Earnings Call Transcript - HCSG Q1 2022

Operator, Operator

Good morning. My name is Chris and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Healthcare Services Group 2022 First 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. 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 the circumstances. As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances. Healthcare Services Group Inc.'s 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. Ted Wahl, President and Chief Executive Officer, you may begin.

Ted Wahl, President and CEO

Thank you, Chris, 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. Overall, I'm very pleased with our start to the year. More efficient labor management, specifically related to premium pay programs and overtime, along with the catch-up of food inflation pass-through increases and continued progress on our service agreement modification efforts, all contributed to improved financial outcomes in the quarter. We remain actively engaged with our customers to modify our service agreements to adjust for the extraordinary inflation experienced over the past year, as well as account for future inflation on a more real-time basis. We expect these service agreement modifications to be completed by the end of Q2, with the goal of exiting the year with cost of services in line with our historical target of 86%. Looking ahead while the industry continues to face workforce availability, inflation and supply chain challenges, we are encouraged by the most recent positive facility census trends. We remain confident in our ability to execute on our near-term objectives, and the long-term growth outlook for the company remains as strong as ever, given the increasing resonance of our value proposition and the attractive demographics. So with those introductory comments, I'll turn the call over to Matt for a more detailed discussion on the quarter.

Matt McKee, CFO

Thank you, Ted, and good morning, everyone. Revenue for the quarter was $426.8 million with housekeeping and laundry and dining and nutrition segment revenues of $201.7 million and $225.1 million respectively. Direct cost of services was reported at $373.3 million or 87.5% as the company continues to be impacted by increases in labor and supply costs. Again, we expect the service agreement modifications that Ted alluded to in his opening remarks to be completed throughout the first half of 2022, with the goal of exiting the year with cost of services in line with our historical target of 86%. Housekeeping and laundry and dining and nutrition segment margins were 10.1% and 4.2% respectively. Selling, general and administrative was reported at $35.7 million, but after adjusting for the $3.8 million decrease in deferred compensation, actual SG&A was $39.5 million, and the company expects 2022 SG&A to approximate 8.5% to 9.5%. Investment and other income for the quarter was reported as a $2 million expense; after adjusting, though, for that $3.8 million decrease in deferred compensation, actual investment income was $1.8 million. That includes a one-time $1.6 million mark-to-market adjustment of a previously recorded long-term liability, and its normalized investment income was $200,000. The company reported an effective tax rate of 28.2% due to discrete items that impacted the Q1 rate and expects a 2022 tax rate of 24% to 26%. Net income for the quarter came in at $11.3 million and earnings were $0.15 per share. Cash outflow from operations for the quarter was $30.2 million and was impacted by a $27.2 million increase in accounts receivable, primarily related to the timing of cash collections, and a $24.9 million increase in accrued payroll; DSO for the quarter was 68 days. I'll also point out that the Q2 2022 payroll accrual will be 12 days, which compares to 11 days in the prior year period of Q2 2021. Just for additional reference, in Q1 and '22, the payroll accrual was five days, and in Q1 of 2021, it was four days. Again, that payroll accrual relates only to timing, and the impact ultimately washes out throughout the full year. We're pleased with the ongoing strength of the balance sheet and the ability to support the business while continuing to return capital to our HCSG shareholders. We announced that the board of directors approved an increase in the dividend to $0.2125 per share, payable on June 24, 2022. The cash balance is supportive, 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 get free cash flow and ultimately maximize return to shareholders. This will mark the 76th consecutive cash dividend payment since the program was instituted in 2003 and the 75th consecutive quarterly increase. That's now a 19-year period that has included four three-for-two stock splits. So with those opening remarks, we'd now like to open up the call for questions.

Operator, Operator

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

Andy Wittmann, Analyst

Good morning. Thank you for taking my question. My first question is regarding the service contract discussions. Ted, could you provide an update on the progress you've made in modifying the percentage of contracts as of the end of the first quarter and where things stand today? This would help us understand the clear path ahead and how much is left to accomplish. There are evident results on your margins, and this information would be useful in assessing where your margins might end up after all of this. I know you've provided guidance, but I'm trying to understand how it plays into the overall picture.

Ted Wahl, President and CEO

Right. And just for some context, Steven, Andy, before that update, I think it will help add some perspective to the answer to your question. I think from a margin improvement perspective, we were about 2% better in Q1 than we were in Q4. Only about a third of that related to the service agreement modification efforts. The balance of that was really the sunset of the Genesis pricing adjustments, as well as more efficient labor management on the base business over time and premium pay, and we can talk about that a bit more. For some perspective, only about a third of the improvement quarter-to-quarter actually related to the service agreement efforts, but overall, I guess to answer your question, we continue to make very good progress, and some what I alluded to was reflected in the Q1 results. As far as quantifying, I think we've touched and remain actively engaged with all of our customers around the inflation-related issues. The overwhelming majority of clients certainly recognize that the cost of doing business has increased, and they appreciate the value of the partnership. So as we've talked about before now, it's a matter of working collaboratively to arrive at the right contract for the partnership and agree to a fair price for the services. But there's still more work to be done. There's no one-size-fits-all solution. It continues to be a bottoms-up client-by-client exercise, and rather than quantifying progress this quarter in terms of percentages, I would point to our goal of exiting the year with 86% cost of services and updating the contracts by the middle of the year. Andy, I can say we are on pace to meet both of those goals.

Andy Wittmann, Analyst

Got it. Okay. And then just maybe a couple more technical questions, I guess, for Matt. Was there anything in the quarter that was more one-time in nature in terms of being able to get reimbursed for maybe some of the overtime or other things that improved the gross margin in the quarter? Also, could you just talk about the revenue contribution from your acquisition in the educational food services for the quarter? So maybe we could back into an organic growth rate, and was there any stock we purchased in the quarter? Thanks.

Matt McKee, CFO

There was no stock repurchase, Andy, just to start with the last question first. As to sort of one-time impacts on margin for the quarter, I would say the answer to that is no. Really, as Ted alluded to, there was a sort of confluence of operational benefits that came by way of more efficiently managing the labor and being able to have a positive impact on the utilization of overtime dollars and drive down some of the incremental spend related to some of those other premium pay type programs. We wouldn't sort of call those out as one-time in nature per se, but I would say outside of that, it really comes down on a go-forward basis to continuing to effectively manage our costs, namely and primarily the labor management and the associated costs via payroll-related expenses. Likewise, continuing to manage our purchasing and supply programs and capturing those increases adequately via the path-through mechanism in the contract. As to the revenue contribution of the small food service company that we acquired in the fourth quarter, it was about $3 million from a revenue perspective in Q1.

Andy Wittmann, Analyst

Great. Thanks, guys, for your answers. Have a good day.

Matt McKee, CFO

Thanks, you too.

Operator, Operator

Our next question is from Tao Qiu with Stifel. Your line is open.

Tao Qiu, Analyst

Good morning, guys. So just to expand on the earlier question about one-time items, if you look at the dining margin, certainly snapshot pretty quickly and we look at the direct cost of services, you achieve 87% this quarter, which is kind of above the end of the year target of 86%. Just trying to see if you guys can quantify the impact of showing up a food cost from prior quarters this quarter. And are there any benefits from supplemental billing revenue this quarter?

Matt McKee, CFO

Would you repeat the last part of your question, Tao?

Tao Qiu, Analyst

I'm trying to understand how the adjustment in food costs from previous quarters has affected this quarter. What is the amount for this quarter, and did you experience any benefits from the supplemental billing revenue during this period?

Matt McKee, CFO

Got it. So with respect to supplemental billing revenue, no benefit in terms of kind of historical what we've seen during COVID with specific premium pay-related programs being funded by the client. Our employees were arm in arm with the client's employees, so those programs had really run off in full by the end of last year. Specifically to the food inflation question, I'd say the benefit that we saw this quarter was the Q3 inflation. If you recall, the third quarter CPI increases are processed administratively and reflected in Q1. So Q3 and Q1 more closely mirrored one another than say Q2 and Q4 did. We didn't have as much of a delta. Now, we have seen continued acceleration of inflation, both in labor as well as food. I think this past quarter, we saw nearly 3% on the labor side of the business and upwards of 4% on the food side. So that should create or will create another delta next quarter between actual food inflation and what we're being reimbursed for. But again, over time, that will catch up and ultimately when inflation stabilizes, it'll turn into a temporary benefit. The idea is not to have intra-quarter variances with respect to the timing of inflation and the reimbursement or payment through the CPI mechanism; it's to have those two more closely mirror one another going forward.

Tao Qiu, Analyst

Got you. Just to clarify, so you're saying because of the two-quarter lag, right? So for the next quarter, you'll probably see a positive delta because of the higher food inflation during the fourth quarter versus, yeah.

Matt McKee, CFO

Yeah, and I'm glad you clarified, we'll actually see a negative delta because, yes, exactly, exactly because we would anticipate that Q2 inflation will be greater than what we experienced in Q4, which is what we would be being reimbursed or paid for via the CPI food at home mechanism.

Tao Qiu, Analyst

Got you. That's helpful. Regarding the DSO, it's 68 days; it's what is up from the prior quarter? And you mentioned that it's mostly due to timing of collection, just wondering, are you guys seeing on the ground in terms of operators' ability to pay and maybe their financial health? Any comment regarding the status of the industry, particularly when you consider the revenue hit they're going to see coming over with PDPM adjustments, sounds like they're not getting additional Medicare increases while expenses still growing pretty fast. Any comment or color on that would be much appreciated. Thank you.

Matt McKee, CFO

Yeah. Specifically to your question, Tao, we haven't seen anything I'd say systematic at this point. There are always facilities or specific client groups that we're in repayment or workout discussions with, but in light of some of the potential reimbursement pressures that are on the community and the regulatory environment that has turned into a political football again, we haven't seen that manifest itself in client payments. I know when you look at the first quarter, there certainly was a shortfall relative to our goal of collecting what we bill. That continues to be our expectation to meet that goal for Q2 and the rest of the year. We did, as you pointed out, highlight that Q1 was primarily related to timing. You have this seasonal element of collections in Q1, as well, where you have the tension of Q4 compared to Q1, where we tend to have higher cash collections and some clients make up for shortfalls they had earlier in the year. To the extent we haven't already caught up on payment, we're going to continue working with those clients, which the vast majority of whom we collaborated with and were aware coming into those final weekly payments or biweekly payments. In some cases, they were still monthly payers. There was going to be a shortfall for the month. Assuming we meet our cash collection goals, we'd expect Q2 cash flow to return back to a favorable $30 million to $35 million type range and expect to continue to meet those collecting what we billed goals for the rest of the year.

Tao Qiu, Analyst

Got you. Thank you.

Operator, Operator

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

Thomas Conlin, Analyst

Hey, good morning. This is Thomas Conlin on for Sean. Thanks for taking the questions. So starting off on the Genesis contract, the pricing modifications that were kind of sunsetted at the end of the year, can you confirm how much of that contributed to Q1 revenue and EPS, I guess, relative to Q4, and was there any upside to the previous pricing or did it kind of revert back to the previous rate?

Matt McKee, CFO

Yeah, so as to Genesis, Thomas, the sunsetting of those pricing adjustments contributed about $2.5 million in Q1. As to the balance of the adjustments with respect to the accounts receivable, we're still on track to be able to have those modifications reduced throughout this year, and they ultimately sunset at the end of 2022. On the topic of Genesis, it's worth noting that when we talk about the bucket of all of our customers with whom we're having conversations about having the right contract structure and fair pricing going forward, Genesis is included in that as well. So we feel comfortable about the sun setting, if you will, of the adjustments we made with Genesis that were agreed upon in 2021, but all the same, we need to make sure that on a go-forward basis, we have the right contract structure and fair pricing in place as well.

Thomas Conlin, Analyst

Okay. That's helpful. Thanks. And then I guess with the plan in place for getting the cost of sales back in order, where are you now on new manager development? Are you back out recruiting and training again? And I guess, what are your thoughts around when you might start adding new facilities again?

Matt McKee, CFO

I would say that without a doubt that priority, and this is really company-wide for Q2, is to make sure that we're doing all of the work necessary to adjust those service agreements and contracts with each and every one of our customers to be able to adequately capture costs as we've discussed, and to make sure that the contract structure on a go-forward basis is favorable and durable as well. Outside of that though, there is a significant focus on management development efforts, and as we've discussed in prior quarters, we are still in the midst of a pandemic or at a minimum, the consequences that have come as a result of the pandemic and COVID in the facility. Making sure we have adequate management capacity to manage the business from an operational perspective and compliance perspective is first and foremost. Then, of course, beyond that, the recruiting, the management training, and development efforts are certainly in service of business development efforts. We're at varying places from a development perspective geographically and based upon the local conditions. When we look at the pipeline of new business opportunities, as we've mentioned previously, our value proposition resonates today greater than it ever has, and the queue of opportunities is significant. We are excited about that ongoing management development and very optimistic that before long we'll have the opportunity to translate that into business development opportunities.

Thomas Conlin, Analyst

Okay, great. That's all for me. Thanks, guys.

Operator, Operator

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

Mitra Ramgopal, Analyst

Yes. Good morning. Thanks for taking the questions. I actually just wanted to follow up on the previous question in terms of management. Are you having greater challenges in terms of retaining especially the senior level, given the tight labor market and opportunities out there?

Matt McKee, CFO

I would say, Mitra, I wouldn't want to sort of deflect and suggest that it's ever easy. Right. We always have to work hard and actively engage with our employees throughout the continuum from the line staff levels up through senior management to make sure that we're actively engaged with them, that they buy into the company's purpose and vision, and that the values that we've established as an organization continue to resonate. But I would say that in spite of the challenges of the labor market, we've had tremendous success in retaining our managers, and that applies not only in the senior management ranks but likewise down through the facility levels. We definitely credit the significant dependence upon and referral to our company values, the purpose and the vision that we've established, and in support of all of those would be the employee engagement programs we've implemented. Those touch again throughout the continuum of employees from senior management all the way down to the line staff level. So retention thankfully has not been as significant a challenge as has been filling new vacancies specifically down at the line staff levels, and that's just based upon the availability of bodies in the labor force. Obviously these challenges are more acute in certain markets compared to others. But generally speaking, back to the crux of your question, Mitra, we are really pleased with the retention that we've had throughout the organization.

Mitra Ramgopal, Analyst

Thanks. That's great. I wanted to ask about the success you've had with nursing home operators and the price increases. Are you experiencing a lot of pushback regarding their occupancy or census being down? They need to find a way to cover the increased costs, right?

Matt McKee, CFO

Of course, Mitra. Anyone's going to push back when they're facing rising costs and they have a vendor partner asking for an increase in billing, and they're not seeing a corresponding increase in their revenue streams. That primarily in this environment relates to the reimbursement. Without a doubt, that's an element of the conversation, but the reality is, as Ted alluded to in one of his earlier comments, our customers recognize that the cost of running our business has increased. From the overwhelming majority of them, at least, they appreciate the value of our partnership and what it is that we bring to the table operationally. You have a conversation where it's very much cards on the table, and we can speak to true data and experience by way of those rising costs at the facility level with our customers. We remind them of the components of the value proposition and the benefits of the partnership. A significant way to do that is to paint the picture of what life looks like without healthcare services group. If we exit the partnership, number one, we take the manager with us. In what would very obviously be described as a challenging labor environment, that customer is going to have to identify, recruit, hire, train, and develop a manager to run the departments that we're exiting; hope that they can operate them anywhere nearly as efficiently as we do. They wouldn't have the additional company or managerial support and resources to be able to assist at the facility level, so a high likelihood that they would be facing deficiencies relative to what it is that healthcare services group was providing. Oh, and by the way, all of the line staff employees are going to go back on their payroll, and they're going to have to pay them market wages and increase their wages appropriately, whether that's inclusive of overtime hours or simply increasing their wages. Any cost increases that have been born by healthcare services group would ultimately flip back to the operator, and any monies that are owed to healthcare services group would be due upon exit of the relationship. When you paint that picture, you educate, and go through the process and talk through the value proposition, customers recognize that our costs are increasing, and it's only fair that we be kept whole. And Mitra, I would just add, so it doesn't get lost in kind of your question, your thinking on how are the clients reacting to this? The approach we took was novel to what many other companies, or many others in the industry would have done. It could have been criticized. Why are you incurring costs that are not being reimbursed by the client on a real-time basis? Why is it taking as long as it is to go through the process? Why can't you send a letter? Why can't you just shut off the lights and walk out the door? We decided early and often that wouldn't be in line with the purpose, vision, and values we were trying to establish. There is a different level of responsibility we have caring for this nation's most vulnerable population. We believe we stepped up during the most difficult time when inflation was rapidly increasing. We continued to provide the services, to do what is right. I don't think the two are mutually exclusive, doing the right thing is good for business. I believe from a client perspective, it enriched their appreciation of the conversations we're having now. That long-term view is in the best interest of the company and the organization, and I think we'll see the fruits of that labor in the months and years to come.

Mitra Ramgopal, Analyst

Thanks. I really appreciate the color. Thanks for taking the questions, guys.

Operator, Operator

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

Nick Spiekhout, Analyst

Hey guys, Nick Spiekhout for Ryan. Most of my questions have been asked, but I guess just kind of a follow-up to that last line. Have you had a decent amount of contracts renegotiated or because of these renegotiations or because of these new service agreement conversations at all, when you are receiving some moderate pushback?

Ted Wahl, President and CEO

We haven't at this point in time. Our expectation is that the vast majority of our clients recognize and appreciate that we'll be successful in delivering on our outcomes.

Nick Spiekhout, Analyst

So then when your comments on your goal to reach your goal by Q2, that goal is 100% of your outstanding contracts to have service agreements or be negotiated without losing any of them. That's kind of like your target.

Ted Wahl, President and CEO

Yeah. Our target is to be as successful as we possibly can at 100%, but we're also not going to, in an at-all-cost type of way, try to meet 100%. There has to be willing participation from both parties, and that word 'fair' needs to be the governing force of whatever contract modifications need to be made as well as what the pricing adjustment is. We have the utmost respect and appreciation for the position our clients are in, and we believe that it's in the best interest of everyone to move forward in a collaborative way and reach an agreement. So 100% is the goal, but not in an at-all-cost type of way to sacrifice the greater outcome that we're trying to achieve longer term, which is exiting the year at 86%, but also to set the company up for success in the future.

Nick Spiekhout, Analyst

Got you. Thanks. And then, I guess just on the positive facility census trends, are those still tracking through April positively as well?

Ted Wahl, President and CEO

Yeah. From an occupancy perspective, if you compare it to where we were in February, occupancy is up about 120 basis points from 72.5% to 73.6% or 73.7%, which is about 15 basis points a week over that eight-week period. That would put the industry on a pace to recover back to that 80% threshold or benchmark that has been set by January of '23. That is admittedly slower than the most desired pace, but if the trend were to continue, that would be something I think the industry would likely be able to work with. For context, before the Delta variant, the occupancy recovery rate was about 20 basis points a week between January and July of '21. The recent trends are favorable, but staffing levels, patient care staffing levels in particular, need to be sufficient to take full advantage of this rising demand.

Nick Spiekhout, Analyst

Okay, great. Thanks, guys. That's it for me.

Operator, Operator

The next question is from Bill Sutherland with The Benchmark Company. Your line is open.

Bill Sutherland, Analyst

Matt, good morning. That census trend that you're seeing, Ted, as it applies to where you guys have more density, your key markets, is it better, is the same? Do you see any weigh-ins that matter to you guys?

Ted Wahl, President and CEO

Nothing I'd say it's still too early to tell, Bill. Nothing noteworthy, and I wouldn't want to broad-brush it and say, well, on a relative basis, you see the same kind of trends between Texas and New York. Every state and locality has its own story. I would say since we're only at eight weeks, a couple months into these positive trends, I think though the trend is positive.

Bill Sutherland, Analyst

Okay. On the M&A front, is that sort of an opportunistic approach you would call it going forward? Are there other opportunities?

Ted Wahl, President and CEO

Very much so. I would say that we're not actively pursuing any opportunities. As you can imagine, there are plenty that are floated in our direction. As to the core market and the core services, the environmental services and dining and nutrition services within the long-term and post-acute care space, there are very few of those kind of pure-play opportunities available. When we think about the ancillary market and the adjacency that exists certainly in the education space, per the acquisition that we did in the fourth quarter of last year, there may be some additional opportunities there to explore. Not actively pursuing, but as always, open opportunistically.

Bill Sutherland, Analyst

I noticed in the 10-K you changed the language slightly in the competitive section to having national competitors. I think was there anything that sort of triggered that change in language?

Ted Wahl, President and CEO

Yeah, that was really just prompted by the fact that Aramark had done an acquisition of an operator that predominantly plays in the long-term and post-acute care space. It was just a little bit of a shift given that Aramark had made that acquisition.

Bill Sutherland, Analyst

Oh, I see. Okay. And then lastly, I'm trying to figure out the leads and lags here in your inflation impacts, Ted. So in the quarter just ended, labor was up about 3%, food for then, when do you feel just, if you wouldn't mind repeating the impact sort of flow through to HCSG?

Ted Wahl, President and CEO

Yeah. That's difficult to quantify because intra-quarter, there are different weights between states, and depending on the overall percentage increase, but the timing of that and how it ultimately flows through is a dynamic type of number. I'd be reluctant to try to quantify that in dollars in any given quarter. It's intended more to provide some directional insight into the type of inflation relative to some of the national benchmarks. When you look at CPI, when you look at BLS data, when you look at the food-at-home metrics that we base the majority of our food-related contract pricing adjustments off of, it was to provide context.

Bill Sutherland, Analyst

And so just from a timing perspective, then you will get a catch-up a quarter later. Is that why you should understand on?

Ted Wahl, President and CEO

On the food side, yes, we would get really a two-quarter lag. And that's exactly what we're working on with the majority of our clients as well on the labor side to have a similar type of mechanism. So inflation is adjusted in the places where we have fixed price contracts. Wage and labor-related inflation is adjusted on a more real-time basis as well. So that's the intention and part of the service agreement modification effort that we're undertaking.

Bill Sutherland, Analyst

And real-time would be realistically a one-quarter or so lag. Is that fair?

Ted Wahl, President and CEO

Yeah. That's fair.

Bill Sutherland, Analyst

Okay. Thanks, gentlemen. Have a good day.

Ted Wahl, President and CEO

Thank you.

Operator, Operator

We have no further questions at this time. I'll turn the call over to Ted Wahl for any closing remarks.

Ted Wahl, President and CEO

Okay. Thank you, Chris. In the quarter ahead, we'll continue to prioritize engaging with our customers to modify our service agreements to adjust for the inflation experience over the past year, as well as account for future inflation on a more real-time basis. We continue to expect the service agreements to be completed by the end of Q2, with the goal of exiting the year with cost of services in line with our historical target of 86%. We'll also continue to execute operationally with an eye towards opportunistic growth. Above all, we remain committed to making decisions that best position the company to deliver long-term shareholder value. On behalf of Matt and all of us at HCSG, I wanted to thank you, Chris, for hosting the call today and thank you again to everyone for participating.

Operator, Operator

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