Healthcare Services Group Inc (HCSG) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Healthcare Services Group second quarter 2010 earnings report call. Today's call is being recorded.

The following remarks and discussions will contain forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933 as amended in Section 21-E of the Securities Exchange Act of 1934. The Exchange Act, as amended, are not historical facts, but rather based on current expectations, estimates and projections about our business and industry, our beliefs and assumptions. Words such as believes, anticipates, plans, expects, will, goal 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 healthcare industry, primarily providers of long-term health care; credit and collection risks associated with this industry; one client accounting for approximately 11% of revenues in the six-month period ended June 30, 2010; risks associated with our acquisition of Contract Environmental Services, Inc., including integration risks, costs, or such business not achieving expected financial results or synergies or failure to otherwise perform as expected; our claims experience related to workers compensation and general liability extreme assurance; the effects of changes and/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, 2009, and Part 1 thereof under government regulation of clients, competition and service agreements collections, and under Item 1-A, Risk Factors.

Many of our clients' revenues are highly contingent on Medicare and Medicaid reimbursement funding rates, which Congress has affected through the enactment of a number of major laws during the past decade, most recently the March 2010 enactment of the Patient Protection and Affordable Care act and Healthcare and Education Reconciliation Act of 2010. Currently, the US Congress is considering either revisions to or additional legislation to reform healthcare in the United States, which, among other initiatives, may impose cost containment measures impacting our clients. These laws and proposed laws have significantly altered or threaten to alter overall government reimbursement funding rates and mechanisms. The overall effect of these laws and trends in the long-term care industry have affected and could adversely affect the liquidity of our clients, resulting in our inability to make payments to us on agreed-upon payment terms.

These factors, in addition to delays in payments from 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 new clients, provide new services to existing clients, achieve modest price increases on our current services agreements with existing clients and maintain internal cost reduction strategies at our various operational levels. Furthermore, we believe that our ability to sustain the internal development managerial personnel is an important factor impacting future operating results and successfully executing projected growth strategies.

I would now like to turn the call over to Mr. Daniel McCartney, CEO. Please go ahead, Mr. McCartney.

Thank you. Good morning, everybody, and thank you for joining us this morning. We released our second-quarter results last night after the close, and we will be filing our 10-Q by the end of next week.

For the second quarter, our revenue was up 13% to $192,954,000. $18 million, or about 11%, was organically achieved, and about $4 million, or a little less than 2%, was due to the acquisition.

Our net income was up 12%, to $8,721,000, or $0.20 a share. Our earnings from operations were $14,564,000, or up more than 26% from 2009. For the six months our revenue increased 14% to $376,755,000, and our net income was $16,149,000, or $0.37 a share. Our direct costs were reduced for the quarter, below 86%. Even with the amount of new business that we added towards the end of the first quarter and the second quarter we were able to get them operating on budget timely, and the people -- our management people in the field did a good job absorbing that new business.

The SG&A expense was reported at 6.8%, down from 7.5% in the first quarter of 2010, when we transitioned the payroll function from the divisional offices to the corporate office. With that completed, the SG&A came down substantially. More accurately, however, the SG&A should be adjusted upwards by about $700,000 due to losses in the deferred compensation investments called for and by our management people. If adjusted, the SG&A was about 7.1% and still could be reduced further to the 6.75% range that we typically target.

The investment income is reported as a $383,000 expense. Obviously, we had no interest expense, since we have no debt, but when the $700,000 is adjusted from the SG&A and reversed, our investment income was actually $400,000 for the quarter, still down from $1.1 million from the first quarter 2009 due to lower interest rates. But that cost us about $0.01-$0.015 for the quarter.

Our balance sheet -- we ended the quarter with over $79 million in cash and securities and a current ratio of better than 6-to-1. The receivables remained in good shape, substantially below 60 days. The Board of Directors approved an increase in the quarterly dividend to $0.23, to be paid in the third quarter. The cash flow and cash balances more than support it, and we still feel it's the most tax-efficient way to get value back to the shareholders. So it's our 28th consecutive increase since we originally instituted the dividend policy in 2003, when the tax laws first changed.

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

(Operator instructions) Michael Gallo, CL King.

First, just on the gross margins, obviously you did a good job ratcheting that up -- a pretty high level relative to how it's been the last few quarters. Is that a level we should assume going forward? Do you still think we should expect that to expand? Obviously, you added a quite a bit of business last quarter and you started to get that on budget. But probably, at least the first month of the second quarter, I would think, would have had still a little bit of a negative impact. Is that something we should expect going forward?

I think you are right about when we start the new business, the first 30 days are typically when we are over budget, and it takes is usually 30 to 60 days to get the facilities on budget. That's why, in the first quarter, I mentioned how much new business was started on the hopes it was a big undertaking to add that many new properties in that short a time frame and make sure we got it on budget. But the guys really did a very good job.

I still think, over the next year, year and a half, we can get the direct costs closer to 85%, improve it a couple basis points each quarter. The primary improvement in margins and direct cost, I think, will still come as food service continues to ramp up. But there's always efficiencies and housekeeping and laundry as well. For example, in the food service this quarter, we kept the food costs below 40% of the cost, and the labor would keep getting spread out over the right base. So I think we can get the direct costs over the next year, year-and-a-half, closer to 85%. And I still think there's margin improvement to get the SG&A, the real SG&A without the deferred compensation adjustments, closer to 6.75%.

So it sounds like there's nothing unusual about the second quarter; it was more you had some unusual effects in the first quarter from adding a lot of business?

That's right.

Would you expect -- you added, I think, almost $9 million of business on a sequential basis. Is that a kind of pace that we should expect?

No.

Then that's just unusually strong; we should expect that to slow down? And conversely, then, we should expect, as that happens, that the gross margins will probably improve somewhat?

Yes. And that pace won't continue; it will be back to our normal sequential increases of maybe half that. But we still target 10% to 15% top-line growth, whether it comes through organic growth, food service or housekeeping and laundry.

I just wanted to touch on the SG&A. I think, again, if you back out the deferred comp, it's still higher than it's been normally. Certainly, with the amount of business that you are doing now relative to where you were, say, a couple years ago, we would have thought that that as a percentage of sales would have an opportunity to come down more significantly. Was there anything more unusual in the second quarter? Was there still some kind of start-up or lingering effects as you brought the payroll in-house, or any just general anomalies, or any -- (multiple speakers)? or any reason (multiple speakers) to come down?

It's just some inefficiencies, some investments we made in some technology and some reporting system. But I really target and expect us to get it closer to 6.75% where we've typically targeted, and then, frankly, try to work it down lower than that.

Right; I would think, over time, as you later in revenue --

There's always a reason that people are finding to invest in something else, you know? Hey, if we got this it would really be more efficient. But in all seriousness, 6.75% is still our target.

Clint Fendley, Davenport.

Good morning, Dan, nice quarter. You mentioned that this marks the 28th consecutive dividend increase since 2003. I wondered if you could discuss the factors that are most important to your board as you guys think about the possibility of any future dividend increases. I know you mentioned cash balances as a primary consideration. Do you look at the dividend yield as well? And I guess, with that nearly at 4.5%, do you consider that against your comp group when you think about any future dividend increases?

I think we really haven't considered the yield to the same degree. But what we have really reviewed is not only that we are earning -- and I know the past few quarters, with what we consider one-time considerations or factors, shouldn't preclude us from increasing the dividend, the $0.01 a share that we had. And we really expect to be able to have that continue.

Now, the tax law was really the motivating factor in 2003 when we changed. And as long as this is the most tax efficient way, we see no reason, as long as the cash flow more than supports it, and obviously the cash balances that we've had on the balance sheet more than support it as well.

And final question -- as we look at the three different segments, was the growth in the quarter, the organic growth of 11%, was that pretty well spread across the three segments, or any detail on those?

More importantly, it was primarily in housekeeping and laundry. More importantly for us, it will spread amongst the seven divisions in an unusually equal way. So it allowed none of the divisions to be overburdened with a disproportionate amount of new business where they would have had more difficulty to get it operating on budget. So the fortunate thing was, it was spread out amongst the divisions more uniformly than we've typically experienced, so that allowed us to get it on budget more quickly than perhaps that same amount of business that was concentrated in one division -- they would have had a more difficult time playing catch-up in all of them. But it was primarily housekeeping and laundry's growth.

Housekeeping and laundry was up about 14% or so for the quarter, and food service was up about 11% or so.

Ryan Daniels, William Blair.

First off, just on your commentary about how new business was spread across all seven divisions fairly equally, is that a sign of just more demand for outsourcing solutions across the country as some of the providers are facing more financial pressure? Or, anything that you could point to, to explain the strength and the diversity of that strength?

I think, in these circumstances especially, there is more demand for the services than any time in our history. And I don't think it's just our services; I think it's the cost pressures are impacting operators to look into outsourcing of all types of services, certainly including ours, to look to cap the cost. I think the new business that we added really for the first six months of this year had been maybe disproportionately either privately owned or large national chains, was spread out amongst their portfolio of facilities that in our structure have encompassed a lot more divisions.

But there's enough demand in each of the divisions were that stop and start that some of the divisions experienced as far as new business in years past are really not so much the case. And from our vantage point, it's really execution. We are doing the right things, developing the right proposals. Adding the new business should be the easier part.

And have you seen any change in retention? Is your client retention actually starting to creep up a little bit, given the challenging economic times and cost pressures?

It has crept up, but where we have always been -- we have always been most vulnerable is when there's a change in ownership or control and the new owner or new decision maker wasn't part of engaging us in the first place. There aren't that many turnover circumstances or acquisitions that are being done in the industry, so there's less of that. I think it's more of that than our execution or the cost containment environment. So our client retention was substantially better than 90% for the quarter.

Just any update you have -- typically, you provided some updates in the Q&A and the food services, how that is ramping and how the different divisions look across the country?

The primary growth has still come from the Northeast, as far as the food service. And the Southeast we split up into two areas, and that has been doing better and showing margin improvement. And the Midwest, we did the same, so the Midwest is still maybe a year away before they'll be in a position to really take full advantage of the opportunity. And the far West has, from a management standpoint, done a better job, even though that was the area we started the food service last. And we are letting them ramp up.

So I think, over the next year or so, the food service margins and growth, without doing anything exciting, will continue to improve. And when I can really say, okay, now we have a national organization in place and now we can more confidently expand the food service more aggressively and say we can grow at a 20% or what have you, and take the shackles off and let them sell it to anybody. But right now we're only letting them sell it to our existing clients. And frankly, we're picking the clients they can sell it to. And that is still going to be the case, I'd say, for the next year.

The last question is, I guess, a follow-up to the first one on the gross margins. Just looking back over the last three or four years, it looks like gross margins are actually higher by about 100 basis points in the first half of the year. And maybe that's just a nuance of timing or some of the stuff you have had with contract starts, etc. But you don't foresee that again -- it sounds like from your commentary, you don't see pressure in the back half of the year on the margin front as we think about our models. And I know you expect it to go up over the next year-and-a-half. But just maybe in the back half of this year, there's nothing that should drive any pressure? Is that fair?

Yes. There's nothing; it's execution more than anything.

Rob Mains, Morgan Keegan.

Just to circle back briefly on the SG&A, is there anything -- I mean, other than the payroll issue in the first quarter -- that you'd attribute to the rise in the first half of this year compared to the last half of last year?

The first half? No, not -- the payroll transition was significant in the fourth and first quarter. But that's been wrung out, so the divisional offices are still open but not staffed the way they were when they had the administrative and payroll responsibilities. So no; it's a couple of modest investments that you could say are exception, but nothing significant. That's why I'm confident we'll get it back down to levels under 7%, where it should be.

I don't know if you've ever been asked a question about your risk statement at the beginning of the call, but one of the risks that was listed was integration of CES. I would think that that's pretty much done now, isn't it?

Yes. You know, when in doubt, stick it in the risk statement, I think, is the mantra that we've been receiving.

You just mentioned, in answering Ryan's question, that you split the Southeast into two subregions.

Two divisions.

Two divisions? Is that -- that doesn't have anything to do with splits with anything but (multiple speakers) --

No; it's more amount of facilities, whether they came from part of the acquisition or they came from organic means. We have a level where we think geography and certain other variables go into the decision-making and the equation. It's still primarily driven by how many properties we feel the divisional management team can really control and can manage effectively.

Mitra Ramgopal, Sidoti.

Now that CES has been integrated, so to speak, and you continue to build cash, any potential opportunities out there as it relates to new acquisitions?

You know, there aren't that many acquisition opportunities that really fit our niche. So when I talk about how I see us growing, our plans are really not considering any acquisitions. If an acquisition opportunity comes along like the couple that we made infrequently over the years, we certainly look at them and, within our parameters, evaluate whether they make sense for us or not. But they are not necessary for our expansion and our growth. But there aren't that many that fit our niche, and if there are we certainly would look at them. And we have had good success with the two that we've done and the management people that have been merged and become part of our Company. So if we can duplicate that, will certainly look at them. But we don't anticipate acquisitions to really be part of our expansion.

Going back to the organic growth and just the ability to add or bring new facilities on, etc., historically you said that one of the big constraints was being able to recruit or train personnel, etc., to take on the facilities. Is that less of an issue now in this environment?

No; that's still a constraint on our growth, the development of management people. We've really never had good luck speeding up the process or hiring management people from other companies and having them acclimate themselves or make a contribution to our management depth. So we are more committed than ever that we have to develop our own management people from within, promote from within and hire at an entry level.

Now, I think we've never had better management people or more depth, for that matter, in the history of the Company. But, obviously, we have a bigger facility base and geography to cover. And I think, rather than in the macro employment sense, although I'm sure that's having some kind of impact, I think it's been more that, as we become more and more established in each of the areas and as a company and an organization in the industry, particularly we've become a more legitimate career choice for a lot of the entry-level management positions. And, it allows them to get over the first year or two years, which are the most difficult times of the apprenticeship, where they learn the business from the ground up, and they can see a more credible career path for them to strive for. And I think it allows them to get over the hump a little bit better.

I'm sure the macro employment sense may have an impact, but if I could -- as objective as I could be, I think it's more as we become more established and well known as a company, I think that has allowed us to keep better management candidates. And it's more likely that we promote people before they are ready as opposed to holding anybody and their career back. So I think that dynamic has really fueled our growth as well.

[David Spire], [Shorter's].

Can you provide any color on cash flow from operations or free cash flow during the quarter?

The 10-Q will be out by the end of next week, but it approximated our net income.

At this time, we have no further questions.

Okay. Again, thank you, guys, for joining us today. I think, going into the second half of the year, we expect to continue to expand our client base in housekeeping and laundry. In this environment, the demand for our services is as great as it's ever been in the 33 years we've been doing this. We will look to improve the food service margins as it continues to expand its client base in a controlled way, and more fully utilize the investment we made in the regional and district management people. We think we'll keep the direct costs below 86% and work our way down to 85%. And we expect the SG&A to be back to our historical norms of 6.75% or in that neighborhood.

As far as the investment income, who knows? But, our business, if you think about it, the strong demand for outsourcing of all kinds really bode well for us. The management people in all divisions, especially in food, continues to develop. So overall, these are pretty good times for us. We've had record revenues this quarter, record net income, and operational income, the base business was up over 26%. So we are pretty happy going into the second half of the year with what we've accomplished.

Thanks again for joining us, and onward and upward.

That does conclude today's conference. Thank you for your participation.