Civitas Solutions, Inc. (NYSE:CIVI) Q3 2018 Earnings Conference Call August 7, 2018 5:00 PM ET
Dwight Robson - Chief Public Strategy & Marketing Officer
Bruce Nardella - Chairman, CEO & President
Denis Holler - CFO
Catherine Anderson - Bank of America Merrill Lynch
Brian Hoffman - Canaccord Genuity Limited
Good afternoon, and welcome to the Civitas Solutions Third Quarter 2018 Earnings Conference Call. [Operator Instructions]. Please note, today's event is being recorded. I would now like to turn the conference over to Dwight Robson. Please go ahead, sir.
Thank you, Rocco. Good afternoon, and welcome to the Civitas Solutions Inc. Fiscal Third Quarter 2018 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 releases with financial statements can be found in the Investor Relations section of our website at civitas-solutions.com.
Please be advised that today's discussion includes forward-looking statements, including predictions, expectations and estimates about our future financial performance, our investments and the impact of acquisitions, rate changes and the legislative initiatives 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 risks and uncertainties that may cause actual results to differ materially from the forward-looking statements we make today. Risks and uncertainties that could cause actual results to differ materially from these forward-looking statements are described in our Form 10-K filed with the SEC. 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 result. 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 fiscal third quarter 2018 results for comparable GAAP measures.
With that, I'll turn the call over to Bruce.
Thank you, Dwight. And thanks everyone, for joining us on today's call to discuss our fiscal third quarter 2018 results. Denis is going to provide you more detail on our financial performance a bit later in the call. But first, I want to briefly comment on some of the quarter's highlights and also provide an update on the external operating environment. We are pleased with our strong third quarter, which was driven by growth and net revenue and EBITDA across all four service lines.
To briefly recap our financial results. Net revenue for the third quarter was $404.5 million, an increase of 8.6% over the same quarter last year Adjusted EBITDA in the third quarter was $51.7 million compared to $42.5 million for the third quarter of last fiscal year. Investors who follow our company know that in recent quarters, management has focused on key initiatives to strengthen our operating performance and our results in the third quarter reflect continued progress on a number of fronts, particularly our G&A cost-containment project.
At the same time, we have been very active in completing acquisitions including our two largest acquisitions since 2003. Our SRS operations are performing very well under a single consolidated management team, and our ARY service line achieved strong organic growth. The ARY expansion is particularly notable because we have struggled to expand this service line in recent years. We scaled back our ARY operations from 15 to 9 states, focused on clinical excellence and enhanced our efforts to recruit and support high-quality foster families. I admit one quarter certainly doesn't qualify as a trend, but I'm very pleased with the progress we've made.
During the third quarter, our direct labor expense was also better than projected, aided by structural items that strengthened our performance as well as our focus on growing less labor-intensive services. However, despite our successful efforts to strengthen our recruitment and retention of caregivers, we continue to operate in a very difficult labor environment. As a result, while our strong third quarter performance has allowed us to increase our adjusted EBITDA guidance for fiscal year 2018 by $2 million, our expectations for upcoming quarters are tempered by labor challenges that we expect will pressure our organic EBITDA growth. We are pleased with the performance of our - of acquisitions during the third quarter, including the sizable Mentis and HSI deals completed last fall.
During the third quarter, we completed two additional acquisitions with total annual revenues of approximately $9 million. As previously announced, the larger of the two deals closed on April 2 when we expanded our ADH services in Massachusetts with the acquisition of the Aging Well and Living Well Adult Day Health Centers. The centers, which generated revenues of approximately $8 million for the 12-month period prior to the acquisition, are great additions to our existing ADH programs in Massachusetts. Also during the quarter, we added an I/DD tuck-in to our Ohio operations.
Subsequent to the quarter, we have completed two noteworthy deals. The first, which we announced last month, was the acquisition of Creative Connections, Inc. or CCI, a Bakersfield, California provider of community-based services for individuals with intellectual and developmental disabilities. Like our market-leading Family Home Agency program in California, CCI specializes in matching adult individuals in need of support with nurturing caregivers interested in welcoming a person with a disability into their private homes.
For the 12-month period prior to the acquisition, CCI generated revenues of approximately $5.8 million. On August 1, we expanded our ADH services to the state of New Hampshire with the acquisition of maintaining independence, which supports approximately 130 seniors and generated annual revenues of approximately $1.4 million during the 12-month period prior to the acquisition. Our analysis indicates that New Hampshire is a favorable market for Adult Day Health services, and we are delighted that it is our fourth ADH state joining Maryland, Massachusetts and New Jersey as we continue to make progress toward our goal of establishing our company as the leading provider of the ADH services. We are very excited about the future of ADH business and its potential to meaningfully contribute to our mission, growth and development in the years ahead.
Moving forward, our M&A pipeline is solid with attractive opportunities in I/DD, SRS and ADH service lines but includes mostly smaller companies and remains weighted towards targets in the earlier stages of development. We intend to remain very aggressive in pursuing attractive acquisition opportunities. But as we noted last quarter, the preponderance of early-stage targets in our pipeline makes it a bit more difficult to predict the timing of additional deals. And now I will make a few comments about the external operating environment. Overall, it appears that state governments finished fiscal 2018 in a solid position with annual tax collections in nearly all of our priority states, coming in ahead or essentially in line with projections, including Minnesota, our largest state, which accumulated a $300 million surplus during state fiscal 2018.
The operating environment remains stable to slightly positive in the vast majority of our 36 states. State fiscal 2018 budgets included funding for modest rate increases in about a dozen states, including several which include a mandatory pass-through for wages or are intended to offset the impact of increases in state minimum wages.
The only significant new negative action is a 7% rate cut in Minnesota effective July 1, which currently impacts approximately 16% of the Minnesotans we support in waiver group homes. This cut was unexpected and was triggered by a CMS decision to withdraw its match of a three year-old rate adjustment due to an inadvertent conflict with other rate changes the state made in 2017. The state legislature attempted to fix this issue in an omnibus budget bill. But for reasons that had nothing to do with this matter, the governor vetoed the bill. Absent a special legislative session, which the governor has said he will not call, the legislature is unable to take further action until the new session begins next January.
In the meantime, litigation has been filed in an effort to reverse the cut, but its ultimate resolution and timing are difficult to predict. As we noted last quarter, several states have appropriated funding for otherwise - or otherwise undertaken initiatives to significantly expand the number of individuals with disabilities who will be able to access community-based services and supports, including a couple of initiatives that are potentially larger in scope than anything we have seen during the last couple of years. We are on track to approve a greater number of new starts in fiscal 2018 than we did a year ago. And we are optimistic that demand for community-based services could drive an increase in our overall investment level in fiscal 2019.
In summary, we're pleased with the progress and growth we have achieved so far in fiscal 2018. I continue to believe, we are very well positioned to execute on our long-term balanced growth strategy and fulfill our mission by providing high-quality, cost-effective services to must-serve populations of adults and children in need of our support. The strength of our business model also gives us confidence in our ability to continue to drive strong free cash flow, reduce leverage over time and grow through disciplined investments in organic and acquisition opportunities. In so doing, we believe we'll be successful in creating long-term value for our stockholders.
As always, I am very grateful to our outstanding workforce, and thank them for their continued hard work and dedication to our mission and the individuals we are so proud to support. At this point, I'll turn the call over to Denis Holler, our Chief Financial Officer, to discuss our financial results in more detail. Denis?
Thanks, Bruce. Moving directly to the results for the third quarter ended June 30. Net revenue grew by $32.2 million or 8.6% over the third quarter of last year to $404.5 million. The increase was primarily due to acquisitions, which accounted for $28.1 million of the increase. Organic revenue growth, net of program closures was $4.1 million. Excluding the impact of these closures, our organic growth would have been $7.4 million or 2% over the third quarter of last year.
New-start investments during the quarter were up slightly over the prior quarter coming in at $1.6 million compared to $1.4 million last year. As Bruce has mentioned, we are seeing positive trends in new-start opportunities and are expecting the investment levels this year to be slightly higher than in 2017 when we incurred $5.6 million in new-start losses.
Our adjusted EBITDA increased by 21.8% to $51.7 million. Adjusted EPS came in at $0.58 per share, an improvement of $0.15 over the same quarter last year. Adjusted EPS is running at $1.92 per share for the trailing four quarters. This represents an adjusted P/E ratio of 8.5 using our 21-day stock price average of $16.29 per share. Our adjusted EBITDA margin, on a gross revenue basis, increased substantially by 140 basis points over the third quarter of last year from 11.2% to 12.6%. Direct labor cost had the largest impact on the increase in our margin, leveraging this quarter by a 100 basis points. However, the majority of this decrease was related to structural items, the largest of which was an adjustment to lower the accrual for our annual incentive compensation plan.
Excluding these items, direct labor as a percent of revenue was still flat with the prior quarter, which represents a significant improvement over recent trends. We also had a 60 basis point decrease in general and administrative cost compared to the third quarter of last year. The improvements, which were driven by efficiencies and cost-containment efforts, included a 20 basis point decrease in labor costs and a 40 basis point decrease in nonlabor costs.
The margin expansion was partially offset by an increase in direct occupancy cost during the quarter. Direct occupancy cost increased by 40 basis points as a result of higher vacancy rates in our waiver group homes and increased rent expenses that was partially driven by the Mentis acquisition. Mentis' business model requires more specialized facilities that have a higher cost relative to revenue than our existing business while delivering margins that are greater than our existing business. We did not own Mentis in the prior quarter. Last, sales adjustments this quarter were flat as a percentage of revenue compared to the third quarter of last year.
Moving to segment results for the quarter. I/DD, our largest business, generated $259.8 million in gross revenue. This represented a $13.3 million or 5.4% increase over the prior quarter. About $12.4 million of this increase was from acquisitions, including HSI that closed at the end of the prior year, and $900,000 which came from organic growth. During the quarter, volumes increased by 4.3% and our average rates increased by 1.1%. Gross revenues in our SRS segment increased by $12.5 million or 15.6% over the third quarter of last year to $92.7 million. All of this increase came from acquisitions, including Mentis, which we closed in October. Our organic growth in SRS was negatively impacted by the program closures I previously mentioned. Excluding these closures, our organic growth would have been $2.1 million or 2.7% for the quarter.
Moving to rate and volume. Our volumes in SRS increased by 9.5% and average rates increased by 6.1%. And as I mentioned before, this growth came from acquisitions. Our ARY segment contributed $38.5 million or approximately 9% of our gross revenues this quarter. Revenues increased by 9.1% compared to the third quarter last year. As Bruce indicated, we are quite pleased to see the turnaround in this business after years of anemic growth. We are experiencing solid growth in both our residential and periodic businesses.
Finally, in our Adult Day Health business, revenues increased by $3.1 million or 22.7% compared to the third quarter of the prior year coming in at $19.5 million. $3.5 million of this growth in revenue came from acquisitions. Our free cash flow this quarter was $28.9 million, which is a decrease of $5.9 million compared to the third quarter of last year. Contributions from acquisitions and the cash benefit associated with tax reform were more than offset by timing differences in payroll and accounts payable, higher interest payments for the additional debt taken on to fund the Mentis acquisition and approximately $2.6 million of exit cost to fund program closures.
Day sales outstanding on our accounts receivable was 44 days, which was 2.5 days lower than the March quarter and about 1.3 days higher than the third quarter of last year. Our collections of accounts receivable remained stable with prior quarters despite experiencing continuing payment delays in some states. Our net leverage dropped below 4x for the first several quarters to 3.9x, as we had been predicting. This was largely due to more of the EBITDA coming from our HSI and Mentis acquisitions being represented in our trailing 12-months EBITDA.
Last quarter, we extended our efficiency program to include facility closures for programs that were either unprofitable or nonstrategic. At quarter end, we had closed 39 programs and incurred cash costs of approximately $5 million. With - this primarily included lease terminations and $7.6 million of noncash expenses, which consisted of the write-off of intangibles - tangible and intangible assets. We expect the margin benefit from closing these programs with little or no profitability to be about $1.7 million annually. And there will be some additional benefit to be realized through program consolidations. There are still a few programs under review. And it is likely there will be additional closures in the fourth quarter. The total cash costs of these new closures are expected to be lower than the $5 million we have recorded to date.
Moving to guidance for fiscal 2018, we are maintaining our net revenue guidance range provided last quarter of $1,580,000,000 to $1,610,000,000 and increasing our adjusted EBITDA guidance by $2 million to a range of $170 million to $173 million. Before I turn the call back over to Bruce, I want to provide some context about what our updated guidance suggests about what we expect in the fourth quarter. Given that our third quarter adjusted EBITDA substantially be consensus, our updated adjusted EBITDA guidance obviously implies a significant sequential decline in the fourth quarter versus the third quarter. And I would highlight three factors to bridge our third quarter adjusted EBITDA with the updated guidance range for fiscal 2018. First, as compared to what we expect for Q4, Q3 benefited from about $2.5 million in structural items, the most significant of which is the reduced incentive compensation expense. Second, we don't expect to maintain our favorable Q3 performance with respect to labor in the fourth quarter. This, and the fact that there is an additional holiday could drive another $4 million to $6 million of expense in the fourth quarter. Third, the 7% rate cut in Minnesota, that Bruce mentioned earlier, was effective July 1, and will reduce Q4 adjusted EBITDA by almost $1 million.
And with that, I'll turn it back over to Bruce.
Thank you, Denis. Rocco, at this point, you can open the lines for questions.
[Operator Instructions]. Today's first question comes from Kevin Fischbeck of Bank of America Merrill Lynch.
This is Catherine Anderson on for Kevin. Other than increase in compensation and providing prospective employees the accurate picture of the work, can you talk about some of your initiatives to address labor issues? And then, can you talk a little bit more about your labor outlook for fiscal 2019 and kind of the seasonal ramp for that year?
Catherine, this is Bruce. Yes, our main focus has been to increase our resources in the field dedicated to hiring people and onboarding people. I think we're doing a marginally better job than we had been doing. And I feel good about that. We have actually been able to hire a few more people than the numbers that are terminating. But the number of people that are exiting the company are still a concern to us. And I think it's driven largely by the full robust economy that exists out there in the marketplace. People have opportunities to leave to get higher wages. So I'm pleased with our hiring capabilities. I am less pleased with our ability to retain people. We're trying to get our supervisors more time with our employees but that has been a challenge.
So as long as this robust hot economy continues where we're - almost, particularly in some of our larger Midwestern states as long as that labor condition continues, I think it's going to be difficult to hold the line or make progress in this regard. So those are the key drivers. And as Denis indicated, we have done a good job at this. But if you look over the long-haul, over the last two years, our margins have eroded because of that labor pressure. We did a good job this year - this quarter and excluding those structural items, we essentially held our labor cost flat as a percentage to revenue. But I think it would be, frankly, unrealistic to expect that to continue certainly in the fourth quarter, and frankly, for quarters to come unless there is something that meaningfully changes in the external environment. I'm not ready to guide yet on 2019. But there - suffice to say that there continues to be a lot of labor challenges out there in this virtually full-employment economy.
Okay. And then for the 7% rate cut in Minnesota. You gave kind of a quarter - quarter-by-quarter impact. But can you give kind of a more annualized impact of that?
Well, that's a quarterly impact so it's probably closer to $4 million, if you're going to annualize that. We continue to work with our trade association and our employees and the powers that be in the state of Minnesota. We're hopeful that when the legislature and the government comes back in the session, we might be able to do something about this rate cut. But right now, we're absorbing the rate cut, effective July 1. And we'll deal with it till there is any action coming from the legislature and the governor's office.
Okay. And then I guess how does that 7% rate cut compare to your expectations going in?
Well, we weren't expecting it at all. Frankly, this was sort of like an inside baseball bureaucratic dealing between CMS and the state of Minnesota. Frankly, it caught us. And I think every other provider and most of the government folks from Minnesota are off-guard. And we're hopeful it can be resolved.
Okay. And then my last one is on the Adult Day Health segment. You've seen some nice growth there. I was just wondering kind of how the margin profile is backing up with your expectations? And kind of what your long-term target margin is for that segment?
Yes, the margins are improving. They are not to where we would like them to be. But they are in the mid-to-high teens. And I'd like to get it to a point where eventually, it's in the high teens. And I think we're on our way. I'm not ready to project when exactly we'll get there, but I'm encouraged by the performance in the growth there.
Bruce, I'd like to give an update on that. I - we spoke on the growth of the Adult Day revenues in the quarter. The revenues increased by $3.6 million. I believe I said $3.1 million. So it's $3.6 million or 22.7% in the quarter.
[Operator Instructions]. It appears that we do have a late question joining in.
Today's next question comes from Richard Close of Canaccord Genuity.
This is Brian Hoffman in for Richard. A quick question on the rate cut in Minnesota. When the legislator does come back in the session in January, what would be the process they would need to go through in order to get that rate reversed? And what sort of timeframe you think that might take?
It's a good question, Brian. This is Bruce. It has to be legislatively approved in both branches of the legislature and the governor would have to sign off on it. The governor did indicate he was supportive of the change. But with the omnibus bill, I think there were too many other items that were included in there, that frankly wasn't in favor of. So we didn't pass the bill. So I'm hopeful that through the legislative process it gets the attention that it deserves sort of on its own. And then we are hopeful that the legislative process will produce a resolution. I really can't guide you on the timing of that though.
Got it. Great. And one more on the direct labor expense. Can you give any more color on - aside from the accrual reversal, any more color on what, I guess, drove the strength in the quarter?
Yes, our wages to revenue was slightly better than it had been in previous quarters. As I said, one of the drivers of that was the fact that we're growing faster the businesses that have a little less reliance on labor. For example, SRS, it's a labor-intensive business, but their rates are higher. So, therefore, the proportion of revenue that is eaten up by labor is less than in our DD operation. So that's been a help in this regard.
And ladies and gentlemen, this concludes our question-and-answer sessions. I would like to turn the conference back over to the management team for any closing remarks.
Thank you, Rocco. We appreciate everyone being on the call today, and we look forward to speaking with you at the conclusion of our fiscal 2018 fourth quarter. Thank you.
And thank you, sir. Today's conference has now concluded. And we thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful evening.