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Healthcare Services Group, Inc. (NASDAQ:HCSG)

Q2 2014 Earnings Conference Call

July 08, 2014 08:30 am ET

Executives

Daniel McCartney - Chairman of the Board, Chief Executive Officer

Ted Wahl - President, Chief Operating Officer, Director

Matt McKee - Vice President

Analysts

Sean Dodge - Jefferies

Sean Hakimi - RBC Capital Markets

A.J. Rice - UBS

Rob Mains - Stifel

Operator

Good day, ladies and gentlemen. Welcome to the Healthcare Services, Inc. 2014 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions).

The matters discussed on today's conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are often proceeded by Words such as believes, anticipates, expects, plans, will, goal, may, intend, assumes or similar expressions. Forward-looking statements reflect management's current expectation as of the date of this conference call and involve certain risks and uncertainties. As with any projection or forecasts they are inherently susceptible to uncertainty and changes in circumstances.

Healthcare Services Group's actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors. Some of the factors that could cause future results to materially differ from recent results or those projected in forward-looking statements are included in our earnings press release issued prior to this call and in our filings with the Securities and Exchange Commission.

We are under no obligation and expressly disclaim any obligation to update or alter its forward-looking statements, whether as a result of such changes, new information, subsequent events or otherwise.

I would like to introduce you to your host for today's conference Mr. Daniel McCartney, Chairman and CEO. Sir, you may begin.

Daniel McCartney

Okay. Thank you and I thank everybody for joining Matt McKee, Ted Wahl and I for our conference call for the second quarter. We released our second quarter results yesterday after the close and will be filing our 10-Q during the week of the 21st.

We increased our revenue by 17% for the quarter to $319 million above our targeted growth rate of 10% to 15%, when compared to the same period in 2013, with Housekeeping and Laundry up more than 15% and food service up 20%, both are new company records. Revenue for the six-month period was up over 15% to $631 million for the same period last year.

We entered 2014 with double-digit growth rate and a run rate going into the year, which was an important significant accomplishment for divisional and regional management people in the field both done a very good job as they more than made up for the 2013 client modifications which put our growth rate at less than 2.5% for the same six-month period last year.

Although operationally and from a client standpoint, we have transition well due to the accelerated expansion, start up costs and delays in some staffing and labor related changes, our direct costs was up about 50 basis points or 60 basis points from our historical target of 86%. Although we have for 38 years demonstrated we can and will get the new business on budget, it will be important for us to improve those results over the next few months as the startup challenges wind down.

In spite of that, 2014 has continued with very good momentum. We continue to expect to grow it double digits with Housekeeping and Laundry likely at the lower end of our growth target and food service at the higher end as it still has a surplus district and regional management capacity and a smaller base.

With that abbreviated overview I will turn it over to Ted for a more detailed review.

Ted Wahl

Thank you, Dan. Revenues for the second quarter increased 17% to $319.3 million compared to the same period last year. Housekeeping laundry grew 15% to $211.4 million. Dining and Nutrition was up over 20% to $107.9 million.

Net income for the quarter came in at $13.9 million or $0.20 per share compared to $12.9 million or $0.19 per share for the prior year's corresponding quarter. As we discussed previously, Q2 of '13 net income was favorably impacted by the enactment of the American Taxpayer Relief Act, which retroactively reinstated certain 2012 job tax credits and lowered our effective tax rate to 28% for the first six months of 2013 compared to 37% for the first half of 2014.

Direct cost of services came in at 86.4%, which is about 50 basis points or 60 basis points above our target of the 86%. Although, we have been slower in working our way towards budget in the second quarter, housekeeping starts, the districts and regions did a good job of transitioning the new business from an operational perspective.

Once the startup phase winds down over the next 30 days to 60 days, we would expect ongoing margin improvement while at the same time continuing to get proper attention and service levels to our existing customers and we will continue to focus on the development of our Dining and Nutrition middle management structure as it progresses towards being more fully utilized. Going forward, our goal is to manage direct cost under 86% on a consistent basis and work our way closer to 85% direct cost of services.

Selling, general and administrative expense was reported at 7% for the quarter, which included a $650,000 gain in the deferred compensation investment accounts held for and by our management people. We would expect our normalized SG&A to continue to be in that 7% to 7.25% range with the ongoing opportunity to garner some modest efficiencies. As we discussed in past quarters, SG&A also includes state gross receipts taxes paid as well as investments in our Biometric Time and Attendance System, and other electronic record-keeping initiatives.

In December, we announced the expansion of our legal department, which in conjunction with the personnel and technology investments made in human resources function should allow the division to comply with the new hire and personnel record-keeping requirements demanded by both, the regulatory environment and job tax credit programs like WOTC.

We also announced in December, the formation of a wholly-owned captive insurance subsidiary as well as enhancements to our credit facility that will provide flexibility in addressing our various insurance needs in the upcoming years. Investment income for the quarter was reported at $800,000, but again after removing the impact of the $650,000 gain in the deferred compensation investment accounts; our actual investment income was $150,000.

Our effective tax rate for the quarter was 37%, and depending on the timing of the WOTC reauthorization should be between 35% and 38% for the remainder of the year. We continue to manage the balance sheet conservatively and at the end of the second quarter had over $68 million of cash and marketable securities and current ratio of better than 3:1.

Our accounts receivable remained in good shape, although our DSO target of 60 days, even with the accelerated organic growth during the first half of the year and transition of the credit collection function for the new clients that were part of the acquisition.

As announced yesterday, in conjunction with our earnings release, the Board of Directors approved an increase in the dividend to $17.375 per share split-adjusted and payable on September 26th. The earnings and cash balances for the quarter more than supported, and with the dividend tax rate in place for the foreseeable future, the cash dividend program continues to be the most tax efficient way to get the value and free cash flow back to the shareholders.

It will be the 45th consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law. It's the 44th consecutive quarter we increased the dividend payment over the previous quarter. That's an 11-year period that included for 4-3-for-2 stock splits.

With those opening remarks, Dan, Matt and I would like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Ryan Daniels of William Blair. Your line is now open.

Unidentified Analyst

Hi. This is [Nick] in for Ryan Daniels. I was wondering, what is the current capacity of managers in the Food Services division. I know it varies by region, but do you still have excess capacity there like you did a few years ago given the strong growth in that division over the last few years?

Daniel McCartney

It really varies between divisions. Some of the divisions in particular the Northeast and maybe some mid-Atlantic regions are more closer to our model of 10 to 12 facilities per district and four to six districts per region, where some of the other division still have an underutilized regional and district capacity, because they are in the formative stages of filling out in the development of the management skills and they in some of the areas may still be averaging seven to eight facilities per district than three to four districts per region, so we still have surplus capacity, but it varies between the 10 divisions depending on how mature they have been as far as the new business development.

Unidentified Analyst

Okay. Great. Thanks. Given the growth that you have seen in Food Services, are you able to gain more economies of scale there in food purchases or is enough of a local that it's not difficult to capture those scale of economies?

Daniel McCartney

I think as far as the food purchases have been concerned, the more volume we been able to create, the more favorable rebate and purchasing power we have as far as our purchases of the food and consumables. The real margin improvement in Food Service primarily has been driven by improvement in labor and that's been spreading out to districts and regions with the right complement of properties, because they are underutilized in our model although we are eating that district and regional cost at the present time as if they are fully mature and up to our scale.

Unidentified Analyst

Okay. Thanks. One last question. How was customer retention in the quarter?

Daniel McCartney

Customer retention has been as good as it has been for the last three to four years which has been better than our 90% target.

Unidentified Analyst

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Sean Dodge of Jefferies. Your line is now open.

Sean Dodge - Jefferies

Hi. Good morning. Thanks for taking the questions.

Daniel McCartney

Hi, Sean.

Sean Dodge - Jefferies

Staying on the dining side, some of the major food or protein cost being up pretty considerably over the last 12 months, I'm curious, the extent to which or if any impact that's having on margins on the dining side? Then do you guys do any hedging or forward contracting when it comes to buying your food?

Daniel McCartney

As far as food purchasing, with respect to the dining and nutrition contracts, we have really separated that from the labor and labor-related increases, where it's set up on a monthly or quarterly basis with each and every client, so it's adjusted more automatically based on either the CPI food at home adjustment or whatever other market basket agreement we have in place, so it's done more mechanically on a monthly or quarterly basis, so we don't have that type of exposure.

Sean Dodge - Jefferies

Okay. Then when it comes to getting DSOs back down to the target, what's created the friction there? Is it pushing a new payment terms down on the Platinum facilities that you acquired? Is it, I guess, pushing those down or is that they haven't complied with some yet or is there something else that's keep you from, to be able to improve on that metric.

Daniel McCartney

I think it's two things, Sean. I think, first, Platinum credit terms were a little bit different than ours and that's going to take a little bit of time to ramp them down to levels that historically we have held our clients to. The new businesses, well you start with the expenses and the start up costs. Then there maybe a 30 or 60-day lag before you start getting the cash flow payments from the new customers, so the clients that we phased in May and June, depending on the terms we negotiated, even if it's a 60-day term customer, we have not received that first payment yet, but we will no an ongoing basis as the relationship evolves, but the startup is where we come up with the upfront cost without the subsequent collection.

Sean Dodge - Jefferies

Thank you very much. Congratulations on the quarter.

Daniel McCartney

Thanks, Sean.

Ted Wahl

Thanks, Sean.

Operator

Thank you. Our next comes from the line of Sean Hakimi of RBC Capital Markets. Your line is now open.

Sean Hakimi - RBC Capital Markets

Thanks. Good morning.

Daniel McCartney

Hi, Sean.

Sean Hakimi - RBC Capital Markets

I have two questions. I guess, first, when we when we looked into the second half, I think your year-over-year comps become a little tougher and housekeeping you bought [in last year] in the third quarter and Dining also saw a pretty big ramp, so I guess, how should we think about growth in the second half? Should we expect a material deceleration from the first half or are there any [factors]?

Ted Wahl

I think, Sean, the demand for Dining and Nutrition service is really no different than Housekeeping and Laundry is still greater than what we are capable of managing, so because dining continues to be almost exclusively a cross-sell opportunity, we focus our expansion efforts really in geographical areas that have a maturing, but still underutilized middle-management structure which is why you may see revenue step ups in certain months or quarters, but not in others.

I know Dan touched on in his opening remarks, but our growth rate for the year and really for the mid-term and long-term continues to be 10% to 15% top-line, with Housekeeping and Laundry at the lower end of that range and then Dining and Nutrition at the higher end of the range.

Sean Hakimi - RBC Capital Markets

Then would it be fair to assume that the first half was pretty good at the higher end or above that, so second half, should we be thinking about something on the maybe towards lower end of that range?

Ted Wahl

I think that's fair, but we would expect our sequential growth in revenue to be consistent with what we have done historically. Again, you are always going to have ebb and flows from one quarter to the next. That's now how we are managing the business. That's not how the divisions and regions are determining who they are transitioning services with, but I think that's fair to say. You could see somewhat of a slowdown in the second quarter, but year-over-year not just for 2014, but 2015, 2016, 2017, 10% to 50% continues to be the target.

Sean Hakimi - RBC Capital Markets

Got you. Just one last question, I guess, more for long-term. It seems like over the next two or three years you are focused on cross-selling Dining to your existing customer base, but I guess if we look beyond that, industry penetration is still pretty low, so there's a lot of new facilities for you to go after in both, Housekeeping and Dining, so I guess my question is, is that going to be another ramp in investment for district and regional level management team and how should we think about your strategy to go after new facilities longer term?

Daniel McCartney

The rate limiting factor in our growth has always been our ability to hire, train and retain talented management people. That's no different today than it was 10 years ago or 30 years ago for that matter, so we are in a perpetual state of recruiting a management development, so I think to your point move more of a focused than ever is replicating that structure, so we have not just the facility-level management people which we certainly emphasize, but the district and regional structure that's maturing at a rate that we are capable of managing and maintaining our growth rate.

That's why in Dining again it's a bit different than Housekeeping and Laundry, and because it's a cross-sell, we are able to steer new business towards the underutilized middle-management structure, but once that's fully flushed out over the next two to three years then the Dining and Nutrition business will grow more than business as usual fashion comparable to Housekeeping and Laundry.

Sean Hakimi - RBC Capital Markets

Great. That's helpful. Thank you.

Daniel McCartney

Excellent. Thanks Sean.

Operator

Thank you and our next question comes from the line of A.J. Rice of UBS. Your line is now open.

A.J. Rice - UBS

Thanks. Hello, everybody.

Daniel McCartney

Morning A.J.

A.J. Rice - UBS

First on maybe just to go back to the cost of services, so that ran a little higher than you were expecting obviously in the quarter. We were expecting at least let's just put it that way and it sounds like you're saying you don't believe that's because the new business is somehow inherently less profitable than was thought originally, but rather that it's taking a little longer to get to target margin on that. Can you just, A, confirmed that? B, talk about maybe give flash out a little further why you're confident you can still get to target margin and why maybe it's taking a little longer.

Daniel McCartney

Yes. I think, if there was - the facility we bid all the jobs, whether it would be union or non-union in the same margin profile with the same margin targets. We don't have specific agreements with customers at the top side. It's all facility-specific, but union or non-union, the 30-day to 90-day startup window, A.J., is really where we are at our most inefficient, because as we have talked about on calls like this before, we are inheriting the staffing patterns and purchasing programs of the in-house operation.

I think, the second phase of the customer transition we highlighted at the beginning of the year did consist of mostly unionized facilities, and with this particular group of union facilities because of the process required by the CBAs and exercising management rights and implementing our staffing patterns will likely be at the higher end of that 30-day to 90-day startup range. Again, once we implement our systems and procedures, there's no difference operationally or financially on how we manage a property, whether it would be union or non-union.

Ted Wahl

I think also, I mean, our benefit the customer is we are going to do it less expensively than they did it before. Now, we think we buy our equipment, the materials and obviously in Food Service, our food purchasing power gives us an edge, but it's still primarily a labor business.

With Housekeeping and Laundry in particular in the growth and accelerated expansion that we experienced, it requires our management people to make the job description changes, get the staffing to the levels that we bid the job at and it usually takes us a 30-day, 45-day period, but with so much absorption some of the changes weren't made as timely as we typically would have done and that's why we have always said, if we add 20 or 30 properties in a quarter more than we expected in particular area, it's not necessarily good for us because it spreads out our management people a little more than we typically would like and the decision-making may take more time and. Unfortunately, that's really what we think happened.

A lot of the changes that our management people know have to be made just took longer than they would have had the growth rate been a little bit more in historical levels. It's a nice problem to have, but it's still an issue that we had to address.

A.J. Rice - UBS

I think in last few two quarters or few quarters ago you were talking about that in the first half you had disposed off business of about $50 million annual revenue that was coming on here and that's part of what we are talking about here. I wonder in the second quarter is that run rate pretty much fully reflected at this point or is there still some of that business is going to step up in the third quarter that wasn't fully reflected in the second?

Ted Wahl

There maybe a few million dollars next quarter that's attributed to that ramp-up, but intent and purpose is the run rate reflected as of Q2.

A.J. Rice - UBS

Okay. I appreciate the comments about growth expectations for the back half of the year. I wondered if I could just drill down a little bit on this the customers behind this $50 million piece. Also, I know last year you had some customer restructuring and sometimes you get some of that business back over time.

Can you comment on the pipeline a little more specifically? Are there more opportunities behind this $50 million that you had in the first half ramp up. Are you seeing any of that business from a year-plus ago start to come back? Then any other more specific things to say about the pipeline, obviously, you are out there blocking tackling every day trying to win new customers.

Daniel McCartney

I think as far as the customer that we that we highlighted at the beginning of the year no different than many of the other large national chains that we work with. We typically don't do all of any other business, but we do more and more each year. That certainly remains the opportunity with this particular group, which we want to make sure every transition goes smoothly with the group that we talked, there is certainly an opportunity for continued expansion and growth, so that remains in place.

With the customer modifications that you referred to in the first quarter and the second quarter of 2013, we are continuing to see momentum with that. Again, that's done locally. No different than any other greenfield Housekeeping and Laundry opportunity that we see throughout the divisional on regional network, so the growth is going to be more normal course of business rather than some sort of chunk that we get at a specific period of time.

Ted Wahl

We still Housekeeping and Laundry typically as the first introductory service. With Housekeeping and Laundry services up to 15%, most of those clients we had the opportunity to ultimately add food service to the menu with services as the lead and so it's Housekeeping and Laundry leads the pack, the opportunity is there once we get our arms around the operational and relationship issues when you started up. There are targets for Food Service expansion as well.

A.J. Rice - UBS

Right. Okay. Then this is sort of an obscure one, but obviously with your settlement at the end of last year in California, there was a pool of money set aside for any claimants and I know they had proactively come forward in May claims. Is there any update on whether you think there will be some of that money that you might get back and if so, is there a specific amount or.

Daniel McCartney

If it does it's certainly going to come in lower than what we originally anticipated, but the difference is going to be immaterial A.J.

A.J. Rice - UBS

Okay. All right. Thanks a lot.

Daniel McCartney

I think the plaintiff's lawyers are making sure of that.

A.J. Rice - UBS

Okay. All right.

Daniel McCartney

Not to be cynical.

A.J. Rice - UBS

Thanks a lot.

Operator

Thank you. Our next question comes from the line of Rob Mains of Stifel. Your line is now open.

Rob Mains - Stifel

Thanks. Good morning.

Daniel McCartney

Good morning, Rob.

Ted Wahl

Hi, Rob.

Rob Mains - Stifel

Ted, a clarification on something you said earlier. If we look out over the next, say, 18 months to the end of next year from the Dietary division, are you saying that the growth will primarily continue to be from the existing installed housekeeping base or that you might start moving outside that?

Ted Wahl

No. It continues to be primarily a cross-sell opportunity, so I would even expand it beyond the next 12 months to 18 months based on what we understand is the customer need and really the customer demand for the services, I would go as far to say over the next three years it is going to continue to be primarily something we only market to our existing customer base.

Daniel McCartney

We haven't, Rob, precluded our regional people from selling it to outside non-housekeeping and laundry customers. It's just that's where the and easier opportunities are, because the relationship is already there. We know the customer. They know us, so their attention is typically spent on the low-hanging fruit, but in some areas we have got momentum with certain clients, including some county and government in [VA] clients who are only interested in Food Service and not Housekeeping and Laundry, so we don't preclude the regional people from only showing it to our existing clients, but that's where they spent most of their attention because it's the easier sale.

Ted Wahl

That trade will continue to be more than 9 out of every 10 new business opportunities in Dining should come from the existing network, but as Dan said there still remains to be opportunity that's driven and it selectively it works within the district or region that's managing it then certainly they have the ability to start that business and sell that business.

Rob Mains - Stifel

Okay, so I can infer then, Ted, that over the next couple or three years you got pretty good visibility that there is enough kind of pent-up demand among Housekeeping customers for dietary services that you can hit the top end of the growth goal for that division.

Ted Wahl

Absolutely.

Rob Mains - Stifel

Okay. Then the other question, we are starting to see some signs of life in the labor market as a whole. Can you update us on recruitment for both, labors and I guess more importantly for management trainees.

Ted Wahl

I think as far as the management people, we have really never had better management people in the history of the company. The modifications of those two clients that we spoke about in the first half of 2013 gave us district and regional management capacity that we wouldn't have had, had that not happened so it enable us with the acquisition and the recent expansion to not strain our management structures as much as it would have had we not had that.

We didn't layoff any district or regional managers during that, because we are confident we would be able to replace the business which in retrospect the last three quarters we certainly have done, but that's an ongoing process.

If we are going to add 500 or 600 new facilities in 2014, we have to hire, train and develop 1,000 management people that we didn't have at the beginning of the year to put a manager and assistant at each property, either for Food Service or for Housekeeping and Laundry. We have to create 50 new districts and 50 new district management people and training managers have to be promoted from within the existing structure. Then to create 10 more regional management teams and ultimately create more division.

If the company has organizationally evolved over the 38 years, it's always been an evolution of the management people, because adding the new business is the easier part, so we feel as confident as ever that the demand for the services has never changed and there is more opportunities for us to go around than ever before and the tighter the operators get impacted by the reimbursement environment, the more demand there is for outsourcing companies of all kinds including ours.

Daniel McCartney

That's why, Rob, we are more committed than ever to the idea of promotion from within, but that it would be done in a decentralized way through the districts and the region, so instead of trying on a centralized basis hire 800 management people, 400 managers, 400 assistant managers to fund 2015 growth objectives. What we are really asking if each of our 370 districts to hire and train one or two management people successfully to fund the one or two facilities they need to add district-by-district to hit our growth objective, so it's really done on a bottoms up basis rather than some top-down dictate from the corporate office.

Rob Mains - Stifel

Right and you are continuing to find qualified candidates I guess.

Daniel McCartney

We are. Yes.

Ted Wahl

I think it's because we have become a more legitimate career choice than before, the more established we get and the longer our track record is, that new recruits and candidates that we look for really do see an entrepreneurial career path for them to follow depending on their ambition ability and that that we have grown consecutively for 38 years, so it's more likely to they are going to get promoted before they are ready rather than us holding anybody's career back.

Rob Mains - Stifel

Okay. Very good. Thank you.

Daniel McCartney

Thanks, Rob.

Operator

Thank you. At this time, I am showing no further questions in the queue. I would like to turn the call over to Daniel McCartney, Chairman and CEO for any closing remarks.

Daniel McCartney

Okay. Thank you and thanks everybody.

Again, before we wrap it up, Matt McKee was just going to give a conference schedule review for the next few months.

Matt McKee

Yes. Thanks, Dan, and good morning everyone. In the upcoming third quarter, we plan to present at C.L. King's 12th Annual Best Ideas Conference, which will be on the 9th of September at the Omni Berkshire Place in New York City.

We are also planning to attend and present at the 5th Annual Credit Suisse Small & Mid-Cap Conference, which will be on September 16th and 17th at the Waldorf Astoria also up in New York, so hopefully we will see some of you there.

Dan, back over to you.

Daniel McCartney

All right. Thanks, Matt. Well, I mean, well into 2014, we expect to continue to expand our client base and Housekeeping and Laundry within our historical targets. We should increase our expansion each quarter and if we execute properly we will maintain our double-digit growth rate and client retention targets.

In this environment as we have always said, the demand for our services is great as it's ever been and remains important for us the balance the client satisfaction measurements as we digest the increased amount of new business and more importantly get them on budget as well simultaneously is keeping the old clients operating effectively from an operational standpoint and a financial standpoint while dealing with all the start up variables a lot for our guys to chew on in the field.

All divisions continue to perform well and better both, any expansion we need to assure consistency with the financial targets and the client satisfaction levels. With the intention our new business startups getting them and keep them on budget, we have to effectively continue to change the staffing, manage the existing client base with no disruption in their services and look to get the direct cost below 86% and work our way down to 85%.

With the changes in state tax policies, we expect the SG&A to be in 7% to 7.25% range with no deferred comp investment impact. We believe the recent expansion of our legal and personal departments will be helpful and a necessary resource for our management people in the field in this litigious environment we find ourselves in.

Our tax provision was 37% for the quarter, but with the Act's extension could be back to 35%. The Senate Finance Committee has approved the bill and its working its way through the House Ways and Means Committee, we expected to be passed, but it hasn't been passed yet, hopefully by the end of summer.

That aside in our business there is still strong demand for the services, for Housekeeping and Laundry and Dining. Our management people in all divisions, especially in Food Service, continue to develop and get better. We believe we will continue to operate on budget and make the improvements required with the new business consistently. Going forward, as we expand overall, these are pretty good times for us.

Thanks again for everybody. Have a summer and onward and upward.

Operator

Ladies and gentlemen, thank you for your participation on today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.

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