Healthcare Services Group Inc Q1 FY2024 Earnings Call

Hello. Welcome to Healthcare Services Group 2024 First Quarter Earnings Conference Call. The matters discussed on today's conference call include forward-looking statements about the business prospects of Healthcare Services Group, Inc. For Healthcare Services Group Inc.'s most recent forward-looking statement notice, please refer to the press release issued this morning, which can be found on our website, www.hcsg.com. Actual results may differ materially from those expressed or implied as a result of various risks, uncertainties and important factors, including those discussed in the Risk Factors MD&A and other sections of the annual report on Form 10-K and the Healthcare Services Group Inc. other SEC filings. And as indicated in our most recent forward-looking statement notice, additionally, management will be discussing certain non-GAAP financial measures. A reconciliation of these items to U.S. GAAP can be found in this morning's press release. I'd now like to hand over the conference to the President and CEO, Ted Wahl; and Chief Communication Officer, Matt McKee. Please go ahead.

Thank you, and good morning, everyone. Matt McKee and I appreciate you joining us today. We released our first quarter results this morning and plan on filing our 10-Q by the end of the week. Today, in my opening remarks, I'll first discuss our Q1 financial highlights and key accomplishments, including the change healthcare disruption and the temporary impact it had on our customers, cash collections, and cash flow. I'll then share our perspective on the latest industry trends and developments. And then lastly, I'll provide an update on our Q2 priorities and outlook for the rest of the year. I'll then turn the call over to Matt for a more detailed discussion on the quarter. So with that overview, I'd like to now discuss our Q1 financial highlights and key accomplishments. Our team delivered strong first quarter results, building on our positive momentum in 2023. For the 3 months ended March 31, 2024, we reported revenue of $423.4 million in line with expectations. Net income and diluted EPS of $15.3 million and $0.21, adjusted net income and adjusted diluted EPS of $16.5 million and $0.22 and adjusted EBITDA of $28.9 million, a 10.7% increase over Q1 of 2023. During the quarter, we managed adjusted cost of services under 86% and continued to grow our new business and manager and training pipelines. We remain confident that we will deliver on our goal of year-over-year growth in 2024 with the majority of those new business adds expected in the second half of the year. On the cash collections front, Q1 has historically been our most challenging quarter, especially on the heels of Q4, which typically sees our strongest collections. The first quarter seasonality is anticipated and accounted for in our cash flow forecasting. However, what was unanticipated was the February Change Healthcare cyberattack. The resulting disruption had a far-reaching impact across the healthcare landscape and affected the claim submissions and billing activities of long-term and post-acute care providers, many of whom are HCSG customers. In spite of these first quarter headwinds, anticipated or otherwise, we achieved 95% cash collections and would have met our first quarter cash flow estimates, if not for the Change Healthcare issue. While this event was disruptive during the quarter, we are confident that the impact on our customers is temporary. We expect to make up for any cash collection delays in the months ahead, which is why we're reiterating our previously shared 2024 cash flow range of $40 million to $55 million. I'd like to now share our perspective on the latest industry trends and developments. Industry fundamentals continue to trend positively, highlighted by a slow but steady increase in workforce availability with the industry adding nearly 100,000 jobs since the beginning of 2023. At the current pace, the sector's workforce will match the 1.6 million pre-pandemic employee levels by the end of 2025. Rising occupancy, which now sits at 79%, is 12 points higher than the January 2021 low and just 1% under pre-pandemic levels, and a stable reimbursement environment, which includes CMS' recently proposed 4.1% increase in Medicare rates for fiscal year 2025, as well as continued positive reimbursement trends at the state level. Reimbursement rates are especially important at this stage of the recovery and helping to offset the increased cost of doing business driven by persistent inflation and the higher cost of capital. On the regulatory front, CMS published its final minimum staffing rule earlier this week. There is a growing list of stakeholders opposed to the rule, including healthcare industry leaders, trade associations like ACA, MedPAC members, and a bipartisan group of legislators, including nearly every R, and a growing number of these. The reasons for their opposition include the unfunded nature of the mandate, the one-size-fits-all approach, the apparent disregard for the realities of present and future nursing availability, and the near certainty that if implemented, the rule would lead to facility closures and ultimately reduce access to care, especially in rural areas. We believe it's highly likely the rule will not be implemented or will undergo significant revision during the extended phase-in period, especially given the inevitability of litigation and the potential for legislation or administration change. As far as our outlook for Q2 and the second half of 2024, our top 3 priorities continue to be as follows: the first is managing adjusted cost of services in line with our target of 86%. We do not take operational execution for granted but have full faith in the ability of our operators to deliver the services on budget. It took a considerable amount of work in 2022 to modify our contracts to better capture wage inflation and cost increases in our pricing on a closer to real-time basis. Those contract enhancements, along with recent positive trends in customer experience, systems adherence, regulatory compliance, and budget discipline provide strong operating momentum heading into the second quarter. We expect Q2 adjusted cost of services to be at or below 86%. Our second priority is delivering year-over-year growth by executing on our organic growth strategy through hiring, training and developing future management candidates, converting opportunities from our sales pipeline into new business adds, and retaining our existing facility business. We estimate a Q2 adjusted revenue range of $420 million to $430 million and remain confident that we will deliver on our goal of year-over-year growth in 2024, with the majority of those new business adds expected in the second half of the year. The third priority is collecting what we bill. We view cash collections as a lagging indicator of industry recovery. While our recent trends have improved compared to 2022 and the first half of 2023, and if not for the Change Healthcare disruption, we would have met our Q1 cash flow estimates. This remains an area of opportunity for the company in 2024. We continue to expect some choppiness throughout the year ahead but anticipate our cash collections gaining strength throughout 2024 and further still into 2025. We estimate a Q2 adjusted cash flow range of $5 million to $15 million and reiterate our previously shared 2024 adjusted cash flow range of $40 million to $55 million. As we round the turn of what has been a prolonged recovery for the industry, the company's underlying fundamentals are stronger than ever, and we remain focused on executing on our strategic priorities to drive growth and deliver meaningful shareholder value in the year ahead. So with those introductory comments, I'll turn the call over to Matt for a more detailed discussion on the quarter.

Thanks, Ted, and good morning, everyone. Revenue was $423.4 million, in line with the company's expectations of $420 million to $430 million. The company estimates Q2 revenue in the range of $420 million to $430 million. Housekeeping and Laundry and Dining & Nutrition segment revenues were $190.5 million and $232.9 million, respectively. Housekeeping & Laundry and Dining & Nutrition segment margins were 9.7% and 7.6%, respectively. Cost of services was $358.9 million. Adjusted cost of services was $357.3 million or 84.4%. The company's goal is to continue to manage adjusted cost of services in the 86% range. SG&A was $46.9 million. Adjusted SG&A was $42.8 million or 10.1%. The company's goal continues to be achieving adjusted SG&A in the 8.5% to 9.5% range. Net income and diluted earnings per share were $15.3 million and $0.21, respectively. Adjusted net income and adjusted diluted earnings per share were $16.5 million and $0.22, respectively. Adjusted EBITDA was $28.9 million or 6.8%. This is a 10.7% increase over Q1 of 2023. Q1 cash flow and adjusted cash flow used in operations were $26 million and $9.2 million, respectively. DSO for the quarter was 88 days. Also as part of our adjusted results, we adjust for the impact of the change in the payroll accrual, but since it will still be included in our reported cash flow from operations, we would point out that the Q2 payroll accrual is 15 days. That compares to the 8 days in the first quarter of 2024 and the 13 days that we had in Q2 of 2023. But again, the payroll accrual only relates to quarter-to-quarter timing. So with those opening remarks, we'd now like to open up the call for questions.

Our first question comes from Bill Sutherland from the Benchmark Company.

Nice print. Ted, can you comment on client retention in the quarter? I’m curious if you had to offset the exits and what the new adds were in the quarter?

From a retention perspective, Bill, our retention was greater than 90%, which is, as you know, our expectation is we're always aspiring for something greater than that, but we were in those levels and expect that to continue to trend along those lines. And from an adds perspective, again, modest adds, which offset some of the exits we had. But by and large, again, looking ahead, we expect to have additional facility adds and really begin to ramp up our new business additions in the second half of the year.

So the cadence would adds to expect would kind of build in the back half of the year as far as new adds?

Yes, we anticipate that the top line will remain similar to what it was from Q1 to Q2, and we expect to see some improvements in the second half of the year, which we will provide more details about in our next call.

Okay. And you adjusted SG&A at 10.1%, it's outside the range. Is there anything in particular there?

When we balanced our capital allocation strategy, we discussed making new and sustained investments focused on organic growth drivers, which we identified as a key aspect of our strategic shift. In Q1, we continued to invest in employee engagement and experience through a company-wide initiative aimed at improving retention and satisfaction among our employees. We've also increased our investments in marketing and branding positions, which we believe are vital for both external and internal stakeholders. Our objective is to transform this area from being neutral to a strength, alongside ongoing technology investments. Recently, we made facility-level investments in Chromebooks and tablets, especially in our dining department, and we intend to keep making these investments, as they are central to our organic growth strategy and key drivers for retention and customer satisfaction. Additionally, we've noticed some increases in travel and entertainment expenses related to overall activity and inflation. However, looking ahead, as we leverage our top line, we anticipate that SG&A as a percentage of revenue will realign with our target. We are committed to this target; it’s primarily a timing issue.

Next question comes from Sean Dodge from RBC Capital Markets.

Ted, you said cash collections in Q1, typically seasonally weak, but certainly impacted by the change outage. How much of a drag do you think change was in the quarter? Are there any bookends you can give us around some quantification there?

The change disruption affected about half of our customers in various ways. Depending on the strength of the relationships our clients had with change, as well as their claims and billing volumes, some were impacted more than others. Larger groups, particularly those with stronger back-office support, managed to mitigate some of the effects by processing manual claims. Most of the affected customers applied for CMS' accelerated and advanced payments program; however, we do not anticipate that additional funding to arrive until late April or early May. Overall, we estimate the difference between forecasted cash flow and adjusted cash flow to be between $12 million and $15 million directly related to the impact of the change. We were able to gather varying levels of detail and validation from some customers, but that is our estimated impact.

Okay. And then you said it should only be temporary in some of the supplemental help impacting kind of hitting later in April. Are you seeing any signs of collections elsewhere? I guess so far to date in April.

In April, we're pacing right on with what our forecast was for the month. So we're, again, confident that the impact, as you mentioned, as we touched on in our opening remarks is temporary and expect to make up for any delays in the months ahead, which, again, is why we reiterated that '24 adjusted cash flow range of $40 million to $55 million.

Okay. Great. And then on cost of sales, so adjusted was 84.4% so you continue to manage that very well. Is there anything else to call out there that's onetime or more transient than helping right now? Or do you think you can kind of continue to operate well within this 86% range?

Yes. I know I touched on it in my opening remarks, but the contract enhancements from 2022 certainly are a key factor in providing the durability and as we see it, the sustainability of our cost of services line, but most importantly, really, Sean, it's the positive trends we see in customer experience, system adherence, regulatory compliance, and budget discipline, which all the credit goes to our teammates that are leading the business in the field and their relationships with our customers and the impact they're able to have within the communities they're servicing. And that's really more than anything central to driving consistency of cost of services and ultimately, margins. So yes, we are very confident in our ability to continue to manage adjusted cost of services at or below 86%. You've seen before, Sean, there's always going to be some month-to-month and quarter-to-quarter movement depending on the timing of new business adds or even exits occasionally, management development investments can impact that even the business mix. But by and large, it's about execution and the consistency of that execution.

Our next question comes from Andy Wittmann from Baird.

Lots of questions on the SG&A. I'm going to add another one too, just for a little bit of a clarification. Ted, you talked about near term, you're making these investments and those make sense. You talked about getting back to your targeted level in some period of time. You didn't talk about how that happens. Does that require offsets in the cost structure to get there? Or do you think that it's just going to be leverage from the revenue growth that you're expecting in the second half and beyond?

Leveraging the fixed portion of our SG&A more than anything else, Sean. And I would also be remiss if I didn't point out that it's not a coincidence that we're seeing our cost of services performance improve, while our SG&A perhaps offsets a portion of that, but we're still benefiting from the improvement in our cost of services. And one does directly relate to the other.

Okay. That makes sense. Regarding the anticipated increase in organic growth for the second half, could you provide more detail? I'm particularly interested in whether one of your segments is expected to experience more growth than the others. Additionally, how confident are you that these contracts are already signed and just awaiting the transition? Any insights you can share about why you believe the second half will demonstrate this growth would be helpful for us.

Yes, Andy, this is Matt. I'll take this one. And we described last quarter the fact that our ramp back to growth will likely not be a clean linear sequential step-up, but directionally we expect ongoing revenue uptick and certainly year-over-year revenue growth. And realistically, we expect to onboard more new business in the back half, as we mentioned previously as compared to the first half. So that's sort of how we're thinking about it, having offered the revenue range expectation in Q2 of that $420 million to $430 million certainly suggests a first half compared to second half step-up in the back half of the year. We did onboard, as Ted mentioned, a modest amount of new business in Q1. But more importantly, we're in the midst of prospect discussions that will amount to more meaningful adds in the back half and the coming quarters even beyond that. So while we have improving visibility into the pipeline business that will convert likely this year, the timing of those adds obviously has an impact on our quarterly top line projections. So in as much as we lock in start dates and have a sense for increasing top line targets, we'll share those. But as it relates to the top line and Bill Sutherland asked about this, we'd be remiss if we didn't remind everyone that a component of top line growth is retaining our existing business. And as we sit here, we don't foresee any significant exits on the horizon, but it's worth reiterating that we're still in the final stages of an ongoing industry recovery. Changes in facility operations or ownership can alter our view on a piece of business. And we have to remain nimble if we believe that it's in our best interest, both in the near term and the long term to exit a client group about whom we might have concerns. But overall, Andy, net-net, we definitely have confidence in our ability to grow the top line year-over-year. The expectation would be that, that growth comes from not only greenfield housekeeping opportunities with new customers, but also the ongoing cross-sell of dining into the existing customer base. We talked last quarter about the benefits of that cross-sell in the sense that we've had an opportunity to really understand the intricacies from an operational perspective as to the dining operation within an existing piece of business, an existing facility with whom we partner on the Environmental Services side and we've established that track record of payment, which obviously, in this environment is more critical than ever. So we do expect that the primary driver of growth will be organic growth within the long-term and post-acute care segment, our primary segment. But we remain committed to the education space as well. And we're sort of in the tail end of what would be described as the selling season in the education space. So we'll probably have greater visibility into growth opportunities in that segment in the coming months here as well.

I appreciate the detail in your answer. My final question is about the minimum staffing requirement and how it will play out. Ted, this isn't a new topic; it's been discussed extensively for a long time. Now that it's finalized, I understand the challenges you've mentioned, including administration changes. What feedback are you receiving from your customers regarding their planning for this? How do they believe this will impact their interactions with you, their willingness to continue with your services, or their likelihood of signing up?

Yes, that's a great question. Broadly speaking, any uncertainty introduced into the industry or sector increases the demand for our services because we provide certainty. Certainty is central to our value proposition, offering peace of mind, cost certainty, and operational certainty. We aim to be a partner that allows operators to focus on what matters most to them, which is patient care. From that perspective, we believe it could impact demand for our services. However, more importantly, we believe that this rule will either not be implemented or will undergo significant changes during the phase-in period. The inevitability of litigation, growing political will for legislative action, and potential changes in administration all contribute to this view. Most in the provider community and industry stakeholders, ourselves included, do not take this rule seriously as a policy. The provider community has encountered genuine policy changes in the past, and this proposal seems far removed from what is feasible, as it is both outdated and unworkable. Mark Parkinson, the President of AHCA, has described it as a 20th-century solution to a 21st-century problem. One cannot help but view this rule with skepticism, especially in an election year, as it appears to be aimed at appeasing a specific constituency. There is a lack of funding, unavailable staff, and no plans to produce the necessary number of RNs. Therefore, we are confident that the rule will either not be implemented or will undergo significant modifications. I appreciate your question, and while it's interesting to consider, the numerous hurdles it faces make its implementation seem very unlikely at this stage.

Our next question comes from Ryan Daniels from William Blair.

This is Jack on for Ryan Daniels. Most of my questions have been asked already. But first, just back on the cash flow expectations. I appreciate that you're reaffirming the $40 million to $55 million cash flow range. And I think you said second quarter cash flow is expected between $0 million and $15 million. So I guess how should we think about this for the remainder of the year, though? Has the Change Healthcare makeup kind of included in the second quarter guidance? I guess I'm just trying to see if you expect to make up a good portion of the Change Healthcare impact in the second quarter. Maybe it sounds like it will trickle into the third quarter too. Hoping I'm on the right track there.

Yes, we previously indicated that cash flow for the second quarter would be between $5 million and $15 million. For the second half of the year, we anticipate a range of $40 million to $50 million. The recovery process is gradual, and we are actively planning and setting expectations with our customers to address the shortfall from the first quarter. This will be an ongoing effort, not just in the second quarter but throughout the remainder of the year, in a manner that will be determined later. Nevertheless, we reaffirm our expectation to meet our target range of $40 million to $55 million.

Okay. Understood. And then just a quick follow-up, too. I think it's been a few quarters since you discussed the Education segment. Just kind of curious if this is an opportunity for second half of 2024 and into 2025. Can you just kind of talk about your expectations here? And then are there any recent updates on the education front?

Yes. I would say we would certainly reiterate our commitment to the opportunity that exists in the education space. There is a bit of seasonality to that market with respect to selling and then obviously, the operations, which largely coincide with the academic year. So there'll be less of a first-half dynamic in the education space in the way that we're speaking about the growth opportunity that exists in our core market, the long-term and post-acute care at least in 2024. So we would view that as more of the longer-term linear growth opportunity. It still represents less than 5% of total company revenue. So with our firm commitment to the growth opportunity there with the compelling nature of the value proposition that we're able to offer in that space relative to the competitive environment, we do still feel very bullish about the opportunity that exists in the education space. So as that grows to be a more meaningful component of total company revenue, we would certainly begin to speak about that more specifically. But generally speaking, firm commitment and still very much a compelling opportunity.

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

This M.J. on for A.J. I would like to ask about whether there seems to be an industry expectation that there's going to be higher ownership turnover at least in the SNF industry year-over-year in '24. Does that propose a significant risk to any of the retention of your businesses? And how would the company think about quantifying that?

Yes. We've not yet seen sort of a significant step up in transactions within the space. Operator changes, ownership changes are certainly a normal course and expected component of our business. We deal with those very well. While theoretically, you're exactly right in the supposition that ownership changes would potentially put us at risk if there is an acquiring company that's coming into a facility that we currently operate, and they either are philosophically opposed to outsourcing or they choose not to specifically partner with Healthcare Services Group or from our perspective, we choose not to partner with them. So that is definitely where we're most at risk. Ted reiterated our expectation that 90% client retention year-over-year remains the target. That's inclusive of any ownership or operator changes. I would point really to the flip side in the sense that typically when there are those owner or operator changes, we're the beneficiary of those acquisitions, right? I mean we would like to think relative to the end market, we're partnering with most of the strongest operators. So those tend to be the folks who are expanding their holdings, expanding their portfolios and acquiring facilities. So assuming we've demonstrated the benefit of our partnership as they go along and increase their holdings, generally speaking, there's no guarantees or assurances but we're along for the ride, right? They recognize the benefits of our partnership when they're acquiring a facility, especially if it's a turnaround opportunity. The last thing they want to prioritize is remedying the environmental service departments or rightsizing the dining departments and getting their food spend under control, all of those issues, which they can very easily shift to Healthcare Services Group. So we would view any increase or uptick in a transactional environment to be beneficial for the company. But you’re correct that we have to work hard, and we have to maintain the business that we currently have through the possibility of ownership or operator transitions.

Great. Maybe just one follow-up. I know that you negotiated a lot of your contracts back in '22 to give it an annual inflation that's more tied to wage increases. Do you have a sense of what the underlying rate increases on the contracts are running? I assume it will be around maybe 3% to 5%? Is that the right way to think about it?

Yes. While the annual increase may not be significant, our goal was to address inflationary increases in food, supplies, and wages in a more timely manner. We made efforts to align with the parameters established in our dining agreements concerning food inflation, which are usually reflected and adjusted quarterly based on the consumer price index for food at home. For Q4, the food at home rate was 50 basis points, and we noticed a slight decrease to 40 basis points in Q1. This reflects the current situation. Additionally, we aimed to align our approach to wage inflation, which dropped from 1.5% in Q3 to 0.8% in Q4. There's a slight delay in the availability of this data, but that's the current state of affairs. We are observing a slowdown in inflation, or disinflation, and our objective is to pass these inflationary increases through as promptly as possible.

As of right now, we don't have any pending questions. I'd now like to hand back over to the President and CEO, Ted Wahl. Thank you.

Okay. Thank you, Ellie. It's an incredibly exciting time for the company as we're rounding the turn of what has been a prolonged recovery for the industry. The challenges we navigated the past few years have further solidified our value proposition, the durability of our business model and our market-leading position. The company's underlying fundamentals are stronger than ever and with the industry at the beginning of a multi-decade demographic tailwind, we are very favorably positioned to capitalize on the opportunities ahead and deliver meaningful long-term shareholder value. So on behalf of Matt and all of us at HCSG, I wanted to thank Ellie for hosting the call today, and thank you again to everyone for joining.

We'd like to thank everyone for attending today's call. We hope you have a wonderful day. Stay safe. You may now disconnect the discussion.