Healthcare Services Group, Inc. (HCSG) Q4 2012 Earnings Report, Transcript and Summary

Good day, and welcome to the Healthcare Services Group Reports Results for 3 Months and Year Ended December 31, 2012. Today's call 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, our beliefs and assumptions. Words such as believes, anticipates, plans, expects, will, goal and similar expressions are intended to identify forward-looking statements, and 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 health care industry, primarily providers of long-term care; credit and collection risks associated with this industry from having several significant clients who each individually contribute at least 3%, with one as high as 7%, to our total consolidated revenues in the 12-month period ending December 31, 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 1 thereof, under Government Regulations of Clients, Competition and Service Agreements/Collections and under Item 1A, Risk Factor. 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 number of major laws and regulations. During the past decade, including March 2010 enactment of the Patient Protection and Affordable Care Act and the Healthcare and Education Reconciliation Act of 2010. On July 29, 2011, the United States Center for Medicare Services issued final rulings, which, among other things, reduced Medicare payments to nursing centers by 11.1% and changed the reimbursement for the provision of group rehabilitation therapy services to Medicare beneficiaries. On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012, which also addressed the provisions of the Budget Control Act of 2011. Under these provisions, the act will reduce federal spending, potentially, beginning of -- in March, 2013 if Congress and the administration do not reach an agreement on means to reduce the national deficit by $1.2 trillion split evenly between domestic and defense spending. Currently, the U.S. Congress is considering further changes or revising legislation relating on -- to health care in the United States, which, among other initiatives, may impose cost-containment measures impacting our clients. These laws and proposed law and forthcoming regulation 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 will be adversely affected in 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 service 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 impacting future operating results and successfully executing projected growth strategies. Now at this time, I'd like to introduce our speakers for today's call: Mr. Ted Wahl, President and Chief Operating Officer; and Mr. Daniel McCartney, Chairman and CEO. Please go ahead, Mr. McCartney.

Okay, thank you. And thank you, everybody, for joining us today. Yesterday, after the close, we released our fourth quarter and year-end results, and we'll be filing our 10-K during the week of the 23rd. When we go through the quarter, I'm going to turn it over to Ted, and Ted is going to talk a little bit about the fourth quarter and year-end results. Ted?

Okay. Thank you, Dan. And really, before we get started, and for the benefit of those of you that maybe aren't as familiar with the company, it was during the fourth quarter of 2011 that we accelerated our expansion, increasing housekeeping and laundry revenues by 16% and dining and nutrition revenues at over 50%, which makes the Q4-Q4 comparisons the most difficult of the year. But we continue to grow the top line within our long-term targeted range of 10% to 15%. Revenues for the quarter increased 11% to $277 million. And for the year, revenues were up over 21% to $1.077 billion. For the quarter, housekeeping and laundry grew at about 7%, and dining and nutrition was up over 20%. For the year, housekeeping and laundry increased 13%, and dining and nutrition grew at over 45%. As we discussed on our previous calls, the accelerated expansion of dining and nutrition is due to the past investments made in the district and regional organizations. The continued development of our management people has allowed us, and really should continue to allow us, to add new dining and nutrition clients within the existing operational structure and to expand dining at a more rapid pace going forward. Our housekeeping and laundry revenues continue to grow within our targeted range for the year. Both quarterly and 12-month revenue numbers were company records. Net income for the quarter was up over 21% to $12.8 million or $0.19 a share compared to $10.6 million or $0.16 a share in the fourth quarter of 2011. For the year, net income increased 16% to $44.2 million or $0.65 per share. Again, all company records. Direct cost of services for the quarter came in at 86.2%, which is slightly above our target of 86%. The districts and regions continue to give proper attention to our existing clients and make progress with the new business we added during the year by implementing operational changes and getting the jobs on budget in a timely manner. Going forward, our goal is to continue to manage direct cost of services at 86% on a consistent basis, and work our way closer to 85% direct cost of services. SG&A was reported at 6.9% for the quarter, just below our targeted range of 7% to 7.25%, with essentially no impact from the deferred compensation investment accounts held for and by our management people. As we discussed in past quarters, SG&A includes gross receipt taxes paid to states like Ohio, Michigan and Texas, as well as the additional resources added from when we expanded our human resource and risk management departments. The departmental expansion has allowed us to be more efficient in the employee benefit and insurance areas, as well as comply with the new hire and personnel recordkeeping requirements demanded by the regulatory environment. It has also positioned us to be the beneficiary of the recently passed American Taxpayer Relief Act of 2012, which renews certain job tax credit programs, including Work Opportunity Tax Credit. In the year ahead, we would expect our SG&A to continue to be in that 7% to 7.25% range, with the ongoing opportunity to garner some modest efficiencies. Earnings from operations for the quarter increased 26% to $19.2 million, and investment income came in at $400,000, again, with no deferred compensation impact. For the year, after adjusting for deferred compensation, earnings from operations increased 22% to $69 million. Actual investment income was $1.2 million for the 12-month period. Our tax rate was 35% for the quarter and 37% for the year. And although the Taxpayer Relief Act was passed in January of 2013, the job tax credit programs that were included as part of the legislation were reauthorized retroactively to January of '12 and prospectively through December of '13, though we plan on recording the '12 portion of the WOTC benefit in the first quarter of '13 and expect our 2013 tax rate to approximately 35%, exclusive of the 2012 benefit. We continue to manage the balance sheet conservatively, and at the end of fourth quarter, had over $90 million of cash and marketable securities, no debt and a current ratio of 4:1. Our accounts receivables remain in good shape, well below our DSO target of 60 days. And finally, 2 weeks ago, the Board of Directors approved an increase in the dividend to $16.58 per share, split adjusted, payable on March 15. The cash flow, cash balances and earnings per share for the quarter more than support it, and with the tax increase -- the dividend tax increase being less than anticipated and 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 39th consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law. It's the 38th consecutive quarter we increased the dividend payment over the previous quarter. That's a 10-year period that included 4 3-for-2 stock splits. And with those opening remarks, Dan and I would like to open up the call for questions.

[Operator Instructions] We'll take our first question from Ryan Daniels. Ryan Daniels - William Blair & Company L.L.C., Research Division: Wanted to start out just on the SG&A front. Obviously, it was a bit below your target, I think the first time we've seen it that low in quite a while. Is that just due to some deferred hiring or spending on the marketing side that you think will tick back up? Or do you think you can sustain kind of a lower 7% level on a go-forward basis?

I think we can sustain that and do better, but I've said that for years. And that's why on the safe side, I always said, if I was going to model it, we'd target 7% and 7.25%. But I think the expansion in the human resources, in particular when we took the payroll functions into the corporate office 2 or 3 years ago, not only improved our efficiencies on our recordkeeping, but some of the technology upgrades have allowed us to not only take advantage of some of the opportunities that were available to us the past few years, but I think position us with the procedures and the resources to be able to absorb our expansion going forward for the next 2 to 3 years without adding the proportionate SG&A expense. So our hope is, as Ted mentioned, some modest efficiencies going forward, although; until we demonstrate we can do it consistently, we still think the safer range is 7% and 7.25% with no deferred comp. But we would expect to be a little more efficient and maybe have some margin improvement in the SG&A area as well. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. That's helpful. And then on the tax run, I think you mentioned it'll be 35% for the full year. That's not including the retroactive portion? So Q1 will be probably low 30% range? Is that a good way to think about the first...

Yes, we haven't quantified what the exact impact will be, but it would be a onetime benefit retroactive for 2012 benefit. But it will be 35% on an equal basis for the year, we expect, and it will be a one-time benefit that will be below that for the first quarter this year when we recognize the benefit. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. Great. And then 2 more maybe bigger-picture ones. Just if we think of health care reform, I'm curious, does that have any potential to help you? In 2 regards: Number one, pushing the rates up that you charge because you'll have to provide insurance for any of your workers, kind of the over-50 employees, does that trigger? And number two, are you seeing more SNFs maybe looking to outsource this function to lower their full-time labor on the payroll, so is that opening up yet another growth opportunity or growth driver for you guys?

I think it's another factor. But really, the demand for the services in both housekeeping and laundry and food have never really been our issue. The constraint on how quickly we grow has really solely been determined by our ability to develop a network of management people that can absorb the growth. There's more demand, but there has been for the 37 years we've been doing it, than we can really do. I think it is safe to say as a metric, because our approach is to mirror the wage rates, benefits, recognize the seniority. The more expensive employees are when they're doing it in-house, the more favorable our reductions become when we propose new services, so I think it will help and will be another factor in their consideration. But it's not going to increase our ability to absorb new business when that's really determined by the management people.

We'll move on to A.J. Rice with UBS.

Maybe just to follow up on that last question a little bit in a different way. I assume that across the country, the nursing homes have a lot of different benefit structures out there, and many of them maybe don't have adequate benefit structures to comply with the ObamaCare mandates. Can you tell us where they're at in understanding what they need to do and how far along they are at on that? And then, maybe also just to make sure we have -- understand exactly what the implication of -- for you is if a nursing home that you're servicing decides that they haven't offered health insurance and now they have to, or something like that?

Well, I think, because we mirror the benefits at [indiscernible] pace, we've been talking to them about what their decision is going to be for their blue-collar workers, and we'll follow suit. We'll get the appropriate increase on the impact for our employees, because had we not been there, they would be experiencing the same increase, and we'll try to mirror the policies that they indicate. Whether it's a union facility or a nonunion facility, whatever the benefit package is that the client has provided before, during and after our tenure, that's what we try to mirror, and we need to get the appropriate passthrough increase to reflect that cost. And from the client standpoint, if the employees -- whether we're paying them or they're paying them, they'd be impacted very similarly.

Right. Right. Is it sort of like the wage increase that it actually has an incremental benefit and helps overall, or is it strictly 100% passthrough where you don't really pick up any increment if they go to a higher-benefit structure?

I'd say it'll be closer to just covering the cost, although we're going to attempt, in the negotiation, to also include it. But because we're going to do it with such visibility and the cost incurred by them will make them reluctant, I think it will be closer to just recovering what the additional expense will be.

Okay. And just for curiosity, is this -- just maybe broader picture, is -- would you consider this, is this a major issue for a lot of nursing homes, or most nursing homes at this point, offering reasonable benefits to comply with the ObamaCare?

I think most have had some provisions and certainly have had coverage, even if there were many med plans that they'll have to adjust to it. But they didn't seem significantly concerned from the national change to the individual operators, I think, frankly, because the way they look at it, it's going to be reflected in their cost reports. And going forward, they expect the government to pick up the increased labor and benefit costs, like any other cost incurred in running the facilities that are still very dependent on Medicaid and Medicare.

[indiscernible] years, obviously a big change, Sun Healthcare was high profile because they were public, was bought by Genesis toward the end of the year. Maybe ask you about whether there's been -- I know you had some business with them. Has there been any impact on your business because of that deal, and just maybe a broader comment on your retention rates. Are they stable?

Our retention rate has stayed, for the year and the quarter, above the 90% that we typically targeted. And even in Genesis and Sun, who were both clients before they merged, Sun more significantly than Genesis, but they're all individual contracts. So as we look at it, they're all at-will contracts, just like an individual facility, and the administrators and directors of nursing, typically, with some operational and corporate approval, made the decision to engage us in the first place. And they all have 30-day cancelable contracts, so as long as we're providing the services, and in their best interest at the local level, we've always historically been able to maintain the relationship no matter what the corporate structure had changed to.

And then finally, my final question. I know last conference call, there was some discussion about evaluating the pace of the rollout of the dietary business, and maybe in the first half of the year, evaluating whether you'd bump up your growth target maybe by the middle part of the year. Can you tell us, is that still something you're thinking about? And if so, what are sort of gating factors that would make you decide either to keep it the same or increase it?

I think our -- 10% to 15% is still our growth target, and that's what we always have felt determined by our management depth but -- as our sustainable growth rate. Food service was different, really starting, as Ted mentioned, in the fourth quarter of 2011, because the investment we made in the management structure that was underutilized for the 2 or 3 years prior to that. When I mentioned, by the middle of this year -- we're going to grow the food service in a more accelerated rate for the next few quarters without doing anything exciting. But our concern is to balance, make sure we're managing the existing customers properly, keeping the client retention where it should be; most importantly, executing consistently both financially and operationally. And then we felt, by the middle of this summer, we'd be able to say, "Okay, here's the sustainable growth rate for food service that we think, at a higher rate, we'll be able to operate and function properly." And that's what I was kind of hedging in the last call and some of the discussions. We just want to make sure we don't stub our toe with last year's accelerated expansion, that we haven't missed anything. The guys are functioning as well and better than we thought, that each quarter we get a little more consistent, a little better, even some of the newer areas of the growth in food service. But we just figure, by the middle of the summer of 2013, we'll be able to say, "Okay, here's our sustainable growth rate for food service with the management structure, and we feel more confident after the 1.5 years of digesting the recent expansion.

Moving on to Michael Gallo with CL King. Michael W. Gallo - CL King & Associates, Inc., Research Division: A couple of bigger-picture questions. You're now, obviously, more than earning the dividend. You've got the cash balances building up towards $90 million. You obviously feel comfortable growing at a higher rate. Should we look to see an acceleration in the dividend growth rate? Or are there other uses of the cash that you see, which again, starting to build up on the balance sheet again?

Other than big management bonuses, we can't find a better use for the cash. The real important factor for us, as I mentioned on the last few calls, has always been the uncertainty of the tax law and how to write tax dividends. And the fact that it only went up to 20% rather than 15%, we see no reason to change our dividend policy. The Board of Directors really looks at it every quarter. We thought the consistency of the increases was important. And certainly, as our earnings per share continue to grow as we expect them to, we'll certainly review and consider maybe a more generous dividend as well. But we review that quarter-to-quarter, and with the tax issue out of the way, it's certainly something we'll consider. Michael W. Gallo - CL King & Associates, Inc., Research Division: All right. Okay, great. In terms of just the other uses of cash, I know occasionally you've done some tuck-in acquisitions over the years. Do you see anything out there from a pipeline perspective? Or is it just not something we should expect to see in the near term?

I think that there aren't really that many acquisition opportunities that fit our niche, and we're looking to diversify. So whatever we project out is typically based on organic growth. If we find an acquisition candidate that fits our criteria, both operationally, personnel wise, and then, of course, financially, we certainly look at it. But we don't need acquisitions or expect to have acquisitions, although we always look at the opportunity if it's there. Michael W. Gallo - CL King & Associates, Inc., Research Division: Okay, great. And then finally, just a bigger-picture question, I want to come back to the SG&A line. Again, south of 7% of sales this quarter, again, excluding the deferred comps, something we haven't seen in some time, but not out of line with what we've seen historically. So given the rate that you're adding top line, again, continuing at double-digit rates, given some of the cost you've already digested from building out the corporate office and bringing the payroll in-house, when I look at that absolute level of, call it, $19 million, maybe $20 million, why shouldn't we able to get better leverage of that as we go forward and ultimately see that 7% range that you're targeting, maybe on the conservative side, just continue to migrate down over time just as the revenue base grows? I guess, is there anything you see at the corporate variety that would give you a hesitation? Because it seems like you've made a lot of the needed investments, at least from what we can see visibly, over the last 2 or 3 years.

I mean, theoretically, you're right. So...

Mike, as you're asking that question, Dan is looking at me and cursing, saying, "I'm the one that forces them to invest in technologies every quarter and promises them efficiencies down the line." But I think there are -- and that's why I mentioned in the opening remarks, there certainly are some opportunities for efficiency that we'll be able to garner going forward. But from an SG&A standpoint, when we look at '13, we would expect it to be in that 7% and 7.25% range. But I -- if we can manage it more closely under 7% and we're confident we can maintain that, we'll certainly communicate that to everyone.

And in all seriousness, I think a lot of the systems and controls that we put in place have really refined recordkeeping, payroll. Certainly bringing it in-house and the technology upgrades required some upfront expense. But it's still primarily personnel as well, and that grows proportionately as we expand. So we think, until we demonstrate it, a few quarters. But theoretically, we think some modest efficiencies and improvement are certainly there for us to be had, in all seriousness. Michael W. Gallo - CL King & Associates, Inc., Research Division: Yes. I guess, just to answer the question -- not to put words in your mouth, but there's nothing structurally that should prohibit getting that leverage, particularly at good levels of revenue growth. I know the IT guys can always find a way to spend a few extra incremental dollars. But you should have made most of the investments at this point over the last years.

That's right. The only thing that proportionately could increase would be clerical support staff as we expand districts and regions throughout the country, but that's much more modest than the upfront expense that we've invested in the last 3 years.

All right, we'll move on to Chad Vanacore with Stifel, Nicolaus. Chad Vanacore - Stifel, Nicolaus & Co., Inc., Research Division: So it looks like you've had another good quarter with strong demand for dietary services. Can you let us know what kind of proportion of new signings were with existing clients versus new clients?

I think almost all. I mean, there's -- it's not a requirement now, but a lot of our management people in the field had enough pent-up demand with the existing clients that, that's obviously where they've concentrated. Although we've gotten some momentum outside with clients that, frankly, were interested in food service and not as interested in housekeeping and laundry, but that's still the exception. I'd say more than 95% of the expansion in food service for the year, and the fourth quarter, were with the existing client base. Chad Vanacore - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And can you remind us about how many dietary clients you have?

It's about 700 out of the 3,500 facilities we're servicing. Chad Vanacore - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And then just switching gears to tax rates. Are there any changes in state taxes that you're aware of for 2013 that we should be aware of for modeling? And anybody moving from a gross receipts tax, from an income tax or vice versa?

No. I mean, right now, there's no states that we've identified that are planning on '13. Other than that, it's an ongoing trend, state-by-state, that they are moving from an income-tax-based system to a gross-receipts-tax-based system. So as that happens, from a modeling perspective, the only adjustment would be the tax that otherwise would be in the income tax line is reported from the -- in the SG&A line. Which, getting back to Mike's earlier questions, as far as SG&A, some of the inefficiencies that we have garnered over the past couple of years have been eaten up, however modest they've been, 20 or 30 basis points, by Ohio, Michigan and New Mexico, Texas gross receipts taxes. So it is an ongoing trend and we would expect to see it, but there's no states in particular that we've identified.

Next we'll move to Steven Charest with Divine Capital Markets.

All my SG&A questions have been covered by the other guys, but I was wondering if you provided a split on the revenues between housekeeping and dietary? And if you had an estimate on the...

Food services is now 33% of the revenue, the housekeeping and laundry was the balance. So the food service continues to be a significant part of the revenue base and growing a little bit faster than housekeeping and laundry, but food services was 33% of our revenue for the quarter and for the year in 2012.

Okay, great. And do you have an estimate on the operating cash flow figure?

Yes. For the quarter, it should be about $25 million. $60 million for the year. But that will be in the K for everybody to see when it's filed in a couple of weeks.

Looks like we have no further questions at this time. I'll turn the conference back over to Dan for any additional or closing remarks.

Okay, thank you. And thanks again, everybody, for joining us today. But going into 2013, we expect to continue to expand our client base and housekeeping and laundry within our historical targets. Even though it's our largest service group, in this environment, the demand for our services really has been as great as it's been for the 37 years we've been doing this. We'll continue to control our growth and balance the expansion with our ability to manage it effectively. It remains the most important criteria for us to balance client satisfaction measurements as we digest the increased amount of new business, not only in this past year, but going forward, and to continue to operate on budget. We'll look to make certain the recent expansion continues to operate consistently and the new districts and regions continue to improve the margins and the operational performance. The food service margins, as we expand that in a controlled way, should continue to improve, and if we execute properly, will ultimately mirror housekeeping and laundry's, but they should improve a couple of basis points quarter-to-quarter, which they did in 2012. All divisions continue to perform better, and with the expansion, we just want to ensure consistency, and that's why we're a little bit hedging what the sustained growth rate in food service can be, and figure we'll have a good feel and be able to confidently commit to it by the summer of 2013. We think we can get the direct cost down below 86% and work our way closer to 85% over the next 1, 1.5 years. Like Ted described, the SG&A, if we're going to model it, there are some efficiencies to be had, but 7%, 7.25% is still the safe target. Our tax provisions is going to be 35% without the onetime catch-up or benefit that we're going to quantify and demonstrate in the first quarter of 2013 for the retroactive part of the Work Opportunity Tax Credit. But we believe the recent growth in the operating on budget -- frankly, in this environment the demand for the services, for both services, has never been greater. We've never had better management people in the history of the company. We have all the financial resources to grow as fast, or our ability to manage it. So overall, these are pretty good times for us. So thanks, again, and onward and upward.

And ladies and gentlemen, that does conclude today's conference call. We thank you for your participation. Have a great day.