Healthcare Services Group: Conditions Are Moving In Favor Of The Bulls, Although The Charts Are Still Directionless

Summary

• It looks like there is a bottom in place for HCSG’s ongoing sequential revenue decline and the management sounded optimistic about business and industry prospects in H2.
• Dining segment margins continue to impress buoyed by lower investments in dietary supplies.
• HCSG has reduced its exposure to Genesis Healthcare (as of Dec-20, outstanding notes and accounts receivables totaled ~$44m) and maintains that the latter has not reneged on its dues.
• Over recent months, there has been some contraction in the forward P/E valuation premium of HCSG, but on the charts, the stock is looking for some leadership and is currently in limbo.

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Context of the article

During my stint as a Seeking Alpha writer, I’ve covered The Healthcare Services Group (NASDAQ:HCSG) a couple of times now, with the most recent article coming out in mid-Feb (if you’re new to this counter, you may also consider reading my first article where I’ve attempted to gauge the merits of the stock from the perspective of both the bulls and the bears). If you’ve been keeping up with my work, you’d note that I’ve tried not to be overly prejudicial to either the naysayers or the flagbearers of the stock. That said, last month the company had come out with its Q1 results and after a long time, it was heartening to see some positive commentary from the management. Here are some of the key highlights from the results and some general thoughts on the stock.

Improved industry and business outlook for H2

One of the dominant themes in the previous Q4-20 results was how cagey and cautious the management had sounded about the outlook; whereas, in the recent Q1-21 result call, I found them to be a lot more optimistic about the business prospects. That said the weak census numbers and limited access to facilities continue to leave their mark on the ongoing revenue attrition, with Q1 revenue only coming in at $408m. Please note that nearly around 3 years ago (say for instance during Q3-18), they were generating quarterly sales to the tune of over $500m. Since then, there’s been a sequential decline nearly every quarter, and currently, they're operating closer to the $400m mark. I believe we are now close to a floor as management confirmed that the Q2 results would be more in line with Q1 and then they believe things will start picking up in H2. What’s driving this improved outlook?

Firstly, it looks as though occupancy rates have begun to stabilize with no further declines (note that a couple of quarters back, the occupancy was down by -10-15% and in Q4 it was down a further -5%). This is so because immunization levels have begun to pick up, driven of course by deeper vaccine penetration. Management stated that the COVID infections amongst the residents and the employees of their facilities were down by 90% between Q4-20 and Q1-21, and this has also helped bring general confidence back on board.

This will now open the gates for greater cross-selling opportunities whereby more of HCSG’s dining and nutrition services can be offered to their housekeeping clients. As of now, the company has less than 50% penetration in providing their dining & nutrition services to their existing housekeeping clients, so there’s scope for further upside here. Crucially, note that over the last few quarters, HCSG has been generating revenue only through its existing facilities, but recently, one has seen some new business wins, and in H2, the company mentioned that they would look to ramp this up even further by way of new greenfield opportunities. All this suggests that potentially by H1-22 we may start seeing the company get closer to the $500m+ quarterly sales run rate.

Dining and nutrition segment margins continue to surprise

Source: Prepared by the writer using data from the quarterly reports

During this relatively difficult period, one of the silver linings of the HCSG story has been how well the dining & nutrition margins have continued to hold up. Earlier it used to average only low-to-mid single digits but over the last 4-5 quarters this has been at a much superior level. In Q4-20 one had seen a sequential decline from 9.2% to 7.7% and there were suggestions that we could see this revert to mid-single digits with the pickup in census and new client wins (new client wins tends to result in greater inefficiencies thereby diluting margins), but this is yet to happen, and interestingly, the margins actually bounced back significantly to 10.4% in Q1-20. As mentioned previously one of the key drivers of this improvement has been the decline in one of the components of the overall costs of services- the usage of dining department supplies. Just for some context, in FY19, dietary supplies accounted for 29.3% of segment revenue; last year this came in at 26.5% and in the most recent Q1-21 it came in even lower at 24.2% (Q1-20:27.6%). Having said that, I doubt there's scope for this to decline any further, more so as the census numbers pick up over the next few quarters.

Source: Prepared by the writer using data from the quarterly reports

Genesis Healthcare developments

Over the last few months, HCSG’s share performance has also been adversely impacted by developments at its largest client- Genesis Healthcare that had previously exhibited significant doubt about its ability to function as a going concern (although Genesis’s revenue contribution to HCSG has been declining over the years from 19.3% in FY18, to 15.6% in FY19, and 14.7% in FY20). That said, HCSG management has maintained that even during this difficult period, collection activity from Genesis has largely remained unaffected (at the end of FY20, HCSG had outstanding accounts and notes receivables from Genesis to the tune of nearly $44m).

Well, in early March, Genesis management came out with a plan to voluntarily delist its stock and engage in some other strategic restructuring steps to boost its capital structure and liquidity position. On the recent Q1-21 call, HCSG management spoke very warmly about their relationship with Genesis and reiterated that the latter has not reneged on their dues. They also stated that even if Genesis decides to undergo some portfolio optimization, HCSG expects to continue to work with the new ownership during the transition, or at the very least, “have a seat at the table to determine if maintaining a partnership at those facilities would be mutually beneficial”. All in all, this risk didn’t look like something that the HCSG management was overly concerned about, and it looks like they are prepared to work with the new ownership that could take over Genesis Healthcare’s facilities.

Biden’s $400 billion plan may prove to be a sentiment booster for the likes of HCSG

In my previous articles, I’ve been hypothesizing about the future of the acute and community healthcare models in a post-COVID world but there’s a school of thought that believes this model could continue to gain traction in the years ahead. I cannot corroborate ground-level conditions but reportedly 90% of all Covid patients in America were taken care of via the home or community model, and it looks as though there seems to be a concerted effort to reduce the pressure on traditional healthcare delivery systems such as hospitals. The Biden administration too has been very keen to deepen the engagement with home and community-based services and is looking to allocate around $400bn over 8 years to this segment as part of his new infrastructure plan. That said there are doubts over how this money will be spent and is yet unclear if the Republicans will give their assent to the original plan.

Closing thoughts

Post the Q1 results, HCSG’s prospects are looking up but the price action on the charts hasn’t changed a great deal and still suggests that the tussle between the bulls and the bears remain in limbo. On the daily charts, there currently is a congregation between the 50 and 100 DMA, rather than any wide gap between the two moving averages (which almost always suggests indecision amongst market participants), and as you can see from the monthly chart, since breaking out of a consolidation zone at the start of the year, the stock hasn’t really gone anywhere over the last few months and just seems to be aimlessly drifting between the $27-$35 levels.

Source: TradingView

Presumably, one of the key reasons for this could be that there hasn’t been any concrete resolution to the SEC investigation which continues to rumble on. As per the latest Q1 report the company mentions that it continues to engage in discussions with the SEC and it has determined that “a liability is reasonably possible and currently estimates a range of possible loss of up to $10 million”. In addition to that, they’ve also incurred around $2m of legal and professional fees related to the SEC issue that has been reported under their Q1-21 SG&A.

Source: YCharts

With regards to the forward P/E valuations, it still continues to trade above its long-term average of 21x (currently at 25.3x), although interestingly there’s been a ~9% contraction in the premium from the levels seen in Feb when I wrote my previous report. If the SEC issue doesn’t throw up any major negative surprises, I’m not sure one will see further contraction in the valuation multiple, more so as the company will look to ramp up its level of buybacks this year, which should likely boost the valuation multiple even further. To sum up, HCSG’s business outlook now looks a lot rosier but I’d suggest investors continue to wait and watch for some definitive resolution to the SEC issue, as that could go anywhere and could potentially jeopardize any bullish momentum.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.