UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

CARRIAGE SERVICES, INC.

(Exact name of registrant as specified in its charter)

DELAWARE		76-0423828
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

3040 Post Oak Boulevard, Suite 300, Houston, TX		77056
(Address of principal executive offices)		(Zip Code)

     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  þ     No  o

     Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Securities Exchange Act of 1934. (Check one):

Large accelerated filer  o     Accelerated filer  þ     Non-Accelerated filer  o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o     No  þ

     The number of shares of the Registrant’s Common Stock, $.01 par value per share, outstanding as of November 1, 2006 was 18,575,678.

 

 

CARRIAGE SERVICES, INC.

INDEX

		Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of December 31, 2005 and September 30, 2006 (unaudited)			3
Consolidated Unaudited Statements of Operations for the Three Months ended September 30, 2005 and 2006 and Nine Months ended September 30, 2005 and 2006			4
Consolidated Unaudited Statements of Cash Flows for the Nine Months ended September 30, 2005 and 2006			5
Condensed Notes to Consolidated Financial Statements (unaudited)			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
Item 3. Quantitative and Qualitative Disclosures about Market Risk			24
Item 4. Controls and Procedures			25
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			25
Item 1A. Risk Factors			25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3. Defaults Upon Senior Securities			25
Item 4. Submission of Matters to a Vote of Security Holders			25
Item 5. Other Information			26
Item 6. Exhibits			26
Signatures			27
Certifications
Computation of Per Share Earnings
Certification of Periodic Financial Reports of Section 302
Certification of Periodic Financial Reports of Section 302
Certification of Periodic Financial Reports of Section 906

PART I – FINANCIAL INFORMATION

CARRIAGE SERVICES, INC.

		December 31,				September 30,
		2005				2006
						(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	7,949			$	4,717
Short term investments			16,908				24,193
Accounts receivable — trade, net of allowance for doubtful accounts of $937 in 2005 and $1,012 in 2006			13,412				12,496
Inventories and other current assets			12,883				12,710
Total current assets			51,152				54,116
Restricted cash			—				5,455
Preneed assets			135,826				130,983
Property, plant and equipment, at cost, net of accumulated depreciation of $45,694 in 2005 and $46,974 in 2006			105,435				103,116
Cemetery property			62,905				56,494
Goodwill			157,358				151,269
Deferred charges and other non-current assets			25,608				24,911
Cemetery perpetual care trust investments			32,356				30,726
Total assets		$	570,640			$	557,070
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of senior long-term debt and capital leases obligations		$	2,074			$	1,550
Accounts payable and accrued liabilities			22,163				18,697
Total current liabilities			24,237				20,247
Senior long-term debt, net of current portion			134,572				134,418
Convertible junior subordinated debenture due in 2029 to an affiliated trust			93,750				93,750
Obligations under capital leases, net of current portion			4,775				4,741
Deferred revenue			183,820				178,072
Total liabilities			441,154				431,228
Commitments and contingencies
Non-controlling interests in perpetual care trust investments			33,112				30,269
Stockholders’ equity:
Common Stock, $.01 par value; 80,000,000 shares authorized;18,458,000 and 18,557,000 shares issued and outstanding at December 31, 2005 and September 30, 2006, respectively			185				186
Additional paid-in capital			190,502				191,260
Accumulated deficit			(92,921	)			(95,095	)
Deferred compensation			(1,392	)			(778	)
Total stockholders’ equity			96,374				95,573
Total liabilities and stockholders’ equity		$	570,640			$	557,070

The accompanying condensed notes are an integral part of these consolidated financial statements.

CARRIAGE SERVICES, INC.

		For the three months								For the nine months
		ended September 30,								ended September 30,
		2005				2006				2005				2006
Revenues
Funeral		$	25,988			$	27,285			$	84,949			$	87,395
Cemetery			9,563				8,215				28,715				27,451
			35,551				35,500				113,664				114,846
Costs and expenses
Funeral			20,025				21,400				62,232				65,267
Cemetery			7,763				8,469				23,217				24,974
			27,788				29,869				85,449				90,241
Gross profit			7,763				5,631				28,215				24,605
General and administrative expenses			3,141				2,751				8,920				8,143
Operating income			4,622				2,880				19,295				16,462
Interest expense			(4,649	)			(4,614	)			(13,961	)			(13,885	)
Additional interest and other costs of senior debt refinancing			—				—				(6,933	)			—
Interest income and other			140				911				(249	)			1,474
Total interest expense and other			(4,509	)			(3,703	)			(21,143	)			(12,411	)
Income (loss) from continuing operations before income taxes			113				(823	)			(1,848	)			4,051
(Provision) benefit for income taxes			(41	)			309				701				(1,520	)
Income (loss) from continuing operations			72				(514	)			(1,147	)			2,531
Income (loss) from discontinued operations, net of tax			598				(51	)			1,245				(4,128	)
Cumulative effect of change in accounting method, net of tax benefit			—				—				(22,756	)			—
Net income (loss)		$	670			$	(565	)		$	(22,658	)		$	(1,597	)
Basic earnings (loss) per common share
Continuing operations		$	—			$	(0.03	)		$	(0.06	)		$	0.14
Discontinued operations			0.04				—				0.07				(0.22	)
Cumulative effect of change in accounting method			—				—				(1.25	)			—
Net income (loss)		$	0.04			$	(0.03	)		$	(1.24	)		$	(0.08	)
Diluted earnings (loss) per common share
Continuing operations		$	—			$	(0.03	)		$	(0.06	)		$	0.13
Discontinued operations			0.04				—				0.07				(0.22	)
Cumulative effect of change in accounting method			—				—				(1.25	)			—
Net income (loss)		$	0.04			$	(0.03	)		$	(1.24	)		$	(0.09	)
Weighted average number of common and common equivalent shares outstanding:
Basic			18,426				18,563				18,294				18,531
Diluted			18,938				18,563				18,294				18,896

The accompanying condensed notes are an integral part of these consolidated financial statements.

CARRIAGE SERVICES, INC

		For the nine months
		ended September 30,
		2005				2006
		(Revised, Note 1)
Cash flows from operating activities:
Net loss		$	(22,658	)		$	(1,597	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
(Income) loss from discontinued operations			(1,245	)			4,128
Cumulative effect of the change in accounting method			22,756				—
Depreciation and amortization			7,202				6,577
Loan cost amortization			576				536
Provision for losses on accounts receivable			2,059				3,143
Net (Gain) loss on sale of business assets			580				(341	)
Stock-based compensation			512				650
Loss on early extinguishment of debt			978				—
Deferred income taxes (benefit)			(701	)			1,520
Changes in assets and liabilities, net of effects from acquisitions and dispositions
Accounts receivable			(1,905	)			860
Inventories and other current assets			(1,770	)			(156	)
Deferred charges and other			(806	)			—
Preneed trust investments			(3,327	)			(4,112	)
Income tax payments, net			(270	)			(249	)
Accounts payable and accrued liabilities			(5,360	)			(3,265	)
Deferred preneed revenue			4,417				1,626
Deferred interest on convertible junior subordinated debenture			(10,345	)			—
Net cash provided by (used in) operating activities of continuing operations			(9,307	)			9,320
Net cash provided by operating activities of discontinued operations			6				435
Net cash provided by (used in) operating activities			(9,301	)			9,755
Cash flows from investing activities:
Acquisitions			(1,285	)			(1,071	)
Net proceeds from sales of assets			223				680
Purchase of short term investments			(20,851	)			(45,927	)
Maturities of short term investments			11,872				38,643
Sales proceeds deposited into restricted accounts			—				(5,455	)
Capital expenditures			(5,582	)			(4,983	)
Net cash used in investing activities of continuing operations			(15,623	)			(18,113	)
Net cash provided by investing activities of discontinued operations			1,533				6,437
Net cash used in investing activities			(14,090	)			(11,676	)
Cash flows from financing activities:
Net payments on bank line of credit			(25,600	)			—
Payments on senior long-term debt and obligations under capital leases			(72,203	)			(1,801	)
Proceeds from the issuance of debt			—				922
Proceeds from the issuance of senior notes			130,000				—
Payment of financing costs			(4,175	)			—
Proceeds from the exercise of stock options and employee stock purchase plan			827				429
Tax benefit from stock-based compensation			—				61
Net cash provided by (used in) financing activities of continuing operations			28,849				(389	)
Net cash used in financing activities of discontinued operations			(71	)			(922	)
Net cash provided by (used in) financing activities			28,778				(1,311	)
Net increase (decrease) in cash and cash equivalents			5,387				(3,232	)
Cash and cash equivalents at beginning of period			1,948				7,949
Cash and cash equivalents at end of period		$	7,335			$	4,717

The accompanying condensed notes are an integral part of these consolidated financial statements.

CARRIAGE SERVICES, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     (a) The Company

     Carriage Services, Inc. (“Carriage” or the “Company”) is a leading provider of products and services in the death care industry in the United States. As of September 30, 2006, the Company owned and operated 131 funeral homes in 27 states and 28 cemeteries in 11 states.

     (b) Principles of Consolidation

     The accompanying consolidated financial statements include the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated.

     (c) Consolidated Statements of Cash Flows

     We have revised the Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 consistent with September 30, 2006 to reconcile net cash provided by (used in) operating activities from net loss instead of net loss from continuing operations.

     (d) Interim Condensed Disclosures

     The information for the three and nine month periods ended September 30, 2005 and 2006 is unaudited, but in the opinion of management, reflects all adjustments which are normal, recurring and necessary for a fair presentation of financial position and results of operations for the interim periods. Certain information and footnote disclosures, normally included in annual financial statements, have been condensed or omitted. The accompanying consolidated financial statements have been prepared consistent with the accounting policies described in our annual report on Form 10-K for the year ended December 31, 2005, and should be read in conjunction therewith. Certain amounts in the consolidated financial statements for the period ended in 2005 in this report have been reclassified to conform to current year presentation.

     (e) Cash Equivalents

     The Company considers all investments purchased with an original maturity of three months or less at the time of purchase to be cash equivalents.

     (f) Use of Estimates

     The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     Allowances from customer cancellations, refunds and bad debts are provided at the date the contract is executed. In addition, we monitor changes in delinquency rates and provide additional bad debt and cancellation reserves when warranted. Our methodologies and the resulting estimates have been reliable in past periods. We do not expect to change the factors and assumptions used in calculating these reserves in the future.

     (g) Stock Plans and Stock Compensation

     The Company has stock-based employee compensation plans in the form of restricted stock, stock option and employee stock purchase plans. The Company accounts for stock-based compensation under Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS No. 123R”). FAS No. 123R requires companies to recognize compensation expense in an amount equal to the fair value of the share-based payment issued to employees over the period of vesting. The fair value of share based payments is determined using the Black-Scholes valuation model. FAS No. 123R applies to all transactions involving issuance of equity by a company in exchange for goods and services, including employee services. The Company adopted FAS No. 123R in the first quarter of 2006, using the modified prospective application method, which results in no restatement of the Company’s previously issued consolidated financial statements.

     Prior to 2006, the Company accounted for stock based compensation under APB No. 25 and provided the disclosures required under SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”

     (h) Accounting Changes and Error Corrections

     The Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting No. 154, “Accounting Changes and Error Corrections” (“FAS No. 154”). This statement is a replacement of Accounting Principles Board Opinion No. 20 and FAS No. 3. FAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle and error corrections. It establishes, unless impracticable and absence of explicit transition requirements, retrospective application as the required method of a change in accounting principle to the newly adopted accounting principle. Also, it establishes guidance for reporting corrections of errors as reporting errors involves adjustments to previously issued financial statements similar to those generally applicable to reporting accounting changes retrospectively. FAS No. 154 also provides guidance for determining and reporting a change when retrospective application is impracticable. FAS No. 154 is effective for accounting changes and corrections of errors made in the fiscal years beginning after December 15, 2005. The Company adopted the requirements beginning January 1, 2006, which had no affect on the Company’s presentation and disclosure.

     (i) Accounting for Income Tax Uncertainties

     In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” The interpretation prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 31, 2006. We are currently evaluating what impact, if any, this statement will have on our financial statements.

2. CHANGE IN ACCOUNTING FOR STOCK-BASED COMPENSATION PLANS

     Prior to January 1, 2006, the Company accounted for employee stock-based awards under the intrinsic value method following the recognition and measurement principle of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment (“SFAS 123R”), which requires, among other things, entities to recognize in the income statement the grant-date fair value of stock options and other stock-based awards over the service periods the awards are expected to vest.

     Pursuant to the provisions of SFAS 123R, the Company applied the modified-prospective transition method. Under this method, the fair value provision of SFAS 123R is applied to new employee stock-based awards granted after December 31, 2005. Measurement and recognition of compensation cost for unvested awards at December 31, 2005, granted prior to the adoption of SFAS 123R, are recognized under the provisions of SFAS No 123, Accounting for Stock-Based Compensation (“SFAS 123”), after adjustments for estimated forfeiture. SFAS 123R no longer permits pro-forma disclosure for income statement periods after December 31, 2005 and compensation expense will be recognized for all stock-based awards based on grant-date fair value.

     Carriage has two types of stock-based compensation plans for which the accounting is changed; stock options and an employee stock purchase plan (“ESPP”). Options to purchase Carriage common stock have typically been granted with an exercise price equal to the fair market value at the date of grant with vesting occurring annually over four years. Because of changes in the Company’s compensation philosophy, options have not been awarded to officers of the Company since 2003 and only a small percentage of the outstanding stock options are currently unvested. The ESPP allows employees, through payroll deductions, to purchase Carriage common stock at 85% of the value of the common stock on the quarterly purchase dates or the annual grant date, whichever is lower.

     The fair value of the stock option awards and the ESPP awards are determined using the Black-Scholes valuation model, which is consistent with the valuation methods previously utilized for the awards in the footnote disclosures required under SFAS 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure. The Company recorded pretax stock-based compensation expense for the stock options and the ESPP totaling $198,000 for the first nine months of 2006. Had SFAS 123R been effective for the first nine months of 2005, the Company would have recorded additional pretax stock-based compensation totaling $234,000.

     The application of SFAS 123R has the following effect on the three and nine months ended September 30, 2006 and 2005, respectively (in thousands).

		Three months ended
		September 30, 2006
										Results under
		As Reported				Effect of Change				Prior Method
Loss from continuing operations before income taxes		$	(823	)		$	45			$	(778	)
Net loss available to common stockholders			(565	)			28				(537	)
Net loss per share available to common stockholders:
Basic		$	(0.03	)		$	—			$	(0.03	)
Diluted			(0.03	)			—				(0.03	)

		Nine months ended
		September 30, 2006
										Results under
		As Reported				Effect of Change				Prior Method
Income from continuing operations before income taxes		$	4,051			$	198			$	3,853
Net loss available to common stockholders			(1,597	)			124				(1,473	)
Net loss per share available to common stockholders:
Basic		$	(0.08	)		$	—			$	(0.08	)
Diluted			(0.09	)			0.01				(0.08	)

		Three months ended
		September 30, 2005
		As Reported				Effect of Change				Pro Forma
Income from continuing operations before income taxes		$	113			$	(78	)		$	35
Net income available to common stockholders			670				(49	)			621
Net income per share available to common stockholders:
Basic		$	0.04			$	—			$	0.04
Diluted			0.04				—				0.04

		Nine months ended
		September 30, 2005
		As Reported				Effect of Change				Pro Forma
Loss from continuing operations before income taxes		$	(1,848	)		$	(234	)		$	(2,082	)
Net loss available to common stockholders			(22,658	)			(146	)			(22,804	)
Net loss per share available to common stockholders:
Basic		$	(1.24	)		$	(0.01	)		$	(1.25	)
Diluted			(1.24	)			(0.01	)			(1.25	)

     The following summary reflects stock option activity and related information for the nine months ending September 30, 2006.

						Weighted-Average				Aggregate
		Shares				Exercise Price				Intrinsic Value
		(in thousands)								(in thousands)
Outstanding at December 31, 2005			1,365			$	3.39
Granted			24			$	4.81
Exercised			(75	)		$	2.76
Cancelled and expired			(23	)		$	7.22
Outstanding at September 30, 2006			1,291			$	3.39			$	2,347
Exercisable at September 30, 2006			1,246			$	3.35			$	2,332

     The total intrinsic value of options exercised was $150,000 during the first nine months of 2006 and $491,000 during the first nine months of 2005. As of September 30, 2006, there was $81,000 of unrecognized compensation cost, net of estimated forfeitures, related to nonvested stock options, which is expected to be recognized over a weighted average period of approximately one year.

     The following summary provides additional information about stock options that are outstanding and exercisable at September 30, 2006 (shares in thousands).

Options Outstanding														Options Exercisable
Actual Range						Weighted-												Weighted-
of Exercise						Average												Average
Prices		Number				Remaining				Weighted-				Number				Remaining				Weighted-
150%		Outstanding				Contractual				Average				Exercisable at				Contractual				Average
increment		at 9/30/06				Life				Exercise Price				9/30/06				Life				Exercise Price
$1.19-     1.56			633				4.2			$	1.49				633				4.2			$	1.49
$2.06-     3.09			152				3.8			$	2.89				152				3.8			$	2.89
$3.12-     4.66			145				6.6			$	4.20				105				6.5			$	4.15
$4.77-     6.19			307				6.0			$	5.02				302				6.0			$	5.00
$13.25- 19.88			48				2.0			$	15.06				48				2.0			$	15.06
$21.00- 27.50			6				0.6			$	21.19				6				0.6			$	21.19
$1.19-   27.50			1,291				4.8			$	3.39				1,246				4.7			$	3.35

     The Company granted stock options covering 24,000 shares to the non-officer directors during 2006 and during 2005. The fair value of the options granted in 2006 totaled $59,000. No additional options were granted in 2005 or the first nine months of 2006. The fair values of stock options granted in 2005 and 2006 and the ESPP granted at the beginning of 2005 and 2006 were estimated using the following assumptions:

		Stock Options				ESPP
2006 Assumptions:
Expected dividend yield			0	%			0	%
Expected volatility			58	%			58	%
Risk-free interest rate			4.25	%			4.25	%
Expected life (years)			5				.25, .50, .75, 1

		Stock Options				ESPP
2005 Assumptions:
Expected dividend yield			0	%			0	%
Expected volatility			50	%			50	%
Risk-free interest rate			3.00	%			3.00	%
Expected life (years)			5				.25, .50, .75, 1

     The expected life of the ESPP grant represents the calendar quarters from the grant date (January 1) to the purchase date (end of each quarter).

3. 2005 CHANGE IN ACCOUNTING FOR PRENEED SELLING COSTS

     On June 30, 2005, the Company changed its method of accounting for deferred obtaining costs, which are preneed selling costs, incurred for the origination of prearranged funeral and cemetery service and merchandise sales contracts. Prior to this change, commissions and other costs that were related to the origination of prearranged funeral and cemetery service and merchandise sales were deferred and amortized with the objective of recognizing the selling costs in the same period that the related revenue is recognized. Under the prior accounting method, the commissions and other direct selling costs, which are current obligations that are paid and use operating cash flow, are not recognized currently in the income statement. The Company believes it is preferable to expense the current obligation for the commissions and other costs rather than defer these

costs. The Company applied this change in accounting method effective January 1, 2005. Therefore, the Company’s results of operations for the three and nine month periods ended September 30, 2005 are reported on the basis of our changed method.

     As of January 1, 2005, the Company recorded a cumulative effect of change in accounting method of $35.8 million pretax or $22.8 million after tax (net of income tax benefit of $13.0 million), or $1.25 per diluted share, which represents the cumulative balance of deferred preneed selling costs in the Company’s consolidated balance sheet.

4. ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS

     On July 25, 2006, Carriage Services, Inc. completed the sale of a funeral home business and a combination funeral home and cemetery business in the state of Indiana. The Company received net proceeds of $6.5 million as follows: (i) the sum of $7.5 million in cash less (ii) the issuance of a note payable to the buyer in the amount of $1.0 million. In accordance with the bank credit facility, approximately $5.5 million of the net cash proceeds are pledged and restricted for use only for acquisitions or capital expenditures. The carrying value of the assets of these businesses was reduced to management’s estimate of fair value less estimated costs to sell by recording impairment charges totaling $5.4 million during the first six months of 2006, a substantial portion of which related to specifically identified goodwill.

     During September 2006, the Company ceased operations at a funeral home business when the lease on the property expired. The carrying value of the assets of this business was reduced to management’s estimate of fair value less estimated costs to sell by recording impairment charges totaling $0.9 million during the second quarter of 2006. The preneed contracts and other business assets were transferred to another company-owned funeral home in the area. No business was held for sale at September 30, 2006.

          The operating results of businesses discontinued during the periods presented, as well as impairments and gains or losses on the disposal, are presented on a comparative basis in the discontinued operations section of the consolidated statements of operations, along with the income tax effect. Likewise, the operating results, impairment charges and gains or losses from businesses sold in the prior year have been similarly reported for comparability. Revenues and operating income for the businesses presented in the discontinued operations section are as follows (in thousands):

		For the three months								For the nine months
		ended September 30,								ended September 30,
		2005				2006				2005				2006
Revenues		$	940			$	210			$	3,377			$	1,949
Operating income		$	112			$	30			$	681			$	355
Gain (losses) on sale and (impairments)			836				(111	)			1,303				(6,443	)
(Provision) benefit for income taxes			(350	)			30				(739	)			1,960
Income (loss) from discontinued operations		$	598			$	(51	)		$	1,245			$	(4,128	)

     During January 2005, the Company closed on the sale of a funeral home business. The sale transaction generated net cash proceeds totaling $0.5 million and a gain of approximately $0.3 million. During May 2005, the Company ceased operations at a funeral home business when the lease on the property expired. The preneed contracts and other business assets were transferred to another company-owned funeral home in the area. During July 2005, the Company closed on the sale of a cemetery business. The sale transaction generated net cash proceeds totaling $1.1 million and a gain of approximately $0.8 million.

5. SHORT TERM INVESTMENTS

     Short term investments are investments purchased with an original maturity of greater than three months but less than a year at the time of purchase. Short term investments at September 30, 2006 consisted of commercial paper with maturity dates that range from October 2006 to February 2007 at rates ranging from 4.96% to 5.25% per annum. Market values approximates cost.

6. GOODWILL AND OTHER INTANGIBLE ASSETS

     Many of the acquired funeral homes and former owners have provided high quality service to families for generations. The resulting loyalty often represents a substantial portion of the value of a funeral business. 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.

The following table presents changes in goodwill for the nine months ended September 30, 2006 (in thousands):

		December 31,
		2005
Goodwill at December 31, 2005		$	157,358
Divestitures			(6,174	)
Acquisitions			85
Goodwill at September 30, 2006		$	151,269

7. PRENEED ASSETS

Preneed assets consist of the following:

		December 31,				September 30,
		2005				2006
Cemetery preneed receivables and trust investments		$	67,995			$	65,974
Funeral preneed receivables and trust investments			50,420				48,182
Receivable from funeral trusts			17,411				16,827
		$	135,826			$	130,983

Cemetery preneed receivables and trust investments

     Cemetery preneed receivables and trust investments, net of allowance for cancellations, represent trust fund assets and customer receivables (net of unearned finance charges) for contracts sold in advance of when the merchandise or services are needed. The components of Cemetery preneed receivables and trust investments in the consolidated balance sheet at December 31, 2005 and September 30, 2006 are as follows (in thousands):

		December 31,				September 30,
		2005				2006
Trust investments		$	54,768			$	53,868
Receivables from customers			17,304				16,554
Unearned finance charges			(3,143	)			(3,157	)
Allowance for doubtful accounts			(934	)			(1,291	)
Cemetery preneed receivables and trust investments		$	67,995			$	65,974

     Cemetery preneed receivables and trust investments are reduced by the trust investment earnings the Company has been allowed to withdraw prior to performance by the Company and amounts received from customers that are not required to be deposited into trust, pursuant to various state laws. Preneed cemetery sales are usually financed through interest-bearing installment sales contracts, generally with terms of up to five years. The interest rates generally range between 12% and 14%.

The cost and market values associated with cemetery preneed trust investments at September 30, 2006 are detailed below (in thousands). The Company believes the unrealized losses related to trust investments at September 30, 2006 are primarily related to changes in market interest rates and equity values and are temporary in nature. Net unrealized gains decreased $0.1 million for the nine months ended September 30, 2006, respectively.

						Unrealized				Unrealized
		Cost				Gains				Losses				Market
Cash and money market accounts		$	2,866			$	—			$	—			$	2,866
Fixed income securities:
U.S. Agency obligations			5,432				3				(57	)			5,378
State obligations			14,663				159				(201	)			14,621
Corporate			3,048				19				(20	)			3,047
Other			6				—				—				6
Common stock			10,235				961				(188	)			11,008
Mutual funds:
Equity			11,221				671				(107	)			11,785
Fixed income			4,845				83				(16	)			4,912
		$	52,316			$	1,896			$	(589	)		$	53,623
Accrued investment income		$	245											$	245
Trust investments														$	53,868
Market value as a percentage of cost															103.0	%

Funeral preneed receivables and trust investments

     Funeral preneed receivables and trust investments, net of allowance for cancellations, represent trust fund assets and customer receivables related to contracts sold in advance of when the services or merchandise is needed. Such contracts are secured by funds paid by the customer to the Company. Funeral preneed receivables and trust investments are reduced by the trust investment earnings the Company has been allowed to withdraw prior to performance by the Company and amounts received from customers that are not required to be deposited into trust, pursuant to various state laws.

     The components of Funeral preneed receivables and trust investments in the consolidated balance sheet at December 31, 2005 and September 30, 2006 are as follows (in thousands):

		December 31,				September 30,
		2005				2006
Trust investments		$	47,678			$	45,215
Receivables from customers			8,709				8,752
Allowance for contract cancellations			(5,967	)			(5,785	)
Funeral preneed receivables and trust investments		$	50,420			$	48,182

     The cost and market values associated with funeral preneed trust investments at September 30, 2006 are detailed below (in thousands). The Company believes the unrealized losses related to trust investments at September 30, 2006 are primarily related to changes in market interest rates and equity values and are temporary in nature. Net unrealized gains increased $0.2 million for the nine months ended September 30, 2006, respectively.

						Unrealized				Unrealized
		Cost				Gains				Losses				Market
Cash and money market accounts		$	24,253			$	—			$	—			$	24,253
Fixed income securities:
U.S. Treasury			369				—				(11	)			358
State obligations			1,680				50				—				1,730
Corporate			2,134				18				(30	)			2,122
Obligations and guarantees of U.S. government agencies			1,179				1				(36	)			1,144
Common stock			1,911				356				(43	)			2,224
Mutual funds:
Equity			10,119				722				(16	)			10,825
Fixed income			2,595				13				(49	)			2,559
Trust investments		$	44,240			$	1,160			$	(185	)		$	45,215
Market value as a percentage of cost															102.2	%

     Upon cancellation of a preneed funeral or cemetery contract, a customer is generally entitled to receive a refund of the corpus and some or all of the earnings held in trust. In certain jurisdictions, the Company is obligated to fund any shortfall if the amounts deposited by the customer exceed the funds in trust including some or all investment income. As a result, when realized or unrealized losses of a trust result in the trust being under-funded, the Company assesses whether it is responsible for replenishing the corpus of the trust.

Receivable from Funeral Trusts

     The receivable from funeral trusts represent assets in trusts which are controlled and operated by third parties in which the Company does not have a controlling financial interest (less than 50%) in the trust assets. The Company accounts for these investments at cost.

Trust Investment Security Transactions

     Investment security transactions recorded in Other income in the Consolidated Statement of Operations for the three and nine months ended September 30, 2006 and 2005 are as follows (in thousands).

		For the three months								For the nine months
		ended September 30,								ended September 30,
		2005				2006				2005				2006
Investment income		$	1,698			$	1,049			$	2,824			$	3,408
Realized gains			390				484				2,023				3,586
Realized losses			(35	)			(285	)			(484	)			(1,506	)
Expenses			(154	)			(267	)			(430	)			(1,101	)
Increase in non-controlling interests in trust investments			(1,899	)			(981	)			(3,933	)			(4,387	)
		$	—			$	—			$	—			$	—

8. CONTRACTS SECURED BY INSURANCE

     Certain preneed funeral contracts are secured by life insurance contracts. Generally, the proceeds of the life insurance policies have been assigned to the Company and will be paid upon the death of the insured. The proceeds will be used to satisfy the beneficiary’s obligations under the preneed contract for services and merchandise. The preneed funeral contracts secured by insurance which are not included in the Company’s consolidated balance sheet totaled $164 million at September 30, 2006.

9. CEMETERY PERPETUAL CARE TRUST INVESTMENTS

     The Company is required by state law to pay a portion of the proceeds from the sale of cemetery property interment rights into perpetual care trust funds. The cost and market values associated with the trust investments held in perpetual care trust funds at September 30, 2006 are detailed below (in thousands). The Company believes the unrealized losses related to the trust investments September 30, 2006 are primarily related to changes in market interest rates and equity values and are temporary in nature. Net unrealized gains increased $0.2 million for the nine months ended September 30, 2006.

						Unrealized				Unrealized
		Cost				Gains				Losses				Market
Cash and money market accounts		$	1,641			$	—			$	—			$	1,641
Fixed income securities:
U.S. Treasury			499				4				(3	)			500
U.S. Agency obligation			5,927				6				(63	)			5,870
State obligations			609				17				—				626
Corporate			1,049				22				(2	)			1,069
Other			370				—				(11	)			359
Common stock			9,160				1,073				(152	)			10,081
Mutual funds:
Equity			5,625				472				(93	)			6,004
Fixed income			4,405				111				(13	)			4,503
		$	29,285			$	1,705			$	(337	)		$	30,653
Accrued investment income		$	73												73
Trust investments														$	30,726
Market value as a percentage of cost															104.9	%

     Non-controlling interests in cemetery perpetual care trusts represent the corpus of those trusts for which the Company is only entitled to receive the income. The components of non-controlling interests in cemetery perpetual care trusts as of December 31, 2005 and September 30, 2006 are as follows:

		December 31,				September 30,
		2005				2006
Trust assets, at market value		$	32,356			$	30,726
Pending withdrawals of income			(719	)			(517	)
Debt due to a perpetual care trust			1,092				—
Pending deposits			383				60
Non-controlling interests		$	33,112			$	30,269

10. DEFERRED REVENUE

The components of deferred revenue in the consolidated balance sheets at December 31, 2005 and September 30, 2006 are as follows:

		December 31,				September 30,
		2005				2006
Deferred cemetery contracts revenue		$	51,928			$	49,521
Deferred preneed funeral contracts revenue			29,446				29,468
Non-controlling interests in funeral and cemetery trust investments			102,446				99,083
		$	183,820			$	178,072

     Non-controlling interests in funeral and cemetery preneed trusts represent deferred revenue related to assets held in the preneed trusts. The Company will recognize the revenue at the time the service is performed and merchandise is delivered. The components of Non-controlling interests in funeral and cemetery preneed trusts as of September 30, 2006 are as follows:

		September 30, 2006
		Preneed				Preneed				Total
		Funeral				Cemetery				Preneed
Trust assets, at market value		$	45,215			$	53,868			$	99,083
Non-controlling interests		$	45,215			$	53,868			$	99,083

11. MAJOR SEGMENTS OF BUSINESS

     Carriage conducts funeral and cemetery operations only in the United States. The following table presents revenue, pretax income from continuing operations and total assets by segment (in thousands):

		Funeral				Cemetery				Corporate				Consolidated
Revenues from continuing operations:
Nine months ended September 30, 2006		$	87,395			$	27,451			$	—			$	114,846
Nine months ended September 30, 2005		$	84,949			$	28,715			$	—			$	113,664
Income (loss) from continuing operations before income taxes:
Nine months ended September 30, 2006		$	22,166			$	2,404			$	(20,519	)		$	4,051
Nine months ended September 30, 2005		$	22,136			$	4,841			$	(28,825	)		$	(1,848	)
Total assets:
September 30, 2006		$	311,474			$	178,063			$	67,533			$	557,070
December 31, 2005		$	322,497			$	189,684			$	58,459			$	570,640

12. SUPPLEMENTAL DISCLOSURE OF STATEMENT OF OPERATIONS INFORMATION

		For the three months								For the nine months
		ended September 30,								ended September 30,
		2005				2006				2005				2006
Revenues
Goods
Funeral		$	11,281			$	11,797			$	37,039			$	37,696
Cemetery			6,940				5,618				20,479				19,030
Total goods		$	18,221			$	17,415			$	57,518			$	56,726
Services
Funeral		$	14,707			$	15,488			$	47,910			$	49,699
Cemetery			2,623				2,597				8,236				8,421
Total services		$	17,330			$	18,085			$	56,146			$	58,120
Total revenues		$	35,551			$	35,500			$	113,664			$	114,846
Cost of revenues
Goods
Funeral		$	10,834			$	11,572			$	34,208			$	35,711
Cemetery			5,604				6,090				16,465				18,221
Total goods		$	16,438			$	17,662			$	50,673			$	53,932
Services
Funeral		$	9,191			$	9,828			$	28,024			$	29,556
Cemetery			2,159				2,379				6,752				6,753
Total services		$	11,350			$	12,207			$	34,776			$	36,309
Total cost of revenues		$	27,788			$	29,869			$	85,449			$	90,241

13. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

     The following information is supplemental disclosure for the Consolidated Statement of Cash Flows (in thousands):

		For the nine months ended
		September 30,
		2005				2006
Cash paid for interest and financing costs		$	31,226			$	16,163
Cash paid for income taxes (state)		$	270			$	249
Restricted common stock issued to officers		$	1,337			$	—
Restricted cash investing and financing activities:
Proceeds from the sale of securities of the funeral and cemetery trusts		$	30,539			$	45,671
Purchases of available for sale securities of the funeral and cemetery trusts		$	38,713			$	38,028
Net deposits (withdrawals) in trust accounts increasing noncontrolling interests		$	7,675			$	1,622

14. DEBT

     In January 2005, the Company issued $130 million of 7.875 percent Senior Notes at par, due in 2015. The proceeds from these notes were used to refinance substantially all senior debt, bring current the cumulative deferred distributions on the convertible junior subordinated debenture and the TIDES, and for general corporate purposes. In March 2005, the Company paid the cumulative deferred distributions on the TIDES totaling $10.9 million. During April 2005, the Company entered into a $35 million senior secured revolving credit facility that matures in five years to replace the existing unsecured credit facility at that time. Borrowings under the new credit facility bear interest at prime or LIBOR options with the current LIBOR option set at

LIBOR plus 300 basis points and is collateralized by all personal property and by funeral home real property in certain states. The facility is currently undrawn.

     Carriage, the parent entity, has no independent assets or operations. All assets and operations are held and conducted by subsidiaries, each of which (except for Carriage Services Capital Trust which is a single purpose entity that holds the debentures issued in connection with our TIDES) have fully and unconditionally guaranteed our obligations under the Senior Notes. Additionally, the Company does not currently have any significant restrictions on our ability to receive dividends or loans from any subsidiary guarantor under the Senior Notes.

     In connection with the senior debt refinancing, 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 (in aggregate $4.2 million after tax, or $0.23 per diluted share) during the first quarter of 2005. In connection with the new senior secured revolving credit facility, the Company recorded a charge to write off $0.2 million or $0.01 per diluted share of unamortized loan costs during the second quarter of 2005. These charges are included in the Consolidated Statement of Operations as additional interest and other costs of senior debt refinancing during nine months ended September 30, 2005.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

     In addition to historical information, this Quarterly Report contains forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include any projections of earnings, revenues, asset sales, acquisitions, cash balances and cash flow, debt levels or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements may include the words “may”, “will”, “estimate”, “intend”, “believe”, “expect”, “project”, “forecast”, “plan”, “anticipate” and other similar words.

Cautionary Statements

          We caution readers that the following important factors, among others, in some cases have affected, and in the future could affect, our actual consolidated results and could cause our actual consolidated results in the future to differ materially from the goals and expectations expressed herein and in any other forward-looking statements made by or on behalf of us. For further information regarding risks associated with our business and the death care industry, see Item 1A – Risk Factors in our annual report filed on Form 10-K for the year ended December 31, 2005.

          Risks related to our business

          (1) Marketing and sales activities by existing and new competitors could cause us to lose market share and lead to lower revenues and gross profit.

          (2) Our ability to generate preneed sales depends on a number of factors, including sales incentives and local and general economic conditions.

          (3) Price competition could also reduce our market share or cause us to reduce prices to retain or recapture market share, either of which could reduce revenues and margins.

          (4) Our ability to execute our growth strategy is highly dependent upon our ability to successfully identify suitable acquisition candidates and negotiate transactions on favorable terms.

          (5) Increased or unanticipated costs, such as insurance, taxes and new computer systems implementations, may have a negative impact on our earnings and cash flows.

          (6) Improved performance in our funeral segment is highly dependent upon successful execution of our standards-based Being the Best operating model.

          (7) Smaller businesses are typically dependent upon one or a few key employees for success.

          (8) Earnings from and principal of trust funds and insurance contracts could be reduced by changes in financial markets and the mix of securities owned.

          (9) Covenant restrictions under our debt instruments may limit our flexibility in operating our business.

          Risks related to the death care industry

          (1) Declines in the number of deaths in our markets can cause a decrease in revenues. Changes in the number of deaths are not predictable from market to market or over the short term.

          (2) The increasing number of cremations in the United States could cause revenues to decline because we could lose market share to firms specializing in cremations. In addition, direct cremations produce minimal revenues for cemetery operations and lower funeral revenues.

          (3) If we are not able to respond effectively to changing consumer preferences, our market share, revenues and profitability could decrease.

          (4) Because the funeral and cemetery businesses are high fixed-cost businesses, changes in revenues can have a disproportionately large effect on cash flow and profits.

          (5) Changes or increases in, or failure to comply with, regulations applicable to our business could increase costs or decrease cash flows.

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 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 interment rights (grave sites and mausoleums) and related merchandise such as markers and memorials. As of September 30, 2006, we operated 131 funeral homes in 27 states and 28 cemeteries in 11 states within the United States. Substantially all administrative activities are conducted in our home office in Houston, Texas.

     Factors affecting our funeral operating results include: 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. 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 40% 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.

     We implemented several significant long-term initiatives in our funeral operations at the beginning of 2004 designed to improve operating and financial results by growing market share and increasing profitability. We introduced a more decentralized, entrepreneurial and local operating model that included operating and financial standards developed from our best funeral operations, along with an incentive compensation plan to reward business managers for successfully meeting or exceeding the standards. The model essentially eliminated the use of financial budgets for the funeral homes. The operating model and standards, which we refer to as “Being the Best,” focus on the key drivers of a successful funeral operation, organized around three primary areas – market share, people and operating and financial metrics. The model and standards are the measures by which we judge the success of each funeral business. To date, the “Being the Best” operating model and standards have not provided overall improvement in profitability. In certain businesses we have determined that the business managers do not possess the characteristics to succeed in this type of culture, and we are actively recruiting new managers who do. We have also determined that this model is most effective in larger businesses. Being the best is not something that occurs easily and quickly, but execution of the model should result in improving performance in 2007 and beyond.

     The cemetery operating results are affected by the size and success of our sales organization because approximately 60% of our cemetery revenues for the nine months ended September 30, 2006 relate to sales of grave sites and mausoleums and related merchandise and services before the time of need. 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 cemetery revenues. Approximately 11% of our cemetery revenues for the nine months ended September 30, 2006 are 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.

     Financial Highlights

     Net loss from continuing operations for the three months ending September 30, 2006 totaled $0.5 million, equal to $(0.03) per diluted share as compared to net income from continuing operations of $0.1 million for the third quarter of 2005. The third quarter is typically our weakest quarter for seasonal reasons. As discussed in the Cemetery Segment, the underperformance was related primarily to lower revenues and higher operating costs at our largest cementery in California.

     Net income from continuing operations for the first nine months of 2006 totaled $2.5 million, equal to $0.13 per diluted share as compared to a net loss from continuing operations of $1.1 million for the first nine months of 2005, or $(0.06) per diluted share. The variance between the two periods was primarily due to a make-whole payment during the first quarter of 2005 to the former debtholders in connection with the repayment of the previously outstanding senior debt. We repaid this senior debt and paid the make-whole payment with proceeds from our $130 million senior note offering, which closed in January 2005. The make-whole payment resulted in additional pre-tax interest of $6.0 million, along with a charge in the amount of $0.9 million to write off the related unamortized loan costs, in total equal to $0.24 per diluted share. During the second quarter of 2005 the Company incurred a loss on the sale of undeveloped land and costs in connection with refinancing the bank credit facility, which together totaled $0.8 million, equal to $0.03 per diluted share. During the third quarter of 2006 the Company recorded a gain on the sale of property of $0.5 million, equal to $0.02 per diluted share. Additionally, the Company recorded charges of approximately $0.9 million for environmental remediation and severance. Excluding the effect of these items, diluted earnings per share from continuing operations for the nine months ending September 30, 2005 equaled $0.21 compared to $0.15 for the nine months ended September 30, 2006.

     There are two areas that management is focusing its efforts to improve results: (1) The Central Region funeral operations which suffered a year over year decline in pretax profitability of $1.6 million, and (2) a cemetery in California, whose pretax earnings have declined by $2.1 million. The decline in profitability in these two areas is equivalent to $0.12 per diluted share for

the nine month period. We recently made changes in leadership over each of these areas to focus on the issues affecting profits, such as local sales management, receivable collections and marketshare losses.

     Loss from discontinued operations for the nine months ending September 30, 2006 totaled $4.1 million, equal to $(0.22) per diluted share. On July 25, 2006, the Company completed the sales of a funeral home business and a combination funeral home and cemetery business in the state of Indiana. We recorded pre-tax impairment charges in 2006 of approximately $5.4 million to write down the current book value to the estimated net proceeds. During September 2006, the Company ceased operations at a funeral home business when the lease on the property expired. The carrying value of the assets of this business was reduced to management’s estimate of the realizable value by recording impairment charges totaling $0.9 million during the second quarter of 2006. The preneed contracts and other business assets were transferred to another company-owned funeral home in the area. Income from discontinued operations for the nine months ending September 30, 2005 totaled $1.2 million, equal to $0.07 per share, and consisted primarily of a gain on the sale of a funeral home business during the first quarter of 2005.

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, as 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 U.S. generally accepted accounting principles excluding certain year end adjustments because of the interim nature of the consolidated financial statements. Our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements included in our annual report on Form 10-K for the year ended December 31, 2005. 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 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 contract is executed. 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 from 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.

Preneed Selling Costs

     On June 30, 2005, the Company changed its method of accounting for deferred obtaining costs, which are preneed selling costs incurred, for the origination of prearranged funeral and cemetery service and merchandise sales contracts. Prior to this change, commissions and other direct selling costs related to originating preneed funeral and cemetery service and merchandise sales contracts were deferred and amortized with the objective of recognizing the selling costs in the same period that the related revenue is recognized. Under the prior accounting method, the commissions and other direct selling costs, which are current obligations are paid and use operating cash flow, are not recognized currently in the income statement. The Company believes it is preferable to expense the current obligation for the commissions and other costs rather than defer these costs. The Company also believes the new accounting method improves the comparability of its reported earnings because all of the public deathcare companies now apply this method.

     The Company applied this change in accounting method effective January 1, 2005. As of January 1, 2005, the Company recorded a cumulative effect of change in accounting method of $35.8 million pretax or $22.8 million after tax (net of income tax benefit of $13.0 million), or $1.25 per diluted share, which represents the cumulative balance of deferred preneed selling costs in

the Company’s consolidated balance sheet at the end of 2004. The Company’s results of operations are reported on the basis of our changed method for all periods presented.

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 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 109, “Accounting for Income Taxes.” 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 restricted stock, stock option and employee stock purchase plans. The Company accounts for stock-based compensation under Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS No. 123R”). FAS No. 123R requires companies to recognize compensation expense in an amount equal to the fair value of the share-based payment issued to employees over the period of vesting. The fair value of share based payment is determined using the Black-Scholes valuation model. FAS No. 123R applies to all transactions involving issuance of equity by a company in exchange for goods and services, including employee services. The Company adopted FAS No. 123R in the first quarter of 2006, using the modified prospective application method, which results in no restatement of the Company’s previously issued annual consolidated financial statements. See Note 2 to the consolidated financial statements.

     Prior to 2006, the Company accounted for stock based compensation under APB No. 25 and provided the disclosures required under SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”

Impairment and Disposal of Long-Lived Assets

     Except as noted for Goodwill, the Company reviews its long-lived assets for impairment when changes in circumstances indicate that the carrying amount of the asset may not be recoverable in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” 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.

Preneed Funeral and Cemetery Trust Funds

     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 does not affect cash flow, net income or the manner in which we recognize and report 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 investment in the Company’s consolidated balance sheet. Unrealized gains and losses attributable to the Company, but that have not been earned through the performance of services or delivery of merchandise, are allocated to deferred revenues.

     Also, in connection with the implementation of FIN 46R, the Company began recognizing income, gains and losses, of the preneed trusts and cemetery perpetual care trusts. The Company recognizes a corresponding expense equal to the recognized 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 earnings, when the contracted services have been performed and merchandise delivered. 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.

RESULTS OF OPERATIONS

     The following is a discussion of the Company’s results of operations for the three and nine month periods ended September 30, 2005 and 2006. Funeral homes and cemeteries owned and operated for the entirety of each period being compared are referred to as “same-store” or “existing operations.”

Funeral Home Segment. The following table sets forth certain information regarding the revenue and gross profit of the Company from the funeral home operations for the three and nine months ended September 30, 2005 compared to the three and nine months ended September 30, 2006.

Three months ended September 30, 2005 compared to three months ended September 30, 2006 (dollars in thousands):

		Three Months Ended
		September 30,								Change
		2005				2006				Amount				Percent
Total same-store revenue		$	25,330			$	26,378			$	1,048				4.1	%
Acquired and closed			45				271				226				*
Preneed insurance commissions revenue			613				636				23				3.8	%
Revenues from continuing operations		$	25,988			$	27,285			$	1,297				5.0	%
Revenues from discontinued operations		$	614			$	94			$	(520	)			*
Total same-store gross profit		$	5,401			$	5,219			$	(182	)			(3.4	%)
Acquired and closed			(51	)			30				81				*
Preneed insurance commissions revenue			613				636				23				3.8	%
Gross profit from continuing operations		$	5,963			$	5,885			$	(78	)			(1.3	%)
Gross profit from discontinued operations		$	126			$	(31	)		$	(157	)			*