Healthcare Services Group Inc Q3 FY2022 Earnings Call

Good morning. My name is Chris and I will be your conference operator today. At this time, I’d like to welcome everyone to the HCSG 2022 third quarter earnings 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. If you’d like to ask a question during this time, simply press star then the number one on your telephone keypad. To withdraw your question, please press star, one again. Thank you. Ted Wahl, President and Chief Executive Officer, you may begin.

Thank you Chris, and good morning everyone. Matt McKee and I appreciate you joining us today. We released our third quarter results this morning and plan on filing our 10-Q by the end of the week. Our third quarter results reflect the ongoing and expected choppiness that we referenced during our second quarter call, and while we have conviction in our ability to manage the controllable components of our business, namely customer satisfaction, systems adherence, regulatory compliance, and budget discipline, we are also realistic about the ongoing challenges that remain within our industry and the broader economy. During the quarter, we successfully executed on our strategy to more favorably position our customer partnerships and agreements. We are confident that this work will yield improved results in the fourth quarter and remain on track to meet our goal of exiting the year with cost of services in line with our historical target of 86%. We will continue to adjust, adapt and aim to deliver optimal results in a way that maintains the quality and integrity of our existing partnerships and opportunistically explores future growth. With those introductory comments, I’ll turn the call over to Matt for a more detailed discussion on our Q3 results.

Thanks Ted, and good morning everyone. Revenue for the quarter was reported at $415.8 million with housekeeping and laundry and dining and nutrition segment revenues of $197.2 million and $218.6 million respectively. As previously disclosed, the third quarter results were impacted by contract modification actions taken by the company resulting in a one-time reduction of approximately $9 million of revenue, and that compares to the previously estimated $17 million and also $9 million in operating income reduction. Housekeeping and laundry and dining and nutrition segment margins were 8.9% and negative 0.2% respectively. Segment margins were impacted by the aforementioned contract modification actions. Direct cost of services was reported at $376.9 million or 90.9%, and cost of services was impacted by a $7.6 million increase in AR reserves primarily related to the $16.2 million increase in aged accounts receivable and the impact that has on the calculation of CECL AR reserves. The majority of the aged AR relates to actions taken as a part of our contract modification work, and as Ted highlighted in his opening remarks, we remain on track to meet our goal of exiting the year with cost of services in line with our historical target of 86%. SG&A was reported at $37 million. After adjusting for the $1.2 million decrease in deferred compensation, actual SG&A was $35.8 million or 8.6%, and we expect 2022 SG&A between 8.5% to 9.5%. Cash used in operations for the quarter was $9.9 million and was impacted by a $16.2 million increase in accounts receivable. As I referenced earlier, the majority of this increase in aged accounts receivable relates to actions taken by the company as part of our contract modification work. Cash used in operations was also impacted by a $15.7 million decrease in accrued payroll. DSO for the quarter was 76 days. Our Q4 cash flow will be impacted by the increase in payroll accrual from six days in Q3 to 15 days in Q4, but that will be offset in part by the $24 million second and final installment of the CARES Act deferred payroll tax repayment. We’re pleased with the ongoing strength of our balance sheet and the ability to support the business while continuing to return capital to HCSG shareholders. We announced that the board of directors approved an increase in the dividend to $0.215 per share payable on December 22, 2022. The cash balance is supported and with the dividend tax rate in place for the foreseeable future, the cash dividend program continues to be the most tax efficient way to return capital to shareholders. This will mark the 78th consecutive cash dividend payment since the program was instituted in 2003 and the 77th consecutive quarterly increase - that’s now a 20-year period that’s included four three-for-two stock splits. With those opening remarks, we’d now like to open up the call for questions.

Our first question is from Andy Wittmann with Baird. Your line is open.

Good morning, everyone. I appreciate you taking my question today. Ted, I wanted to begin with your comments on gross margins. You have consistently expressed your commitment to reaching an 86% exit rate for the year. It's been a few quarters since you've been making contract modifications and engaging in those discussions, and it seems that even if you account for the receivable write-off this quarter, you might still be looking at around 300 basis points sequentially for the fourth quarter. I understand you plan to end the year with this target in mind, so while it may not exactly hit 86 in the fourth quarter, it feels like there is substantial work ahead. My question is, what gives you confidence in achieving that target, and what changes do you anticipate in the next three months to help reach that goal?

Yes, well I guess, you referenced Q4 and without having a crystal ball for Q4, it absolutely is not our expectation that it would print at that 86%. I think we’ve been clear, hopefully clear, Andy, that that’s really a Q1 target, which is why we focused and have tried to orient everyone around our goal of exiting the year at that run rate without the impact being reflected in Q4. The strategy that we’ve had with a lot of these negotiations, for a variety of reasons, are really that they’re more back-end loaded, and again we won’t begin to realize the benefits of that from a P&L perspective until Q1 of ’23, so that, I think, is the first point I’d want to make. To your point, we’ve done an extraordinary amount of work over the past year in modifying our contracts, and it’s a goal that we’ve very aggressively pursued during the third quarter and we’re going to continue to pursue in the fourth quarter. I will say that after Q4, we’re confident that the initiative phase of the contract modification work is going to be behind us, but the emphasis on capturing recent and future inflation on a more real-time basis is going to continue to be an area of focus and an opportunity of ours going forward. But again, based on the work we’ve either completed, Andy, or expect to complete before the end of the year, we are as resolute as we possibly could be about meeting our goal of exiting the year with cost of services in line with that target.

Okay. To achieve that, how much more work is needed? In your forecast for this quarter, you expected to exit several contracts, but you didn’t exit as many as anticipated. Should we be considering anything else regarding the revenue run rate from the remaining work to be done before year-end? Also, could you provide guidance on what that run rate might look like, similar to how you did last quarter?

Yes, I believe there are many factors at play regarding the timing of the contract modifications, which, as I mentioned earlier, are primarily back-end loaded. For Q4, after adjusting for the one-time revenue reduction in Q1 and considering the potential new business additions in Q4, alongside the business additions from Q3 and the offsets from exits, we estimate that Q4 will be between 420 and 430.

Great guys, I’ll yield the floor. Thanks a lot.

Great, thanks Andy.

Our next question is from Sean Dodge with RBC Capital Markets. Your line is open.

Thanks, good morning. Maybe starting with the contract modifications in the quarter, Matt, you mentioned those being a little bit less than you all had initially anticipated. Can you just give us a little bit more detail on maybe why that was?

Yes, really that was just the accounting treatment, Sean. There was that initial assessment in which we thought there would be the $17 million one-time impact on revenue with the corresponding $9 million reduction in operating income, and after several reviews internally and leveraging external partners and consultants, it was determined that the appropriate treatment was the $9 million reduction, one time in nature in both revenue and operating income.

Okay, that’s helpful, thank you. You’ve been doing a lot of work on the contract modifications. I guess if we set all of that aside and maybe take a step back, what’s the backdrop like now for hourly labor? Have things started to ease up there, or does that still remain challenging?

It’s a little bit of both, Sean. It remains a challenge, there’s no doubt about that, but we’ve seen ongoing stabilization with modest improvement, bearing in mind this is very much a market to market dynamic. While wage growth remains high relative certainly to historical norms, the pace of that growth has continued to slow since about March or so, and there’s been modest incremental increase in the overall nursing home workforce, which is a good thing, but we still remain near a 30-year low, and that’s just for the industry in general. As for HCSG more specifically, we noted on the last call some of the positive signs in our hiring and retention, and we’re approaching the point at which we feel comfortable calling them trends. We’ve seen a nice rise in application rates and a tailing off of the terminations and separations, and most importantly and from our perspective is a notable decrease in the number of open job postings, so it remains a challenge but we’re definitely starting to see improvement.

Okay, great. Thanks again.

The next question is from Ryan Daniels with William Blair. Your line is open.

Hey guys, this is Jack on for Ryan Daniels. Just for a point of clarification, you were expecting a one-time negative revenue impact this quarter of about $17 million, but instead it came in at $9 million, correct? So if I am thinking about this correctly, it’s still above your estimated range for last quarter modestly. Can you just comment on what kind of drove this revenue outperformance? Is this more a factor of price increases, or just any additional color you have would be appreciated.

Yes Jack, the majority of the higher than expected revenue was related to, I guess, what I would describe as opportunistic new business additions, opportunistic in the sense that we were able to fairly seamlessly reassign our managers from the facilities that we exited in Q2 as part of that contract modification initiative, right into new business opportunities which certainly helped to offset the impact of those exits, so that was really the primary driver of it more than anything related specifically to the contract modification and the related billing increases, which as I mentioned earlier, we won’t really see until Q1 in earnest, the impact in Q1.

Thank you. As a follow-up, I see that accounts receivable has increased this quarter compared to the previous one, although it was impacted by the one-time factors you mentioned earlier. Additionally, days sales outstanding has increased by about 5 days. You previously mentioned that you were in a good position to collect on what you bill and potentially recover some cash collections in the second half. I'm trying to understand if you expect the cash collection impact to be more noticeable in the fourth quarter and into the first quarter of 2023, suggesting that this is mostly a timing issue that's been delayed. How should we approach this moving forward? Thank you.

Yes, to elaborate on your point, during the last quarter we discussed that the majority of the year-to-date shortfall, which is more than half, continued into Q3 and was largely due to more intentional negotiation as part of contract modifications. We have engaged with our customers to find mutually beneficial solutions for moving forward. Our goal last quarter was to recover part of that shortfall in Q3 and Q4, but that timing has changed to reflect more of a 2023 focus as we have recalibrated some repayment plans, including when they are set to begin. Regarding those repayment plans, many have resulted in promissory notes, which I want to highlight again, as they've always been a key part of our overall collections strategy. Promissory notes formalize outstanding indebtedness, are interest-bearing, and often include a security interest, providing us a position at the secured interest table even if it is subordinate to a senior secured lender. For these reasons, promissory notes have historically had a strong payment track record for our company. To date, alongside our contract modification efforts, we’ve generated over 20 million promissory notes, primarily in Q2 and Q3, and I expect that number to increase in Q4 as well. We will strive to recover as much as possible before the year ends, but it’s really in 2023 that many of the recent promissory notes and repayment agreements are set to begin.

Awesome, thank you guys.

Okay, thanks Jack.

The next question is from Mitra Ramgopal with Sidoti. Your line is open.

Yes, good morning, and thanks for taking the questions. First, I was just curious, as you bring on new business, if you already have personnel waiting to be deployed or are you running the business sort of at a lean state right now, that you’d have to go out and hire managers, etc.?

No, the good spot that we’re in, Mitra, relative to new business and onboarding new facilities is we’re back into that very localized effort in the sense that just as our management development efforts have always taken place locally, we want that to run in concert with our business development efforts, so there are certain geographies, of course, because the recruiting, training, development and ultimately retention of management candidates happens locally, there are some geographies that are further along that continuum right now than others. But generally speaking, we are equipped to opportunistically look out for growth opportunities, so management development, the availability of managers won’t be a drag on that, really, from our perspective when we think about growth. It remains that opportunistic selective assessment of the new business opportunities, given where we are with the industry landscape and some of the challenges that continue, namely with respect to the availability of labor and the impact that that’s had on census for clients and prospective clients.

Okay, thanks. Speaking of census, if you could just touch on the occupancy you’re seeing amongst your clients. Increasingly we’re hearing talk about a potential COVID surge in fourth quarter, new strains, etc. How do you see yourself positioned to deal with that, especially the nursing home industry?

The latest occupancy data is somewhat encouraging on an industry-wide basis, with the census gradually rising. Currently, national occupancy is around 75.2%. Our company is slightly above that by a few points. This 75.2% figure is about 1.2% higher than what we reported in Q2, equating to an increase of roughly 10 basis points per week throughout the quarter. If this trend continues, the industry could reach an occupancy rate of 80% by the end of 2023. While this is not a definitive target, it does provide a frame of reference compared to pre-pandemic levels. This projection does not account for any potential COVID surges or similar issues in Q4, and we haven’t heard any concerns from our clients regarding that. They are planning for various health scenarios, including flu and other infectious diseases, but no specific COVID-related issues have been highlighted. Moving forward, the key to long-term occupancy and overall industry recovery over the next 12 to 18 months will rely on staffing. The availability of labor is crucial for occupancy recovery, which in turn is vital for the industry's overall recovery.

Okay, thanks. That’s great. Then you might have mentioned this earlier, but if you could remind us in terms of the contract modifications, has it been completed or do you expect it to get done by year-end?

There are still a few loose ends in groups that we're addressing, but after the fourth quarter, this initiative phase will be behind us. The focus on capturing recent and future inflation, which has been the main driver of this initiative, will remain an area of focus and opportunity. However, regarding the initiative and our efforts to highlight the progress and timing of that progress during this call, it will be something that we move past.

Thanks, and then finally, I know the dividend obviously is a priority, but given where the stock’s trading, should we be looking also in terms of capital being used for share buybacks?

The buyback has always been a consideration for the board. In terms of capital allocation strategy, the dividend is a top priority and a significant part of that strategy, coming second only to organic growth and internal investment. The board will continue to assess capital allocation on a quarterly basis. Therefore, a buyback option could arise if the right situation or opportunity presents itself. For now, organic growth, internal investment, and the dividend remain the board's main priorities regarding capital allocation.

Okay, thanks again for taking the questions.

Great.

The next question is from Brian Tanquilut with Jefferies. Your line is open.

Hey, good morning guys. I guess my question is as we think about these contract modifications, right, it’s clear that you were focused on putting inflation adjustors in there, which we appreciate; but as we think about the health of the industry right now, how should we be thinking about potential client turnover or increases in bad debt as you roll out these new contract structures?

You know, Brian, as Ted alluded to, we’re through the majority of the work, not that the work will ever cease. It may shift from an initiative phase, but then it evolves very much into business as usual, and we think about the main levers in our contracts being pricing, contract structure, and payment terms, right, all of which are essentially open for negotiation at any point between the customers and ourselves. We feel fairly confident in that, and clearly we called out some facility exits in Q2 as a result of the directional result of negotiations with certain clients in the final stages here. That’s not to say that we wouldn’t potentially exit additional facilities, but as we sit here, we’re not anticipating that to be anything significant or meaningful. I would say that the experience that we had in Q3 that we talked about in very seamlessly replacing the business that we exited from Q2 into Q3, that we have a high level of confidence that should we need to exit facilities, we’d be able to very seamlessly repurpose those managers into new business opportunities as well, so not in any way looking to negate the possibility but confident in the fact that directionally, we’re feeling very positive about retaining the business partnerships. If there are instances as a result of these negotiations, or for any other reason, that we’re exiting business, it’s not something that we do cavalierly but we do retain that confidence that we would be able to replace that business.

That makes sense. I guess my second question, as I think about a potential economic slowdown here as we look at 2023, maybe you can remind us how the business fared during the last recession and how you’re preparing for a potential recession here as we enter 2023.

Yes, we are consistently monitoring the general economy. It's important to note that our industry has not fully recovered to pre-pandemic levels regarding workforce and occupancy. Interestingly, a slack labor market might actually enhance workforce availability during a recession, potentially benefiting occupancy rates, as having the right staff is crucial to meet the pent-up demand. Historically, our industry has shown resilience during past recessions, and our performance reflects that. However, given the unique circumstances of the post-pandemic landscape, the impact on the industry as we face a possible recession remains uncertain. Nevertheless, I believe that an economic slowdown could lead to an increase in available workers for our industry.

Got it, thanks guys.

Great, thanks.

We have no further questions at this time. I’ll turn it over to Mr. Wahl for any closing remarks.

Great, well thank you, Chris. In the quarter ahead, we will continue to prioritize contract modifications to capture both recent and 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%. We will prioritize cash collections with the goal of collecting what we bill, and we will prioritize operational execution with the goal of delivering on our operational imperatives of client satisfaction, systems adherence, regulatory compliance, and budget discipline. Above all, we remain committed to making decisions that best position us to deliver long-term shareholder value, so on behalf of Matt and all of us at Healthcare Services Group, I wanted to thank Chris for hosting the call today and thank you again to everyone for joining.

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.