Healthcare Services Group - Q2 2023

Transcript

Operator (participant)

Hello, my name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the HCSG 2023 Q2 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you'd like to ask a question during this time, simply press star, then one on your telephone keypad. To withdraw your question, please press star one again. 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 Healthcare Services Group, Inc.'s other SEC filings, and as indicated in our most recent forward-looking statements notice. Additionally, management will be discussing certain non-GAAP financial measures. A reconciliation of these items to US GAAP can be found in this morning's press release. Thank you. Ted Wahl, Chief Executive Officer, you may begin.

Ted Wahl (President and CEO)

Thank you, and good morning, everyone. Matt McKee and I appreciate you joining us today. We released our Q2 results this morning and plan on filing our 10-Q by the end of the week. For the three months ended June 30th, 2023, we reported revenue of $418.9 million, GAAP net income of $8.6 million, or $0.12 per share, and adjusted EBITDA of $26.3 million. Today, in my opening remarks, I'll discuss our Q2 key accomplishments, as well as our outlook for the back half of the year. I'll then turn the call over to Matt for a more detailed discussion on the quarter. Overall, we delivered strong service execution during the quarter.

Our KPIs related to customer experience, systems adherence, and regulatory compliance all trended positively in Q2, leading to high quality and consistent outcomes for our client partners. I'd now like to highlight our Q2 key accomplishments. The first accomplishment I'd like to highlight is our strong core earnings. For the third consecutive quarter, we achieved our direct cost target of 86%, excluding CECL. We managed SG&A within our targeted range, and we delivered adjusted EBITDA of $26.3 million. The second key accomplishment I'd like to highlight is collecting what we billed in May and June. This achievement came on the heels of falling short of our April cash collections target as our clients braced for the May 11th expiration of the Public Health Emergency.

Although we did not meet our quarterly cash collection objectives, the results we delivered in May and June provide us with positive momentum heading into Q3 and positions us well for a strong back half of the year. Lastly, I'd like to highlight the continued progress we made in replenishing our new business pipeline during the H1 of the year as we continue to have a growing pipeline of future client partners heading into the back half of 2023 and 2024. While the timing of new business ads remains dynamic, we are planning for a sequential top-line growth in the H2 of the year compared to the H1 of the year, and estimate a Q3 revenue range of $420 million-$430 million.

Looking ahead, industry fundamentals continue to improve. A stabilizing labor market and select state-based reimbursement increases have contributed to the gradual but steady occupancy recovery. While there remains uncertainty as to what a minimum staffing requirement might look like for the industry, we remain hopeful that CMS will fully consider the impact on operators before finalizing a rule and have confidence in our customers' ability to manage any such rule. We enter the H2 of the year with three clear priorities. The first is continuing to manage direct costs at 86%, excluding CECL. The second is collecting what we bill, building on the strong momentum gained in May and June. The third, and perhaps the most impactful, is the realization of our business development efforts yielding new facility starts.

There is a high level of internal enthusiasm as we pivot to growth mode through the back half of 2023 and into 2024. With those introductory comments, I'll turn the call over to Matt for a more detailed discussion on our Q2 results.

Matt McKee (Chief Communications Officer)

Thanks, Ted. Good morning, everyone. Revenue for the quarter was reported at $418.9 million, with housekeeping and laundry and dining and nutrition segment revenues of $190.8 million and $228.1 million, respectively. Housekeeping and laundry and dining and nutrition segment margins were 8.7% and 5.5%, respectively. Direct cost of services was reported at $367.7 million, or 87.8%. Direct costs included an $11.3 million increase in our CECL AR reserves. As Ted mentioned in his opening remarks, we again met our goal of managing the business with cost of services in line with our historical target of 86%, excluding CECL. SG&A was reported at $41.4 million.

After adjusting for the $2.3 million increase in deferred compensation, actual SG&A was $39.1 million, or 9.3%. We expect 2023 SG&A between 8.5%-9.5%. The effective tax rate was 24.6%, and the company expects a 2023 tax rate of 24%-26%. Cash flow from operations for the quarter was $7.4 million and was impacted by an $18.8 million increase in accrued payroll and a $39 million increase in accounts receivable related to the timing of cash collections. DSO for the quarter was 83 days. We would point out that the Q3 payroll accrual will be seven days.

That compares to the 13 days that we had in the Q2 of 2023, and the six days that we had in the Q3 of 2022. The payroll accrual only relates to timing, and the impact ultimately washes out through the full year. With those opening remarks, we'd now like to open up the call for questions.

Operator (participant)

Thank you. As a reminder, if you would like to ask a question, please press star, then one on your telephone keypad. Our first question is from Sean Dodge with RBC Capital Markets. Your line is open.

Sean Dodge (Managing Director Equity Research)

Thanks. Good morning. Ted, I just want to start with your comments around collections, tough in April, but sounds like improved in May and June. I guess, you know, post the close of the quarter, are there any big outstanding balances you've now collected that kind of helped true some of this up? Maybe just kind of give us a sense of DSOs for 83 in the Q2. You know, are those going to be able to come down as we go through the balance of the year?

Ted Wahl (President and CEO)

Yeah, it's a great question, Sean. You know, we've talked about DSO before in this forum and other forums. DSO, for us, we view more as a byproduct of executing our collection strategies than a, you know, an indicator as to our success. Obviously, it's something we consider and we focus on. You know, we do view each and every account holistically in terms of our assessments. I think to your question, specifically, if we're going to be recapturing specifically, the April delayed payments. I can tell you, we are actively working with our customers on finalizing plans, including in the form of promissory notes, to make up some of that April shortfall in the coming months.

The timing is TBD on that, but we are actively engaged on repayment plans, which could be a nice cash flow tailwind for the back half of the year. You know, beyond that, our goal remains to collect what we bill in the quarter ahead, and we're going to continue to focus on increasing payment frequency, proactively using and utilizing promissory notes, and then remaining disciplined in our decision-making for both new customers as well as existing business. You know, again, it's we did not meet our objective in April, but the momentum we gained in May and June, and what we've seen July to date, has really been positive, and we feel good about the back half of the year from a collection standpoint.

Sean Dodge (Managing Director Equity Research)

Okay, great. If we look at cost of sales and adjust out the CECL reserves, through the first two quarters, you've actually been able to manage that closer to 85%. With your comment that you're continuing to target 86% for the full year, is that just a function of the investments you're making around kind of staffing up and positioning now for growth, or is there something else that's happening there that we should expect kind of the core cost of sales, again, excluding CECL, to kind of increase over the course of the year?

Ted Wahl (President and CEO)

Yeah. At or below 86%, Sean, to your point, is the target. You know, we exited the year with the 86% run rate. Third consecutive quarter now that we've been able to, ex-CECL, deliver on that, on that target. To your point, it's accounting for, of course, execution risk, which is always a consideration, but growth. You know, when we factor in growth the back half of the year, that's always going to have a negative temporary impact on cost of sales. You know as well as anyone, when we start a new piece of business, we're inheriting the existing payrolls, we're inheriting the supply budgets. Typically, there's a degree of margin compression as we work to implement our systems and staffing patterns over the first 60 to 90 days.

I think that'll be viewed and should be viewed as a positive as we head into the H2 of the year, because we are expecting and have pivoted already to growth mode going into the H2 of 2023.

Sean Dodge (Managing Director Equity Research)

Okay, that's great. Thanks again.

Operator (participant)

The next question is from Andy Whitman with Baird. Your line is open.

Andy Whitman (Senior Research Analyst)

Good morning, guys, and thanks for taking my question. I guess, Ted, I wanted to ask about the new business pipeline here somewhat. You know, over the years, the challenge for you has been keeping facility managers in your training program, and having those people ready to go when you're ready to launch new facilities. I guess in the last two years, I haven't been asking about the strengths and the performance and the amount of people you've got in this training program. Given that you're talking more confidently about growth now, I thought it'd be worth talking to you and having you talk about how you're able to hire for those positions, the fullness of that training pipeline, and if you're ready to go should some of your customers decide to turn on the switch for Healthcare Services Group.

Matt McKee (Chief Communications Officer)

Yeah. Andy, I'll address that. This is Matt. I'm glad you asked about this, and I think we touched on this component of our growth trajectory a bit last quarter. To dive in a little bit deeper, you're exactly right. You know, one of the major contingencies of our ability to grow historically has always been overall, our management capacity, but more specifically, having the appropriate number of managers working through the queue in our management training program. You know, our compelling pitch, if you will, or the employee-based value proposition historically has been that one is able to grow one's career with Healthcare Services Group, that as the company grows, one has the opportunity to develop one's own career and promotional trajectory.

In light of not having put up much top-line growth over the course of the past few years, that's created a different challenge for the organization, and, you know, it's one that we were certainly mindful of, if not outright concerned about. What that required of us was to sort of be overly communicative and transparent with our managers, both our existing managers, who've committed, at least a significant portion of their careers to the organization, and folks, with whom we were having discussions from a recruiting perspective. you know, we've been very transparent about the rationale as to why it didn't make sense for us to be onboarding new business and, you know, in growth mode over the course of the past few years.

That's enabled us, quite honestly, Andy Whitman, to be a bit more selective and judicious, not only in our hiring, but in replacing managers who perhaps were underperforming in what have clearly been significantly challenging operational times and an overall challenging operating environment. You know, you think back to the clinical challenges and limitations that COVID presented, you know, on the heels of that, the labor challenges and the overall, you know, struggles that we faced with respect to the availability of labor and managing our payroll-related costs. You know, we needed top-notch managers through all of those conditions. You know, that's been a bit of a carrot that we've been able to hold out for folks to keep them motivated and engaged within the organization.

You know, Ted alluded to, in his opening remarks, the sort of palpable enthusiasm that's running through the organization as we pivot to growth mode. You know, that has, you know, massive effects and reverberations in that not only is everyone excited to see, you know, our results, you know, in putting up top-line growth, but, you know, from a more personal career developmental perspective, what does that mean by way of growth opportunities? You know, long end around and answer to your question, I would remind you that the recruiting efforts and the management training program is executed locally.

Of course, as is always the case, we're going to have variability as to, you know, some districts and regions being far ahead of the curve, and really being prepared for specific onboarding opportunities as to new business in the Q3 and Q4 here. Other geographies may still be struggling with labor market implications and staffing challenges, so perhaps they're not quite as far along that continuum. As an organization in total, Andy, very much having been focused on the back half of the year as the inflection point toward growth, we have been building and managing our management capacity toward that, and we feel extremely confident that our management capacity aligns very well with the geographic opportunities that we've indicated as most likely to come on board here in the back half of the year.

Andy Whitman (Senior Research Analyst)

Great. That's helpful. I guess, just as a follow-up to that, I guess I just wanted to understand a little bit more on the confidence level of the H2 revenue growth rate. You gave this 420-430. Obviously, that suggests sequential growth, which is good. I guess maybe the first question would be, does that 420-430 range, is that business that's already been started as we sit here today, or are there facilities that still need to transition here during the rest of the quarter and able to hit that target? I guess, maybe just more broadly, Ted, maybe if you could just comment on, sounds like the pipeline's there.

You made a comment that, you know, I think you said if and when the customers decide to go, what needs to happen, do you think, for those customers to really pull the trigger, that you've been having dialogue with, that you feel like you're, like, you know, could add to the top line? What needs to happen to get them over the hump?

Ted Wahl (President and CEO)

I think in terms of the confidence or our conviction around the $420-$430, it's a mix, Andy. You know, we obviously, we wouldn't have provided that range if we didn't have a high degree of conviction that we were going to be able to deliver in that range. You know, then it's a combination of business that we've already have in hand, that we started towards the end of Q2, and, you know, new business adds that we'll have throughout the quarter. The bigger question you had about the pipeline and, you know, what's the gating factor to a customer pulling the trigger, it's a collaboration. You know, the pipeline's robust. Every customer group, every prospective customer has a different set of circumstances to it.

In many cases, it's just to piggyback off of Matt's commentary on management development, it's a function of where do we have the depth, where do we have the bench strength to be able to take on new business? You know, we've always talked about the single greatest gating factor on growth isn't the demand for the services or the amount of opportunities that are out there. It's our own ability to hire, develop, train, and then successfully deploy management candidates. That remains as true as ever today. I know we haven't talked about it in recent quarters and years as much as we had historically, but pivoting to growth mode here, that'll be front and center in our own internal assessments and analysis and focus. You know, I'd imagine it'll be a conversation we have quarter to quarter in this forum.

Nothing necessarily as a, you know, generally speaking, as a catalyst to put a specific customer group over the hump. It's just a prospective client-by-client assessment and, you know, where our management development efforts and capacity match up with the demand, that's where we're able to execute on the growth strategy.

Andy Whitman (Senior Research Analyst)

Okay, great. Thank you very much. Have a good day.

Ted Wahl (President and CEO)

Thank you, Andy.

Operator (participant)

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

Taji Phillips (Equity Research Associate)

Hi, good morning, you have Taji on for Brian. Thank you for taking my question. My first question has to do with margins in both segments, right? You had housekeeping at 8.7%, dining at 5.5%. As we think about, you know, your pivot into growth mode for the second half of the year, just curious, what particularly needs to happen in order for you to see alleviation in margins, especially throughout the year in both segments, and for you to see that translation to the bottom line?

Ted Wahl (President and CEO)

Taji, it's a great question. I think specifically from a segment perspective, there's always going to be some movement, whether it be month to month or quarter to quarter, largely due to execution, you alluded to it, new business ads, there's other considerations that are happening each and every day in our field-based operations. Just as an add-on to that, we don't talk about it because it's not really material, around the edges, there's even some seasonality, whether it's the number of holidays in a quarter, sometimes the timing of supplemental billings. We have union buyouts at different times during the year. I would say, just for some additional context from a margin perspective, if you look back pre-COVID, our segment margins were in that 9%-10% range for EVS and 5%-6% range for dining.

We would expect to track and trend in and around those levels for 2023, even with, you know, the expectations we have around growth and the margin compression that could create, again, with the degree of quarter-to-quarter variability.

Taji Phillips (Equity Research Associate)

Thanks. That's really helpful. Just last question for me. Just curious, as we think about CECL AR reserves and other adjustments, can you maybe talk about the sustainability of these adjustments? I think, you know, you had talked about how, like, CECL's pretty formulaic and, you know, at times volatile, but any thoughts around, you know, where this could settle out when you expect to, I guess, see the adjustments kind of taper out in your P&L?

Ted Wahl (President and CEO)

I know we've discussed it at previous times on this call, just to maybe take a step back to your question, Taji, the industry, it's still recovering. It has not yet recovered. That's the primary reason why coming into the year, even on the heels of a very strong Q4 cash collections quarter, we expected some fits and starts on the collections front, especially in the H1 of the year. That's why we provided, coming into the year, more modest cash flow estimates. That's why we highlighted our expectation for volatility around CECL. We don't expect that to be the new norm, you know, in the quarters and years ahead. In this current environment, it was expected that we would see some CECL volatility.

I think that said, specifically to this quarter, you know, as it was a difficult environment, we expected that, especially with the May 11th expiration of the Public Health Emergency. We saw clients really, you know, looking to maximize their own liquidity and flexibility, that impacted our April efforts. you know, overall, any negative impact on our customer base, specific to the Public Health Emergency, was really less than feared, we were successful in executing on our strategies in May and June, which is why we highlighted that strong momentum heading into the back half of the year. getting back to your question around CECL, specifically, as we're consistently collecting what we bill, we would absolutely expect CECL to moderate and to become more normalized.

We'll continue to make the adjustment in the, in the adjusted EBITDA table, irrespective of whether it's an upward adjustment or a downward adjustment, because we do believe longer term, you know, write-offs, actual write-offs is a more effective way and probably more indicative of what, you know, would actually be a P&L charge for HCSG. Again, in terms of the actual business side of it, as cash flow and as cash collections improve, which we expect them to do the back half of the year, we would expect CECL to moderate.

Taji Phillips (Equity Research Associate)

Thanks, Ted.

Ted Wahl (President and CEO)

Appreciate it, Taji.

Operator (participant)

The next question is from Jack Senft with William Blair. Your line is open.

Jack Senft (Equity Research Associate)

Yeah. Hi, good morning, Jack on for Ryan this morning. Any additional insight into how you're getting comfort over, you know, any potential exposure to the finalized rule that might increase staffing requirements? You know, is the comfort coming from client conversations, or are you doing more site-specific analyses to gauge risk? Just kind of curious how you're thinking about this potential headline.

Ted Wahl (President and CEO)

Yeah, Jack, it's a good question, and it's certainly, you know, as you alluded to, it's certainly a talk within the industry right now. I think the latest is that the proposed plan is expected soon, although we've heard that, you know, for months at this point, but all industry stakeholders remain on high alert. I'd say the industry view slash perspective is around minimum staffing, is that if there were an appropriate pilot and appropriate phase-in periods, and with it, a recognition of the labor constraints, and it was fully funded, then the industry would, and really has leaned into that type of framework. If it's an unfunded mandate without recognizing the realities on the ground, I do not believe that would be well received.

You know, from our perspective, you know, assuming there is a minimum staffing requirement announced later this year, our assessment of it is it would likely be very narrow, meaning it would be related to patient care staff only. It would likely have a phase-in period of up to five years, probably in the three to five-year range. There would likely be a robust waiver process, especially for rural facilities.

It would have to survive political changes in administration and all the inevitable litigation that would come with it. There's a lot of road to hoe here, Jack, but I would say stay tuned. There's going to be more to come from a minimum staffing perspective, but in the meantime, we'll wait and see. You know, I think just to bring it back to us for a moment, the fact that that uncertainty is out there, around, you know, not just the regulatory environment, but also, you know, the recovery of the industry, the reimbursement environment, does force, to a degree, providers to look for ways to create more certainty in their business. You know, we've talked about this before, but the central theme in our value proposition is providing operational and financial peace of mind.

Not just with the minimum staffing requirement, but all of the other variables within the industry, some of which are not necessarily new, you know, creates that demand for the types of services that we're able to provide.

Jack Senft (Equity Research Associate)

Okay, that's super insightful. Appreciate that. I guess just switching gears a little bit, you know, any update on your capital allocation strategy?

Ted Wahl (President and CEO)

No, from our perspective, it continues to, you know, go down the path we expected it to. Our number one capital allocation priority continues to be internal investment and investment in organic growth drivers. You know, we remain active on the inorganic front and exploring activities, looking to build, you know, selectively inorganic opportunities that we can, you know, fold in strategically within the company. There's nothing to announce, but that's something we remain active in, and, you know, we continue to keep an eye open for buyback opportunities. We did not have any buybacks in Q2, but that will continue to be a very selective, a very opportunistic approach that we take towards buybacks.

Jack Senft (Equity Research Associate)

Got it. Yeah, that's all for me. Thank you.

Ted Wahl (President and CEO)

Thanks, Jack.

Operator (participant)

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

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

Hey, good morning, guys. Thanks for the question. The state-based reimbursement that you called out in the PR this morning, can you give us a little color on the states that we have, you know, a higher number of contracts? Just kind of curious, the benefit that those facilities are starting to see at a state level.

Matt McKee (Chief Communications Officer)

Yeah, Bill, over the past 12 months, really, there's been a number of state-based wins, and some of those states are, you know, high density states for us with respect to our client facilities. You know, you think about Florida, Illinois, Pennsylvania, you know, more recently, Texas and Ohio. There's variability there, right? I mean, although one may classify a reimbursement increase in a particular state as a win, there's degrees, right? For instance, the state of Ohio just had a pretty substantial dollar PPD increase that was above what was expected. Ohio, historically, has not been the best state from an operating perspective. You contrast that with Texas, that did, in fact, get an increase, but it was, I'll say, less than what operators were hoping for.

It's been quite some time since the state of Texas did, in fact, get an increase. You could put that on the board technically as a win, in that it was an increase that providers were able to secure, but still deemed insufficient. You know, another state would be New York, which was a bit mixed, where there was, you know, a 6.5% reimbursement rate increase that was a bit higher than what was initially proposed, but certainly sub what the industry was looking for in light of, you know, massively increasing costs for operators in that state and really quite a lag in time from the prior reimbursement rate increase.

It's a mixed bag and certainly something that we pay attention to, Bill, you know, at the state-based levels and from an overall regulatory and reimbursement-based perspective. Much more important for us, obviously, is how that trickles down and impacts the facility and the operator. It's one component of that overall financial assessment, inclusive of, you know, occupancy, payer mix, and how they're able to staff and manage their nursing departments as well, and the effect that that has overall on occupancy.

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

Okay. I noticed housekeeping revenue was down just a bit, quarter on quarter. Is that a couple more exits involved there? I'm just curious about the renewal rate.

Matt McKee (Chief Communications Officer)

Yeah, that's right, Bill. We did exit some business. We would classify that as more normal course exits, so, you know, nothing substantial, the full run rate of which was reflected in the quarter. You know, while we're talking about the segment-level revenue, I would note that dining, we saw a bit of a step-up there, and that was just a couple of new business ads. Again, nothing substantial. Both the housekeeping exit and the dining ads really were fully reflected in the run rate revenue for the quarter.

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

Okay. Are your contract, the expansions that you're getting in education, you're reflecting, you know, in the overall numbers. Is that right?

Matt McKee (Chief Communications Officer)

That's correct, Bill. They're reflected, respectively in housekeeping and laundry, and then also dining segment as well.

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

Okay. Is that part of the back half uplift?

Matt McKee (Chief Communications Officer)

It is. That's correct.

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

Mm-hmm. Okay. Last one, you mentioned doing at least $30 million in free cash for the full year. Does that still look like the right way to think about it?

Ted Wahl (President and CEO)

You know, I think looking to the back half of the year, specifically, we're still targeting that $25 million-$30 million range. Depending on where we fall in that range or if we exceed that range, that could, you know, obviously have an impact on the number you just shared. $20 million-$30 million is our back half of the year target for no free cash flow.

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

The back half. Okay. Thanks, Ted.

Ted Wahl (President and CEO)

Fantastic. Great.

Bill Sutherland (Senior Equity Research Analyst and Director of Research)

Okay.

Matt McKee (Chief Communications Officer)

Thank you, Bill.

Operator (participant)

We have no further questions at this time. I'll turn it back to the presenters for any closing remarks.

Ted Wahl (President and CEO)

Great. Thank you, Chris. In the months ahead, we remain confident in our ability to control the controllables, realistic about the ongoing challenges that remain within our industry and broader economy, and focused on executing on our strategic priorities to drive growth and deliver long-term value to our shareholders. 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 to everyone for joining.

Operator (participant)

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