Good day, ladies and gentlemen, and welcome to the Healthcare Services Group, Inc. 2014 Third Quarter Conference Call. [Operator Instructions] Before we begin today, I'd like to read the company's safe harbor language. The matters discussed on today's conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are often preceded by words such as believes, 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. As with any projections or forecasts, they are inherently susceptible to uncertainty and changes in circumstances. Healthcare Services Group's actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors. Some of these factors could cause future results to materially differ from recent results, or those projected in forward-looking statements, are included in our earnings press releases issued prior to the call and in our filings with the Securities and Exchange Commission. We are under no obligation and expressly disclaim any obligation to update or alter its forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise. It is now my pleasure to introduce your host for today's conference call, Mr. Daniel McCartney, Chairman and CEO. You may begin, sir.

Okay. Thank you, and thank you, everybody, for joining Ted Wahl, Matt McKee and I for our conference call for the third quarter. We released our third quarter results yesterday after the close, and we'll be filing our 10-Q the week of the 26th. In the third quarter, our revenues increased 7% for the quarter to $320 million when compared to the same period in 2013, the period in 2013 when we made the acquisition. The revenues for the 9 months was up over 30 -- 13% to $951 million to the same period. We entered 2014 with a double-digit growth rate, which was a significant accomplishment for our divisional and regional management people, as they more than made up for the 2013 client modifications during the first 6 months last year, which put our growth rate at less than 2.5%. The expansion continued the past 3 quarters and reversed that trend, and we've continued to build from there. 2014 has continued with very good momentum. And going into 2015 with the new business we announced that we're starting in the fourth quarter, we expect to continue to grow at double digits, with housekeeping and laundry likely at the lower end of our growth targets, and food service returning to the higher end as it still has a surplus of management capacity and a smaller base. In addition, the company is moving forward with the expansion of our insurance programs, utilizing our captive insurance subsidiary that we introduced in 2013. In 2015, we will transition our workers' compensation, as well as certain employee health and welfare insurance programs, added to the general liability coverage that is currently included in the captive. As previously discussed, the captive gives us flexibility in the management of the claims, reduces our cost and gives…

Thank you, Dan. And we continue to see strong demand for both housekeeping and laundry and Dining & Nutrition Services, and they're in the process of transitioning new service agreements, with annualized revenues in excess of $120 million. These opportunities and others like it continue to be driven by an ongoing focus on recruiting and developing on-site management teams for both services, as well as the maturation and capacity of our dining and nutrition middle management structure. Revenues for the third quarter increased 7% to $320.1 million compared to the same period last year. Housekeeping and laundry grew over 9% to $211.6 million. Dining & Nutrition was up almost 4% to $108.5 million. Year-to-date September revenues were up nearly 13% to $951.6 million. Both quarterly and year-to-date September revenues were company records. Excluding the one-time charges Dan described, net income would have been over $15 million or $0.21 to $0.22 per share, assuming an effective tax rate of 35% to 38% compared to the $13.8 million or $0.20 per share in the third quarter of last year. As we previously discussed, Q3 '13 net income was favorably impacted by the enactment of the American Taxpayer Relief Act, which retroactively reinstated 2012 job tax credits and lowered our effective tax rate to 30% for the first 9 months of 2013 compared to 37% for the first 9 months of 2014. Direct cost of services for the quarter came in at 98.6%, which includes nearly 13% of nonrecurring charges. Going forward, our goal is to continue to manage direct cost of services under 86% on a consistent basis and work our way closer to 85% direct cost of services. Selling, general and administrative expense was reported at 12.3% for the quarter. But after adjusting for a 5.5% of nonrecurring charges and the…

[Operator Instructions] Our first question comes from Ryan Daniels with William Blair.

The first one is on the insurance captive. Dan, can you talk a little bit more, number one, about the level of savings you think you might be able to achieve in '15 and beyond. And then number two, where would we see that on the income statement? I'm assuming that would be in lower direct cost?

Yes. I think when fully implemented, I mean, our projections, and that's really the trial that we used for the general liability to work out the administrative kinks in 2014, but our projections, when fully implemented, it could be as high as $8 million to $10 million annually. So annually -- and as the company grows, the savings should grow proportionately and the financial benefits continue. And if we get more efficiencies, it could do even better. But we want to, as we said, move it methodically and -- but the projection seemed better than we originally anticipated. And that's really what prompted our decision to coordinate it with the health and welfare plans implemented in 2015.

And Ryan, you'll see on the P&L, the majority of that will show up in direct cost of services, specifically, the underwriting profit, as well as the efficiencies, and the health and welfare programs. There will be some costs that are reflected in SG&A, some cost savings that are reflected in SG&A as well, but the majority is going to be the direct cost of services.

Okay, that's helpful. And then in regards to the kind of the legal costs from restructuring, will some of that spill onto the fourth quarter as well? I assume the complete restructuring is not done, so will there be more expenses? Or is that pretty much complete?

We booked everything that we expect to happen, so it's complete.

Okay. And then I guess, last question. Just looking at the strong net new sales, how should we think about that from a modeling purpose, number one, split between housekeeping and linen and laundry? And then number two, as we think about the fourth quarter, how much of that will roll into Q4 versus kind of being a full run rate maybe in Q1 of '15?

Of the $120 million, it's split pretty evenly, Ryan, between housekeeping and dining. And if I were modeling it, I'd assume 50%, maybe upwards of 2/3 would fall into the Q4, with the balance and the full run rate being reflected in Q1.

Our next question comes from Sean Dodge with Jefferies.

So you guys were up 13% to date on revenue, but sequentially, there wasn't much progression in the third quarter. Can you talk a little bit about what happened? There was just a little bit of a hangover from the implementations you've been working on in the previous quarters? Or were there some losses? Or was there something else happening behind the scenes?

Really, Sean, the primary driver of why we're able to take on an expansion like this is management capacity. So in the buildup, to be able to make sure we have the managerial wherewithal, not just from an on-site management perspective, but also at the district and regional level, we really had to basically wind-down some of the new opportunities that we are on the comp for Q3 and push them out over into the fourth quarter and really the first half of next year, so we could focus on the opportunities we have with these 4 particular customers we're expanding with.

Okay, that's helpful...

I think also, Sean, one of the differences that I've noticed from our historical business development has been more corporate control or involvement in the decision-making, where historically, our strategy with the national chains has always been to neutralize the corporate people, get them to feel comfortable with outsourcing in general, and then us as a company, specifically, but sell the services locally property by property. And there, our people in the field were able to control the startups and negotiate with each of the properties the appropriate starting date and able to control without it being as choppy, quarter-to-quarter. With more corporate involvement in the decision-making, our approach is still to have separate service agreements with each of the properties, but if a chain says, okay, we agreed to the program, let's start these 20 on such and such a date, it's not our preference but we're not going to say no. And that means in the preparation, anticipating the close, you may think you're going to get the okay in the third quarter but it falls into October, and it's a bigger amount of new business than it typically would have been in the first 32 years when it was more facility by facility expansion.

And just to add to what Dan said, that dynamic is even more prevalent with the dining and nutrition cross-sell because if you have a regional customer with a cluster of, say, 20 facilities in an area, our preference after selling it locally would be to phase in the properties over a 12-month period in conjunction with the development of our management people, so we can open up and transition the facilities appropriately. The customer in that cross-sell example may have a preference to turnkey their properties on 1 day for a variety of different reasons, operational and financial. For us to do that, we have to oftentimes push that opportunity out 6 to 12 months to give our management people time to prepare for the opening. So that's just the stage that we're at as a company in dining and nutrition. I would suggest that, that will likely be the -- what happens over the next 2 to 3 years as we continue to flesh out our middle management structure.

Understood. That's a good explanation. And then last quarter, you guys had talked about -- you were still working to bring some of the facilities from the December expansion agreement on budget. I think they were the more -- there were the unionized facilities. How did that progress during the quarter? And how much, if any, did kind of those still not being on budget during the quarter? How much did that weigh on margins?

There was some continued overhang, as we alluded to even on our second quarter call, into July and August, but as of September, they were pretty much online.

Yes. The guys really did a good job getting that new business on budget and digesting it. And I think that even demonstrates more. If you grew it 16%, 17%, it also underscores the choppiness on when you get these corporate clients as we did in the second quarter. So it's more choppy quarter-to-quarter than it has been. We're still looking at it on an annualized rate and trying to smooth out the choppiness. But the guys did a good job in the field with that new business...

Outstanding job.

Getting it on budget. But for 37 years, that's been our business, to get these low margin type of customers on budget as quickly as possible. Sometimes, it just took us a little bit longer than it should have.

Our next question comes from Michael Gallo with CL King.

I just wanted to drill in a little bit. It looks like you did a pretty good job on the SG&A, 6.7% in the quarter. You're going to be folding in now $120 million run rate business. Any reason that you think, other than conservatism, why we shouldn't start to see that old 7% target start to leverage, particularly as you add a lot of business? Or is there any real major associated costs next year relative to this year that would eat up some of that operating leverage?

I think with the expansion that we really made last year at the end of 2013 and into 2014 of the human resources, personnel management, the legal department and this working environment we find ourselves in, the divisional guys needed more support perhaps than we had in the corporate office for some personnel matters and the like, but we think it positioned us to absorb the new business and put the systems and lines of communication and resources in place to support the kind of growth that we're experiencing, really, for the next 2 years. But there's no argument to say we shouldn't be more efficient in the SG&A line, but until we consistently get it under 7%, I'd be reluctant to quantify it.

As Dan said, until we consistently do it, although this is our third consecutive quarter we've been at or below 7% SG&A, Mike, which is why I know it's subtle, but even in our opening remarks, we talked about how our SG&A target's going to be in and around 7%, ideally sub-7% rather than that 7% to 7.25% range. So I think we -- we're optimistic based on the last 3 quarters and the things that Dan highlighted that we're going to be able to run it 7% or sub-7% over the next 12 months.

Yes. I know, just to sort of drill in on it. I mean, you've been below that for 3 quarters. You're adding a substantial amount of new business. You have made a lot of investments already. It sounds like there's nothing that you know of, significant investments, that you're going to have to make on the SG&A line that you're contemplating today, that you think you'll need as you head to 2015. Is that fair?

It's a fair point.

Yes. We think we're in good position to absorb that new business with the infrastructure we have in place now.

Our next question comes from Chad Vanacore with Stifel.

So what do you think fundamentally is leading to you adding so much new business in the fourth quarter and the first quarter?

Well, first, the demand for the services is as great as it's ever been, so that's really never been the issue for us as far as our expansions concerned. Having the pipeline and the consistent development of management people, and because we're still firmly committed to promotion from within, it constrains how quickly you can expand in spite of the demand. So I think it's a stop and start type of decision-making within the divisions depending on the quality of their management development, but as far as the demand for the services, and even the larger chains and this cost containment environment looking to reduce or control their cost, getting the new business is the easier part. Coordinating the actual start up may be choppy quarter-to-quarter. If we add 30 or so buildings more in a quarter, we may grow at 15%, 16%. It's not necessarily good for us from a management development standpoint, but on the other hand, if we're 20% or 30% short that we actually opened in that quarter, we may grow at 7% or 8%. But the new business, the guys have been working on these facilities probably for the better part of 6 months and doing the planning. It's like death of a salesman. You're always waiting for the next close, so I don't think it had any change in the demand. It's just the luck of the draw and when they closed, and the efforts of our guys over the past 6 to 9 months in developing the working relationship with these customers. Most of the customers, we had already been doing many of their facilities, and it's just an expansion, the relationship, while they watch and look and assess our contribution to their organization before they expand it.

Okay. All right. And then it sounds like you're pretty positive on dietary going forward. Can you fill that one out a little bit?

Yes. I mean, when you look at our run rate heading into the balance of the year and the plan going forward, I think it's consistent with where we thought it would be. The goal -- and dining continues to be -- I know now the captive programs and the opportunity are getting some attention, but that continues to be from a day-to-day operational perspective, the real margin opportunity for the company. And I'm not saying it's easy, but the easier part is layering in the new business over the next 2 to 3 years. As we demonstrated over the past 2 to 3 years, lumpiness aside, implementing our policies and procedures and having the management talent to run the business and keep the customer satisfaction levels where they're at is the more difficult part. But having demonstrated our ability to do that over the past 2 or 3 years, when you tease that out, Chad, over the next 2 or 3 years, we would expect the margins to continue to expand, if not quarter-to-quarter, year-over-year, until they ultimately mirror those of housekeeping and laundry. And that assumes growth at the higher end of our historical targets, but we are going to have quarters and even years where it's higher than the 10% to 15% range. Obviously, we're set up, assuming we can keep the retention rates in line with our historical retention rates, we're set up for a 15% to 20% type year in 2015.

Our next question comes from Mitra Ramgopal with Sidoti.

I was just wondering if you could give us an update on the competitive environment, especially as it relates to the new business. Did you see, in terms of the bids, et cetera, less competition? And does that potentially give you the chance to get even more favorable pricing?

I think the competition and the environment, there's like ebbs and flows, but I think it's a safe assessment to say we have still little or no competition. On the lower end, in a particular market, you may find janitorial companies that do office buildings, smoke restoration, and some other building service functions and do a few healthcare facilities. And on a larger end, you may compete with a Sodexo, a Marriott, ARAMARK on hospitals or larger chains or facilities. More recently, I think some of the commercial cleaning operators have dipped their toe in it again, and it's not worked out as well as they expected, but that's been going on for 37 years. And they're all successful companies, but really haven't had an impact on our market niche. So I'd say if we delivered 10 proposals still more than 90% of the time, we're competing with them doing it themselves and we use the outsourcing option.

Our next question comes from A.J. Rice with UBS.

A couple of questions, if I could ask. On the restructuring, creating the captive, I know part of that is you're hoping to get $20 million to $25 million of extra -- of incremental cash. Can you just give us a little bit of a sense of when you expect to see that come in?

We'd be disappointed if, by the second quarter, the reorganization wasn't completed, but that would be reflected by year-end, A.J., once we file the return and are able to receive the accelerated deductions.

So the actual receipt of the cash would happen later in the year or next year?

It would, yes.

Okay. Any update on the WOTC tax credit? I know at one point, that was attached to the Highway Bill but the Highway Bill hasn't been passed. What's your latest thinking on that?

I know Orrin Hatch, as ranking member of the Senate Finance Committee, confirmed last month that he is all but certain the extenders bill, which includes WOTC would pass during the lame duck session after the November midterm elections. And we continue to assume that it past is prologue. The program's been in place for 17 years. The 4 times it was delayed during the 17-year history was retroactively reauthorized back to the previous expiration date, so there was no break in the continuity of the credits, and that's certainly consistent with industry lobby that we speak with regarding these types of items, as well as what our service providers believe will happen. So we're optimistic during the lame duck session, it is ultimately passed, but if it's not during the Q4, then it would be Q1, and it would be treated the way it was treated at the beginning of 2013.

And we're keeping the records in the payroll functions as if it's ultimately going to be passed, and we're in a position to execute and have all the documentation and appropriate records to be the beneficiary of it.

And the one thing, since you brought up taxes, A.J., it's not something we're highlighting because we're still in the process of structuring our ideas around the reorganization. But for the first time in the company history, we should have some flexibility with respect to state tax planning. So the reorganization should potentially provide some upside from a state tax payment perspective. And at its infancy stages, it could be 100 to 200 basis points on our effective tax rate. That's really a 2016 opportunity, but that's yet another derivative benefit of the captive insurance program and the associated reorganization.

Okay. And just on the new business. Obviously, we have these work role challenges in the bowls of business you brought in the spring that you've talked about before. Is there anything like that, that we should be aware of with this new business or otherwise? Obviously, it's a large contract, so does that have a margin profile that's somehow different than your long-term corporate average? Give us some flavor on that.

No. This group is -- these groups are consistent, from a margin profile perspective, with where we typically target our facility level margins. And I think one of the benefits to this expansion compared to even the expansion we had during the first half of 2014 this year, is that it's spread across all 10 divisions and it's a nice complement of both housekeeping and dining and nutrition growth. So our targeted range for getting the jobs on budget is unchanged, 30 to 60 days is the expectation. You could see some margin pressure during the fourth quarter as we would with any type of expansion, but we wouldn't expect anything outside the ordinary.

And I think the other advantage is that the bulk of the new business that we're phasing in in the fourth quarter are existing clients, so the same nuance with the new client that you have to be delicate in some of the changes that you implement wouldn't be the case now because we've worked with them together already. They know our MO. They know if they want the financial benefits, we're going to have to make operational changes more abruptly than we would if it was a client that didn't have a frame of reference on how we're going to operate.

Okay. I know with the block of business from the spring, you guys had said that at that point, it wasn't all of their business, and there was hope there might be follow-on business. I would ask, I know you haven't mentioned who these 4 are, but is that part of what this is, one of these 4 is just further add-ons to what you had in the spring?

No, these 4 are separate and discrete from the group we expanded with during the first half of the year.

And with these 4, would this pretty much encompass all the facilities of these 4 operators?

No, there continues to be opportunity at some level with all 4 groups. Obviously, with a couple of the groups, there's more opportunity than others, but we're -- one in particular is a cross-sell, an existing housekeeping customer with Dining & Nutrition Services. And then the others, as Dan said, is expanding with an existing customer on housekeeping and laundry side. And then there's a greenfield housekeeping and laundry and dining opportunity. So it's kind of a nice mix of all 3 -- all 3 types of ways that we secure new business.

The next question comes from Michael Gallo with CL King.

Hey, Dan, just a follow-up question on the captive. Is there anything that's still left out in the captive? And will you also use -- still use a third-party for catastrophic or other claims? Or at this point, will everything be in the captive as of Jan 1?

I think the way to think about captive, Mike, is almost in 2 separate buckets. We're going to have the majority of our property and casualty insurance in the captive, so that being workers' compensation and general liability. The second bucket would be our health and welfare programs. If and when we decide to move to a fully self-funded health and welfare for major medical, that would likely fall into the captive. And then for our voluntary health and welfare programs, like short-term disability, life insurance, and limited medical, will absolutely be in the captive once they're approved by the regulators. But we set up with the catastrophic plans to have no different a risk profile than we did with Zurich all these years. It's capped out if it goes -- if the claim goes over a certain amount, so we really profiled the captive to give us the same protection and insulation that we had with the Zurich coverage for these 25 years.

Stop losses and protections will be in line with where we've been historically, so yes, we're taking no undue risk or even additional risk than we would have otherwise had.

Our next quarter comes from Toby Wann with Obsidian Research.

Just quickly on the food service business, it looks like revenue growth was only up about 4%. Kind of maybe if you guys could kind of talk about maybe why there were some softness there versus kind of your historical, I think, stated goals of high teens growth there.

Yes. I think we alluded to this earlier, Toby, but really, the idea when we are taking on a swath of business like this, they're -- specifically in dining and nutrition because it's a cross-sell, you'll continue to see some lumpiness over the next 2 to 3 years as we continue to flesh out our middle management structure. Because, often times, when we're cross-selling the Dining & Nutrition Services to an existing housekeeping and laundry customer, although it's not our preference, it is the prospect or the customer's preference to do the transition over a 10-day period or over a 3-week period rather than over a 6- to 12-month period as we would prefer. Now if that's what their preference is, we may not have the managerial wherewithal to be able to do the transition when they want us to do it, so we have to push it out, make sure we continue to develop on-site management candidates, and that we have that mature middle management developed so we can take on and transition the business in a rip the Band-Aid off type of way. So that's really why you see some stops and starts and some slowdowns quarter-to-quarter. But that's just the stage that we're at on the dining and nutrition side, which is why, again, over the next 2 to 3 years, until we fully flesh out that middle management structure, you'll probably see some quarters where we have flat sequential growth and then a step up in a given quarter. But our year-over-year goals haven't changed and the targets are continuing -- continue to be at the high-end of that 10% to 15% range, with some quarters, 15% to 20%. Obviously, we're set up going into next year for a 20-plus type percentage growth.

But each of the 10 divisions are also at a different stage as far as their management depth and development bench absorbing that new business as well. So some of them would be able to be more proactive as far as adding the new business in a more evenhanded way where others have to prepare for new growth and take a pass as far as what locally they develop, anticipating a 15 or 20 facility add-on in 1 period as part of these corporate deals. So that also contributes to the choppiness. Out of the 10 divisions, they're not all at the same level as far as management development strength on the bench.

And I'm not showing any further questions at this time. I'd like to turn the conference back over to Daniel McCartney for closing remarks.

Okay. Guys, before we wrap it up, Matt McKee wanted to review our conference schedule for the next few months. So Matt?

Thanks, Dan. Good morning, everyone. We'd actually be, during the fourth quarter, presenting and attending at 3 different conferences, all of which are going to be in New York City. On November 13, we'll be at the SunTrust Robinson Humphrey Conference, which will be at the Westin Grand Central Hotel. On November 18, we'll be presenting at the Stifel Healthcare Conference, which is going to be at the New York Palace Hotel. And then on the 2nd of December, we'll be at the Janney Capital Markets Conference, which is at the JW Marriott Essex House. Again, all 3 of those conferences will be at New York. So hopefully, we'll see some of you folks there.

Okay. Thanks, Matt. I guess to wrap it up, in spite of the complexities of the captive insurance subsidiary, it really gives us an improved platform financially, administratively and more flexibility from an operational standpoint that will benefit us for years to come. It will be very good for the company. Ending 2014, we expect to continue to expand our client base in housekeeping and laundry within our historical targets. In the fourth quarter, the growth rate will be at a more accelerated pace because of new business we added in the third quarter that's going to be started. And it will be phased in over the quarter to give us a good platform going into 2015. The environment and demand for the services, like I said, has been as great as it's ever been. And a lot of our clients are doing acquisitions of smaller operators, which created even a more multitude of opportunities, and that's where the choppiness comes in in the decision-making, but they're existing clients already so we have a different working relationship with some of them than a new potential client. But it remains important for us to balance the client satisfaction. The client retention has still been very good and better than our historical 90% levels. But keeping the new business running properly and operating on budget without taking our eye off the ball from the existing clients becomes and has always been the challenge. All divisions keep performing better, but with any expansion, we must assure ourselves of the consistency, the financial targets and the client satisfaction, existing and new business. We'll look to get and keep the direct costs normalized, below 86%, work our way closer to 85%. And with the changes in some of the state tax policies, the staffing changes, the normalized SG&A costs should be at 7% or below. The expansion of our legal and personnel departments have positioned us, we think, to absorb this new business in this new regulatory environment and still operate properly. We think that the Taxpayer Relief Act will be extended with the WOTC included. And our tax rate could get back to 35% maybe in the lame duck session, as Ted said, but that aside, our business still benefits from strong demand for housekeeping and laundry and food service. We've never had better management people in the history of the company in all divisions, and it just needs us to consistently execute, especially in food service. So as we continue to expand, our best days are still ahead of us. These are pretty good times for us. So thank you for joining us, and onward and upward.

Well, ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.