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Healthcare Services Group, Inc. (NASDAQ:HCSG)

Q4 2008 Earnings Call Transcript

February 10, 2009 4:30 pm ET

Executives

Daniel McCartney – Chairman and CEO

Richard Hudson – CFO and Secretary

Analysts

Michael Gallo – C.L. King

Ryan Daniels – William Blair

Mitra Ramgopal – Sidoti

Rob Mains – Morgan, Keegan

Eric Gommel – Stifel Nicolaus

Clinton Fendley – Davenport

Bryan Sell [ph] – Peak Financial [ph]

Operator

Good day everyone and welcome to the Healthcare Services Group Incorporated reports results for the third [ph] quarter of 2008. This is a reminder that today's conference is being recorded. Before introducing the speaker today, the company would like to read a cautionary statement regarding forward-looking statements.

Unidentified Company Speaker

The discussion this afternoon will contain forward-looking statements within the meaning of section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Act of 1934, as amended. They are not historical facts but rather based on current expectations, estimates and projections about our business and industry; our beliefs and assumptions. Words such as believes, anticipates, plans, expects, will, goal, and similar expressions are intended to identify forward-looking statements. The inclusion of forward-looking statements should not be regarded as a representation by us that any of our plans will be achieved. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Such forward-looking statement and information is also subject to various risks and uncertainties. Such risks and uncertainties include, but are not limited to; risks arising from our providing services exclusively to the healthcare industry, primarily providers of long-term care; credit and collection risks associated with this industry; one client accounting for approximately 15% of revenues in the year ended September 31, 2008; risks associated with our acquisition of Summit Services Group Inc.; our claims experience related to Workers' Compensation and general liability insurance; the effects of changes in or interpretations of laws and regulations governing the industry, including state and local regulations pertaining to the taxability of our services; and the risk factors described in our Form 10-K for the year ended December 31, 2007 in various parts.

Many of our clients' revenues are highly contingent on Medicare and Medicaid reimbursement funding rates, which Congress has affected through the enactment of a number of major laws during the past decade. These laws have significantly altered or threatened to alter overall government reimbursement funding rates and mechanisms. The overall affect of these laws and trends in the long-term care industry have affected and could adversely affect the liquidity of our clients, resulting in their inability to make payments to us on agreed-upon terms. These factors, in addition to delays in payment from clients, have resulted in and could continue to result in significant additional bad debt in the near future. Additionally, our operating results would be adversely affected if unexpected increases in the cost of labor and labor-related costs, materials, supplies and equipment used in performing our services could not be passed on to our clients.

In addition, we believe that to improve our financial performance we must continue to obtain service agreements with new clients, provide new services to existing clients, achieve modest price increases on current service agreements with existing clients, and maintain internal cost reduction strategies at our various operational levels. Furthermore, we believe that our ability to sustain the internal development of managerial personnel is an important factor impacting future operating results and successfully executing projected growth strategies.

Operator

Thank you, and now I would like to introduce today’s speaker, Mr. Daniel McCartney, CEO. Mr. McCartney, please go ahead.

Daniel McCartney

Thank you and thank you everybody for joining us on this conference call. We reported our year-end and fourth quarter results and our 10-K we plan to file in about two weeks, but the release is a little earlier. We reported – our revenues were up more than 5% to $154,563,000 for the quarter and $602,718,000 or up 4% for the year. We continued to make up for the impact of the loss of two of our corporate chains in the first quarter 2008, which we had mentioned in previous releases and quarter. They've reduced our revenue $13 million in annualized sales and about $3.5 million per quarter. Going into the first quarter of 2009, we won't have that comparison to deal with any more. But our new business has been steady, especially the third and fourth quarter, and we still expect to be at our double-digit revenue target in 2009, and if not in the first quarter of 2009, certainly close to it.

Our net income was $7,283,000 or $0.17 a share for the quarter or $26,614,000 or $0.60 a share for the year. The direct costs were a little bit above the 86%. Our housekeeping supplies, food purchases, and bad debt reserves were little higher than historically they had been. Our SG&A for the quarter was 6% and 6.5% for the year.

In the fourth quarter, the 6% SG&A also includes the reduced deferred comp expense for the deferred comp balances and investments that were a loss. So it also reduced our net income and no P&L impact and that is very it looks distorted. If you added that back the SG&A was about 6.5% for the quarter as well.

Our investment income was about $2,700,000 less than it was in 2007. The balance sheet, we ended the quarter and the year with over $87 million in cash and marketable securities. We took about $50 million of our cash balances and put them into income yielding securities, tax-exempt marketable securities, just to try to get a little better return. Very short-term and very safe but try to improve the return a little bit.

Receivables stayed at 56, 57 days as they were in the third quarter. We still managed the receivables and credit as aggressively as we had in the past few years. I guess in summary, our direct costs were little bit higher than we expected them to be with the housekeeping food purchases a little bit higher than the bad debt reserve above our historical levels. We expect still to be able to reduce the direct cost and get them closer to 85% over the next year.

Food service has continued to improve and impact the direct costs on a positive light. Food service pre-tax income was up 15% on a 4% increase in sales. So, we expect that improvement to continue as the districts and regions in food service get more fully utilized; and get a little bit better investment income next year and be the beneficiary of easier comparisons. We think we are going through 2009 in pretty good shape.

So with that abbreviated review, I will open up to questions.

Question-and-Answer Session

Operator

Sir, are you ready to take questions now?

Daniel McCartney

Yes.

Operator

Thank you. (Operator instructions) We will take our first question today from Michael Gallo of C.L. King.

Michael Gallo – C.L. King

Hi, good afternoon.

Daniel McCartney

Hi, Mike.

Michael Gallo – C.L. King

Couple of questions, Dan. The gross margins, nice improvement sequentially from Q3, but still below your longer-term targets. I was wondering if there was any additional workers’ comp or bad debt reserves built into those numbers, or just anything that affected that comparison.

Daniel McCartney

The real – the housekeeping supplies were up about little less than 0.5%, and food services were up – food purchases were up close to 1% and that is really what caused the direct cost to be over 86%. We still – we expect that to not be in a continuous basis. A lot of new startups, yes, some initial purchases for housekeeping supplies, for example, but we expect those expenses to be back to their historical levels, and do expect to get below 86% and frankly work our way down to 85% in the direct cost area over the next year.

Michael Gallo – C.L. King

There was nothing really unusual, it sounded like just some timing of purchases and things like that. Is that a fair way to characterize it?

Daniel McCartney

Yes.

Michael Gallo – C.L. King

And then just second question, I mean, obviously everyone is looking at the state budget gap. California is certainly front and center of that. I was wondering if you have any sense for what might happen from sort of the state reimbursement side of things as we head through this year.

Daniel McCartney

I think most of the state budgets as far as Medicaid payments have been put in place. The cash flow issues in California are certainly a different issue, but what we are getting from most of our clients are they expect to be paid. Not like in the summer, where the budget impasse precluded them from passing the budget till almost October, and they didn't get any funding. They still expect to get paid. So, you know, with maybe some slight disruptions, we don't see that really as being a problem for us in California being the most degree. Just put all the states – or at least rhetorically talking about the same kind of issues, but I think the Medicaid rates have been set unless there is an acute cash flow issue state-by-state. I really don't think it will impact us to any great degree.

Michael Gallo – C.L. King

Okay, and just any further comments, just overall health of the customer base, obviously you had those two customers that our left in the year, and so haven't had any significant new issues since then. Any kind of update on where things are in terms of – do you see anything problematic in the customer base, you know, it is pretty much, you know, things are pretty much the same?

Daniel McCartney

I think our issues are still customer specific that state-by-state you hear a little bit different rhetoric as far as what their deficits are and how it is going to impact future spending. But, the way we managed the credit really in the last seven or eight years is we really look at it rather than in the aggregate, customer by customer and try to make our judgments like we did in the first quarter of 2008 with the clients getting beyond the terms that we felt comfortable with, and we are not comfortable with the explanation or the projection of when they will get back to the credit terms. We still keep the clients on a shorter string and lead billings [ph] faster than historically we ever had and we are going to continue to do that regardless of the state issues. If it becomes more acute because of specific states we will assess that, but we really don't see that being the case for the time being anyhow.

Michael Gallo – C.L. King

Okay, thanks a lot.

Daniel McCartney

Okay.

Operator

Next we will take a question from Ryan Daniels with William Blair.

Ryan Daniels – William Blair

Hi, good afternoon Dan. Just a couple of quick follow-ons, first off sticking with the changes that have issues earlier in the year. I know there was one that entered bankruptcy in September, and I was curious if you got any updates their regarding recapturing some of your accounts receivable or have they gone to the Creditors’ committee guys, where does that stand and what are your thoughts there?

Daniel McCartney

Haven't yet, but there is still – they had an exclusivity period to put their plan together that has been extended twice and now it will be extended till the end of February. They are still saying they are expecting the reorganization to give the creditors an option either to be paid in full over a period of time or take a discount upfront, which we will assess when it is put in place. So they are not saying anything different but the plan hasn’t been submitted to the court yet. So until that happens, we are going to keep the reserve as it is and not look until we have more definitive recovery options to assess at that time what we should do.

Ryan Daniels – William Blair

Got you. So maybe some ‘09 upside but at this point just wait and see?

Daniel McCartney

Yes.

Ryan Daniels – William Blair

Okay, and then in regards to the market if we look at the macro environment and unemployment spiking up recently, does that position your organization better on the hiring front, on the retention front, are there kind of countercyclical advantages to your model, almost that will allow you to continue to grow through this period?

Daniel McCartney

I think what will happen for the most part, and it will be around the edges. It want have any dramatic impact, but I think that perhaps because we match whatever the wage rate or benefits are that the facility pays, perhaps the future increases won’t be as generous as they have been in the past because that labor market has changed to some degree. But I think that is going to be specific in different areas too. I think some will be impacted more, others to be competitive. We will still have to give the kind of increases they have given before. So, I don't think it is going to help or hurt to any great degree. If I had to say on which side of the ledger, I would say may be the increases that customers give their blue-collar workers and therefore the increases we would look to get may be a little less than they have been in the past, but I don't expect them to be too much.

Ryan Daniels – William Blair

And that would impact your pricing and therefore revenue growth a bit, but probably wouldn't touch your profitability whatsoever, is that fair to say?

Daniel McCartney

Yes, yes. Instead of getting a 3% increase across the board, it may beat 2.5% because they feel it to be competitive. You only have to get that kind of wage increase.

Ryan Daniels – William Blair

Sure. Okay. And then, can you talk may be a little bit about the proposal pipeline. I think you have stated in the past it takes around 60 to 90 days from time you enter a facility to where that might actually be in operations, generating revenues. So any color there of how you ended the year, or maybe how you are starting ‘09 given the pressures on your clients. Is it still a pretty good selling environment for you?

Daniel McCartney

I think really the last, the third and fourth quarters were the best quarters we have had in a long time and the new business we added in the fourth quarter will have the full benefit of the first quarter. So, we think if we are not at double digits by the first quarter, we will be very close to it as far as revenue growth. Now, we don't have then the facilities to change that we discussed from the first quarter 2008, you know, hurting the comparison after the first quarter.

Ryan Daniels – William Blair

Right. Okay, great. And then two more quick housekeeping ones, I don't know if you have this offhand, but do you have a breakdown between food and housekeeping/linen and laundry revenues or maybe just food revenues?

Daniel McCartney

They've both been about 4% or 5%. They are both in the same neighborhood for the year. Food service probably a little bit higher in the fourth quarter.

Ryan Daniels – William Blair

Okay, that is helpful. And then total number of clients, do you have that offhand?

Richard Hudson

It'll be over 2400.

Ryan Daniels – William Blair

2400, okay great. Thanks. Nice quarter.

Richard Hudson

Thanks.

Operator

Your next question today will come from Mitra Ramgopal of Sidoti.

Mitra Ramgopal – Sidoti

The ability to hire personnel.

Daniel McCartney

Mitra, we missed the first part of your question.

Mitra Ramgopal – Sidoti

Yes, hi Dan. Given the environment out there, you know, I think one of the things constraining your growth is the ability to hire personnel. Is it, are you finding it a lot easier now to recruit and likely accelerate your expansion?

Daniel McCartney

I think we are really not affected. The management development for us is where we concentrated our efforts and that has always been the constraint on our growth. So, we are not really affected to any great degree by any macro employment. It is really the profiles that we have been able to procure, really dependent on us getting and improve the orientation and training more than them being committed. I can't work in a financial community now, so I'm going to look at different options and perhaps, end up in the service area in the healthcare field. The candidates we still look for really (inaudible) and are not affected to any great degree by the macro sense, maybe modestly. Our success is really getting through that 90 and 120 day period and being in a position to get through the difficult parts and understand our business and be skilled and entrepreneurial enough to start their way up, and because we are committed still to promote from within. There is just no shortcuts for that. So, it may modestly improve the candidates or the amount of candidates we get. But it is still really up to us to efficiently run the training program, which will dictate our success more than any overall labor view.

Mitra Ramgopal – Sidoti

Okay. And if you look back in ‘08, I think top line grew about 4% and you seem pretty confident that we should be seeing double-digit top line growth for ‘09. I don't know if you can give us a little more color in terms of what will help us to get there?

Daniel McCartney

Well, I mean I think first of all we just have to hit our targets this year. Have facility expansion, keep our client retention where it should be. What hurt us if you just add the $13 million in sales as the two chains hurt us for the year at $3.5 million per quarter that we had to make up. If you add that back to it and that is more our typical year and it puts us close to double digits even in 2008. So, that is why we feel more optimistic and have always even though maybe the results hadn’t always shown it that we would get back. It would just take us a couple of quarters to get back to the double digits and the 15% top line that we try to target internally.

Mitra Ramgopal – Sidoti

Okay, and did you buy back any stock in the quarter?

Daniel McCartney

In the quarter, I don't think we did. I think we bought back a little less than $5 million of stock for the year, but I don't think we did any in the fourth quarter.

Mitra Ramgopal – Sidoti

Okay, thanks again.

Daniel McCartney

Okay, thanks.

Operator

Next we will hear from Rob Mains, Morgan Keegan.

Rob Mains – Morgan, Keegan

Good afternoon Dan. Food costs were up, what was that related to?

Daniel McCartney

I think we had a lot of new startup since. The prices plateaued a little bit but perhaps with the new startups, they spent about almost 1% more than it had been in the previous quarter. It is still below 40%. But we were down around 37.5% in our estate [ph]. So, we still expect it to be below 40% but I think there were lot of new start-ups where we do our original, the bulk of our start up purchasing, both include housekeeping and laundry. I think that more than anything contributes to the increase in the expense.

Rob Mains – Morgan, Keegan

Okay, so it is analogous [ph] to the growth in housekeeping with the supplies expense?

Daniel McCartney

Yes.

Rob Mains – Morgan, Keegan

Okay. The retention rate in the quarter, was it still within your target?

Richard Hudson

Yes, it was better than 90%.

Daniel McCartney

You know, the first quarter of 2008, that was just unusual to have just that many properties affect us, and it just put us behind as far as the revenue growth and impacted us until we were worked those quarters out.

Rob Mains – Morgan, Keegan

Okay, and when you look at the new contracts that you signed in the quarter, was there a typical breakdown between food and housekeeping, or was one stronger than the other?

Daniel McCartney

No, they both were in the same category. The differences – the food service has a bigger impact because of the bubble of revenue, and secondarily food service expansion that we are concentrating on primarily in the Northeast part of the country with this higher wage rates. So they are highly valued contracts than if they were in other parts of the country where the wage rates were lower. So, I think in 2009 you will see food services growth be a little bit more accelerated than housekeeping and laundry. It is supposed to be the area that we are concentrating on. For housekeeping and laundry, we are growing throughout the country. So the same amount of facilities will have the same impact.

Rob Mains – Morgan, Keegan

And with the food service geographically, do you think that the growth you will see this year will still mostly be in the Northeast, are you looking at opening up some of the other regions?

Daniel McCartney

We are growing in the other regions, but the ones that were really letting be more aggressive and fully ramp up as far as the district and regional coverage are in the Northeast because that is where we have been the strongest. The Southeast is a little further behind. The Midwest is coming along maybe faster than the Southeast in some areas, but both still have good potential and frankly the far West, which was our newest area was performing better than we expected. We haven't added new business yet, but as far as consistency in performance they have really done a good job out there as well.

Richard Hudson

Our growth in food service will primarily still be in the Northeast, although the other areas will add some new business just by being around.

Rob Mains – Morgan, Keegan

Okay. And the last question, on the balance sheet, any kind of idea about what the investment the marketable securities might be able to do for investment income?

Daniel McCartney

It will be modest. It'll be some – it will be a better return than we have gotten where we had it before, but they won't be dramatically different but it is hard – we will have a better feel for it when the K comes out.

Rob Mains – Morgan, Keegan

Okay, fair enough. Thank you.

Daniel McCartney

Okay, thanks.

Operator

Next, we will take a question from Eric Gommel of Stifel Nicolaus.

Eric Gommel – Stifel Nicolaus

Hi, Dan.

Daniel McCartney

Hi, Eric.

Eric Gommel – Stifel Nicolaus

Hi, I know you might have addressed this, I think you said SG&A was about 6.5% of revenue if you look out –

Daniel McCartney

(inaudible).

Eric Gommel – Stifel Nicolaus

Okay. So, you know, in ’09, I mean, I think you talked about it being around 6.75% or 6.5%, I mean, how do you think about that?

Daniel McCartney

That is where I think it should be. Our current model, it shouldn't be higher than 6.75%, but we could get some efficiencies, and you could make the argument, the overheads spread out over a bigger base, should reduce. But we haven't done it consistently, so I always use 6.75%, couple of basis points more or less quarter-to-quarter as the target. But 6.5% to 6.75% is probably a safer target.

Eric Gommel – Stifel Nicolaus

And then, you know, if I think about the quarters next year, I mean just sort of a sequential ramp up maybe first-quarter to fourth quarter, is that the right way to think about it. I think this year was a little bit more lumpy because of some of those issues you were talking about?

Daniel McCartney

Yes, I think if you look second, third and fourth quarter we just continued to expand just not as rapidly as we would have liked, but when you dig a hole that such significant two clients changed the relationship in the first quarter, you just don't make it up. So as we continued to ramp up over the quarter you start to recover, but I think going into the first quarter, we will be in good shape. We expect to hit our targets, to keep client retention where it should be. We should be back to our double-digit target in 2009.

Eric Gommel – Stifel Nicolaus

Okay, and then just a couple of other little things, I mean, I get it from some of your comments that on the workers’ comp side, no significant spikes or issues there?

Daniel McCartney

The workman's comp was really a third-quarter aberration. So, we expected that to go to historical levels. The direct cost really impacted by the purchase of the housekeeping and food supplies more than anything.

Eric Gommel – Stifel Nicolaus

And then the last thing, this is more of a big picture issue. I mean, do you have any concerns with the new administration that may be a little bit more pro-Labor that you were going to have any issues, I mean, from an organizing standpoint. Is that something you are really not to worry about given you are just managed, you are kind of – you managed, you're in charge of the managers. They managed the fee – employee that doesn't really impact you. How do you think about that?

Daniel McCartney

We really don't manage the facilities differently and if the facilities unionize, we assent for a contract and we are happy to abide by the union contract. If it is non-union, we match the wag rates and benefits as well. So, it really doesn't impact us and frankly, I know it is counterintuitive, but more the employees get paid the better it is for us.

Eric Gommel – Stifel Nicolaus

Okay, fair enough. Thanks Daniel.

Daniel McCartney

Thank you.

Operator

Our next question today will come from Clinton Fendley of Davenport.

Clinton Fendley – Davenport

Good afternoon Dan.

Daniel McCartney

Hi, Clint. How are you doing?

Clinton Fendley – Davenport

Doing well.

Daniel McCartney

Good.

Clinton Fendley – Davenport

We did see a bit of a drop on the accrual for the insurance claims, I wondered what the reason for that was?

Daniel McCartney

You know, we performed better, you know, I said in the – you mean for the quarter right?

Clinton Fendley – Davenport

That is correct.

Daniel McCartney

I think a third-quarter was just – we had an unusual amount of claims and we paid them off and we make our calculation and so it does of what the ultimate claims will be, and so we just had better claim experience in the fourth quarter than we did in the third.

Clinton Fendley – Davenport

Okay.

Daniel McCartney

We really expect that. I mean, I think I said in the third quarter we had an unusual amount of claims from our historical levels.

Clinton Fendley – Davenport

Okay, and then a higher level question, as budgets are just expected to be under tremendous amount of pressure in almost any business in ‘09, I mean how does that affect both the value proposition as well as the decision making on the part of your customer base as they consider outsourcing?

Daniel McCartney

Well, I think for us the tighter our clients get squeezed the more they look for outsourcing services of all kinds not just for us that can do it in a cost-efficient way. So, I think from that vantage point the tighter their budget pressures become, the more they look for outsourcing and really the better it is for us, and we just had to make sure we manage the credit the way we have in the past seven or eight years, and, you know, not allow us to be the bridge to those budgetary differences. And that is why we have left more buildings for six or seven years then we did in the first 25 years of the company's existence, but that is why the receivables have been below 60 days for the last seven or eight years. So in summary, the tighter they get squeezed, the better, as long as it is nothing (inaudible) 1997, 1998, 1999 were in the balance budget amendment fiasco that impacted the industry so badly.

Clinton Fendley – Davenport

I may have missed it in the intro, but the DSOs for the quarter were?

Daniel McCartney

57 days, little less than 57.

Clinton Fendley – Davenport

Okay, great. Thanks, Dan.

Daniel McCartney

Okay.

Operator

(Operator instructions) Next up, we will go Bryan Sell [ph] with Peak Financial [ph].

Bryan Sell – Peak Financial

Hi, a quick question on the dividend, is it the board's policy or has the board’s policy changed at all in terms of how much it wants to pay out.

Daniel McCartney

No, I think we really look at every quarter, but we, you know, we are at $0.60 and we paid out $0.58 in a dividend last year. I think, balance sheet allowed to be reviewed every quarter by the board. We expect to be in a position to be able to distribute our earnings to a great degree to shareholders.

Bryan Sell – Peak Financial

But in terms of that policy, is that something that one would expect to continue to try to pay out as much of those earnings as possible.

Daniel McCartney

It is not a policy but I would say that is a reasonable expectation.

Bryan Sell – Peak Financial

I understand. Great, thank you very much.

Daniel McCartney

Okay.

Operator

(Operator instructions) And Mr. McCartney, there appears to be no further questions. I will turn things back over to you for any additional or closing remarks.

Daniel McCartney

Okay, guys. Thank you for – like I said the 10-K will be filed in two weeks. Thank you for joining us for this conference and (inaudible). Take care. Thanks.

Operator

Once again, everyone that does conclude today's conference. Thank you all for your participation and have a great day.

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