance costs may also increase in the future due to the volume of claims associated with
Hurricanes Katrina, Rita and Wilma. Additionally, we have experienced increases in health insurance costs. Additional increases in insurance costs cannot be predicted.
Our Chairman Emeritus may have a significant and disproportionate influence on the outcome of election of directors and other matters presented for a vote of shareholders and this control may be exercised in a manner that may conflict with the interests of shareholders.
As of October 31, 2005, our Chairman Emeritus, Frank B. Stewart, Jr., held 7,235,623 shares (or approximately 7 percent) of our outstanding Class A common stock and all of the 3,555,020 outstanding shares of our Class B common stock. Because each share of Class B common stock is entitled to 10 votes on all matters presented for a vote by our shareholders, Mr. Stewart controls approximately 30 percent of our total voting power, while holding approximately 10 percent of our outstanding equity. Accordingly, Mr. Stewart may have a significant and disproportionate influence over the election of directors and other matters requiring the affirmative vote of our shareholders and this control may be exercised in a manner that may conflict with the interest of shareholders. Additionally, because Louisiana law and our articles of incorporation require the affirmative vote of two-thirds of the voting power present to approve certain major transactions and any amendments to our articles of incorporation, Mr. Stewart may have the ability to prevent the consummation of such actions, even if they are recommended by our Board of Directors and favored by a substantial majority of our shareholders.
Servicing our debt will require a significant amount of cash, and our ability to generate sufficient cash depends on many factors, some of which are beyond our control.
Our ability to make payments on and to refinance our debt depends on our ability to generate cash flow. This, to a significant extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. In addition, our ability to borrow funds in the future to make payments on our debt will depend on our meeting the financial covenants in our senior secured credit facility and other debt agreements we may have in the future. Our business may not generate cash flow from operations, and future borrowings may not be available to us under our senior secured credit facility or otherwise in an amount sufficient to enable us to pay our debt or to fund other liquidity needs. As a result, we may need to refinance all or a portion of our debt on or before maturity. We may not be able to refinance any of our debt on favorable terms, or at all. Any inability to generate sufficient cash flow or refinance our debt on favorable terms could have a material adverse effect on our financial condition.
Increases in interest rates would increase interest costs on our variable-rate long-term debt and could have a material adverse effect on our net income and earnings per share.
Amounts borrowed under the senior secured credit facility are subject to variable interest rates. Any significant increase in interest rates could increase our interest costs on our variable-rate long-term debt or indebtedness incurred in the future, which could decrease our net income and earnings per share materially.
Our ability to maintain compliance with our covenants under our senior secured credit facility and 6.25 percent senior notes is dependent upon many factors, one of which is our ability to file timely reports with the SEC. Covenant restrictions may also limit our ability to operate our business.
The restatements described in Note 2 to the consolidated financial statements included in Item 8 as well as our failure to deliver financial statements within the specified deadlines in our senior secured credit facility resulted in a default and potential event of default under the facility. We sought and received waivers of the defaults and potential events of default related to the restatements and failure to deliver audited consolidated financial statements by the specified deadline. A waiver granted an extension to deliver the audited consolidated financial statements for a date subsequent to this filing. We delivered the financial statements within the time period specified in the waiver. We believe our incomplete July 31, 2005 Form 10-Q filed with the SEC met the financial statement compliance requirements of our senior secured credit facility. We believe we were in compliance with the terms of the senior secured credit facility.
The indenture governing our 6.25 percent notes requires us to furnish to the trustee for forwarding to the holders of the notes, within the time periods specified in the SEC’s rules and regulations, all quarterly and annual financial information that would be required to be contained in a filing with the SEC on Forms 10-Q and 10-K, including a “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and, with respect to the annual information only, a report on the annual financial statements from our certified independent accountants. In addition, we must file a copy with the SEC for public availability within the time periods specified in the SEC’s rules and regulations. An event of default would occur if we failed to provide that information within 30 days after receipt of written notice by the trustee or holders of at least 25 percent of the principal amount outstanding. We furnished our July 31, 2005 Form 10-Q to the trustee and filed it with the SEC, and believe that doing so complied with the requirements of the indenture. We have not received a default notice from the trustee or note holders with respect to the late filing of the Form 10-K for the fiscal year ended October 31, 2005 and have now filed this report with the SEC. We believe we are in compliance with the terms of our 6.25 percent notes.
Our senior secured credit facility and the indenture governing the 6.25 percent senior notes contain, among other things, covenants that restrict our and our subsidiaries’ activities. Our senior secured credit facility limits, among other things, our and the guarantors’ ability to: borrow money; pay dividends or distributions; purchase or redeem stock; make investments; engage in transactions with affiliates; engage in sale and leaseback transactions; consummate specified asset sales; effect a consolidation or merger or sell, transfer, lease, or otherwise dispose of all or substantially all of our assets; and create liens on our assets. In addition, our senior secured credit facility contains specific limits on capital expenditures. Furthermore, our senior secured credit facility requires us to maintain specified financial ratios and satisfy financial condition tests. The indenture governing the 6.25 percent senior notes restricts our and the guarantors’ ability to create liens on assets, enter into sale and leaseback transactions and merge or consolidate with other companies. Our and our subsidiaries’ future indebtedness may contain similar or even
more restrictive covenants.
These covenants may require that we take action to reduce our debt or to act in a manner contrary to our business objectives. In addition, events beyond our control, including changes in general economic and business conditions, may affect our ability to satisfy these covenants. We might not meet those covenants, and the lenders might not waive any failure to meet those covenants. A breach of any of those covenants could result in a default under such indebtedness. If an event of default under our senior secured credit facility occurs, the lenders could elect to declare all amounts outstanding thereunder, together with accrued interest, to be immediately due and payable. Any such declaration would also result in an event of default under the indenture governing the 6.25 percent senior notes. For additional information, see “Liquidity and Capital Resources” included in Item 7.
The payment of dividends on our common stock in the future is subject to uncertainties.
The declaration of dividends on our common stock in the future is subject to the discretion of our Board of Directors each quarter after its review of our financial performance. Our ability to pay dividends is restricted under our senior credit facility. See Note 16 to the consolidated financial statements included in Item 8.
Unanticipated litigation or negative developments in pending litigation could have a material adverse effect on our financial statements.
We are a defendant in the litigation described in Note 21 to the consolidated financial statements included in Item 8 and other litigation in the ordinary course of business. The outcome of litigation is inherently uncertain and adverse developments or outcomes can result in significant monetary damages, penalties or injunctive relief against us.
Our projections do not include any earnings from acquisition activity. Several important factors, among others, may affect our ability to consummate acquisitions.
Although we have not made any significant acquisitions in recent years, we may in the future. Any such acquisitions have risks. We may fail to identify suitable acquisition candidates, and even if we do, acquisitions may not be completed on acceptable terms or successfully integrated into our existing business. We may not be able to find businesses for sale at prices we are willing to pay. Acquisition activity, if any, will also depend on our ability to enter new markets. Due in part to our lack of experience operating in new areas and to the presence of competitors who have been in certain markets longer than we have, such entry may be more difficult or expensive than we anticipate.
We have had significant changes in the application of generally accepted accounting principles to our business. No assurances can be given that we will not face similar issues in the future.
In recent years we have had significant changes in the application of generally accepted accounting principles to our business. These changes have sometimes made it difficult to compare results from one period to the next and have also resulted in reclassifications and restatements of previously reported results. We can give no assurances that we will not face similar issues in the future.
Risks Related to the Death Care Industry
Declines in the number of deaths in our markets can cause a decrease in revenues. Changes in the number of deaths are not predictable from market to market or over the short term.
Declines in the number of deaths could cause at-need sales of funeral and cemetery services, property and merchandise to decline, which could decrease revenues. Although the United States Bureau of the Census estimates
that the number of deaths in the United States will increase by approximately 1 percent per year from 2000 to 2010, longer lifespans could reduce the rate of deaths. Changes in the number of deaths can vary among local markets and from quarter to quarter, and variations in the number of deaths in our markets or from quarter to quarter are not predictable. However, generally the number of deaths fluctuates with the seasons with more deaths occurring during the winter months primarily resulting from pneumonia and influenza. These variations can cause revenues to fluctuate.
Our comparisons of the change in the number of families served to the change in the number of deaths reported by the Centers for Disease Control and Prevention (“CDC”) from time to time may not necessarily be meaningful. The CDC receives weekly mortality reports from 122 cities and metropolitan areas in the United States within two to three weeks from the date of death and reports the total number of deaths occurring in these areas each week based on the reports received from state health departments. The comparability of our funeral calls to the CDC data is limited, as reports from the state health departments are often delayed, and the 122 cities reporting to the CDC are not necessarily comparable with the markets in which we operate.
The increasing number of cremations in the United States could cause revenues to decline because we could lose market share to firms specializing in cremations. In addition, basic cremations produce no revenues for cemetery operations and lesser funeral revenues and, in certain cases, lesser profit margins than traditional funerals.
Our traditional cemetery and funeral service operations face competition from the increasing number of cremations in the United States. Industry studies indicate that the percentage of cremations has steadily increased and that cremations will represent approximately 36 percent of the deaths in the United States by the year 2010, compared to 29 percent in 2003. In fiscal years 2002, 2003, 2004 and 2005, 35 percent, 36 percent, 37 percent and 38 percent, respectively, of the funeral services we performed in our continuing operations were cremations. The trend toward cremation could cause cemeteries and traditional funeral homes to lose market share and revenues to firms specializing in cremations. In addition, basic cremations (with no funeral service, casket, urn, mausoleum niche, columbarium niche or burial) produce no revenues for cemetery operations and lower revenues than traditional funerals and, when delivered at a traditional funeral home, produce lower profit margins as well.
Because the funeral and cemetery businesses are high fixed-cost businesses, positive or negative changes in revenue can have a disproportionately large effect on cash flow and profits.
Funeral homes and cemetery businesses must incur many of the costs of operating and maintaining facilities, land and equipment regardless of the level of sales in any given period. For example, we must pay salaries, utilities, property taxes and maintenance costs on funeral homes and maintain the grounds of cemeteries regardless of the number of funeral services or interments performed. Because we cannot decrease these costs significantly or rapidly when we experience declines in sales, declines in sales can cause margins, profits and cash flow to decline at a greater rate than the decline in revenues.
Changes or increases in, or failure to comply with, regulations applicable to our business could increase costs or decrease cash flows.
The death care industry is subject to extensive regulation and licensing requirements under federal, state and local laws. For example, the funeral home industry is regulated by the Federal Trade Commission, which requires funeral homes to take actions designed to protect consumers. State laws impose licensing requirements and regulate preneed sales. Embalming facilities are subject to stringent environmental and health regulations. Compliance with these regulations is burdensome, and we are always at risk of not complying with the regulations.
In addition, from time to time, governments and agencies propose to amend or add regulations, which could increase costs or decrease cash flows. For example, federal, state, Puerto Rican and other regulatory agencies have considered and may enact additional legislation or regulations that could affect the death care industry. Several jurisdictions and regulatory agencies have considered or are considering regulations that could require more liberal refund and cancellation policies for preneed sales of products and services, limit or eliminate our ability to use surety bonding, impose or increase trust requirements and prohibit the common ownership of funeral homes and cemeteries in the same market. If adopted by the regulatory authorities of the jurisdictions in which we operate,
these and other possible proposals could have a material adverse effect on us, our financial condition, our results of operations, our cash flows and our future prospects.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The following table shows the number of funeral homes and cemeteries we operated in each of our geographic operating segments as of October 31, 2005:
Number
of
Funeral
Number of
Operating Segment
Homes
Cemeteries
Geographic Areas
Western Division - Funeral
Alabama, Arkansas, California, Illinois, Iowa, Kansas, Louisiana, Mississippi, Missouri, Nebraska, New Mexico, Oregon, Texas, Washington
Western Division - Cemetery
Alabama, Arkansas, California, Iowa, Kansas, Louisiana, Mississippi, Missouri, Nebraska, New Mexico, Oregon, Texas, Washington, Wisconsin
Eastern Division - Funeral
Alabama, Florida, Georgia, Maryland, North Carolina, Pennsylvania, South Carolina, Tennessee, Virginia, West Virginia and Puerto Rico
Eastern Division - Cemetery
Alabama, Florida, Georgia, Kentucky, Maryland, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia, West Virginia and Puerto Rico
As of October 31, 2005, approximately 75 percent of our 231 funeral home locations were owned by our subsidiaries, and approximately 25 percent were held under operating leases. The leases have terms ranging from 1 to 13 years, except for one lease that expires in 2032 and five leases with the Archdiocese of Los Angeles that expire in 2039. An aggregate of $0.5 million of our term notes are secured by mortgages on some of our funeral homes; these notes were either assumed by us upon our acquisition of the property or represent seller financing for the acquired property.
As of October 31, 2005, we owned 144 cemeteries covering a total of approximately 10,039 acres. Approximately 39 percent of the total acreage is available for future development.
We own a 98,200 square-foot building in suburban New Orleans that we use for our corporate headquarters, shared services center, human resources, communications, internal audit and information systems departments.
Item 3.
Item 3. Legal Proceedings
For a discussion of our current litigation, see Note 21 to the consolidated financial statements included in Item 8.
In addition to the matters described in Note 21, we and certain of our subsidiaries are parties to a number of other legal proceedings that have arisen in the ordinary course of business. While the outcome of these proceedings cannot be predicted with certainty, we do not expect these matters to have a material effect on our consolidated financial position, results of operations or cash flows.
We carry insurance with coverages and coverage limits that we believe to be adequate. Although there can be no assurance that such insurance is sufficient to protect us against all contingencies, we believe that our insurance protection is reasonable in view of the nature and scope of our operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 4(a). Executive Officers of the Registrant
The following table sets forth certain information with respect to our executive officers. Each of the following has served in the capacity indicated for more than five years, except as indicated below.
Name
Age
Position
Kenneth C. Budde
President, Chief Executive Officer and Director(1)
Everett N. Kendrick
Executive Vice President, Chief Operating Officer and President - Sales and Marketing Division(2)
Thomas M. Kitchen
Executive Vice President, Chief Financial Officer and Director(3)
Brent F. Heffron
Executive Vice President and President-Eastern Division(4)
Lawrence B. Hawkins
Executive Vice President and President-Investors Trust, Inc.
G. Kenneth Stephens, Jr.
Executive Vice President and President-Western Division(5)
Randall L. Stricklin
Senior Vice President and President-Corporate Development(6)
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Market Information
Our Class A common stock trades on the Nasdaq National Market under the symbol STEI. The fifth character “E” is currently appended to the trading symbol until we regain compliance with Nasdaq’s continued listing requirements. For additional information, see Note 26 to the consolidated financial statements included in Item 8.
On January 31, 2006, the closing sale price as reported by the Nasdaq National Market was $5.54. The following table sets forth, for the periods indicated, the range of high and low sale prices, as reported by the Nasdaq National Market. As of December 30, 2005, there were 1,294 record holders of our Class A common stock. Record holders include persons holding Class A common stock on behalf of one or more beneficial owners who are not holders of record.
There is no established public trading market for our Class B common stock. As of December 30, 2005, our Chairman Emeritus, Frank B. Stewart, Jr., was the record holder of all of our shares of Class B common stock. Our Class A and Class B common stock are substantially identical, except that holders of Class A common stock are entitled to one vote per share, and holders of Class B common stock are entitled to ten votes per share. Each share of Class B common stock is automatically converted into one share of Class A common stock upon transfer to persons other than certain affiliates of Frank B. Stewart, Jr. As of October 31, 2005, by virtue of his beneficial ownership of outstanding Class A and Class B common shares, Mr. Stewart controlled approximately 30 percent of our total voting power and held approximately 10 percent of our outstanding equity.
Dividends
On October 5, 2000, our Board of Directors suspended the payment of quarterly dividends on our common stock. On March 28, 2005, our Board of Directors approved the initiation of a quarterly cash dividend of two and one-half cents per share of common stock. Although we intend to pay regular quarterly cash dividends for the foreseeable future, the declaration and payment of future dividends are discretionary and will be subject to determination by the Board of Directors each quarter after its review of our financial performance.
Sales of Unregistered Equity Securities
For many years, we have maintained a 401(k) plan through which employees may invest in our Class A common stock or other investment choices. We have a Registration Statement on Form S-8 in effect for this 401(k) plan. In January 2003, we adopted a separate plan for the employees of our Puerto Rican subsidiary (the “Puerto Rico Plan”). Employees of this subsidiary were also permitted to invest in our Class A common stock through the Puerto Rico Plan. We did not file a separate Registration Statement on Form S-8 with the Securities and Exchange
Commission for the Puerto Rico Plan until December 8, 2004. From January 1, 2003 to December 7, 2004, three participants in the Puerto Rico Plan acquired a total of 1,146 units in the Stewart Enterprises, Inc. Stock Fund (approximately 1,643 shares of our Class A common stock based upon the closing sale price of our Class A common stock on December 7, 2004 of $7.50 per share) through the Puerto Rico Plan as a result of employee contributions, employer matching contributions and employee transfers from other investment funds or plans. Because participants in the Puerto Rico Plan purchased shares of our Class A common stock through the Puerto Rico Plan prior to the filing of the Registration Statement, these participants may have the right to rescind their purchases or recover damages if they no longer own the shares, subject to the applicable statute of limitations. Due to the small number of unregistered shares sold, our potential liability is not material.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
We have a stock repurchase program under which we are authorized to invest up to $30.0 million in the repurchase of our common stock. As of October 31, 2005, we had approximately $22.0 million remaining available under the plan. The table below provides information about purchases made by or on behalf of us, or of any “affiliated purchaser” as defined in SEC rules, of our equity securities registered pursuant to Section 12 of the Exchange Act, for each month during the fourth quarter of fiscal year 2005, in the format required by SEC rules. As indicated by the table, there were no such repurchases during the fourth quarter of fiscal year 2005.
Issuer Purchases of Equity Securities
(1)
On March 28, 2005, we announced a new stock repurchase program, authorizing the investment of up to $30.0 million in the repurchase of our common stock. Repurchases under the new program will be limited to our Class A common stock, and will be made in the open market or in privately negotiated transactions at such times and in such amounts as management deems appropriate, depending upon market conditions and other factors.
Item 6.
Item 6. Selected Financial Data
Restatements and Reclassifications
The following selected consolidated financial data for the fiscal years ended October 31, 2001 through October 31, 2005 are derived from our audited consolidated financial statements, as restated and reclassified. As discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Restatement of Historical Financial Statements
We have restated our consolidated financial statements for fiscal years 2004 and 2003, all the quarters therein and the first three quarters of fiscal year 2005. The restatements are primarily the result of:
(A)
The incorrect determination of operating and reportable segments and reporting units related to the application of FASB Statement No. 142, “Goodwill and Other Intangible Assets,” (“SFAS No. 142”), which also had the effect of changing the charges recorded for the assets sold as part of our plan initiated in December 2003 to sell a number of businesses, and the net book value of assets held for sale on our balance sheet.
(B)
Errors identified in revenue recognition of preneed cemetery merchandise and services contracts and recognition of realized trust earnings on preneed cemetery and funeral merchandise and services contracts.
(C)
Other miscellaneous adjustments, including adjustments for lease-related accounting practices.
The restatement for these errors is discussed in more detail below.
Segments and Reporting Units
We re-evaluated our application of FASB Statement No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”), and determined that we had incorrectly identified our operating and reportable segments for all prior periods. We concluded that we had eleven operating and reportable segments, which consisted of a corporate trust management segment and a funeral and cemetery segment for each of five geographic areas: Central, Western, Eastern, Southern - Florida and All Other. Our historical presentation of segment data had consisted of two operating and reportable segments, funeral and cemetery. As part of our strategic planning process discussed in “Business Strategy” in Item 1, in the fourth quarter of fiscal year 2005, we reorganized and revised our operating divisions from four to two and revised our operating and reportable segments. For further discussion of the revision of our operating and reportable segments in the fourth quarter of 2005, see
Note 22 to the consolidated financial statements included in Item 8.
The correction of our operating segments had the related effect of requiring changes in our reporting units for purposes of goodwill impairment reviews under SFAS No. 142, retroactive to the November 1, 2001 adoption date of SFAS No. 142. Our evaluation of goodwill should have been performed to include 13 reporting units as opposed to the two reporting units historically identified. As a result of the reorganization and revision of our divisions effective for the fourth quarter of fiscal year 2005, we revised our evaluation of goodwill based upon 11 reporting units. For further discussion of the change in our reporting units in the fourth quarter of 2005, see Note 3(g).
The restatement of our operating segments and reporting units resulted in the need to correct our goodwill impairment reviews as of November 1, 2001 (the date we adopted SFAS No. 142) and as of October 31, 2002, 2003 and 2004. Consequently, we recorded a $209.4 million ($193.1 million after tax, or $1.78 per diluted share) charge on November 1, 2001 as a cumulative effect of change in accounting principle for the adoption of SFAS No. 142. Our previously reported financial statements did not include a goodwill impairment charge upon the initial adoption of SFAS No. 142 on November 1, 2001 or during our annual assessment in the fourth quarter of fiscal year 2002. We also restated our previously reported fiscal year 2003 goodwill impairment charge of $73.0 million ($66.9 million after tax, or $.62 per share) because based on our revised reporting units, no goodwill impairment charge for the year ended October 31, 2003 was necessary.
Further, the restatement of goodwill on our balance sheet had the effect of changing the net book value of the assets we sold as part of our plan to sell a number of our businesses and the net book value of assets held for sale on our balance sheet. Due to these changes and changes in the classification of certain businesses between continuing operations and discontinued operations, the gain or loss on those sales has been re-evaluated and restated. In 2003, this resulted in an additional net gain of $2.1 million, representing a gain of $1.3 million related to continuing operations as originally reported and a gain of $0.8 million related to discontinued operations. In 2004, this resulted in an additional net gain of $0.6 million, representing a loss of $0.5 million related to continuing operations as originally reported and a gain of $1.1 million related to discontinued operations.
Deferred Revenue Project
In connection with our internal control assessment under Section 404 of Sarbanes-Oxley, we undertook a project (the “deferred revenue project”) in 2005 to verify the balances in deferred preneed cemetery revenue and deferred preneed funeral revenue by reviewing substantially all of the preneed cemetery and funeral service and merchandise contracts included in our backlog. This process involved the review of nearly 700,000 preneed contracts. The deferred revenue project resulted in our assessment that deferred revenue was misstated and therefore we needed to restate our prior period financial statements for fiscal years 2001 through 2004, including the quarters therein, and the first three quarters of 2005. The adjustment impacted the cumulative effect of adopting SAB No. 101 on November 1, 2000, and reported revenues and earnings for fiscal years 2001 through 2004 and the first three quarters of 2005.
We identified errors in the amount of recorded revenue, deferred revenue and related deferred trust earnings associated with cemetery merchandise and funeral service and merchandise contracts. The errors also resulted in restatements to the amount of preneed selling costs recorded upon the adoption of SAB No. 101, and in subsequent years and also the charge for the 2005 cumulative effect of change in accounting principle related to preneed selling costs adopted effective November 1, 2004. See Note 3(f) and 4(a) to the consolidated financial statements included in Item 8.
The overall impact of the deferred revenue project on net earnings and earnings per share for the first three quarters of 2005 and fiscal years 2004, 2003, 2002 and 2001 was a decrease in net earnings of $18.2 million (including $11.9 million, or $.11 per share, related to the cumulative effect of change in accounting principle for preneed selling costs), $12.0 million, $13.2 million, $19.2 million and $18.1 million, respectively, and a decrease in earnings per share of $.16, $.11, $.12, $.18 and $.17, respectively. The 2005 amount reflects the adjustment to the previously reported unaudited results through July 31, 2005. The deferred revenue project also resulted in changes to our consolidated balance sheet as described in footnote 13 to the Selected Financial Data table included in Item 6 and Note 2 to the consolidated financial statements included in Item 8.
Other Adjustments
As previously disclosed in our Form 10-Q for the second quarter of fiscal year 2005, we reviewed our lease-related accounting practices and determined that certain adjustments related to rent escalations and leasehold improvement amortization were necessary. The cumulative effect of these adjustments for all prior periods amounted to a charge of $1.8 million ($1.1 million after tax, or $.01 per share). We evaluated the materiality of these operating lease adjustments on our financial statements and concluded that the impact of these adjustments was not material. As a result, we recorded the cumulative effect of these prior period adjustments of $1.8 million as non-cash charges to funeral and cemetery costs in the second quarter of fiscal year 2005. Because we are amending our Form 10-K for the year ended October 31, 2004 for the restatements discussed above under the heading “Restatement of Financial Statements,” we are now required to record the lease adjustments in the periods they were actually incurred. In this filing, we removed the cumulative effect of this prior period adjustment of $1.8 million ($1.1 million after tax) and will remove it from subsequent amended Form 10-Q filings for January 31, 2005, April 30, 2005 and July 31, 2005. We also recorded other immaterial miscellaneous adjustments.
The information included in “Results of Operations” below reflects the restated amounts. A summary of the effects of these restatements on our financial statements can be found in Note 2 to the consolidated financial statements included in Item 8.
Overview of Fiscal Year 2005
We are the third largest provider of funeral and cemetery products and services in the death care industry in the United States. As of December 30, 2005, we owned and operated 231 funeral homes and 144 cemeteries in 26 states within the United States and Puerto Rico.
We sell cemetery property and funeral and cemetery products and services both at the time of need and on a preneed basis. Our revenues in each period are derived primarily from at-need sales, preneed sales delivered out of our backlog during the period (including the accumulated trust fund earnings or build-up in the face value of insurance contracts related to these preneed deliveries), preneed cemetery property sales and other items such as perpetual care trust earnings and finance charges.
Results of Operations
For fiscal year 2005, we had a net loss of $143.3 million compared to net earnings of $36.7 million for fiscal year 2004. Contributing to the net loss was a charge of $153.2 million for the cumulative effect of change in accounting principle related to the change in our method of accounting for preneed selling costs, implemented effective November 1, 2004. Fiscal year 2005 earnings from continuing operations before the cumulative effect of change in accounting principle decreased by $22.2 million to $8.8 million, compared to $31.0 million for fiscal year 2004. Contributing to the decline were charges for the loss on early extinguishment of debt of $32.8 million related to the refinancing of our senior secured credit facility and our 10.25 percent senior subordinated notes. Also contributing to the decline was a $9.9 million increase in funeral costs, of which $5.4 million was due to the 2005 change in accounting for preneed selling costs and the remainder was due primarily to increased health insurance costs. Corporate general and administrative expenses increased $2.3 million due primarily to increased professional fees associated with our defense of the class action litigation, the Section 404 internal controls review process, the deferred revenue project and additional audit related services. We also recorded a $9.4 million charge for net hurricane-related costs. Further discussion of the hurricanes affecting us during fiscal year 2005 can be found below in the section entitled “Hurricanes.” In addition, cemetery revenues declined $2.1 million primarily due to a decrease in revenue associated with the construction of cemetery projects, a decrease in earned finance charges, a decrease in revenue due to Hurricane Katrina and an increase in bad debt resulting from the impact of Hurricane Katrina.
Partially offsetting these declines, interest expense decreased by $16.8 million to $30.5 million in fiscal year 2005 from $47.3 million in fiscal year 2004, reflecting the results of the refinancing of our senior secured credit facility and 10.25 percent senior subordinated notes at lower rates and a $39.5 million decrease in average debt outstanding. As of October 31, 2005 we had achieved our lowest net debt level in nine years. In addition, funeral revenue increased $2.9 million from $271.2 million in fiscal year 2004 to $274.1 million in fiscal year 2005 primarily due to increased same-store funeral call growth of 0.3 percent and an increase in average revenue per call of 2.7 percent. Same-store results include the three funeral homes impacted by Hurricane Katrina. Excluding these funeral homes, same-store funeral call growth increased 0.9 percent. We believe that the increase in funeral calls reflects the implementation of our 2005 strategic plan beginning in July 2005, and can also be attributed to our funeral home incentive compensation plan implemented during the first quarter of fiscal year 2005. Management
believes this increase is a significant accomplishment given that this is the first year since 1994 that we have experienced positive year-over-year call growth.
For fiscal year 2004, we achieved a 9 percent increase in preneed funeral sales, which was in line with our goal of 5 percent to 10 percent for 2004. For fiscal year 2005, we achieved a 5 percent increase in preneed funeral sales, which was in line with our goal of 4 percent to 8 percent for 2005. For fiscal year 2004, we achieved a 9 percent increase in cemetery property sales, which was in line with our goal of 5 percent to 10 percent for 2004. For fiscal year 2005, we achieved a 0.9 percent increase in cemetery property sales, which was below our stated goal of 4 percent to 8 percent, due in part to the effects of Hurricanes Katrina, Rita and Wilma.
Debt Refinancing
On November 19, 2004, we completed the refinancing of our senior secured credit facility and recorded a charge for early extinguishment of debt of $2.7 million ($1.7 million after tax, or $.02 per share) to write off fees associated with the previous credit facility. On February 11, 2005, we completed the private offering of $200.0 million principal amount of our 6.25 percent senior notes due 2013. We also borrowed $130.0 million in additional term loan debt under our senior secured credit facility. We used the net proceeds from these transactions, together with a portion of our available cash, to repurchase $298.2 million in aggregate principal amount of our 10.75 percent senior subordinated notes due 2008 and to pay related tender premiums, fees, expenses and accrued interest of $28.9 million. In the second quarter of fiscal year 2005, we recorded a charge for early extinguishment of debt of $30.0 million ($19.2 million after tax, or $.18 per share) representing the bond tender premium, related fees and expenses and the write-off of unamortized fees. In the third quarter of fiscal year 2005, the remaining 10.75 percent senior subordinated notes were redeemed. We recorded a charge for early extinguishment of debt of $0.1 million representing the call premium and write-off of remaining unamortized fees on the 10.75 percent senior subordinated notes. For additional information, see Note 16 to the consolidated financial statements included in Item 8.
Dividends and Stock Repurchase Plan
In March 2005, our Board of Directors approved the initiation of a quarterly cash dividend of two and one-half cents per share of common stock. A total of $8.2 million in dividends was paid on April 29, 2005, July 29, 2005 and October 18, 2005. Although we intend to pay regular quarterly cash dividends for the foreseeable future, the declaration and payment of future dividends are discretionary and will be subject to determination by the Board of Directors each quarter after its review of our financial performance (see “Forward-Looking Statements” included herein and Item 1A. “Risk Factors”).
On March 28, 2005, we announced a new stock repurchase program, authorizing the investment of up to $30.0 million in the repurchase of our common stock. On March 17, 2005, we completed our initial stock repurchase program, having repurchased 4,400,000 shares since its inception. Since the inception of the new stock repurchase program through October 31, 2005, we have repurchased 1,200,000 shares of our Class A common stock at an average price of $6.64 per share. At current stock prices, the use of our cash to pay dividends, repurchase stock, reduce debt and construct funeral homes on our cemeteries or those of unaffiliated third parties continues to be more attractive than acquisitions. However, if acquisition pricing improves, we believe that growing our organization through acquisitions may again be a good business strategy, as it will enable us to enjoy important synergies and economies of scale from our infrastructure.
Strategic Plan
In July 2005, we began to implement a new strategic plan. For a description of the plan, see “Business Strategy” in Item 1. Business. As a result of the strategic planning process, in July 2005, we named a new Chief Operating Officer and announced that we were reorganizing our operating divisions from four to two: Eastern and Western, effective for the fourth quarter of fiscal year 2005. These changes are a result of our recent strategic planning process. For the year ended October 31, 2005, we incurred $1.5 million in charges related to this reorganization, and expect to benefit from annual pre-tax cost savings of between $2 million and $2.5 million (see “Forward-Looking Statements” included here and Item 1A. “Risk Factors”).
Hurricanes
On Monday, August 29, 2005, Hurricane Katrina struck the New Orleans metropolitan area and the Mississippi and Alabama Gulf Coasts. Our executive offices and Shared Services Center are located in a building
we own in the New Orleans metropolitan area, and no significant damage occurred to that building. For the month of September, we temporarily housed most of the Shared Services Center functions, such as cash receipts and disbursements, customer service, contract processing and information technology in Orlando, Florida, in newly-leased and existing Company office space, and temporarily housed other functions such as the executive offices, treasury, accounting, trust administration, human resources, training, communications, marketing, tax and compliance in the Dallas, Texas area in newly-leased office space.
Of our 231 funeral homes and 144 cemeteries, three funeral homes and five cemeteries, which represent approximately four percent of our annual revenues and approximately five percent of our annual gross profit, are located in the New Orleans metropolitan area, have suffered substantial damage and are conducting business in temporary facilities until repairs are completed. Our mausoleum construction and sales business, Acme Mausoleum, which primarily operates in southwest Louisiana and Texas, was also negatively impacted by Hurricanes Katrina and Rita. Including Acme Mausoleum, the New Orleans area funeral home and cemetery operations represent approximately six percent of our annual revenue and gross profit. The book value of net property and equipment, receivables, inventory and cemetery property at the affected properties amounted to approximately $24.7 million prior to the storms. As of October 31, 2005, 2004 and 2003, total revenues of these facilities amounted to $19.8 million, $21.8 million and $22.7 million, respectively.
Hurricanes Katrina, Rita and Wilma also interrupted business in Florida, Alabama, Mississippi and Texas primarily due to evacuations and power-outages. We have insurance coverage related to property damage, incremental costs and property operating expenses we incurred due to damage caused by Hurricane Katrina. As of October 31, 2005, we had incurred approximately $20.9 million in expenses related to Hurricane Katrina including the write-off of damaged buildings, equipment and inventory, demolition costs, debris removal, record restoration, general cleanup, temporary living facilities for employees, relocation expenses and other costs. We expect to receive insurance proceeds of at least $11.5 million currently based on the status of our insurance review, $0.5 million of which had been received as of October 31, 2005. We believe that a significant portion of the remainder of the loss we experienced may be covered by insurance. For additional information, see Note 24 to the consolidated financial statements included in Item 8.
Forecasts
For a discussion of our forecasts for continuing operations in fiscal year 2006 and the principal assumptions underlying the forecasts, see the discussion under the heading “Forward-Looking Statements” below.
Preneed - Backlog, Trust Portfolio and Cash Impact of Sales
Overview
We believe that preneed funeral and cemetery property sales are two of the primary drivers of sustainable long-term growth in the number of families served by our funeral homes and cemeteries. Our preneed funeral service and merchandise sales and preneed cemetery service and merchandise sales are deferred into our backlog while our preneed cemetery property sales are recognized currently in accordance with SFAS No. 66, “Accounting for Sales of Real Estate.” For a detailed discussion of our revenue recognition policies and how we account for our at-need sales, preneed sales and trust earnings, see Notes 3(i), 3(j), 3(k), and Notes 5 through 8 to the consolidated financial statements included in Item 8.
Backlog
We estimate that as of October 31, 2005 the future value of our preneed funeral and cemetery services and merchandise backlog represented approximately $2.0 billion of revenue to be recognized in the future as these prepaid products and services are delivered. This represents the face value of the backlog plus the earnings that are projected on the funds held in trust and the estimated build-up in the face value of insurance contracts. It assumes no future preneed sales and assumes maturities each year consistent with our experience, with the majority of existing contracts expected to mature over the next 15 years. As of October 31, 2005, the value of the preneed backlog, excluding any future earnings on the funds held in trust and any build-up in the face value of insurance contracts, but including unrealized earnings and losses on the funds held in trust and realized earnings and losses on the funds held in trust not yet recognized as revenue, was approximately $1.6 billion.
Trust Portfolio
We maintain three types of trusts and escrow accounts: (1) preneed funeral merchandise and services, (2) preneed cemetery merchandise and services and (3) cemetery perpetual care. Because a portion of the funds we receive from preneed sales are deposited into the trusts and invested in a variety of debt and equity securities and other investments, the performance of the trusts’ investments can affect our current and future revenue streams. From 1991 through 1999, we achieved an overall annual realized return of 8.0 percent to 9.0 percent in our domestic trusts. However, the average realized return on our domestic trusts was 5.8 percent, 6.3 percent, 4.3 percent, 4.8 percent, 2.6 percent and 4.3 percent for fiscal years 2000, 2001, 2002, 2003, 2004 and 2005, respectively. These returns represent interest, dividends and realized capital gains or losses but not unrealized capital gains or losses. For fiscal year 2005, including realized and unrealized gains and losses, we achieved a 6.8 percent return on our funeral and cemetery merchandise and services trust and a 3.5 percent return on our perpetual care trust. For the last three years, including realized and unrealized gains and losses, our funeral and cemetery merchandise and services trusts achieved a total return of 8.8 percent, and our perpetual care trust achieved a total return of 7.9 percent. We recognize earnings and losses realized by preneed funeral and cemetery merchandise and services trusts based on delivery of underlying products and services. We recognize all earnings and losses realized by our cemetery perpetual care trusts currently, including capital gains and losses in those jurisdictions where capital gains can be withdrawn and used for cemetery maintenance. As a result, depressed stock prices and low returns on fixed-income investments put pressure on perpetual care trust earnings recognized in fiscal year 2005 and may do so again in fiscal year 2006. Because approximately 60 percent of our total trust portfolio is currently invested in a diversified group of equity securities, we would generally expect our portfolio performance to improve if the performance of the overall stock market improves, but we would also expect its performance to deteriorate over time if the overall stock market declines.
We mark our trust portfolio to market value each quarter. Changes in the market value of the trusts are recorded by increasing or decreasing trust assets included in the preneed funeral and cemetery receivables and trust investments line items on the balance sheet, with a corresponding increase or decrease in the deferred preneed revenue and non-controlling interest line items on the balance sheet. Therefore, there is no effect on net income.
We determine whether or not the investment portfolio has an other than temporary impairment on a security-by-security basis. A loss is considered other than temporary if the security has a reduction in market value compared with its cost basis of 20 percent or more for a period of six months or longer. In addition, we periodically review our investment portfolio to determine if any of the temporarily impaired assets should be designated as other than temporarily impaired due to changes in market conditions or concerns specific to the issuer of the securities. If a loss is other than temporary, the cost basis of the security is adjusted downward to its market value, which is allocated to the non-controlling interests in the trusts. This affects our footnote disclosure but does not have an effect on our financial statements, since the trust portfolio is already marked to market value each quarter. The footnotes disclose the adjusted cost basis and how much of the losses are considered other than temporary. Accordingly, unrealized gains and losses reflected in the tables in Notes 5, 6 and 7 to the consolidated financial statements included in Item 8 are temporary as the cost basis in these tables have already been adjusted to reflect the other than temporary unrealized losses. Our preneed funeral and cemetery merchandise and services trusts and escrow accounts had other than temporary declines of $81.8 million and $43.2 million, respectively, as of October 31, 2005, from their original cost basis. They had net unrealized appreciation (depreciation) of $3.0 million and $(.4) million, respectively, as of October 31, 2005 resulting from temporary unrealized gains and losses. See Notes 5 and 6 to the consolidated financial statements included in Item 8.
Our cemetery perpetual care trust accounts had other than temporary declines of $30.3 million as of October 31, 2005, from their original cost basis. They had net unrealized appreciation of $2.8 million as of October 31, 2005 resulting from temporary unrealized gains and losses. See Note 7 to the consolidated financial statements included in Item 8. Unrealized gains and losses in the cemetery perpetual care trusts and escrow accounts do not affect current earnings but unrealized losses could limit the capital gains available to us and could eventually result in lower returns and lower revenues than we have historically achieved from these trusts.
Aggregate unrealized losses for twelve months or longer for temporarily impaired investments totaled $16.1 million at October 31, 2005. Of that amount, approximately 91 percent, or $14.7 million, were generated by common stock investments in 54 companies that are included in the S&P 500 Index. These securities represent approximately 12 percent of the securities in our portfolio. We believe the decline in the value of these stocks is primarily due to the general decline in the S&P 500 Index over the 2002 to 2003 timeframe. Since early 2003, the S&P 500 Index has risen significantly. Although we cannot predict future stock prices, our management expects that the S&P 500 Index will continue to recover and that these stocks may recover along with the overall Index. We also have the ability and intent to hold these investments for the forecasted recovery period.
Whether or not we classify an investment as temporarily impaired or other than temporarily impaired has no effect on our basic consolidated financial statements (i.e., balance sheet, statement of earnings, statement of cash flows and statement of shareholders’ equity) because the investments are marked to market value each quarter and are included in the financial statements at current market value in accordance with our accounting under FASB Interpretation No. 46 (“FIN 46R”). The classification only affects the footnote presentation. The cost basis of investments classified as other than temporarily impaired is reduced to market value in the “Adjusted Cost Basis” column in Notes 5, 6 and 7, whereas other investments are included in that column at their actual cost basis.
We perform a separate analysis to determine whether our preneed contracts are in a loss position, which would necessitate a charge to earnings. For this analysis, we determine which trusts are in a net loss position by comparing the aggregate market value of the trust’s investments with the aggregate actual cost basis of the investments. If the aggregate cost basis exceeds the aggregate market value of the investments, the trust is considered to be in a net loss position. For trusts in a net loss position, we add the sales prices of the underlying contracts and net realized earnings, then subtract net unrealized losses to derive the net amount of proceeds for contracts associated with the trusts in question as of that particular balance sheet date. We look at unrealized gains and losses based on current market prices quoted for the investments, but we do not include future expected returns on the investments in our analysis. We compare the amount of proceeds to the estimated costs to deliver the contracts, which consist primarily of merchandise costs. If a deficiency were to exist, we would record a charge to earnings and a corresponding liability for the expected loss on the delivery of those contracts from our backlog. Due to the margins of our preneed contracts and the relatively high trust portfolio returns we enjoyed prior to fiscal year 2000, there is currently substantial capacity for additional market depreciation before a contract loss would result.
Cash Impact of Preneed Sales
The impact of preneed sales on near-term cash flow depends primarily on the commissions paid on the sale, the portion of the sale required to be placed into trust and the terms of the particular contract (such as the size of the down payment required and the length of the contract). We generally pay commissions to our preneed sales counselors based on a percentage of the total preneed contract price, but only to the extent cash is paid by the customer. If the initial cash installment paid by the customer is not sufficient to cover the entire commission, the remaining commission is paid from subsequent customer installments. However, because we are required to place a portion of each cash installment paid by the customer into trust, we may be required to use our own cash to cover a portion of the commission due on the installment from the customer. Accordingly, preneed sales are generally cash flow negative initially but become cash flow positive at varying times over the life of the contract, depending upon the trusting requirements and the terms of the particular contract.
Cash expended for preneed funeral and preneed cemetery services and merchandise sales is expensed as incurred. See Note 4(a) to the consolidated financial statements included in Item 8 for a discussion of the change in accounting for preneed selling costs in fiscal year 2005.
Overview of Critical Accounting Policies
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and assumptions (see Note 3(b) to the consolidated financial statements included in Item 8). We believe that of our significant accounting policies (discussed in Note 3 to the consolidated financial statements included in Item 8), the following are both most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective or complex judgment.
Deferred Revenue and Revenue Recognition
Funeral revenue is recognized when funeral services are performed. Our funeral receivables included in current receivables primarily consist of amounts due for funeral services already performed. We sell price-guaranteed prearranged funeral contracts through various programs providing for future funeral services at prices prevailing when the agreements are signed. Revenues associated with sales of prearranged funeral contracts, which include accumulated trust earnings and increasing insurance benefits, are deferred until such time that the funeral services are performed (see Note 3(i) to the consolidated financial statements included in Item 8).
Revenue associated with cemetery merchandise and services is recognized when the service is performed or merchandise is delivered. Revenue associated with preneed cemetery property interment rights is recognized in accordance with the retail land sales provision of SFAS No. 66. Under SFAS No. 66, revenue from constructed
cemetery property is not recognized until a minimum percentage (10 percent) of the sales price has been collected. Revenue related to the preneed sale of cemetery property prior to its construction is recognized on a percentage of completion method of accounting. Revenue associated with sales of preneed merchandise and services is not recognized until the merchandise is delivered or the services are performed (see Note 3(j) to the consolidated financial statements included in Item 8).
We defer all dividends and interest earned and net capital gains and losses realized by preneed funeral trust and preneed cemetery merchandise trust accounts until the underlying service or the merchandise is delivered.
In February 2006, we completed our reconciliation of deferred revenue to the underlying preneed contracts, which resulted in the identification of a significant number of reconciling items. Our reconciliation of these items led to the restatements described above under “Restatement of Historical Financial Statements” and in Note 2 to the consolidated financial statements included in Item 8. In connection with the deferred revenue project, we also identified material weaknesses in our internal control over financial reporting as of October 31, 2005, as described in Item 9A.
Variable Interest Entities
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities.” This interpretation clarifies the application of ARB No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, the FASB revised FASB Interpretation No. 46 (“FIN 46R”).
We implemented FIN 46R as of April 30, 2004, which resulted in the consolidation of our preneed funeral and cemetery merchandise and services trusts and our cemetery perpetual care trusts. This implementation was as of April 30, 2004 and only affected our consolidated balance sheet and had no impact on our second quarter 2004 results of operations or cash flows. In subsequent periods, the implementation of FIN 46R, as it relates to the consolidation of trusts, affects classifications within the balance sheet, statement of earnings and statement of cash flows, but has no effect on shareholders’ equity, net cash flow or the recognition and reporting of revenues or net earnings. For a more detailed discussion of our accounting policies after the implementation of FIN 46R, see Notes 3(k) and 5 through 8 to the consolidated financial statements included in Item 8.
Allowance for Doubtful Accounts
Management must make estimates of the uncollectibility of our accounts receivable. We establish a reserve for uncollectible installment contracts and trade accounts based on a range of percentages applied to accounts receivable aging categories. These percentages are based on an analysis of historical collection and write-off experience. These estimates are impacted by a number of factors, including changes in the economy and demographic or competitive changes in our areas of operation. If circumstances change, our estimates of the recoverability of amounts due to us could change by a material amount.
Depreciation of Long-Lived Assets
Buildings and equipment are recorded at cost and are depreciated over their estimated useful lives, ranging from 10 to 40 years and from 3 to 10 years, respectively, primarily using the straight-line method. These estimates of the useful lives may be affected by such factors as changes in regulatory requirements or changing market conditions.
Valuation of Long-Lived Assets
We review the carrying value of our long-lived assets whenever events or circumstances indicate that the carrying amount may not be recoverable. This review is based on our projections of anticipated undiscounted future cash flows and compares the estimated undiscounted future cash flows to be generated by those assets to the carrying amount of those assets. The net carrying value of any assets not fully recoverable would be reduced to fair value. While we believe that our estimates of undiscounted future cash flows are reasonable, different assumptions regarding such cash flows and comparable sales values could materially affect our evaluations.
In the fourth quarter of 2003, we identified a number of small businesses to close or sell in fiscal year 2004. Although at the time of identification, the assets did not meet the criteria as assets held for sale per SFAS No. 144,
we reviewed the carrying amount of these businesses compared to their fair value and recorded a noncash charge of $31.8 million related to the impairment of these long-lived assets. Of this amount, $10.2 million was included in continuing operations and $21.6 million was included in discontinued operations in the 2003 consolidated statement of earnings upon these businesses meeting the discontinued operations criteria of SFAS No. 144 in fiscal year 2004. Fair value was established based on our best estimate and is subject to revision in future periods as properties are actually sold or closed. For fiscal year 2004, we evaluated our long-lived assets, recorded impairment charges of $0.8 million and sold several assets that we held for sale at a net gain of $0.6 million. The net effect was that we reported gains on dispositions, net of impairment losses, of ($0.2) million in continuing operations and recorded gains on dispositions, net of impairment losses, of $2.4 million in discontinued operations. In fiscal year 2005, we recorded gains on dispositions, net of impairment losses, of $1.3 million in continuing operations and $1.1 million in discontinued operations. See Note 14 to the consolidated financial statements included in Item 8.
Valuation of Goodwill
Our historical evaluation of goodwill was performed at the funeral and cemetery segment levels, which we previously reported as our reporting units. However, this evaluation was incorrect and our operating segments, as defined by SFAS No. 131, and reporting units, as defined in SFAS No. 142, were required to be restated as discussed in Note 2 to the consolidated financial statements included in Item 8. This restatement of reporting units resulted in the need to correct our goodwill impairment reviews as of November 1, 2001 (the date we adopted SFAS No. 142) and as of October 31, 2002, 2003 and 2004. For further discussion of the resulting charges, see Note 2 to the consolidated financial statements included in Item 8.
Goodwill of a reporting unit must be tested for impairment on at least an annual basis. We conduct our annual goodwill impairment analysis during the fourth quarter of each fiscal year. In addition to an annual review, we assess the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value of goodwill may be greater than its fair value. Factors we consider important that could trigger an impairment review include significant underperformance relative to historical or projected future operating results, significant changes in the manner of the use of our assets or the strategy for our overall business and significant negative industry or economic trends.
In reviewing goodwill for impairment, we first compare the fair value of each of our reporting units with their carrying amounts (including goodwill). If the carrying amount of a reporting unit (including goodwill) exceeds its fair value, we then measure the amount of impairment of the reporting unit’s goodwill by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of a reporting unit’s goodwill is determined in a manner similar to the amount of goodwill determined in a business combination. That is, we allocate the fair value of the reporting unit to all of the assets and liabilities of that unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment charge is recorded when the carrying amount of goodwill exceeds its implied fair value.
Our goodwill impairment test involves estimates and management judgment using a discounted cash flow valuation methodology. Step two of our impairment test involves determining estimates of the fair values of our assets and liabilities. We may obtain assistance from third parties in assessing the fair value of certain of our assets, primarily real estate, in performing our step two analysis. If these estimates or their related assumptions change in the future, we may be required to record further impairment charges for these assets. Goodwill amounted to $272.7 million as of October 31, 2005 and 2004.
Accounting for Income Taxes
As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from the different treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we include an expense within the tax provision in the statement of earnings.
Significant management judgment is required in determining our provision for income taxes, deferred tax
assets and liabilities and any valuation allowance recorded against our net deferred tax assets. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to change our allowance, which could materially impact our financial condition and results of operations.
Preneed Selling Costs
On May 31, 2005, we changed our method of accounting for preneed selling costs incurred related to the acquisition of new prearranged funeral and cemetery service and merchandise sales. We have applied this change in accounting principle effective November 1, 2004. Therefore, our results of operations for the year ended October 31, 2005 are reported on the basis of our changed method. Prior to this change, commissions and other costs that varied with and were primarily related to the acquisition of new prearranged funeral and cemetery service sales and prearranged funeral and cemetery merchandise sales were deferred and amortized in proportion to the preneed revenue recognized in the period in a manner consistent with SFAS No. 60, “Accounting and Reporting for Insurance Companies.” We have decided to change our accounting for preneed selling costs to expense such costs as incurred. We concluded that expensing these costs as they are incurred would be preferable to the old method because it will make our reported results more comparable with other public death care companies, better align the costs of obtaining preneed contracts with the cash outflows associated with obtaining such contracts and eliminate the burden of maintaining deferred selling cost records.
As of November 1, 2004, we recorded a cumulative effect of change in accounting principle of $254.2 million ($153.2 million after tax, or $1.40 per diluted share), which represents the cumulative balance of deferred preneed selling costs in the deferred charges line in the condensed consolidated balance sheet at the time of the change. See Note 4(a) to the consolidated financial statements included in Item 8 for additional information.
Estimated Insurance Loss Liabilities
We purchase comprehensive general liability, automobile liability and workers compensation insurance coverages structured within a large deductible/self-insured retention premium rating program. This program results in the Company being primarily self-insured for claims and associated costs and losses covered by these policies. Historical insurance industry experience indicates some degree of inherent variability in assessing the ultimate amount of losses associated with the types of claims covered by the program. This is especially true due to the extended period of time that transpires between when the claim might occur and the full settlement of such claim, often many years. We continually evaluate the receivables due from our insurance carriers as well as loss estimates associated with claims and losses related to these insurance coverages with information obtained from our primary insurer.
With respect to health insurance that covers substantially all of our employees, we purchase individual and aggregate stop loss coverage with a large deductible. This program results in the Company being primarily self-insured for claims and associated costs up to the amount of the deductible, with claims in excess of the deductible amount being covered by insurance. Expected claims are based on actuarial estimates; actual claims may differ from those estimates. We continually evaluate our claims experience related to this coverage with information obtained from our insurer.
Assumptions used in preparing these estimates are based on factors such as claim settlement patterns, claim development trends, claim frequency and severity patterns, inflationary trends and data reasonableness. Together these factors will generally affect the analysis and determination of the “best estimate” of the projected ultimate claim losses. The results of these evaluations are used to assess the reasonableness of our insurance loss liability.
The estimated liability on the uninsured legal and employment-related claims are established by management based upon the recommendations of professionals who perform a review of both reported claims and estimate a liability for incurred but not reported claims. These liabilities include the estimated settlement costs. Although management believes estimated liabilities related to uninsured claims are adequately recorded, it is possible that actual results could significantly differ from the recorded liabilities.
We also have insurance coverage related to property damage, incremental costs and property operating expenses we incurred due to damage caused by Hurricane Katrina. A significant portion of the expenses incurred is expected to be recovered when we negotiate a final settlement with our insurance carriers. For additional information, see Note 24 to the consolidated financial statements included in Item 8.
Results of Operations
The following discussion segregates the financial results of our continuing operations into our various segments, grouped by our funeral and cemetery operations. For a discussion of discontinued operations, see Note 14 to the consolidated financial statements included in Item 8. For a discussion of our segments, see Note 22 to the consolidated financial statements included in Item 8. As there have been no material acquisitions or construction of new locations in fiscal years 2005 and 2004, results from continuing operations reflect those of same-store locations.
Comparison of Fiscal Year 2005 to Fiscal Year 2004
As described above in “Critical Accounting Policies,” on May 31, 2005, we changed our method of accounting for selling costs incurred related to preneed funeral and cemetery service and merchandise sales. We have applied this change in accounting principle effective November 1, 2004. Prior to this time, we deferred preneed selling costs and amortized them into expense in proportion to the preneed revenue recognized in the period. We now expense these costs in the period incurred. In the discussion below, the amounts presented in the tables for the year ended October 31, 2004 reflect historical amounts and therefore are not adjusted for this accounting change. In order to present results for the year ended October 31, 2004 comparable to those of 2005 which include the accounting change, we have also included a discussion of the net preneed selling costs for 2004 and their effect on gross profit. The effect of net preneed selling costs is calculated by removing the amortization of deferred selling costs and including in expense the preneed selling costs incurred during 2004. The result of that calculation is the net preneed selling costs that would have reduced 2004 gross profit if the accounting change had been implemented in fiscal year 2004.
Year Ended October 31, 2005 Compared to Year Ended October 31, 2004-Continuing Operations
Funeral Operations
Same-Store Analysis(3)
(1)
Corporate trust management consists of the trust management fees and funeral merchandise and service trust earnings recognized with respect to preneed contracts delivered during the period. Trust management fees are established by us at rates consistent with industry norms and are paid by the trusts to our subsidiary, Investor’s Trust, Inc. The trust earnings represent earnings realized over the life of the preneed
Consolidated Operations - Funeral
Total funeral revenue from continuing operations increased $2.9 million, or 1.1 percent, for the year ended October 31, 2005, compared to the corresponding period in 2004. Our same-store businesses achieved a 3.2 percent increase in the average revenue per traditional funeral service and a 4.0 percent increase in the average revenue per cremation service. There was also an increase in trust earnings recognized upon the delivery of preneed funerals. This resulted in an overall 2.7 percent increase in the average revenue per funeral service for our same-store businesses. We experienced a 0.3 percent increase in the number of funeral services performed by our same-store businesses, or 190 events out of the 60,495 total same-store events performed, which includes the impact of Hurricane Katrina on our New Orleans funeral homes. Excluding these three funeral homes, same-store funeral services increased 0.9 percent. We believe the increase in funeral services can be attributed to the funeral home incentive compensation plan implemented in the first quarter of 2005 and to the execution of our strategic plan. We believe a number of factors contributed to the increases in our average revenue per traditional and cremation service. We believe the primary factors were normal inflationary price increases, more effective merchandising and packaging, our focus on training, customized funeral planning and personalization and a new program for arranger incentives.
Funeral gross profit margin from continuing operations decreased from 25.3 percent in the year ended October 31, 2004 to 22.5 percent in the year ended October 31, 2005, primarily due to the $9.9 million increase in funeral costs. Funeral costs from continuing operations for the year ended October 31, 2004 do not include $5.6 million of net preneed selling costs associated with the accounting change as described above. Including these costs, the pro forma funeral gross profit margin from continuing operations would have been 23.3 percent for the year ended October 31, 2004. The remaining decrease in the funeral margin is primarily due to increased health insurance costs due to an increase in the number of high-dollar claims in 2005. Direct funeral costs (which primarily include salaries and wages, merchandise costs, selling costs and maintenance) declined. The cremation rate for our same-store operations was 37.4 percent for the year ended October 31, 2005 compared to 36.6 percent for the year ended October 31, 2004.
Segment Discussion - Funeral
Funeral revenue in the Eastern division funeral segment increased primarily due to an increase in the number of funeral services performed by the same-store businesses of 1.9 percent and an increase in the average revenue per funeral service in the same-store businesses of 2.5 percent. Funeral revenue in the Western division segment decreased primarily due to a decrease in the number of funeral services performed by the same-store businesses of 1.3 percent, which includes the impact of Hurricane Katrina on our New Orleans funeral homes. Excluding these funeral homes, same-store funeral services decreased 0.4 percent. The decrease in funeral services performed was partially offset by an increase in the average revenue per funeral service in the same-store businesses of 2.7 percent. Funeral revenue in the corporate trust management segment increased due primarily to an increase in trust earnings recognized upon the delivery of preneed funerals of $0.3 million, partially offset a decrease in trust
management fees of $0.1 million.
Funeral gross profit margin for the Eastern division and Western division funeral segments decreased primarily due to the change in accounting principle for preneed selling costs in 2005 and due to increased health insurance costs. Direct funeral costs (which primarily include salaries and wages, merchandise costs, selling costs and maintenance) declined. The loss in revenue in the Western division, due in part to the reduction in funeral services performed resulting from Hurricane Katrina, negatively impacted the Western division funeral gross profit margin.
As demonstrated in the table above, the same-store cremation rate increased for both the Eastern and Western division funeral segments.
Cemetery Operations
(1)
Corporate trust management consists of the trust management fees and cemetery merchandise and service trust earnings recognized with respect to preneed contracts delivered during the period. Trust management fees are established by us at rates consistent with industry norms and are paid by the trusts to our subsidiary, Investor’s Trust, Inc. The trust earnings represent earnings realized over the life of the preneed contracts delivered during the relevant periods. See Notes 6 and 8 to the consolidated financial statements included in Item 8 for information regarding the cost basis and market value of the trust assets and current performance of the trusts (i.e. current realized gains and losses, interest income and dividends). Trust management fees included in cemetery revenue for 2005 and 2004 were $4.9 million and $4.7 million, respectively, and cemetery trust earnings recognized with respect to preneed contracts delivered included in cemetery revenue for 2005 and 2004 were $6.3 million and $5.9 million, respectively. Perpetual care trust earnings are included in the revenues and gross profit of the related geographic segment.
(2)
Cemetery costs from continuing operations for the year ended October 31, 2004 do not include net preneed selling costs of $4.3 million, which would have been expensed if the accounting change described above had been implemented in fiscal year 2004. Had we included these costs in 2004, cemetery gross profit from continuing operations for the year ended October 31, 2005 would have decreased $1.5 million from $42.0 million for the year ended October 31, 2004.
Consolidated Operations - Cemetery
Cemetery revenue from continuing operations decreased $2.1 million, or 0.9 percent, for the year ended October 31, 2005, compared to the corresponding period in 2004, primarily due to a decrease in revenue associated with the construction of cemetery projects, a decrease in earned finance charges, a decrease in revenues as a result of Hurricane Katrina and an increase in bad debt recorded as a result of Hurricane Katrina of approximately $1.6 million. Revenue related to the sale of cemetery property prior to its construction is recognized on a percentage of completion method of accounting as construction occurs. Gross cemetery property sales increased 0.9 percent for the year ended October 31, 2005 compared to the year ended October 31, 2004 from $99.2 million to $100.1 million.
We experienced an annualized average return, excluding unrealized gains and losses, of 3.8 percent in our perpetual care trusts for the year ended October 31, 2005 resulting in revenue of $8.2 million, compared to 3.1 percent for the corresponding period in 2004 resulting in revenue of $6.4 million. Perpetual care trust earnings are included in the geographic segments’ revenue and gross profit. See Note 7 and 8 to the consolidated financial statements included in Item 8 for information regarding the cost basis and market value of those trust assets and the current performance of the trusts (i.e. current realized gains and losses, interest income and dividends).
Cemetery gross profit margin from continuing operations decreased from 20.8 percent in the year ended October 31, 2004 to 18.4 percent in the year ended October 31, 2005. Cemetery costs from continuing operations for the year ended October 31, 2004 do not include $4.3 million of net preneed selling costs associated with the accounting change as described above. Including these costs, the pro forma cemetery gross profit margin from continuing operations would have been 18.9 percent for the year ended October 31, 2004. The remaining decrease is due to the decrease in revenue described above and from increased health insurance costs due to the increase in the number of high-dollar claims in 2005. Direct cemetery costs (which primarily include cemetery property costs, merchandise costs, selling costs, salaries and wages and maintenance) also increased.
Segment Discussion - Cemetery
Cemetery revenue in the Eastern division cemetery segment increased primarily due to an increase in revenue associated with the construction of cemetery projects, an increase in merchandise deliveries and increased perpetual care trust earnings. Cemetery revenue in the Western division cemetery segment decreased primarily due to a decrease in revenue associated with the construction of cemetery property, a decrease in revenues as a result of Hurricane Katrina, and an increase in bad debt of approximately $1.6 million as a result of Hurricane Katrina. Cemetery revenue in the corporate trust management segment increased due to a $0.4 million increase in trust earnings recognized upon the delivery of preneed cemetery merchandise and services and a $0.2 million increase in trust management fees.
Cemetery gross profit margin for the Western division and Eastern division cemetery segments decreased due to the change in accounting principle for preneed selling costs in 2005 and increased health insurance costs. The Western division cemetery gross profit margin also declined due to the increase in bad debt resulting from Hurricane Katrina. Direct cemetery costs (which primarily include cemetery property costs, merchandise costs, selling costs, salaries and wages and maintenance) also increased.
Discontinued Operations
In December 2003, we announced plans to close or sell a number of small businesses, primarily small funeral homes, most of which were acquired as part of a group of facilities, that were performing below acceptable levels or no longer fit our operating profile. The operating results of those businesses that were sold in fiscal years 2004 and 2005 are reported in the discontinued operations section of the consolidated statements of earnings. We determined that the carrying value of these businesses exceeded their fair market value and recorded a noncash impairment charge in the fourth quarter of fiscal year 2003. Fair value was established based on our best estimate and is subject to revision in future periods as properties are actually closed or sold. Included in discontinued operations for the year ended October 31, 2005 were gains on dispositions, net of impairment losses, of approximately $1.1 million compared to $2.4 million that was recognized for the year ended October 31, 2004. Revenues for fiscal year 2005 were $1.2 million compared to $12.7 million in fiscal year 2004. The effective tax rate for our discontinued operations for the year ended October 31, 2005 was a 6.6 percent benefit compared to a 47.9 percent benefit for the same period in 2004. For additional information, see Notes 14 and 19 to the consolidated financial statements included in Item 8.
Other
Corporate general and administrative expenses for the year ended October 31, 2005 increased $2.3 million compared to the same period in 2004 primarily due to increased professional fees associated with our Sarbanes Oxley Section 404 compliance effort and increased legal and professional fees relating in part to the class action lawsuits.
As of October 31, 2005, we had recorded net expenses of $9.4 million related to Hurricane Katrina. For additional information, see Note 24 to the consolidated financial statements included in Item 8.
In accordance with SFAS No. 142, we performed our annual goodwill impairment review during the fourth quarters of fiscal years 2005 and 2004. There was no impairment charge during 2005 or 2004 related to goodwill. For additional information on goodwill, see Notes 2 and 3(g) to the consolidated financial statements included in Item 8.
We recorded charges of $1.5 million for the year ended October 31, 2005 related to the reorganization of our divisions in the fourth quarter of fiscal year 2005. In December 2003, we announced a reduction and restructuring of our workforce and recorded $2.4 million in related charges during the year ended October 31, 2004. We also recorded a charge of $1.0 million for separation pay related to a former executive officer during fiscal year 2004. These charges are presented in the “Separation charges” line item in the consolidated statements of earnings.
During the fourth quarter of fiscal year 2003, we identified a number of small businesses to close or sell, mostly funeral homes, and determined that their carrying value exceeded their fair values. In accordance with SFAS No. 144, we recorded a noncash impairment charge of $31.8 million during the fourth quarter of fiscal year 2003, of which $10.2 million was included in continuing operations. For fiscal year 2004, we evaluated our long-lived assets, recorded impairment charges of $0.8 million and sold several assets that we held for sale at a net gain of $0.6 million. The net effect was that we reported gains on dispositions, net of impairment losses, of ($0.2) million in continuing operations. In 2005, we recorded $1.3 million in gains on dispositions, net of impairment losses. For additional information, see Note 14 to the consolidated financial statements included in Item 8. The charges are presented in the “Gains on dispositions and impairment (losses), net” line item in the consolidated statement of earnings.
Total depreciation and amortization was $21.4 million for the year ended October 31, 2005 compared to $48.4 million for the same period in 2004. Depreciation and amortization from continuing operations was $21.4 million for the year ended October 31, 2005 compared to $47.8 million for the same period in 2004. Amortization in fiscal year 2004 included $25.0 million of deferred selling costs. Effective November 1, 2004, we changed our accounting principle for selling costs related to preneed funeral and cemetery service and merchandise sales, and we no longer amortize these costs but rather expense them as incurred.
Interest expense decreased $16.8 million to $30.5 million for the year ended October 31, 2005 compared to $47.3 million for the same period in 2004 due to a $39.5 million decrease in average debt outstanding and a 295 basis-point decrease in the average interest rate.
Other operating income, net, was $1.4 million and $2.1 million for the years ended October 31, 2005 and 2004, respectively, and primarily included net gains on the sale of assets which were not included in our businesses classified as held for sale.
The effective tax rate for our continuing operations for the year ended October 31, 2005 was 27.2 percent compared to 37.0 percent for the year ended October 31, 2004. The change in the effective tax rate was primarily due to the greater impact of the dividend exclusion related to dividends received from our trust income on a reduced level of book income caused by the increased costs associated with the early extinguishment of debt as well as costs attributable to Hurricane Katrina. The dividend exclusion relates to dividends received for investments in certain trusts for which we recognize earnings for tax purposes as earned by the trust. For additional information, see Note 19 to the consolidated financial statements included in Item 8.
On May 31, 2005, we changed our method of accounting for selling costs incurred related to new preneed funeral and cemetery service and merchandise sales. As of November 1, 2004, we recorded a cumulative effect of change in accounting principle of $254.2 million ($153.2 million after tax, or $1.40 per diluted share), which represents the cumulative balance of deferred preneed selling costs in the deferred charges line in the condensed
consolidated balance sheet at the time of the change. See Note 4(a) to the condensed consolidated financial statements for additional information.
As of October 31, 2005 and December 30, 2005, our outstanding debt totaled $410.0 million and $409.8 million, respectively. Of the total debt outstanding as of October 31, 2005, approximately 49 percent was subject to fixed rates averaging 6.2 percent, and 51 percent was subject to short-term variable rates averaging approximately 5.6 percent. On November 19, 2004, we completed the refinancing of our senior secured credit facility and recorded a charge for early extinguishment of debt of $2.7 million ($1.7 million after tax, or $.02 per share) to write off fees associated with the previous credit facility. On February 11, 2005, we completed the private offering of $200.0 million principal amount of our 6.25 percent senior notes due 2013. We also borrowed $130.0 million in additional term loan debt under our senior secured credit facility. We used the net proceeds from these transactions, together with a portion of our available cash, to repurchase $298.2 million in aggregate principal amount of our 10.75 percent senior subordinated notes due 2008 and to pay related tender premiums, fees, expenses and accrued interest of $28.9 million. In the second quarter of fiscal year 2005, we recorded a charge for early extinguishment of debt of $30.0 million ($19.2 million after tax, or $.18 per share) representing the bond tender premium, related fees and expenses and the write-off of unamortized fees. In the third quarter of fiscal year 2005, the remaining 10.75 percent senior subordinated notes were redeemed. We recorded a charge for early extinguishment of debt of $0.1 million representing the call premium and write-off of remaining unamortized fees on the 10.75 percent senior subordinated notes. See Note 16 to the consolidated financial statements included in Item 8 for additional information.
Preneed Sales into and Deliveries out of the Backlog
We achieved a 5.1 percent increase in preneed funeral sales for the year ended October 31, 2005 compared to the same period in 2004.
The revenues from our preneed funeral and cemetery merchandise and service sales are deferred into our backlog and are not included in our operating results presented above. We added $171.7 million in gross preneed sales to our funeral and cemetery merchandise and services backlog (including $72.6 million related to insurance-funded preneed funeral contracts) during the year ended October 31, 2005 to be recognized in the future (net of cancellations) as these prepaid products and services are delivered, compared to gross sales of $165.7 million (including $67.3 million related to insurance-funded preneed funeral contracts) for the corresponding period in 2004. Deliveries out of our preneed funeral and cemetery merchandise and services backlog, including accumulated trust earnings related to these preneed deliveries, amounted to $149.1 million for the year ended October 31, 2005, compared to $148.1 million for the corresponding period in 2004, resulting in net increases in the backlog of $22.6 million and $17.6 million for the years ended October 31, 2005 and 2004, respectively.
Comparison of Fiscal Year 2004 to Fiscal Year 2003
For fiscal year 2004, we had net earnings of $36.7 million, compared to a net loss of $18.0 million in fiscal year 2003. Fiscal year 2003 results include a $19.1 million loss in discontinued operations, while fiscal year 2004 results include $5.7 million of net earnings from discontinued operations. Earnings from continuing operations increased $29.9 million, from $1.1 million in fiscal year 2003 to $31.0 million in fiscal year 2004. Fiscal year 2004 results reflect an increase in gross profit of $16.4 million and a decrease in interest expense of $6.3 million. The improvement in gross profit was primarily a result of our cost savings initiatives and an increase in cemetery revenues. Cemetery revenues increased in large part due to the success of our cemetery property sales initiative. The decrease in interest expense was due to a $79.5 million decrease in average debt outstanding, partially offset by a 32 basis-point increase in the average interest rate. Fiscal year 2003 results include a $11.3 million loss on early extinguishment of debt due to the redemption of our $99.9 million Remarketable Or Redeemable Securities (“ROARS”). In addition, fiscal year 2003 results include ($10.2) million of net gains on dispositions and impairment (losses), whereas fiscal year 2004 results include ($0.2) million of net gains on dispositions and impairment (losses).
Year Ended October 31, 2004 Compared to Year Ended October 31, 2003-Continuing Operations
Funeral Operations
Same-Store Analysis
(1)
Corporate trust management consists of the trust management fees and funeral merchandise and service trust earnings recognized with respect to preneed contracts delivered during the period. Trust management fees are established by us at rates consistent with industry norms and are paid by the trusts to our subsidiary, Investor’s Trust, Inc. The trust earnings represent earnings realized over the life of the preneed contracts delivered during the relevant periods. See Notes 5 and 8 to the consolidated financial statements included in Item 8 for information regarding the cost basis and market value of the trust assets and current performance of the trusts (i.e. current realized gains and losses, interest income and dividends). Trust management fees included in funeral revenue for 2004 and 2003 were $5.5 million and $5.2 million, respectively, and funeral trust earnings recognized with respect to preneed contracts delivered included in funeral revenue for 2004 and 2003 were $13.2 million and $12.6 million, respectively.
Consolidated Operations - Funeral
Total funeral revenue from continuing operations increased $2.1 million for the year ended October 31, 2004, compared to the corresponding period in 2003. Our same-store businesses achieved a 3.6 percent increase in the average revenue per traditional funeral service and a 4.9 percent increase in the average revenue per cremation service. There was also an increase in trust earnings recognized upon the delivery of preneed funerals. This resulted in an overall 2.3 percent increase in the average revenue per funeral service for our same-store businesses. That increase was offset by a 1.0 percent decline in the number of funeral services performed by our same-store businesses, or 633 events out of the 60,792 total same-store events performed. We believe a number of factors contributed to the increases in our average revenue per traditional and cremation service. We believe the primary factors were normal inflationary price increases, more effective merchandising and packaging, our focus on training, customized funeral planning and personalization and a new program for arranger incentives.
Funeral gross profit margin from continuing operations increased from 21.8 percent in the year ended October 31, 2003 to 25.3 percent in the year ended October 31, 2004. This improvement was due primarily to reduced general and administrative costs in the funeral segment resulting from our cost reduction initiatives as discussed in “Business Strategy” included in Item 1. In addition, direct funeral costs (which primarily include salaries and wages, merchandise costs, selling costs and maintenance) declined slightly. The cremation rate for our same-store operations was 36.6 percent for the year ended October 31, 2004 compared to 35.9 percent for the year ended October 31, 2003.
Segment Discussion - Funeral
Funeral revenue in the Western division funeral segment increased primarily due to an increase in the average revenue per funeral service in the same-store businesses of 2.4 percent, offset by a decrease in the number of funeral services performed of 1.0 percent. Funeral revenue in the corporate trust management segment increased due primarily to an increase in trust earnings recognized upon the delivery of preneed funerals of $0.6 million and an increase in trust management fees of $0.3 million.
Funeral gross profit margin for the Western division and Eastern division funeral segments increased primarily due to reduced general and administrative costs resulting from our cost reduction initiatives as discussed in “Business Strategy” included in Item 1. In addition, direct funeral costs (which primarily include salaries and wages, merchandise costs, selling costs and maintenance) declined. Also, funeral gross profit margin in the Western division segment increased primarily due to an increase in revenue as discussed above.
As demonstrated in the table above, the same-store cremation rate increased for the Western division and Eastern division funeral segments.
Cemetery Operations
(1)
Corporate trust management consists of the trust management fees and cemetery merchandise and service trust earnings recognized with respect to preneed contracts delivered during the period. Trust management fees are established by us at rates consistent with industry norms and are paid by the trusts to our subsidiary, Investor’s Trust, Inc. The trust earnings represent earnings realized over the life of the preneed contracts delivered during the relevant periods. See Notes 6 and 8 to the consolidated financial statements included in Item 8 for information regarding the cost basis and market value of the trust assets and current performance of the trusts (i.e. current realized gains and losses, interest income and dividends). Trust management fees included in cemetery revenue for 2004 and 2003 were $4.7 million and $4.4 million, respectively, and cemetery trust earnings recognized were $5.9 million and $6.2 million,
respectively. Perpetual care trust earnings are included in the revenues and gross profit of the related geographic segment.
Consolidated Operations - Cemetery
Cemetery revenue from continuing operations increased $13.4 million, or 6.4 percent, for the year ended October 31, 2004, compared to the corresponding period in 2003, primarily due to an increase in cemetery property sales, construction during the year on various cemetery development projects and an improvement in our bad debt experience. Our sales organization was very successful with our preneed cemetery property sales initiative. Gross cemetery property sales increased 8.9 percent for the year ended October 31, 2004 compared to the year ended October 31, 2003 from $91.1 million to $99.2 million, which was in line with our stated goal of 5 percent to 10 percent. This increase in cemetery property sales accounted for approximately half of the cemetery revenue increase with the remaining increase due primarily to progress on the construction of various cemetery property sold prior to construction and the improvement in our bad debt experience. Revenue related to the sale of cemetery property prior to its construction is recognized on a percentage of completion method of accounting as construction occurs.
We experienced an annualized average return, excluding unrealized gains and losses, of 3.1 percent in our perpetual care trusts for the year ended October 31, 2004 resulting in revenue of $6.4 million, compared to 4.2 percent for the corresponding period in 2003 resulting in revenue of $7.9 million. Perpetual care trust earnings are included in the Western division and Eastern division segments’ revenue and gross profit. See Note 7 and 8 to the consolidated financial statements included in Item 8 for information regarding the cost basis and market value of those trust assets and the current performance of the trusts (i.e. current realized gains and losses, interest income and dividends).
Cemetery gross profit margin from continuing operations increased from 19.1 percent in the year ended October 31, 2003 to 20.8 percent in the year ended October 31, 2004. This improvement resulted from increased cemetery revenue as discussed above, combined with reduced general and administrative costs in the cemetery segment resulting primarily from our cost reduction initiatives as discussed in “Business Strategy” included in Item 1. Direct cemetery costs (which primarily include cemetery property costs, merchandise costs, selling costs, salaries and wages and maintenance) increased as a result of the increased revenue.
Segment Discussion - Cemetery
Cemetery revenue in the Western division and Eastern division segments increased primarily due to an increase in cemetery property sales. For further discussion on our preneed cemetery property sales initiative, see “Consolidated Operations - Cemetery.” The Western division segment also benefited from an improvement in bad debt experience. Cemetery revenue in the Western division segment increased primarily due to an increase in construction during the year on various cemetery development projects. For further discussion, see “Consolidated Operations - Cemetery.”
Cemetery gross profit margin for the Western and Eastern division cemetery segments increased primarily due to increased cemetery revenue as discussed above, combined with reduced general and administrative costs resulting from our cost reduction initiatives as discussed in “Business Strategy” included in Item 1. Direct cemetery costs (which primarily include cemetery property costs, merchandise costs, selling costs, salaries and wages and maintenance) increased as a result of the increased revenue.
Discontinued Operations
In December 2003, we announced plans to close or sell a number of small businesses, primarily small funeral homes, most of which were acquired as part of a group of facilities, that were performing below acceptable levels or no longer fit our operating profile. The operating results of those businesses that were sold in fiscal years 2003, 2004 and 2005 are reported in the discontinued operations section of the consolidated statements of earnings. We determined that the carrying value of these businesses exceeded their fair market value and recorded a noncash impairment charge in the fourth quarter of fiscal year 2003. Fair value was established based on our best estimate and is subject to revision in future periods as properties are actually closed or sold. Included in discontinued operations for the year ended October 31, 2004 were gains on dispositions, net of impairment losses, of approximately $2.4 million compared to an impairment loss of $21.6 million that was recognized for the year ended October 31, 2003. Revenues for fiscal year 2004 were $12.7 million compared to $19.3 million in fiscal year 2003. The effective tax rate for our discontinued operations for the year ended October 31, 2004 was a 47.9 percent benefit compared to an 8.3 percent benefit for the same period in 2003. A benefit was recorded for the discontinued
operations in fiscal year 2004 because we determined that certain tax benefits on asset sales would be realized. For additional information, see Notes 14 and 19 to the consolidated financial statements included in Item 8.
Other
Corporate general and administrative expenses for the year ended October 31, 2004 decreased $.6 million compared to the same period in 2003 primarily due to decreases in salaries and legal fees.
In accordance with SFAS No. 142, we performed our annual goodwill impairment review during the fourth quarters of fiscal years 2004 and 2003. There was no impairment charge during 2004 or 2003 related to goodwill. For additional information on goodwill, see Notes 2 and 3(g) to the consolidated financial statements included in Item 8.
In December 2003, we announced a reduction and restructuring of our workforce. We recorded $2.4 million in related charges during the year ended October 31, 2004. We also recorded charges of $1.0 million and $2.5 million for the years ended October 31, 2004 and 2003, respectively, for separation pay related to former executive officers. The charges are presented in the “Separation charges” line item in the consolidated statements of earnings.
During the fourth quarter of fiscal year 2003, we identified a number of small businesses to close or sell, mostly funeral homes, and determined that their carrying value exceeded their fair values. In accordance with SFAS No. 144, we recorded a noncash impairment charge of $31.8 million during the fourth quarter of fiscal year 2003, of which $10.2 million was included in continuing operations. For fiscal year 2004, we evaluated our long-lived assets, recorded impairment charges of $0.8 million and sold several assets that we held for sale at a net gain of $0.6 million. The net effect was that we reported gains on dispositions, net of impairment losses, of ($0.2) million in continuing operations. For additional information, see Note 14 to the consolidated financial statements included in Item 8. The charge is presented in the “Gains on dispositions and impairment (losses), net” line item in the consolidated statement of earnings.
Total depreciation and amortization was $48.4 million for the year ended October 31, 2004 compared to $49.2 million for the same period in 2003. Depreciation and amortization from continuing operations was $47.8 million for the year ended October 31, 2004 compared to $47.5 million for the same period in 2003.
Interest expense decreased $6.3 million to $47.3 million for the year ended October 31, 2004 compared to $53.6 million for the same period in 2003 due to a $79.5 million decrease in average debt outstanding, partially offset by a 32 basis-point increase in the average interest rate.
On May 1, 2003, we exercised our right to redeem our outstanding $99.9 million Remarketable Or Redeemable Securities (“ROARS”) rather than allowing them to be remarketed and recorded a loss on early extinguishment of debt of $11.3 million in fiscal year 2003.
Other operating income, net, was $2.4 million for the years ended October 31, 2004 and 2003 and primarily included net gains on the sale of assets which were not included in our businesses classified as held for sale.
Investment and other income (expense), net, increased $.9 million to $.2 million for the year ended October 31, 2004. A write-down of certain marketable securities occurred in 2003, which had market value losses that were deemed to be other than temporary.
The effective tax rate for our continuing operations for the year ended October 31, 2004 was 37.0 percent compared to 77.1 percent for the year ended October 31, 2003. We recorded a valuation allowance on the impairment of long-lived assets which significantly increased the rate. For a discussion on the increase in the valuation allowance, see Note 19 to the consolidated financial statements included in Item 8. The effective tax rate was also impacted by the reduced book income in 2003 compared to 2004 and the increase in state taxes for 2003. We operate in many different states through over 200 entities. Therefore, the mix of income by location can have an impact on state taxes.
As of October 31, 2004 and January 3, 2005, our outstanding debt totaled $416.8 million and $413.0 million, respectively. Of the total debt outstanding as of October 31, 2004, including the portion subject to the interest rate swap agreement in effect as of October 31, 2004, approximately 85 percent was subject to fixed rates averaging 10.1 percent, and 15 percent was subject to short-term variable rates averaging approximately 4.0 percent.
In order to hedge a portion of the interest rate risk associated with our variable-rate debt, effective March 11, 2002, we entered into two interest rate swap agreements, each involving a notional amount of $50.0 million. One of the agreements expired on March 11, 2004, and the other expires on March 11, 2005. As of October 31, 2004, the effective rate of the debt hedged by the remaining interest rate swap was 6.765 percent. On November 19, 2004, we completed the refinancing of our senior secured credit facility. No amounts under the new senior secured credit facility are hedged by the remaining interest rate swap. See Note 16 to the consolidated financial statements included in Item 8 for additional information.
Preneed Sales into and Deliveries out of the Backlog
In the third quarter of fiscal year 2003, we increased our focus on preneed sales as part of our operating initiatives, and that effort helped us achieve a 9.4 percent increase in preneed funeral sales for the year ended October 31, 2004 compared to the same period in 2003.
The revenues from our preneed funeral and cemetery merchandise and service sales are deferred into our backlog and are not included in our operating results presented above. We added $165.7 million in gross preneed sales to our funeral and cemetery merchandise and services backlog (including $67.3 million related to insurance-funded preneed funeral contracts) during the year ended October 31, 2004 to be recognized in the future (net of cancellations) as these prepaid products and services are delivered, compared to gross sales of $159.9 million (including $65.5 million related to insurance-funded preneed funeral contracts) for the corresponding period in 2003. Deliveries out of our preneed funeral and cemetery merchandise and services backlog, including accumulated trust earnings related to these preneed deliveries, amounted to $148.1 million for the year ended October 31, 2004, compared to $148.6 million for the corresponding period in 2003, resulting in a net increases in the backlog of $17.6 million and $11.3 million for the years ended October 31, 2004 and 2003, respectively.
Liquidity and Capital Resources
Cash Flow
Comparison of Fiscal Year 2005 to Fiscal Year 2004
Our operations provided cash of $52.8 million for the year ended October 31, 2005 compared to $93.6 million for the comparable period in 2004. The 2005 amount included a cash inflow of approximately $19 million for cash withdrawn from trust accounts during the year resulting from the determination during the deferred revenue project that those amounts had not been withdrawn in prior periods, even though the related services and merchandise had been delivered in prior periods. The 2005 amount also included a cash outflow of approximately $2.5 million related to Hurricane Katrina. The 2004 amount included a $33.2 million tax refund received during the first quarter of 2004 resulting from a change in tax accounting methods for cemetery merchandise revenue. In fiscal year 2005, we also recorded $25.5 million for premiums paid for the early extinguishment of debt related to the debt refinancings occurring in 2005.
Our investing activities resulted in a net cash outflow of $12.4 million for the year ended October 31, 2005, compared to a net cash inflow of $0.5 million for fiscal year 2004. The change was primarily due to $19.8 million in proceeds from asset sales in fiscal year 2004 compared to $10.0 million in fiscal year 2005.
Our financing activities resulted in a net cash outflow of $21.4 million for the year ended October 31, 2005, compared to a net cash outflow of $91.3 million for the comparable period in 2004. The change was due primarily to repayments of long-term debt of $85.3 million in fiscal year 2004 compared to net repayments of $6.8 million ($446.8 million in repayments, net of $440.0 million in proceeds) in fiscal year 2005. We used the $33.2 million tax refund included in operating cash flow to reduce our outstanding Term Loan B in the first quarter of fiscal year 2004. We also used $13.7 million in fiscal year 2005 compared to $19.3 million in fiscal year 2004 to repurchase stock under our stock repurchase program. On March 28, 2005, our Board of Directors approved the initiation of a quarterly cash dividend of two and one-half cents per share of common stock, and we used $8.2 million for dividends payments in 2005.
Comparison of Fiscal Year 2004 to Fiscal Year 2003
Our operations provided cash of $93.6 million for the year ended October 31, 2004 compared to $57.1 million for the comparable period in 2003. The 2004 amount included a $33.2 million tax refund received during the first quarter of 2004 resulting from a change in tax accounting methods for cemetery merchandise revenue and a
cash outflow of $2.1 million for separation pay. The 2003 amount included a $23.3 million tax refund received related to the sale of our foreign operations and a cash outflow of $0.4 million for separation pay. The increase in operating cash flow was also due in part to the increase in earnings. In fiscal year 2003, we also paid $12.7 million to avoid a remarketing right in connection with the redemption of our $99.9 million Remarketable Or Redeemable Securities.
Our investing activities resulted in a net cash inflow of $0.5 million for the year ended October 31, 2004, compared to a net cash outflow of $15.4 million for fiscal year 2003. The change was primarily due to $19.8 million in proceeds from asset sales in fiscal year 2004 compared to $2.3 million in fiscal year 2003.
Our financing activities resulted in a net cash outflow of $91.3 million for the year ended October 31, 2004, compared to a net cash outflow of $51.4 million for the comparable period in 2003. The change was due primarily to repayments of long-term debt of $85.3 million in fiscal year 2004 compared to net repayments of $48.2 million ($203.2 million in repayments, net of $155.0 million in proceeds) in fiscal year 2003. We used the $33.2 million tax refund included in operating cash flow to reduce our outstanding Term Loan B in the first quarter of fiscal year 2004. The $155.0 million in proceeds from long-term debt received in 2003 was incurred in connection with the redemption of our $99.9 million Remarketable Or Redeemable Securities. We also used $19.3 million in fiscal year 2004 compared to $3.0 million in fiscal year 2003 to repurchase stock under our stock repurchase program.
Contractual Obligations and Commercial Commitments
As of October 31, 2005, our outstanding debt balance totaled $410.0 million. The following table details our known future cash payments (in millions) related to various contractual obligations as of October 31, 2005.
We expect to be able to reduce our debt with approximately $5.5 million of remaining income tax benefits related to the sale of our foreign operations which we expect to receive by the end of fiscal year 2007.
On November 19, 2004, we completed the refinancing of our senior secured credit facility. On February 11, 2005, we completed the private offering of $200.0 million principal amount of our 6.25 percent senior notes due 2013. We also borrowed $130.0 million in additional term loan debt under our senior secured credit facility. We used the net proceeds from these transactions, together with a portion of our available cash, to repurchase $298.2 million in aggregate principal amount of our 10.75 percent senior subordinated notes due 2008 and to pay related tender premiums, fees, expenses and accrued interest. In the third quarter of fiscal year 2005, the remaining senior
subordinated notes were redeemed. For additional information, see Note 16 to the consolidated financial statements included in Item 8.
In connection with the issuance of the 6.25 percent senior notes, we entered into a registration rights agreement that requires that a registration statement be filed and declared effective by the SEC, and that an exchange offer be conducted providing for the exchange of the unregistered notes for similar registered notes, all within specified times. So far, we have been unable to cause the required registration statement to become effective and therefore are required to pay additional interest to the note holders until the default is cured. Additional interest began to accrue on June 12, 2005 at a rate of 0.50 percent per annum on the principal amount of the notes for a period of 90-days. The additional interest increases 0.50 percent for each 90-day period thereafter so long as the default exists, up to a maximum increase of 1.50 percent per annum. The additional interest is payable at the regular interest payment dates. The additional interest increased to 1.00 percent on September 11, 2005 and increased to 1.50 percent on December 11, 2005. As of October 31, 2005, we had incurred $0.5 million in additional interest charges.
The following table details our future payments and maturities of long-term debt as of October 31, 2005.
We also had $12.7 million of outstanding letters of credit as of October 31, 2005, and we are required to maintain a bond to guarantee our obligations relating to funds we withdrew in fiscal year 2001 from our preneed funeral trusts in Florida. We substituted a bond to guarantee performance under certain preneed funeral contracts and agreed to maintain unused credit facilities in an amount that will equal or exceed the bond amount. The surety company has the right to terminate the bond at any time, and if that were to occur and we were not able to obtain a replacement, we would be required to fund the trusts with cash equal to the bond amount. As of October 31, 2005, the balance of the Florida bond was $41.1 million. We believe that cash flow from operations will be sufficient to cover our estimated cost of providing the related prearranged services and products in the future.
As of October 31, 2005, there were no amounts drawn on our $125.0 million revolving credit facility. As of October 31, 2005, our availability under the revolving credit facility, after giving consideration to the aforementioned letters of credit and bond obligation, was $71.2 million.
For a discussion of our stock repurchase program and dividend payments, see “Overview of Fiscal Year 2005 - Dividends and Stock Repurchase Plan” above in this Item 7.
The restatements described in Note 2 to the consolidated financial statements included in Item 8 as well as our failure to deliver financial statements within the specified deadlines in our senior secured credit facility resulted in a default and potential event of default under the facility. We sought and received waivers of the defaults and potential events of default related to the restatements and failure to deliver audited consolidated financial statements by the specified deadline. A waiver granted an extension to deliver the audited consolidated financial statements for a date subsequent to this filing. We delivered the financial statements within the time period specified in the waiver. We believe our incomplete July 31, 2005 Form 10-Q filed with the SEC met the financial statement compliance requirements of our senior secured credit facility. We believe we were in compliance with the terms of the senior secured credit facility.
The indenture governing our 6.25 percent notes requires us to furnish to the trustee for forwarding to the holders of the notes, within the time periods specified in the SEC’s rules and regulations, all quarterly and annual financial information that would be required to be contained in a filing with the SEC on Forms 10-Q and 10-K, including a “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and, with respect to the annual information only, a report on the annual financial statements from our certified independent accountants. In addition, we must file a copy with the SEC for public availability within the time periods specified in the SEC’s rules and regulations. An event of default would occur if we failed to provide that information within 30 days after receipt of written notice by the trustee or holders of at least 25 percent of the principal amount outstanding. We furnished our July 31, 2005 Form 10-Q to the trustee and filed it with the SEC, and believe that doing so complied with the requirements of the indenture. We have not received a default notice from the trustee or note holders with respect to the late filing of the Form 10-K for the fiscal year ended October 31, 2005 and have now filed this report with the SEC. We believe we are in compliance with the terms of our 6.25 percent notes.
Capital Expenditures
For fiscal year 2005, capital expenditures amounted to $22.6 million, which included $17.5 million for maintenance capital expenditures, $2.0 million for new growth initiatives and $3.1 million related to a building we purchased which was previously leased. We have no material commitments for capital expenditures in fiscal year 2006 other than approximately $5 million related to the Archdiocese of Los Angeles funeral homes and another funeral home project.
Off-Balance Sheet Arrangements
Our off-balance sheet arrangements as of October 31, 2005 consist of the following two items:
(1)
the $41.1 million bond we are required to maintain to guarantee our obligations relating to funds we withdrew in fiscal year 2001 from our preneed funeral trusts in Florida, which is discussed in Note 21 to the consolidated financial statements included in Item 8; and
(2)
the insurance-funded preneed funeral contracts, which will be funded by life insurance or annuity contracts issued by third-party insurers, are not reflected in our consolidated balance sheets, and are discussed in Note 3(j) to the consolidated financial statements included in Item 8.
Ratio of Earnings to Fixed Charges
Our ratio of earnings to fixed charges was as follows:
eliminate the coverage deficiency.
For purposes of computing the ratio of earnings to fixed charges, earnings consist of pretax earnings from continuing operations plus fixed charges (excluding interest capitalized during the period). Fixed charges consist of interest expense, capitalized interest, amortization of debt expense and discount or premium relating to any indebtedness, and the portion of rental expense that management believes to be representative of the interest component of rental expense.
Effect of Recent Accounting Standards
For additional information on changes in accounting principles and new accounting principles, see Note 4 to the consolidated financial statements included in Item 8.
Inflation
Inflation has not had a significant impact on our operations over the past three years, nor is it expected to have a significant impact in the foreseeable future.
Forward-Looking Statements
Certain statements made herein or elsewhere by us or on our behalf that are not historical facts are intended to be forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may include the words “may,” “will,” “estimate,” “intend,” “continue,” “believe,” “expect,” “plan” or “anticipate” and other similar words. These statements include any projections of earnings, revenues, asset sales, cash flow, debt levels or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements contained in this report include statements relating to (1) anticipated future performance of our preneed sales program, (2) anticipated future performance of funds held in trust, (3) anticipated mortality trends, (4) potential results of our operating initiatives and strategic plan, (5) our ability to control costs, (6) our current plans for deployment of our projected cash flow, (7) projections regarding potential insurance recoveries for hurricane losses, (8) the success and timing of selling the small businesses designated as held for sale, and (9) our ability to realize the carrying value of our deferred tax assets.
The financial forecast information included in this Form 10-K have been prepared by, and are the responsibility of, our management. PricewaterhouseCoopers LLP has neither examined nor compiled the financial forecasts and, accordingly, PricewaterhouseCoopers LLP does not express an opinion or any other form of assurance with respect thereto. The PricewaterhouseCoopers LLP report included in this Form 10-K relates to our historical financial statements included in Item 8. It does not extend to the forecasted information and should not be read to do so.
Accuracy of forecast information is dependent upon assumptions about events that change over time and is thus susceptible to periodic change based on actual experience and new developments. Forecasts are based on a variety of estimates and assumptions made by our management with respect to, among other things, industry performance; general economic, market, industry and interest rate conditions; preneed and at-need sales activities and trends; fluctuations in cost of goods sold and other expenses; capital expenditures; and other matters that cannot be accurately predicted, may not be realized and are subject to significant business, economic and competitive uncertainties, all of which are difficult to predict and many of which are beyond our control. Accordingly, there can be no assurance that the assumptions made in preparing forecast information will prove accurate, and actual results may vary materially from those contained in the forecasts. For these reasons, the forecast information should not be regarded as an accurate prediction of future results, but only of results that may be obtained if substantially all of our principal expectations are realized.
We caution readers that we assume no obligation to update or publicly release any revisions to forward-looking statements made herein or any other forward-looking statements made by us or on our behalf.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The market risk inherent in our market risk sensitive instruments and positions is the potential change arising from increases or decreases in the prices of marketable equity securities and interest rates as discussed below. Generally, our market risk sensitive instruments and positions are characterized as “other than trading.” Our exposure to market risk as discussed below includes forward-looking statements and represents an estimate of possible changes in fair value or future earnings that would occur assuming hypothetical future movements in equity markets or interest rates. Our views on market risk are not necessarily indicative of actual results that may occur, and do not represent the maximum possible gains and losses that may occur. Actual gains and losses, fluctuations in equity markets, interest rates and the timing of transactions, may differ from those estimated.
Marketable Equity Securities
As of October 31, 2005 and 2004, our marketable equity securities subject to market risk consisted principally of investments held by our preneed funeral and cemetery merchandise and services trusts and our cemetery perpetual care trusts and escrow accounts and had fair values of $609.9 million and $518.2 million, respectively, which were determined using final sale prices quoted on stock exchanges. Each 10 percent change in the average market prices of the equity securities held in such accounts would result in a change of approximately $61.0 million and $51.8 million, respectively, in the fair value of such accounts.
Our preneed funeral and cemetery merchandise and services trusts and our cemetery perpetual care trusts and escrow accounts, all of which are managed by ITI, are further discussed in Notes 5, 6 and 7 to our consolidated financial statements included in Item 8.
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Shareholders of Stewart Enterprises, Inc.:
We have completed an integrated audit of Stewart Enterprises, Inc.’s 2005 consolidated financial statements and of its internal control over financial reporting as of October 31, 2005 and audits of its 2004 and 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Stewart Enterprises, Inc. and its subsidiaries (“the Company”) at October 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company has restated its 2004 and 2003 consolidated financial statements.
As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for preneed selling costs incurred related to the acquisition of new prearranged funeral and cemetery service and merchandise sales on November 1, 2004. As discussed in Note 3(k) to the consolidated financial statements, the Company changed its method of accounting for the Company’s preneed funeral and cemetery merchandise and services trusts and the Company’s cemetery perpetual care trusts in 2004.
Internal control over financial reporting
Also, we have audited management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Stewart Enterprises, Inc. did not maintain effective internal control over financial reporting as of October 31, 2005, because of the effect of material weaknesses relating to (1) revenue recognition on preneed cemetery merchandise and services contracts and (2) recognition of realized trust earnings on preneed cemetery and funeral contracts. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment of the effectiveness of internal control over financial reporting as of October 31, 2005:
1.
The Company did not maintain effective controls over revenue recognition related to preneed cemetery merchandise and services contracts. Specifically, the Company did not maintain effective controls over the reconciliation of recorded revenues to revenues based on physical delivery of preneed cemetery merchandise to ensure completeness and accuracy of recorded preneed cemetery merchandise revenue and deferred preneed cemetery revenue. This control deficiency resulted in the restatement of the Company’s annual 2004 and 2003 consolidated financial statements including all quarters therein and the first three quarters of fiscal year 2005. This control deficiency could result in the misstatement of cemetery merchandise revenues and of deferred preneed cemetery revenues that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency represents a material weakness.
2.
The Company did not maintain effective controls over recognition of realized trust earnings on preneed cemetery and funeral contracts. Specifically, the Company did not maintain effective controls to recognize realized trust earnings upon the delivery of the related preneed cemetery and funeral merchandise and performance of preneed funeral services to ensure accuracy of recorded realized trust earnings and deferred trust earnings. This control deficiency resulted in the restatement of the Company’s annual 2004 and 2003 consolidated financial statements including all quarters therein and the first three quarters of fiscal year 2005. This control deficiency could result in the misstatement of cemetery and funeral revenues and of the deferred revenue associated with preneed cemetery and preneed funeral contracts sold on a preneed basis that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly management determined that this control deficiency represents a material weakness.
These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2005 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.
In our opinion, management’s assessment that Stewart Enterprises, Inc. did not maintain effective internal control over financial reporting as of October 31, 2005 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the COSO. Also, in our opinion, because of the effects of the material weaknesses described above on the achievement of the objectives of the control criteria, Stewart Enterprises, Inc. has not maintained effective internal control over financial reporting as of October 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO.
PricewaterhouseCoopers LLP
New Orleans, Louisiana
February 17, 2006
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS (LOSS)
(Dollars in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
(continued)
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Dollars in thousands, except per share amounts)
(continued)
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Dollars in thousands, except per share amounts)
(1)
Amount includes shares of Class A common stock with a stated value of $1 per share and includes 3,555 shares (in thousands) of Class B common stock.
See accompanying notes to consolidated financial statements.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands, except per share amounts)
(continued)
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(1) The Company
Stewart Enterprises, Inc. (the “Company”) is a provider of funeral and cemetery products and services in the death care industry in the United States. Through its subsidiaries, the Company offers a complete range of funeral merchandise and services, along with cemetery property, merchandise and services, both at the time of need and on a preneed basis. As of October 31, 2005, the Company operated 231 funeral homes and 144 cemeteries in 26 states within the United States and Puerto Rico. The Company has five operating and reportable segments consisting of a corporate trust management segment and a funeral and cemetery segment for each of two geographic areas: Western and Eastern. Additional information on segments can be found in Note 22.
(2) Restatement
The Company has restated its consolidated financial statements for fiscal years 2004 and 2003, all the quarters therein and the first three quarters of fiscal year 2005. The restatements are primarily the result of:
(A)
The incorrect determination of operating and reportable segments and reporting units related to the application of FASB Statement No. 142, “Goodwill and Other Intangible Assets,” (“SFAS No. 142”), which also had the effect of changing the charges recorded for the assets sold as part of its plan initiated in December 2003 (see Note 14) to sell a number of businesses, and the net book value of assets held for sale on its balance sheet.
(B)
Errors identified in revenue recognition of preneed cemetery merchandise and services contracts and recognition of realized trust earnings on preneed cemetery and funeral merchandise and services contracts.
(C)
Other miscellaneous adjustments, including adjustments for lease-related accounting practices.
The restatement for these errors is discussed in more detail below.
Segments and Reporting Units
The Company re-evaluated its application of FASB Statement No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”), and determined that it had incorrectly identified its operating and reportable segments for all prior periods. The Company concluded that it had eleven operating and reportable segments, which consisted of a corporate trust management segment and a funeral and cemetery segment for each of five geographic areas: Central, Western, Eastern, Southern - Florida and All Other. The Company’s historical presentation of segment data had consisted of two operating and reportable segments, funeral and cemetery. As part of the Company’s strategic planning process, in the fourth quarter of fiscal year 2005, the Company reorganized and revised its operating divisions from four to two and revised its operating and reportable segments. For further discussion of the revision of the Company’s operating and reportable segments in the fourth quarter of 2005, see Note 22.
The correction of the Company’s operating segments had the related effect of requiring changes in the Company’s reporting units for purposes of goodwill impairment reviews under SFAS No. 142, retroactive to the November 1, 2001 adoption date of SFAS No. 142. The Company’s evaluation of goodwill should have been performed to include 13 reporting units as opposed to the two reporting units historically identified. As a result of the reorganization and revision of the Company’s divisions effective for the fourth quarter of fiscal year 2005, the Company revised its evaluation of goodwill based upon 11 reporting units. For further discussion of the change in the Company’s reporting units in the fourth quarter of 2005, see Note 3(g).
The restatement of the Company’s operating segments and reporting units resulted in the need to correct its goodwill impairment reviews as of November 1, 2001 (the date the Company adopted SFAS No. 142) and as of October 31, 2002, 2003 and 2004. Consequently, the Company recorded a $209,400 ($193,090 after tax, or $1.78 per diluted share) charge on November 1, 2001 as a cumulative effect of change in accounting principle for the adoption of SFAS No. 142. The Company’s previously reported financial statements did not include a goodwill impairment charge upon the initial adoption of SFAS No. 142 on November 1, 2001 or during its annual assessment in the fourth quarter of fiscal year 2002. The Company also restated its previously reported fiscal year 2003 goodwill impairment
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(2) Restatement - (Continued)
charge of $73,000 ($66,900 after tax, or $.62 per share) because based on its revised reporting units, no goodwill impairment charge for the year ended October 31, 2003 was necessary.
Further, the restatement of goodwill on the Company’s balance sheet had the effect of changing the net book value of the assets the Company sold as part of the Company’s plan to sell a number of its businesses and the net book value of assets held for sale on the Company’s balance sheet. Due to these changes, the gain or loss on those sales has been corrected. In 2003, this resulted in an additional net gain of $2,170, representing a gain of $1,334 related to continuing operations as originally reported and a gain of $836 related to discontinued operations. In 2004, this resulted in an additional net gain of $579, representing a loss of $523 related to continuing operations as originally reported and a gain of $1,102 related to discontinued operations.
Deferred Revenue Project
In connection with the Company’s internal control assessment under Section 404 of Sarbanes-Oxley, it undertook a project (the “deferred revenue project”) in 2005 to verify the balances in deferred preneed cemetery revenue and deferred preneed funeral revenue by reviewing substantially all of the preneed cemetery and funeral service and merchandise contracts included in its backlog. This process involved the review of nearly 700,000 preneed contracts. The deferred revenue project resulted in the Company’s assessment that the recorded amount of deferred revenue was misstated, and therefore, the Company needed to restate its prior period financial statements for fiscal years 2001 through 2004, including the quarters therein, and the first three quarters of 2005. The adjustment impacted the cumulative effect of adopting SAB No. 101 on November 1, 2000, and reported revenues and earnings for fiscal years 2001 through 2004 and the first three quarters of 2005.
The Company identified errors in the amount of recorded revenue, deferred revenue and related deferred trust earnings associated with cemetery merchandise and funeral service and merchandise contracts. The errors also resulted in restatements to the amount of preneed selling costs recorded upon the adoption of SAB No. 101, and in subsequent years and also the charge for the 2005 cumulative effect of change in accounting principle related to preneed selling costs adopted effective November 1, 2004. See Note 3(f).
The overall impact of the deferred revenue project on net earnings and earnings per share for the first three quarters of 2005 and fiscal years 2004 and 2003 was a decrease in net earnings of $18,211 (including $11,862, or $.11 per share, related to the cumulative effect of change in accounting principle for preneed selling costs), $11,989 and $13,191, respectively, and a decrease in earnings per share of $.16, $.11 and $.12, respectively. The 2005 amount reflects the adjustment to the previously reported unaudited results through July 31, 2005.
Other Adjustments
As previously disclosed, in the Company’s Form 10-Q for the second quarter of fiscal year 2005, the Company reviewed its lease-related accounting practices and determined that certain adjustments related to rent escalations and leasehold improvement amortization were necessary. The cumulative effect of these adjustments for all prior periods amounted to a charge of $1,839 ($1,149 after tax, or $.01 per share). The Company evaluated the materiality of these operating lease adjustments on its financial statements and concluded that the impact of these adjustments was not material. As a result, the Company recorded the cumulative effect of these prior period adjustments of $1,839 as non-cash charges to funeral and cemetery costs in the second quarter of fiscal year 2005. Because the Company is amending its Form 10-K for the year ended October 31, 2004 for the restatements discussed above under the heading “Restatement of Financial Statements,” the Company is now required to record the lease adjustments in the periods they were actually incurred. In this filing, the Company removed the cumulative effect of this prior period adjustment of $1,839 ($1,149 after tax) and will remove it from subsequent amended Form 10-Qs for January 31, 2005, April 30, 2005 and July 31, 2005. The Company also recorded other miscellaneous immaterial adjustments.
A summary of the effects of the restatements described above on the Company’s financial statements for the years ended October 31, 2004 and 2003 and as of October 31, 2004 is presented below.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(2) Restatement - (Continued)
(1)
The previously reported amounts represent amounts reported in the April 12, 2005 Form 8-K.
(2)
Represents adjustments which are immaterial individually and in the aggregate relating to lease-related accounting practices and other miscellaneous adjustments.
(3)
Represents the October 2005 classification of continuing and discontinued operations.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(2) Restatement - (Continued)
(1)
The previously reported amounts represent amounts reported in the April 12, 2005 Form 8-K.
(2)
Represents adjustments which are immaterial individually and in the aggregate relating to lease-related accounting practices and other miscellaneous adjustments.
(3)
Represents the October 2005 classification of continuing and discontinued operations.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(2) Restatement - (Continued)
(1)
The previously reported amounts represent amounts reported in the April 12, 2005 Form 8-K.
(2)
Represents adjustments which are immaterial individually and in the aggregate relating to lease-related accounting practices and other miscellaneous adjustments.
(3)
Represents the October 2005 classification of continuing and discontinued operations. See Note 3(f) for further discussion.
(1)
The previously reported amounts represent amounts reported in the April 12, 2005 Form 8-K.
(2)
Represents adjustments which are immaterial individually and in the aggregate relating to lease-related accounting practices and other miscellaneous adjustments.
(3) Summary of Significant Accounting Policies
(a) Principles of Consolidation
The accompanying consolidated financial statements include the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated. A discussion of discontinued operations, assets held for sale and liabilities associated with assets held for sale can be found in Note 14.
(b) Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and these differences could be material.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
(c) Fair Value of Financial Instruments
Estimated fair value amounts have been determined using available market information and the valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts the Company could realize in a current market. The use of different market assumptions or valuation methodologies could have a material effect on the estimated fair value amounts.
The carrying amounts of cash and cash equivalents and current receivables approximate fair value due to the short-term nature of these instruments. The carrying amount of receivables due beyond one year approximates fair value because they bear interest at rates currently offered by the Company for receivables with similar terms and maturities. The carrying amounts of marketable securities and marketable securities included in preneed funeral trust investments, preneed cemetery trust investments and cemetery perpetual care trust investments are stated at fair value as they are classified as available for sale under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The fair value of the Company’s long-term variable-rate and fixed-rate debt is estimated using quoted market prices, where applicable, or future cash flows discounted at rates for similar types of borrowing arrangements as discussed in Note 16.
Any investment with a fair market value that has been less than its cost basis by 20 percent or greater for more than six months as of the respective balance sheet reporting date is considered to be other than temporarily impaired. The Company periodically reviews its investment portfolio to determine if any of the temporarily impaired assets should be designated as other than temporarily impaired. This evaluation includes determining if the Company has the ability and intent to hold these investments for its forecasted recovery period and determining if there have been any changes in market conditions or concerns specific to the issuer of the securities. Otherwise, an investment with a fair market value that is less than its cost basis is considered to be temporarily impaired. This evaluation of impairment with respect to the Company’s trust portfolio is performed each quarter using quoted market prices. If a loss is other than temporary, the cost basis of the security is adjusted downward to its market value. This affects the Company’s footnote disclosure, but does not otherwise have an effect on the financial statements, since the trust portfolio amount as reported in the consolidated balance sheet is already marked to market value each quarter.
(d) Inventories
Inventories are stated at the lower of cost (specific identification and first-in, first-out methods) or net realizable value. The portion of developed cemetery property that management estimates will be used in the next twelve months is included in inventories. Such estimates are based on the Company’s historical experience or results.
(e) Buildings and Equipment
Buildings and equipment are recorded at cost and are depreciated over their estimated useful lives, ranging from 10 to 40 years and from 3 to 10 years, respectively, primarily using the straight-line method. Maintenance and repairs are charged to expense whereas renewals and major replacements that extend the assets’ useful lives are capitalized. For the fiscal years ended October 31, 2005, 2004 and 2003, depreciation expense totaled $21,424, $23,469 and $25,274, respectively.
The Company reviews for continued appropriateness the carrying value of its long-lived assets whenever events and circumstances indicate a potential impairment. This review is based on its projections of anticipated undiscounted future cash flows. If indicators of impairment are present, the Company evaluates the undiscounted future cash flows estimated to be generated by those assets compared to the carrying amount of those assets. The net carrying value of assets not recoverable are reduced to fair value. While the Company believes that its estimates of undiscounted future cash flows are reasonable, different assumptions regarding such cash flows and comparable sales values could materially affect its evaluations.
(f) Preneed Selling Costs
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
On May 31, 2005, the Company changed its method of accounting for preneed selling costs incurred related to the acquisition of new prearranged funeral and cemetery service and merchandise sales. The Company has applied this change in accounting principle effective November 1, 2004. Prior to this change, commissions and other costs that varied with and were primarily related to the acquisition of new prearranged funeral and cemetery service and merchandise sales were deferred and amortized in proportion to preneed revenue recognized during the period in a manner consistent with SFAS No. 60, “Accounting and Reporting for Insurance Companies.” This expense amortization was included in amortization of preneed selling costs in the consolidated statement of cash flows. Accordingly, fiscal years 2004 and 2003 include the amortization of these deferred selling costs while fiscal year 2005 does not. For the years ended October 31, 2004 and 2003, amortization of preneed selling costs was $24,952 and $23,932. The Company changed its accounting for preneed selling costs to expense such costs as incurred. The Company concluded that expensing these costs as they are incurred would be preferable to the old method because it makes its reported results more comparable with other public death care companies, better aligns the costs of obtaining preneed contracts with the cash outflows associated with obtaining such contracts and eliminates the burden of maintaining deferred selling cost records. As of November 1, 2004, the Company recorded a cumulative effect of change in accounting principle of $254,241 ($153,180 after tax, or $1.40 per diluted share), which represents the cumulative balance of deferred preneed selling costs in the deferred charges line on the Company’s condensed consolidated balance sheet at the time of the change. In addition to the charge for the cumulative effect of change in accounting principle, the effect of the change in accounting principles for the year ended October 31, 2005 was a decrease in net earnings of $4,957, or $.04 per share, which represents the selling costs expensed in excess of what the amortization of preneed selling costs would have been had the Company not changed its accounting method.
(g) Goodwill
The Company’s historical evaluation of goodwill was performed at the funeral and cemetery segment levels, which the Company previously reported as its reporting units. The revision of the Company’s operating segments and reporting units resulted in the need to perform goodwill impairment reviews of the revised reporting units as of November 1, 2001 (the date the Company adopted SFAS No. 142) and as of October 31, 2002, 2003 and 2004. For further discussion of the restatement to report the resulting charge for the cumulative effect of the adoption of SFAS No. 142 and the restatement of the goodwill impairment charge previously reported in fiscal year 2003, see Note 2.
As discussed in Note 2, the Company’s evaluation of the goodwill of its operations will now consist of 11 reporting units. Those reporting units include: corporate trust management; the Western division funeral operating segment comprised of three reporting units (Western-North region, Western-South region and Midwestern, Southern and Southwestern regions aggregated); the Western division cemetery operating segment comprised of two reporting units (Western-North region and the Western-South, Midwestern, Southern and Southwestern regions aggregated); the Eastern division funeral operating segment comprised of three reporting units (Southern region, Puerto Rico region and the Northern and Central regions aggregated); and the Eastern division cemetery operating segment comprised of two reporting units (Puerto Rico region and the Southern, Northern and Central regions aggregated).
The Company’s goodwill impairment test involves estimates and management judgment and was performed using a discounted cash flow valuation methodology. Step two of the impairment test involves determining estimates of fair values of the Company’s assets and liabilities. The Company may obtain assistance from third parties in assessing the fair value of certain of its assets, primarily real estate, in performing the step two analysis.
Goodwill of a reporting unit must be tested for impairment on at least an annual basis. The Company conducts its annual goodwill impairment analysis during the fourth quarter of each fiscal year. In addition to an annual review, the Company assesses the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may be greater than fair value. Factors the Company considers important that could trigger an impairment review include significant underperformance relative to historical or projected future operating results, significant changes in the manner of the use of the Company’s assets or the strategy for its overall business and significant negative industry or economic trends.
In reviewing goodwill for impairment, the Company first compares the fair value of each of its reporting units with its carrying amount (including goodwill). If the carrying amount of a reporting unit (including goodwill) exceeds its fair value, the Company then measures the amount of impairment of the reporting unit’s goodwill by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
implied fair value of a reporting unit’s goodwill is determined in a manner similar to the amount of goodwill determined in a business combination. That is, the Company allocates the fair value of the reporting unit to all of the assets and liabilities of that unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment charge is recorded when the carrying amount of goodwill exceeds its implied fair value. The Company’s annual goodwill assessment for the year ended October 31, 2005 resulted in no goodwill impairment charge for fiscal year 2005.
Goodwill in excess of net assets of companies acquired totaled $272,729 as of October 31, 2005 and 2004. Accumulated amortization in goodwill was $62,767 as of October 31, 2005 and 2004. The Company has approximately $76,000 of tax deductible goodwill as of October 31, 2005, which will be amortized over the next eight years for tax purposes. Goodwill and changes in goodwill by operating segment from October 31, 2003 to October 31, 2004 are presented below.
(h) Stock-Based Compensation
At October 31, 2005, the Company had three stock-based employee compensation plans, which are described in more detail in Note 20. The Company accounts for those plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123.” No compensation cost related to stock options is reflected in net earnings, as all options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the grant date. The expense related to the restricted stock granted in fiscal years 2005 and 2004 is reflected in earnings and amounted to $704 and $650 for the years ended October 31, 2005 and 2004, respectively. See Note 3(o) for further discussion on the Company’s restricted stock. The FASB issued SFAS No. 123R in December 2004, which is effective for the Company in the first quarter of fiscal year 2006. The Company has evaluated the impact of its adoption on its financial statements. See Note 4(b) for additional information. The following table illustrates the effect on net earnings (loss) and net earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
See Note 20 for further information regarding the Company’s stock options outstanding as of October 31, 2005, 2004 and 2003 and the proforma calculations.
(i) Funeral Revenue
The Company sells price-guaranteed prearranged funeral services and merchandise under contracts that provide for delivery of the services and merchandise at the time of death. Prearranged funeral services are recorded as funeral revenue in the period the funeral is performed. Prearranged funeral merchandise is recognized as revenue upon delivery. Prior to performing the funeral or delivering of the merchandise, such sales are deferred. Funeral services and merchandise sold at the time of need are recorded as funeral revenue in the period the funeral is performed or the merchandise is delivered.
Because preneed services or merchandise will not be provided until the future, most states require that all or a portion of the customer payments under these contracts be protected for the benefit of the customers pursuant to applicable law. Some or all of the funds may be required to be placed into trust accounts (“trust-funded preneed funeral contracts”). Alternatively, where allowed, customers may purchase a life insurance or annuity policy from third-party insurance companies to fund their preneed funeral contracts (“insurance-funded preneed funeral contracts”). The funeral goods and services selected at the time of contract origination will be funded by the insurance policy proceeds, which include increasing insurance benefits. Under either customer funding option, the Company enters into a preneed funeral contract with the customer to provide funeral services in the future.
When a trust-funded preneed funeral contract is entered into, the Company records an asset (included in preneed funeral receivables and trust investments) and a corresponding liability (included in deferred preneed funeral revenues) for the contract price. Principal amounts deposited in the trust or escrow accounts generally range from 70 percent to 90 percent of each installment received. The sale of caskets is treated in some jurisdictions in the same manner as the sale of cemetery merchandise and in some jurisdictions as the sale of funeral services for trusting purposes. As the customer makes payments on the contract prior to performance by the Company, the Company deposits into the related trust the required portion of the payment and reclassifies the corresponding amount from deferred preneed funeral revenues into non-controlling interest in funeral and cemetery trusts.
The Company defers all dividends and interest earned and net capital gains and losses realized by preneed funeral trust or escrow accounts until the underlying service or merchandise is delivered.
Deferred preneed funeral revenue represents future funeral contract revenues. In addition to amounts receivable from customers and amounts not required to be trusted, this includes distributed and distributable trust investment earnings associated with unperformed trust-funded preneed funeral contracts where the related cash or investments are not held in trust accounts (generally because the Company was permitted to withdraw the cash from the trust before performance of the service or delivery of the merchandise). Future funeral contract revenues and non-distributable net trust investment earnings where the related cash or investments are held in trust accounts are included in non-controlling interest in funeral and cemetery trusts.
Upon cancellation of a trust-funded preneed funeral contract, a customer is generally entitled to receive a refund of the funds held in trust. In many jurisdictions, the Company may be obligated to fund any shortfall if the amounts deposited by the customer exceed the funds in trust including investment income at the time of cancellation. If the fair market value of the trusts were to decline below the estimated costs to deliver the underlying products and services, the Company would record a charge to earnings to record a liability for the expected loss on the delivery of contracts in the Company’s backlog. Based upon this assessment, no loss amounts have been required to be recognized as of October 31, 2005.
Insurance-funded preneed funeral contracts that will be funded by life insurance or annuity contracts issued by third-party insurers are not reflected in the consolidated balance sheet. The net amount of these contracts that have not been fulfilled as of October 31, 2005 and 2004 was $383,897 and $352,092, respectively, of which $71
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
relates to assets held for sale at October 31, 2004. With insurance-funded preneed funeral contracts, the Company earns a commission if it acts as agent on the sale of the policies. Customer payments of premiums on the insurance policies are sent directly to the insurance company, and the insurance premium receivables and related customer payments are not recorded on the Company’s financial statements. Insurance commissions are recognized as revenue at the point at which the commission is no longer subject to refund. The costs related to the commissions are expensed as incurred. Nothing more is recorded until the contracted service or merchandise is delivered. At that time, the face amount of the contract and the build-up in the face value of the contract (i.e., the policy proceeds) are recorded as funeral revenue, and the related expenses are recorded. A receivable from the insurance company for the policy proceeds is recorded as a funeral receivable.
(j) Cemetery Revenue
The Company sells price-guaranteed preneed cemetery merchandise and services under contracts that provide for delivery of the merchandise and services at the time of need. Preneed cemetery merchandise and service sales are recorded as cemetery revenue in the period the merchandise is delivered or service is performed. Prior to that time, such sales are deferred. Cemetery merchandise and services sold at the time of need are recorded as cemetery revenue in the period the service is performed or the merchandise is delivered.
Some or all of the funds received under preneed cemetery contracts for merchandise or services may be required to be placed into trust accounts, pursuant to applicable state law. With respect to the preneed sale of cemetery merchandise, the Company is generally required to place in trust 30 percent to 50 percent of each installment received. With respect to the preneed sale of cemetery services, the Company is generally required to place in trust 70 percent to 90 percent of each installment received. When a trust-funded preneed cemetery contract is entered into, the Company records an asset (included in preneed cemetery receivables and trust investments) and a corresponding liability (included in deferred preneed cemetery revenues) for the contract price. As the customer makes payments on the contract prior to performance by the Company, the Company deposits into the related trust the required portion of the payment and reclassifies the corresponding amount from deferred preneed cemetery revenues into non-controlling interest in funeral and cemetery trusts.
Deferred preneed cemetery revenue represents future preneed cemetery revenues to be recognized upon delivery of merchandise or performance of services. In addition to the amounts receivable from customers and amounts not required to be trusted, this includes distributed and distributable trust investment earnings associated with unperformed preneed cemetery services or undelivered preneed cemetery merchandise where the related cash or investments are not held in trust accounts (generally because the Company was permitted to withdraw the cash from the trust before performance of the service or delivery of the merchandise). Future contract revenues and non-distributable net trust investment earnings where the related cash or investments are held in trust accounts are included in non-controlling interest in funeral and cemetery trusts.
The Company defers all dividends and interest earned and net capital gains and losses realized by preneed cemetery merchandise and services trust or escrow accounts until the underlying merchandise or service is delivered. Principal and earnings are withdrawn only as the merchandise or services are delivered or contracts are cancelled, except in jurisdictions that permit earnings to be withdrawn currently and in unregulated jurisdictions where escrow accounts are used.
The Company sells price-guaranteed cemetery contracts providing for property interment rights. For preneed sales of interment rights (cemetery property), the associated revenue and all costs to acquire the sale are recognized in accordance with SFAS No. 66, “Accounting for Sales of Real Estate.” Under SFAS No. 66, recognition of revenue and costs must be deferred until 10 percent of the property sale price has been collected. Revenue related to the preneed sale of cemetery property prior to its construction is recognized on a percentage of completion method of accounting as construction occurs. The Company measures the percentage of completion by taking the costs incurred to date and dividing that number by the total projected cost of the project.
Pursuant to cemetery perpetual care contracts and laws, a portion, generally 10 percent, of the proceeds from cemetery property sales is deposited into perpetual care trusts. The income from these trusts, which have been established in most jurisdictions in which the Company operates cemeteries, is used for maintenance of those cemeteries, but principal, including in some jurisdictions net realized capital gains, must generally be held in
STEWART ENTERPRISES, INC.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
perpetuity. As payments are received, the Company generally funds the perpetual care trust in the same proportion as the payment bears to the contract amount. For example, if the Company receives 20 percent of the contract price, it places in trust 20 percent of the total amount to be placed in trust for that contract. The Company currently recognizes and withdraws all dividend and interest income earned and, where permitted, capital gains realized by cemetery perpetual care funds.
Some of the Company’s sales of cemetery property and merchandise are made under installment contracts bearing interest at prevailing rates. Finance charges are recognized as cemetery revenue under the effective interest method over the terms of the related installment receivables.
(k) Preneed Funeral and Cemetery Merchandise and Services Trusts and Cemetery Perpetual Care Trusts
The Company implemented FASB Interpretation No. 46 (“FIN 46R”) as of April 30, 2004, which resulted in the consolidation of the Company’s preneed funeral and cemetery merchandise and service trusts and the Company’s cemetery perpetual care trusts. The implementation of FIN 46R affects certain line items in the consolidated balance sheet and statement of earnings as described below, but has no impact on net earnings. Also, the implementation of FIN 46R did not result in any net changes to the Company’s consolidated statement of cash flows, but does require disclosure of certain financing and investing activities. See Notes 5, 6 and 7.
Although FIN 46R required consolidation of the preneed funeral and cemetery merchandise and service trusts and cemetery perpetual care trusts, it did not change the legal relationships among the trusts, the Company and its customers. In the case of preneed funeral and cemetery merchandise and services trusts, the customers are the legal beneficiaries. In the case of cemetery perpetual care trusts, the Company does not have a legal right to the cemetery perpetual care trust assets. For these reasons, upon consolidation of the trusts, the Company recognized non-controlling interests in its financial statements to reflect third-party interests in these trusts in accordance with SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” The Company classifies deposits to the funeral and cemetery merchandise and services trusts as non-controlling liability interests and classifies deposits to the cemetery perpetual care trusts as non-controlling interests outside of liabilities.
All of these trusts hold investments in marketable securities, which have been classified as available-for-sale and are reported at fair value, with unrealized gains and losses excluded from earnings and initially reported as a separate component of accumulated other comprehensive income or loss in the Company’s consolidated balance sheet pursuant to the provisions of SFAS No. 115. Unrealized gains and losses attributable to the non-controlling interest holders are reclassified from accumulated other comprehensive income or loss to non-controlling interest in funeral and cemetery trusts and perpetual care trusts in the Company’s consolidated balance sheet. Unrealized gains and losses attributable to the Company, but that have not been earned through the performance of services or delivery of merchandise are reclassified from accumulated other comprehensive income or loss to non-controlling interest in funeral and cemetery trusts or non-controlling interest in cemetery perpetual care trusts.
The Company recognizes realized earnings of the preneed funeral and cemetery merchandise and services trusts and cemetery perpetual care trusts within investment and other income, net (with a corresponding debit to the related trust asset). The Company then recognizes a corresponding expense within investment and other income, net, representing the realized earnings of these trusts attributable to the non-controlling interest holders (with a corresponding credit to non-controlling interest in funeral and cemetery trusts or non-controlling interest in cemetery perpetual care trusts, as the case may be). The Company also simultaneously recognizes a similar expense for realized earnings of the trusts attributable to the Company (with a corresponding credit to deferred preneed funeral or cemetery revenue), when such earnings have not been earned by the Company through the performance of services or delivery of merchandise. The net effect is an increase by the amount of the realized earnings in both the trust asset and the related non-controlling interest and deferred revenue; there is no effect on net earnings. In the case of preneed funeral and cemetery merchandise and services trusts, the Company recognizes as revenues amounts attributed to the non-controlling interest holders and the Company upon the performance of services and delivery of merchandise, including realized earnings accumulated in these trusts (with corresponding debits to non-controlling interest in funeral and cemetery trusts and to deferred preneed funeral revenues or deferred preneed cemetery revenues, as the case may be). In the case of cemetery perpetual care trusts, the Company recognizes investment earnings in cemetery revenues when such earnings are realized and permitted to be legally withdrawn by the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
Company (with a corresponding debit to non-controlling interest in cemetery perpetual care trusts). These earnings and related funds are intended to defray cemetery maintenance costs.
The end result of FIN 46R is that the Company’s trust assets are recorded on the consolidated balance sheet at their market value and included in preneed receivables and trust investments with corresponding credits to deferred preneed revenue and non-controlling interest in the trusts. The realized earnings on these trust assets under FIN 46R flow into and out of the statement of earnings through investment and other income, net with no net effect on revenue or net earnings. Both prior to and after the adoption of FIN 46R, accumulated trust earnings from the preneed funeral and cemetery merchandise and services trusts are recognized as revenue when the related merchandise and services are delivered, and cemetery perpetual care trust earnings are recognized as revenue as they are realized in the trust and permitted to be legally withdrawn by the Company.
(l) Allowance for Doubtful Accounts
The Company establishes a reserve based on a range of percentages applied to accounts receivable aging categories. These percentages are based on historical collection and write-off experience. The Company also recorded approximately $1,606 of increased bad debt reserve in the Western division cemetery segment related to the areas affected by Hurricane Katrina as discussed in Note 24.
(m) Income Taxes
Income taxes are accounted for using the asset and liability method under which deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect on deferred taxes for a change in tax rates is recognized in income in the period that includes the enactment date. Management provides a valuation allowance against the deferred tax asset for amounts which are not considered more likely than not to be realized. The valuation allowance is attributed primarily to capital losses for which the Company does not expect to receive a benefit. For additional information, see Note 19.
For the purpose of calculating income taxes for discontinued operations, earnings (loss) from discontinued operations is segregated into two categories: operating results and gain or loss on dispositions. Operating results are tax effected in the ordinary manner (i.e., income tax expense on net operating income, income tax benefit on net operating loss).
For calculating the gain or loss on dispositions, businesses held for sale are grouped by sale type (i.e., stock sale or asset sale). Those classified as asset sales are netted, and any losses are characterized as “ordinary.” An income tax benefit is calculated on these losses. Those classified as stock sales are netted, and any losses are characterized as “capital.” An income tax benefit is calculated on these losses. The Company’s current policy is to provide a valuation allowance for this benefit because capital losses are deductible only against capital gains, and the Company cannot at this time predict with certainty its ability to generate sufficient capital gains in future periods to absorb the losses before the carry-forward expiration given the significant amount of capital losses that were incurred in prior years.
As sales are finalized, the Company adjusts the gain or loss for changes in actual sales proceeds as compared to estimates, and for basis differences at the time of sale, as well as any changes in the type of sale. Sales originally anticipated to be stock sales but consummated as asset sales will generate ordinary losses. The Company records a tax benefit and adjusts the valuation allowance for the respective amount resulting from the changes in circumstances surrounding the finalized sale. This adjustment is allocated to continuing operations or discontinued operations according to its original sourcing of the income or loss.
(n) Earnings Per Common Share
Basic earnings per common share is computed by dividing net earnings by the weighted average number of common shares outstanding during each period. Diluted earnings per common share is computed by dividing net earnings by the weighted average number of common shares outstanding plus the number of additional common shares that would have been outstanding if the dilutive potential common shares (in this case, exercise of the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
Company’s time-vest stock options and non-vested restricted stock awards) had been issued during each period as discussed in Note 18.
(o) Derivatives
The Company accounted for its derivative financial instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities.” The notional amounts of derivative financial instruments do not represent amounts exchanged between parties and, therefore, are not a measure of the Company’s exposure resulting from its use of derivatives. The amounts exchanged are calculated based upon the notional amounts as well as other terms of the instruments, such as interest rates, exchange rates or other indices. In accordance with SFAS No. 133, the Company accounted for its sole derivative instrument, a $50,000 interest rate swap which expired in March 2005, as a cash flow hedge whereby the fair value of the interest rate swap is reflected as a liability in the accompanying consolidated balance sheet as of October 31, 2004 with the offset recorded to other comprehensive income. As of October 31, 2004, the fair value of the interest rate swap, net of taxes, was $333. The Company had no remaining interest rate swaps as of October 31, 2005.
(p) Estimated Insurance Loss Liabilities
The Company purchases comprehensive general liability, automobile liability and workers compensation insurance coverages structured within a large deductible/self-insured retention premium rating program. This program results in the Company being primarily self-insured for claims and associated costs and losses covered by these policies. Historical insurance industry experience indicates some degree of inherent variability in assessing the ultimate amount of losses associated with the types of claims covered by the program. This is especially true due to the extended period of time that transpires between when the claim might occur and the full settlement of such claim, often many years. The Company continually evaluates the receivables due from its insurance carriers as well as loss estimates associated with claims and losses related to these insurance coverages with information obtained from its primary insurer.
With respect to health insurance that covers substantially all of the Company’s employees, the Company purchases individual and aggregate stop loss coverage with a large deductible. This program results in the Company being primarily self-insured for claims and associated costs up to the amount of the deductible, with claims in excess of the deductible amount being covered by insurance. Expected claims are based on actuarial estimates; actual claims may differ from those estimates. The Company continually evaluates its claims experience related to this coverage with information obtained from its insurer.
Assumptions used in preparing these estimates are based on factors such as claim settlement patterns, claim development trends, claim frequency and severity patterns, inflationary trends and data reasonableness. Together these factors will generally affect the analysis and determination of the “best estimate” of the projected ultimate claim losses. The results of these evaluations are used to assess the reasonableness of the Company’s insurance loss liability.
The estimated liability on the uninsured legal and employment-related claims are established by management based upon the recommendations of professionals who perform a review of both reported claims and estimate a liability for incurred but not reported claims. These liabilities include the estimated settlement costs. Although management believes estimated liabilities related to uninsured claims are adequately recorded, it is possible that actual results could significantly differ from the recorded liabilities.
The Company also has insurance coverage related to property damage, incremental costs and property operating expenses it incurred due to damage caused by Hurricane Katrina. A significant portion of the expenses incurred by the Company is expected to be recovered when the Company negotiates a final settlement with its insurance carriers as discussed in Note 24.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(3) Summary of Significant Accounting Policies - (Continued)
(q) Dividends
On March 28, 2005, the Company announced that its Board of Directors approved the initiation of a quarterly cash dividend of two and one-half cents per share of common stock. The first dividend was paid on April 29, 2005. Dividends were also paid on July 29, 2005 to shareholders of record as of July 15, 2005 and on October 18, 2005 to shareholders of record as of October 4, 2005. Although the Company intends to pay regular quarterly cash dividends for the foreseeable future, the declaration and payment of future dividends are discretionary and will be subject to determination by the Board of Directors each quarter after its review of the Company’s financial performance.
(r) Leases
The Company has noncancellable operating leases, primarily for land and buildings, that expire over the next 1 to 13 years, except for six leases that expire between 2032 and 2039. As of October 31, 2005, approximately 75 percent of the Company’s 231 funeral locations were owned by the Company’s subsidiaries and approximately 25 percent were held under operating leases. The Company records operating lease expense for leases with escalating rents on a straight-line basis over the life of the lease, including reasonably assured lease renewals. The Company amortizes leasehold improvements in an operating lease over the shorter of their economic lives or the lease term, including reasonably assured lease renewals.
(s) Reclassifications
Certain reclassifications have been made to the 2004 and 2003 consolidated financial statements. All businesses sold in fiscal year 2003 (the year of initial adoption of SFAS No. 144), fiscal year 2004 and fiscal year 2005 that met the criteria for discontinued operations under SFAS No. 144 have been classified as discontinued operations for all periods presented. Results associated with real estate sold or intended to be sold as part of the divestiture plan have been included in continuing operations for all periods. See Note 14 for a discussion of discontinued operations.
Premiums paid on early extinguishment of debt previously reported in cash flows from financing activities are now reported in cash flows from operating activities.
The foregoing reclassifications in themselves had no effect on the Company’s total net income or loss, total shareholders’ equity or the net increase or decrease in cash.
(4) Change in Accounting Principles and New Accounting Principles
(a) Preneed Selling Costs
As discussed in Note 3(f), on May 31, 2005, the Company changed its method of accounting for preneed selling costs incurred related to the acquisition of new prearranged funeral and cemetery service and merchandise sales. The Company has applied this change in accounting principle effective November 1, 2004. The Company concluded that expensing these costs as they are incurred would be preferable to the old method because it makes its reported results more comparable with other public death care companies, better aligns the costs of obtaining preneed contracts with the cash outflows associated with obtaining such contracts and eliminates the burden of maintaining deferred selling cost records. As of November 1, 2004, the Company recorded a cumulative effect of change in accounting principle of $254,241 ($153,180 after tax, or $1.40 per diluted share), which represents the cumulative balance of deferred preneed selling costs in the deferred charges line on the Company’s condensed consolidated balance sheet at the time of the change. The effect of the change in accounting principles for the year ended October 31, 2005 in addition to the cumulative effect was a decrease in net earnings of $4,957 or $.04 per share. If this change in accounting principle had been in effect in fiscal years 2004 and 2003, net earnings (loss) would have been $30,739 and ($24,721) for fiscal years 2004 and 2003, respectively, and basic and diluted net earnings (loss) per share would have been $.28 and ($.23) for fiscal years 2004 and 2003, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(4) Change in Accounting Principles and New Accounting Principles-(Continued)
(b) Other Changes
In December 2004, the FASB revised its SFAS No. 123 (“SFAS No. 123R”), “Accounting for Stock Based Compensation.” The revision establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services, particularly transactions in which an entity obtains employee services in share-based payment transactions. The revised statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is to be recognized over the period during which the employee is required to provide service in exchange for the award. Changes in fair value during the requisite service period are to be recognized as compensation cost over that period. In addition, the revised statement amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits be reported as a financing cash flow rather than as a reduction of taxes paid. The provisions of the revised statement are effective for financial statements issued for the first interim reporting period of the first fiscal year that begins on or after June 15, 2005. Based on current options and restricted stock outstanding, selection of the modified prospective method and an implementation date of November 1, 2005, the Company estimates that the adoption of SFAS No. 123R would have the impact of reducing diluted earnings per share by approximately $.01 per share in fiscal year 2006.
In March 2004, the FASB issued Emerging Issues Task Force (“EITF”) 03-1, “Impairment and Its Application to Certain Investments.” EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued Staff Position EITF 03-1-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-1 to investments in securities that are impaired. In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, and directed the staff to issue proposed FSP EITF 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1,” as final. The final FSP supersedes EITF Issued No. 03-1 and EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.” The final FSP (retitled FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”) replaces the guidance set forth in paragraphs 10-18 of EITF Issue 03-1 with references to existing other-than-temporary impairment guidance. FSP FAS 115-1 codifies the guidance set forth in EITF Topic D-44 and clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than- temporary, even if a decision to sell has not been made. FSP FAS 115-1 is effective for other-than-temporary analysis conducted in periods beginning after December 15, 2005. This pronouncement as it relates to the Company’s trusts will have no impact on net earnings.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” This statement will be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this statement was issued. This statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change.
(5) Preneed Funeral Activities
Preneed Funeral Receivables and Trust Investments
Preneed funeral receivables and trust investments represent trust assets and customer receivables related to unperformed, price-guaranteed trust-funded preneed funeral contracts. The components of preneed funeral receivables and trust investments in the consolidated balance sheet as of October 31, 2005 and 2004 are as follows:
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(Dollars in thousands, except per share amounts)
(5) Preneed Funeral Activities-(Continued)
The cost and market values associated with preneed funeral merchandise and services trust assets as of October 31, 2005 are detailed below. The adjusted cost basis of the funeral merchandise and services trust assets below reflect an other than temporary decline in the trust assets of approximately $81,829 as of October 31, 2005 from their original cost basis. The Company believes the unrealized losses reflected below of $12,586 related to trust investments are temporary in nature.
The estimated maturities and market values of debt securities included above are as follows:
The cost and market values associated with preneed funeral merchandise and services trust assets as of October 31, 2004 are detailed below. The adjusted cost basis of the funeral merchandise and services trust assets below reflect an other than temporary decline in the trust assets of approximately $76,135 as of October 31, 2004 from their original cost basis. The Company believes the unrealized losses reflected below of $13,735 related to trust investments are temporary in nature.
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(Dollars in thousands, except per share amounts)
(5) Preneed Funeral Activities-(Continued)
During the year ended October 31, 2005, purchases and sales of available for sale securities included in trust investments were $221,780 and $152,417, respectively. These sales resulted in realized gains and losses of $12,968 and $7,256, respectively. Reflected in other comprehensive income for the year ended October 31, 2005 was a $3,017 reduction in net unrealized losses associated with the available for sale securities of the funeral trust and a corresponding ($3,017) reclassified to non-controlling interest. During the six months ended October 31, 2004 (as FIN 46R became effective on April 30, 2004), purchases and sales of available for sale securities included in trust investments were $28,871 and $110,433, respectively. These sales resulted in realized gains and losses of $10,159 and $11,215, respectively. Reflected in other comprehensive income for the year ended October 31, 2004 was a $5,658 increase in net unrealized losses associated with the available for sale securities of the funeral trust and a corresponding ($5,658) reclassified to non-controlling interest.
The following table shows the gross unrealized losses and fair value of the preneed funeral merchandise and services trust investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of October 31, 2005 and 2004. A loss is considered other than temporary if the security has a reduction in market value, compared with its cost basis, of 20 percent or more for a period of six months or longer.
(6) Preneed Cemetery Merchandise and Service Activities
Preneed Cemetery Receivables and Trust Investments
Preneed cemetery receivables and trust investments represent trust assets and customer receivables for contracts sold in advance of when the merchandise or services are needed. The receivables related to the sale of preneed property interment rights are included in the Company’s current and long-term receivables discussed in Note 11. The components of preneed cemetery receivables and trust investments in the consolidated balance sheet as of October 31, 2005 and 2004 are as follows:
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(Dollars in thousands, except per share amounts)
(6) Preneed Cemetery Merchandise and Service Activities -(Continued)
The cost and market values associated with the preneed cemetery merchandise and services trust assets as of October 31, 2005 are detailed below. The adjusted cost basis of the cemetery merchandise and services trust assets below reflect an other than temporary decline in the trust assets of approximately $43,209 as of October 31, 2005 from their original cost basis. The Company believes the unrealized losses reflected below of $6,615 related to trust investments are temporary in nature
The estimated maturities and market values of debt securities included above are as follows:
The cost and market values associated with the preneed cemetery merchandise and services trust assets as of October 31, 2004 are detailed below. The adjusted cost basis of the cemetery merchandise and services trust assets below reflect an other than temporary decline in the trust assets of approximately $42,537 as of October 31, 2004 from their original cost basis. The Company believes the unrealized losses reflected below of $6,098 related to trust investments are temporary in nature.
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(Dollars in thousands, except per share amounts)
(6) Preneed Cemetery Merchandise and Service Activities -(Continued)
During the year ended October 31, 2005, purchases and sales of available for sale securities included in trust investments were $133,501 and $110,342, respectively. These sales resulted in realized gains and losses of $8,296 and $2,033, respectively. Reflected in other comprehensive income for the year ended October 31, 2005 was a $430 increase in net unrealized losses associated with the available for sale securities of the cemetery merchandise trust and a corresponding ($430) reclassified to non-controlling interest. During the six months ended October 31, 2004 (as FIN 46R became effective on April 30, 2004), purchases and sales of available for sale securities included in trust investments were $31,930 and $52,704, respectively. These sales resulted in realized gains and losses of $5,074 and $4,401, respectively. Reflected in other comprehensive income for the year ended October 31, 2004 was a $1,566 increase in net unrealized losses associated with the available for sale securities of the cemetery merchandise trust and a corresponding ($1,566) reclassified to non-controlling interest.
The following table shows the gross unrealized losses and fair value of the preneed cemetery merchandise and services trust investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of October 31, 2005 and 2004. A loss is considered other than temporary if the security has a reduction in market value, compared with its cost basis, of 20 percent or more for a period of six months or longer.
(7) Cemetery Interment Rights and Perpetual Care Trusts
Earnings realized from cemetery perpetual care trust investments that the Company is legally permitted to withdraw are recognized in current cemetery revenues and are used to defray cemetery maintenance costs which are expensed as incurred. Recognized earnings related to these cemetery perpetual care trust investments were $8,199, $6,396 and $7,887 for the years ended October 31, 2005, 2004 and 2003, respectively.
The cost and market values of the trust investments held by the cemetery perpetual care trusts as of October 31, 2005 are detailed below. The adjusted cost basis of the cemetery perpetual care trusts below reflect an other than temporary decline in the trust assets of $30,299 as of October 31, 2005 from their original cost basis. The Company believes the unrealized losses reflected below of $10,363 related to trust investments are temporary in nature.
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(Dollars in thousands, except per share amounts)
(7) Cemetery Interment Rights and Perpetual Care Trusts-(Continued)
The estimated maturities and market values of debt securities included above are as follows:
The cost and market values of the trust investments held by the cemetery perpetual care trusts as of October 31, 2004 are detailed below. The adjusted cost basis of the cemetery perpetual care trusts below reflect an other than temporary decline in the trust assets of $30,524 as of October 31, 2004 from their original cost basis. The Company believes the unrealized losses reflected below of $6,017 related to trust investments are temporary in nature.
During the year ended October 31, 2005, purchases and sales of available for sale securities were $111,349 and $98,774, respectively. These sales resulted in realized gains and losses of $4,876 and $1,315, respectively. Reflected in other comprehensive income for the year ended October 31, 2005 was a $2,817 decrease in net unrealized losses associated with the available for sale securities of the cemetery perpetual care trust and a corresponding ($2,817) reclassified to non-controlling interest. During the six months ended October 31, 2004 (as FIN 46R became effective on April 30, 2004), purchases and sales of available for sale securities were $24,525 and
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(Dollars in thousands, except per share amounts)
(7) Cemetery Interment Rights and Perpetual Care Trusts-(Continued)
$25,544, respectively. These sales resulted in realized gains and losses of $1,165 and $2,411, respectively. Reflected in other comprehensive income for the year ended October 31, 2004 was a $7,989 decrease in net unrealized losses associated with the available for sale securities of the cemetery perpetual care trust and a corresponding ($7,989) reclassified to non-controlling interest.
The following table shows the gross unrealized losses and fair value of the cemetery perpetual care trust investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of October 31, 2005 and 2004. A loss is considered other than temporary if the security has a reduction in market value, compared with its cost basis, of 20 percent or more for a period of six months or longer.
(8) Non-Controlling Interest in Funeral and Cemetery Trusts and in Perpetual Care Trusts
The components of non-controlling interest in funeral and cemetery trusts and non-controlling interest in perpetual care trusts at October 31, 2005 are as follows:
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(Dollars in thousands, except per share amounts)
(8) Non-Controlling Interest in Funeral and Cemetery Trusts and in Perpetual Care Trusts -(Continued)
The components of non-controlling interest in funeral and cemetery trusts and non-controlling interest in perpetual care trusts at October 31, 2004 are as follows:
Investment and other income (expense), net
The components of investment and other income (expense), net in the consolidated statement of earnings for the year ended October 31, 2005 and 2004 are detailed below.
(1)
Investment and other income, net is comprised of interest income primarily on the Company’s cash, cash equivalents and marketable securities not held in trust.
(9) Cash and Cash Equivalents
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The Company deposits its cash and cash equivalents with high quality credit institutions. Such balances typically exceed applicable FDIC insurance limits. The October 31, 2004 balance below includes $2 of cash and cash equivalents of assets held for sale.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(10) Marketable Securities
The market value of marketable securities as of October 31, 2005 and 2004 was $1,302 and $1,297, respectively, which included gross unrealized gains of $6 and $0 and gross unrealized losses of $11 and $0, respectively, for fiscal years 2005 and 2004. The Company realized net losses on marketable securities of $0, $101 and $1,100 for the years ended October 31, 2005, 2004 and 2003, respectively. The cost of securities sold was determined by using the average cost method.
(11) Receivables
Installment contracts due within one year and due beyond one year include receivables in the Company’s preneed cemetery property sales only. Receivables for preneed funeral and cemetery merchandise and services sales are included in preneed funeral receivables and trust investments and preneed cemetery receivables and trust investments as discussed in Notes 5 and 6.
The Company’s receivables as of October 31, 2005 are expected to mature as follows:
(12) Inventories and Cemetery Property
Inventories are comprised of the following:
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
Cemetery property is comprised of the following:
The portion of developed cemetery property that management estimates will be used in the next twelve months is included in inventories. The Company evaluates the recoverability of the cost of undeveloped cemetery property based on undiscounted expected future cash flows.
(13) Condensed Consolidating Financial Statements of Guarantors of Senior Subordinated Notes
The following tables present the condensed consolidating historical financial statements as of October 31, 2005 and 2004, and for the fiscal years ended October 31, 2005, 2004 and 2003, for the direct and indirect domestic subsidiaries of the Company that serve as guarantors of the senior subordinated notes, and the financial results of the Company’s subsidiaries that do not serve as guarantors. Non-guarantor subsidiaries include the Puerto Rican subsidiaries, Investors Trust, Inc. and certain immaterial domestic subsidiaries which are prohibited by law from guaranteeing the senior subordinated notes. The guarantor subsidiaries are each wholly-owned directly or indirectly by the Company, except that the Company owned 99.5 percent and 98.4 percent of two immaterial guarantor subsidiaries.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Statements of Earnings and Other Comprehensive Income
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Statements of Earnings and Other Comprehensive Income
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Statements of Earnings and Other Comprehensive Income
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Balance Sheets
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Balance Sheets
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Statements of Cash Flows
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes-(Continued)
Condensed Consolidating Statements of Cash Flows
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(13) Condensed Consolidating Financial statements of Guarantors of Senior Subordinated Notes (Restated) - (Continued)
Condensed Consolidating Statements of Cash Flows
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(14) Discontinued Operations, Assets Held for Sale and Impairment Charges
In fiscal year 2003, SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” was adopted by the Company. In accordance with SFAS No. 144, the Company reviews its long-lived assets for impairment when changes in circumstances indicate that the carrying amount of the asset may not be recoverable. SFAS No. 144 requires that long-lived assets to be held and used be recorded at the lower of carrying amount or fair value. Long-lived assets to be disposed of are to be recorded at the lower of carrying amount or fair value, less cost to sell. In December 2003, the Company announced plans to close or sell a number of small businesses, primarily small funeral homes, most of which were acquired as part of a group of facilities, that were performing below acceptable levels or no longer fit the Company’s operating profile. Although the Company identified these businesses during the fourth quarter of fiscal year 2003, they did not meet all of the criteria in SFAS No. 144 for classification as discontinued operations or assets held for sale until the first quarter of fiscal year 2004. These businesses were properly classified as discontinued operations in the 2004 Form 10-K. However, as of the end of the Company’s first fiscal quarter of 2005, primarily because the businesses had at that time been held for sale longer than one year, they no longer met the accounting criteria to be classified as held for sale. Accordingly, in the Company’s Form 10-Q for the quarter ended January 31, 2005, there were 11 unsold businesses that were previously included in discontinued operations that were reclassified back into continuing operations and were no longer reflected as “assets held for sale.” On April 15, 2005, the Company filed a Form 8-K that showed the effect of reclassifying these businesses back into continuing operations for fiscal years 2000 through 2004. As of October 31, 2005, the Company had sold seven of these businesses and as a result has reclassified them back into discontinued operations. Results associated with real estate sold or intended to be sold as part of the divestiture plan have been included in continuing operations for all periods as these assets do not meet the criteria to be classified as discontinued operations.
During the fourth quarter of fiscal year 2003, the Company determined that the carrying value of a number of these assets and businesses exceeded their fair value. As required by SFAS No. 144, the Company recorded an impairment charge of $31,830 during the fourth quarter of fiscal year 2003 of which $10,206 ($8,387 after tax, or $.08 per share) is included in continuing operations and $21,624 ($19,604 after tax, or $.18 per share) is included in discontinued operations. The fair market value was determined by specific offer or bid, or an estimate based on a multiple or percentage of historical results.
During fiscal year 2004, the Company evaluated its long-lived assets, recorded impairment charges of $849 and sold several assets that it held for sale at a net gain of $645. The net effect was that the Company recorded gains on dispositions, net of impairment losses, of ($204) for year ended October 31, 2004 in continuing operations, which is included in “Gains on dispositions and impairment (losses), net” in the consolidated statement of earnings. The Company also recorded gains on dispositions, net of impairment losses related to discontinued operations for the year ended October 31, 2004 of $2,426. In fiscal year 2005, the Company recorded gains on dispositions, net of impairment losses, of $1,297 in continuing operations and $1,104 in discontinued operations.
A tax benefit was recorded for the discontinued operations during the years ended October 31, 2005 and 2004 because the Company determined that certain tax benefits on asset sales would be realized. For additional information, see Note 19.
In the consolidated statements of earnings, the impairment charges related to the write-down of these long-lived assets occurring in 2003, 2004 and 2005 in continuing operations are reflected in the “Gains on dispositions and impairment (losses), net” line item. The related assets and liabilities associated with assets held for sale are shown in separate line items in the consolidated balance sheet titled “assets held for sale” and “liabilities associated with assets held for sale.” As of October 31, 2004, the assets held for sale (excluding $2 of cash and cash equivalent investments of the operations held for sale as of October 31, 2004) and the liabilities associated with assets held for sale line items in the balance sheet represent the assets and liabilities, respectively, of certain domestic assets, primarily funeral homes and real estate.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(14) Discontinued Operations, Assets Held for Sale and Impairment Charges-(Continued)
A summary of the assets and liabilities included in the “assets held for sale” and “liabilities associated with assets held for sale” line items at October 31, 2004 and the operating results of the discontinued operations for the years ended October 31, 2005, 2004 and 2003, respectively, are as follows:
(15) Separation Charges
On July 14, 2005, the Company named a new Chief Operating Officer and announced that it was reorganizing its operating divisions, effective for the fourth quarter of fiscal year 2005. The reorganization consolidated operations from four operating divisions to two: Eastern and Western. These changes are a result of the Company’s recent strategic planning process. The total charge for severance and other costs associated with the reorganization including relocation costs of certain personnel, exit of the leases associated with certain administrative facilities and charges associated with certain leasehold improvements of the related leases is expected to be approximately $1,750. During fiscal year 2005, the Company recorded $1,507 ($942 after tax, or $.01 per share) in related costs, of which $300 related to the separation pay of a former executive officer. The Company has paid approximately $460 of these costs as of October 31, 2005.
In December 2003, the Company announced plans to restructure and reduce its workforce by approximately 300 employees throughout the organization. During fiscal year 2004, the Company recorded a charge for severance and other costs associated with the workforce reductions of $2,435 ($1,510 after tax, or $.01
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(15) Separation Charges-(Continued)
per share). There are no material remaining costs under the workforce reduction plan. The plan was completed June 1, 2004.
In the third quarter of fiscal years 2004 and 2003, the Company recorded charges of $1,000 and $2,450, respectively, related to separation pay of former executive officers. For additional information, see Note 21.
(16) Long-term Debt
As of October 31, 2004, the Company’s revolving credit facility was set to mature in June of 2005, and the Company’s Term Loan B was set to mature in October of 2005. On November 19, 2004, the Company entered into an amended and restated senior secured credit facility consisting of a $125,000 five-year revolving credit facility and a $100,000 seven-year Term Loan B. Thus, in the October 31, 2004 balance sheet, the $59,000 outstanding balance of the revolving credit facility and the $54,005 outstanding balance of the Term Loan B were classified as long-term debt. During the first quarter of fiscal year 2005, the Company incurred a charge for the early extinguishment of debt of $2,651 ($1,723 after tax, or $.02 per share) to write off fees associated with the prior facility.
The new facility originally consisted of a $125,000 five-year revolving credit facility and a $100,000 seven-year Term Loan B. The senior secured credit facility also included an accordion feature which provided for the Company to borrow additional funds on a one-time basis. As a result of the refinancing, the leverage-based grid pricing for the interest rate on the Company’s revolving credit facility was reduced to LIBOR plus 150.0 basis points at closing, representing a 50 basis-point reduction. The grid for the revolving credit facility ranges from 137.5 to 200.0 basis points. The Company pays a quarterly commitment fee of 37.5 to 50.0 basis points, based on the Company’s consolidated leverage ratio. The interest rate on the Company’s Term Loan B was reduced to LIBOR plus 175.0 basis points, which is 75 basis points below the prior facility and is not subject to grid pricing. In connection with the refinancing in February 2005 of substantially all of the Company’s 10.75 percent senior subordinated notes (which is discussed below), the Company borrowed an additional $130,000 in Term Loan B under the aforementioned accordion feature of its senior secured credit facility. The Term Loan B matures on November 19, 2011 with 94 percent of the principal due in 2011, and the revolving credit facility matures on November 19, 2009.
As of October 31, 2005, there were no amounts drawn on the Company’s $125,000 revolving credit facility. As of October 31, 2005, after giving consideration to the $12,745 of outstanding letters of credit and $41,061 bond the Company is required to maintain to guarantee its obligations relating to funds it withdrew in fiscal year 2001 from trust funds in Florida, the Company’s availability under the revolving credit facility was $71,194. As of October 31, 2005 and 2004, the weighted average interest rates of the Company’s revolving credit facility and Term Loan B that were not hedged by the interest rate swap agreement in effect at October 31, 2004 and were subject to short-term variable interest rates of approximately 5.6 percent and 4.0 percent, respectively. See Note 3(o) for information on derivatives. The Company’s revolving credit facility includes a provision whereby the revolving credit commitment may be terminated by the lenders if an event of default occurs and is continuing.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(16) Long-term Debt-(Continued)
The senior secured credit facility is governed by three financial covenants:
•
Maintenance on a rolling four quarter basis of a maximum consolidated leverage ratio (funded debt (net of domestic cash, cash equivalents and marketable securities) divided by EBITDA (as defined)) - Maximum 3.50x,
•
Maintenance on a rolling four quarter basis of a minimum consolidated interest coverage ratio (EBITDA (as defined) divided by interest expense) - Minimum 2.50x, and
•
Maintenance on a rolling four quarter basis of a maximum consolidated senior secured leverage ratio (total funded senior secured debt divided by EBITDA (as defined)) - Maximum 3.00x with step-downs.
The covenants include required mandatory prepayments from the proceeds of certain asset sales and debt and equity offerings (with the first $25,000 per year of asset sale proceeds considered to be an optional prepayment), limitations on liens, limitations on mergers, consolidations and asset sales, limitations on incurrence of debt, limitations on dividends, stock redemptions and the redemption and/or prepayment of other debt, limitations on investments and acquisitions and limitations on transactions with affiliates. If there is no default or event of default, the Company may pay cash dividends and repurchase its stock, provided that the aggregate amount of the dividends and stock repurchased plus other types of restricted payments in any fiscal year does not exceed $30,000 plus any positive amounts in the discretionary basket. The discretionary basket is the sum of the Company’s cash and cash equivalents as of October 31, 2004 plus a percentage of equity proceeds as defined in the agreement plus the first $25,000 of asset sale proceeds plus 100 percent of net cash from operating activities minus cash used or committed to be used for capital expenditures, investments and acquisitions. The agreement also limits capital expenditures in any fiscal year to $40,000, with a provision for the carryover of permitted but unused amounts. The cost of acquisitions is unlimited if the consolidated leverage ratio is less than or equal to 3.00 to 1.00 and the consolidated senior secured leverage ratio is less than or equal to 1.75 to 1.00, after giving proforma effect to the acquisition; otherwise, the limit is $75,000 in any fiscal year, with a provision for the carryover of permitted but unused amounts.
Obligations under the senior secured credit facility are guaranteed by substantially all existing and future direct and indirect domestic subsidiaries of the Company formed under the laws of any one of the states or the District of Columbia of the United States of America (“SEI Guarantors”).
The lenders under the senior secured credit facility have received a first priority perfected security interest in (i) all of the capital stock or other equity interests of each of the domestic subsidiaries of the Company and 65 percent of the voting capital stock of all direct foreign subsidiaries and (ii) all other present and future assets and properties of the Company and the SEI Guarantors except (a) real property, (b) vehicles, (c) assets to which applicable law prohibits security interest therein or requires the consent of a third party, (d) contract rights in which a security interest without the approval of the other party to the contract would constitute a default thereunder and (e) any assets with respect to which a security interest cannot be perfected.
On February 18, 2005, the Company completed its tender offer and consent solicitation for any and all of its $300,000 10.75 percent senior subordinated notes. The Company purchased a total of $298,250 in aggregate principal amount of the notes in the offer. In the second quarter of fiscal year 2005, the Company incurred a charge for early extinguishment of debt of approximately $30,057 ($19,210 after tax, or $.18 per share) representing $25,369 for a tender premium, related fees and expenses and $4,688 for the write-off of the remaining unamortized fees on the senior subordinated notes.
The Company funded the tender offer for the 10.75 percent senior subordinated notes, including related tender premiums, fees, expenses and accrued interest of $28,931, with the net proceeds of the $130,000 in additional Term Loan B borrowings described above, a portion of its available cash, and the net proceeds of the issuance of $200,000 6.25 percent senior notes due 2013 (the “6.25 percent senior notes”), which were issued on February 11, 2005.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(16) Long-term Debt-(Continued)
The Company redeemed the remaining $1,750 principal amount of senior subordinated notes on the first call date of July 1, 2005 at the aggregate redemption price of $1,844, which was funded by cash on hand. In the third quarter of fiscal year 2005, the Company recorded a charge for the early extinguishment of debt of approximately $114 including the call premium and write-off of the remaining unamortized fees on the senior subordinated notes.
The 6.25 percent senior notes are governed by the terms of an indenture dated as of February 11, 2005. Prior to February 15, 2009, the 6.25 percent senior notes are not redeemable. Beginning on February 15, 2009, the Company may redeem the 6.25 percent senior notes in whole or in part at any time at the redemption prices set forth in the indenture, plus any accrued and unpaid interest. In addition, upon a change of control of the Company, holders of the 6.25 percent senior notes will have the right to require the Company to repurchase all or any part of their 6.25 percent senior notes for cash at a price equal to 101 percent of the aggregate principal amount of the 6.25 percent senior notes repurchased, plus any accrued and unpaid interest.
The 6.25 percent senior notes are guaranteed, jointly and severally, by the SEI Guarantors, and are the Company’s general unsecured and unsubordinated obligations, and the guarantees of the 6.25 percent senior notes are the SEI Guarantors’ general unsecured and unsubordinated obligations. Accordingly, they will rank equally in right of payment with all of the Company’s, in the case of the 6.25 percent senior notes, and the SEI Guarantors’, in the case of their guarantees of the 6.25 percent senior notes, existing and future unsubordinated indebtedness and senior to any existing and future subordinated indebtedness.
In addition, the 6.25 percent senior notes effectively rank junior to any of the Company’s, and the guarantees of the 6.25 percent senior notes effectively rank junior to the SEI Guarantors’, existing and future secured indebtedness, including obligations under the Company’s senior secured credit facility, to the extent of the assets securing such indebtedness.
The indenture contains affirmative and negative covenants that, among other things, limit the Company and the SEI Guarantors’ ability to engage in sale and leaseback transactions, effect a consolidation or merger or sale, transfer, lease, or other disposition of all or substantially all assets, and create liens on assets. The indenture also contains customary events of default. Upon the occurrence of certain events of default, the Trustee or the holders of the 6.25 percent senior notes may declare all outstanding 6.25 percent senior notes to be due and payable immediately.
In connection with the issuance of the 6.25 percent senior notes, the Company entered into a registration rights agreement that requires that a registration statement be filed and declared effective by the SEC, and that an exchange offer be conducted providing for the exchange of the unregistered notes for similar registered notes, all within specified times. The Company has so far been unable to cause the required registration statement to become effective and therefore is required to pay additional interest to the note holders until the default is cured. Additional interest began to accrue on June 12, 2005 at a rate of 0.50 percent per annum on the principal amount of the notes for a period of 90-days. The additional interest increased 0.50 percent for each 90-day period thereafter so long as the default exists, up to a maximum increase of 1.50 percent per annum. The additional interest is payable at the regular interest payment dates. The additional interest increased to 1.00 percent on September 11, 2005 and increased to 1.50 percent on December 11, 2005. As of October 31, 2005, the Company incurred $528 in additional interest charges.
Under the dividend and stock repurchase restrictions in the senior secured credit facility, the Company could use up to $74,137 to pay dividends or repurchase its stock as of October 31, 2005.
The restatements described in Note 2 as well as the Company’s failure to deliver financial statements within the specified deadlines in its senior secured credit facility resulted in a default and potential event of default under the facility. The Company sought and received waivers of the defaults and potential events of default related to the restatements and failure to deliver audited consolidated financial statements by the specified deadline. A waiver granted an extension to deliver the audited consolidated financial statements for a date subsequent to this filing. The Company delivered the financial statements within the time period specified in the waiver. The Company believes its incomplete July 31, 2005 Form 10-Q filed with the SEC met the financial statement compliance requirements of its senior secured credit facility. The Company believes it was in compliance with the terms of the senior secured credit facility.
The indenture governing the 6.25 percent notes requires the Company to furnish to the trustee for forwarding to the holders of the notes, within the time periods specified in the SEC’s rules and regulations, all quarterly and annual financial information that would be required to be contained in a filing with the SEC on Forms 10-Q and 10-K, including a “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and, with respect to the annual information only, a report on the annual financial statements from our certified independent accountants. In addition, the Company must file a copy with the SEC for public availability within the time periods specified in the SEC’s rules and regulations. An event of default would occur if the Company failed to provide that information within 30 days after receipt of written notice by the trustee or holders of at least 25 percent of the principal amount outstanding. The Company furnished its July 31, 2005 Form 10-Q to the trustee and filed it with the SEC, and believes that doing so complied with the requirements of the indenture. The Company has not received a default notice from the trustee or note holders with respect to the late filing of the Form 10-K for the fiscal year ended October 31, 2005 and has now filed this report with the SEC. The Company believes it is in compliance with the terms of its 6.25 percent notes.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(16) Long-term Debt-(Continued)
In April 1998, the Company issued $200,000 of 6.40 percent Remarketable Or Redeemable Securities (“ROARS”) due May 1, 2013 (remarketing date May 1, 2003). In connection with the Company’s June 2001 refinancing transactions, the Company repurchased $100,103 of the ROARS on June 29, 2001. Outstanding 6.40 percent ROARS were required to be redeemed by the Company or remarketed by the remarketing dealer on May 1, 2003. On May 1, 2003, when the remarketing dealer elected to remarket the ROARS, the Company exercised its right to redeem the ROARS rather than allow them to be remarketed. The Company paid the remarketing dealer $12,691, the contractually specified value of the remarketing right, which was based on the 10-year Treasury rate of 3.894 percent. Net of the $1,532 unamortized ROARS option premium and $130 in costs, the Company recorded a charge of $11,289 ($7,338 after tax, or $.07 per share) in the third quarter of fiscal year 2003.
As of October 31, 2005, the Company’s subsidiaries had approximately $1,925 of long-term debt that represents notes the subsidiaries issued as part of the purchase price of acquired businesses or debt the subsidiaries assumed in connection with acquisitions. Approximately $459 of this debt is secured by liens on the stock or assets of the related subsidiaries.
Scheduled principal payments of the Company’s long-term debt for the fiscal years ending October 31, 2006 through October 31, 2010, are approximately $3,168 in 2006, $2,839 in 2007, $2,396 in 2008, $2,218 in 2009 and $2,202 in 2010. Scheduled principal payments thereafter are $397,204.
(17) Guarantees
The Company’s obligations under its senior secured credit facility and 6.25 percent senior notes are guaranteed by all of its existing and future direct and indirect subsidiaries formed under the laws of the United States, any state thereof or the District of Columbia, except for specified excluded subsidiaries. For additional information regarding the senior secured credit facility and senior notes, see Note 16.
All obligations under the senior secured credit facility, including the guarantees and any interest rate protection and other hedging agreements with any lender or its affiliates, are secured by a first priority perfected security interest in (1) all capital stock and other equity interests of the Company’s existing and direct and indirect domestic subsidiaries, other than certain domestic subsidiaries acceptable to the agents, (2) 65 percent of the voting equity interests and 100 percent of all other equity interests (other than qualifying shares of directors) of all direct existing and future foreign subsidiaries, and (3) all other existing and future assets and properties of the Company and the guarantors, except for real property, vehicles and other specified exclusions.
Louisiana law gives Louisiana corporations broad powers to indemnify their present and former directors and officers and those of affiliated corporations against expenses incurred in the defense of any lawsuit to which they are made parties by reason of their positions. The Company’s By-laws make mandatory the indemnification of directors and officers permitted by Louisiana law. The Company has in effect a directors’ and officers’ liability insurance policy that provides for indemnification of its officers and directors against losses arising from claims asserted against them in their capacities as officers and directors, subject to limitations and conditions set forth in such policy. The Company has also entered into indemnity agreements with each director and executive officer,
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(17) Guarantees-(Continued)
pursuant to which the Company has agreed, subject to certain exceptions, to purchase and maintain directors’ and officers’ liability insurance. The agreements also provide that the Company will indemnify each director and executive officer against any costs and expenses, judgments, settlements and fines incurred in connection with any claim involving him or her by reason of his or her position as director or officer, provided that the director or executive officer meets certain standards of conduct.
As of October 31, 2005, the Company has guaranteed long-term debt of its subsidiaries of approximately $964 that represents notes the subsidiaries issued as part of the purchase price of acquired businesses or debt the subsidiaries assumed in connection with acquisitions.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(18) Reconciliation of Basic and Diluted Per Share Data
Options to purchase 1,073,690 shares of common stock at a price ranging from $6.90 to $7.03 per share were outstanding during the year ended October 31, 2005, but were not included in the computation of diluted earnings per share because the exercise prices of the options were greater than the average market price of the common shares. These options expire on November 18, 2011 and December 20, 2011. Options to purchase 43,312 shares at $6.96 per share were outstanding during the year ended October 31, 2005, but were not included in the computation of diluted earnings per share because the exercise prices of the options were greater than the average market price of the common shares. These options expired on April 12, 2005.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(18) Reconciliation of Basic and Diluted Per Share Data-(Continued)
Options to purchase 537,903 shares of common stock at prices ranging from $6.96 to $27.25 per share were outstanding during the year ended October 31, 2004, respectively, but were not included in the computation of diluted earnings per share because the exercise prices of the options were greater than the average market price of the common shares.
Options to purchase 6,626,621 shares of common stock at prices ranging from $4.28 to $27.25 were outstanding during the year ended October 31, 2003 but were not included in the computation of diluted earnings per share because the exercise prices of the options were greater than the average market price of the common shares.
(19) Income Taxes
Income tax expense (benefit) is comprised of the following components:
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(19) Income Taxes-(Continued)
The reconciliation of the statutory tax rate to the effective tax rate is as follows for continuing operations:
Deferred tax assets and liabilities consist of the following:
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(19) Income Taxes-(Continued)
As discussed in Note 14, in the fourth quarter of fiscal year 2003, the Company recorded an impairment of long-lived assets. Based on its assessment of the probability of realizing the $15,938 in tax benefits associated with the potential losses generated from the impairment, the Company determined that an $11,985 tax valuation allowance was appropriate. The $11,985 valuation allowance was required because the Company anticipated the majority of sales would generate capital losses due to the expected nature of the sales transactions. The Company believed it would likely not generate sufficient capital gains over the relevant time period against which it could offset these future capital losses given the existing capital loss carryforwards it already has available to it. Sales completed in 2004 generated primarily ordinary losses based on the type of sale transaction (asset sale). A tax benefit was recorded in 2004 for these sales. Upon completion of the asset sales, the entire book basis was removed, but there remained a tax basis in the stock of the unliquidated subsidiaries. Therefore, the Company has recorded a full valuation allowance against the associated tax benefit of the remaining tax basis in these subsidiaries because it is not likely that it will realize a tax benefit upon the liquidation of the subsidiaries. Accordingly, the valuation allowance as of October 31, 2004 was reduced to $9,744. The result of the transactions was to reduce the tax valuation allowance by $2,241. There were no changes in 2005 that would cause a material change to the discussion above.
The Company received a $33,222 income tax refund in first quarter of 2004 due to a change in the tax accounting methods for cemetery merchandise revenue. At the end of fiscal year 2003, the Company had decreased its deferred tax asset and increased receivables by $33,222. When the refund was received in the first quarter of 2004, the Company increased cash and decreased the corresponding receivable. During the third quarter of 2003, the Company received a tax refund of $23,334 related to the sale of its foreign operations. The Company used these refunds to reduce its outstanding debt balance.
(20) Benefit Plans
Stewart Enterprises Employees’ Retirement Trust
The Company has a defined contribution retirement plan, the “Stewart Enterprises Employees’ Retirement Trust (A Profit-Sharing Plan) (“SEERT”).” This plan covers substantially all employees with more than one year of service who have attained the age of 21. Contributions are made to the plan at the discretion of the Company’s Board of Directors. Additionally, employees who participate may contribute 100 percent of their earnings, up to the limit set by the Internal Revenue Code. Employee contributions of up to five percent of earnings are eligible for Company matching contributions at the rate of $.50 for each $1.00 contributed. The Company’s expense, including the Company’s matching contributions, for the fiscal years ended October 31, 2005, 2004 and 2003 was approximately $2,165, $2,091 and $2,152, respectively.
Stewart Enterprises Puerto Rico Employees’ Retirement Trust
On January 1, 2003, the Stewart Enterprises Puerto Rico Employees’ Retirement Trust, a defined contribution retirement plan, became effective when the Company adopted the Banco Popular de Puerto Rico Master Defined Contribution Retirement Plan. Individuals employed in Puerto Rico by the Company or certain of its
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(Dollars in thousands, except per share amounts)
(20) Benefit Plans-(Continued)
subsidiaries and affiliates are eligible to participate in this plan upon reaching the age of 21 and the completion of one year of service. Employees in Puerto Rico who were formerly participating in the Stewart Enterprises Employees’ Retirement Trust had their account balances transferred to this plan in February 2003. Eligible employees may contribute up to 10 percent of their earnings, up to a maximum annual contribution of $8. Employee contributions of up to five percent of earnings are eligible for Company matching contributions at the rate of $0.50 for each $1.00 contributed. Additional contributions may also be made to this plan at the discretion of the Company’s Board of Directors. The Company’s expense, including the Company’s matching contributions, for the fiscal years ended October 31, 2005, 2004 and 2003 was $108, $109 and $108, respectively.
Non-qualified Supplemental Retirement and Deferred Compensation Plan
The Company has a non-qualified key employee defined contribution supplemental retirement plan, which provides certain highly compensated employees the opportunity to accumulate deferred compensation which cannot be accumulated under the SEERT due to certain limitations. Contributions are made to the plan at the discretion of the Company’s Board of Directors. Additionally, employees who participate may contribute up to 15 percent of their earnings. The first 5 percent of such employee contributions are eligible for Company matching contributions at the rate of $.50 for each $1.00 contributed. The Company’s expense, including the Company’s matching contributions, for the fiscal years ended October 31, 2005, 2004 and 2003 was approximately $210, $386 and $525, respectively.
Supplemental Executive Retirement Plan
On April 1, 2002, the Company adopted an unfunded, non-qualified defined benefit supplemental retirement plan, the “Stewart Enterprises, Inc. Supplemental Executive Retirement Plan (“SERP”)” to provide for the payment of pension benefits to a select group of highly-compensated management employees. The retirement plan is non-contributory and provides retirement benefits based on final average compensation, position and the participant’s age, years of service or years of participation in the SERP. The plan is construed in accordance with and governed by the laws of the State of Louisiana, except to the extent that the plan is governed by the Employee Retirement Income Security Act of 1974, as amended. The Company’s expense for the fiscal years ended October 31, 2005, 2004 and 2003 was $1,877, $1,800 and $1,960, respectively. The Company’s liability as of October 31, 2005 and 2004 was $6,278 and $4,712, respectively.
1995 Incentive Compensation Plan
In August 1995, the Board of Directors adopted, and in December 1995 and December 1996 amended, the 1995 Incentive Compensation Plan, which has been approved by the Company’s shareholders, pursuant to which officers and other employees of the Company may be granted stock options, stock awards, restricted stock, stock appreciation rights, performance share awards or cash awards by the Compensation Committee of the Board of Directors. Under the plan, the Compensation Committee may accelerate the exercisability of any option at any time at its discretion, and the options become immediately exercisable in the event of a change of control of the Company, as defined in the plan.
From July 1998 to February 1999, the Company granted new options under the 1995 Incentive Compensation Plan to officers and employees for the purchase of 3,682,250 shares of Class A common stock at exercise prices equal to the fair market value at the grant dates, which ranged from $16.00 to $27.25 per share. One-third of the options became exercisable in 20 percent annual increments beginning on July 17, 1999. The remaining two-thirds of the options would become exercisable in full on the first day between the grant date and July 17, 2003 that the average of the closing sale prices of a share of Class A common stock over the 20 preceding consecutive trading days equals or exceeds $67.81, which represents a 20 percent annual compounded growth in the price of a share of Class A common stock over five years. All of the options expired on July 31, 2004.
In January 2000, the Company granted new options under the 1995 Incentive Compensation Plan to officers and employees for the purchase of 4,018,168 shares of Class A common stock at exercise prices equal to the fair market value at the grant dates, which ranged from $5.50 to $6.00 per share. The options became exercisable in 25 percent annual increments beginning January 21, 2001. All of these options expired on January 21, 2005. In January 21, 2005, 2,737,604 of these options had been exercised, and 1,280,564 options had been forfeited.
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(Dollars in thousands, except per share amounts)
(20) Benefit Plans-(Continued)
From February 2003 to June 2003, the Company granted new options under the 1995 Incentive Compensation Plan to officers and employees for the purchase of 200,000 shares of Class A common stock at an exercise price of $5.16. The options became exercisable in 50 percent annual increments beginning February 14, 2004. All of these options expired on April 12, 2005. On April 12, 2005, 200,000 of these options had been exercised, and none had been forfeited.
From November 2003 to March 2004, the Company granted new options under the 1995 Incentive Compensation Plan to officers and employees for the purchase of 141,000 shares of Class A common stock at exercise prices equal to the fair market value at the grant dates, which ranged from $5.16 to $6.96 per share. The options vested immediately. All of these options expired on January 31, 2005 or April 12, 2005. On April 12, 2005, 87,124 of these options had been exercised, and 53,876 had been forfeited.
On December 22, 2003, the Company granted new options to its executive officers for the purchase of 780,000 shares of Class A common stock at an exercise price of $5.44. These options became exercisable in one-third increments beginning October 31, 2004. All of these options expire on December 22, 2013. As of October 31, 2005, 143,334 of these options had been exercised, and 303,332 had been forfeited.
On November 18, 2004, the Company granted new options to an executive officer for the purchase of 428,000 shares of Class A common stock at an exercise price of $7.03 per share. These options become exercisable in the following manner: 25 percent on November 18, 2005, 25 percent on November 18, 2006 and 50 percent on November 18, 2007. These options expire on November 18, 2011. As of October 31, 2005, none of these options have been exercised or forfeited.
On December 20, 2004, the Company granted new options to two executive officers for the purchase of 373,600 shares of Class A common stock at an exercise price of $6.90 per share. These options become exercisable in the following manner: 25 percent on December 20, 2005, 25 percent on December 20, 2006 and 50 percent on December 20, 2007. On December 20, 2004, the Company also granted new options to other executive officers for the purchase of 233,500 shares of Class A common stock at an exercise price of $6.90 per share, which vest in equal 25 percent portions on December 20, 2005, 2006, 2007 and 2008. All of these options expire on December 20, 2011. As of October 31, 2005, none of these options have been exercised and 46,700 had been forfeited.
2000 Incentive Compensation Plan
The Board of Directors adopted, and in April 2000 the shareholders approved, the 2000 Incentive Compensation Plan pursuant to which officers and other employees of the Company may be granted stock options, restricted stock or other stock-based awards by the Compensation Committee of the Board of Directors. From April 2000 through June 2003, the Company had granted options to officers and other employees for the purchase of a total of 3,389,532 shares of Class A common stock at exercise prices equal to the fair market value at the grant dates, which ranged from $2.22 to $6.96 per share. The options generally became exercisable in 25 percent annual increments beginning on April 12, 2001. All of these options expired on April 12, 2005. At that point, 2,624,970 of these options had been exercised, and 764,562 options had been forfeited.
On November 18, 2004, the Company granted new options to an executive officer for the purchase of 147,000 shares of Class A common stock at an exercise price of $7.03 per share. These options become exercisable in the following manner: 25 percent on November 18, 2005, 25 percent on November 18, 2006 and 50 percent on November 18, 2007. These options expire on November 18, 2011. As of October 31, 2005, none of these options have been exercised or forfeited.
Directors’ Stock Option Plan
Effective January 2, 1996, the Board of Directors adopted, and in December 1996 amended, the Directors’ Stock Option Plan, which has been approved by the Company’s shareholders. In January 2000, the Company granted 14,400 new options to purchase shares of Class A common stock under the Directors’ Stock Option Plan to each
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(Dollars in thousands, except per share amounts)
(20) Benefit Plans-(Continued)
director of the Company who is not an employee of the Company. A total of 72,000 options were granted at an exercise price of $6.00 per share. The options vested immediately. All of these options expired on January 31, 2005. On January 31, 2005, 57,600 of these options had been exercised, and 14,400 options had been forfeited.
2000 Directors’ Stock Option Plan
The Board of Directors adopted, and in April 2000 the shareholders approved, the 2000 Directors’ Stock Option Plan pursuant to which each director of the Company who is not an employee of the Company was granted an option to purchase 50,000 shares of the Company’s Class A common stock on April 13, 2000. The Company granted a total of 200,000 options at an exercise price equal to the fair market value at the grant date, which was $4.30 per share. On December 18, 2001, the Company granted 58,334 options at an exercise price equal to fair market value at grant date, which was $6.05 per share. The options generally became exercisable in 25 percent annual increments beginning on April 13, 2001. On February 18, 2004, the Company granted 2,083 options at an exercise price equal to the fair market value at the grant date, which was $6.25 per share. The Compensation Committee may accelerate the exercisability of any option at any time at its discretion, and the options become immediately exercisable in the event of a change of control of the Company, as defined in the plan. All of these options expired on January 31, 2005. At that point, 210,417 of these options had been exercised, and 50,000 options had been forfeited.
2005 Directors’ Stock Plan
The Board of Directors adopted, and in April 2005 the shareholders approved, the 2005 Directors’ Stock Plan, which authorizes a total of 400,000 shares of Class A common stock to be issued under the Plan to non-employee directors. Incentives under the Plan may be granted in any one or a combination of the following forms: options to purchase shares of common stock, stock appreciation rights, shares of restricted stock, restricted stock units and other stock-based awards. As of October 31, 2005, none of these shares had been granted.
Employee Stock Purchase Plan
On July 1, 1992, the Company adopted an Employee Stock Purchase Plan. This plan was terminated and replaced by the 2003 Employee Stock Purchase Plan (the “Plan”), which was approved by the Company’s shareholders at its 2003 annual meeting. The Company authorized 1,000,000 shares for issuance under the Plan. The Plan provides to eligible employees the opportunity to purchase the Company’s Class A common stock semi-annually on June 30 and December 31. The purchase price is established at a 15 percent discount from fair market value, as defined in the Plan. As of October 31, 2005, 223,990 shares had been acquired under this Plan.
Statement of Financial Accounting Standards No. 123
The Company has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and continues to apply APB Opinion No. 25 and related interpretations in accounting for its stock-based compensation plans. The following table is a summary of the Company’s stock options outstanding as of October 31, 2005, 2004 and 2003, and the changes that occurred during fiscal years 2005, 2004 and 2003.
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(Dollars in thousands, except per share amounts)
(20) Benefit Plans-(Continued)
The following table further describes the Company’s stock options outstanding as of October 31, 2005.
The fair value of the Company’s stock options used to compute pro forma net earnings (loss) and earnings (loss) per share disclosures in Note 3(h) is the estimated present value at grant date using the Black-Scholes option pricing model with the following weighted average assumptions for fiscal years 2005, 2004 and 2003, respectively: expected dividend yield of zero percent for all years; expected volatility of 43.3 percent, 38.9 percent and 38.7 percent; risk-free interest rate of 4.4 percent, 4.4 percent and 4.8 percent; and an expected term of 4.3 years, 3.9 years and 3.8 years.
Likewise, the fair value of shares acquired through the Employee Stock Purchase Plan is estimated on each semi-annual grant date using the Black-Scholes option pricing model with the following weighted average assumptions for fiscal years 2005, 2004 and 2003, respectively: expected dividend yield of 0.4 percent for 2005 and zero percent for 2004 and 2003; expected volatility of 54.9 percent, 62.7 percent and 59.7 percent; risk-free interest rate of 2.6 percent, 1.1 percent and 1.3 percent; and an expected term of .5 years for all years.
Stock Repurchase Plan
On March 28, 2005, the Company announced a new stock repurchase program, authorizing the investment of up to $30,000 in the repurchase of the Company’s common stock. The Company had previously announced its initial stock repurchase program in June of 2003 of up to $25,000 (which was subsequently increased by $3,000 to a total of $28,000). On March 17, 2005, the Company completed its initial stock repurchase program, having repurchased 4,400,000 shares since its inception. Repurchases under the new program will be limited to the Company’s Class A common stock, and will be made in the open market or in privately negotiated transactions at such times and in such amounts as management deems appropriate, depending upon market conditions and other factors. These repurchases reduce the weighted average number of common shares outstanding during each period. Since the inception of the new program through October 31, 2005, the Company had repurchased 1,200,000 shares of its Class A common stock at an average price of $6.64 per share.
Restricted Stock
On December 22, 2003, the Company granted 271,000 shares of restricted stock to its executive officers (of which 113,999 shares have been cancelled as of October 31, 2005 and 27,972 shares were withheld to cover the tax
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(20) Benefit Plans-(Continued)
obligation related to the vested restricted stock as of October 31, 2005). The restricted stock vests in equal one-third portions at October 31, 2004, October 31, 2005 and October 31, 2006. On November 18, 2004, the Company granted 72,000 shares of restricted stock to an executive officer, which vests 25 percent on November 18, 2005, 25 percent on November 18, 2006 and 50 percent on November 18, 2007. On December 20, 2004, the Company granted 58,000 shares of restricted stock to executive officers, which vests 25 percent on December 20, 2005, 25 percent on December 20, 2006 and 50 percent on December 20, 2007. On December 20, 2004, the Company also granted 36,500 shares of restricted stock to executive officers, which vest in equal 25 percent portions on December 20, 2005, 2006, 2007 and 2008 (of which 7,300 shares have been cancelled as of October 31, 2005). Once granted, the restricted stock is included in total shares outstanding but is not included in the weighted average number of common shares outstanding in each period used to calculate basic earnings per common share until the shares vest.
(21) Commitments, Contingencies and Related Party Transactions
Litigation
Henrietta Torres and Teresa Fiore, on behalf of themselves and all others similarly situated and the General Public v. Stewart Enterprises, Inc., et al.; No. BC328961 on the docket of the Superior Court for the State of California for the County of Los Angeles, Central District. This purported class action was filed on February 17, 2005, on behalf of a nationwide class defined to include all persons, entities and organizations who purchased funeral goods and/or services in the United States from defendants at any time on or after February 17, 2001. The suit named the Company and several of its Southern California affiliates as defendants and also sought to assert claims against a class of all entities located anywhere in the United States whose ultimate parent corporation has been the Company at any time on or after February 17, 2001.
In May, 2005, the court ruled that this case was related to similar actions against Service Corporation International (“SCI”) and Alderwoods Group, Inc., and designated the SCI case as the lead case. The case against the Company effectively has been held in abeyance while the court tests plaintiff’s legal theories in the lead case. Rulings on legal issues in the lead case will apply equally in the case against the Company, and the court has allowed the Company to participate in hearings and briefings in the lead case.
As a result of demurrers, the plaintiff in the lead case has amended her complaint twice. On January 31, 2006, however, the court overruled SCI’s demurrer to the third amended complaint and established a schedule leading to hearing on a motion for summary judgment in early July to test the viability of the named plaintiff’s claim against SCI.
The third amended complaint in the lead case alleges that the SCI defendants violated the “Funeral Rule” promulgated by the Federal Trade Commission by failing to disclose that the prices of certain goods and services they obtained from third parties specifically on the plaintiff’s behalf exceeded what the defendants paid for them. The plaintiff alleges that by failing to comply with the Funeral Rule, defendants (i) breached contracts with the plaintiffs, (ii) were unjustly enriched, and (iii) engaged in unfair, unlawful and fraudulent business practices in violation of a provision of California’s Business and Professions Code. The plaintiff seeks restitution damages, disgorgement, interest, costs, and attorneys’ fees.
Although the plaintiffs have amended their complaint against the Company once as a result of a demurrer in the lead case, they have not amended their complaint to correspond with the third amended complaint in the lead case. Because the matter is in its early stages, the likelihood of liability and the extent of any damages cannot be reasonably assessed at this time. The Company intends to aggressively defend itself in this matter.
In re: Funeral Consumer Antitrust Litigation - On May 2, 2005, a purported class action lawsuit entitled Funeral Consumers Alliance, Inc, et al. v. Service Corporation International, Alderwoods Group, Inc., Stewart Enterprises, Inc., Hillenbrand Industries, Inc., and Batesville Casket Co. (“FCA Case”) was filed in the Federal District Court for the Northern District of California, on behalf of a nationwide class defined to include all consumers who purchased a Batesville casket from the funeral home defendants.
The suit alleges that the defendants acted jointly to reduce competition from independent casket discounters and fix and maintain prices on caskets in violation of the federal antitrust laws and California’s Business and
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(21) Commitments, Contingencies and Related Party Transactions-(Continued)
Professions Code. The plaintiffs seek treble damages, restitution, injunctive relief, interest, costs and attorneys’ fees.
Thereafter, five substantially similar lawsuits were filed in the Northern District of California asserting claims under the federal antitrust laws and various state antitrust and consumer protection laws. These five suits were transferred to the division in which the FCA Case was pending and consolidated with the FCA Case (collectively referred to as the “Consolidated Consumer Cases”).
On July 8, 2005, a purported class action was filed in the Northern District of California entitled Pioneer Valley Casket Co., Inc., et al. v. Service Corporation International, Alderwoods Group, Inc., Stewart Enterprises, Inc., Hillenbrand Industries, Inc., and Batesville Casket Co. (“Pioneer Valley Case”). The Pioneer Valley Case involves the same claims asserted in the Consolidated Consumer Cases, except that it was brought on behalf of a nationwide class defined to include only independent casket retailers.
On July 15, 2005, the defendants filed motions to dismiss for failure to plead facts sufficient to establish viable antitrust and unfair competition claims. On September 9, 2005, the Court denied the defendants’ motions to dismiss, without prejudice, but ordered the plaintiffs to file an amended and consolidated complaint that satisfies the objections raised in the motions to dismiss.
At the defendants’ request, the Court also issued orders in late September 2005 transferring the Consolidated Consumer Cases and the Pioneer Valley Case to the United States District Court for the Southern District of Texas. The transferred Consolidated Consumer Cases have been consolidated before a single judge in the Southern District of Texas. The Pioneer Valley Case has been consolidated with these cases for purposes of discovery only.
On October 12, 2005, the consumer plaintiffs filed a first amended consolidated class action complaint. Defendants then filed motions to dismiss the first amended complaint, which are pending. On October 21, 2005, Pioneer Valley filed a first amended complaint. Defendants then filed motions to dismiss, which are pending. Discovery is underway in both cases. Because these matters are in their preliminary stages, the likelihood of liability and the extent of any damages cannot be reasonably assessed at this time. The Company intends to aggressively defend itself in these matters.
A similar action captioned Ralph Lee Fancher, on behalf of himself and all others similarly situated v. Service Corporation International, Alderwoods Group, Inc,. Stewart Enterprises, Inc., Hillenbrand Industries, Inc., Aurora Casket Co., York Group, Inc., and Batesville Casket Co., was filed in the United States District Court for the Eastern District of Tennessee on behalf of consumers in twenty-three states and the District of Columbia who purchased caskets. The allegations of fact were essentially the same as those made in the FCA Case, but the plaintiff in this suit alleges that the defendants violated state antitrust, consumer protection and/or unjust enrichment laws. The plaintiff in this purported class action withdrew his complaint on August 2, 2005, and re-filed a nearly identical complaint under Tennessee law and on behalf of only Tennessee consumers in the Northern District of California on September 23, 2005, the same day that the Consolidated Consumer Cases were transferred to the Southern District of Texas. This matter has now been transferred to the Southern District of Texas, and consolidated with the Consolidated Consumer Cases for purposes of discovery. Because these matters are in their preliminary stages, the likelihood of liability and the extent of any damages cannot be reasonably assessed at this time. The Company intends to aggressively defend itself in these matters.
State Attorney General Civil Investigative Demands - On August 4, 2005, the Attorney General for the State of Maryland issued a civil investigative demand to the Company seeking documents and information relating to funeral and cemetery goods and services. The Attorney General for the State of Florida issued a similar civil investigative demand to the Company. The Company is cooperating with the attorneys general and has begun providing them with information relevant to their investigations. Because these matters are in their preliminary stages, the likelihood of liability and the extent of any damages cannot be reasonably assessed at this time. The Company intends to aggressively defend itself in these matters.
In addition to the matters above, the Company and certain of its subsidiaries are parties to a number of legal proceedings that have arisen in the ordinary course of business. While the outcome of these proceedings cannot be predicted with certainty, management does not expect these matters to have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company.
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(Dollars in thousands, except per share amounts)
(21) Commitments, Contingencies and Related Party Transactions-(Continued)
Leases
The Company has noncancellable operating leases, primarily for land and buildings that expire over the next 1 to 13 years, except for six leases that expire between 2032 and 2039. Rent payments under these leases were $4,997, $5,755 and $5,799 for the years ended October 31, 2005, 2004 and 2003, respectively. The Company leased office space from a non-affiliated company through September 30, 2004. Rental payments to the non-affiliated company were $295 for the year ended October 31, 2004 and $322 for the year ended October 31, 2003. The Company’s future minimum lease payments as of October 31, 2005 are $4,813, $3,808, $3,100, $2,727, $2,153 and $18,457 for the years ending October 31, 2006, 2007, 2008, 2009, 2010 and later years, respectively.
Other Commitments and Contingencies
The Company has entered into non-compete agreements with prior owners of acquired subsidiaries that expire through 2012. During fiscal year 2001, the Company decided to relieve some of the prior owners and key employees of their obligations not to compete; however, the payments will continue to be made in accordance with the contract terms. The Company’s future non-compete payments as of October 31, 2005 are $1,929, $1,538, $1,209, $328, $242 and $310 for the years ending October 31, 2006, 2007, 2008, 2009, 2010 and later years, respectively.
The Company carries insurance with coverages and coverage limits that it believes to be adequate. Although there can be no assurance that such insurance is sufficient to protect the Company against all contingencies, management believes that its insurance protection is reasonable in view of the nature and scope of the Company’s operations.
The Company is required to maintain a bond ($41,061 as of October 31, 2005) to guarantee its obligations relating to funds the Company withdrew in fiscal year 2001 from its preneed funeral trusts in Florida. This amount would become senior debt if the Company was to borrow funds under the revolving credit facility to extinguish the bond obligation by returning to the trusts the amounts it previously withdrew that relate to the remaining preneed contracts.
Related Party Transactions
In July 2005, the Company announced the retirement of Michael K. Crane, Sr., Senior Vice President and President of the Central Division, effective October 31, 2005. As part of his separation agreement, he is entitled to receive $300 in equal installments over a two year period beginning in May 2006. The Company recorded the $300 charge in the fourth quarter of fiscal year 2005 but will make the payments in accordance with the terms of the agreement.
In June 2004, the Company entered into a separation agreement with William E. Rowe who stepped down from his position as President and Chief Executive Officer. As part of Mr. Rowe’s separation agreement, the Company will pay Mr. Rowe $1,000 in equal installments over a two year period, beginning November 1, 2004. The Company recorded the $1,000 charge in the third quarter of fiscal year 2004 but will make the payments in accordance with the terms of the agreement.
In July 2003, the Company entered into a retirement benefits agreement with Frank B. Stewart, Jr., who retired from his position as Chairman of the Board and became Chairman Emeritus of the Company. As part of Mr. Stewart’s retirement benefits agreement, the Company agreed to pay Mr. Stewart $1,650, payable in three installments of $550 each. The first payment was made within five days after the announcement of his retirement. The second payment was made on June 20, 2004, and the final payment was made on June 20, 2005. The Company recorded the $1,650 charge in the third quarter of 2003.
In June 2003, the Company announced that Brian J. Marlowe, Chief Operating Officer, had stepped down. According to the terms of his employment agreement, he was entitled to receive an amount equal to two years of salary, or $800, over two years. The Company recorded the $800 charge in the third quarter of 2003 and has paid all of the $800 commitment as of October 31, 2005.
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(Dollars in thousands, except per share amounts)
(21) Commitments, Contingencies and Related Party Transactions-(Continued)
In January 1998, the Company discontinued an insurance policy on the life of Mr. Frank B. Stewart, Jr., Chairman Emeritus of the Company. In order to purchase a replacement policy, The Stewart Family Special Trust borrowed $685 from the Company pursuant to a promissory note due 180 days after the death of Mr. Stewart. Interest on the note accrues annually at a rate equal to the Company’s cost of borrowing under its revolving credit facility and is payable when the principal becomes due. The amount of the loan was equal to the cash value received by the Company upon the discontinuance of the prior insurance policy. The loan proceeds were used by the trust to purchase a single premium policy on the life of Mr. Stewart. Certain of the beneficiaries of The Stewart Family Special Trust are members of Mr. Stewart’s family. The loan was approved by all of the disinterested members of the Board of Directors. The outstanding balance of the loan at October 31, 2005, including accrued interest, was approximately $1,044.
The father of G. Kenneth Stephens, Jr., Executive Vice President and President of the Company’s Western Division, has an 81 percent ownership interest in Cemetery Funeral Supply, Inc., a vendor of the Company. For the years ended October 31, 2005, 2004 and 2003, the Company paid Cemetery Funeral Supply, Inc. $226, $252 and $281, respectively.
(22) Segment Data
The Company re-evaluated its application of FASB Statement No. 131, and restated its operating and reportable segments during fiscal year 2005 to include eleven operating and reportable segments. The Company’s historical presentation of segment data had incorrectly consisted of two operating and reportable segments, funeral and cemetery. The tables below reflect restated segment information for fiscal years 2004 and 2003 and as of October 31, 2004 to reflect the correct segments.
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(22) Segment Data-(Continued)
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(22) Segment Data-(Continued)
(1)
All Other consists of the Company’s operations in Puerto Rico.
(2)
Preneed sales amounts represent total preneed funeral and cemetery service and merchandise sales generated in the applicable period, net of cancellations.
As a result of the Company’s strategic planning process, effective for the fourth quarter of fiscal year 2005, the Company reorganized its operating divisions from four to two and revised its operating and reportable segments. The Company’s new presentation as a result of its strategic planning process reflects five operating and reportable segments consisting of a corporate trust management segment and a funeral and cemetery segment for each of two geographic areas: Western and Eastern.
As of October 31, 2005, the Company operated two geographic divisions each with a division president: Western division and Eastern division. The Western division consists of 122 funeral homes and 50 cemeteries in Alabama, Arkansas, California, Illinois, Iowa, Kansas, Louisiana, Mississippi, Missouri, Nebraska, New Mexico, Oregon, Texas, Washington and Wisconsin. The Eastern division consists of 109 funeral homes and 94 cemeteries in Alabama, Florida, Georgia, Kentucky, Maryland, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia, West Virginia and Puerto Rico.
The corporate trust management segment includes (i) the funeral and cemetery service and merchandise trust earnings recognized for GAAP purposes, which are further described below, and (ii) fee income related to the Company’s wholly-owned subsidiary, Investor’s Trust, Inc., “ITI.” Trust assets and the earnings on those assets are associated exclusively with preneed sales. Because preneed services and merchandise will not be provided until an unknown future date, most states require that all or a portion of the customer payments under preneed contracts be placed in trust or escrow accounts for the benefit of the customers.
ITI serves as investment advisor exclusively to the Company’s trust funds. ITI provides investment advisory services to the trusts for a fee. The Company has elected to perform these services in-house, and the fees are recognized as income as earned.
The corporate trust management segment revenues reflect (1) investment management fees earned and (2) the realized earnings related to preneed contracts delivered. Earnings recognition in this segment is unrelated to investment results in the current period. Current investment results of the funeral and cemetery merchandise and
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(22) Segment Data-(Continued)
service trusts are deferred until the underlying products and services are delivered and are not reflected in the statement of earnings but are disclosed in Notes 5, 6, and 8 along with the cost and market value of the trust assets. The Company’s fee income related to management of its trust assets, the investment income recognized on preneed contracts delivered and the trust assets are referred to as “corporate trust management” for the benefit of the divisions.
Perpetual care trust earnings are reported in the geographic segments, as these revenues are recognized currently and are used to maintain the cemeteries. Perpetual care trust earnings and the cost and market values of the perpetual care trust assets are presented in Note 7.
The accounting policies of the Company’s segments are the same as those described in Note 3. The Company evaluates the performance of its segments and allocates resources to them using a variety of profitability metrics. The most comprehensive of these measures is gross profit.
The Company also measures its preneed sales growth year-over-year. Preneed sales and the accounting for these sales are discussed in Notes 3(i), 3(j) and 3(k). Although the Company does not consider its preneed selling activities to be a separate segment, the Company is providing additional disclosure of preneed funeral and cemetery merchandise and service sales in its segment footnote as preneed sales are reviewed monthly by the Company’s CODM to assess performance and allocate resources. Preneed sales are strategically significant to the Company as those sales are one of the primary drivers of market share protection and growth. As such, the CODM reviews the preneed sales data in addition to revenue and gross profit.
The Company’s operations are product-based and geographically-based. As such, the Company’s primary reportable segments presented in the following table are based on products and services and their geographical orientation.
The Company’s funeral homes offer a complete range of funeral services and products both at the time of need and on a preneed basis. The Company’s services and products include family consultation, removal and preparation of remains, the use of funeral home facilities for visitation, worship and funeral services, transportation services, flowers and caskets. In addition to traditional funeral services, all of the Company’s funeral homes offer cremation products and services. The Company’s cemetery operations involve the sale of cemetery property and related merchandise, including lots, lawn crypts, family and community mausoleums, monuments, memorials and burial vaults, along with the sale of burial site openings and closings and inscriptions. Cemetery property and merchandise sales are made both at the time of need and on a preneed basis.
The Company incurs certain costs at the divisional or regional level that benefit all of the funeral homes and cemeteries in the division or region, such as division management compensation, divisional and regional headquarters overhead, insurance costs and legal and professional fees. These costs are allocated to the facilities in the regions or divisions using various methods including their proportionate share of sales (which can include preneed sales) or payroll. These costs are included in funeral and cemetery costs.
The Company incurs certain other costs at its Shared Services Center that benefit all of the funeral homes and cemeteries, such as the costs to process contracts, make collections, pay vendors, deliver information system services and deliver human resource services. These costs are allocated to the divisions and further allocated to the facilities in the division using various methods including their proportionate share of sales (which can include preneed sales) and the number of employees. These costs are included in funeral and cemetery costs.
For a discussion of discontinued operations, see Note 14. The table below presents restated information about reported segments for the fiscal years ended October 31, 2005, 2004 and 2003 for the Company’s continuing operations only based on the Company’s reportable segments following the fourth quarter of fiscal year 2005 reorganization:
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(22) Segment Data-(Continued)
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(22) Segment Data-(Continued)
A reconciliation of total segment gross profit to total earnings from continuing operations before income taxes and cumulative effect of change in accounting principle for the fiscal years ended October 31, 2005, 2004 and 2003, is as follows:
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(23) Supplementary Information
The detail of certain income statement accounts is as follows for the fiscal years ended October 31, 2005, 2004 and 2003.
(24) Hurricane Related Charges
On Monday, August 29, 2005, Hurricane Katrina struck the New Orleans metropolitan area and the Mississippi and Alabama Gulf Coasts. The Company’s executive offices and Shared Services Center are located in a building it owns in the New Orleans metropolitan area, and no significant damage occurred to that building. However, most of the approximately 400 employees who work at this location did not have access to their homes until late September or early October, and many of those homes remain uninhabitable. For the month of September, the Company temporarily housed most of the Shared Services Center functions, such as cash receipts and disbursements, customer service, contract processing and information technology in Orlando, Florida, in newly-leased and existing Company office space, and temporarily housed other functions such as the executive offices, treasury, accounting, trust administration, human resources, training, communications, marketing, tax and compliance in the Dallas, Texas area in newly-leased office space. As of October 31, 2005, the Company had used approximately $2,500 in cash on hand for hurricane related expenses. Beginning in early October, the executive offices and Shared Services Center were open and operating.
Of the Company’s 231 funeral homes and 144 cemeteries, three funeral homes and five cemeteries, which represent approximately 4 percent of the Company’s annual revenues and approximately five percent of its annual gross profit, are located in the New Orleans metropolitan area, have suffered substantial damage and are conducting business in temporary facilities until repairs are completed. The Company’s mausoleum construction and sales business, Acme Mausoleum, which primarily operates in southwest Louisiana and Texas, was also negatively impacted by Hurricanes Katrina and Rita. Including Acme Mausoleum, the New Orleans area funeral home and cemetery operations represent approximately six percent of the Company’s annual revenue and gross profit. The
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(24) Hurricane Related Charges-(Continued)
book value of net property and equipment, receivables, inventory and cemetery property at the affected properties amounted to approximately $24,700 prior to the storms. For the years ended October 31, 2005, 2004 and 2003, total revenues of these facilities amounted to $19,800, $21,815 and $22,668, respectively.
Hurricanes Katrina, Rita and Wilma also interrupted business in Florida, Alabama, Mississippi and Texas primarily due to evacuations and power-outages. The Company has insurance coverage related to property damage, incremental costs and property operating expenses it incurred due to damage caused by Hurricane Katrina. As of October 31, 2005, the Company had incurred approximately $20,897 in expenses related to Hurricane Katrina including the write-off of damaged buildings, equipment and inventory, demolition costs, debris removal, record restoration, general cleanup, temporary living facilities for employees, relocation expenses and other costs. The Company expects insurance proceeds of at least $11,531 currently based on the status of its insurance review, $500 of which had been received as of October 31, 2005. The remaining $11,031 in insurance proceeds to be received is included in current receivables in the consolidated balance sheet for fiscal year 2005. The net amount of $9,366 is included in the “Hurricane related charges, net” line in the consolidated statement of earnings for fiscal year 2005. The Company believes that a significant portion of the remainder of the loss it experienced may be covered by insurance. When the Company and its insurance carriers agree on the final amount of the insurance proceeds the Company is entitled to, the Company will record any related gain at that time. The Company also recorded approximately $1,606 of increased bad debt reserve in the Western division cemetery segment related to the areas affected by Hurricane Katrina.
(25) Quarterly Financial Data (Unaudited)
As discussed in Notes 2, 3(s) and 14, the Company has restated its operating and reportable segments and its reporting units, has recorded charges related to its deferred revenue project and has reclassified the results of certain businesses previously reported as discontinued operations to continuing operations. The quarterly financial data in the table below has been restated and reclassified for these changes.
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(25) Quarterly Financial Data (Unaudited)-(Continued)
Changes in the number of deaths can vary among local markets and from quarter to quarter, and variations in the number of deaths in the Company’s markets or from quarter to quarter are not predictable. However, generally the number of deaths fluctuates with the seasons with more deaths occurring during the winter months primarily resulting from pneumonia and influenza. These variations can cause revenues to fluctuate.
(26) Subsequent Events
The Company received a Staff Determination Letter from the Nasdaq Listing Qualifications Department on October 25, 2005 notifying the Company that because it filed its third quarter 2005 Form 10-Q prior to completion of the review by its independent registered public accounting firm and without the certifications of its Chief Executive Officer and Chief Financial Officer, that the Company is not in compliance with the continued listing requirements of Nasdaq Marketplace Rule 4310(c)(14).
On November 17, 2005, the Company appeared before a Nasdaq Listing Qualifications Panel to seek an
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(26) Subsequent Events-(Continued)
extension of time to complete the filing and thereby regain compliance with the listing standard. On December 12, 2005, the Company received a response from the Nasdaq Listing Qualifications Panel which granted its request for continued listing on the Nasdaq National Market of its Class A common stock, provided that the Company files its completed Form 10-Q for the quarter ended July 31, 2005 and Form 10-K for the fiscal year ended October 31, 2005 no later than February 15, 2006. On February 3, 2006, Nasdaq notified the Company that the Company’s failure to file the Form 10-K for the fiscal year ended October 31, 2005 by February 1, 2006 was an additional violation of the continued listing requirements, but that the extension of time previously granted by the Panel for the filing was not affected by this notice. The Company was granted an additional extension of time to February 22, 2006.
Nasdaq also notified the Company on January 17, 2006 that the Company’s filing on October 24, 2005 of the Form 10-K/A for the fiscal year ended October 31, 2004 prior to completion of the audit by its independent registered public accounting firm and without the certifications of its Chief Executive Officer and Chief Financial Officer was an additional noncompliance with the continued listing requirements of Nasdaq Marketplace Rule 4310(c)(14). This matter was previously disclosed to and discussed with the Nasdaq Listing Qualifications Panel. The Company was granted an extension of time in which to file this report to April 7, 2006.
Item 9.
Item 9. Changes in and Disagreements with Accountants in Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A. Controls and Procedures
Disclosure Controls and Procedures.
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required financial disclosure.
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s Disclosure Committee and management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon, and as of the date of this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective because of the material weaknesses described below. In light of the material weaknesses described below, the Company performed additional analysis and other post-closing procedures to ensure our consolidated financial statements are prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the consolidated financial statements included in this Annual Report on Form 10-K fairly present in all material respects our financial position, results of operations and cash flows for the periods presented.
Management’s Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies and procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of October 31, 2005. In making this assessment, management used the criteria described in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. We identified the following material weaknesses in our assessment of the effectiveness of internal control over financial reporting as of October 31, 2005:
1.
The Company did not maintain effective controls over revenue recognition related to preneed cemetery merchandise and services contracts. Specifically, the Company did not maintain effective controls over the reconciliation of recorded revenues to revenues based on physical delivery of preneed cemetery merchandise to ensure completeness and accuracy of recorded preneed cemetery merchandise revenue and deferred preneed cemetery revenue. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for all annual and interim periods beginning with fiscal year 2001, the period in which
the Company adopted Staff Accounting Bulletin No. 101 (“SAB 101”) “Revenue Recognition in Financial Statements”, through fiscal year 2004 and the first three quarters of fiscal year 2005. Prior to the adoption of SAB 101, the Company recognized preneed cemetery merchandise revenues at the time a contract was entered into with a customer. This control deficiency could result in the misstatement of cemetery merchandise revenues and of deferred preneed cemetery revenues that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency represents a material weakness.
The Company did not maintain effective controls over recognition of realized trust earnings on preneed cemetery and funeral contracts. Specifically, the Company did not maintain effective controls to recognize realized net trust earnings upon the delivery of the related preneed cemetery and funeral merchandise and performance of preneed funeral services to ensure accuracy of recorded realized trust earnings and deferred trust earnings. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for all annual and interim periods for fiscal year 2001 through fiscal year 2004 and the first three quarters of fiscal year 2005. This control deficiency could result in the misstatement of cemetery and funeral revenues and of the deferred revenue associated with preneed cemetery and preneed funeral contracts sold on a preneed basis that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly management determined that this control deficiency represents a material weakness.
Because of the material weaknesses described above, we have concluded that the Company did not maintain effective internal control over financial reporting as of October 31, 2005 based on the criteria in the Internal Control - Integrated Framework issued by the COSO.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of October 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
Plan for Remediation
Management, with the oversight of the Audit Committee, has been addressing the material weaknesses described above in our internal control over financial reporting and its impact over disclosure controls and procedures and is committed to effectively remediating these deficiencies as expeditiously as possible. We have devoted significant time and resources to the remediation efforts having completed a detailed review and assessment of nearly 700,000 contracts. Also, we are in the process of enhancing our automated delivery systems over cemetery merchandise and are establishing a team to design and implement an improved system for tracking and reporting trust earnings. Further, the Company is undertaking steps to improve its employee training programs at both cemetery and funeral locations which will include reiteration to the appropriate personnel of the importance of performing their responsibilities in accordance with Company policies and procedures.
Changes in Internal Control over Financial Reporting
As previously discussed in the Current Report of Form 8-K dated September 12, 2005, the Company did not maintain effective controls over the determination of operating and reportable segments in accordance with accounting principles generally accepted in the United States of America. Specifically, the Company did not maintain effective controls to properly identify its segments and reporting units for purposes of reporting its segment results and assessing goodwill impairments in accordance with accounting principles generally accepted in the United States of America. This control deficiency resulted in the restatement of the Company’s interim and annual consolidated financial statements for 2004 and 2003, the annual consolidated financial statements for 2002, and adjustments to the consolidated financial statements for the first three quarters of 2005. The Company took a series of steps during the fourth quarter of fiscal year 2005 designed to improve these control processes, including re-assessing the information provided to the Company’s Chief Operating Decision Maker and how that information affects the determination of the Company’s operating segments as well as assessing the economic similarity for reportable segments and reporting unit determination in the Company’s goodwill impairment analysis. The Company concluded this material weakness has been remediated as of October 31, 2005 given the series of steps taken. Other than the changes discussed above, there have been no changes in the Company’s internal control over
financial reporting during the quarter ended October 31, 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information regarding executive officers required by Item 10 may be found under Item 4(a) of this report.
The information regarding directors and compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, required by Item 10 is incorporated by reference to the Registrant’s definitive proxy statement relating to its 2006 annual meeting of shareholders, which proxy statement will be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year.
We have adopted the Stewart Enterprises, Inc. Code of Business Conduct and Ethics (the “code”), a code of ethics that applies to all employees, including our Chief Executive Officer, Chief Financial Officer and Corporate Controller. The code is available at the Company website where all of its public filings are available free of charge on the same day they are filed with the SEC. The Company’s website address is www.stewartenterprises.com. Any substantive amendments to the code, or any waivers granted for any directors or our Chief Executive Officer, Chief Financial Officer or Corporate Controller will be disclosed in a report on Form 8-K.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 is incorporated by reference to the Registrant’s definitive proxy statement relating to its 2006 annual meeting of shareholders, which proxy statement will be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year.
Notwithstanding the foregoing, in accordance with Items 306 and 402(a)(8) of Regulation S-K and Item 7(d)(3) of Schedule 14A, the information contained in the Company’s proxy statement under the subheading “Compensation Committee Report on Executive Compensation” and “Total Return Comparison,” and under the subheading “Audit Committee” (except for information following the heading “Audit Fees” therein), shall not be deemed to be filed as part of or incorporated by reference into this Form 10-K.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by Item 12 is incorporated by reference to the Registrant’s definitive proxy statement relating to its 2006 annual meeting of shareholders, which proxy statement will be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year.
Equity Compensation Plan Information
The following table provides information about our common stock that may be issued under equity compensation plans as of October 31, 2005:
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 is incorporated by reference to the Registrant’s definitive proxy statement relating to its 2006 annual meeting of shareholders, which proxy statement will be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by Item 14 is incorporated by reference to the Registrant’s definitive proxy statement relating to its 2006 annual meeting of shareholders, which proxy statement will be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a)
Documents filed as part of this report:
(1) Financial Statements
The Company’s consolidated financial statements listed below have been filed as part of this report:
(2) Financial Statement Schedule for the years ended October 31, 2005, 2004 and 2003
Report of Independent Registered Public Accounting Firm on Financial Statement
Schedule II-Valuation and Qualifying Accounts
All other schedules are omitted because they are not applicable or not required, or the information appears in the financial statements or notes thereto.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
FINANCIAL STATEMENT SCHEDULE
To the Board of Directors and Shareholders
of Stewart Enterprises, Inc.:
Our audits of the consolidated financial statements of Stewart Enterprises, Inc. and Subsidiaries referred to in our report dated February 17, 2006 appearing in Item 8 of this Form 10-K, also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
As discussed in Note 2 to the consolidated financial statements, the Company has restated its 2004 and 2003 consolidated financial statements.
PricewaterhouseCoopers LLP
New Orleans, Louisiana
February 17, 2006
STEWART ENTERPRISES, INC.
AND SUBSIDIARIES
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
(Unaudited)
(Dollars in thousands)
Item 15(a)(3) Exhibits
The Company hereby agrees to furnish to the Commission, upon request, a copy of the instruments which define the rights of holders of the Company’s long-term debt. None of such instruments (other than those included as exhibits herein) represent long-term debt in excess of 10 percent of the Company’s consolidated total assets.
Management Contracts and Compensatory Plans or Arrangements
Company and Lawrence B. Hawkins, Brent F. Heffron, Randall L. Stricklin, G. Kenneth Stephens, Jr. and Michael K. Crane (incorporated by reference to Exhibit 10.15 to the Original 2004 Form 10-K)
10.28 to the Company Annual Report on Form 10-K for the fiscal year ended October 31, 1994 (the “1994 10-K”)); and Amendment thereto dated January 1, 2002 (incorporated by reference to Exhibit 10.54 to the 2001 10-K); Amendment thereto dated January 1, 2003 (incorporated by reference to Exhibit 10.34 to the 2002 10-K); Amendment dated September 24, 2003 (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended January 31, 2004); Amendment thereto dated January 1, 2004; Commission File No. 1-15449 (incorporated by reference to Exhibit 10.29 to the Original 2004 Form 10-K); Amendment thereto dated March 28, 2005
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on February 17, 2006.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Exhibit Index