Healthcare Services Group, Inc. (HCSG) Q2 2012 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Healthcare Services Group Inc. 2012 Second Quarter Conference Call. Today's conference is being recorded. The discussion to be held and any schedules incorporated by reference into it will contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934. The Exchange Act, as amended, which are not historical facts, but rather are based on current expectations, estimates and projections about our business and industry, are beliefs and assumptions. Words, such as believe, 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 care; credit and collection risks associated with this industry from having several significant clients, who each individually contributed at least 3% with one as high as 7% to our total consolidated revenues in the 3- and 6-month period ended June 30, 2012; our claims experience related to workers' compensation and general liability insurance; the effects of changes in 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, 2011, in Part I thereof under Government Regulations of Clients, Competition and Service Agreements/Collections and under Item IA, Risk Factors. Many of our clients' revenues are highly contingent on Medicare and Medicaid reimbursement funding rates, which Congress and related agencies have affected through the enactment of a number of major laws and regulations during the past decade, including the March 2010 enactment of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010. Most recently, on July 29, 2011, the United States Center for Medicare Services issued final rulings, which among other things, will reduce Medicare payments to nursing centers by 11.1% and change the reimbursements for the provision of group rehabilitation therapy services to Medicare beneficiaries. Currently, the U.S. Congress is considering further changes or revising legislation relating to healthcare in the United States, which among other initiatives, may impose cost-containment measures impacting our clients. These laws and proposed laws and forthcoming regulations have significantly altered or threatened to significantly alter overall government reimbursement funding rates and mechanisms. The overall effect of these laws and trends in the long-term care industry has affected and could adversely affect the liquidity of our clients, resulting in their 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 current service 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 of managerial personnel is an important factor in impacting future operating results and successfully executing projected growth strategies. At this time, I would like to turn the conference over to Daniel McCartney, CEO and Chairman. Please go ahead.

Okay, thank you, and good morning, everybody, and thank you for joining us. We released our second quarter results yesterday after the close. We'll be filing our 10-Q the week of the 23rd. For the second quarter, our revenues were up 26% to $267,108,000. And for the 6-month period, our revenue increased 25% to $527,715,000. Housekeeping and laundry grew at about 16%, and food service, better than 52% -- 58% for the quarter and 16% and 56% for the 6-month period. As we discussed in our fourth and first quarter calls, we expected to continue to accelerate our expansion in food service, not because of any change in demand in the Medicare environment necessarily because demand has never been our issue, but due to the investment we made in regional and district management people over the past few years that have gotten better and gave us the confidence we could expand more aggressively as they got better at executing in their positions. Their continued development allowed us to begin new food service clients within the existing operational structure and expand more rapidly than we had in the years past. In addition, our housekeeping and laundry services continue to grow at slightly better than our targeted range of 10% to 15%. All quarterly and 6-month revenue numbers were all company records. The net income increased by 15% for the quarter to $11,302,000 or $0.17 a share, compared to $0.15 in 2011, and 13% to $19,899,000 or $0.29 a share for the 6-month period, again all company records. Our direct costs for the second quarter were 86.2% as we got the new business we started in the fourth quarter 2011 and the first quarter of this year and the new districts and regions progressed in implementing the changes we needed to make, and frankly, just getting the jobs running on budget. We expect to continue that progress with the new business. The margin improvement should continue without taking our eye off the ball and given the proper attention to our existing clients. We continue to work towards getting our direct cost back under 86%. Our SG&A costs were reported at 6.9% for the second quarter. But due to a loss of about $359,000 in the deferred comp accounts for and held by our management people, which should be reversed, our SG&A adjusted was really 20 basis points higher or about 7.1% within the range of our 7% and 7.25% range for the SG&A. That's what we think our SG&A cost are going to remain with no deferred comp impact considered. As in past quarters, the SG&A also includes some states like Ohio, Michigan and Texas, that changed to a gross receipts tax that's expensed in the SG&A and the additional resources we added in the benefits in payroll department that have allowed us to meet some new hiring, personnel recordkeeping and be more efficient in the employee benefits insurance areas and to benefit from certain job tax credits when they're available. Our earnings from operation were reported as $18,378,000. But again, adjusting for the deferred comp impact, our earnings from operation actually were $18,728,000, an increase of better than 28%. Investment income as reported is a $95,000 expense. Obviously, we have no debt, so there is no interest expense. When the $359,000 adjustment from the SG&A is made and reversed, the company's investment income was actually about $250,000 for the quarter. Our tax rate was 38% compared to 34% in the second quarter 2011 as Congress has still not finalized the Worker Opportunity Act and some other tax credits that we benefited from -- at least, they haven't approved it yet. On our balance sheet, we ended the quarter with over $77 million in cash and securities. Our current ratio, better than 4:1. The receivables remained in good shape, well below our target of 60 days. And finally, the Board of Directors approved an increase in the dividend to $0.16 and about 0.0033 cents per share split adjusted to be paid in the third quarter on August 24, the cash flow, cash balances and earnings per share for the quarter more than support it. And as we've discussed in the past, since the tax law is in play still, at least for 2012, we still feel it's the most tax-efficient way to get the free cash flow back to the shareholders. The increase is our 36th consecutive quarterly increase since the dividend was originally instituted in 2003 when the tax law first changed, and that's after 4, 3-for-2 stock splits during that period of time. Before I open it up for questions, I wanted to review some areas that those who know the company are very familiar with, but some others may not be. First, as far as our market potential. Since the company's inception in 1977, we've traditionally targeted long-term care facilities. And as we've expanded state-by-state over these 35 years, we always introduced ourselves to those markets. All industry estimates project that there are about 16,000 nursing homes, over 6,000 acute care hospitals, over 20,000 assisted living and retirement communities without considering any of the offshoot types like subacute care, rehabilitation centers, psychiatric hospitals and many other healthcare-related facilities and clinics, et cetera. Usually, any facility below 60 beds is typically too small for us as it wouldn't support the full time management teams we feel we need, although there are exceptions. Our point in going over any of these industry facts is no matter how it's calculated, after 35 years servicing 3,400 facilities approximately, we've not come close to maxing out our potential client base. Finally, on this topic is again, those who are familiar with the company know, more than 35% of our clients are facilities that are part of large national chains, and in fact, it's been the market niche that we've grown the fastest with over the past few years. A second topic is our service agreements. Our service agreements have always been at-will contracts with a 30- to 90-day cancellation clause by either party. The recent Medicare and Medicaid debates and rates setting have increased the demand for our services. But again, demand for our services have never been the constraint on how quickly we could grow. Those again, who are familiar with the company are aware that our approach and our service agreements have us mirroring the wage rates and conditions of employment, union or nonunion, that our clients operate with. Due to this approach, as the facility increases its wage rates for its blue collar support staff, our contract prices adjusted as well and our employees receive the same. If a client decides for whatever reason to freeze or not give any type of increase to its staff, we would follow their policy, so our employees are treated no differently. In spite of the cost pressures for Medicare and Medicaid, very few clients have frozen their wage rates. And I'd say that the average increase has remained in the 2% to 3% this year as well as the past few years. And then finally, our dividend policy. Since we've instituted the cash dividend when the tax law changed, we felt it was still the most tax-efficient way to get the free cash flow back to the shareholders without affecting the company's growth or stock buyback program, if and when the opportunity presented itself. That's still the case. With the company having more than sufficient cash balances, no debt, continuous growth for 35 years, we've increased the dividend 36 quarters consecutively, with 4 stock splits. And with the tax law in place, we expect that trend and policy to continue. So with that, I'll open it up to questions.

[Operator Instructions] We'll go first to Michael Gallo with CL King.

Question, just -- Dan, can you talk a little about the opportunity in hospitals, obviously, in area historically? And you still have certainly plenty of, plenty of opportunities in long-term care. But is hospitals an area that you see some opportunity? Obviously, you tend to be willing to operate on much lower margins, at least on the gross level than some of your big competitors in the hospital space?

Well, I think for the hospitals, they've always been part, but a small part, of our client base. You want to be identified or recognized as an expert "in 1 marketplace or another." But I'd say out of the 3,400 facilities, probably 100 are hospitals. How we really handle the hospitals, typically, whether it's a community hospital or part of a chain, they're much more bureaucratic in their approach, they get a consultant to put an RFP out. And when we're in those marketplaces, we're invited in to bid, and we get our fair share of the hospital market. And every 2 or 3 years typically, it goes out to bid again. So we've developed the expertise required, the specifications and the modification of certain procedures, infection control and the like. And more recently, we've done the same thing in the food service area that translate well for the hospitals when we bid those jobs as well. So I don't see our focus changing, although hospitals have continued to be a bigger part of our expansion than they had, certainly, in the early stages of the company. Typically, somebody else convinces them of the outsourcing option, and then we're invited in to bid. Although we've been more attentive in the initial contact with the hospitals than we had maybe 5 years ago.

Dan, then second question, I'm just -- obviously, nice improvement in the margins this quarter, better job getting the business on budget. You still had obviously very robust revenue growth this quarter. I guess my question is, as you kind of brought this business online, do you feel comfortable of being able to manage the margins at these kind of levels of revenue growth? And then also, when I look at the 10% to 15% kind of longer-term growth targets you have out there, and certainly, you managed that over the years, even housekeeping has been growing much faster than that. And obviously, food service, for the foreseeable future, should grow a lot faster than that. So I was wondering if you feel more comfortable at the high end of the range in the near term, at least as food service rolls out? I mean obviously, it's going to continue to be above that, certainly at least, in the third quarter just by what you've already added.

I certainly more comfortable than I did in the first quarter when we were having a more difficult time getting all the new business on budget. But as I said in the first quarter call, March showed the improvement, but it was important for us to sustain it throughout the second quarter. The guys have done a good job in not only absorbing the new business in housekeeping and laundry and food, without taking their eye off the ball from the existing clients and having too much margin erosion. Although I think there's still margin improvement to be had within the existing business, but now it's more a grind-them-down business as usual type of approach rather than try and digest the new business. I think as long as we execute, put a couple of quarters together where we demonstrate we can sustain this kind of progress and improvement, then we'll be able to more confidently say what we think we can expand without compromising the day-to-day stuff that we need to do to make the company click. But we think that the 10% to 15% growth is the minimum we should expect to do. And if we execute, by the end of the year, we'll have a good idea that this could be our sustainable growth rate, and then we'll be able to more confidently tell it to everybody that we've demonstrated not only can we digest this, but we've executed consistently and be able to more confidently say what we think our expansion can be going forward, which may be more ambitious than it has been in the past. Certainly, in food service, but there's still plenty of activity and room to expand in housekeeping and laundry as well.

We'll go next to Mitra Ramgopal with Sidoti.

Dan, just a couple of questions. Again, going back to the business you were bringing on, is it more a case where someone is outsourcing it for the first time, or are you also taking business away from competitors?

In almost all cases, it's somebody outsourcing for the first time. There really is very, very limited competition, and I'd say more than 95% of the time, that we're awarded a new contract or entered into a new service agreement. It's where they were doing it themselves when we were the outsourcing option. In the hospitals, it may be a little different, but certainly 95% of the time in long-term care, that's the case.

And again, with regards to the business you're bringing on, is it more a case of just timing things coming together and having the right people in place, et cetera, or is there something different you're doing that maybe you haven't done in recent years?

I think it's more the case that the district and regional management people that had been promoted really in the fourth quarter and first quarter of this year that took new positions. If we added 300 new food service contracts, for example, that means there were 35 district management positions that didn't exist before. And the district management people and the regional management people that were promoted were getting their sea legs, and for the first time, operating at a different level than they were before. And in retrospect, it took them a little more time, and maybe I should have been aware, we should have been aware of that, but than it did in January and February to make the cuts, get the jobs running on budget, and simultaneously, having the client be satisfied and happy with the services. So it's a lot to ask. I think they demonstrated the last 4 months, significant improvement, not only in the margins, but the client satisfaction levels. And that's what has allowed us to grow at a more rapid rate more than anything else. There's always been more demand than we can do. The discipline has always had to been the development of management people and not getting ahead of ourselves other, rather than a change in the marketplace.

Would you say also that maybe the economic slowdown would sort of pressure the providers to sort of outsource the business more? Or is that really not been an issue?

I'm sure that's what's increased the demand. I think almost as important, outsourcing has become more accepted in the long-term care industry. It's not the new idea like it was in the late '70s and early '80s when almost 100% of long-term care facilities, everybody did everything in-house. Now the trends are much different. Maybe for financial reasons certainly, but if it wasn't an operational benefit the clients wouldn't do it, so I think it's both. We've demonstrated we can be a good asset, allow them to concentrate on their core business where we take the support service or more mundane part of their business, financially and operationally, the headaches away from them. So I think it's both. But the demand in our observation has always been there. Our execution and credibility, with a lot of the clients over the years, has been just as an important part of them making the decision.

We'll go next to Ryan Daniels with William Blair.

It's Andy O'Hara in for Ryan this morning. Just a couple of quick ones here. First, I was wondering why shares outstanding jumped by about $1 million sequentially?

Well, there were some options.

There was nothing sort of unusual there?

No.

Okay, cool. And then do you have the approximate number of clients in both housekeeping and food services at the end of the quarter?

Say that again?

The number of clients in housekeeping.

We don't give out the clients. There's about 3,400 in total. We're doing about 700 in food service.

Okay, perfect. And then for the food services clients that you added during the quarter, were they pretty evenly spread out again? Or was there a particular region that was strong?

No, it's been that way for the last 3 quarters, and it's been spread out over all the divisions.

We'll go next to Rob Mains with Stifel, Nicolaus.

Dan, in the past, you've talked about why some of the bigger players in like the hospital industry haven't moved down to compete with you in housekeeping. Are you seeing any of them looking at the dietary business or does that also seem to be something that's kind of exclusively your province?

No, I think that in our client base in our food service proposals, we're typically again, and I think the same ratio, competing with them doing it themselves in where you see outsourcing option, so the margins [ph] that shows arrow marks have really not been a factor in our observation with any of our clients in the food service area any more than the service missed [ph] the arrow marks were in the housekeeping and laundry area.

Got it. And then any kind of cost trends for commodities worth mentioning at this point?

No, I mean it's been relatively flat, I'd say, the last 3 years for us. And simultaneously, we've just become better purchasers and been able to negotiate better deals with the different manufacturers in food service or food distributors. But there's not been any significant commodity cost impact, certainly, like we experienced in 2009.

Okay, and then the last question. We saw the Genesis Sun merger announced. And if one were to buy that various factors and that cause consolidation among nursing home operators, in your experience, when there's been M&A among the nursing homes, is that an opportunity for HCSG in that, that's one of the -- housekeeping and dietary might be one of the synergies that people might look for a business competition? Or is it kind of business as usual still selling at 1 facility at a time?

In most cases, it's still business as usual. I use the example that Beverly, for example, has been a client since 1983, but they've gone through so many changes, private, public in Pasadena, in Fort Smith, Arkansas and now in Plano, Texas, the corporate entities have changed dramatically, Kindred, that our strategy with the corporate clients has been to educate and neutralize the corporate people, get them to feel comfortable with outsourcing, in general, and us as a company specifically, but sell the services locally property by property. And as long as our -- and because they're at-will contracts we're only there because that particular operational person or administrator, sees us in their best interest. And no matter what the corporate structure may or may not be, in almost all the cases, the decision is left up to the local provider. And now that we've become more well known and all the large national chains or almost all of them are clients, we're not doing anywhere near all of some of their business, but we're doing more every year. And some of them, we're doing a significant part of their business. But it's been in Golden Living's case, for example, a 28-year relationship that we sold property by property to where now you're doing 90% of their facilities. So the consolidation and ebbs and flows, we've really experienced for 35 years, seeing the trends go back and forth. As long as we execute at the property level, our client retention has remained pretty solid no matter what the corporate structure changes will be.

And we'll take our final question from James Terwilliger with Benchmark.

Nice numbers here in the quarter. Most of my questions have been answered, but in your opening remarks, I'm very familiar with your dividend program and your desire to give shareholders back some funds, but you also mentioned the stock buyback program. Can you -- are you doing anything with the stock buyback program?

We've always had an authorization, and I know at different times, that created some liquidity issues. But I'd say since the program was instituted, maybe more than 10 years ago, we bought about $45 million worth of our stock back. We still have 800,000 shares on the last authorization because we like having it available. If the opportunity is there, we'd be able to go back and utilize it. But in 2003 or since then, it's really been significant that the cash flow has gone back to the shareholders in the form of the dividend, rather than as aggressive a buyback as we had prior to 2003.

When you look at the pipeline of the new business, I mean I know you've added great revenue growth here of 26%, extremely strong. What does the pipeline of the new business look like in terms of the bids and the RFPs that are sitting on your desk? Is that...

Very few are RFPs, except for the hospitals. But the pipeline, the regional directors and the regional management people, through the 10 divisions, have always enough activity anticipating that we're going to execute the new business properly and then anticipating the next quarter's' growth. And frankly, the new opportunities have been as significant as they've ever been in the 35 years we've been doing this. But as I said, probably too many times for you guys to hear, that's never been our problem. But there's more opportunities for us to pursue. And as long as we don't get ahead of ourselves, execute the existing properties and get the new business on budget properly, we'll be able to in a controlled way, continue to expand quarter-to-quarter because there's no lack of opportunity for us to chase.

Okay. And my last question is when I look at the -- and I know this has been talked about at length. But when I look at the gross margin improvement from the first quarter to the second quarter, maybe 110 basis points off the top of my head, what were the drivers of -- if you could drill down a little bit, what were the drivers of the gross margin improvement from Q1 to Q2?

As we talked in the fourth quarter more specifically when the margins -- when the direct costs were over 87% and the first quarter, when we start that much new business, that's where the most significant investment is. And it's usually to get the inventory levels for housekeeping and laundry and linen, up primarily in food service to the levels we feel we need to operate. So that was an anticipated investment we had to make. What we didn't do as well as we should have, we also absorbed all the employees on our payroll when we start and usually takes us 30 to 60 days to make the staffing adjustments and cuts to get the jobs running on budget. And it just took us longer than it should have when we started that much new business in the first quarter. And I mentioned in the first quarter call that in March, it demonstrated we were making good progress. It just took us longer than it should, but we're able to sustain that and improve upon it and get more of the accounts on budget. So it came from just getting the new business, more where it was bid, where it took us a little longer than it should have in the first quarter. And that's where the direct cost margin improvement came from.

And we have no further questions at this time. I'll turn the conference back over to Mr. McCartney.

Okay, again, thanks, everybody, for joining us today. But going into the third quarter, really for the remainder of the year, we continue to -- we expect to continue to expand our client base in housekeeping and laundry in a very controlled way, probably at the top end of our growth targets typically. In this environment, the demand for the service is still -- it's great as it's ever been. We'll continue to control our growth rate, attempt to balance the expansion with new clients, without taking our eye off the ball with the existing clients. It remains important for us to balance the client satisfaction measurements. And our client retention has been much better than 90% that we typically historically have targeted. And we want to get the new business on budget, maybe more timely than we did the first quarter as we expand, without taking the new -- the older clients for granted. So it's a balancing act. The guys have done a very good job in the second quarter executing from the facility manager, the district manager and the regional management level. And we expect to be able to do the blocking and tackling everyday to be able to execute properly. We're more confident in the consistency of the new district and regional managers in housekeeping and laundry and food service, really in all 10 of the divisions. And as we've more fully utilized the management people, our expectations are to have the margins continue to improve, and we look to get the direct cost below 86%. We think that the SG&A will stay in the 7%, 7.25% range, excluding any deferred comp impact one way or the other. We think our tax provision's going to remain at 38%, depending on what Congress does. We could be the beneficiary down the road, but we're not planning on that, it will be a nice outcome if it comes in. But in our business, there's still strong demand for the services, housekeeping and laundry and dining, our management people in all divisions, and especially in food service, continue to develop and get better. We believe the recent growth will continue to operate on budget. And consistently going forward, we'll do what's required to make sure we execute as well as we can. So overall these are pretty good times for us. Thanks again for everybody joining us. Have a good summer and onward and upward.

Thank you, ladies and gentlemen. That does conclude today's conference call. We'd like to thank you, all, for your participation.