Healthcare Services Group Inc Q2 FY2022 Earnings Call

Good morning, my name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Healthcare Services Group, Inc. Second Quarter 2022 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. The matters discussed on today's conference call include forward-looking statements about the business prospects of Healthcare Services Group, Inc. Forward-looking statements are often preceded by words such as believes, expects, anticipates, plans, will, goal, may, intends, assumes or similar expressions. Forward-looking statements reflect management's current expectations as of the date of this conference call and involve certain risks and uncertainties. The forward-looking statements are based on assumptions that we have made in light of our industry experience and our perceptions of historical trends, current conditions, expected future developments, and other factors that we believe are appropriate under these circumstances. As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances. Healthcare Services Group, Inc. actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors and the forward-looking statements are not guarantees of performance. Some of the factors that could cause future results to materially differ from recent results or those projected in forward-looking statements are included in our earnings press release issued prior to this call and in our filings with the Securities and Exchange Commission. We are under no obligation and expressly disclaim any obligation to update or alter the forward-looking statements, whether as a result of such changes, new information, subsequent events or otherwise. Thank you. Mr. Ted Wahl, President and CEO, you may begin your conference.

Okay. Thank you, Rob, and good morning everyone. Matt McKee and I appreciate you joining us today. We released our second quarter results this morning and plan on filing our 10-Q by the end of the week. As we enter the back half of the year we've now either completed or are in the final stages of negotiation with our clients in modifying our service agreements. A goal we very aggressively pursued throughout the second quarter. As we continue to engage with our clients to capture both recent and future inflation on a more real-time basis, several components of our partnership may be considered in the negotiations. Among those are restructuring our notes receivable with certain clients, altering the timing of collections with others, and even exercising our termination rights when we are unable to reach an agreement. While we recognize that some of these decisions may have a temporary impact on our reported results, we remain confident that these service agreement modifications will further strengthen our client partnerships and position us to exit the year with cost of services in line with our historical target of 86%. To that end, before we get into the specifics of the Q2 results, I would like to discuss several items related to our service agreement modification efforts that we expect will affect our Q3 results. First, we expect Q3 revenue to be affected by an estimated $10 million related to facility exits. The facility exits primarily reflect instances in which we could not reach agreement with customers to capture recent and future inflation on a more real-time basis. Second, we anticipate a one-time reduction of $17 million in revenue and $9 million in operating income, net of reserves related to the expected restructuring of our note receivable with a certain client. Because this is a negotiated restructuring with an existing customer, we expect that this will be accounted for as a one-time reduction of $17 million in revenue and $9 million in operating income rather than a bad debt expense. After considering the estimated impact from the facility exits and one-time reduction related to the anticipated note restructuring, we estimate Q3 reported revenue base of $395 million to $400 million, and then a Q4 revenue base of $412 million to $417 million, absent any new business additions or facility assets. Finally, there was a temporary impact on cash collections in the quarter, primarily as a result of proactively altering the timing of collections with certain clients. In the second half of 2022, we expect to make up a portion of these amounts in addition to collecting what we bill. Overall, our negotiations to modify the service agreements have come with certain puts and takes, but we believe will position us much more favorably in the long term. So with those introductory comments, I'll turn the call over to Matt for a more detailed discussion on Q2 results.

Thanks, Ted, and good morning everyone. Revenue for the quarter was $424.9 million, with housekeeping & laundry and dining & nutrition segment revenues of $199.1 million and $225.8 million, respectively. Now, Q2 was impacted by around $2.5 million related to the facility exit that Ted just mentioned with three quarters of that in dining and about a quarter of it in housekeeping. Direct cost of services was reported at $379.4 million or 89.3% and cost of services was impacted by a $7 million increase in accounts receivable reserves related to a client group that was placed into receivership. And as Ted mentioned earlier, we remain on track to meet our goal of exiting the year with cost of services in line with our historical target of 86%. Housekeeping & laundry and dining & nutrition segment margins were 9% and 4.5%, respectively. SG&A was reported at $29.3 million, but after adjusting for a $6.4 million decrease in deferred compensation actual SG&A was $35.7 million or 8.4%. And we expect 2022 SG&A to approximate 8.5% to 9.5%, in that range. We reported an effective tax rate of 17.3% and expect a 2022 tax rate between 24% and 26%. Net income for the quarter came in at $6.8 million and earnings were $0.09 per share. As I highlighted earlier, Q2 operating income was impacted by a $7 million increase in accounts receivable reserves related to a client group that was placed into receivership, which reduced operating income by $7 million and reported earnings per share by about $0.07 per share. Cash flow from operations for the quarter was $9 million and was impacted by a $31.6 million increase in accounts receivable, primarily related to the timing of cash collections, offset in part by a $19.4 million increase in accrued payroll. Days Sales Outstanding (DSO) for the quarter was 71 days. And as far as the payroll accrual, we would point out that the Q3 payroll accrual will be 6 days and that compares to the 12 days that we had in the second quarter. But the payroll accrual only relates to timing and the impact ultimately washes out through the full year. We're pleased with the ongoing strength of our balance sheet and the ability to support the business, while continuing to return capital to our shareholders. We announced that the Board of Directors approved an increase in the dividend to $0.21375 per share payable on September 23, 2022. The cash balance is supported and with the dividend tax rate in place for the foreseeable future cash dividend program remains the most tax-efficient way to get free cash flow and ultimately maximize return to shareholders. This will mark the 77th consecutive cash dividend payment since the program was instituted in 2003 and a 76th consecutive quarterly increase. That's now a 19-year period that's included four three-for-two stock splits. So with those opening remarks we'd now like to open up the call for questions.

Your first question comes from the line of Andy Wittmann from Baird. Your line is open.

Hi, great. Thanks. Good morning guys. I wanted to ask, I guess, questions related to the revenue line. And specifically, Ted, maybe you could talk a little bit about the dynamics on the price increases that you're trying to realize in response to the inflation versus the customer lost. Sequentially the revenues were down just a smidge, but I would imagine that the price increases were a decent factor. Can you just help us understand where you think by the end of the year when you get to Q4, how the dynamic between price increases and customer losses going to wash out on the revenue line? In other words, do you think that the price increases will more than offset the customer losses that may result from the pricing discussions that you're having?

I believe there is definitely some potential for growth in the revenue estimates we provided, which range from $395 million to $400 million for Q3 and $412 million to $417 million for Q4. However, our visibility is mainly tied to the 86% cost of services. We are still actively working on some negotiations that are in the final stages, and we want to be respectful of that process by keeping details private. There is potential for some upside in that range we've given, but we're confident in the revenue base we've shared. We are also committed to the 86% cost of services target. From the beginning of the year, we've known that achieving this would require a comprehensive effort tailored to each client. We've made considerable progress, particularly in the second quarter, but for now, the ranges for revenue and cost of services that we've shared are the ones we feel most comfortable with.

Can you elaborate on the gross margin target of 86% compared to the results from the quarter? How representative are the quarter's results of your gross margin? Were the changes you implemented reflected in this quarter, and do you expect much higher rates in Q3 and Q4? I'm trying to grasp the degree of effort required to reach the 86% goal and how much the changes you made influenced the second quarter results.

Yeah. While we did have the client that was placed into receivership, which impacted cost of services by about $7 million. So if you adjusted it for that, cost of services would have been more in line with where we were last quarter, which reflected certainly some traction and some gains we had as a result of the service agreement modification efforts, as well as operational improvements around labor management, specifically related to overtime and premium pay. But to your point, Andy, the efforts and ultimately the results of the service agreement modification efforts are really more back-end loaded, meaning, they won't be realized in full until the first quarter of 2023, which is why we're framing it and orienting our strategies around exiting the year at that 86% cost of services run rate.

Okay. Thanks guys.

Your next question comes from the line of Tao Qiu from Stifel. Your line is open.

Hey, good morning. I'm curious if you guys could provide some colors on the trend of labor and food costs in the quarter? And just regarding kind of the guidance on the quarterly revenue. The $17 million step-up from the third quarter to the fourth quarter, is that a reflection of the real-time pricing adjustment that we achieved through the contract negotiations?

I’ll address the second question first, Tao. As Ted mentioned, we are still in the final stages of negotiations with several clients, so we haven't fully completed that process yet. This makes it challenging to predict the exact outcomes and their effects, particularly in terms of revenue and potential fluctuations as we progress through the latter half of the year from a margin standpoint. Our goal is to establish a solid partnership that allows us to exit the year at 86%. We expect that during these final negotiation stages, there may be some additional fluctuations, and the path to reaching 86% might not be perfectly linear with corresponding revenue increases. However, we are in the final stages, and once this work is done, we are focused on achieving our target of 86% by year-end.

And, Tao, just to put a finer point on even Matt’s commentary if I heard you correctly. Yes. That $17 million one-time reduction that we anticipate to revenue in the third quarter, which would have a corresponding $9 million reduction in operating income, would strictly be one-time. If this negotiation or if that restructuring plays out the way we believe it may, that would be a one-time effect in Q3, which would then, again, it would not be part of recurring revenue, it's just the accounting treatment of how that particular transaction or restructuring would be handled.

So the bounce back in the fourth quarter just reflect the one-time nature of that loss.

That's exactly right.

Right. And then to your initial question, Tao, as to sort of the inflationary environment. I would say that we're sort of comparable to last quarter. As far as the labor side, there were some stabilization and some signs of improvement related to our internal data and experience. From an industry perspective, if we think more broadly about the skilled nursing industry, for the first time in over two years we saw some improvement in the nursing home workforce data. From March through June preliminary data suggest that there were about 13,000 hires added to the industry. So we're still looking to get back to pre-pandemic levels of employees within the space and there was a bit of an uptick between March and June. So that's encouraging. The most recent five months of data also suggest that wages of employees, more broadly within the nursing and residential care facilities may be stabilizing and this is reflective of our experience as well. The industry saw a then-high in wages in January, followed by a drop in subsequent months and preliminary numbers for May looked to be level with January. And our numbers are comparable, a similar trend with the peak in March that has dropped modestly through May. Similarly our application data is trending in a positive direction. We've seen a steady climb in the applications received. We've gotten about 33% more applications in June compared to the month of January. So currently hires are outpacing employee separations, which is obviously encouraging and that's where we need to continue to drive that dynamic. So stabilization and modest improvement is certainly encouraging, but there is obviously still quite a ways to go within the industry end market in general to really foster that full recovery of staffing, which would then have the trickle-down impact on occupancy as well. As to the sort of broader inflationary metrics, Tao, we saw CPI similarly in the quarter about 2.6% change in Q2, food at home inflation specifically was about 3.4% and wage inflation was about 2.1%. So again, the theme would be stabilization and some encouraging signs.

Got you. Those are very helpful points. One more clarification from me. You mentioned that you guys are considering adjusting timing of collection as one of the factors that you could use for negotiations. Just curious, would these adjustments be one-time or permitting in nature? And how do you think about where DSO will shape up in the second half?

Again client-specific, very situational. What I can tell you without getting into specific examples that we either settled on or may work through is that, overall, if you think about the shortfall that we had in the first half of the year, more than half of that was driven through intentional negotiation and we expect to make up a significant portion of that through the back half of the year, in addition to collecting what we bill. So that said, temporary in many cases, Tao, although there were some instances where we decided to make permanent adjustments, but they were all, again, client by client bottoms-up strategy and when that's a tactic in that strategy, that's no different, it's very client-driven.

Understood. Thank you.

Your next question comes from the line of Sean Dodge from RBC Capital Markets. Your line is open.

Thanks. Good morning. Is there any more detail you can share around the client group that was placed into receivership? I guess you got both housekeeping and dining client, any book ends you can kind of give us around how much revenue they contribute? And then maybe any thoughts you have on your ability to retain that business?

Yeah. So, Sean, without getting into the specifics, that was a client group. We did in fact provide both dining and housekeeping services there. It was placed into receivership and that facility will be shuttering its doors. So to your point, we will be obviously walking away from that piece of business. As far as the revenue contribution, it’s about $2 million per quarter would be among that group, the revenue impact between both services.

Okay, that's helpful. Thanks. And then I guess it’s been six or seven months now since you made the acquisition into the education market. Are there any updates you can give us on thoughts or timelines around when we could see maybe a more meaningful push there?

Yeah. Sean, unlike sort of the base business within the skilled nursing end market, there is quite a bit of seasonality to that end market as you’d probably imagine. So we're sort of in the operational ramp-up phase. Right now really the spring is kind of the selling season where schools are looking to make determinations as to whether to outsource or to potentially switch their outsourcing partners in the upcoming anticipation of the fall academic year beginning. So we are in sort of operational phase right now, but I would point out that as we worked our way through what would be kind of called the sales season in the education end market. We were successful and really expanding our outreach with both Environmental Services and in dining services as well. So not necessarily ready to talk about specific revenue contribution per se, but I'd say that, what has been initiated as a potential new end market to explore is increasingly appealing from our perspective.

Okay, it sounds good. Thanks again.

Your next question comes from the line of A.J. Rice from Credit Suisse. Your line is open.

Hey guys. This is Nate on for A.J. I just had a real quick question, I guess on how we should be thinking about dietary margins going forward kind of given the two-quarter lag in any food inflation pass-through? I guess specifically, if we think that the delta between actual food inflation and what we are being reimbursed for kind of shifts more favorably in the future. I guess, could we see any benefit to margin?

We could see some potential benefit. There was a negative impact due to the lag in the second quarter. If inflation either slows down or levels off, we might experience some residual improvement in margins related to the non-labor aspect of the billion. While there's a possibility for this to happen, we are not relying on it. Our focus will remain on operational execution, which is where we expect to see continued margin improvements, along with our customer modification efforts. However, to your point, this could serve as a temporary boost at some point in the future.

Yeah. Just to speak to that sort of immediate future more specifically, Nate. The first quarter food at home inflation was 3.9%. So that's what you'd see reflected in the pass-through in the third quarter and then the second quarter was 3.4%, so that you'd see pass-through in the fourth quarter.

Thanks guys. Very helpful.

Your next question comes from the line of Ryan Daniels from William Blair. Your line is open.

Hey, good morning guys. This is Jack on for Ryan Daniels. Thanks for taking my question. I think a lot of my questions have been touched on already, but just kind of curious how the remainder of the service agreement modifications went with customers? I guess, especially as it relates to the exits that you mentioned in your prepared remarks. So I guess like, did you find that as time went on and inflationary concerns kind of grew in the overall market that kind of had to pivot your approach for these negotiations and conversations? And with that said, did you experience greater push back kind of towards the end of the first half of the year?

I want to highlight that the process is still ongoing, so we can't fully analyze it just yet. This has been one of our largest efforts in terms of company-client interactions. As Ted mentioned earlier, there were many aspects of the customer relationship that we discussed, all aimed at positioning Healthcare Services Group favorably for a lasting partnership with our customers. Several factors influenced this, including persistent inflation, the labor market, and its impact on occupancy rates. Additionally, we've seen a significant reduction in available federal funds, shifting operators' focus toward state reimbursement and financial support. The key takeaway is that there were numerous factors at play. We are confident that we secured what we needed from our customers, and in cases where we didn't, we opted to exit. Anyone who has followed our company knows we don't take leaving a facility lightly, especially not multiple facilities. When we do exit, we part on amicable terms and continue to monitor the market conditions of that facility. We understand that clients may realize the challenges of operating without Healthcare Services Group and might come back to us after experiencing these difficulties. To summarize, we have exited certain businesses as we finalize negotiations, but there's no indication that we will need to leave more facilities. While we don't expect that, we are prepared if it happens. Despite all these complexities, we believe we're making the right decisions to position the company and maintain client relationships effectively going forward.

Great. Understood. I truly appreciate the comments on that. Thanks. And then just a follow-up, in terms of occupancy, I know last quarter it was kind of mentioned that this would be an area to watch closely going forward into the next six months or so, and that was tracking pretty well and favorably in terms of recovery. So just kind of curious what you're seeing in terms of health of the end market now? And is the industry still on pace to recover back to the, I think, the 80% benchmark by beginning 2023? So any additional insight you have would be great.

I think it's important to take a step back and acknowledge that the ongoing recovery in census is largely influenced by staffing levels. These two factors are being closely monitored and will significantly impact the recovery pace. The latest occupancy data is not as positive as it was about a quarter ago, showing some stagnation. Currently, national occupancy is around 74%, which is slightly up from the end of March. This suggests that the industry could reach recovery around the middle to late 2023, rather than early 2023. However, we remain optimistic about the industry's recovery; it's just a question of when it will happen. Staffing will be a crucial element in that recovery. In the short term, we need to stay disciplined and make informed decisions. Ultimately, it is a matter of timing, and we will keep a close watch on these developments.

Great. Thanks for taking my questions.

Your next question comes from the line of Mitra Ramgopal from Sidoti. Your line is open.

Yes. Hi, good morning, and thanks for taking the question. Just wanted to follow-up a little on the occupancy as it starts to tick up a little. Are you getting more inbound calls and do you have the ability to take on new business in light of the difficulty in the market right now?

I think opportunistically, Mitra, yes. Aside from monitoring all the dynamics I mentioned earlier, very closely the continued pressures on the providers certainly coupled with the secular trends we've talked about previously amplify our value proposition. They have increased demand, inbound calls to your point for our services and they create opportunities to grow the company. Our focus disproportionately this year and I think heading this year to date and then heading into the back half of the year continues to be on the base business and the service agreement modification efforts, but we do expect opportunistically to grow in the back half of the year as well when the situations present themselves. And then certainly in 2023 with the contract modifications behind us, we'll be able to refocus our attention on that top line expansion that we've talked about for many years.

Okay, thanks. And just to be clear, in terms of the revenue guidance for Q3, Q4, that's assuming no new business?

Yeah, that assumes a neutral state ex any facility exits or new business adds.

Okay, great. Thanks for taking the questions.

Your next question comes from the line of Sean Dodge from RBC Capital Markets. Your line is open.

Yeah. Thank you. Just a quick follow-up. Ted, you mentioned that the pricing reset will be phased in over the back half of the year, did that $412 million to $417 million range you gave for Q4, should we think about that being a run rate for the quarter or do you anticipate exiting Q4 at something better than that as those prices get rolled in?

The run rate for Q4 is uncertain. I want to clarify that we don't have complete visibility into the timing of some revenue additions. We know the timing for modified service agreements we've negotiated, but for those still being finalized, we lack clarity. Therefore, our revenue guidance reflects our expectations. Any updates, whether positive or negative, will be shared in next quarter's call or the one after. However, we do anticipate ending the year with an 86% cost of services. We have less visibility into the timing of revenue additions for the latter half of the year, but we are confident that by the first quarter of next year, the modifications will be settled, and everyone will see the progress we've made and the results of our actions.

Okay, great. Thanks again.

And your next question comes from the line of Brian Tanquilut from Jefferies. Your line is open.

Hey, good morning guys. Thanks for letting me ask the question. I guess, Ted, first question for you. So as we think about the health of the client base, right? I think we've all been focused on your biggest client over the last year or so, a little bit of a surprise here will be receivership of this one client. So how are you thinking about the health of the remaining client base as we think about the challenges that the industry continues to face as you said, recovery in occupancy won't happen until mid to late next year?

The industry is currently in a recovery phase, but the speed of that recovery remains uncertain. In the long term, there is confidence in a full recovery, though it may be delayed due to ongoing staffing challenges. We closely monitor our internal data, particularly how our customers are paying us. Our expectations for the latter half of the year are that we will not only collect what we bill but also recover some amounts that were temporarily extended to customers or cover shortfalls for specific reasons. We will continue to watch the situation closely, but while the timing of the recovery is still unknown, we remain optimistic that we will return to around 80% occupancy and assess the situation from there.

I just wanted to add Ryan. Yeah. Ryan, sorry, another add on to that, I don't think we've mentioned thus far would be the 90-day extension of the public health emergency, which has a favorable impact, not only in the three-day stay requirement, but similarly it has a more pronounced effect on reimbursement rates in certain states. And that kind of dovetails into the other point that I want to make, which is, certainly from our perspective we keep an eye on the macro national level data, not only from a broader industry perspective, but within our customer base, but increasingly meaningful is what happens within certain states as it relates to whether it's a public health emergency related provisions that each state might be supplementing or state-based reimbursement increases that we're seeing. So the operating environment is increasingly varied from state to state based upon the level of support supplementation that each state is providing. So, that of course factors into our calculus as well when we're assessing the health of our current customer base. And likewise to Mitra's question, looking out over the new business opportunities in the immediate future as well.

I understand. Ted, there was an article this morning about the proposed increase in nurse staffing ratios at nursing homes by CMS. Have you discussed this with your clients and what impact it might have on your business as well as theirs?

Yeah. I think there is so much uncertainty around proposed regulations that I think the industry, other than monitoring it closely and Matt alluded to it, there are so many state by state variances. We're always planning for different scenarios, but now that hasn't been a big topic of conversation among the customer base.

And I would like to sort of add to that Brian. Two things, the most obvious of which is, we don't provide nurses. So as far as the direct impact on us, it's non-existent. But the corollary to that would be that, generally speaking, with additional uncertainty and pressure that operators face, they're forced to look at being as efficient as possible, they're looking to contain their costs in any way that they possibly can. The primary way in which they are able to achieve that is in outsourcing services of all types, right? Including the types of services that we provide, so we've talked about the residents of our value proposition in the face of increasing uncertainty and perhaps potentially additional regulatory burdens, that does nothing but further increase the residents of our value proposition.

I appreciate it. And then last question from me, as we think about the revenue base shrinking here a little bit, at least near-term, right? And I appreciate the gross margin targets, but how should we be thinking about your ability to reduce G&A to adjust to the shrinking top line?

Yeah, it's a great question, Brian. And the reality is that, there is largely fixed cost in G&A. So from our perspective, when we exit a new piece of business the primary objective is to be able to re-assign the facility-based manager to a new opportunity as quickly as possible. Whether that's an existing piece of business where we have the opportunity to upgrade perhaps an underperforming manager or if it's repurposing that manager into a new business opportunity, but from our perspective, if you think about SG&A, we've talked about 8.5% to 9.5% on a percentage basis as we're looking at exiting some of that business and the corresponding impact on revenue. The way to think about SG&A is probably in that $37 million to $39 million range, which obviously on a percentage basis with some of the revenue reduction is going to be on the higher end. But we have every confidence that when we get back into growth mode there are certainly opportunities for leverage there on the SG&A line.

Got it. All right, thanks guys.

And there are no further questions at this time. Mr. Ted Wahl I turn the call back over to you for some closing remarks.

Okay, great. Thank you, Rob. In the quarter ahead we will continue to prioritize modifying our service agreements to adjust for the significant inflation experienced during the past year, as well as account for future inflation on a more real-time basis, with the goal of exiting the year with cost of services in line with our historical target of 86%. Increasing cash collections with the goal of collecting what we bill and making up a portion of the shortfall from the first half of the year and of course operational execution with the goal of delivering on our operational imperative as we provide an extraordinary service and experience to our customers. So on behalf of Matt and all of us at Healthcare Services Group, I wanted to thank Rob for hosting the call today. And again, thank you to all of you for joining.

This concludes today's conference call. You may now disconnect.