News Column

CARRIAGE SERVICES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 5, 2014

OVERVIEW

General

We operate two types of businesses: funeral homes, which account for approximately 75% of our revenues, and cemeteries, which account for approximately 25% of our revenues. Funeral homes are principally service businesses that provide funeral services (traditional burial and cremation) and sell related merchandise, such as caskets and urns. Cemeteries are primarily sales businesses that sell interment rights (grave sites and mausoleum spaces) and related merchandise, such as markers and outer burial containers. As of June 30, 2014, we operated 167 funeral homes in 27 states and 32 cemeteries in 11 states. Substantially all administrative activities are conducted in our home office in Houston, Texas. We have implemented a long-term strategy in our operations designed to improve operating and financial results by growing market share and increasing profitability. We have a decentralized, entrepreneurial and local operating model that includes operating and financial standards developed from our best operations, along with an incentive compensation plan to reward business managers, known as "Managing Partners" for successfully meeting or exceeding the standards. The model essentially eliminated the use of line-item financial budgets at the location level in favor of the standards. The operating model and its standards, which we refer to as the "Standards Operating Model," focus on the successful execution of a handful of local market drivers of high and sustainable operating and sales performance over long periods of time, e.g. market share, preneed property sales, average revenue per funeral contract and interment, highly motivated and skilled service and sales staff, strong entrepreneurial leadership, profit margin management and other drivers. The model and standards are the measures by which we judge the success of each business. We also implemented short-term (one-year) Being the Best and long-term (five years) Good to Great Incentive Programs that recognize and reward those Managing Partners that can achieve and sustain a high level (over 70%) of "Standards Achievement." The potential incentives over long periods of time are in the range of compensation that independent owners of these businesses would receive. To date, the Standards Operating Model has driven significant changes in our organization, leadership and operating practices. Most importantly, the Standards Operating Model has allowed us to measure the sustainable revenue growth and earning power of our portfolio businesses. The Standards Operating Model led to the development of our "Strategic Acquisition Model," described below under "Acquisitions," which guides our acquisition and disposition strategy. We expect both models to drive long-term, sustainable increases in market share, revenue, earnings and cash flow. The standards are not designed to produce maximum short-term earnings because we do not believe such performance is sustainable without ultimately stressing the business, which often leads to declining market share, revenues and earnings. Important elements of the Standards Operating Model include: Balanced Operating Model - We believe a decentralized



structure works

best in the deathcare industry. Successful execution of the



Standards

Operating Model is highly dependent on strong local leadership, intelligent risk taking, entrepreneurial drive and corporate



support

aligned with the key drivers of a successful operation



organized

around three primary areas - market share, people and operating financial metrics. Incentives Aligned with Standards - Empowering Managing



Partners to

do the right things in their operations and local communities,



and

providing appropriate support with operating and financial



practices,

will enable long-term growth and sustainable profitability.



Each

Managing Partner participates in a variable incentive plan



whereby he

or she earns a percentage of his or her respective business'



earnings

based upon the actual standards achieved as long as the



performance

exceeds our minimum standards. The Right Local Leadership - Successful execution of our operating model is highly dependent on strong local leadership as defined by our customized 4E Leadership Model, intelligent risk taking and entrepreneurial empowerment. A Managing Partner's performance is judged according to achievement of the standards for that business. Funeral and Cemetery Operations Factors affecting our funeral operating results include: demographic trends relating to population growth and average age, which impact death rates and number of deaths; establishing and maintaining leading market share positions supported by strong local heritage and relationships; effectively responding to increasing cremation trends by selling complementary services and merchandise; controlling salary and merchandise costs; and exercising pricing leverage related to our at-need business to increase average revenue per contract. In simple terms, volume and price are the two variables that affect funeral revenues. The average revenue per contract is influenced by the mix of traditional burial and cremation services because our average cremation service revenue is approximately one-third of the average revenue earned from a traditional burial service. Funeral homes have a relatively fixed cost structure. Thus, small changes in revenues, up or down, normally cause significant changes to our profitability. - 37 -



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Our funeral volumes have increased from 24,403 in 2010 to 29,854 in 2013 (compounded annual increase of 7.0%). Our funeral operating revenue, excluding financial revenue, has increased from $124.2 million in 2010 to $154.8 million in 2013 (compounded annual increase of 7.4%). The increases are primarily a result of businesses we have acquired in the last five years and our ability to increase the average revenue per funeral through expanded service offerings and packages. Additional funeral revenue from preneed commissions and preneed funeral trust earnings has increased from $8.1 million in 2010 to $9.2 million in 2013. We experienced an increase of 0.4% in volumes and 1.2% in funeral operating revenues in the first six months of 2014 compared to the first six months of 2013, primarily due to an increase in volumes and revenues from our acquired funeral home businesses. See "Results of Operations" below for the definition of acquired businesses. The percentage of funeral services involving cremations has increased from 43.2% for the year ended 2010 to 46.9% for the year ended 2013, and was 46.8% for the first six months of 2014. On a same store basis, the cremation rate has risen to 47.0% for the first six months of 2014, up from 46.3% for the year ended December 31, 2013, and 46.2% for the comparable six month period in 2013. The cremation rate for our acquired funeral home businesses was 46.3% for the first six months of 2014 compared to 49.6% for the comparable six month period in 2013. Cemetery operating results are affected by the size and success of our sales organization. Approximately 48.0% of our cemetery revenues for the year ended December 31, 2013 related to preneed sales of interment rights and related merchandise and services. For the six months ended June 30, 2014, those preneed sales were approximately 48.8% of total cemetery revenues. We believe that changes in the economy and consumer confidence affect the amount of preneed cemetery revenues. Cemetery revenues from investment earnings on trust funds were approximately $3.9 million, or 14.8%, of total cemetery revenues for the six months ended June 30, 2014, down from $4.3 million, or 16.7%, of total cemetery revenues for the six months ended June 30, 2013. Changes in the capital markets and interest rates affect this component of our cemetery revenues. Our cemetery financial performance from 2010 through 2013 was characterized by increasing levels of operating revenues and field-level profit margins. Cemetery operating revenue increased from $37.8 million in 2010 to $40.5 million in 2013. Our goal is to build broader and deeper teams of sales leaders and counselors in our larger and more strategically located cemeteries in order to focus on the growth of our preneed property sales. Additionally, a portion of our capital expenditures in 2014 is designated to expand our cemetery product offerings. Financial Revenue We market funeral and cemetery services and products on a preneed basis. Preneed funeral or cemetery contracts enable families to establish, in advance, the type of service to be performed, the products to be used and the cost of such products and services. Preneed contracts permit families to eliminate issues of making deathcare plans at the time of need and allow input from other family members before the death occurs. We guarantee the price and performance of the preneed contracts to the customer. Preneed funeral contracts are usually paid on an installment basis. The performance of preneed funeral contracts is usually secured by placing the funds collected in trust for the benefit of the customer or by the purchase of a life insurance policy, the proceeds of which will pay for such services at the time of need. Insurance policies, intended to fund preneed funeral contracts, cover the original contract price and generally include an element of growth (earnings) designed to offset future inflationary cost increases. Revenue from preneed funeral contracts, along with accumulated earnings, is not recognized until the time the funeral service is performed. The accumulated earnings from the trust investments and insurance policies are intended to offset the inflation in funeral prices. Additionally, we generally earn a commission from the insurance company from the sale of insurance-funded policies reflected as Preneed Insurance Funeral Commission within Funeral Revenue. The commission income is recognized as revenue when the period of refund expires (generally one year), which helps us defray the costs we incur to originate the preneed contract (primarily commissions we pay to our sales counselors). Preneed sales of cemetery interment rights are usually financed through interest-bearing installment sales contracts, generally with terms of up to five years with such earnings reflected as Preneed Cemetery Finance Charges within Cemetery Revenue. In substantially all cases, we receive an initial down payment at the time the contract is signed. If an interest-bearing installment contract is paid in full within one year, Preneed Cemetery Finance Charges are reduced by any accrued finance charges related to the contract. We have established a variety of trusts in connection with funeral home and cemetery operations as required under applicable state laws. Such trusts include (i) preneed funeral trusts; (ii) preneed cemetery merchandise and service trusts; and (iii) perpetual care trusts. These trusts are typically administered by independent financial institutions selected by us. Investment management and advisory services are provided either by our wholly-owned registered investment advisor (CSV RIA) or independent financial advisors. As of June 30, 2014, CSV RIA provided these services to two institutions, which have custody of 79% of our trust assets, for a fee based on the market value of trust assets. Under state trust laws, we are allowed to charge the trust a fee for advising on the investment of the trust assets and these fees are recognized as income as the advisory - 38 -



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services are provided. The investment advisors establish an investment policy that gives guidance on asset allocation, investment requirements, investment manager selection and performance monitoring. The investment objectives are tailored to generate long-term investment returns without assuming undue risk, while ensuring the management of the assets is in compliance with applicable laws. Applicable state laws generally require us to deposit a specified amount (which varies from state to state, generally 50% to 100% of the selling price) into a merchandise and service trust fund for preneed cemetery merchandise and service sales. The related trust fund income earned is recognized when the related merchandise and services are delivered. In most states, regulations require a portion (generally 10%) of the sale amount of cemetery property and memorials to be placed in a perpetual care trust. The income from perpetual care trusts provides a portion of the funds necessary to maintain cemetery property and memorials in perpetuity. Perpetual care trust fund income is recognized, as earned, in our cemetery revenues. Acquisitions Our growth strategy includes the execution of our Strategic Acquisition Model. We assess the strategic positioning of acquisition candidates based on the size of the business, competitive standing in the market (market share), market size, market demographics, client family revenue profile (customer preferences), barriers to entry, institutional strength of the brand, and long term volume and price trends. Acquisition candidates are prequalified using our Standards Operating Model and 4E Leadership Model to determine alignment with our operating strategy. The value of the acquisition candidates is based on local market competitive dynamic which allows for appropriate and differentiating enterprise valuations and flexibility to customize the transactions. In general terms, should a target business be acceptable per the criteria above, we will then determine the value of the target using a discounted cash flow methodology. In May 2014, we acquired six businesses from certain subsidiaries of Service Corporation International ("SCI"). We acquired four businesses in New Orleans, Louisiana, consisting of four funeral homes, one of which was a combination funeral home and cemetery, and two funeral home businesses in Alexandria, Virginia (collectively the "SCI Acquisition") for a total of $54.9 million. The impact of the SCI Acquisition on our operations is described more fully below under "Results of Operations." During the six months ended June 30, 2013, we purchased land for approximately $6.0 million to be used for funeral home expansions. Financial Highlights Net income from continuing operations for the three months ended June 30, 2014 totaled $3.9 million, equal to $0.21 per diluted share, compared to net income from continuing operations of $3.6 million, equal to $0.20 per diluted share for the three months ended June 30, 2013. Net income from continuing operations for the three months ended June 30, 2014 included a loss of approximately $1.0 million on the early extinguishment of debt related to the fifth amendment to our Credit Facility which became effective in connection with our acquisition of six businesses from SCI in May 2014. Additionally, we recognized $0.7 million related to the accretion of the discount on our convertible subordinated notes issued in March 2014. Net income from continuing operations for the six months ended June 30, 2014 totaled $5.5 million, equal to $0.30 per diluted share, compared to net income from continuing operations of $9.0 million, equal to $0.46 per diluted share, for the six months ended June 30, 2013. Net income from continuing operations for the six months ended June 30, 2014 included a loss of approximately $1.0 million on the early extinguishment of debt related to the fifth amendment to our Credit Facility which became effective in connection with our acquisition of six businesses from SCI in May 2014, a loss of approximately $3.8 million on the redemption of our convertible junior subordinated debentures and $0.9 million related to the accretion of the discount on our convertible subordinated notes issued in March 2014. Additionally, we recognized a gain of $1.1 million in connection with the purchase of a funeral home building previously leased under a capital lease. Total revenue for the three and six months ended June 30, 2014 was $56.5 million and $112.2 million, respectively, an increase of 5.0% and 1.1%, respectively, from the comparable periods in 2013. Our funeral segment experienced an increase in revenue and gross profit during the three and six months ended June 30, 2014 as compared to the same period of 2013 as a result of the SCI Acquisition. Our cemetery segment experienced an increase in revenue and gross profit during the three and six months ended June 30, 2014 due to the higher preneed property sales and at-need property and merchandise and services sales as well as an increase in acquisition contracts due to the SCI Acquisition. For the three months ended June 30, 2014, we experienced a decrease in general and administrative expenses due to decreases in severance costs, incentive compensation and consulting costs. For the six months ended June 30, 2014, we experienced an increase in general and administrative expenses due to increases in incentive compensation, stock-based compensation, acquisition and divestiture expenses and severance costs. We also present our financial performance in our "Operating and Financial Trend Report" ("Trend Report") as reported in our earnings release and discussed on our earnings call for the quarter ending June 30, 2014. This Trend Report is used as a supplemental financial measurement statement by management and investors to compare our current financial performance with our previous results and with the performance of other deathcare companies. The Trend Report is a Non-GAAP statement from continuing operations that also provides insight into underlying trends in our business. We do not intend for this - 39 -



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information to be considered in isolation or as a substitute for other measures of performance prepared in accordance with GAAP. The Non-GAAP financial measures in the Trend Report include such measures as "Adjusted Net Income," "Adjusted Basic Earnings Per Share," "Adjusted Diluted Earnings Per Share," "Consolidated EBITDA," "Adjusted Consolidated EBITDA," "Funeral, Cemetery and Financial EBITDA," "Total Field EBITDA" and "Special Items." These financial measurements are defined as similar GAAP items adjusted for Special Items and are reconciled to GAAP in our earnings release and on the Trend Reports posted on our website (www.carriageservices.com). In addition, our presentation of these measures may not be comparable to similarly titled measures in other companies' reports. We are providing below a reconciliation after tax of net income from continuing operations (a GAAP measure) to Non-GAAP net income (a non-GAAP measure). Non-GAAP net income is defined as net income from continuing operations adjusted for Special Items, including Withdrawable Trust Income, acquisition and divestiture expenses, severance costs and other items in the table below. The adjustment of Special Items in Non-GAAP income allows management to focus on the evaluation of operating performance as it primarily relates to our operating expenses. In certain states, we are allowed to withdraw realized trust earnings prior to delivery from cemetery merchandise and services trusts, which management describes as "Withdrawable Trust Income." The Withdrawable Trust Income, pre-tax, totaled $0.2 million and $0.7 million for the three and six months ended June 30, 2013, respectively, and $0.6 million and $0.8 million for the three and six months ended June 30, 2014, respectively. While the Withdrawable Trust Income is not recognized as revenue in our Consolidated Statements of Operations, it increases cash flow from operations. The Withdrawable Trust Income is treated as a special item in our Non-GAAP net income calculation. For the Three Months Ended June 30, For the Six Months Ended June 30, (In millions) 2013 2014 2013 2014 Net income from continuing operations, as reported $ 3.6 $ 3.9 $ 9.0 $ 5.5 Special items, net of tax at federal statutory rate of 34% Withdrawable trust income 0.1 0.4 0.5 0.5 Acquisition and divestiture expenses 0.1 0.2 0.1 0.6 Severance costs 0.3 0.2 0.4 0.5 Consulting fees 0.2 - 0.2 0.2 Other incentive compensation - - - 0.7 Accretion of discount on convertible subordinated notes - 0.4 - 0.6 Costs related to credit facility 0.2 0.7 0.2 0.7 Loss on redemption of convertible junior subordinated debentures - - - 2.5 Gain on asset purchase - - - (0.7 ) Other special items 0.1 - (0.5 ) 0.4 Tax adjustment from prior period - - 0.6 - Non-GAAP net income $ 4.6 $ 5.8 $ 10.5 $ 11.5 OVERVIEW OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of the Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate estimates and judgments, including those related to revenue recognition, realization of accounts receivable, inventories, goodwill, other intangible assets, property and equipment and deferred tax assets and liabilities. We base our estimates on historical experience, third party data and assumptions that we believe to be reasonable under the circumstances. The results of these considerations form the basis for making judgments about the amount and timing of revenues and expenses, the carrying value of assets and the recorded amounts of liabilities. Actual results may differ from these estimates and such estimates may change if the underlying conditions or assumptions change. Historical performance should not be viewed as indicative of future performance because there can be no assurance that our results of operations will be consistent from year to year. Management's discussion and analysis of financial condition and results of operations ("MD&A") is based upon our Consolidated Financial Statements presented herewith, which have been prepared in accordance with accounting principles generally accepted in the United States. Our significant accounting policies are more fully described in Note 1 to our - 40 -



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Consolidated Financial Statements included in this Form 10-Q. Our critical accounting policies are those that are both important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective and complex judgment. These critical accounting policies are discussed in MD&A in our Annual Report on Form 10-K for the year ended December 31, 2013. There have been no significant changes to our critical accounting policies since the filing of our Annual Report on Form 10-K for the year ended December 31, 2013. RECENT DEVELOPMENTS On April 14, 2014, we entered into a fifth amendment to our Credit Facility (the "Fifth Amendment"), which provided for an increase in our revolving credit facility from $125 million to $200 million and new funding under our term loan whereby $125 million became outstanding upon effectiveness of the Fifth Amendment. The Fifth Amendment became effective upon the closing of the SCI Acquisition on May 15, 2014. Borrowings under the term loan facility are subject to installment payments of 7.5% of the principal amount in the first two years following the effective date, 10.0% for the third and fourth years following the effective date and 12.5% per year thereafter with the balance payable upon maturity on March 31, 2019. Installment payments are made quarterly beginning September 30, 2014. The Fifth Amendment also modified our financial covenants so that we must maintain a leverage ratio of 3.75 to 1.00 through March 30, 2015 and 3.50 to 1.00 thereafter. In connection with the Fifth Amendment, we recognized a loss of $1.0 million to write-off the related unamortized deferred loan costs. On May 15, 2014, we completed the acquisition of six businesses from certain subsidiaries of SCI. We acquired four businesses in New Orleans, Louisiana, consisting of four funeral homes, one of which was a combination funeral home and cemetery, and two funeral businesses in Alexandria, Virginia for a total of $54.9 million. The assets and liabilities were recorded at fair value and included goodwill of $33.8 million. We acquired substantially all of the assets and assumed certain operating liabilities. The pro forma impact of the acquisition on the prior periods is not presented as the impact is not material to our reported results. The results of the acquired businesses are included in our results of operations from the date of acquisition. RESULTS OF OPERATIONS The following is a discussion of our results of continuing operations for the three and six months ended June 30, 2013 and 2014. The term "same store" or "existing operations" refers to funeral homes and cemeteries acquired prior to January 1, 2010 and operated for the entirety of each period being presented. Funeral homes and cemeteries purchased after December 31, 2009 are referred to as "acquired." This classification of acquisitions has been important to management and investors in monitoring the results of these businesses and to gauge the leveraging performance contribution that a selective acquisition program can have on total company performance. Depreciation and amortization and regional and unallocated funeral and cemetery costs are not included in operating profit. - 41 -



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Funeral Home Segment. The following tables set forth certain information regarding the revenues and operating profit from our funeral home operations for the three months ended June 30, 2013 compared to the three months ended June 30, 2014. Three months ended June 30, 2013 compared to three months ended June 30, 2014 (dollars in thousands): Three Months Ended June 30, Change 2013 2014 Amount % Revenues: Same store operating revenue $ 29,612$ 29,163$ (449 ) (1.5 )% Acquired operating revenue 8,121 10,657 2,536 31.2 % Preneed funeral insurance commissions 481 563 82 17.0 % Preneed funeral trust earnings 2,222 1,809 (413 ) (18.6 )% Total $ 40,436$ 42,192$ 1,756 4.3 % Operating profit: Same store operating profit $ 11,344$ 10,388$ (956 ) (8.4 )% Acquired operating profit 2,432 3,632 1,200 49.3 % Preneed funeral insurance commissions 165 282 117 70.9 % Preneed funeral trust earnings 2,208 1,797 (411 ) (18.6 )% Total $ 16,149$ 16,099$ (50 ) (0.3 )% Funeral home same store operating revenues for the three months ended June 30, 2014 decreased $0.4 million, or 1.5%, when compared to the three months ended June 30, 2013. Same store operating contracts decreased 1.1%, from 5,624 in the second quarter of 2013 to 5,564 in the second quarter of 2014, and the average revenue per contract decreased slightly from $5,506 in the second quarter of 2013 to $5,500 in the second quarter of 2014. The average revenue per contract includes the impact of the funeral trust fund earnings recognized at the time that we provide the services pursuant to the preneed contract. Excluding funeral trust earnings, the average revenue per contract decreased $24 from $5,265 for the three months ended June 30, 2013 to $5,241 for the three months ended June 30, 2014. The number of traditional burial contracts decreased 4.8%, while the average revenue per burial contract increased 2.7% from $8,339 in 2013 to $8,565 in 2014. The cremation rate for same store businesses increased from 46.5% in the second quarter of 2013 to 47.3% in the second quarter of 2014 and the number of cremation contracts increased slightly from 2,616 in the second quarter of 2013 to 2,634 in the same period of 2014. The average revenue per same store cremation contract increased 1.3% to $3,115. Cremations with services increased from 32.6% of total cremation contracts in the second quarter of 2013 to 33.3% in the second quarter of 2014. The average revenue for "other" contracts, which are charges for merchandise or services for which we do not perform a funeral service and which made up approximately 7.6% of the total number of contracts in the second quarter of 2014, decreased from $2,625 in 2013 to $2,222 in 2014. Same store operating profit for the three months ended June 30, 2014 decreased $1.0 million, or 8.4%, from the comparable three months of 2013 and, as a percentage of funeral same store operating revenue, decreased from 38.3% in 2013 to 35.6% in 2014. The decrease in operating profit is primarily the result of the decrease in revenue, an increase in bad debt expense and non-recurring favorable adjustments to operating expenses in 2013 that did not occur in 2014. Funeral home acquired revenues for the three months ended June 30, 2014 increased $2.5 million, or 31.2%, when compared to the three months ended June 30, 2013, as we experienced a 25.0% increase in the number of contracts, and an increase of 5.7%, to $5,366, in the average revenue per contract for those acquired operations. Acquired revenues for the three months ended June 30, 2014 include approximately $1.3 million of revenue contributed by the funeral homes acquired from SCI in May 2014. Excluding funeral trust earnings, the average revenue per contract increased 5.0% to $5,242 in 2014. The number of traditional burial contracts increased 36.7%, and the average revenue per burial contract increased 2.5% to $8,175. The cremation rate for the acquired businesses was 50.7% in the second quarter of 2013 compared to 46.5% for the second quarter of 2014. The average revenue per cremation contract increased 3.7% to $3,227 for the second quarter of 2014 and the number of cremation contracts increased from 824 in the second quarter of 2013 to 945 in the second quarter of 2014, a 14.7% increase. Cremations with services increased from 35.1% in the three months ended June 30, 2013 to 35.7% for the three months ended June 30, 2014. The increase in the average revenue per contract for acquired operations and the decline in the cremation rate is because the newly acquired businesses serve primarily traditional burial families. Acquired operating profit for the three months ended June 30, 2014 increased $1.2 million, or 49.3%, from the comparable three months of 2013 and, as a percentage of revenue from acquired businesses, was 34.1% for the second quarter - 42 -



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of 2014 compared to 29.9% for the first quarter of 2013. Acquired operating profit for the three months ended June 30, 2014 includes approximately $0.6 million of operating profit contributed from the funeral homes acquired from SCI in May 2014. Salaries and benefits of acquired operations, as a percentage of revenue, are generally higher as a percentage of revenue than existing locations. As these acquired businesses transition into our Standards Operating Model, we expect to see operating profit margins rise toward those on a same store basis. The two categories of financial revenue (insurance commissions and trust earnings on matured preneed contracts) on a combined basis decreased 12.2% in revenue and 12.4% in operating profit in the three months ended June 30, 2014 as compared to the three months ended June 30, 2013 as a result of lower earnings on trust contracts. Trust earnings also include trust management fees charged by our wholly-owned registered investment advisor based on the fair market value of the trust assets. Six months ended June 30, 2013 compared to six months ended June 30, 2014 (dollars in thousands): Six Months Ended June 30, Change 2013 2014 Amount % Revenues: Same store operating revenue $ 63,103$ 60,469$ (2,634 ) (4.2 )% Acquired operating revenue 17,267 20,836 3,569 20.7 % Preneed funeral insurance commissions 989 1,127 138 14.0 % Preneed funeral trust earnings 3,936 3,725 (211 ) (5.4 )% Total $ 85,295$ 86,157$ 862 1.0 % Operating profit: Same store operating profit $ 24,999$ 22,471$ (2,528 ) (10.1 )% Acquired operating profit 5,645 7,405 1,760 31.2 % Preneed funeral insurance commissions 280 599 319 113.9 % Preneed funeral trust earnings 3,908 3,706 (202 ) (5.2 )% Total $ 34,832$ 34,181$ (651 ) (1.9 )% Funeral home same store operating revenues for the six months ended June 30, 2014 decreased $2.6 million, or 4.2%, when compared to the six months ended June 30, 2013. Same store operating contracts decreased 3.7% from 12,025 in the six months ended of June 30, 2013 to 11,576 in the six months ended June 30, 2014, while the average revenue per contract remained flat at $5,485 for both periods. The average revenue per contract includes the impact of the funeral trust fund earnings recognized at the time that we provide the services pursuant to the preneed contract. Excluding funeral trust earnings, the average revenue per contract decreased $24 from $5,248 for the six months ended June 30, 2013 to $5,224 for the six months ended June 30, 2014. The number of traditional burial contracts decreased 7.1%, while the average revenue per burial contract increased 2.8% from $8,310 in 2013 to $8,544 in 2014. The cremation rate for same store businesses increased from 46.2% in 2013 to 47.0% in 2014, while the number of cremation contracts decreased 2.0% from 5,552 in 2013 to 5,443 in 2014. The average revenue per same store cremation contract remained flat for both year to date periods. Cremations with services declined from 33.0% of total cremation contracts in the first six months of 2013 to 32.3% in the first six months of 2014. The average revenue for "other" contracts, which are charges for merchandise or services for which we do not perform a funeral service and which made up approximately 7.6% of the total number of contracts in the first six months of 2014, decreased 7.8% to $2,196. Same store operating profit for the six months ended June 30, 2014 decreased $2.5 million, or 10.1%, from the comparable six months of 2013 and, as a percentage of funeral same store operating revenue, decreased from 39.6% in 2013 to 37.2% in 2014. The decrease in operating profit is primarily the result of the decrease in revenue, an increase in bad debt expense and non-recurring favorable adjustments to operating expenses in 2013 that did not occur in 2014. Funeral home acquired revenues for the six months ended June 30, 2014 increased $3.6 million, or 20.7%, when compared to the six months ended June 30, 2013, as we experienced a 14.7% increase in the number of contracts, and an increase of 6.0%, to $5,333, in the average revenue per contract for those acquired operations. Acquired revenues for the six months ended June 30, 2014 include approximately $1.3 million of revenue contributed by the funeral homes acquired from SCI in May 2014. Excluding funeral trust earnings, the average revenue per contract increased 5.2% to $5,214. The number of traditional burial contracts increased 22.7%, and the average revenue per burial contract increased 4.7% to $8,145. The cremation rate for the acquired businesses was 49.6% in the first six months of 2013 compared to 46.3% for the first six months - 43 -



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of 2014. The average revenue per cremation contract increased 2.8% to $3,166 for the first six months of 2014, and the number of cremation contracts increased 6.9% to 1,849. The increase in the average revenue per contract for acquired operations and the decline in the cremation rate is because the newly acquired businesses serve primarily traditional burial families. Cremations with services decreased from 35.1% in the six months ended June 30, 2013 to 34.5% for the six months ended June 30, 2014. Acquired operating profit for the six months ended June 30, 2014 increased $1.8 million, or 31.2%, from the comparable six months of 2013 and, as a percentage of revenue from acquired businesses, was 32.7% for the first six months of 2013 compared to 35.5% for the first six months of 2014. Acquired operating profit for the six months ended June 30, 2014 includes approximately $0.6 million of operating profit contributed from the funeral homes acquired from SCI in May 2014. Salaries and benefits of acquired operations, as a percentage of revenue, are generally higher as a percentage of revenue than same store locations. As these acquired businesses transition into our Standards Operating Model, we expect to see operating profit margins rise toward those on a same store basis. The two categories of financial revenue (insurance commissions and trust earnings on matured preneed contracts) on a combined basis decreased 1.5% in revenue primarily due to lower earnings on trust contracts. Operating profit for the two categories of financial revenue on a combined basis increased 2.8% in the six months ended June 30, 2014 as compared to the six months ended June 30, 2013 as a result of lower preneed commission costs and preneed promotional expenses. Trust earnings also include trust management fees charged by our wholly-owned registered investment advisor based on the fair market value of the trust assets. Cemetery Segment. The following tables set forth certain information regarding the revenues and operating profit from the cemetery operations for the three months ended June 30, 2013 compared to the three months ended June 30, 2014. Three months ended June 30, 2013 compared to three months ended June 30, 2014 (dollars in thousands): Three Months Ended June 30, Change 2013 2014 Amount % Revenues: Same store operating revenue $ 10,827$ 11,382$ 555 5.1 % Acquired operating revenue 74 334 260 351.4 % Cemetery trust earnings 2,086 2,276 190 9.1 % Preneed cemetery finance charges 388 320 (68 ) (17.5 )% Total $ 13,375$ 14,312$ 937 7.0 % Operating profit: Same store operating profit $ 3,329$ 3,568$ 239 7.2 % Acquired operating (loss) profit (19 ) 134 153 n/a Cemetery trust earnings 2,040 2,236 196 9.6 % Preneed cemetery finance charges 388 320 (68 ) (17.5 )% Total $ 5,738$ 6,258$ 520 9.1 % Cemetery same store operating revenues for the three months ended June 30, 2014 increased $0.6 million, or 5.1%, from $10.8 million for the three months ended June 30, 2013 to $11.4 million for the three months ended June 30, 2014. Preneed property sales increased $0.3 million, or 4.5%. We experienced a 7.6% increase in the number of preened interment rights (property) sold, while the average price per interment increased 1.2% to $2,876. The percentage of those preneed interment rights sold that we were able to recognize as revenue, because we received at least 10% of the sales price from the customer, decreased from 94.3% in the three months ended June 30, 2013 to 92.0% in the three months ended June 30, 2014. Revenue from deliveries of preneed merchandise and services increased 1.8% to $1.1 million for the three months ended June 30, 2014. Same store at-need revenue increased $0.3 million, or 7.4%, and the number of at-need contracts increased 3.4%. Cemetery same store operating profit for the three months ended June 30, 2014 increased $0.2 million, or 7.2%. The increase in cemetery same store operating profit was a result of the increase in revenue offset, in part, by an increase in promotional costs and bad debt expense. As a percentage of revenues, cemetery same store operating profit increased from 30.7% in 2013 to 31.3% in 2014. - 44 -



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Cemetery acquired revenue and acquired operating profit increased in 2014 due to the cemetery acquired from SCI in May 2014 which contributed $0.3 million in revenue and $0.1 million in operating profit. The two categories of financial revenue consist of trust earnings and finance charges on preneed receivables. Total trust earnings for the three months ended June 30, 2014 increased 9.1% when compared to the three months ended June 30, 2013. Earnings from perpetual care trust funds totaled approximately $1.6 million for the three months ended June 30, 2013 and 2014. Trust earnings recognized upon the delivery of merchandise and service contracts increased 21.4% to $0.4 million from the same period in 2013. Trust earnings also include trust management fees charged by our wholly-owned registered investment advisor based on the fair market value of the trust assets. Finance charges on the preneed contracts decreased 17.5% due to the reversal of approximately $0.1 million of finance charges previously accrued on contracts that were paid within one year of the contract date. Six months ended June 30, 2013 compared to six months ended June 30, 2014 (dollars in thousands): Six Months Ended June 30, Change 2013 2014 Amount % Revenues: Same store operating revenue $ 20,518$ 21,094$ 576 2.8 % Acquired operating revenue 143 389 246 172.0 % Cemetery trust earnings 4,280 3,860 (420 ) (9.8 )% Preneed cemetery finance charges 698 657 (41 ) (5.9 )% Total $ 25,639$ 26,000$ 361 1.4 % Operating profit: Same store operating profit $ 6,349$ 6,408$ 59 0.9 % Acquired operating (loss) profit (46 ) 125 171 n/a Cemetery trust earnings 4,186 3,797 (389 ) (9.3



)%

Preneed cemetery finance charges 698 657 (41 ) (5.9 )% Total

$ 11,187$ 10,987$ (200 ) (1.8 )% Cemetery same store operating revenues for the six months ended June 30, 2014 increased $0.6 million, or 2.8%, when compared to the six months ended June 30, 2013. Preneed property sales remained flat at approximately $10.3 million for the six months ended June 30, 2013 and 2014. We experienced a 1.3% increase in the number of preened interment rights (property) sold and the average price per interment increased 0.9% to $2,793. The percentage of those interment rights sold that we were able to recognize as revenue, because we received at least 10% of the sales price from the customer, decreased from 93.3% in the six months ended June 30, 2013 to 91.6% in the six months ended June 30, 2014. Revenue from deliveries of preneed merchandise and services declined $0.1 million, or 6.2% in 2014 as compared to 2013. Same store at-need revenue increased $0.7 million, or 8.4%, and the number of at-need contracts increased 0.2%. Cemetery same store operating profit for the six months ended June 30, 2014 increased 0.9% from $6,349 for the six months ended June 30, 2013 to $6,408 for the six months ended June 30, 2014. The increase in cemetery same store operating profit was due to the increase in cemetery same store revenue offset by an increase in promotional costs and bad debt expense. As a percentage of revenues, cemetery same store operating profit was 30.9% and 30.4% for the six months ended June 30, 2013 and 2014, respectively. Cemetery acquired revenue and acquired operating profit increased in 2014 due to the cemetery acquired from SCI in May 2014 which contributed $0.3 million in revenue and $0.1 million in operating profit. The two categories of financial revenue consist of trust earnings and finance charges on preneed receivables. Total trust earnings for the six months ended June 30, 2014 decreased 9.8% when compared to the six months ended June 30, 2013. Earnings from perpetual care trust funds totaled $3.2 million for the six months ended June 30, 2013, compared to $2.6 million for the six months ended June 30, 2014, a decrease of $0.6 million, or 17.8%. Trust earnings recognized upon the delivery of merchandise and service contracts increased 1.5% in the six months ended June 30, 2014 compared to the same period in 2013. Trust earnings also include trust management fees charged by our wholly-owned registered investment advisor based on the fair market value of the trust assets. Finance charges on the preneed contracts decreased 5.9%. - 45 -



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Regional and Unallocated Funeral and Cemetery Costs. Regional and unallocated funeral and cemetery costs for the three months ended June 30, 2014 decreased $0.6 million, or 26.8%, compared to the three months ended June 30, 2013 primarily due to a $0.8 million decrease in incentive compensation for field management and their employees, offset in part, by an increase of $0.3 million in severance and legal costs and expenses associated with regional training. Regional and unallocated funeral and cemetery costs for the six months ended June 30, 2014 decreased $1.0 million, or 19.7%, compared to the six months ended June 30, 2013 primarily due to a $0.3 million decrease in regional management salaries and benefits and a $0.9 million decrease in incentive compensation for field management and their employees offset, in part, by a $0.2 million increase in costs related to legal expenses and expenses associated with regional training. General and Administrative. General and administrative expenses totaled $6.8 million for the three months ended June 30, 2014, a decrease of $0.2 million, or 3.2%, compared to the three months ended June 30, 2013 primarily due to a $0.7 million decrease in costs related to consulting and severance expenses, salaries and benefits, and incentive compensation. These decreases were offset, in part, by a $0.3 million increase in stock-based compensation and a $0.2 million increase in divestiture and acquisition expenses. General and administrative expenses totaled $16.2 million for the six months ended June 30, 2014, an increase of $2.8 million, or 21.1%, compared to the six months ended June 30, 2013 primarily due to an increase of $0.6 million in incentive compensation, a $1.1 million increase in stock-based compensation, a $0.9 million increase in acquisition and divestiture expenses and a $0.2 million increase in severance costs. Interest Expense. Interest expense, net was $3.7 million and $2.7 million for the three months ended June 30, 2013 and 2014, respectively, and $6.3 million and $5.5 million for the six months ended June 30, 2013 and 2014, respectively. Interest expense decreased as a result of our new convertible subordinated notes issued in May 2014 which have a fixed interest rate of 2.75% compared to our junior convertible subordinated notes which had an interest rate of 7%. Additionally, the Third Amendment to the Credit Facility, completed in the second quarter of 2013, lowered our interest rate by 50 basis points. Accretion of Discount on Convertible Subordinated Notes. For the three and six months ended June 30, 2014, we recognized accretion of the discount on our convertible subordinated notes issued in March 2014 of $0.7 million and $0.9 million, respectively. Accretion is calculated using the effective interest method based on a stated interest rate of 6.75%. Loss on Early Extinguishment of Debt. In April 2014, we entered into the Fifth Amendment to our Credit Facility. As a result, we recognized a loss of $1.0 million to write-off the related unamortized deferred loan costs. Loss on redemption of convertible subordinated debentures. On March 17, 2014, we called for the redemption of all our outstanding convertible junior subordinated debentures due 2029 held by Carriage Services Capital Trust and the corresponding TIDES at a price $50 per $50 principal amount of the convertible junior subordinated debentures being redeemed, plus accrued and unpaid interest to the redemption date. As of April 16, 2014, all of the TIDES had been redeemed. For the six months ended June 30, 2014, we recognized a total loss of $3.8 million as a result of the write-off of the related unamortized debt issuance costs of $2.9 million and $0.9 million for the premium paid on the convertible junior subordinated debentures redeemed. Other Income. For the six months ended June 30, 2014, we recognized a gain of $1.1 million in connection with the purchase of a funeral home building previously leased under a capital lease. Income Taxes. We recorded income taxes at the estimated effective rate of 37.9% for the year ended December 31, 2013 and 39.0% for the first six months ended June 30, 2014. We have approximately $48.0 million of state net operating loss carry forwards that will expire between 2015 and 2035, if not utilized. Based on management's assessment of the various state net operating losses, it has been determined that it is more likely than not that we will not be able to realize the tax benefits of certain portions of the state losses. Accordingly, a valuation allowance has been established and is reviewed every quarter related to the deferred tax asset for the state operating losses. At June 30, 2014, the valuation allowance totaled $0.3 million. - 46 -



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LIQUIDITY AND CAPITAL RESOURCES Our primary sources of liquidity and capital resources are internally generated cash flows from operating activities and availability under our Credit Facility (as defined below under Debt Obligations). We generate cash in our operations primarily from at-need sales and delivery of preneed sales. We also generate cash from earnings on our cemetery perpetual care trusts. We believe that existing cash balances, future cash flows from operations and borrowings under our Credit Facility will be sufficient to meet our anticipated working capital requirements, capital expenditures, scheduled debt payments, commitments, dividend payments and acquisitions for the foreseeable future. Based on our recent operating results, current cash position, anticipated future cash flows and sources of financing that we expect to have available, we do not anticipate any significant liquidity constraints in the foreseeable future. However, if our capital expenditures or acquisition plans for 2014 change, we may need to access the capital markets to obtain additional funding. Further, to the extent operating cash flow or access to and cost of financing sources are materially different than expected, future liquidity may be adversely affected. Please read Part I, Item IA "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2013. We intend to use cash on hand and borrowing under our Credit Facility primarily to acquire funeral home and cemetery businesses and for internal growth projects, such as cemetery inventory development and funeral home expansion projects. We have the ability to draw on our revolving credit facility, subject to customary terms and conditions of the credit agreement. We believe that existing cash balances, future cash flows from operations and the borrowing under our Credit Facility described above will be sufficient to meet our anticipated working capital requirements, capital expenditures, scheduled debt payments, commitments, dividends and acquisitions for the foreseeable future. Cash Flows We began 2014 with $1.4 million in cash and other liquid investments and ended the second quarter with $0.7 million in cash. As of June 30, 2014, we had borrowings of $42.4 million outstanding on our revolving credit facility. The following table sets forth the elements of cash flow for the six months ended June 30, 2013 and June 30, 2014 (in millions):


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