Tuesday, May 12, 2009

Losing Deferred Revenue

For value investors, a drop in the price level of the stock market does not necessarily mean the value of these businesses has changed. But there are exceptions. Companies that have certain types of pension plans will be in trouble, as we discussed two months ago; thanks to the drop in the stock market, these firms will now have a shortfall between the funds they control and what they owe their employees. But just because a company you are considering doesn't have this type of pension plan does not make it immune to changes in the price level of the market. Consider Service Corp (SCI), provider of funeral services.

The nature of SCI's business is such that many customers prepay for their funeral requirements, thereby taking the burden off of their families. Because this money is not yet earned, it is classified on the balance sheet as "deferred revenue" (similar to how a football team receives cash upfront for a game that has not yet been played, or a home builder gets a down payment for a house not yet built). To maximize returns, SCI invests part of this money in the market.

Unfortunately, much of this money has been lost. The company has unrealized losses of over $600 million in these accounts! With SCI having a market cap of just $1.2 billion, this is not an insignificant amount.

We've discussed before how deferred revenue can be a useful gauge in determining what a company's future earnings will look like. Investors who don't consider how that deferred revenue is invested can end up way off in their valuations!

Disclosure: None

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