Healthcare Services Group Inc (HCSG) 2014 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Healthcare Services Inc. 2014 second quarter earnings conference call.

(Operator Instructions)

The matters discussed in today's conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are often preceded by words such as believes, anticipates, expects, plans, will, goal, may, intends, assumes, or similar expressions. Forward-looking statements reflect management's current expectations as of the date of this conference call, and involve certain risks and uncertainties. As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances. Healthcare Services Group's actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors.

Some of the factors that could cause future results to materially differ from recent results or those projected in forward-looking statements are included in our earnings press release issued prior to this call, and in our filings with the Securities and Exchange Commission. We are under no obligation, and expressly disclaim any obligation to update or alter its forward-looking statements, whether as a result of such changes, new information, subsequent events or otherwise. I would like to introduce you to your host for today's conference, Mr. Daniel McCartney, Chairman and CEO. Sir, you may begin.

Okay. Thank you, and thank everybody for joining Matt McKee, Ted Wahl and I, for our conference call for the second quarter. We released our second quarter results yesterday after the close, and we will be filing our 10-Q during the week of the 21st. Our second quarter results -- we increased our revenue by 17% for the quarter to $319 million, above our targeted growth rate of 10% to 15% when compared to the same period in 2013, with housekeeping and laundry up more than 15% and food service up 20%. Both are new company records. Revenue for the six month period was up over 15% to $631 million for the same period last year.

We entered 2014 with double-digit growth rate and a run rate going into the year, which was an important and significant accomplishment for our divisional and regional management people in the field. Both have done a very good job as they more than made up for the 2013 client modifications, which put our growth rate at less than 2.5% for the same six month period last year. Although operationally and from a client standpoint we transitioned well, due to the accelerated expansion, start-up costs and delays in some staffing and labor related changes, our direct cost was up about 50 or 60 basis points from our historical target of 86%.

Although we have for 38 years demonstrated we can and will get the new business on budget, it will be important for us to improve those results over the next few months, as the start-up challenges wind down. In spite of that, 2014 has continued with very good momentum. We continue to expect to grow at double-digits, with housekeeping and laundry likely at the lower end of our growth target and food service at the higher end, as it still has a surplus district and regional management capacity and a smaller base. And with that abbreviated overview, I will turn it over to Ted for a more detailed review.

Thank you, Dan. Revenues for the second quarter increased 17% to $319.3 million, compared to the same period last year. Housekeeping and laundry grew 15% to $211.4 million. Dining and nutrition was up over 20% to $107.9 million. Net income for the quarter came in at $13.9 million or $0.20 per share, compared to $12.9 million or $0.19 per share for the prior year's corresponding quarter. As we discussed previously, Q2 of 2013 net income was favorably impacted by the enactment of the American Taxpayer Relief Act which retroactively reinstated certain 2012 job tax credits, and lowered our effective tax rate to 28% for the first six months of 2013, compared to 37% for the first half of 2014.

Direct cost of services came in at 86.4%, which is about 50 or 60 basis points above our target of 86%. Although we have been slower in working our way towards budget in the second quarter housekeeping starts, the districts and regions did a good job of transitioning in the new business from an operational perspective. Once the start-up phase winds down over the next 30 to 60 days, we would expect ongoing margin improvement, while at the same time continuing to give proper attention and service levels to our existing customers. And we will continue to focus on the development of our dining and nutrition middle management structure, as it progresses towards being more fully utilized. Going forward, our goal is to manage direct costs under 86% on a consistent basis, and work our way closer to 85% direct cost of services.

Selling, general and administrative expense was reported at 7% for the quarter, which included a $650,000 gain in the deferred compensation investment accounts held for and by our management people. We would expect our normalized SG&A to continue to be in that 7% to 7.25% range with the ongoing opportunity to garner some modest efficiencies. As we discussed in past quarters SG&A also includes state gross receipt taxes paid, as well as investments in our biometric time and attendance system and other electronic record keeping initiatives. In December, we announced the expansion of our legal department, which in conjunction with the personnel and technology investments made in our human resource function, should allow the divisions to comply with the new hire and personnel record keeping requirements demanded by both the regulatory environment and job tax credit programs like WOTC.

We also announced in December the formation of a wholly-owned captive insurance subsidiary, as well as enhancements to our credit facility that will provide flexibility in addressing our various insurance needs in the upcoming years. Investment income for the quarter was reported at $800,000, but again after removing the impact of the $650,000 gain in the deferred compensation investment accounts, our actual investment income was $150,000. Our effective tax rate for the quarter was 37%, and depending upon the timing of the WOTC reauthorization should be between 35% and 38% for the remainder of the year.

We continue to manage the balance sheet conservatively, and at the end of the second quarter had over $68 million of cash and marketable securities, and a current ratio of better than 3 to 1. Our accounts receivable remained in good shape below our DSO target of 60 days, even with the accelerated organic growth during the first half of the year, and transition of the credit and collection function for the new clients that were part of the acquisition.

As announced yesterday in conjunction with our earnings release, the Board of Directors approved an increase in the dividend to $0.17375 per share, split adjusted and payable on September 26. The earnings and cash balances for the quarter more than support it, and with the dividend tax rate in place for the foreseeable future, the cash dividend program continues to be the most tax efficient way to get the value and free cash flow back to the shareholders. It will be the 45th consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law. It is the 44th consecutive quarter we increased the dividend payment over the previous quarter. That is an 11 year period that included four 3-for-2 stock splits. And with those opening remarks, Dan, Matt and I would like to open up the call for questions.

(Operator Instructions)

And our first question comes from the line of Ryan Daniels of William Blair. Your line is now open.

Hello, this is Nick Hiller in for Ryan Daniels. So I was just wondering, what is the current capacity of managers in the food services division? I know it varies by region, but do you still have excess capacity there, like you did a few years ago given the strong growth in that division over the last few years?

It really varies between divisions. Some of the divisions, in particular the Northeast and maybe some mid-Atlantic regions are more closer to our model of 10 to 12 facilities per district, and 4 to 6 districts per region, where some of the other divisions still have an underutilized regional and district capacity, because they are in the more formative stages of filling out in the development of the management skills, and they, in some of the areas may still be averaging 7 to 8 facilities per district, and 3 to 4 districts per region. So we still have surplus capacity, but it varies between the 10 divisions depending upon how mature they have been as far as the new business development.

Okay, great. Thanks. And given the growth that you have seen in food services, are you able to gain more economies of scale around food purchases, or is enough of that -- is enough of it local that is difficult to capture those scale economies?

I think as far as the food purchases have been concerned, the more volume we have been able to create, the more favorable rebate and purchasing power we have as far as our purchases of the food and the consumables. The real margin improvement in food service primarily has been driven by improvement in labor, and that has been spreading out the districts and regions with the right complement of properties, because they are underutilized in our model, although we are eating that district and regional cost at the present time as if they are fully mature and up to our scale.

Okay, thanks. And one last question, how is customer retention in the quarter?

Customer retention has been as good as it has been for the last three to four years, which has been better than our 90% target.

Okay. Thank you.

Thank you. And our next question comes from Sean Dodge of Jefferies. Your line is now open.

Hello, good morning. Thanks for taking the questions.

Hey, Sean.

Staying on the dining side. So with some of the major food or protein costs being up pretty considerably over the last several months, I am curious the extent to which, or if any impact that is having on margins on the dining side? And then, do you do any hedging or forward contracting when it comes to buying your food?

Yes. As far as food purchasing with respect to the dining and nutrition contracts, we have really separated that from the labor and labor-related increases, where it is set up on a monthly or quarterly basis with each and every client. So it is adjusted more automatically based on either the CPI food at home adjustment, or whatever other market basket --or whatever other market basket agreement we have in place. So it is done more mechanically on a monthly or quarterly basis, so we don't have that type of exposure.

Okay. And then, when it comes to getting the DSOs back down to target, what is creating the friction there? Is it pushing the new payment terms down on the Platinum facilities that you acquired? Is it I guess, pushing those down, or is it they haven't complied with them yet? Or is there something else that is keeping you from being able to improve on that metric?

I think it is two things, Sean. I think, first, the Platinum credit terms were a little bit different than ours, and that is going to take a little bit of time to ramp them down to the levels that historically we have held our clients to. But the new business is -- well, you start with the expenses and the start-up costs, and there may be a 30 or 60 day lag before you start getting the cash flow payments from the new customers. So the clients that we phased in in May and June, depending on the terms we negotiated, even if it is a 60 day term customer, we have not received that first payment yet, but we will on an ongoing basis as the relationship evolves. But the start-up is where we come up with the upfront costs, without the subsequent collection.

Understood. All right. Thank you very much, and congratulations on the quarter.

Thank you, Sean.

Thanks, Sean.

Thank you. And our next question comes from the line of Sean Kim of RBC Capital Markets. Your line is now open.

Thanks, good morning.

Hey, Sean.

I have two questions. I guess, first, when we look into the second half, I think your year-over-year comps become a little tougher. In housekeeping, you bought Platinum last year in the third quarter, and dining also saw a pretty big ramp. So I guess, how should we think about growth in the second half? Should we expect a material deceleration from the first half, or are there any offsetting factors?

I think, Sean, the demand for dining and nutrition services is really is no different than housekeeping and laundry, is still greater than what we are capable of managing. So because dining continues to be almost exclusively a cross-sell opportunity, we focus our expansion efforts really in geographical areas that have a maturing, but still underutilized middle management structure. Which is what you may see revenues step up in certain months or quarters, but not in others.

And I know Dan touched on it in his opening remarks. But our growth rate for the year, and really for the mid-term and long-term continues to be 10% to 15% top line, with housekeeping and laundry at the lower end of that range, and then dining and nutrition at the higher end of the range.

But would it be fair to assume that -- the first half was pretty good, at the higher end or above that. So second half, should we be thinking about something on the -- maybe towards the lower end of that range?

I think that is fair. But we would expect our sequential growth in revenue to be consistent with what we have done historically. Again, you are always going to have ebbs and flows from one quarter to the next. That is not how we are managing the business, that is not how the divisions and regions are determining who they are transitioning services with, but I think that is fair to say, you could see somewhat of a slowdown in the second quarter. But year-over-year, not just for 2014, but for 2015, 2016 and 2017, 10% to 15% continues to be the target.

Got you. And just one last question, I guess, more long-term -- it seems that over the next two or three years, you are focused on cross-selling dining to your existing customer base. But I guess if we look beyond that, industry penetration is still pretty low, so there are a lot of new facilities for you to go after in both housekeeping and dining. So I guess my question is, is there going to be another ramp in investment for the district and regional level management team? And how should we think about your strategy to go after new facilities longer-term?

Well, the rate limiting factor in our growth has always been our ability to hire, train and retain talented management people. That is no different today than it was 10 years ago, or 30 years ago for that matter. So we are in a perpetual state of recruiting and management development. So I think to your point, more of a focus than ever is replicating that structure.

So we have not just the facility level management people which we certainly emphasize, but the district and regional structure that is maturing at a rate that we are capable of managing and maintaining our growth rate. That is why in dining again, it is a bit different than housekeeping and laundry, and because it is a cross-sell we are able to steer new business towards the underutilized middle management structure. But once that is fully fleshed out over the next two to three years, then the dining and nutrition business will grow more in a business as usual fashion, comparable to housekeeping and laundry.

Great. That is helpful. Thank you.

Excellent. Thanks, Sean.

Thank you. And our next question comes from the line of A.J. Rice of UBS. Your line is now open.

Thanks. Hello, everybody.

Good morning, A.J.

First on -- maybe just go back to the cost of services, so that ran a little higher than you were expecting obviously in the quarter, and we were expecting at least, let's put it that way. And it sounds like you are saying, you don't believe that is because the new business is somehow inherently less profitable than was thought originally, but rather that it is taking a little longer to get to target margin on that. Can you just, a, confirm that and, b, talk about maybe get -- flesh out a little further why you are confident you can still get to target margin, and why it maybe it is taking a little longer?

Yes, I think -- well, the facility we bid all the jobs whether it be union or nonunion in the same margin profile with the same margin targets. We don't have specific agreements with customers at the top side. It is all facility-specific. But union or nonunion, the 30 to 90 day start-up window, A.J., is really where we are at our most inefficient. Because as we have talked about on calls like this before, we are inheriting the staffing patterns and purchasing programs of the in-house operation.

I think the second phase of the customer transition we highlighted at the beginning of the year, did consist of mostly unionized facilities. And with this particular group of union facilities, because of the process required by the CBAs in exercising management rights and implementing our staffing patterns, we will likely be at the higher end of that 30 to 90 day start-up range. But again, once we implement our systems and procedures, there is no difference operationally or financially on how we manage a property, whether it be union or nonunion.

And I think also, A.J., like I mean, our benefit to the customer is we are going to do it less expensively than they did it before. Now we think we buy our equipment and materials, and obviously in food service, our food purchasing power gives us an edge, but it still primarily a labor business. And with housekeeping and laundry in particular, and the growth and accelerated expansion that we experienced, it requires our management people to make the job description changes, get the staffing to the levels that we bid the job at, and it usually takes us a 30, 45 day period. But with so much absorption, some of the changes weren't made as timely as we typically would have done.

And that is why we have always said, if we add 20 or 30 properties in a quarter more than we expected in a particular area, it is not necessarily good for us. Because it spreads out our management people a little more than we typically would like, and the decision-making may take more time, and unfortunately that is really what we think happened. A lot of the changes that our management people know have to be made just took longer than they would have, had the growth rate been a little bit more in the historical levels. It is a nice problem to have, but it is still an issue that we had to address.

Okay. I think, in the last few quarters, or a few quarters ago -- you were talking about in the first half, you had this bolus of business of about $50 million in annual revenue that was coming on here, and that is part of what we are talking about here. I wonder in the second quarter, is that run rate pretty much fully reflected at this point? Or is there still some of that business that is going to step up in the third quarter that wasn't fully reflected in the second?

Yes, there may be a few million dollars next quarter that is attributed to that ramp-up. But for all intents and purposes, the run rate is reflected as of Q2.

Okay. And I appreciate the comments about growth expectations for the back half of the year. I wondered if I could just drill down a little bit on this -- the customers behind this $50 million piece. Also I know last year you had some customer restructuring, and sometimes you get some of that business back over time. Can you comment on the pipeline a little more specifically?

Are there more opportunities behind this $50 million that you had in the first half ramp-up? Are there -- are you seeing any of that business from a year plus ago start to come back, and then any other more specific things to say about the pipeline? Obviously, you are out there blocking, tackling everyday, trying to win new customers.

Well, I think as far as the customer that we highlighted at the beginning of the year, no different than many of the other large national chains that we work with. We typically don't do all of any of their business, but we do more and more each year. That certainly remains the opportunity with this particular group, which we want to make sure every transition go smoothly. With the group that we talked about, there is certainly an opportunity for continued expansion and growth, so that remains in place.

And with the customer modifications that you referred to in the first quarter, into the second quarter of 2013, we are continuing to see momentum with that. But again, that is done locally, no different than any other greenfield housekeeping and laundry opportunity that we see throughout the divisional and regional networks. So the growth is going to be more normal course of business, rather than some sort of chunk that we get at a specific period of time.

But we still sell housekeeping and laundry typically as the first or introductory service. And with housekeeping and laundry services up 15% there -- most of those clients, we have the opportunity to ultimately add food service to the menu of the services as the lead-in. So as housekeeping and laundry leads the pack, the opportunity is there once we get our arms around the operational and relationship issues when you start it up, there are targets for food service expansion as well.

Right. Okay. And then, this is sort of an obscure one, but obviously with your settlement at the end of last year in California, there was a pool of money set aside for any claimants, and I know they had to proactively come forward and make claims. Is there any update on whether you think there will be some of that money that you might get back, and if so, is there a specific amount that or -- ?

If it does it is certainly going to come in lower than what we originally anticipated, but the difference is going to be immaterial, A.J.

Okay. All right. Thanks a lot.

I think the plaintiff's lawyers are making sure of that.

Yes. Okay. (Laughter).

Right. Not to be cynical.

Thanks a lot.

Thank you. And our next question comes from the line of Rob Mains of Stifel. Your line is now open.

Thanks, good morning.

Good morning, Rob.

Hey, Rob.

Ted, can -- a clarification on something you said earlier, if we look out over the next say,18 months to the end of next year, in the dietary division, are you saying that the growth will primarily continue to be from the existing installed housekeeping base, or that you might start moving outside that?

Yes. No, it continues to be primarily the -- a cross-sell opportunity. So I would even expand it beyond the next 12 to 18 months, based on what we understand as the customer needs, and really the customer demands for the services. I would go as far as to say, over the next three years it is going to continue to be primarily something we only market to our existing customer base.

But we haven't, Rob, precluded our regional people from selling it to outside non-housekeeping and laundry customers. It is just that is where the greater and easier opportunities are, because the relationship is already there. We know the customer, they know us, so their attention is typically spent on the low-hanging fruit. But in some areas, we have gotten momentum with certain clients, including some county and government and VA clients who were only interested in housekeeping and -- or in food service, and not housekeeping and laundry. So we don't preclude the regional people from only selling it to our existing clients, but that is where they have spent most of their attention, because it is the easier sale.

And that -- it will continue to be more than 9 out of every 10 new business opportunities in dining should come from the existing network. But as Dan said, there is still -- remains to be opportunity that is driven. And if selectively it works within the district or region that is managing it, then certainly they have the ability to start that business and sell that business.

Okay. So I can infer then Ted, that over the next couple three years, you have got pretty good visibility that there is enough kind of pent-up demand among housekeeping customers for dietary services, that you can hit the top end of the growth goal for that division?

Absolutely.

Okay. And then the other question, we are starting to see some signs of life in the labor market as a whole. Can you update us on recruitment for both laborers, and I guess more importantly, for management trainees?

I think as far as the management people, we really never had better management people in the history of the Company. The modifications of those two clients that we spoke about in the first half of 2013, gave us district and regional management capacity that we wouldn't have had, had they -- had that not happened. So it enabled us with the acquisition and the recent expansion to not strain our management structure as much as it would have, had we not had that. We didn't lay off any district or regional managers during that, because we are confident we be able to replace the business, which in retrospect last three quarters we certainly have done.

But that is an ongoing process. If we are going to add 500 or 600 new facilities in 2014, we have to hire, train and develop a 1,000 management people that we didn't have at the beginning of the year, to put a manager and assistant at each property, either for food service, or for housekeeping and laundry. We have to create 50 new districts, and 50 new district management people, and training managers have to be promoted from within the existing structure, and then to create 10 more regional management teams, and ultimately create more divisions.

So as the Company has organizationally evolved over the 38 years, it has always been an evolution of the management people, because adding the new business is the easier part. So we feel as confident as ever, that the demand for the services has never changed, and there is more opportunities for us to go around than ever before. And the tighter the operators get impacted by the reimbursement environment, the more demand there is for outsourcing companies of all kinds, including ours.

And that is why, Rob, we are more committed than ever to the idea of promotion from within, but that it be done in a decentralized way, through the districts and the regions. So instead of trying to -- on a centralized basis, hire 800 management people, 400 managers, 400 assistant managers to fund 2015 growth objectives, all we are really asking is each of our 370 districts to higher one or -- to hire and train one or two management people successfully, to fund the one or two facilities they need to add district by district to hit our growth objectives. So it is really done on a bottoms-up basis, rather than some top-down dictate from the corporate office.

Right. And you are continuing to find qualified candidates, I guess?

We are, yes.

And I think it is because we have become a more legitimate career choice than before. The more established we get, and the longer our track record is, that new recruits and the candidates that we look for really do see an entrepreneurial career path for them to follow, depending on their ambition and ability and that we have grown consecutively for 38 years. So it is more than likely they are going to get promoted before they're ready, rather than us holding anybody's career back.

Okay. Very good. Thank you.

Okay. Thanks, Rob.

Thank you. And at this time, I am showing no further questions in the queue. I would like to turn the call over to Daniel McCartney, Chairman and CEO for any closing remarks.

Okay. Thank you, and thanks everybody, again. Before we wrap it up, Matt McKee was just going to give a conference schedule review for the next few months.

Yes. Thanks, Dan, and good morning, everyone. In the upcoming third quarter, we plan to present at CL King's 12th Annual Best Ideas Conference, which will be on the 9th of September at the Omni Berkshire Place in New York City. We are also planning to attend and present at the 5th Annual Credit Suisse Small and Mid Cap Conference, which will be on September 16 and 17 at the Waldorf-Astoria, also up in New York. So hopefully, we will see some of you there. And Dan, back over to you.

All right. Thanks, Matt. Well, I mean, well into 2014 we expect to continue to expand our client base in housekeeping and laundry within our historical targets. We should increase our expansion each quarter, and if we execute properly we will maintain our double-digit growth rate and client retention targets. In this environment as we have always said, the demand for our services is as great as it has ever been. It remains important for us to balance the client satisfaction measurements as we digest the increased amount of new business, and more importantly get them on budget, as well simultaneously as keeping the old clients operating effectively from operational standpoint and a financial standpoint, while dealing with all the start-up variables. A lot for our guys to chew on in the field.

All divisions continue to perform well and better. But with any expansion, we need to ensure consistency with the financial targets and the client satisfaction levels, with the intention on new business start-ups, getting them and keep them on budget, we have to effectively continue to change the staffing, manage the existing client base, with no disruption in their services, and look to get the direct costs below 86%, and work our way down to 85%.

With the changes in the state tax policies, we expect the SG&A to be in 7%, 7.25% range with no deferred comp investment impact. We believe the recent expansion of our legal and personnel departments will be helpful in a necessary resource for our management people in the field in this litigious environment we find ourselves in. Our tax provision was 37% for the quarter, but with the Act's extension it could be back to 35%. Senate Finance Committee has approved the Bill, and it is working its way through the House Ways and Means Committee. We expect it to be passed, but it hasn't been passed yet, hopefully by the end of the summer.

That aside, in our business there still strong demand for the services for housekeeping and laundry and dining. Our management people in all divisions, especially in food service, continue to develop and get better. We believe we will continue to operate on budget and make the improvements required with the new business consistently. And going forward, as we expand, overall these are pretty good times for us. So thanks again for everybody. Have a good summer, and onward and upward.

Ladies and gentlemen, thank you for your participation on today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.