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Executives

Daniel P. McCartney - Chairman of the Board and Chief Executive Officer

Analysts

Ryan Daniels - William Blair & Company L.L.C., Research Division

Michael W. Gallo - CL King & Associates, Inc., Research Division

James Terwilliger - The Benchmark Company, LLC, Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Healthcare Services Group (HCSG) Q3 2012 Earnings Call October 10, 2012 8:30 AM ET

Operator

Good day, everyone, and welcome to the Healthcare Services Group 2012 Third Quarter Conference Call.

The discussion to be held and any schedules incorporated by reference into it 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 Exchange Act of 1934, the Exchange Act, as amended, which are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, our beliefs and assumptions.

Words such as believes, anticipates, plans, expects, will, goals 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 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 health care industry, primarily providers of long-term care; credit and collection risks associated with this industry from having several significant clients, who each individually contributed to at least 3% with one as high as 7% to our total consolidated revenues in the 3- and/or 9-month periods ended September 30, 2012; 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; our workforce and services provided, including state and local regulations pertaining to the taxability of our services; and the risk factors described in our Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2011, in Part I thereof under Government Regulations of Clients, Competition and Service Agreements and Collections and under Item IA, Risk Factors.

Many of our clients' revenues are highly contingent on Medicare and Medicaid reimbursement funding rates, which Congress and related agencies have affected through the enactment of a number of major laws and regulations during the past decade, including the March 2010 enactment of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010. Most recently, on July 29, 2011, the United States Center for Medicare Services issued final rulings, which among other things, reduced Medicare payments to nursing centers by 11.1% and changed the reimbursements for the provision of group rehabilitation therapy services to Medicare beneficiaries.

Currently, the U.S. Congress is considering further changes or revising legislation relating to the health care in the United States, which among other initiatives, may impose cost-containment measures impacting our clients.

These laws and proposed laws and forthcoming regulations have significantly altered or threatened to significantly alter overall government reimbursement funding rates and mechanisms. The overall effect of these laws and trends in the long-term care industry has affected and could adversely affect the liquidity of our clients, resulting in their inability to make payments to us on agreed-upon payment terms.

These factors, in addition to delays in payments from our clients, have resulted in and could continue to result in significant additional bad debts 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 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 our 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 in 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.

Also, as a reminder, today's call is being recorded. And at this time, I would like to turn the conference over to Mr. Daniel McCartney, Chairman and CEO of Healthcare Services Group. Please go ahead, sir.

Daniel P. McCartney

Okay, thank you. And good morning, everybody. Thank you for joining us. We released our third quarter results yesterday after the close, and we'll be filing our 10-Q the week of the 23rd. But for the third quarter, our revenues were up 24% to $272 million. For the 9-month period, revenues increased 25% to $800 million. Housekeeping and laundry grew at about 14%. And food service, better than 58% for the quarter, and 14% and 56% for the 9-month period.

As we discussed in previous calls, we continue to execute the expansion, the accelerated expansion, of the food service due to the investment we have made in the regional district management people over the past few years, and their continued improvement and development has allowed us to service new food service clients within the existing operational structure and to expand more rapidly. In addition, our housekeeping and laundry services continue to grow within our 10% to 15% targeted range. Quarterly and 9-month revenues were all company records.

Our net income increased over 15% for the quarter to $11.5 million or $0.17 a share compared to $0.15 a share in 2011 in the third quarter when our tax rate was 34% in 2011. Net income increased 14% to $31 million or $0.47 a share for the 9-month period, again, all company records.

The direct cost for the third quarter were modestly below 86% as new business we started and the new districts and regions kept making progress in implementing the changes, getting the jobs running on budget more timely without taking their eye off the ball with the existing clients. We expect to continue that progress with the new business margin improvement while giving the proper attention to the older clients, and we expect to work towards keeping our direct cost below 86% and working our way down over the next few quarters closer to 85%.

The SG&A costs were reported at 7.6% for the third quarter due to a gain of $774,000, and the deferred compensation accounts that we hold for our management people increased SG&A expense about 30 basis points. So the real or adjusted SG&A expense was about 7.3%, slightly above our range of 7%, 7.25%. We expect the SG&A expense to stay in the 7%, 7.25% range going forward. And as discussed in past quarters, the SG&A also includes the changes in some states like Ohio, Michigan and Texas, to a gross receipts tax rather than in our tax provision. And it also reflects the additional resources we added to the payroll and benefits department, which allows us to meet the new higher personnel recordkeeping requirements in this regulatory environment and be more efficient in the insurance areas and employee benefits and to be prepared to benefit from certain job tax credits that we previously benefited from when and if the credits are approved from Washington again.

Our earnings from operation are reported at $17.6 million. But adjusting for the deferred compensation, our earnings and pre-tax income was up over 21%. Investment income was reported at $962,000. But again, with the adjustment from the SG&A, our real company investment income was about $200,000 for the quarter.

As I previously mentioned, our tax rate was 38%, up from 34% in the third quarter 2011 as the worker opportunity and other tax credits just haven't been finalized for fiscal year 2012.

On the balance sheet, we ended the quarter with about $74 million in cash and securities, still no debt. Our current ratio are better than 4:1, and the receivables remained in good shape, well below our target of 60 days.

And finally, the board approved an increase to the dividend to $0.165 a share, split adjusted. The cash flow, cash balances and earnings per share for the quarter more than support it. And since the tax laws are still in place at least for 2012, we still feel it's the most tax efficient way to get the free cash flow back to the shareholders. It's our 37th increase in the dividend since it was originally instituted in 2003, and that's after 4, 3 [ph] for 2 stock splits.

So with that abbreviated summary, I'll open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Ryan Daniels with William Blair.

Ryan Daniels - William Blair & Company L.L.C., Research Division

Let me start just the first one on the forward outlook. Obviously, I guess the big question here on the revenue line is you start going into some very difficult comparisons given the huge new business you took on in the fourth quarter. And I know you've always stuck with kind of a double-digit top line growth rate. Could we see that dip a bit over the next quarter or 2 just given the bulk [ph] of business you had in Q4 and the difficult comp that creates?

Daniel P. McCartney

We think as long as -- housekeeping and laundry is really unaffected, so their target is still 10% to 15%. We think we'll be at a more accelerated rate than even prior to the expansion in the fourth quarter 2011 in food service, although it's not going to be at the 50% rate that we've benefited. But we still think it will be higher than our average rate. And as long as we digest the new business, keep demonstrating we continue to operate effectively financially and operationally, that I'd say by the middle of next year, we'll be able to more comfortably say, okay, we think our sustained growth is going to be at 15% to 20% instead of the 10% to 15% historically with primarily food service being the more ambitious driver. But I think we'll do better than our historical rates, maybe not each quarter but certainly at the high end of the range of the next quarter or 2. And the payoff will be going forward when we have the management depth play a little catch-up and be able to demonstrate what the sustained growth rate will be. But it will be no less than we've experienced in double digits historically.

Ryan Daniels - William Blair & Company L.L.C., Research Division

Okay, that's very helpful color. And then maybe as a follow-on to that, can you talk a little bit about your management capacity and utilization, specifically in the food services division? I know you've had a little bit of excess capacity in some regions. Do you still feel pretty good about taking on that new business? Or maybe an update on the talent pool there and how that's progressed.

Daniel P. McCartney

Yes. I think food service, in our basic model, 8 to 12 facilities per district, 4 to 6 districts per region, for example, the cookie cutter that we use. And food service, it's still underutilized, although nowhere near what it's been with the recent expansion that we've had. But some areas are a little more sparse than others. Some areas have had -- needed more time to absorb the new business and operate effectively. So we've really calibrated it more district- and region-specific as opposed to across the board. But they're nowhere near at maximum capacity as housekeeping and laundry is. So that's why we're confident we'll keep accelerating the food service expansion, because the management resources are still, in our method, underutilized.

Ryan Daniels - William Blair & Company L.L.C., Research Division

Okay, great. And then 2 more quick ones. The first, just curious if you have the current metric of how penetrated the core housekeeping, linen and laundry client base is with food services at this point, still under 25% or so?

Daniel P. McCartney

Yes, yes. We still -- we're doing maybe about 700 of the 3,400 or so clients, food service. So there's still pent-up demand within our existing client base. And frankly, the controlling factor is how well our districts and regions can operate effectively as to how quickly we expand that within the client base.

Operator

Next, we'll hear from Michael Gallo with CL King.

Michael W. Gallo - CL King & Associates, Inc., Research Division

A couple of questions. Dan, you've really digested now the food service additions in Q4 and Q1, and the margin's improved there significantly. Are we at the point where we'll get -- where you'll get ready to tuck in a significant number again? Maybe not as many as the fourth quarter, but I know you had kind of slowed things down a little bit as you digested some of that new business.

Daniel P. McCartney

I think it will be more -- it will be on the higher end of the ranges. It won't be what we've experienced in the fourth and first quarter of 2012, and the fourth quarter of 2011, but it will be at the higher range because not only of the demand, but our ability to manage it effectively. So -- but it won't be at the rate of 50% that we've enjoyed, especially when we started those new buildings in the -- primarily in the fourth and first quarter.

Michael W. Gallo - CL King & Associates, Inc., Research Division

Okay, great. Second question, Dan, you seem to express maybe a little more confidence on this call as we've seen the margins improve at getting the direct cost down to 85%. How much of that is just getting more comfortable with the food service versus some further improvements or better management in the housekeeping, linen and laundry business? And how quickly do you think you can get there?

Daniel P. McCartney

The margin improvement has primarily been improvement in the food service. We're eating the cost of the middle management people for years, why they improved, got better and our structure became more solidified throughout the country. But -- and we were eating that cost. One is spread out over the right amount of properties, and there's still room for us to improve that. And then at the facility level, with the startup cost being out of the way where we're the most inefficient with additional labor or startup cost per inventory or food inventory and address that, that's -- our margin improvement in food service came from both, utilization at the district and regional management people with the right complement of properties and then without the significant startups, getting those new jobs on budget more timely after the initial inefficiencies usually takes us 30, 60 days. Sometimes, like the first quarter of this year, took us 90 days to get the new business on budget. But now it's done in a more business-as-usual fashion like housekeeping and laundry, and we think we'll keep chipping away and get the direct cost closer to 85% over the next few quarters.

Operator

Next, we'll hear from James Terwilliger with the Benchmark Company.

James Terwilliger - The Benchmark Company, LLC, Research Division

Real quick. When I look at your bottom line growth, you're putting up great numbers. You had a nice quarter, right in line with everyone's estimates. But the bottom line growth probably isn't as robust because of this tax rate issue. We're going from a 38% tax in 2012 back to a 34% tax in 2011. Can you update me and everyone on the Worker Opportunity Tax Credit? Is there any visibility with that? And what should we be looking for a tax rate in 2013?

Daniel P. McCartney

Well, we wrote our congressmen, but we don't know if we have that much juice. In all seriousness, we're optimistic it's going to pass, and every part of the long-term care lobby indicates that it will but probably not till after the election. And in the meantime, we're providing our tax rate as if it's not going to pass. And if it does, we'll be in good shape and certainly the beneficiary as we were in 2011, but I'd be reluctant to predict anything, frankly.

James Terwilliger - The Benchmark Company, LLC, Research Division

So for 2013, then we -- it would be conservative to assume the current tax rate going forward?

Daniel P. McCartney

Yes, yes. And that's what we're doing until it's changed.

James Terwilliger - The Benchmark Company, LLC, Research Division

Okay. And real quick. If we look at housekeeping and laundry and linen, you're in that 10% to 15% historical growth rate. The food service has been absolutely on fire. Did you say 58% food service revenue growth this quarter?

Daniel P. McCartney

Yes.

James Terwilliger - The Benchmark Company, LLC, Research Division

And you're doing a fantastic job there. You are going to come up against maybe some more difficult comps as we move into next year. If we look at the food service, do you think that business can grow 20%, 25%, and then maybe for the company as a whole, a blended average would be more like 15% revenue growth in 2013?

Daniel P. McCartney

That's what we're anticipating. But as I tried to caution everybody, I just want to make sure we absorb the new business and the growth that we've experienced effectively without some of the company's operational metrics being compromised. And then I'd say by the middle of next year, we'll say what the sustainable growth rate could be going forward. But certainly, it will be higher than our historical average the next few quarters just because of what we've been doing and the capacity we had in the food service organization and the pent-up demand. But I think by the middle of next year, it will be more -- startups will be done. We'll have solidified the operational performance and the operational personnel throughout the country and throughout the 10 divisions. And then we'll be able to more confidently say, okay, this is what we think our sustained growth rate will be going forward. But it will be in a more accelerated rate, not as high as 50%, but at a more accelerated rate the next few quarters without doing anything exciting.

Operator

Next, will hear from AJ Rice with UBS.

Albert J. Rice - UBS Investment Bank, Research Division

First, just maybe on the housekeeping. Obviously, in the quarter, you came in toward the high end of your targeted growth rate, and I think generally, the feeling has been that housekeeping would be more towards the lower end. Can you comment on what you saw that ended up driving the stronger performance there than maybe what has been trend line?

Daniel P. McCartney

I think with the housekeeping and laundry, I would say 2 things, and I don't have any empirical data to support this, but I think with food service expansion, frankly, the competitive juices and housekeeping and laundry, guys were maybe a little bit more attentive than they would've been otherwise as far as the growth opportunities were concerned. The demand for the services, even in housekeeping and laundry, although little recently, food service got most of the attention because of the dramatic change in expansion, the demand for housekeeping and laundry services has been as great as it's ever been, too. The constraint on how quickly we can expand that is the development of management people. We were able to do it in food service more aggressively because we had built-in capacity of management, people that were underutilized. But housekeeping and laundry, it's much less the case. But we think that housekeeping and laundry, it's sometimes quarter-to-quarter the luck of the draw. That's why we such have such a wide range of the revenue impact and not to get to far in the weeds, but for example, you add properties in the higher wage states, it has a bigger impact on revenue because it's a wage rate-driven. So facilities in the Northeast with higher wages, 200-bed facility could be 3x the revenue that the same size property staffed exactly the same way in Omaha with the lower wage rates would be. So depending on where we get the new properties, it impacts the effect on revenue. But I think food -- housekeeping and laundry, I think it's safe and conservative to say it will stay in the 10% to 15% range, hopefully on the higher end but certainly within that range. And food service will still grow at a more dramatic rate because of the management capacity, not because of any difference in demand for the services.

Albert J. Rice - UBS Investment Bank, Research Division

Okay. And then maybe I'll just ask you about commodities. Obviously, you're expressing some optimism about gross margin trends potentially, but the commodity price, particularly in dietary, continue to bounce around. Can you comment on where you stand there and what new opportunities to manage that may be presenting themselves?

Daniel P. McCartney

I think, first of all, as we've become more attractive to the food distributors as a client, the custom, more volume purchasers, and we're educated purchasers as well, to tell you the truth, as far as some of the national account status we've been able to achieve. With different rebate programs, et cetera, we think we're in much better shape as far as being impacted less than our clients as far as commodity cost changes. But a few years ago, some of you might remember, our trigger in our service agreements typically had been triggered by the wage rate increase because we matched and mirrored the wage rate and benefits that if a customer gave a 3% increase, that would trigger an increase to our contract price. And we really did food service the same way. In 2008, 2009, the last time commodity costs were going up more dramatically, the commodity cost increases were going up more rapidly than the wage rate accelerator allowed us to. But then we went back to the client to get those costs covered. The argument is had we not been there, they'd be experiencing the same increase. They're all at-will contracts, and we're only there because we're in the clients' best interest. So we're not going to be trapped with commodity cost outstripping our contract price. Now some of the contracts also are more explicit with the CPA accelerator in the service agreements on top of the labor trigger. So if the commodity costs go up, we pass the cost to the client. We sit down and meet them, go over what the impact will be. They'd be experiencing the same impact. We're not making it up. And we feel that we're in good shape to cover ourself on both ends [ph].

Operator

And that is all the time that we do have for questions. I would like to turn the conference back over to Mr. McCartney for any additional or closing remarks.

Daniel P. McCartney

Okay. Thank you again. Thanks, everybody, for joining us. But going into the fourth quarter and the remainder of the year, we expect to continue to expand our client base in housekeeping and laundry. In this environment, even though we've been doing it a long time, the demand for the services is still as great as it's ever been. We'll continue to control our growth and attempt to balance the expansion with our ability to manage it effectively and timely. It remains of utmost importance to us to balance the client satisfaction measurements as we digest the increased amount of new business and operate it all satisfactorily to the customer and on budget. We look to make certain the recent expansion continues to operate, improve the margins, primarily again in food service, and expand the food service margins as we grow the client base but in a controlled way. Since we're now more confident in the consistency of the newest regional and district management people in dining services in all areas, we'll more fully utilize the management capacity, get them closer to our model, and that's where the bulk of the margin improvement is going to come from. We have to keep the attention on the startups but not take our eye off the ball with the existing client base. We'll look to keep the direct cost below 86%, work our way down to 85%. And the SG&A costs are going to stay in the 7%, 7.5% range. We may get some efficiencies. But if I were going to be conservatively modeling it, that's where I expect us to be, excluding any deferred compensation impact. Our tax provision is going to remain at about 38% until Congress finalizes the tax credit programs we discussed. But in our business, frankly, this demand for the services is as strong as ever in all services. We believe we never had better management people in a better, more consistent management structure on both divisions in the history of the company. All the other trends are still in our favor, cost containment, demographics, et cetera. So for us, these are pretty good times. So thank you for joining us and onward and upward.

Operator

And that does conclude today's teleconference. Thank you, all, for joining.

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