Civitas Solutions' (CIVI) CEO Bruce Nardellaon on Q1 2016 Results - Earnings Call Transcript

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Civitas Solutions (NYSE:CIVI)

Q1 2016 Earnings Conference Call

February 9, 2016 17:00 PM ET

Executives

Dwight Robson - Chief Public Strategy and Marketing Officer

Bruce Nardella - President and CEO

Denis Holler - CFO

Analysts

Richard Close - Canaccord Genuity

A.J. Rice - UBS

Paula Torch - Avondale Partners

Kevin Fischbeck - Bank of America/Merrill Lynch

Joshua Raskin - Barclays Capital

John Ransom - Raymond James & Associates, Inc.

Richard Close - Canaccord Genuity

Jennifer Lynch - BMO Capital Markets

Operator

Good afternoon and welcome to the Civitas Solutions First Quarter Fiscal 2016 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please also note that today’s event is being recorded.

At this time, I’d like to turn the conference call over to Mr. Dwight Robson. Sir, please go ahead.

Dwight Robson

Thank you, Jamie. Good afternoon and welcome to Civitas Solutions Inc. fiscal first quarter 2016 earnings conference call. I’m joined by Bruce Nardella, President and Chief Executive Officer; and Denis Holler, Chief Financial Officer.

Before we begin, if you do not already have a copy, our press release with financial statements can be found in the Investor Relations section of our Web site at civitas-solutions.com. Please be advised that today’s discussion includes forward-looking statements including predictions, expectations, estimates and other information that might be considered forward-looking. Throughout today’s discussion, we will present some important factors relating to our business which could affect these forward-looking statements.

The forward-looking statements are also subject to risk and uncertainties that may cause actual results to differ materially from the statements we make today. We are not obligating ourselves to release any updates to these forward-looking statements in light of new information or future events. As a result, we caution you against placing undue reliance on these forward-looking statements and would encourage you to review our filings with the SEC for a discussion of these factors and other risks that may affect our future results or the market price of our stock.

We will be referring to certain non-GAAP financial measures such as adjusted EBITDA, adjusted EBITDA margins and free cash flow because we believe such measures are appropriate ways to discuss our financial results. However, please remember these are non-GAAP financial measures and should not be considered alternatives to other GAAP measures such as net income or income from operations. I refer you to our press release issued today detailing our first quarter fiscal 2016 results for comparable GAAP measures.

With that, I’ll turn the call over to Bruce.

Bruce Nardella

Thank you, Dwight and thanks everyone for joining us on today’s call to discuss our fiscal first quarter 2016 results. Our financial performance during the quarter reflected steps we’ve taken that we believe position us very well for the future. First, as of the quarter end, pursuant to a strategic review of our ARY service loan concluded last June, we’ve substantially completed the divestiture of a significant portion of low margin ARY services in five states. The children and adolescence that remained in our care into January were all transitioned to new providers prior to the end of last month.

Second, as we projected during our last conference call, during the first quarter we significantly increased our investment in new start initiatives to respond to an uptick in demand and support organic growth.

During the last two years, our new start spending moderated compared to record levels of investment in fiscal years 2012 and 2013. Those years have record new start investment with an average of $8 million invested in each year were a big part of what drove our accelerated organic growth in margin expansion last year.

We are excited that an increased number of organic opportunities could drive again drive our level of new start investment beyond $8 million this fiscal year. Consistent with what we said last quarter, we continue to project an increase in new start investments for fiscal 2016 of approximately $2.5 million above the total investment level of $5.7 million in fiscal 2015.

Both of these strategic decisions to divest certain ARY operations and increase new start investments, depressed our growth in margin during the first quarter. The divested ARY operations generated $12.8 million and $700,000 in net revenue and EBITDA respectively during the first quarter of fiscal 2015.

During the first quarter of this year, the same operations generated nearly $7 million in net revenue and incurred a loss of $800,000. Also during the first quarter, we invested approximately $700,000 more in new start as compared to the same quarter one year ago. As a result, the year-over-year cumulative impact on EBITDA of the ARY in new start actions is approximately $2.2 million.

During the first quarter, we closed two acquisitions with total annual revenues of approximately $8.8 million. The larger of the two with about $7 million of the annual revenue is an Indiana provider of services to individuals with intellectual and developmental disabilities and there is a good compliment to our existing I/DD platform in the future [ph] state.

The smaller deal was a tuck-in acquisition of a provider of SRS residential and day services in southern California. The level of M&A activity to begin the year was relatively light, especially compared to last fiscal year when we came out of the gate at a faster clip with a majority of the revenue acquired in the year coming to us in transactions that closed during approximately the first 100 days. However, this is strictly due to the vagaries of timing related to the signing in closing of deals. Our M&A pipeline remains robust.

Subsequent to the end of Q1, we closed two additional acquisitions with annual revenues of more than $10 million, including a deal announced this afternoon through which we acquired three Massachusetts Adult Day Health centers. These centers with annualized revenues of approximately $8.7 million augment our existing Adult Day Health operations in the Boston area and also extent our ADH platform into Central Massachusetts in the City of Worcester, New England’s second largest City.

With these newly acquired ADH centers, we now operate 11 centers in Massachusetts, serving approximately 1,900 elders. In addition, two new centers are currently under construction in Massachusetts which we expect to open during the fourth quarter of fiscal 2016.

As most on this call are likely aware we entered the adjacent ADH market just short of 18 months ago to establish another platform from which we can grow, both organically and through selective acquisitions. The ADH market is large, it’s growing, and it’s highly fragmented and a great compliment to our network of high quality and cost effective community based services.

We remain very excited about the future of our ADH services and their potential to meaningfully contribute to our Company’s mission, growth and development in the years ahead. The second acquisition closed subsequent to the end of the first quarter was the SRS tuck-in variety as we acquired a Michigan provider of home and community based rehabilitation services.

Denis will provide more detail on our financial performance later in this call, but I first wanted to take a few minutes to discuss some of the first quarter highlights. Net revenue for the first quarter ended December 31, 2015 was $345.7 million, an increase of 3.3% from the year earlier period. Approximately 20% of net revenue growth was organic with acquisitions making up the balance.

As I noted earlier, while the ARY divestiture was substantially complete by the end of the first quarter of fiscal 2016, those operations contracted during the quarter as we transitioned to young people served to other providers, effecting our organic and overall growth. Excluding the divested ARY services from both periods, net revenue for the first quarter of fiscal 2016 increased 5.3%.

Adjusted EBITDA decreased 10.3% to $36.3 million. Denis will describe in more detail the major drivers of the year-over-year change, but I want to briefly highlight three factors. As those who have followed our Company for a while are aware, our performance in the first quarter of fiscal 2015 was lifted by a $4.2 million benefit from unusual circumstances related to the implementation of a new high deductible health insurance and variable compensation plans.

As expected, the benefit in Q1 of fiscal 2016 from the same items was much smaller at $1.2 million or $3 million less than the first quarter of fiscal 2015. The ARY divestitures had a total negative impact on that adjusted EBITDA of $1.5 million and as planned we invested about $700,000 more in new starts compared to the year earlier period.

Excluding the impact of these three factors from the year-over-year comparison, adjusted EBITDA goes from decreasing by 10.3% to an increase of 2.8% in the first quarter of fiscal 2016.

Our I/DD and SRS service lines which generate approximately 67% and 20% of our total net revenue respectively performed very well with increases in both volume and average daily rates in both service lines in the quarter compared to the same period the previous year.

For the first quarter of 2016, I/DD gross revenue grew by 4.9% and SRS gross revenue grew by 10.1%. In the eight states where we continue to provide ARY services, gross revenues were up 4.1% over the first fiscal quarter of 2015.

Consistent with my comments last quarter, the operating environment remains very stable. Overall, state revenues remain positive and are running ahead of projections in most of our key markets. The exception remains the state of West Virginia where weak state revenue collections have been driven by lower energy prices.

West Virginia is the only one of eight states heavily dependent on oil, natural gas, and mining where we’ve sizeable publicly funded revenues. Against this backdrop, the state continues to implement significant changes to it’s I/DD waiver program. The magnitude of impact is substantial.

Roughly equivalent to a 10% rate cut on the top line and virtually without precedent in our 35-year history. An advocacy group filed a lawsuit on behalf of individuals served under the waiver program. That legal challenge is pending with the parties due back in court next month, but we continue to assume that our team in West Virginia will have to manage through these changes without any relief.

The results of our West Virginia operations were a significant headwind for our I/DD service line and overall growth during the first quarter. Although we believe the impact will be greater during the first half of this year, we expect West Virginia will suppress our growth throughout fiscal 2016. However, the projected impact of these changes is accounted for in our fiscal 2016 revenue and adjusted EBITDA guidance, which we’re affirming today.

And finally, there is one additional recent development that I want to highlight. We recently announced the launch of our new Clinical Advisory Council, a multi disciplinary team of health and human service experts that will advice our leadership on best clinical practices, including evidence based and evidence informed models aimed at further enhancing service quality and outcomes for the individuals we serve.

We’ve attracted to the council a group of clinicians with an impressive breadth and depth of experience. I’m grateful for their support and look forward to working with them to support our programs in enhancing more lives across the nation.

At this point, I’d like to turn the call over to Denis Holler, our Chief Financial Officer to discuss our financial results in more detail. Denis?

Denis Holler

Thanks, Bruce. This quarter our I/DD and SRS businesses continued to grow organically and through acquisitions. While it is true that our growth rates have moderated compared to 2015, our new start investments are increasing. Although our ARY business has continued to lag, that is entirely to -- due to our divestitures which were largely completed during the quarter.

Costs associated with our high deductible health plan have become more predictable, resulting in stable margins as opposed to the margin expansion we experienced in fiscal 2015. Additionally, the trend of higher labor costs and occupancy costs have continued as we experienced competition for labor in some markets, increased overtime and increases in rent and utility costs.

Working capital driven by improving accounts receivable collections and lower interest costs showed improvement over the prior quarter, even as we made our first estimated tax payments as we anticipate becoming a cash tax [technical difficulty] 2016 for the first time in many years. Lastly, our net income, earnings per share, and effective tax rate were all negatively impacted by a one-time non-deductible charge related to our former equity plan.

Moving to the results for the quarter, net revenues grew by $11.2 million or 3.3% over the first quarter of the prior year. The increase included $8.9 million from acquisitions and $2.3 million from organic growth. Net revenue and organic growth were negatively impacted by the operating results of our ARY divestitures. Excluding these operations, net revenue increased by $17 million or 5.3% of which $8.1 million was organic growth.

Our human services segment which represents 80.3% of our revenue, increased 2.1% over the prior quarter. Our SRS segment, which represents 19.7% of our revenue, increased 8.6% over the prior quarter.

Trends in our continuing businesses remain positive, resulting in organic growth this quarter despite significant headwind in the state of West Virginia, I/DD gross revenues grew by 4.9% with more than half of that organic or 2.9%. SRS gross revenues grew at a rate of 10.1% with 3.1% of that organic and gross revenue for the remaining ARY operations grew at 4.1%, all of which was organic. Driving the growth in the remaining ARY operations was an improvement in average rates, resulting from service and acuity mix.

Organic growth came primarily from the maturation of new starts. New starts initiated from fiscal 2012 through this quarter contributed $5.2 million to the growth in revenue. Although growth from new starts has been trending down in recent quarters, as our programs from peak investment years mature, our level of investment in new starts increased during the quarter, a trend we expect to continue throughout the remainder of fiscal 2016. New start losses were $1.9 million during the current quarter, up from $1.3 million in the same quarter of the prior year.

Adjusted EBITDA decreased by 10.3% over the prior quarter and our adjusted EBITDA margin declined by 160 basis points to 10.5%. The main drivers of this net decrease are as follows. Consistent with recent trends, we did not leverage direct labor in the quarter. Excluding the impact of the higher health insurance expense, which I’ll discuss next. Direct labor consumes 70 basis points of margin. The main reasons for this were increased labor cost due to a ramp up of new starts and overtime, primarily within our I/DD business which is the result of increased vacant positions.

Moving to our health insurance expense, as we disclosed last year, we experienced an unusually high favorable adjustment to our health reserves during the first quarter of fiscal 2015, resulting from lower than expected claims on our high deductible consumer driven plan. This largely recurred during the first quarter of this year, which resulted in an increase of 40 basis points compared to the prior quarter.

Continuing the trend from recent quarters, occupancy costs consume 30 basis points of margin year-over-year, although as a percent of revenue it has remained consistent with our fourth quarter. This is due to lower occupancy rates in our I/DD residential service line and increases in rent, utilities and repair and maintenance costs across our portfolio.

Finally, the ARY divestitures created a $1.5 million headwind or 40 basis points year-over-year. After adjusting for one-time in structural items, the normalized margin would have been 10.8% this quarter compared to 11.1% in the prior quarter.

Net loss during the first quarter of this year and the prior year, included charges related to changes in our capital structure or non-routine transactions that impacted comparability. During the first quarter of 2016, we incurred a $10.5 million stock-based compensation charge related to awards under our former equity compensation plan that vested in October 2015.

The full impact of this expense which was not deductible for tax purposes was $4.3 million to our book tax expense and resulted in an unusually high tax rate of 155%. Our effective tax rate guideline of 50% for the fiscal year remains unchanged.

During the first quarter of last year, we incurred capital structure and IPO related costs totaling $16.1 million, excluding these items net income would have been $5 million this quarter and $6.6 million in the prior quarter.

Net loss for common share from continuing operations was $0.15 for the first quarter of fiscal 2016 compared to a net loss per share from continuing operations of $0.09 for the same period last year. Excluding the impact of the $10.5 million non-recurring stock compensation charge we recorded and the IPO and capital structure related charges recorded during the first quarter of the prior year, net income per common share would have been $0.13 this quarter compared to $0.18 during the first quarter of last year.

Free cash flow in the first quarter is usually negative due to the payout of incentive compensation for the prior fiscal year ended September 30. In 2015 and 2016, these payments included the variable pay plan for our direct care staff. That said, free cash flow this quarter showed marked improvement coming in at a negative $2.5 million compared to a negative $14.5 million during the first quarter of fiscal 2015. Most of this difference is structural, because the first quarter last year absorbed approximately $12.6 million in cash IPO and capital structure related costs associated with redeeming our senior notes.

In addition, this quarter we made our first estimated federal tax payment for approximately $5 million as we project in 2016 we will be a cash tax payer for the first time in many years. Significant improvements in cash flow came from lower interest costs and the improvement in days sales outstanding on our accounts receivable from 43.4 days in the first quarter of fiscal 2015 to 40.9 days this quarter.

Cash flow is also benefited by capital expenditures for the quarter of $9.1 million or just 2.6% of net revenue. Although this is consistent with the prior quarter, it is considerably short of our modeling guidelines for the year, which have been set at 3.3% to 3.5% of net revenue. This is a seasonal trend and we expect to catch up later in the year.

As Bruce mentioned, we’re holding to the guidance provided last quarter for net revenue and adjusted EBITDA. For net revenue, our range is $1.400 billion to $1.440 billion and our adjusted EBITDA range is $161 million to $165 million. Finally, the modeling guidelines provided last quarter remain unchanged.

With that, I’ll turn it back to Bruce.

Bruce Nardella

Thank you, Denis. And with those comments, we’d like to open the line for questions. Jamie?

Question-And-Answer Session

Operator

[Operator Instructions] Our first question comes from Richard Close from Canaccord Genuity. Please go ahead with your question.

Richard Close

Yes, I had a couple questions. First, Bruce, I was wondering if you could talk a little bit about what’s going on in various states. I saw today where the Pennsylvania governor dropped his budget today and included funding, I guess, requests for reducing the waiting list; I think about 60.7 million, if I’m not mistaken. So if you could maybe talk a little bit about any opportunities in Pennsylvania, maybe what’s going on California? I think Governor Brown is catching a lot of heat for under funding disabilities, services, maybe what’s going on in Connecticut and Rhode Island, if you have any opportunities in those states as well?

Bruce Nardella

Yes, thanks Richard. We’ve been paying a lot of attention to Pennsylvania, because the governor a while back in his budget did indeed include expansion to reduce the waiting list. However, Pennsylvania remains the only state in the country that has not yet passed the budget. So that revenue increase has not yet found its way obviously into the state and has yet to result in any increased services there. But we’re watching that one very closely. In general, across the country the overall budget picture is very solid. I’d say it’s slightly positive in general. We are seeing a few moves in a couple of states. The states you mentioned, Rhode Island and Connecticut are not states that we focus on and have services. So they -- we’d not get that at least at this point in time as a significant mover of our business. But there is still opportunities, for example, as we mentioned in the last quarter’s call, the state of Ohio remains a state that is focusing on reducing waiting list and getting people out of institutional care and we think in the mid to long range, that’s going to be a great opportunity. Other than that, we’ve not seen anything in the way of storm clouds in terms of our -- either our rate or volume picture going forward. And as you know we’re fairly early on in the process just about all the states governors have submitted their budgets and they’re in the -- just beginning the legislative process there. But at least at this stage, we consider ourselves to be in very good shape.

Richard Close

And then my question regarding M&A, you mentioned that you haven’t done as much in the first part of this year as compared to the first 100 days last year, but the pipeline remains robust and encouraged to see some action on the adult day side here recently. Can you give us a comparison in terms of, I guess, what the roughly $19 million in deals you’ve done year-to-date compares to last year, where you stand there?

Bruce Nardella

In terms of that $19 million ….

Richard Close

Annualized revenue.

Bruce Nardella

Yes. I think last year it was -- I think it was -- actually I don’t have that right here. I’ll get that for you, one second Richard. But actually the reason why if you recall back to last year, the reason why I specifically said the first 100 days is because very early on in Q2 within the first two weeks of January last year, we did a couple of substantial acquisitions as well. So the quarter-over-quarter, it was the quarter last year was higher than the quarter this year. But right out of the chute in Q2, there were a couple of substantial acquisitions as well.

Richard Close

Okay. I’ll follow-up with Dwight. Thank you.

Bruce Nardella

I believe the revenue last quarter was $14.8 million in revenue and $8.8 million in this year, ’16. So that’s the difference in the quarter.

Richard Close

Okay. Thanks.

Operator

Our next question comes from A.J. Rice from UBS. Please go ahead with your question.

A.J. Rice

Thanks. Hello, everybody. First off, maybe just to make sure I understand the context, You’re holding the line on guidance for the year and I just -- I know you don’t give quarterly guidance, but the $36 million of adjusted EBITDA in the first quarter, would you describe that as generally being inline with what you guys were expecting or broadly speaking or if you maintain the guidance you have to catch up or are you a little ahead, how would you describe it?

Bruce Nardella

Well, we certainly -- we don’t give guidance by quarter. We don’t give guidance in terms of either acquired revenue and EBITDA versus organic, but we got out of the chute slowly in terms of the acquisitions. And as I noted in my statement earlier that’s purely a timing issue and frankly the drag that was created by the ARY continuing to proceed through the first quarter, a year-ago we didn’t anticipate that we were hoping to be out of that earlier. And I think the -- overall, we’re generally pleased, but West Virginia is a big state for us and that was a big headwind for us. So I’d say other than West Virginia we’re generally pleased when you come out of the chute slow in acquisitions, I usually can breathe a little easy, because I know based on our pipeline it’s purely just a matter of the -- being unable to pinpoint the timing on closing deals. So that’s what I’d say. And the timing of our organic growth projects, we came out -- we’re coming out of the chute investing a lot of money early on and as you know this is happening while those class years of 2012 and 2013 have largely matured. So that has slowdown the growth rate a bit. So, those two things combined, depressed the growth picture overall, but I’d much rather deal with explaining that because I think in the end as we’ve proven in the past those new start investments will pay great dividend.

A.J. Rice

Okay. Thanks for that. And then, just going back to the question, to the comments on acquisitions, you obviously have done some across all the major buckets in the last six months that you would like to pursue. Can you tell us whether there is any change in the pricing metrics for any of the buckets, Adult Day Care, I/DD or SRS, and is there any change in the competitive landscape when those deals come up?

Bruce Nardella

The competitive landscape remains relatively the same and thus far what we’ve seen is the pricing has remained the same. The only thing I’d say is that as we’ve -- I believe we’ve indicated on previous calls, we assume that Adult Day Health acquisitions were going to be priced relatively similar to the SRS acquisitions. Now we all know that was not the case as we jumped into the Adult Day Health with our platform acquisition in September 2014. But I’m glad to say that with our first acquisition since then that has been the case, so our acquisitions are ranging from say 2 to 2.5 times up to around 5 times. The SRS and the ADH are closer to that 5 times range and the human service ones continued to be -- we’ve got them as low as 2 to 2.5, but most of them set around that 3 to 4 times. So that has not materially changed at all.

A.J. Rice

Okay. And then maybe one last thing, I appreciate the comment about free cash flow for the quarter and how that’s improved year-to-year. Any thoughts on what you think you might do for the year in terms of free cash flow and objectives in terms of leverage for the year?

Bruce Nardella

Denis?

Denis Holler

Yes, well as you know A.J., we don’t really guide on free cash flow where you certainly you know what the performance was last year. We will become a tax payer this year, which will effect that and -- but to be offset by growth in the business. So certainly stable, but I wouldn’t characterize it specifically.

A.J. Rice

Okay. Anything on leverage target or what do [multiple speakers]?

Denis Holler

Yes, I think what we said on leverage is that; first of all we’re very, very happy with our current leverage level. As we said, the business can sustain higher leverage levels, and for a larger acquisition opportunity we would certainly consider taking that on. But we don’t communicate specific targets.

A.J. Rice

Okay. All right. Thanks a lot.

Operator

Our next question comes from Paula Torch from Avondale Partners. Please go ahead with your question.

Paula Torch

Great. Thank you everyone. Good afternoon. I have a couple of questions. The first one is on new starts. I believe you said earlier that you were projection about a $2.5 million investment above last year, and just looking at the first quarter run rate, I think that suggest maybe a little bit higher than that. So I was just wanting to see if you could talk about the new start investments, and how they could change throughout the year, and how should maybe we expect the rest of the year to flow between the remaining quarters? And also where is the bulk of the new start investment going to go? Is it going to be still at more I/DD or I know you’re doing some de novo’s with ADH, wondering if you can give us more color on how that will flow?

Bruce Nardella

A lot of the new start investments are in I/DD programs, in a lot of day programs compared to previous years. Significant investment still in our SRS, particularly the NeuroRestorative end of the business, we continue to see opportunities there, and largely due to the expansion of publicly funded Medicaid waiver programs. And then finally, although it’s a very small piece of our business, we do have two de novo new starts in the ground for ADH. So, that would take our 11 up to 13 and we hope to open those doors in the fourth quarter of this year. So that’s pretty much the breakdown. And it’s hard to pinpoint exactly how the investment drag will play out over the next three quarters of the fiscal year. I mean, we have a general sense. That $2.5 million could end up being a $2 million increase or could end up being a $3 million increase. Some of it has to do with the rate of fill, our ability to hire staff and retain them. Some programs actually reach some breakeven point; start generating a profit prior to in advance of what we have planned for and some of them lag longer. So, I would take that $2.5 million as a sort of a range, and we might fall a little short of that or we might invest a little beyond that. But that’s the make up of the new starts though.

Paula Torch

Okay. Thank you for that color, I appreciate it. And just looking at some of the key metrics from the queue [ph], looking at I/DD and the volume growth year-over-year in the quarter, certain -- like I think it was a low single digit about 3.4% versus 8.3% last year. So, I’m sort of moderated a little bit. Is that mostly due to West Virginia and pressures there or is there anything else going on in the I/DD business that could impact volume growth for the remainder of the year, and how are you feeling about that?

Bruce Nardella

Well, I think when you look at it in the Q2, the growth rates are impacted by the new starts. But I think largely -- largely what's going on there is you’re seeing the impact of West Virginia, that’s the biggest part of that. And I believe our gross revenue increase in I/DD was 4.9% even with the drag of West Virginia. Now I will say though, in terms of price impact, we’re probably receiving somewhat less of a tailwind due to pricing at this point in our fiscal year compared to the tailwind we were receiving in the first quarter of 2015. I think at that point we’re close to almost 1% across the board. I think in this situation we’re closer to about half of a percent. So that’s part of -- perhaps part of the impact as well. But I think the largest thing; it’s the West Virginia impact and just a slight bit of a headwind due to pricing.

Paula Torch

Okay, thank you. And then, I guess, one quick one on West Virginia, and then I’ll have another follow-up. You mentioned the litigation and the lawsuit; how long do you think this could take to be resolved? And just wondering, how you’re going to go about mitigation pressures in the near-term, and I realize that it’s baked into your guidance already. But as you think about the business in West Virginia, is it better to sort of move some of those resources potentially if you get the feeling that longer term the pressures could exist or how quickly can you respond in that state?

Bruce Nardella

Yes, to the first part of your question, how long will that litigation take to resolve itself? There’s really no way of knowing. These things can be protracted long and drawn out in appeals and who knows. So the position that we are taking is our management team is working very hard to cut our cost where we can without affecting the quality of services that we provide. Now that’s very hard to do, because we’re still serving an off a lot of people in West Virginia, and this redesign has, essentially as I said in my comments resulted in nearly a 10% hit in the rate environment, but we’re still serving a lot of people. So we have to look at our G&A expenses, make some savings. I do think we’ll make some progress there. We’re still working on it. It is a work in progress. And I do think we’ll mitigate some of that. I’m not prepared to say how much at this point in time, but I think the impact on the back half of the year will be less than it is -- it will be in the front half of the year.

Paula Torch

Okay. And then maybe just one last quick one, I know you talked about the Clinical Advisory Council. And I think maybe last year in the first quarter you updated us a little bit on client satisfaction and clinical outcome color. I was wondering if you could just give us a little bit more information on that specifically SRS, and what does that mean for long-term growth potential there?

Bruce Nardella

Yes, I don’t have the updated -- actually we’re having a meeting on this, I believe tomorrow to get our updated Q1 results. I saw a preliminary that was not yet finalized. We’re very much in line with where we were last year on client satisfaction in all of our other metrics -- our Mayo-Portland results for our NeuroRestorative services continue to be excellent. I think the larger the database becomes and the more clear it becomes that people that are involved with our programming in the community can realize meaningful gains in their functionality. I think it can only benefit the business going forward. I haven’t seen anything to indicate that we have taken any steps backwards in the quality front. As a matter of fact I feel very good about it.

Paula Torch

Okay. Thank you so much.

Operator

Our next question comes from Kevin Fischbeck from Bank of America/Merrill Lynch. Please go ahead with your question.

Kevin Fischbeck

Great, thanks. Just, I want to go back to the West Virginia comment. I think you answered it in that last round of questions. But when you say that the West Virginia pressure is going to be less second half of the year, are you -- you’re referring to cost actions that you’re going to take at the company to mitigate it on your side. You’re not assuming rate increases or anything or the loss is going to be successful to have a better impact in the back half of the year?

Denis Holler

That’s right, Kevin, two things. We’ll get to the cost equation and also we started to see the impact of these changes last year in the fourth quarter. So, the year-over-year comparison is going to lessen somewhat because we started to see the impact of these changes in the fourth quarter, but its going to take some time to get to the cost, and they will show up more in the second half. But at this point, we’re not projecting any rate release at all.

Kevin Fischbeck

Okay. And can you remind us how much West Virginia is of the I/DD business?

Denis Holler

Well, it’s a fairly sizable state. We’re in the probably the $70 million to $75 million range and our I/DD services are well over approaching $700 million.

Kevin Fischbeck

Okay. And I guess, when we think about, you guys gave some good numbers in there around kind of how to think about adjusted EBITDA growth. I think you came up with 2.3%, if you kind of adjust the factors that you mentioned. And I guess, the organics adjusted growth on the revenue side was more like 5%. So when we think about 5% adjusted same store revenue growth and 2.3% EBITDA growth, what were the biggest I guess, deltas there because I guess, you mentioned labor cost wasn’t clear to me, whether labor cost was related to the new starts, or the overtime of the new starts, whether that was a core number? And I guess, the other thing you mentioned which I wasn’t a 100% sure about was just, why rent and utilities, repair and maintenance was just abnormally high, is that something we should expect to go forward or it is kind of one time?

Denis Holler

Yes, the increase in occupancy was certainly there compared to the first quarter of last year, but it was actually flat to the fourth quarter 2015. So it looks like its stabilized. I mean, I would be -- I’m not projecting any significant moves there, so I think that will start to normalize. Our labor increases were probably around 70 basis points, and that’s got to do with -- about 20 basis points is due to the increase in our new start investments which are all very labor intensive and they’re not generating revenue or very little revenue. And then the remainder, the 50 basis points frankly is an increase in certain markets in overtime rates, as vacancies have increased in certain markets.

Kevin Fischbeck

And is that something that you would expect to persist through the rest of the year, and I guess, are including guidance respectively?

Denis Holler

Well, it remains to be seen. I mean, we have action plans to target all the states to try and attract more qualified people and frankly to hold on to them longer. One of the things that we’re seeing is that the vacancies are being created because there are other opportunities in certain markets for people to go to particularly for some of the lower wage workers that we employ. But we’re hopeful that we’ll get some improvement, frankly at this point 50 basis points I think are, I think is a manageable increase. I would be concerned if it got substantially higher than that, but I think we can deal with this. One thing we have seen in a couple of states, say California for example has given some rate increases to deal with wage pass-throughs. The state of Ohio as of January 1, has implemented a rate increase and a substantial portion of that will be required to be pass-through in wages. So, I think there are some tools out there for us to deal with this, but we are very much focused on attracting more qualified people and working on keeping them longer and increasing our retention rates. So, I can deal with an increase in overtime to where it is today. As I said, if it substantially grows beyond that then I think we’d have to -- that would be more of a concern.

Kevin Fischbeck

Okay. I guess, just to maybe [indiscernible], 50 basis points increase, are you saying 50 basis points of growth year-over-year or you’re saying 50 basis points to margin?

Denis Holler

It’s at margin.

Kevin Fischbeck

The margin headwind, okay. And then, I guess so maybe an other way to think about the normalized margin you’re saying would have been I think 10.8% versus 11.1%, and you kind of outlined I guess 57 basis points just from that. But I guess, what's going right as kind of the offset there?

Denis Holler

Well, I think the biggest thing is, when you have a growth rate in your SRS business of 10.1%, it’s a little higher margin business than your human service business. So it’s that sort of leveraging up due to the business mix frankly. Certainly ADH is helping a little bit with that, and some of our -- a lot of our states had some very good growth where we’re able to leverage our in-state overheads to. So those things are still very positive signs overall for this book of business.

Kevin Fischbeck

All right. Okay, thanks.

Operator

Our next question comes from Josh Raskin from Barclays. Please go ahead with your question.

Joshua Raskin

Hi, thanks. Good evening, guys. I just want to get back to labor expense. It sounds like you’re filling vacancies with overtime. I remember you guys talking about in the past variable comp for sort of all employees in light of the EBITDA coming in higher than expected in the previous year, and I’m just curious are you seeing any impact in terms of retention, has that helped at all? And then secondarily, did the guidance assume any of that recurs or should we assume that those payments are not going to recur?

Bruce Nardella

Actually we’ve seen the last reports that we were reviewing regarding that in the first quarter. We’ve seen our turnover rates actually go down in a handful of our states where we provide I/DD services where most of those on a quarterly -- yearend onetime variable pay bonuses were paid down. So, I think it’s a little too early to draw many conclusions from that, but at least the early sign seem to be fairly good. I do not see that variable pay program as being the lasting and only solution to this problem. There is going to have to be at some point some wage increases that will hopefully be supported by rate increases, and we have seen this in a few of our states, I just mentioned California and Ohio. And as you remember, a year and a half ago, in our largest state we received a 5% rate increase in Minnesota and a substantial portion of that was tied to wage increases. So in short, I think the variable pay plan helps but it, I would look at it as one piece of the puzzle that we are going to need to ultimately get this workforce to the point where we want it. So its just one piece of the puzzle, and I think thus far it’s worked, but we’re going to have to add to that to get some lasting improvement.

Joshua Raskin

And so what is the turnover that you were talking about the higher overtime with that end markets where you didn’t have these variable incentive programs?

Bruce Nardella

Actually some of that did -- that’s true. In some of those states obviously in ARY states we’re not paying variable pay bonus in a lot of those states, so we continue to have some high turnover there as well.

Joshua Raskin

Okay. And then just, on the M&A side, you guys have done a couple of different segments. I don’t know what Adult Day kind of jumps out at the largest revenue contribution. And I’m just curious, is that because it’s a relatively new area for you when you’re seeing more opportunity or is it the returns. It doesn’t sound like valuations are more compelling relative to the other areas, but maybe returns are better. I’m just curious, is there -- is Adult Day more attractive today and if so, why?

Denis Holler

Well, we think it’s attractive because it reminds us a lot of the DD market years ago. It’s fragmented; it’s growing. There’s a forward CAGR on this business, Josh. You probably heard us talking about it it’s projected to grow at a CAGR of like 7% because of the demographic trends in the country. So we like it, and it’s fragmented. And frankly organizations with two or more centers, this one operates three centers, but providers that deliver services in two or more centers are pretty few and far between. So we consider ourselves very fortunate to have brought this one into the fold. But the thing that makes it attractive is that, it’s a growing market, it’s a large population to serve, its in programming that we’re very familiar with, and its also funding that we’re very familiar with and comfortable with, and those are state based waiver programs. All those things line up perfectly within our mission and we will have -- we’re excited that we’re able to follow up with this acquisition, and rest assured there are others in our pipeline as well.

Joshua Raskin

Okay. Thanks, guys.

Operator

Our next question comes from John Ransom from Raymond James. Please go ahead with your question.

John Ransom

Hi, good evening. Just a couple of clarifications. So your guidance for the year which you reaffirmed today, what has changed relative to your expectations when you gave the initial guidance? Is West Virginia its bad, but is it any worse than you thought it was initially?

Denis Holler

I think its probably having a slightly bigger impact than we originally thought. Part of it has to do with the complexity of that system, John. Those are periodic billable units and although we serve 100s of people residentially, they’re all billed in 15 minute increments, and just what rules changes affected which 15 minute billable units was very hard to project. So as it plays out its having a significant impact as we projected. I would say it’s having slightly more of an impact. Any time you’re dealing with incremental revenue like that its going to have a disproportionate effect on your profitability and that’s what we are seeing here. But I do feel that, compared to some of the other good things that are going on in the business that all outs being equal and giving us a little time to wrestle with this thing, I think we’ll be able to solve some of the problem, not all of it with some cost moves. And as I said make up for it in other parts of the business.

John Ransom

So in terms of a net EBITDA effect, I know you mentioned cost cuts. Is it a couple of million bucks, maybe worse on a net basis something like that?

Denis Holler

Yes, we don’t give specific guidance on EBITDA per state, but the impact in this state in the quarter was about $1 million to the bottom line.

John Ransom

That’s after-tax net income?

Denis Holler

No, that’s pre-tax.

John Ransom

Okay. So about a $1 million bad guy this quarter but maybe gets worse or abates as you move through the other comps get easier and you take some costs out, okay.

Denis Holler

Yes.

John Ransom

And then the other -- and we’re just checking our math. But if we look at your -- lets just take the midpoint of your adjusted EBITDA guidance, and we take out the one-timers for both last year and this year. Could you just sort of recast and make sure we have this right kind of the midpoint growth in that adjusted EBITDA? Assuming you’re taking out the net health cost that you mentioned in the quarter, anything else that we should think about from a year-over-year basis, and just in terms of thinking about the organic growth of the business?

Denis Holler

Well, the other one is the ARY business. We think that’s obviously a drag here in the first quarter, and that was a contributor in the second quarter. The other thing to remember too is there was profitability generated by those exiting ARY states in the second quarter as well last year, and that will not be there. But that …

John Ransom

Can you remind me what the total was last year compared to the loss this year, what the hurdle is?

Denis Holler

About $2.3 million in the first half -- hold on; $2.1 million in the first half.

John Ransom

All right. So if we take the $2.1 million, we add in $3.1 million of a healthcare bad guy that’s about $5 million -- little over $5 million that you’re having to jump over this year, and then adding West Virginia on top of that?

Denis Holler

Yes.

John Ransom

So maybe something like $7 million net bad guy this year in that range, and so as we think about the adjusted growth we would kind add back $7 million to this year. Something like that, are we in the ballpark?

Denis Holler

Yes, I would like to go through your math with your John offline, but those are all the big headwinds that we’re accounting for as we come up with an adjusted growth rate.

John Ransom

And then lastly, as we think about the year, kind of I know you don’t quarterly, but what is kind of approximate percentages first half versus second half on adjusted EBITDA, and how is that change versus your initial guidance. You’re factoring in maybe the pace of M&A in West Virginia. So in other words maybe you thought that the beginning of the year would be 45 and 55 or something, and now its 40 and 60, is there any way to kind of think about that?

Bruce Nardella

Yes, I would have to follow-up with -- I don’t think the differential is going to be that big. But as we said, I think at the close of our fiscal year 2015, our profitability, particularly our profitability is backend loaded because of the nature of some of our new start investments and which programs are turning. So there was substantial ramp up due to the improvement in new start profitability from the class years of 2014 and ’15. So, we’ll have to follow-up with you on exactly that percentage breakdown. And as you know, we always project -- the only thing we project on acquisitions is a deployment of $25 million. We got off to a slow start, but I have no reason to believe we’re not going to be successful there and potentially exceed that.

John Ransom

Great. Thanks a lot.

Operator

Our next question comes from Richard Close from Canaccord Genuity. Please go ahead with your question.

Richard Close

Yes, just a quick follow-up. I think there was a contingent consideration adjustment in the quarter, $2.9 million. Denis, can you give us a little bit more detail what exactly that was?

Denis Holler

Sure, Richard. We saw last year the accounting rules changed a bit on this. And when you record an earn-out with respect to an acquisition, you fair value it when you make the acquisition. And this was an ABI business that we bought last year, we valued the earn-out at $6 million, and that was based on them hitting their -- the projections we had going in. And the accounting rules now say that, okay once you do that, any change off of that in estimate flows through the P&L as part of operations, so that decreased by the $2.9 million, and due to the fact that there was a empty facility that we bought that was licensed and ready to go. And there was a projected fill rate for that facility. The earn-out goes over two years. So we’re very confident, the business is doing very well. We’re going up the facility, but our projections have been taking longer to fill that up, and that’s why we have to value that earn-out down, and we marked it down this quarter. But we still feel very good about the business. We also -- have also taken adjustments to EBITDA. So, as we deal with these new accounting rules, as we have shift and earn-outs and they flow through operations, we’ll pull those out. So they will not be in our adjusted EBITDA.

Richard Close

Okay. Thank you.

Operator

And our final question today comes from Jennifer Lynch from BMO. Please go ahead with your question.

Jennifer Lynch

Hi. Thanks for squeezing me in here. Just two really quick follow-ups, I may have missed this during the other state specific commentary, but any update on Mississippi. I know we’ve talked about that as a state with some forward momentum. And then finally, on de novo ADH facilities, can you just remind us if there is a different timeline to profitability for de novo’s in the Adult Day Health space compared to your other units? Thanks very much.

Bruce Nardella

Yes, Mississippi, we continue to operate a number of day programs there, but frankly we feel that the biggest opportunity is going to be when the state finally sets new rates for residential offerings, particularly waiver based group homes which they have not done yet. So we are providing day program services and some hourly supports called, supported living. We are told that the state is very close to releasing these new rates to be effective for July 1, and again this is part of their agreement with the Federal Government in order to provide more opportunities in the community and to depopulate their institutions. We’ve been at this for a while now, the better part of two years. But so, I still remain actually very hopeful that Mississippi is going to turn into a big opportunity, certainly bigger than what we’ve seen over the last two years, because we’ve been essentially shutout of the residential component of those services, because the rates are not supportive. So there is -- I hope to have better news in subsequent calls on Mississippi. And as far as the rate to profitability for de novo’s in Adult Day Health, my sense is we don’t have a lot of experience. We just launched our first two. My sense is it probably will take us around the same amount of time, maybe a little longer just because these Adult Day Health centers can range in capacity between a 100 to 150 people. So you’re going to have to get a substantial census in there to cover your costs of, the building as well as the staffing cost. But I wouldn’t see them being appreciably different perhaps a little longer, but we will be learning this as we go, as we have our first two de novo’s in the ground right now.

Jennifer Lynch

Very good. [Indiscernible]. Thanks very much.

Operator

And ladies and gentlemen, that concludes today's question-and-answer session. I’d like to turn the conference call back over to management for any closing remarks.

Denis Holler

Yes. Thank you, Jamie. I just wanted to clarify one point I said, it didn’t give us enough credit I said. Our DD business was around $700 million and its approaching $900 million annualized, so I apologize for that error. But in summary, I’d just like to make a few comments. Our acquisition pipeline remains robust and strong. We’re continuing to pursue increased investments in our new start initiatives that frankly have us very excited, and we’re expanding our higher margin SRS services in new and existing markets. And finally evidenced by the news today, we’re leveraging our entry into the large and growing market for Adult Day Health services. So our fundamentals remain strong and we continue to make excellent progress in achieving our strategic goals. I’m very grateful to our outstanding workforce, and thank them for their continued hard work and dedication to our mission, and the individuals that we are proud to support. And I’d like to thank all of our stockholders. I look forward to keeping you updated on the Civitas story as we move forward. Thank you very much.

Operator

Ladies and gentlemen, that does conclude today's conference call. We do thank you for attending. You may now disconnect your telephone lines.

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