Healthcare Services Group Inc (HCSG) 2018 Q2 法說會逐字稿

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  • Operator

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  • The matters discussed on today's conference call will include forward-looking statements about the business prospects of Healthcare Services Group, Inc.

  • within the meaning of the Private Securities Litigation Reform Act of 1995.

  • Forward-looking statements are often preceded by words such as believes, expects, anticipates, 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.

  • The forward-looking statements are based on assumptions that we have made in light of our industry experience and our perceptions of historical trends, current conditions, expected future developments and other factors that we believe are appropriate under the circumstances.

  • As with any projection or forecast, they're 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, and the forward-looking statements are not guarantees of performance.

  • 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 the forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise.

  • Good day, ladies and gentlemen, and welcome to the Healthcare Services Group Inc.

  • 2018 Second Quarter Conference Call.

  • (Operator Instructions) As a reminder, this conference is being recorded.

  • I would now like to introduce your host for today's conference, Ted Wahl, President and CEO.

  • You may begin.

  • Theodore Wahl - President, CEO & Director

  • Thank you, Gigi, and good morning, everyone.

  • Matt McKee and I all appreciate you joining us today for the conference call.

  • We released our second quarter results yesterday after the close and plan on filing our 10-Q the week of July 30.

  • The health care industry continues to face regulatory challenges and reimbursement uncertainties, but in our view, a bit less so than a year ago.

  • Many providers have expressed cautious optimism about CMS' proposed reimbursement system, the patient-driven payment model and the possibility of PDPM being a meaningful step towards a more predictable and sustainable reimbursement framework for the future.

  • The 2.4% market basket update, which takes effect October 1, is also a recent and positive development and will go a long way in offsetting some of the inflationary pressures that many operators continue to experience.

  • And a lot of the hard work that needed to be done around operator debt loads and rental rates has happened over the past year or so.

  • There is certainly more work to be done on this front, but again a good amount of the heavy lifting has already happened.

  • We enter the second half of 2018 having digested the new business brought on during the prior year and over the next couple of quarters, we'll look to selectively expand and continue to replenish the management pipeline so we're prepared for the next wave of growth in 2019 and beyond.

  • As those facilities recently brought on budget continue to mature throughout the rest of the year, we would expect ongoing margin improvement, with the goal of exiting 2018 at 14% gross margins, with the full improvement being reflected in Q1 of '19.

  • Cash collections and cash flow is also an area that's received a great deal of attention and focus, inside and outside the company; and deservedly so, especially in light of some of the stress the industry has experienced as of late.

  • We have more personnel and process capability in this area than ever before and continue to focus on enhancing visibility into our customers' business performance and strengthening payment terms and conditions.

  • Over the next 12 to 18 months, our goal remains to collect what we bill, and we continue to expect operating cash flow to approximate net income over that time period.

  • So with that abbreviated overview, I'll turn the call over to Matt for a more detailed discussion on the quarter.

  • Matthew J. McKee - VP of Strategy

  • Thanks, Ted, and good morning, everyone.

  • Obviously, as we're lapping the expansion that we undertook in the second quarter of 2017, we face more challenging year-over-year comps this quarter and for the balance of 2018.

  • But having said that, revenues for the quarter were up 7% to $504 million.

  • Housekeeping and laundry was up 1% to $246 million, and Dining and Nutrition grew at 13% coming in at $258 million.

  • Net income for the quarter was $25.8 million, and earnings per share came in at $0.35 per share.

  • Direct cost of services is reported at 86.9%, which remains higher than our target of 86%.

  • Now the segment margins will be in the Q, but we'd expect housekeeping to be in line with last quarter and the Dining segment margins to show some modest improvement compared to the first quarter.

  • Now as reflected in our cost of services, some of that improvement was offset, and that was primarily by the timing and mix of premium payments related to our insurance programs.

  • We expect these costs to even out over the rest of the year, as is the norm.

  • And as Ted mentioned in his opening remarks, our near-term goal remains to manage direct costs back to 86% by year's end and ultimately continue working our way closer to 85% direct cost of services, which remains an opportunity for us.

  • SG&A was reported at 6.8% for the quarter.

  • There was about a $900,000 impact from the change in the deferred compensation investment accounts held for and by our management people.

  • So the actual SG&A was right around 6.6%.

  • And we'd expect SG&A to continue to be below 7% going forward with the ongoing opportunity to garner additional modest efficiencies.

  • Investment income for the quarter was reported at $1.3 million, but again after adjusting for the $900,000 change in deferred comp, actual investment income was around $400,000.

  • Our effective tax rate for the quarter was 22.5%, and we expect our rate to be in and around this range for the rest of 2018, that's excluding the share-based payment accounting impact.

  • To the balance sheet, at the end of the first quarter, we had $88 million of cash and marketable securities and a current ratio of 3:1.

  • DSO was around 62 days, and cash flow from operations came in at $3.5 million compared to $24 million in Q1.

  • I just wanted to unpack a little bit the major contributors to that number.

  • It was primarily due to the $20 million decrease in the payroll accrual.

  • And just so it's clear, the payroll accrual is simply related to the cutoff of our payroll period relative to the end of the quarter, and that evens out over the course of the year.

  • But just for some added color, the third quarter accrual will more closely mirror that which we saw in the first quarter, and our Q4 payroll accrual will look a lot more like the second quarter.

  • And as to the DSO, that day increase also contributed to the cash flow.

  • And really that increase was mostly related to Massachusetts and California state budget delays, which is not uncommon.

  • As we announced yesterday, the Board of Directors approved an increase in the dividend to $0.19375 per share, that will be payable on September 28.

  • The year-to-date cash flows and cash balances 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.

  • This is now the 61st consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law, and it's now the 60th consecutive quarter that we've increased the dividend payment over the previous quarter, now a 15-year period that included 4 3-for-2 stock splits.

  • So with those opening remarks, we'd now like to open up the call for questions.

  • Operator

  • (Operator Instructions) And our first question is from Sean Dodge from Jefferies.

  • Sean Wilfred Dodge - Equity Analyst

  • So on margins, they were pretty flat sequentially.

  • Given the ongoing work around Genesis, can you talk about why we didn't see any improvement there?

  • And then, now that you have all of the facilities that were added in 2017 on budget, where are you guys running at on gross margins right now?

  • Did finally getting those on budget put you well on our way ahead of where you were in the second quarter as far as kind of tracking back towards this 14% target exiting the year?

  • Theodore Wahl - President, CEO & Director

  • I think, Sean, as far as the -- if you're looking at it sequentially, every quarter, every month that you can imagine, there is a lot of different costs within cost of services that increase or decrease in any given time period.

  • And I think we highlighted insurance, and insurances as being one of them depending -- and that really depends on what is our employee mix at any given moment in time, what's the timing of payments on premiums or premium true-ups.

  • Now typically that normalizes over the course of any given year.

  • But again, if you're looking at it sequentially quarter-over-quarter in a vacuum, it probably impacted cost of services by about 20 or 30 basis points.

  • So I think, when you look at, there would have been modest margin improvement had it not been for that.

  • And now that we've really delivered on what our expectations were heading into July with respect to the Q2 and really the 2017 business, we would expect to see ongoing margin improvement throughout the rest of the year.

  • But what we're targeting really just to share what we're thinking internally is really end of the year, by December, to be back at 14% margins, knowing like in any systems integration, there is always the adherence part, there is always the quarter-to-quarter fluctuations.

  • But for us, it's all about end of the year being at 14% margins and coming into the first quarter of '19 in that 14% or better world that we were in pre-Q2 of '17.

  • That's our thinking on margins and how we see the rest of the year playing out.

  • Sean Wilfred Dodge - Equity Analyst

  • And then, the path from here to there, Ted you mentioned some systems integration.

  • Is it going to be pretty linear or are there things that are going to cause maybe more of a stair-step like result in savings?

  • Theodore Wahl - President, CEO & Director

  • We would expect -- if we're looking Q2 to Q3 and then Q3 to Q4, Sean, I'd be disappointed if we didn't see incremental margin improvement, I'll put it that way.

  • But since it is an operational exercise, the stair step rather than the linear one, we feel most comfortable looking at it over a 6-month period than isolating how we're progressing in any given week or month.

  • Sean Wilfred Dodge - Equity Analyst

  • Got it.

  • Okay.

  • And then the healthier end market is certainly my concern.

  • It sounds like you're incrementally positive there.

  • Can you update us on activity during the quarter?

  • Were there any more meaningful client reorganizations, write-downs, reserving of accounts receivable that you had to do subsequent to the 2 we discussed last quarter?

  • Theodore Wahl - President, CEO & Director

  • No, there weren't.

  • And -- but you're right.

  • I think the industry sentiment seems to be one of cautious optimism, as I mentioned in my opening remarks.

  • And I think PDPM has generally been well received.

  • Although it's way too early to tell, it certainly simplifies or has the possibility of simplifying reimbursement.

  • I think, as it's written out, reduces payment buckets or categories by 80%, and there is all sorts of administrative easings that take place along with that, which would make the operators and the provider community more efficient and allow them to operate in a leaner type of overhead model.

  • So I think that's a benefit.

  • And the market basket increase was certainly a pleasant surprise.

  • I think the community was expecting one, but this was as high of a market basket increase as we had in quite some time.

  • And -- but I think to your point, Sean, it continues to be internally for us irrespective of the industry and the environment, high area of focus for us.

  • We have great people in this function.

  • We have the process and the capability.

  • We're constantly innovating with individual customers as well as on the whole around how we can better position ourselves, how we can strengthen the partnerships with our customers for the long haul, because we don't plan on going anywhere.

  • This is -- we're in no rush in terms of doing the right thing.

  • So I think it's been a collaborative exercise in many instances with our customers.

  • And I think -- again, that's generally been well received once all of us understand our positions.

  • And I would only add to that, in addition to the work we're doing internally, we've also spent a lot of time in conversations with our shareholders and as a board on how we can further increase visibility into this area going forward.

  • And one of the plans we have is to include -- there is a schedule in our 10-K, which is the allowance for doubtful accounts schedule.

  • It's in the MD&A, and it's been traditionally included on an annual basis.

  • We're looking to include that as part of our Q filings going forward.

  • And that will give all of us a common platform to have real meaningful conversations about how we're thinking about the environment, how we're thinking about exposures and opportunities, and it just gives us a common platform.

  • So I think that's a good opportunity as well going forward from the visibility and transparency perspective.

  • Operator

  • Our next question is from Ryan Daniels from William Blair.

  • Ryan Scott Daniels - Partner and Healthcare Analyst

  • You talk a lot about the strength in the sales pipeline and end-market demand.

  • I'm curious if you could speak to the pipeline for management talent given the current labor market and if that is a perhaps growth bottleneck at all or if you feel pretty good about your recruiting position at this point.

  • Matthew J. McKee - VP of Strategy

  • Thanks for the question, Ryan.

  • Really for us, we go to great lengths to have our partners understand not only the importance of that management training and development pipeline, but the mechanics of it.

  • In other words, emphasizing the fact that all of our recruiting and the training and development happens locally.

  • We don't have health care university that resides in Chicago or here in Bensalem.

  • So for us, it is very much a localized exercise.

  • Having said that, certainly, the great expansion efforts that we undertook as a company in 2017 involved not only our Dining management folks, but likewise our housekeeping management personnel who help to broker the introductions at the facility level and further facilitate the introduction of our operations and systems into the facilities as well, recognizing that they certainly had very well-established relationships with the administrator and other department heads at the facility in addition to knowing the building and having that impact in that conversion that we undertook last year.

  • So if you look out company-wide, there are certainly pockets where we are further along in that management development continuum, if you will, but total company if you look, it's been severely depleted.

  • Now how does our ability to recruit managers correspond to the overall labor environment?

  • We've generally been pretty well buffered against those dynamics, Ryan, and the reason for that is that management candidates who come to Healthcare Services Group are attracted to the upward mobility, that career development pathway that we can offer them rather than being attracted to a market premium wage that they're going to be paid as a management training candidate relative to another comparable-type position that they may be able to get at another company.

  • So the individual who is looking at opportunities and weighing out to say, "Well, geez, I'd be paid $2,000 less annually to be a management trainee with Healthcare Services Group rather than being a shift supervisor at a big-box store.

  • This isn't the job for me." Well, if that's their view, then this probably isn't the opportunity for them.

  • We far prefer the candidate who looks at the opportunity with Healthcare Services Group and in their mind says, "Yes, sure, maybe I'll make $2,000 less per year as a management trainee candidate, but that's going to be short-lived, because I know that I'll make it through, I'll be assigned to be an account manager, ideally get promoted to a larger facility and greater responsibility and greater comp" and then continue on that pathway of developing their career.

  • So they're looking much more so at the career opportunity and corresponding comp opportunity much more so than just the moment-in-time entry-level position.

  • So that dynamic has certainly served us well, number one, and most importantly, our ability to attract high-caliber talent that would otherwise not be attracted to this industry or more specifically, the types of work that we perform.

  • And then secondarily, buffers us against some of those labor market dynamics that you alluded to.

  • Ryan Scott Daniels - Partner and Healthcare Analyst

  • Okay.

  • And then as we look forward, how should we think about the growth in the 2 segments?

  • I know anniversarying the Genesis food services, that growth will slow.

  • I'm curious if there is more of a focus on housekeeping, kind of ramping up that core business, especially as that tends to be a higher-margin business given the management scale you have there already.

  • So any more of a balance going forward or are you going to continue to have more skew towards food?

  • Theodore Wahl - President, CEO & Director

  • Yes.

  • I think it'll just naturally skew towards food in the sense that it's -- the opportunity is -- just from a dollar value perspective is twice that of housekeeping and laundry, coupled with the fact that it's a cross-sell primarily for us still today, and we're -- more than 60% of our existing customer base is not currently utilizing our services in Dining.

  • So they've already surpassed the first 2 hurdles as, a, am I open to outsourcing; and b, is HCSG a viable partner in that endeavor?

  • So I think it will naturally skew towards food.

  • But to your point, and just building off of what just Matt just talked about, with management development being one of the highest -- it's always -- it's the lifeblood of the company, it's always a priority.

  • But in light of now the 2017 business being digested, the all hands-on deck nature and leveraging any and all resources available kind of passing, the focus turns now towards replenishing that pipeline, building out that pipeline, which is why selective expansion really in both segments for the balance of the year.

  • But looking towards 2019, with a build-out pipeline quality and quantity, I would just also add that that's really a local endeavor.

  • That's not maps and push pins in a corporate office and HCSG training taking place at Chicago University.

  • That continues to be done by our training managers at the facility level in conjunction with our district leadership.

  • So -- but that really will be the lift to housekeeping growth.

  • And we would expect, as we've expected -- as we've talked about in the past, Ryan, in a normal environment, without the comps quarter-over-quarter, that mid-single-digit type growth in housekeeping over the next few years.

  • And in Dining, we continue to expect that mid-teens -- low to mid-teens type growth.

  • Ryan Scott Daniels - Partner and Healthcare Analyst

  • Okay, that's helpful.

  • And then just last one very quickly.

  • I know you've highlighted in the past the potential of maybe sell initially into the private pay senior housing space on the food side, if there's enough scale there now?

  • Can you give us a little bit of an update of that status and outlook?

  • Matthew J. McKee - VP of Strategy

  • Yes, thanks, Ryan, and you're correct.

  • We've absolutely spoken about senior living as a longer-term opportunity for dining services specifically.

  • Those type of facilities, assisted living, independent living facility is generally not attractive candidates for our housekeeping and laundry services given the fact that there is a more ambulatory resident population, lower acuity levels, they're typically cleaning their own apartments and doing their own personal laundry.

  • And those facilities tend toward more of a universal aid model rather than having a dedicated carved-out housekeeping and laundry department with a housekeeping manager.

  • And for us, a facility needs to be able to support having a full-time on-site housekeeping manager in order to be an attractive candidate for our services.

  • But certainly, with respect to dining, they would be absolutely ideal candidates for our services.

  • The question that was in our heads as we thought about that opportunity was always, do you make that platform product or do you acquire it?

  • And that was the debate that we've had internally recognizing that there was really no rush to get into that market.

  • But certainly, the Genesis partnership has added additional clarity to that opportunity for us.

  • And by that, I mean really the Genesis team brought a heck of a lot of culinary expertise and a product that was specifically designed to service that sort of short-term rehab and senior living environment.

  • So that is a product that we believe that we can leverage, we can scale.

  • So rather than looking at senior living as a longer-term opportunity, perhaps the Genesis capabilities in that product could be scaled to more of a midterm or even near-term opportunity for us.

  • Now number one, the pipeline of business opportunities within our existing customer base, as Ted just mentioned, that cross-sell opportunity is absolutely far and away, our #1 priority and the ultimate low-hanging fruit for us as a company.

  • Beyond that, you've got the remaining facilities that comprise our 23,000 facility addressable market for housekeeping services, and we've certainly built a reputation there through the 4 decades that we've been in operation.

  • But beyond that, again, definitely a longer-term opportunity for dining services in that senior living market.

  • And for us, it would be a methodical and selective expansion.

  • We wouldn't expect to have kind of a product launch or a new division launch and make some sort of splashy entrée.

  • The reality is that there's plenty of opportunity for us in the smaller, more regional-type facilities that really align more closely with the existing skilled nursing facilities that we're servicing, and oftentimes there is that kind of crossover ownership of a regional operator who owns a dozen or so skilled nursing facilities and maybe 3 or 4 assisted living facilities as well.

  • So plenty of opportunities to leverage those relationships and most likely, our existing operational structure, albeit with a different facility-specific culinary offering to service that market.

  • So tremendous opportunity for us as we look out to the future.

  • Operator

  • Our next question is from Michael Gallo from CL King.

  • Michael W. Gallo - MD & Director of Research

  • Ted and Matt, I know you talked about getting back to kind of 14% plus gross margins by the end of the year.

  • But I was wondering as we look on a longer term more structural basis, is there anything you see about the mix of food service or the business that you added last year, do you think will prevent you getting closer to 15%?

  • And also, if you can update us on the recent rollout of the onboarding software?

  • What percentage of facilities have that in place?

  • And then what kind of benefits you expect to see?

  • And whether you're seeing all -- any of those yet or whether you expect that to come?

  • Matthew J. McKee - VP of Strategy

  • Sure.

  • Thanks, Mike.

  • As far as the Dining margin and how that will impact total company gross margins, as we sit here today, we are very confident in the opportunity that exists for that segment, specifically, and that as a driver toward returning total company gross margins back to 14% and ultimately that opportunity to continue to drive towards 15% total company gross margins.

  • And the primary driver remains the same, that being the underutilized middle-management structure that continues to exist in dining services.

  • Recognizing that, at this point, it's very specific geographically based opportunity given the fact that in our mid-Atlantic and Northeast divisions, we really do have the district managers in Dining overseeing the appropriate number of facilities and the regional level directors of operations overseeing the appropriate number of districts.

  • It's just that in the Southeast and Midwest and the Far West, those middle-management positions remain significantly underutilized.

  • So that's the primary driver of the Dining services segment opportunity, but as we continue to drive that full utilization of the middle-management structure, we absolutely have confidence that we can drive toward, at a minimum, the 14% gross margins and certainly beyond that.

  • There is nothing structural in any of the new business that we onboarded, nor in the Dining business in general that would preclude us from that further margin opportunity for the company.

  • Theodore Wahl - President, CEO & Director

  • And Mike, I would only remind everyone too that, it may -- when Matt went through the fact that we still have this underutilized middle-management structure, again, I would just remind everyone that the vast majority of the 2017 new business adds were in that Northeast and mid-Atlantic footprint.

  • So we didn't garner that incremental operating leverage.

  • Now if it were in the Southeast, the Midwest, the Far West, then we would have had additional and more immediate margin expansion.

  • But that dynamic continues to be the case, as Matt said, going forward.

  • That's the opportunity for us not just to work towards 14%, but really the pathway to 15%.

  • Matthew J. McKee - VP of Strategy

  • And then Mike, as to your question on the electronic onboarding program, continue to see a tremendous degree of success with that.

  • Really positive feedback from our managers in the field as far as the utilization of that platform.

  • Because it is state-specific and custom-crafted toward the state-specific onboarding requirements, it has been more of a phased approach.

  • As we sit here today, we're in probably 3/4 of the states in which we operate and the balance would be those states that we have kind of more state-specifics requirement that need to be embedded into that platform.

  • But absolutely no hurdles or impediments that will preclude us from ultimately rolling that platform out to all of our facilities.

  • So again, tremendous feedback that we've gotten, very positive at the facility level as far as freeing up our managers and certainly from a compliance perspective to make sure that all of those applications are complete and that from a documentation perspective, we've got everything now stored electronically in the cloud that we can access that information anytime, readily available.

  • Michael W. Gallo - MD & Director of Research

  • Is it too early to quantify kind of what kind of longer-term impact do you expect from that?

  • And sort of as a follow-up to that, where you kind of scan in documents and the like on kind of all your existing employees over time or is it really just as the new employees get onboarded, they're all kind of going to digital environment?

  • Matthew J. McKee - VP of Strategy

  • Right now, Mike, Phase 1 is definitely focused on onboarding new employees.

  • That's been the priority.

  • In some of the geographies in which the onboarding has been rolled out for a longer period of time, they have kind of advanced the ball to now include scanning and uploading current employee information so that, that can now reside in a central repository electronically in the cloud, readily accessible.

  • So that's been the move there.

  • But definitely, the priority for us has been to roll out the platform to each of the geographies that have not yet had that program rolled out.

  • And as far as quantifying in ROI, Mike, it's really more qualitatively that we'll see some benefits and that's definitely in freeing up our managers most importantly, rather than having to sort of coach a new employee through what could be a 125-page onboarding paper packet of information to dot all the Is and cross all the Ts, fill out the state-specific requirements and forms, abuse registry checks, background screening, et cetera.

  • That manager can now be out in the floor coaching and managing the facility -- employees in the facility, managing our quality assurance programs, interacting with the customer.

  • So that's definitely been the most significant benefit, not one that we're easily able to quantify, but certainly, at least anecdotally the feedback we've gotten nothing but positive and has served that end in freeing up our managers much more.

  • Michael W. Gallo - MD & Director of Research

  • Yes.

  • I was just wondering, again, sort of as a follow-up to that, whether you'll be able to kind of -- as you free that up, whether you'll be able to kind of fold more facilities longer term into the -- into an individual manager?

  • Matthew J. McKee - VP of Strategy

  • It really -- Mike, the benefit really exists at the facility level.

  • The district manager, who is overseeing multiple facilities, is really, generally speaking, not much involved in that onboarding process at the facility level.

  • That's much more managed by our facility level account manager.

  • So that's where the benefit in freeing up their additional capacity to do more within the facility is a benefit.

  • But if that function had been one that was served by the district manager, that's where you may see the impact of allowing them to oversee additional facilities, but because that function is really a facility-specific function, you wouldn't get that kind of multifacility benefit.

  • Operator

  • Our next question is from Andrew Wittmann from Baird.

  • Andrew John Wittmann - Senior Research Analyst

  • I wanted to dig into the housekeeping margins.

  • You said they're kind of flat sequentially.

  • Last quarter, they were really good, they were 11.7% and just as I was looking back over the last 3 years, I mean, the average is closer to like 9.5%.

  • So I guess, the question is, why are the margins so high today, and how sustainable is that, maybe even in the near term over the balance of the year?

  • Theodore Wahl - President, CEO & Director

  • I think, the most significant impact on the housekeeping margins has been that management pipeline, that management trainee role that we talked about before, with those resources being allocated in a different type of way to the growth we've taken on over the past 12 months, as we've talked about earlier in the call.

  • So that's been a -- that's had a meaningful impact on it.

  • And the other part, I think that, maybe we don't spend enough time talking about is, we are managing it we believe more effectively than maybe in years passed.

  • And that's largely due to the increased visibility we've had and continue to have as a company.

  • And I would just point to the biometric time clock as one example of that, where we're able to -- that's evolved from -- when we first rolled it out, it was more of a compliance tool and then it was a timekeeping device and then it became a way for us to on a real-time basis actively manage payroll on a day to day, week to week, which is required, and that's how we've been able to ensure that the cookie-cutter does not dull as we continue to expand.

  • As -- we have as much, if not more visibility into what's happening at the facility level today as we did 2 decades ago, which may sound counterintuitive considering the size of the company today relative to that time, but technology has been the primary reason for that.

  • And again, I think the biometric time clock among other enhancements as exhibit A.

  • Andrew John Wittmann - Senior Research Analyst

  • That's interesting.

  • So just as you look at -- if you look at the balance of the year and really better growth in '19, is this the right housekeeping margin you think for the next couple of quarters?

  • Theodore Wahl - President, CEO & Director

  • We think it will begin to come back down to earth, Andy, as we're -- again, as we're building out the management depth, I think it will continue to be at or perhaps better than historical highs for really the second reason I pointed to.

  • But for us, we would expect housekeeping to return back to historical levels, but at the higher end, if not maybe setting the new historical trend.

  • But that decrease will be more than offset by what we expect to be the continued increase in the Dining & Nutrition margins.

  • Matthew J. McKee - VP of Strategy

  • But you better believe we're going to continue to try to maintain those margins, Andy.

  • We're not conceding anything.

  • We're going to continue to focus to identify technology and further efficiencies as Ted alluded to.

  • Andrew John Wittmann - Senior Research Analyst

  • Yes, for sure.

  • Okay, super helpful.

  • Then, I guess, my last question here is around -- just looking at your kind of credit quality of the customer base.

  • And you guys have kind of mentioned -- obviously, commented on the last quarter that this is something you have to scrutinize a little bit more that this is something you'd be looking at more closely.

  • I guess, advancing 3 months here, Ted, what have you done to look at your customer base as credit quality receivables that you have, the timeliness with which they're paying you in order to affect change on a go-forward basis?

  • I'm just kind of curious for an update more than anything on that line.

  • Theodore Wahl - President, CEO & Director

  • Yes.

  • I would say that the single most significant impact around increasing our visibility, which we view as the key in any relationship, has been around advancing or accelerating payment terms.

  • So moving a customer that was historically on a monthly payment to a biweekly payment and then opportunistically advancing those on biweekly payments to weekly payments.

  • Because when we have a higher frequency of payments, it allows us to engage in conversation when there is a shortfall or there is a miss rather than waiting until the end of a month.

  • So that I would say has been more impactful over the last 12 months than any other single thing we've done.

  • And again, that's not a new concept, but we've been much more focused on engaging and I'd say collaborating because a lot of those conversations, Andy, they're not do this or else with our customers.

  • I mean, we're partners.

  • We're in this for the long term with them.

  • So it's a collaboration around, "Hey, how can we strengthen the partnership, how can we create that neutral space for that win-win where it's better for you, maybe it aligns better with your cash flow customer, maybe it aligns better with your Medicare or Medicaid payment." So they're the types of conversations we're having on an ongoing basis.

  • But that has been significant.

  • If you looked at where we were a year ago and where we are today, there has been a meaningful shift in increasing the frequency of payments across our entire cross-section of customers.

  • And we've talked about it before, but also the ongoing movement towards when it makes sense specifically with the Dining & Nutrition cross-sell, but also outside of that, engaging in conversations about promissory notes, which again from a strengthening terms and conditions perspective, that certainly accomplishes that because it's a legally binding document that [memorializes] the indebtedness, so you're already over the first hurdle in would-be workout that the indebtedness or the amount owed is agreed upon in writing.

  • So that short circuits any sort of workout conversations by a significant amount of time.

  • And then all the other benefits that come along with that, like cross guarantees, personal guarantees, security interests like an interest-bearing component.

  • So they've been 2 of the areas we focused on.

  • And then, obviously, systems and process internally.

  • And from a human capital perspective, having the right cross-section of leaders here with different subject matter expertise as well as I mentioned technology earlier, making sure we have the right technology in place to be able to evaluate the metric so we can react in a meaningful way when it warrants that.

  • Operator

  • Our next question is from A.J. Rice from Crédit Suisse.

  • Albert J. William Rice - Research Analyst

  • To go back to the comments about cash flow, obviously there seemed to be a lot of focus on that.

  • So I think if I've got the numbers right, year-to-date you're looking at about $27 million, $28 million of cash flow from operations.

  • If you lay out the payroll dynamic, it sounds like the second half is going to mirror the first half pretty much and your DSOs are sitting at around 62, last quarter 61.

  • What has to change or how do you move from where you're at now to get a, I mean, I think net income this year depending on whether or not you have a charge is probably going to run somewhere in the $80 million to $100 million range.

  • How -- what has to change from where we're at today to where we're at by year-end to get you to that net income equals cash flow that you reiterated as your target?

  • Theodore Wahl - President, CEO & Director

  • Yes.

  • I think you mentioned 2 of the most significant ones.

  • But in a world where we're collecting what we bill with a 30-day lag, that would drive DSO into -- it would stabilize and drive DSO downward, AJ, so just by virtue of collecting what we bill each and every month.

  • So that would be one tailwind to that cash flow, which we've done historically.

  • That's our goal going forward.

  • And then the other one you mentioned is the margin improvement that will naturally provide a lift for cash flow.

  • So they would be the 2 biggest components that we'll talk about certainly every quarter when we're all together and we're evaluating each and every week on how we're performing and how that impacts the cash flow of the company.

  • Albert J. William Rice - Research Analyst

  • So what would be a reasonable target for DSOs then and concerning 61, 62 now that you think...

  • Theodore Wahl - President, CEO & Director

  • We think where we're at right now, we would expect -- we expect a stable DSO-type environment.

  • Again, we had this past quarter -- it was actually a strong quarter in terms of cash collections.

  • And we looked at it -- you look at it both from the more significant customers and then you have to look at it how many at the local level, what were the payments like.

  • So you're looking at kind of batting average as well as slugging percentage, if you will, and you're measuring it in a variety of different ways.

  • But overall, we had a very strong quarter.

  • It was unfortunate that Massachusetts' budget was not signed on too.

  • But again that would have been an additional $5 million or $6 million.

  • And then obviously, with increased margins and then an additional -- some other opportunities that certainly are there to make inroads into some of the slippage that happened over the past 12 months.

  • So that's what we're focusing on.

  • But I think a reasonable target to think of is, the starting point would be the first half of the year and then depending on how some of these other factors impact at least the back half of the year, could be $10 million to $20 million more compared to the first half of the year.

  • But again, it just depends on, as I said, the collecting what we bill, which we'll talk about as well as the margin expansion that we're hoping to have incrementally.

  • But really targeting the end of the year in terms of that 14% and then running into 2019.

  • Albert J. William Rice - Research Analyst

  • Okay.

  • Then looking at the sequential operating income, I think you were down $1 million or so.

  • If you -- I think we would have thought you'd have been up a little bit, maybe up $1 million, $1.5 million.

  • I know you highlighted -- I mean it sounds like the margins of the 2 businesses were pretty much -- we don't have the specifics yet, but it just sounds like they were pretty much on track.

  • You mentioned this premium -- extra premium payment.

  • It sounds like there might also be a little higher accrual for bad debt, I guess.

  • Is that true?

  • And if it's true, are you accruing a little higher level now post what happened with the charge in the first quarter of bad debt going forward and maybe give us some flavor on that?

  • Theodore Wahl - President, CEO & Director

  • Yes.

  • I'd say sequentially it was a very modest increase, AJ, regarding the bad debt expense, and that was -- there is -- that will vary quarter to quarter.

  • I wouldn't say it as a reaction to Q1.

  • But we're certainly -- we continue to scrutinize and evaluate each and every account, and what our expectations are going forward.

  • I talked about, where I mentioned earlier, the enhanced disclosures and transparency that we're going to include in the Q, so we have a platform to have this type of conversation in a very qualitative way.

  • But I'd say, the other, when you look at it quarter-over-quarter, it was second quarter, second quarter.

  • That's where your point is spot on, that it was about $1 million or so higher Q2 to Q2.

  • So again, I wouldn't say that's the new norm, but to have some modestly higher bad debt expense as well as timing of health and welfare.

  • In any other quarter, it wouldn't even rise to the level of this conversation because we're typically not talking about a quarterly swing of 20 basis points or 30 basis points in direct cost of services and touting it one way or the other, because we're looking at this over a 6, 12, 18-month period, right?

  • It's a continuum for us.

  • It's certainly not a quarter-to-quarter business.

  • But that was all -- we tried to provide a little bit more color, because we knew it was a high area of focus for -- certainly for us and we knew it would be a point of conversation for today.

  • So I wanted to provide as much color to cost of services as possible.

  • Albert J. William Rice - Research Analyst

  • Okay.

  • And when I look at the growth, last year second quarter and this year second quarter, Dining is up 13%.

  • Is that -- I mean, I think a lot of the new business came on at the beginning of last year second quarter, so you would've anniversaried it.

  • But is that 13% sort of the run rate for Dining or is that a benefit from some further add-ons that happened over maybe the course of the quarter last year, now you're getting...

  • Theodore Wahl - President, CEO & Director

  • It's primarily run rate.

  • There is some sequential step up, but it's primarily -- it was more modest.

  • I think it may have been $3 million or so quarter-over-quarter, AJ.

  • So it's mostly run rate and carryover from 2017.

  • Albert J. William Rice - Research Analyst

  • Okay.

  • So then as we look at the back half of the year, it sounds like you're looking to do some additions, but you're not back to normal additions, but you have some tailwind in Dining, so it will be -- even if you don't add a lot of new accounts, you're going to get some benefit there or does that really revert down to maybe low to mid-single digit absent any new accounts?

  • Theodore Wahl - President, CEO & Director

  • Yes, I think -- yes, there is tailwind, I guess, if you're thinking of sequential improvement quarter-over-quarter as being a tailwind.

  • I would just say, without -- the comps, we added $65 million of business in the quarter -- in the second quarter of last year.

  • So when we start to talk about percentage comps, obviously it's somewhat distorted.

  • So what would it look like next year at this time, I would -- and what does this mean for the back half of the year?

  • I think you touched on this idea of selective expansion.

  • So yes, it doesn't mean that we're not going to grow in either housekeeping or Dining for the balance of the year.

  • It's just going to be selective.

  • We're going to be focusing as a priority on building out the management pipeline and then opportunistically taking on customers and taking on new business that aligns with our management development efforts and our management depth.

  • And then going into next year, we'll be in a position, I think, to grow more in line with where we've been historically and in a -- without getting again percentage to percentage versus an unusually high growth 2017 year.

  • But we would expect that normal course of single-digit housekeeping and laundry and low, mid-single digits Dining.

  • But that's how we're thinking about it here.

  • Albert J. William Rice - Research Analyst

  • Low to mid-single digits or low to mid-double-digit percentage?

  • Theodore Wahl - President, CEO & Director

  • Double digits, I'm sorry, if I misspoke there.

  • Yes, low to middle double digits in Dining.

  • Albert J. William Rice - Research Analyst

  • All right.

  • And then so that just sort of takes me to my last question or last issue to bring up.

  • I mean years ago, you guys used to talk about 10% to 15% top line growth, 15% to 20% earnings growth.

  • It seemed like in the last few years that obviously that obviously the base has gotten a lot bigger, you sort of moved that to 8% to 12% and maybe mid-teens earnings growth.

  • Obviously, the last 3 quarters have disrupted that.

  • When you come out the other end of this in '19 and beyond, do you have view -- I mean, is sort of the 8% to 12% and mid-teens still a reasonable long-term annual earnings growth target or is it something different from that?

  • Theodore Wahl - President, CEO & Director

  • We believe it is, that if we're looking out over the next 3 years and again without ex-ing out the comps, as I talked about earlier, but over any 3 to 5-year period, when we look at the pipeline, the demand for the services, the management capability and capacity that we expect to have, certainly double-digit type revenue growth, you said 8% to 12%, but -- whether it's high single digits or low double digits overall.

  • And by segment, housekeeping, we'd expect to be in that mid-single-digit range and Dining & Nutrition in the low to mid-double digits.

  • And I think to your point, AJ, as you pointed out, that would deliver mid-teens type earning growth, because we continue to have that under-levered middle-management structure.

  • That would be the primary driver of earnings growing at an accelerated rate relative to top line growth.

  • Operator

  • Our next question is from Chad Vanacore from Stifel.

  • Chad Christopher Vanacore - Senior Analyst

  • So one thing that stuck out to me, revenues were fairly flat in the quarter sequentially.

  • Can you go in a little more detail about why that top line growth was slower and then what trend we should expect through the year on overall top line?

  • Matthew J. McKee - VP of Strategy

  • I think, like we've talked about, Chad, it's really -- we can't grow the business, we can't add facilities unless we have the management capacity to do so.

  • And certainly that's a localized effort.

  • But if you look at it from a total company, certainly lagging in that management development function company-wide, as we sit here talking about that virtuous cycle that we've referenced in the past, that being primary function and most important being management development, and specifically developing new managers through our training and development program rather than focusing on kind of the management development, which is related to promoting and developing account managers to be multifacility managers to become district managers, and developing district managers to become regional directors of operations.

  • So certainly, it's that entry-level management position in which we're lacking currently.

  • And we're not able to add facilities unless we've got that management capacity, specifically a well-trained and developed manager to be able to place in as an account manager at that facility.

  • So that's been the primary drag on the top line opportunities, if you will, Chad.

  • And certainly, we are committed to delivering a tremendous customer experience to driving that high degree of customer satisfaction, ultimately customer retention.

  • And for all those reasons, as has always been the case, we're committed to that internal training and development of our managers, not leading with our chin and trying to put managers out before they're ready to deliver that high degree of customer experience.

  • So that's where we are right now.

  • And certainly, there are other areas in the country that are further along that continuum of having managers in the queue, and they'll be able to add new business on a more accelerated basis relative to others.

  • But total company-wide, we're certainly, if you had to characterize us as where we are in that continuum of that virtuous cycle, definitely leaning more heavily toward management and development, which then leads into management capacity and ultimately that primes us to enter the sort of business development portion of that cycle.

  • Chad Christopher Vanacore - Senior Analyst

  • So Matt, right now, what's constraining that management development pipeline?

  • And then what can you do to affect that so that you get more employees through that pipeline?

  • Matthew J. McKee - VP of Strategy

  • Yes, it's a good question, Chad.

  • And really it just comes down to the management folks who are tasked with -- you think about the -- within the district structure, there is a district training manager who is tasked with screening resumes, conducting interviews, hiring folks and ultimately helping to shepherd them through the training program, which is delivered at additional facilities.

  • There are account managers who would be bringing a candidate through that 90-day training program within their facility, all the while maintaining the customer relationship, delivering the operational and quality performance and managing the other line staff employees at the facility and hitting their budgetary targets.

  • So when you have such significant expansion, those facility level training managers and the district training managers get pulled into additional expansion-related opportunities and other operational issues more so than focusing on that recruiting effort, the interviewing and shepherding those folks through the training program.

  • We wish that wasn't the case.

  • We wish that we could continue to be all things to all people in that regard, but the reality is when you have that significant type of expansion, it truly is an all-hands-on-deck exercise.

  • And because of that, those folks who would otherwise be focused on that management development, the recruiting, the training function have been pulled in to help facilitate systems implementation, operational and qualitative issues and helping to manage the clients, both existing and newer clients that we expanded with in 2017.

  • Chad Christopher Vanacore - Senior Analyst

  • All right.

  • And another question just on cash flows.

  • You mentioned a $20 million decline in payroll accrual.

  • So that's a significant change versus historical and the cash use.

  • Was that because you cut some contracts and handed those employees back to the operators or is that something else going on there?

  • Theodore Wahl - President, CEO & Director

  • No.

  • And just -- Matt touched on it in the opening remarks, Chad, I think when we -- the payroll accrual, it's always been something we've talked about it.

  • It evens out over the course of the year, and it's strictly related to the timing of when the pay period closes, when the pay period -- when that pay period is funded and then how many days between those 2 -- the close and the funding are left for the remainder of the quarter that had not either been -- that are either unpaid or not funded and then that becomes our payroll accrual, which is why there is always variability in any given year or any given quarter, rather.

  • But over the course of the year, that evens out.

  • And that's why we've spent a lot of -- which is good, and we will continue to do so, spend a lot of time, and Matt called out, what the payroll accrual would look like in the third quarter and the fourth quarter, just to give everybody some visibility into the impact that has.

  • But that's really not related to underlying cash flow and cash generation.

  • That's just fluctuations that happen that over the course of a year, it's a net 0 impact.

  • It's just the quarter-to-quarter fluctuations.

  • What we're focused on internally, we'll communicate and we'll speak about the impact of the payroll accrual, but we're focused on cash generation vis-à-vis cash collections from customers, vis-à-vis margin expansion as well as, obviously, other opportunities we have with respect to cash flow.

  • So that -- hopefully that clarifies a little bit, I know, the conversation around the payroll accrual, but again, it evens itself out over the course of any given year.

  • Chad Christopher Vanacore - Senior Analyst

  • Okay.

  • I'm just looking at it because it looks abnormally large and it's a use of cash.

  • Theodore Wahl - President, CEO & Director

  • No.

  • We have about -- we accrue roughly $3 million a day of payroll.

  • So if a quarter ends with 7 days accrued, the accrual is $20 million.

  • If it ends up being $15 million accrued, then the accrual ends up being $35 million.

  • So it's just -- or $30 million.

  • It just depends on how much we have in payroll at the end of a given -- we don't control it.

  • We just have a biweekly payroll that each and every -- every other week is paid.

  • And then at the end of the quarter, whatever is unpaid is accrued.

  • Chad Christopher Vanacore - Senior Analyst

  • All right.

  • So fair to say you think it evens out throughout the year?

  • Theodore Wahl - President, CEO & Director

  • It does even out.

  • It's been there for decades.

  • So no changes.

  • There is no impact to the underlying business related to the fluctuation in payroll.

  • Chad Christopher Vanacore - Senior Analyst

  • All right.

  • Then just one more on cash flow.

  • So DSOs ticked up sequentially by about 1 day.

  • How is that impacting cash flow, and then what steps are you taking to improve that cash collection process?

  • I know earlier you said basically tightening your, I want to say, your payables timing.

  • Matthew J. McKee - VP of Strategy

  • Yes, for us, Chad, with respect to the impact on cash flow, you can think about 1 day of billing being around $5.5 million.

  • So when you have an increase in DSO of a day, that's a negative $5.5 million impact on cash that we otherwise would have had.

  • And really this quarter that day increase, Ted talked through some of the enhancements and the focus that we're placing in the credit and collection functions, and we've been very pleased with the progress that we've had in that regard, although there remains additional opportunity.

  • That increase in DSO was primarily related to Massachusetts, specifically.

  • California, not unlike in past years, had a delay in approving their fiscal year budget as well, but we were actually able to collect nearly all of the monies owed in California.

  • We did have an impact in Massachusetts, though, and not uncommonly, they've not yet approved their fiscal year '19 budget.

  • That created a lag in reimbursement payments that the operators receive from the state.

  • Now, understanding that that's the norm, the operators in Massachusetts tend to sort of brace themselves and manage their cash outflows much more conservatively at the tail end of the fiscal year, obviously prioritizing payroll until that new budget is approved.

  • So we've been in close communication with our clients in Massachusetts, and indications are that the legislature will pass their budget shortly.

  • Operators will be made whole, our customers will be able to catch us up.

  • So we've got a pretty high degree of confidence in that trend reversing itself quickly.

  • Outside of Massachusetts, there was really not any noteworthy shift in our DSO.

  • And we do, as I said, believe that there remains opportunity to selectively improve the credit and the payment terms with certain customers of ours, all of which would have a positive impact on DSO and cash flow.

  • Operator

  • Our next question is from Bill Sutherland from The Benchmark Company.

  • William Sutherland - Equity Analyst

  • I think I'm good.

  • All questions asked and addressed.

  • Operator

  • At this time, I'm showing no further questions.

  • I would like to turn the call back over to Ted Wahl, President and CEO, for closing remarks.

  • Theodore Wahl - President, CEO & Director

  • All right, great.

  • Thank you.

  • And it's incredibly exciting to imagine all of the possibilities that await and know that our future really does begin with our great people going beyond and living out our purpose, exemplifying our values and fulfilling the company's vision.

  • That is our pathway to ensuring sustainable, profitable growth over the long term.

  • As we enter the second half of 2018, the company's underlying fundamentals are strong and there is more demand for the services than we can manage.

  • We continue to operate in a recession-proof market niche and the demographic trends have been and continue to be in our favor.

  • We're in a strong cost-containment environment that's really increased the demand for outsourcing services of all kinds, including ours.

  • We have the most talented management team that we've had in the history of the company, and we have the financial wherewithal to grow the business as fast as our ability to manage it.

  • It's for all of those reasons, we know our best days lie ahead of us.

  • So on behalf of Matt and all of us at Healthcare Services Group, I wanted to thank, Gigi, for hosting the call today.

  • And thank you again to everyone for participating.

  • Operator

  • Ladies and gentlemen, thank you for your participation in today's conference.

  • This concludes the program.

  • You may now disconnect.