SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ý                 Annual Report Pursuant To Section 13 Or 15(d) Of The Securities Exchange Act Of 1934

For The Fiscal Year Ended December 31, 2004

o                 Transition Report Pursuant To Section 13 Or 15(d) Of The Securities Exchange Act Of 1934

Commission File Number: 1-11961

CARRIAGE SERVICES, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (713) 332-8400

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ý

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934. 

Yes o No ý

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2004 was approximately $74.93 million based on the closing price of $5.04 per share on the New York Stock Exchange.

The number of shares of the registrant’s Common Stock, $.01 par value per share outstanding as of March 15, 2005 was 17,969,000.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement to be delivered in connection with the 2005 annual meeting of stockholders are incorporated in Part III of this Report.

CAUTIONARY NOTE

This annual report contains forward-looking statements of our management regarding factors that we believe may affect our performance in the future.  Such statements typically are identified by terms expressing our future expectations or projections of revenues, earnings, earnings per share, cash flow, market share, capital expenditures, effects of operating initiatives, gross profit margin, debt levels, interest costs, tax benefits and other financial items.  All forward-looking statements, although made in good faith, are based on assumptions about future events and are therefore inherently uncertain, and actual results may differ materially from those expected or projected.  Important factors that may cause our actual results to differ materially from expectations or projections include those described under the heading “Forward-Looking Statements” in Item 7.  Forward-looking statements speak only as of the date of this report, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur.

PART I

ITEM 1.  BUSINESS

GENERAL

We are a leading provider of death care services and merchandise in the United States. We operate two types of businesses: funeral homes, which currently account for approximately 75% of our total revenue, and cemeteries, which currently account for approximately 25% of our total revenue. As of December 31, 2004, we operated 135 funeral homes in 28 states and 30 cemeteries in 12 states. For the year ended December 31, 2004, we had revenues of $150.2 million and earnings from continuing operations of $11.0 million. We primarily serve suburban markets and believe we are a market leader (first or second) in most of those markets. We provide funeral and cemetery services and products on both an “at-need” (time of death) and “preneed” (planned prior to death) basis.

Our operations are divided into two business segments:

•                  Funeral Home Operations.  Funeral homes are principally service businesses that provide burial and cremation services and sell related merchandise, such as caskets and urns. Given the high fixed cost structure associated with funeral home operations, we believe the following are key factors affecting our profitability:

•                  favorable demographic trends in terms of 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 packaging complementary services and merchandise;

•                  controlling salary and merchandise costs; and

•                  exercising pricing leverage related to our at-need business to increase average revenues per contract.

•                  Cemetery Operations.  Cemeteries are primarily a sales business that provides interment rights (grave sites and mausoleums) and related merchandise, such as markers and memorials. Our cemetery operating results are impacted by the success of our sales organization because approximately 36% of our cemetery revenues during the year ended December 31, 2004 was generated from preneed sales of interment rights. We believe that changes in the level of consumer confidence (a measure of whether consumers will spend money on discretionary items) also impact the amount of such preneed sales. Cemetery revenues generated from at-need service and merchandise sales generally are subject to many of the same key profitability factors as in our funeral home business. Approximately 8% of our cemetery revenues during the year ended December 31, 2004 was attributable to investment earnings on trust funds and finance charges on installment contracts.

Our business strategy is based on strong, local leadership and entrepreneurial principles that we believe drive market share, revenue growth, and profitability in our local markets. Our operating model emphasizes:

•                  decentralized management of our local businesses;

•                  financial and operational standards based upon drivers of success of our best businesses;

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•                  variable compensation that rewards our funeral home managers as if they are owners;

•                  finding, developing and retaining the best people in our industry; and

•                  information technology designed to support local business and corporate management decisions, measure performance of our businesses against our financial and operational standards, and ensure adherence to established internal control procedures.

Our near-term objectives for 2005 and 2006 include:

•                  continuing to improve our operating and financial performance by executing our “Being the Best” funeral operating model and implementing a similar operating model in our cemetery segment;

•                  increasing our profitability and cash flow, and continuing to improve our credit profile;

•                  initiating a disciplined acquisition program of funeral businesses that match a profile based on our Being the Best standards.

Our longer-term objectives over the next five years include:

•                  continuous improvement and portfolio optimization driven by our Being the Best operating model;

•                  increasing market share and profitability;

•                  formalizing and fully implementing a disciplined acquisition program; and

•                  raising equity proceeds to enhance our capital structure and support our growth strategy as appropriate opportunities arise.

DEATH CARE INDUSTRY

Death care companies provide products and services to families in three principal areas: (i) ceremony and tribute, generally in the form of a funeral or memorial service; (ii) disposition of remains, either through burial or cremation; and (iii) memorialization, generally through monuments, markers or inscriptions. The death care industry in the United States is characterized by the following fundamental attributes:

Death Rates

Death rates in the United States have been relatively stable on a long-term historical basis. The number of deaths in the United States increased at an annual rate of approximately 1% for the period from 1980 to 2000. From 2001 to 2003, death rates deviated from this long-term trend by declining year-over-year for a three-year period, which is the first time year-over-year declines occurred since the mid-1970s. The death rate for 2004 was flat compared to 2003.  Despite this recent trend, the number of deaths per year in the United States is expected to increase from 2.4 million in 2004 to 2.6 million in 2010 according to the United States Bureau of the Census. In addition, the segment of the United States population over 65 years of age is expected to increase by over 13% from 34.9 million in 2000 to 39.6 million in 2010.

Cremation

In recent years, there has been a steady, gradual increase in the number of families in the United States that have chosen cremation as an alternative to traditional methods of burial. According to industry studies, cremations represented approximately 10% of the U.S. burial market in 1980 and approximately 28% in 2002. Cremation rates can vary significantly based upon geographic, religious and cultural traditions. Historically, direct cremation has been offered as a less costly alternative to a traditional burial. However, cremation is being increasingly accepted as part of a package of funeral services that includes memorials, merchandise and options for the interment of remains.

Highly Fragmented Ownership

We estimate that there are approximately 22,000 funeral homes and 10,000 cemeteries in the United States, and that the domestic funeral service industry generated approximately $15 billion of revenue in 2003. The four largest public operators of both funeral homes and cemeteries in the United States are Service Corporation International, Alderwoods Group (formerly known as The Loewen Group), Stewart Enterprises, and Carriage Services. We believe these four companies collectively represent approximately 20% of death care revenues in the United States. Independent businesses represent the remaining amount of industry revenue, accounting for an estimated 80% share. During most of the 1990s, there was a trend toward independent firms consolidating with public operators. However, few acquisitions have occurred since 1999 and there have been a number of independent entrants in local markets. As a

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result, the industry continues to be characterized by a large number of locally-owned, independent businesses.

Heritage and Tradition

Death care businesses have traditionally been family-owned businesses that have built a local heritage and tradition through successive generations, providing a foundation for ongoing business opportunities from established client family relationships and related referrals. Given the sensitive nature of our business, we believe that relationships fostered at the local level build trust in the community and are a key driver of market share. While new entrants may enter any given market, the time and resources required to develop local heritage and tradition serve as important barriers to entry.

Deleveraging

Until 1999, the industry experienced consolidation of independent death care businesses by a few large, primarily publicly owned death care consolidators that sought to benefit from economies of scale, improved managerial control, more effective operating strategies and greater financial resources. From 2000 to 2004, these consolidators have been divesting selected properties and other assets, and using proceeds from such dispositions, together with free cash flow, to accelerate debt reduction. We expect the level of dispositions to substantially decline in the near-term and anticipate that some of the public consolidators may resume acquisition programs.

Preneed Marketing

In addition to at-need sales, we and certain other death care providers sell products and services on a preneed basis. Selling products and services on a preneed basis, if properly executed, provides a backlog of future revenue and enhances the heritage and market share of an established funeral home or cemetery. However, preneed sales lock in the revenue from future services at current prices and result in paying certain costs, such as sales commissions, at the time the preneed contract is originated.

BUSINESS STRATEGY

Implement Operating Initiatives

During the last four years, we and the other public consolidators have been restructuring our organizations and improving our financial condition, liquidity and balance sheets by reducing debt. During the second half of 2003, we implemented several significant changes in our funeral organization and operations to improve operating and financial results by growing market share and profitability. On January 1, 2004, we introduced a more decentralized and entrepreneurial financial operating model for our funeral homes. The execution of our Being the Best standards-based funeral operating model has resulted in operational improvements in our funeral segment during 2004. Those operational improvements include, among other things, improved showroom presentation and merchandising, achievement of higher prices per service and improved staffing and cost management.  Key elements of our overall business strategy include the following:

•             Decentralized Funeral Operating Model.  We believe that a decentralized operating model is best suited to grow market share and improve financial performance in the funeral industry. This new operating model focuses on key drivers of a successful funeral business, organized around three primary areas — market share, people, and operational and financial metrics. Successful execution of our new operating model is highly dependent on strong local leadership, entrepreneurial empowerment and corporate support. In order to align this model with financial performance across the organization, we developed a set of customized standards for each funeral business based on the financial results and attributes of our best properties, adjusting for size and percentage of cremations. Our managing partners participate in a variable bonus plan in which they earn a fixed percentage of their business’ earnings based upon the actual standards achieved. Under this new program, we believe our managing partners have the opportunity to be compensated at close to the same level as if they owned the business.

•             Family Service Cemetery Operating Model.  We view our cemetery operations, which traditionally have been more sales-oriented, as a different business from our funeral operations, which are more service-oriented. We are focusing our efforts in our cemetery segment on building heritage among new client families. A principal initiative has been to emphasize property sales, which strengthen the ties between our cemeteries and these clients. We are also in the process of developing a standards-based operating model for our cemeteries. We expect to implement a limited operating model in 2005 and a fully developed standards-based model in 2006.

•             Presentation and Packaging of Services and Merchandise.  We believe packaging funeral services and merchandise offers both simplicity and convenience for our client families. Well-conceived and thoughtful packages eliminate much of the effort and discomfort experienced by client families concerning matters about which they do not have much knowledge during a

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very stressful and emotional time. We have entered into updated arrangements with four primary casket suppliers to support our strategy and control wholesale costs. We also anticipate that our packaging strategy will result in increased revenue per cremation service over time as more families select packages that provide services and merchandise. The percentages of funeral services conducted by us in which cremation was chosen as the manner in which to dispose of remains was 30% for the year ended December 31, 2003 and 31% for the year ended December 31, 2004. For the year ended December 31, 2004, approximately 63% of the number of our total cremation services were direct cremations (where no viewing, visitation, or merchandise is involved, although a memorial service may be held) and 37% included additional services and merchandise.

Preneed Funeral Sales Program.  We operate under a local, decentralized preneed sales strategy whereby each business location customizes its preneed program to its local needs. We emphasize insurance-funded contracts over trusted contracts in most markets, as insurance products allow us to earn commission income to improve our cash flow and offset a significant amount of the up-front costs associated with preneed sales. In addition, the cash flow and earnings from insurance contracts are more stable than traditional trust fund investments. In markets that depend on preneed sales for market share, we supplement the arrangements written by funeral directors with sales sourced by sales counselors and third party sellers.

•             Decrease Overhead Costs.  We periodically perform targeted reviews of our systems and support services with the objective of improving effectiveness and decreasing overhead costs. We recently completed an upgrade of our funeral services system to improve its features and functions and expect to implement a cemetery system in mid-2005. We will continue to review and change corporate processes to improve efficiency and effectiveness.

•             Renewed Corporate Development Efforts.  We believe that our improved capital structure, resulting from the $130 million debt offering in January 2005, position us to pursue a strategy of disciplined growth, affording us the flexibility to redeploy our free cash flow toward selective acquisitions that meet our criteria. We expect to continue to improve our credit profile as we invest our cash flow into businesses that will contribute incremental revenues, earnings and cash flow. We will be applying the standards and practices established under our Being the Best operating model to qualify acquisition candidates, ensuring that they are a proper fit and can be readily integrated into our portfolio. Ideal candidates would be those that are demonstrated market leaders, have strong local management, have owners and family members whose objectives are aligned with ours, and have field-level operating margins consistent with our best performing properties. We will look to geographic areas that complement our existing markets, with a primary focus on suburban markets with growing populations of 100,000 or more, preferably in the Northeast and on the West Coast. We expect to give the most serious consideration to firms with at least 200 to 400 calls annually (or at least $1 million in annual revenue).

•             Improve Credit Profile Through Cash Flow and Debt Reduction. During 2004 we continued our focus on generating cash from our operations, managing capital expenditures and paying down debt to improve our credit profile.  The goal was to reaccess the markets to refinance the long term debt, $76.9 million of which was scheduled to mature in 2006.  Cash from operating activities totaled $24.2 million and capital expenditure totaled $5.7 million, the net of which ($18.5 million) along with proceeds from sales of assets and other items, allowed us to reduce long-term debt by $25 million in 2004.

•             Accessing Capital Markets.  In January 2005 we met our goal of reaccesssing the capital markets by completing an offering of $130 million in senior debt due in 2015 and bears interest of 7.785% per annum.  We used the net proceeds to pay off our senior debt.  This transaction extended the maturity of our senior debt and provides us more financial flexibility.

OUR STRENGTHS

Market Leader in Our Suburban and Rural Markets.  We are the fourth largest publicly traded death care company in the United States. Our operations are located in suburban and rural markets, where we primarily compete with smaller, independent operators with significantly less financial and managerial resources. Most of our suburban markets have populations of 100,000 or more. In over 70% of our funeral home markets, we believe that we are either first or second in local market share.

Partnership Culture.  Our funeral homes and cemeteries are managed by individuals with extensive death care experience, often within their local markets. Our funeral home managing partners have responsibility for day-to-day operations but are required to follow our Being the Best operating and financial standards. This strategy allows each local business to maintain its unique identity within its local market and to capitalize on its reputation and heritage while our senior management maintains supervisory controls and provides support services from our corporate headquarters. We believe our culture will be very attractive to owners of premier independent businesses that fit our profile of suitable acquisition candidates.

Flexible Capital Structure.  We believe that the capital structure we have had in place since mid-1999 has provided us with financial flexibility, which allowed us to focus our efforts on improving operations and our credit profile. Following the successful execution of our debt reduction initiatives using free cash flow primarily to pay down debt, we used the net proceeds from our debt offering in January 2005 to pay off our existing senior debt, which further improves our capital structure and financial flexibility.

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After completion of the offering, we have four primary components in our capital structure:

•                  the $130 million senior notes issued in January 2005 which have a 2015 maturity;

•                  a revolving credit facility, described under the heading “Liquidity and Capital Resources” in Item 7;

•                  our convertible junior subordinated debenture payable to our affiliate trust, which has the ability to defer payments of interest, and a 2029 maturity; and

•                  our common stock.

Stable Cash Flow and Debt Reduction.  Since 2000, we have demonstrated the ability to generate stable cash flow and to repay debt with cash flow from operations and asset sales. We have also demonstrated an ability to manage capital expenditures to a consistent level. We have reduced senior debt and contingent obligations from previous acquisitions by $86.9 million, or 44%, from $197.2 million at December 31, 2000 to $110.3 million at December 31, 2004. Free cash flow (cash flow from operations less capital expenditures) for 2004 totaled $18.5 million, including the $7.0 million benefit from deferring interest payments on the subordinated debenture to affiliate.  We remain committed to using free cash flow to continue to improve our credit profile and to fund a selective growth strategy.

Strong Field-Level Operating Margins.  We believe that our field-level operating margins are among the highest reported by the public companies in the death care industry and that this performance is a testament to the success of our business strategies. These strong margins and the ability to control costs are important advantages in a business such as ours that is characterized by a high fixed-cost structure. We will continue to seek ways to improve our financial performance, and we believe that our standards-based operating model implemented at the beginning of 2004 will continue to yield positive improvement in our financial results.

Effective Management of Funeral Preneed Sales.  We believe our local, decentralized strategy allows us to adapt our preneed sales selectively to best address the competitive situation in our markets. In highly competitive markets, we execute a more aggressive preneed sales program. In less competitive markets where we have a strong market position, we deploy a more passive preneed sales program. In certain of our markets, we do not deploy a formal preneed program. This approach allows us to target the investment in preneed sales to markets where we have the opportunity to reinforce our market share. Because approximately 80% of our revenues are generated from at-need sales, we retain significant pricing leverage in our funeral business.

Integrated Funeral Information Systems.  We have implemented sophisticated information systems to support local business decisions and to monitor performance of our businesses compared to financial and performance standards. All of our funeral homes are connected to our corporate headquarters, which allows us to monitor and assess critical operating and financial data in order to analyze the performance of individual locations on a timely basis. Furthermore, our information system infrastructure provides senior management with a critical tool for monitoring and adhering to our established internal controls, which is critical given our decentralized model and the sensitive nature of our business operations.

Proven Management Team.  Our senior management team, headed by Mel Payne for the last 13 years, is characterized by a dynamic culture that reacts quickly and proactively to address changing market conditions and emerging trends. We believe this culture has been critical to our successful recent efforts and will provide an important advantage as the death care industry evolves. We are committed to continue operating an efficient corporate organization and strengthening our corporate and local business leadership. We believe that our Being the Best operating model will ensure this commitment at all levels of the organization.

OPERATIONS

We conduct our funeral and cemetery operations only in the United States. Our operations are divided into two segments: funeral operations and cemetery operations. Information for each of our segments is presented below and in our financial statements set forth herein.

Funeral Home Operations

At December 31, 2004, we operated 135 funeral homes, including two funeral homes held for sale, in 28 states. Funeral home revenues currently account for approximately 75% of our total revenues. The funeral home operations are managed by a team of experienced death care industry professionals and selected region-level individuals with substantial management experience in service industries. See Note 17 to the consolidated financial statements for the year ended December 31, 2004, for segment data related to funeral home operations.

Our funeral homes offer a complete range of services to meet a family’s funeral needs, including consultation, the removal and preparation of remains, the sale of caskets and related funeral merchandise, the use of funeral home facilities for visitation and

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worship, and transportation services. Most of our funeral homes have a non-denominational chapel on the premises, which permits family visitation and religious services to take place at one location and thereby reduces our transportation costs and inconvenience to the family.

Funeral homes are principally a service business that provides burial and cremation services and sells related merchandise, such as caskets and urns. Given the high fixed cost structure associated with funeral home operations, we believe the following are key factors affecting our profitability:

•             favorable demographic trends in terms of population growth and average age, which impact death rates and number of deaths;

•             leading market share positions supported by strong local heritage and relationships;

•             effectively responding to increasing cremation trends by packaging complementary services and merchandise;

•             controlling salary and merchandise costs; and

•             exercising pricing leverage related to our at-need business to increase average revenues per contract.

Cemetery Operations

As of December 31, 2004, we operated 30 cemeteries, including one cemetery held for sale, in 12 states. The cemetery operations are managed by a team of experienced death care industry and sales professionals. Cemetery revenues currently account for approximately 25% of our total revenues. See Note 17 to the consolidated financial statements for the year ended December 31, 2004, for segment data related to cemetery operations.

Our cemetery products and services include interment services, the rights to interment in cemetery sites (including grave sites, mausoleum crypts and niches) and related cemetery merchandise such as memorials and vaults. Cemetery operations generate revenues through sales of interment rights and memorials, installation fees, fees for interment and cremation services, finance charges from installment sales contracts and investment income from preneed cemetery merchandise and perpetual care trusts.

Cemeteries are primarily a sales business. Our cemetery operating results are impacted by the success of our sales organization because approximately 36% of our cemetery revenues was generated from preneed sales of interment rights during the year ended December 31, 2004. An additional 17% of our 2004 cemetery revenues was from deliveries of merchandise and services previously sold on preneed contracts. We believe that changes in the level of consumer confidence (a measure of whether consumers will spend money on discretionary items) also impact the amount of such preneed sales. Cemetery revenues generated from at-need services and merchandise sales generally are subject to many of the same key profitability factors as in our funeral home business. Approximately 8% of our cemetery revenues was attributable to investment earnings on trust funds and finance charges on installment contracts during the year ended December 31, 2004.

Preneed Programs

In addition to sales of funeral merchandise and services, cemetery interment rights and cemetery merchandise and services at the time of need, we also 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, in accordance with prices prevailing at the time the contract is originated, rather than when the products and services are delivered. Preneed contracts permit families to eliminate issues of making death care plans at the time of need and allow input from other family members before the death occurs.

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, are not recognized until the time the funeral service is performed. 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). Additionally, we generally earn a commission from the insurance company from the sale of insurance-funded policies. The direct marketing commissions and costs incurred from the sale of preneed funeral contracts are deferred and amortized on an actuarial method to match the expected maturity of the preneed contracts.

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In addition to preneed funeral contracts, we also offer “preplanned” funeral arrangements whereby a client determines in advance substantially all of the details of a funeral service without any financial commitment or other obligation on the part of the client until the actual time of need. Preplanned funeral arrangements permit a family to avoid issues of making death care plans at the time of need and enable a funeral home to establish relationships with a client that may eventually lead to an at-need sale.

Preneed sales of cemetery interment rights are usually financed through interest-bearing installment sales contracts, generally with terms of up to five years. We always receive an initial downpayment at the time the contract is signed in substantially all cases. The interest rates generally range between 12% and 14%. Preneed sales of cemetery interment rights are generally recorded as revenue when 10% of the contract amount related to the interment right has been collected. Merchandise and services preneed contracts are also paid on an installment basis, but over a shorter term. Revenue is recorded when delivery has occurred. Costs related to generating the preneed contracts and delivery of the products and services are recognized concurrently with the related revenue. Allowances for customer cancellations and refunds are accrued at the date that the sale is recognized as revenue and periodically evaluated thereafter based upon historical experience.

Carriage sold 5,192 and 4,834 preneed funeral contracts during the years ended December 31, 2003 and 2004, respectively. At December 31, 2004, we had a backlog of 60,504 preneed funeral contracts to be delivered in the future. Approximately 20% of the funeral revenues recognized during each of the last three years and during the twelve months ended December 31, 2004 originated through preneed contracts. Cemetery revenues that originated from preneed contracts represented approximately 50% of Carriage’s net cemetery revenues for both 2003 and 2004.

As of December 31, 2004, we employed a staff of 196 advance-planning and family service representatives for the sale of preneed products and services.

TRUST FUNDS AND INSURANCE CONTRACTS

We have established a variety of trusts in connection with our funeral home and cemetery operations as required under applicable state law. 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. We also use independent financial advisors to consult with us on investment policies and evaluate investment results.

Preneed funeral sales generally require deposits to a trust or purchase of a third-party insurance product. All preneed funeral sales are deferred until the service is performed. The trust fund income earned and any increase in insurance benefits are also deferred until the service is performed, in order to offset possible inflation in cost when providing the service in the future. The related assets and deferred revenue are reflected on Carriage’s balance sheet. In most states, we are not permitted to withdraw principal or investment income from such trusts until the funeral service is performed. Some states, however, allow for the retention of a percentage (generally 10%) of the receipts to offset any administrative and selling expenses, which we defer until the service is provided. The aggregate balance of our preneed funeral contracts held in trust, insurance contracts and receivables from customers was approximately $231 million as of December 31, 2004.

We are generally required under applicable state laws to deposit a specified amount (which varies from state to state, generally 50% to 100% of selling price) into a merchandise and service trust fund for cemetery merchandise and services preneed sales. The related trust fund income earned is recognized when the related merchandise and services are delivered. We are generally permitted to withdraw the trust principal and the accrued income when the merchandise is purchased, when service is provided by us or when the contract is cancelled. The merchandise and service trust fund balances, in the aggregate, totaled approximately $53.1 million as of December 31, 2004.

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 these perpetual care trusts provides the funds necessary to maintain cemetery property and memorials in perpetuity. The trust fund income is recognized, as earned, in cemetery revenues. While we are entitled to withdraw the income from our perpetual care trust to provide for the maintenance of the cemetery property and memorials, we are not entitled to withdraw any of the principal balance of the trust fund. The perpetual care trust balances totaled approximately $31.2 million at December 31, 2004.

For additional information with respect to our trusts, see Note 4 to the consolidated financial statements for the year ended December 31, 2004.

COMPETITION

The operating environment in the death care industry has been highly competitive. Publicly traded companies operating in the United States are Service Corporation International, Alderwoods Group (formerly known as The Loewen Group), Stewart Enterprises, Keystone North America and StoneMor Partners. In addition, a number of smaller, non-public companies have been active in

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acquiring and operating funeral homes and cemeteries.

Our funeral home and cemetery operations usually face competition in the markets that they serve. Our primary competition in most of our markets is from local independent operators. We have observed an increase in new start-up competition in certain areas of the country, which in any one market may have impacted our profitability because of the high fixed cost nature of funeral homes. Market share for funeral homes and cemeteries is largely a function of reputation and heritage, although competitive pricing, professional service and attractive, well-maintained and conveniently located facilities are also important. Because of the importance of reputation and heritage, market share increases are usually gained over a long period of time. The sale of preneed funeral services and cemetery property has increasingly been used by many companies as a marketing tool to build market share.

There has been increasing competition from providers specializing in specific services, such as cremations, who offer minimal service and low-end pricing. We also face competition from companies that market products and related information over the Internet and non-traditional casket stores in certain markets. We have experienced relatively limited impact in our specific markets from these competitors to date.

REGULATION

Our funeral home operations are subject to substantial regulation by the Federal Trade Commission ( the “FTC”), as well as other federal, state and local agencies. Certain regulations contain minimum standards for funeral industry practices, require extensive price and other affirmative disclosures to the customer at the time of sale and impose mandatory itemization requirements for the sale of funeral products and services. The FTC has been reviewing the Trade Rule on Funeral Industry Practices (the “Funeral Rule”), which defines certain acts or practices as unfair or deceptive and contains certain requirements to prevent these acts or practices. At this time, the FTC has not proposed changes to the regulation.  We believe we are in substantial compliance with the Funeral Rule.

We are subject to the requirements of the federal Occupational Safety and Health Act (“OSHA”) and comparable state statutes. The OSHA hazard communication standard, the United States Environmental Protection Agency community right-to-know regulations under Title III of the federal Superfund Amendment and Reauthorization Act and similar state statutes require us to organize information about hazardous materials used or produced in our operations. Certain of this information must be provided to employees, state and local governmental authorities and local citizens.

Our operations, including our preneed sales activities and the management and administration of preneed trust funds, are also subject to regulation, supervision and licensing under state laws and regulations. We believe that we are in substantial compliance with all such laws and regulations.

In accordance with the rules of the New York Stock Exchange, we submitted a Section 12(a) CEO Certification in 2004, which was not qualified in any manner.  In addition, in accordance with the rules, attached as Exhibits 31.1 and 31.2 are our CEO and CFO certifications as required by Section 302 of the Sarbanes-Oxley Act of 2002.

EMPLOYEES

As of December 31, 2004, we and our subsidiaries employed 1,814 employees, of whom 873 were full-time and 941 part-time. All of our funeral directors and embalmers possess licenses required by applicable regulatory agencies. We believe that our relationship with our employees is good. None of our employees or our subsidiaries’ employees is a member of a collective bargaining unit.

AVAILABLE INFORMATION

Our address is www.carriageservices.com. Available on this website under “Investor Relations-Investor Relations Menu – SEC Filings,” free of charge, are Carriage’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, insider reports on Forms 3, 4 and 5 filed on behalf of directors and officers and amendments to those reports as soon as reasonably practicable after such materials are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”).

Also posted on our website, and available in print upon request, are charters for the Company’s Audit Committee, Compensation Committee and Corporate Governance Committee. Copies of the Code of Business Conduct and Ethics and the Corporate Governance Guidelines are also posted on the Company’s website under the “Corporate Governance” section. Within the time period required by the SEC and the New York Stock Exchange, Inc., the Company will post on its website any modifications to the Codes and any waivers applicable to senior officers as defined in the applicable Code, as required by the Sarbanes-Oxley Act of 2002.

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ITEM 2.  PROPERTIES

At December 31, 2004, we operated 135 funeral homes and 30 cemeteries in 28 states. Carriage owns the real estate and buildings for 79% of our funeral homes and leases facilities for the remaining 21%. Carriage owns 25 cemeteries and operates five cemeteries under long-term contracts with municipalities and non-profit organizations at December 31, 2004. Eleven funeral homes are operated in combination with cemeteries. The 30 cemeteries operated by Carriage have an inventory of unsold developed lots totaling approximately 118,000 and 115,000 at December 31, 2003 and 2004, respectively. In addition, approximately 619 acres are available for future development. We anticipate having a sufficient inventory of lots to maintain our property sales for the foreseeable future. The specialized nature of our business requires that our facilities be well-maintained. Management believes this standard is met.

The following table sets forth certain information as of December 31, 2004, regarding Carriage’s properties used by the funeral homes segment and by the cemeteries segment identified by state:

(1)               The leases, with respect to these funeral homes, have remaining terms ranging from one to fifteen years, and, generally, we have the right to renew past the initial terms and a right of first refusal on any proposed sale of the property where these funeral homes are located.

Carriage’s corporate headquarters occupy approximately 32,500 square feet of leased office space in Houston, Texas. At December 31, 2004, we operated 575 vehicles, of which 570 are owned and 5 are leased.

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ITEM 3.  LEGAL PROCEEDINGS

Carriage and our subsidiaries are parties to a number of legal proceedings that arise from time to time 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 adverse effect on the financial statements.

We carry insurance with coverages and coverage limits consistent with our assessment of risks in our business and of an acceptable level of financial exposure. Although there can be no assurance that such insurance will be sufficient to mitigate all damages, claims or contingencies, we believe that our insurance provides reasonable coverage for known asserted or unasserted claims. In the event the Company sustained a loss from a claim and the insurance carrier disputed coverage or coverage limits, the Company may record a charge in a different period than the recovery, if any, from the insurance carrier.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Carriage’s Common Stock is traded on the New York Stock Exchange under the symbol “CSV”. The following table presents the quarterly high and low sale prices as reported by the New York Stock Exchange:

As of March 15, 2005, there were 17,969,000 shares of Carriage’s Common Stock outstanding. The Common Stock shares outstanding are held by approximately 290 stockholders of record. Each share is entitled to one vote on matters requiring the vote of stockholders. We believe there are approximately 5,000 beneficial owners of the Common Stock.

We have never paid a cash dividend on our Common Stock.  Carriage currently intends to retain earnings to fund the growth and development of our business. Any future change in our policy will be made at the discretion of our Board of Directors in light of the financial condition, capital requirements, earnings prospects of Carriage and any limitations imposed by lenders or investors, as well as other factors the Board of Directors may deem relevant.

Carriage has a compensation policy for fees paid to its directors under which our directors may choose to receive director compensation fees either in the form of cash compensation or equity compensation based on the fair market value of our common stock based on the closing price published by the New York Stock Exchange on the date the fees are earned.  On January 12, 2005, Carriage issued 10,288 shares of its common stock to three of its directors who elected to receive their fourth quarter 2004 fees in equity compensation.  No underwriter was used in connection with this issuance.  Carriage relied on the Section 4(2) exemption from the registration requirements of the Securities Act of 1993, as amended.

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ITEM 6.  SELECTED FINANCIAL DATA

The following table sets forth selected consolidated financial information for Carriage that has been derived from the audited consolidated financial statements of Carriage as of and for each of the years ended December 31, 2000, 2001, 2002, 2003, and 2004. These historical results are not necessarily indicative of our future performance.

Our historical financial data included in the table below as of and for the years ended December 31, 2000 and 2001 is derived from our consolidated financial statements audited by Arthur Andersen LLP, independent public accountants, which has ceased operations. The historical financial data included in the table below as of and for the years ended December 31, 2002, 2003 and 2004 is derived from our consolidated financial statements audited by KPMG LLP, independent registered public accounting firm.

We adopted FASB Interpretation No. 46, as revised (“FIN 46R”), “Consolidation of Variable Interest Entities an Interpretation of Accounting Research Bulletin (ARB) No. 51” as of March 31, 2004. The adoption of FIN 46R resulted in the consolidation of funeral and cemetery merchandise and service, and perpetual care trusts in our consolidated balance sheet at fair value. We do not consolidate certain funeral trusts for which we do not absorb a majority of their expected losses and, therefore, are not considered a primary beneficiary of these funeral trusts under FIN 46R. The adoption of FIN 46R also resulted in the deconsolidation of Carriage Services Capital Trust, the issuer of TIDES preferred securities. Instead, we now report as a liability the junior subordinated debenture payable to the Trust. Amounts and balances prior to March 31, 2004 have not been restated to reflect the adoption of FIN 46R. The adoption of FIN 46R has not impacted our consolidated statements of operations or cash flows. Certain financial information has been restated from information presented in the Company’s Form 10-K for the year ended December 31, 2003. See notes 2 and 4 of Notes to Consolidated Financial Statements.

We adopted Statement of Financial Accounting’s Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144) during 2004.  The application of that standard resulted in, among other things, the presentation of the revenues and expenses, as well as gains, losses and impairments, from business units sold, discontinued or held for sale in the discontinued operations section of the consolidated statements of operations for all periods presented.

You should read this historical financial data together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this report and Carriage’s consolidated financial statements and notes thereto included elsewhere in this report.

(1)          When the TIDES were issued in 1999, we reported the securities as a component of temporary equity because they have predominantly equity-like characteristics which are not normally found in debt securities (including traditional subordinated debt). In 2004, we changed that classification to report the securities as subordinated debt in order to comply with a new accounting standard. The securities continue to be treated as equity for purposes of the financial covenants under our existing senior notes and our existing credit facility.

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ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

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 a service business that provide funeral services (burial and cremation) and sell related merchandise, such as caskets and urns. Cemeteries are primarily a sales business that sells real estate (grave sites and mausoleums) and related merchandise such as markers and memorials. Substantially all administrative activities are conducted in our home office in Houston, Texas.

Factors affecting our funeral operating results include the number of deaths in the markets we serve; whether we gain or lose market share relative to our competitors in the markets we operate; the price that we sell our services and merchandise; and the cost of providing services, primarily the salaries and benefits expense related to our professional and support staff, and the cost of merchandise. 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 and cremation services because our average cremation service revenue is approximately 37% of the average revenue earned from a traditional funeral service during the year ended December 31, 2004. Funeral homes have a high fixed cost structure. Thus, small changes in revenues, up or down, may cause disproportionate changes to our profitability.

During the second half of 2003, we implemented several significant changes in our funeral operations designed to improve operating and financial results by growing market share and increasing profitability. We introduced a more decentralized, entrepreneurial and local operating model. At the same time, we introduced operating and financial standards developed from our best funeral operations. The new operating model and standards focus on the key drivers of a successful funeral operation, organized around three primary areas – market share, people and operating and financial metrics. A portion of local management’s compensation is variable based on their success as measured against these standards. We first began operating under this model in 2004.  We have experienced benefits from the new model during the last half of 2004.  For example, better merchandising, the implementation of packages in certain locations and updates to our pricing resulted in a strong increase in the average revenue per service.  We also believe that we have made better decisions in hiring new staff, training existing staff and managing the workload which resulted in lower salaries and benefits costs.  We expect that by focusing on the key drivers, we will increase market share and improve profitability over time.

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The cemetery operating results are affected by the success of our sales organization as currently approximately 36% of our cemetery revenues relate to preneed sales of interment rights. We believe that changes in the level of consumer confidence (a measure of whether consumers will spend for discretionary items) also affects the amount of preneed sales. Approximately 8% of our cemetery revenues are currently attributable to investment earnings on trust funds and finance charges on installment contracts. Changes in the capital markets and interest rates affect this component of our cemetery revenues.

From 1996 to 2000, we accumulated a large amount of debt and contingent obligations from acquisitions. Our business strategy during the last four years focused on increasing operating cash flow and improving our financial condition by reducing debt to lower our interest expense and improve our credit profile. We have not been actively seeking businesses to acquire since 1999; instead we have been focused on selling underperforming businesses and reducing our debt. From September 2000, when we initiated a process to identify underperforming businesses, to December 31, 2004, we sold 36 funeral homes and 12 cemeteries along with 20 parcels of excess real estate. We used the proceeds of approximately $26 million from those sales to reduce our debt. We have reduced our debt and contingent obligations by approximately $87 million during the period January 1, 2001 through December 31, 2004.  During January 2005 we refinanced our senior debt by issuing $130 million of Senior Notes due in 2015.  This refinancing represented a milestone.  The refinancing was the culmination of the effort to reaccess the capital markets and to extend the maturities of our senior debt and to gain the flexibility to reinvest our free cash flow in our core business.  We can now use the net cash proceeds from the offering and our free cash flow to grow our Company through selective acquisitions.  We also intend to amend our existing bank credit facility, which initially will not be drawn on.  We expect the amended credit facility to be secured and contain more favorable covenants.

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 on-going basis, we evaluate estimates and judgments, including those related to revenue recognition, realization of accounts receivable, intangible assets, property and equipment and deferred tax assets. 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 the margins, operating income and net earnings as a percentage of revenues will be sustained consistently from year to year.

Management’s discussion and analysis of financial condition and results of operations are 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 summarized in Note 1 to the consolidated financial statements. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Funeral and Cemetery Operations

We record the sales of funeral merchandise and services when the funeral service is performed. Sales of cemetery interment rights are recorded as revenue in accordance with the retail land sales provisions of Statement of Financial Accounting Standards (SFAS) No. 66, “Accounting for Sales of Real Estate”. This method generally provides for the recognition of revenue in the period in which the customer’s cumulative payments exceed 10% of the contract price related to the real estate. Costs related to the sales of interment rights, which include property and other costs related to cemetery development activities, are charged to operations using the specific identification method in the period in which the sale of the interment right is recognized as revenue. Revenue from the sales of cemetery merchandise and services are recognized in the period in which the merchandise is delivered or the service is performed. Revenues to be recognized from the delivery of merchandise and performance of services related to contracts that were acquired in acquisitions are typically lower than those originated by the Company and are likely to exceed the cash collected from the contract and received from the trust at maturity.

Allowances for customer cancellations, refunds and bad debts are provided at the date that the sale is recognized as revenue based on our historical experience. In addition, we monitor changes in delinquency rates and provide additional bad debt and cancellation reserves when warranted. When preneed funeral services and merchandise are funded through third-party insurance policies, we earn a commission on the sale of the policies. Insurance commissions are recognized as revenues when the commission is no longer subject to refund, which is usually one year after the policy is issued.

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Deferred Obtaining Costs

Deferred obtaining costs consist of sales commissions and other direct related costs of originating preneed sales contracts. These costs are deferred and amortized into funeral and cemetery costs and expenses over the period we expect to perform the services or deliver the merchandise covered by the preneed contracts. The periods over which the costs are recognized are based on actuarial statistics for the actual contracts we hold, provided by a third-party administrator.

Goodwill and Other Intangible Assets

The excess of the purchase price over the fair value of net identifiable assets acquired, as determined by management in transactions accounted for as purchases, is recorded as goodwill. Many of the acquired funeral homes have provided high quality service to families for generations. The resulting loyalty often represents a substantial portion of the value of a funeral business.  Goodwill is typically not associated with or recorded for the cemetery businesses. In accordance with SFAS No. 142, we discontinued amortizing goodwill as of January 1, 2002, and instead we review the carrying value of goodwill at least annually on reporting units (aggregated geographically) to determine if facts and circumstances exist which would suggest that this intangible asset might be carried in excess of fair value. Fair value is determined by discounting the estimated future cash flows of the businesses in each reporting unit at the Company’s weighted average cost of capital less debt allocable to the reporting unit and by reference to recent sales transactions of similar businesses. The calculation of fair value can vary dramatically with changes in estimates of the number of future services performed, inflation in costs and the Company’s cost of capital, which is impacted by long-term interest rates. If impairment is indicated, then an adjustment will be made to reduce the carrying amount of goodwill to fair value.

Income Taxes

The Company and its subsidiaries file a consolidated U.S. federal income tax return and separate income tax returns in the states in which we operate. We record deferred taxes for temporary differences between the tax basis and financial reporting basis of assets and liabilities, in accordance with SFAS No. 109, “Accounting for Income Taxes”, (Note 12).  The Company records a valuation allowance to reflect the estimated amount of deferred tax assets for which realization is uncertain.  Management reviews the valuation allowance at the end of each quarter and makes adjustments if it is determined that it is more likely than not that the tax benefits will be realized.

Stock Compensation Plans

The Company has stock-based employee compensation plans in the form of stock option and employee stock purchase plans, which are more fully described in Note 13. The Company accounts for stock-based compensation under APB Opinion No. 25, “Accounting for Stock Issued to Employees” whereby no compensation expense is recognized in the Consolidated Statement of Operations 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.”

In December 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation.  Statement 123 (R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows.  Statement 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values and the pro forma disclosure alternative is no longer allowable under Statement 123 (R).  The revised standard is effective for public entities in the first interim or annual reporting period beginning after June 15, 2005, which for the Company will be the third quarter of fiscal 2005 ending September 30, 2005.  The Company is currently evaluating the impact of the adoption of Statement 123(R), which will result in additional pre-tax compensation expense beginning in the third quarter of 2005 for remaining unvested stock options, any future stock option grants and the employee stock purchase plan.  Management believes that the adoption of SFAS 123R will provide results similar to the pro-forma disclosure for SFAS 123 (Note 1).

We have also granted restricted stock to certain officers of the Company, which vest over a period of four years. These shares are valued at the dates granted and the value is charged to operations as the shares vest.

ACCOUNTING CHANGES AND RECENTLY ISSUED ACCOUNTING STANDARDS

Impairment of Investments

In March 2004, the FASB reached consensus on the guidance provided by Emerging Issues Task Force Issue 03-1 (EITF 03-1), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.”  The guidance is applicable to debt and equity securities that are within the scope of FASB Statement of Financial Accounting Standard (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  EITF 03-1 specifies that an impairment would be considered

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other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence of the contrary.  EITF 03-1 was scheduled to be effective for reporting periods ending after June 15, 2004.  The measurement and recognition provisions relating to debt and equity securities have been delayed until the FASB issues additional guidance.  The disclosure requirements continue to be effective in annual financial statements for fiscal years ending after June 15, 2004.  We adopted the disclosure provisions during the period ended June 30, 2004.  The adoption of the measurement and recognition provisions will not have a material impact on the consolidated financial statements, result of operations or liquidity of the Company.

Impairment of Long-Lived Assets

Except as noted for Goodwill and deferred obtaining costs, the Company reviews its long-lived assets for impairment when changes in circumstances indicate that the carrying amount of the net asset may not be recoverable in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144).  Assets to be disposed of and assets not expected to provide any future service potential to the Company are recorded at the lower of carrying amount or fair value less estimated cost to sell.  The revenues and expenses, as well as gains, losses and impairments, from those assets are reported in the discontinued operations section of the Consolidated Statement of Operations for all periods presented which represents a change in classification to our previously issued consolidated financial statements in prior filings including our annual reports on Form 10-K for the years reflected in our consolidated financial statements included in this annual report.

Goodwill

The effect of SFAS No. 142 on the Company, which was adopted as of the beginning of 2002, included eliminating the amortization of goodwill, the identifying reporting units for the purpose of assessing potential future impairments of goodwill and the testing for impairments of goodwill on an annual basis.  The Company performs an annual review of goodwill by comparing the fair value of the Company’s reporting units (funeral home businesses by region) to the carrying value of the reporting units.  No impairment was indicated for 2004.

Consolidation of Variable Interest Entities

The Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, as revised, (“FIN 46R”), “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51.” This interpretation clarifies the circumstances in which certain entities that do not have equity investors with a controlling financial interest must be consolidated by its sponsor. The Company implemented FIN 46R as of March 31, 2004, which resulted, for financial reporting purposes, in the consolidation of the Company’s preneed and perpetual care trust funds. The investments of such trust funds have been reported at market value and the Company’s future obligations to deliver merchandise and services have been reported at estimated settlement amounts. The Company has also recognized the non-controlling financial interests of third parties in the trust funds. There was no cumulative effect of an accounting change recognized by the Company as a result of the implementation of FIN 46R. The implementation of FIN 46R affected certain accounts on the Company’s balance sheet beginning March 31, 2004 as described below; however, it did not affect cash flow, net income or the manner in which the Company recognizes and reports revenues.

Although FIN 46R requires consolidation of preneed and perpetual care trusts, it does not change the legal relationships among the trusts, the Company and its customers. In the case of preneed trusts, the customers are the legal beneficiaries. In the case of perpetual care trusts, the Company does not have a right to access the corpus in the perpetual care trusts. For these reasons, the Company has recognized non-controlling interests in our financial statements to reflect third party interests in these consolidated trust funds.

Both the preneed trusts and the cemetery perpetual care trusts hold investments in marketable securities which have been classified as available-for-sale. The investments are reported at fair value, with unrealized gains and losses allocated to Non-controlling interests in trust investments 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 is allocated to deferred revenues.

Also beginning March 31, 2004, the Company recognizes realized income, gains and losses of the preneed trusts and cemetery perpetual care trusts. The Company recognizes a corresponding expense equal to the realized earnings of these trusts attributable to the non-controlling interest holders. When such earnings attributable to the Company have not been earned through the performance of services or delivery of merchandise, the Company will record such earnings as deferred revenue.

For preneed trusts, the Company recognizes as revenues amounts attributed to the non-controlling interest holders and the Company, including accumulated realized earnings, when the contracted services have been performed and merchandise delivered.

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For cemetery perpetual care trusts, the Company recognizes investment earnings in cemetery revenues when such earnings are realized and distributable. Such earnings are intended to defray cemetery maintenance costs incurred by the Company.

Also, the Company was required to deconsolidate Carriage Services Capital Trust (the “Trust”), a trust established in 1999 to issue redeemable convertible preferred securities. The Company’s obligation to the Trust consists of convertible junior subordinated debentures. The preferred securities of the Trust were previously classified as temporary equity in the consolidated balance sheet. As a result of deconsolidating the Trust, the Company now reports its obligation to the Trust, the convertible junior subordinated debentures, as a long-term liability.

SELECTED INCOME AND OPERATIONAL DATA

The following table sets forth certain income statement data for Carriage expressed as a percentage of net revenues for the periods presented:

The following table sets forth the number of funeral homes and cemeteries owned and operated by Carriage for the periods presented:

The following is a discussion of Carriage’s results of operations for 2002, 2003, and 2004. The term “same-store” or “existing operations” refers to funeral homes and cemeteries owned and operated for the entirety of each period being compared.

YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003

The following is a discussion of the Company’s results of operations for the years ended December 31, 2003 and 2004.

Diluted earnings per share from continuing operations were $0.60.  Excluding the reduction in the deferred tax valuation allowance of $4.1 million or $0.22 per diluted share, the 15.2 percent improvement from $0.33 to $0.38 per share was attributable to lower interest expense and improvements in both funeral and cemetery profitability.  Net income, which includes the effect of discontinued operations, totaled $0.51 per diluted share ($0.29 per share excluding the reduction in the deferred tax valuation allowance equal to $0.22 per share) compared to $0.37 per share for 2003. A significant portion of the decrease is attributable to impairment charges before taxes of $ 3.7 million, equal to $ 0.13 per diluted share, net of gains totaling $1.0 million pretax, equal to $0.03 per diluted share, from the sales in 2004 of three funeral home businesses.

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Funeral Home Segment.  The following table sets forth certain information regarding the net revenues and gross profit of the Company from the funeral home operations for the year ended December 31, 2004 compared to the year ended December 31, 2003. For purposes of our discussion, the revenue and gross profit of our businesses identified to be sold are included in the same-store classification up to the quarter prior to their sale.

* not meaningful

Funeral same-store revenues for the year ended December 31, 2004 increased $0.6 million, or 0.5%, when compared to the year ended December 31, 2003, as we experienced an increase of 3.4% to $4,903 in the average revenue per service for those existing operations and the number of services declined by 659, or 2.9%. Cremation services represented 31.9% of the number of funeral services during 2004, compared to 30.7% for 2003.

Total funeral same-store gross profit for the year ended December 31, 2004 increased $0.6 million, or 2.2% from 2003, as a result of the increase in same-store revenues given the predominately fixed cost structure of our businesses. Funeral costs and expenses remained constant from 2003.

Cemetery Segment.  The following table sets forth certain information regarding the net revenues and gross profit of the Company from the cemetery operations for the year ended December 31, 2004 compared to the year ended December 31, 2003:

* not meaningful

No cemetery businesses were acquired or sold during the two years; one cemetery is held for sale.

Cemetery same-store revenues for the year ended December 31, 2004 increased $2.9 million, or 8.4%, over the year ended December 31, 2003, and cemetery same store gross profit increased $0.2 million, or 2.6%, over 2003. Revenues from preneed

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interment sales increased $2.6 million. Though the number of interments sold on a preneed basis remained the same, the average price per space increased 15.1%. Continuing gross margin decreased from 24.8% for the year ended December 31, 2003 to 23.7% for the year ended December 31, 2004 due to higher sales discounts, bad debts and facilities and grounds costs. Higher sales discounts on property negatively impacted revenues and gross profit by $0.8 million year-over-year. Bad debts were $1.0 million higher than the prior year and facilities and grounds expenses increased $0.3 million, primarily due to higher property taxes, insurance and utilities.

Other.  General and administrative expenses increased $0.2 million for the year ended December 31, 2004 primarily because 2004 included higher depreciation on computer and software additions during the last 12 months and higher professional fees, a large portion of which related to compliance with the Sarbanes-Oxley Act of 2002.

Other charges consist primarily of a pretax charge of $0.5 million to write off capitalized costs of a cemetery accounting system development project that the Company terminated.

Included in other income for 2004 are pretax gains totaling $0.9 million from the sales of real estate and other assets.

Interest expense for the year ended December 31, 2004 declined $0.9 million, or 4.9%, compared to the year ended December 31, 2003. While the debt outstanding has decreased by approximately $25 million, or 19.2%, during 2004, we are not reporting a proportional decrease in interest expense because the current year expense is negatively impacted by higher loan fees and compound interest on the deferred interest on the convertible subordinated debentures.

Income Taxes.  The Company recorded income taxes for continuing operations at the effective rate of 38.5 percent and 37.6 percent (excluding the effect of the change in the valuation allowance) for the years ended December 31, 2003 and 2004, respectively. For federal income tax reporting purposes, Carriage has had net operating loss carryforwards to offset Federal taxable income in 2003 and 2004. Carriage also has approximately $67 million of state net operating loss carryforwards. When the Company incurred restructuring costs and write-downs in late 2000 and proceeded to dispose of low performing businesses, it could not be assured that it would generate enough future taxable income to utilize the tax benefits created by the tax losses on asset sales.  To acknowledge this uncertainty, the Company recorded a valuation allowance to offset these tax benefits until such time that it could be determined it would be more likely than not the Company would be able to realize the tax benefits.  The Company recognized tax benefits related to the change in the valuation allowance related to its deferred tax assets of $0.1 million and $4.1 million in 2003 and 2004, respectively.  The remaining valuation allowance at December 31, 2004 is attributable to the deferred tax asset related to the state operating losses.

YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002

Funeral Home Segment.  The following sets forth certain information regarding Carriage’s net revenues and gross profit from our funeral home operations during the years ended December 31, 2002 and 2003:

* not meaningful

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Funeral same-store revenues for the year ended December 31, 2003 were 1.7% less when compared to the year ended December 31, 2002, as we experienced a decrease of 2.3% in the number of funeral service contracts from 24,293 to 23,740 and an increase of 0.6% in the average revenue per contract from $4,713 to $4,743 for those existing operations. The decline in the number of funeral service contracts of 2.3% was due in part to the decline in the number of deaths of 1.4% in 2003 compared to 2002 based on statistics published by the CDC, as adjusted for non-reporting cities. We also believe that we lost market share in certain areas based on our analysis of obituary reports for those markets. Approximately 30% of the funeral services were cremation services compared to 28% in 2002. The average revenue per cremation services increased 0.7% compared to 2002. The change in mix from traditional to cremation services resulted in a decline of $1.7 million in revenue for 2003 compared to 2002. Of the funeral services performed during 2002 and 2003, approximately 18.5% and 19.5%, respectively, were prearranged.

Though total funeral revenues including discontinued operations declined by $3.5 million, funeral costs and expenses actually increased by $1.3 million, resulting in a decline in gross profit including discontinued operations of $4.8 million. From an operational perspective, the funeral business is a relatively fixed cost business. If variable costs had remained constant as a percentage of net revenues, the $3.5 million reduction in revenue would have been associated with a reduction in cost of approximately $0.7 million to $1.0 million. The negative cost and expense variance was due primarily to increases in merchandise costs, bad debts and property casualty and general liability insurance. Merchandise costs were approximately $0.8 million higher as vendors increased their prices to Carriage at the beginning of 2003 at a rate higher than the Company was able to increase its prices to the public. Bad debts were $0.8 million higher than 2002 because the Company realized some significant recoveries during 2003 from a centralized collection process installed in 2002. Property casualty and general liability insurance costs increased $0.7 million due to higher premium costs and claims.

Cemetery Segment.  The following sets forth certain information regarding Carriage’s net revenues and gross profit from cemetery operations for the years ended December 31, 2002 and 2003:

* not meaningful

No cemetery businesses were acquired or sold during the two years; one cemetery is held for sale.

The higher cemetery net revenues resulted in part from a $0.4 million increase in at need revenues as a result of an increase in the average value per contract of 5.8% from $942 to $997, though the volume of at-need contracts declined 2.5% from 14,681 to 14,311. We also experienced an increase in preneed property sales of $0.7 million, primarily the result of a 10.2% increase in the number of preneed contracts written from 7,729 to 8,521. The average preneed contract value declined 7.6% from $2,196 to $2,029. These increases were offset in part by $0.4 million less trust income and $0.4 million less in deliveries of previously prearranged merchandise and services. Cemetery gross profit increased on a year-over-year basis primarily due to $0.4 million less bad debt expense in 2003.

Other. General and administrative expenses for the year ended December 31, 2003 decreased slightly from 2002. Lower ($0.6 million) lease expense from the buyout of a computer lease obligation in early 2003 was mitigated in part by higher ($0.3 million) depreciation expense. Higher overall salaries and wages in 2003 offset the $0.5 million officer termination cost in 2002. Higher legal fees and franchise taxes in 2003 totaling $0.6 million compared to $0.5 million incurred for professional fees related to a change in tax accounting methods.

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Interest expense for the year ended December 31, 2003 declined $1.8 million compared to the year ended 2002 primarily because outstanding debt declined period over period.  Cash flow from operations and proceeds from the sales of business assets have provided the source of funds to reduce the debt outstanding during 2002 and 2003.  During 2003, total outstanding debt was reduced by $13.6 million.  Reductions in interest rates during 2002 and 2003 and the expiration of a floating for fixed interest rate swap in May 2003 also contributed (to a lesser degree) in reducing interest expense.

Income Taxes. The Company recorded income taxes at the effective rate of 38.5% (excluding the affect of the change in valuation allowance) for the years ended December 31, 2002 and 2003, respectively.  See Note 12 to the consolidated financial statements.  The slightly lower tax rate in 2003, compared to 2002, is based on the utilization of certain state loss carryforwards.  Because of the ability to use the net operating loss to offset taxable income and the timing of when revenue and expenses are recognized for tax purposes, we did not pay Federal income taxes in 2002 and 2003.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents totaled $1.9 million at December 31, 2004, representing a decrease of $0.1 million from December 31, 2003. It has been Carriage’s practice to apply available cash against its revolving line of credit, described below, to minimize interest expense. If the Company needs cash for working capital or investment purposes, it may draw on the line of credit so long as the Company is in compliance with the loan covenants and committed funds are available. For the year ended December 31, 2004, cash provided by operating activities was $24.2 million compared to $14.7 million for the year ended December 31, 2003, in part because pretax income from continuing operations increased $1.6 million. The current year period also benefited from the deferral of interest payments in the amount of $7.0 million on the convertible junior subordinated debenture compared to $3.3 million in the prior year period.  Additionally, the cost of originating preneed contracts declined $1.3 million compared to the prior year.  Cash used in investing activities was $1.3 million for the year ended December 31, 2004 compared to cash used in the amount of $1.8 million for the year ended December 31, 2003. Cash used for capital expenditures declined $0.5 million from $6.2 million in 2003 to $5.7 million in 2004.  The majority of our cashflow in 2004 was used to reduce debt.

The outstanding principal of our senior debt at December 31, 2004 totaled $110.3 million and consisted of $70.5 million in aggregate principal amount under our existing senior notes, $25.6 million outstanding under our existing unsecured credit facility, and $14.2 million in acquisition indebtedness and capital lease obligations. Additionally, $1.1 million in letters of credit have been issued under the existing unsecured credit facility and were outstanding at December 31, 2004.

Our existing unsecured credit facility, as amended, provides for borrowings up to $45 million and matures in March 2006. Interest is payable at either prime rate plus 1.25% or a rate indexed to LIBOR at the Company’s option. Currently, the LIBOR option is set at LIBOR plus 275 basis points.  The Company’s credit facility was amended subsequent to year end to permit the issuance of Senior Notes.  In addition, the Company entered into a letter of commitment with Bank of America, its lead lender, for a $35 million Senior Secured Credit Facility.  The Senior Secured Credit Facility would mature five years from the closing date, would be secured by the Company’s assets (including certain funeral home real property) and would include financial covenants and limitations on stock redemptions, dividends and acquisitions.  The commitment is subject to certain conditions precedent to closing and completion of definitive documentation. 

In January 2005, the Company issued $130 million of 7.875% Senior Notes due in 2015.  The proceeds from these notes were used to refinance all of the senior debt, bring current the deferred distributions on the convertible junior subordinated debentures and the TIDES, and for general corporate purposes.  In connection with the early retirement of the senior debt, the Company made a required “make whole” payment of $6.0 million in the form of additional interest and recorded a charge to write off $0.7 million of unamortized loan costs.  These charges equal $4.2 million after tax, or $0.23 per diluted share, and will be reported in the first quarter of 2005.

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The following table sets forth the consolidated capitalization as of December 31, 2004 on an actual basis and on an as adjusted basis to give effect to the $130 million offering of 7.875% Senior Notes due in 2015 and the transactions paying off our senior debt and accrued interest.

The net proceeds of this offering, which were approximately $125.5 million after deducting the initial purchasers’ discount and offering expenses, were used to pay in full the principal, accrued but unpaid interest, and “make-whole” payments on the existing senior notes; repay all outstanding borrowings under our existing unsecured credit facility; pay the cumulative deferred interest on the subordinated debt to affiliate current; and fund general corporate purposes.

Subsequent to the above-described refinancing transactions, we will enjoy the extended maturity of our debt, a more flexible covenant package and the continuing right to defer distributions payable in respect of the TIDES for up to five years. Notwithstanding our ability to defer payment of distributions in respect of the TIDES, we resumed cash payments of interest on the TIDES on March 1, 2005, which aggregate approximately $6.5 million on an annual basis. While we will have the ability to borrow additional amounts under our amended senior secured credit facility, our intention is to fund anticipated capital expenditures, acquisitions, if any, and other operating requirements from existing cash balances and cash flow from operations.

A total of $93.8 million was outstanding on December 31, 2004 on our convertible junior subordinated debentures. Amounts outstanding under the debentures are payable to the Company’s affiliate trust, Carriage Services Capital Trust, bear interest at 7.0% and mature in 2029. Substantially all the assets of the Trust consist of the convertible junior subordinated debentures of the Company. The Trust issued 1.875 million shares of TIDES. The rights of the debentures are functionally equivalent to those of the TIDES.

The convertible junior subordinated debentures payable to the affiliated trust and the TIDES each contain a provision for the deferral of interest payments and distributions for up to 20 consecutive quarters. During the period in which distribution payments are deferred, distributions will continue to accumulate at the 7.0% annual rate. Also, the deferred distributions themselves accumulate distributions at the annual rate of 7.0% and are recorded as a liability. During the deferral period, we are prohibited from paying dividends on the common stock or repurchasing its common stock, subject to limited exceptions. In complying with the conditions of our existing unsecured credit facility, we began deferring interest payments on the subordinated debentures payable to our affiliated trust. As a result, cash distributions on the TIDES have been deferred and recorded as a liability, beginning with the September 1, 2003 payment. The condition was imposed by the lenders to ensure that we had sufficient available borrowings under our existing unsecured credit facility to retire the Series A maturities of the existing senior notes in July 2004 and to accommodate the two commitment reductions in 2005.

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Contractual Obligations

The following table summarizes our balance sheet liabilities to make future payments as of December 31, 2004. Where appropriate we have indicated the footnote to our annual consolidated financial statements where additional information is available.