Healthcare Services Group - Q3 2023

Transcript

Operator (participant)

Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Healthcare Services Group, Inc. third quarter 2023 earnings conference 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 followed by 1 on your telephone pad. 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 at 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 U.S. GAAP can be found in this morning's press release. Thank you. Ted Wahl, President and CEO, you may begin your conference.

Ted Wahl (President and CEO)

Thank you and good morning, everyone. Matt McKee, I appreciate you joining us today. We released our third quarter results this morning and plan on filing our 10-Q by the end of the week. Today, in my opening remarks, I will first discuss our third quarter financial highlights and key accomplishments. Next, I'll provide an update on recent client restructuring actions. I will then share our perspective on the latest industry trends and developments, and then finally, I'll share our fourth quarter and 2024 outlook. I'll then turn the call over to Matt to provide a more detailed discussion on the quarter, including our basis for GAAP to non-GAAP reporting. So with that overview, I'd like to now discuss our third quarter financial highlights and key accomplishments.

For the three months ended September 30, 2023, we reported revenue of $411.4 million and adjusted revenue of $424 million, in line with our expectations of $420 million-$430 million. We reported net loss and diluted loss per share of $5.5 million and $0.07 per share, and adjusted net income and adjusted diluted earnings per share of $12.5 million and $0.17 per share, a 13.9% and 13.3% increase, respectively, over Q3 2022. We reported adjusted EBITDA of $23.3 million, a 10.2% increase over Q3 2022, and we reported cash flow from operations of $2.9 million and adjusted cash flow from operations of $18 million, a 208.9% increase over Q3 2022.

We entered the second half of the year with three clear priorities and made substantial progress on all three during the quarter. The first was continuing to manage adjusted cost of services at 86%, which we did. The second was collecting what we bill, building on the strong momentum that we gained in May and June. In Q3, we delivered our strongest cash collections of the year, collecting over 98% of what we billed, with the modest shortfall primarily related to the timing of new business adds during the quarter. The third priority was executing on our organic growth strategy. Adjusted revenue for the quarter was up sequentially. Our sales pipeline is growing, and our recruiting and management development efforts are ramping up as we ready ourselves for growth. Now, moving on to some of the recent client restructuring actions.

We had two long-term clients initiate restructurings during the quarter. As part of their restructuring actions, these customer groups divested facilities to new operators. We're pleased to report that we've entered into new agreements with those new operators to retain the business and ensure many more years of partnership. As a result, we expect a neutral to positive effect on future revenue and earnings related to these facilities. These client downsizing actions are in line with the ongoing shift in the sector from large, multi-state operators to smaller regional operators. This shift is a very good thing for us for many reasons, not the least of which is diversity of AR risk. I would also add that notably, Genesis is not one of the restructurings.

We continue to be very encouraged by the positive direction of their organization as they work towards their goal of having a leaner, healthier, regional footprint, and with our most recent conversations regarding our partnership going forward, both operationally and financially. I'd like to now share our perspective on the latest industry trends and developments. As we look towards 2024, industry fundamentals continue to improve, and a stabilizing labor market and select state-based reimbursement increases have contributed to the gradual but steady occupancy recovery. On the regulatory front, on September 1, CMS proposed the minimum staffing rule, which triggered a 60-day comment period that will remain open until November 6, 2023. A final rule is expected mid-2024.

There is a growing list of stakeholders opposed to the rule, including healthcare industry leaders, trade associations like AHCA, MedPAC members, and a bipartisan group of legislators, including 28 senators and counting.... 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 as proposed, the rule would lead to facility closures and ultimately reduce access to care, particularly in rural areas. In addition to the public comment period, any rule would have to survive an onslaught of litigation, political changes in administration, and at least on some level, be funded. From our perspective, there remains great uncertainty as to whether any final rule would ultimately be implemented, at least a rule that resembles the current proposal.

As far as our outlook for the fourth quarter in 2024, we enter Q4 with three clear priorities. The first is continuing to manage adjusted cost of services in line with our target of 86%. The second is collecting what we bill, building on the strong momentum gained in May, June, and Q3. We're raising our expectations for second half of 2023 cash flow from operations from $20 million-$30 million, to what is now $35 million-$45 million. The third priority is continuing to execute on our organic growth strategy. Our Q4 adjusted revenue estimated range is $420 million-$430 million. We look forward to ending the year on a strong note and expect our positive operating, cash collection, and new business trends to continue into 2024.

So with those introductory comments, I'll turn the call over to Matt for a more detailed discussion on the quarter, including our basis for GAAP to non-GAAP reporting.

Matt McKee (Chief Communications Officer)

Thank you, Ted, and good morning, everyone. For those of you who saw the press release this morning, you might have noticed that we introduced supplemental non-GAAP financial tables. The rationale for these supplemental schedules is to enhance transparency by providing even greater visibility into current business trends, to increase period-to-period comparability, and more closely align our reporting with how management views the business. So with that context, I'd like to now move on to a more detailed discussion of the quarter. Revenue was $411.4 million. Adjusted revenue was $424 million. Housekeeping and laundry, and dining and nutrition segment revenues were $190.9 million and $220.5 million, respectively.

Adjusted housekeeping and laundry, and dining and nutrition segment revenues were $194.6 million and $229.4 million, respectively. Housekeeping and laundry, and dining and nutrition segment margins were 5.4% and 0.9%, respectively. Adjusted housekeeping and laundry, and dining and nutrition segment margins were 7.2% and 4.7%, respectively. Cost of services was $377.6 million. Adjusted cost of services was $366.2 million, or 86.4%, in line with our target of 86%. Our goal is to continue to manage adjusted cost of services in the 86% range. SG&A was $39.0 million.

Adjusted SG&A was $40.3 million or 9.5%, within the company's targeted range of 8.5%-9.5%, and we expect to continue to manage adjusted SG&A within that targeted range. Third quarter cash flow and adjusted cash flow from operations were $2.9 million and $18.0 million, respectively. As Ted mentioned in his opening remarks, we raised our expectations for second half 2023 cash flow from operations from $20-$30 million to $35-$45 million. DSO for the quarter was 82 days. Adjusted DSO was 79 days, a 4-day improvement over last quarter.

Also, as part of our adjusted results, we adjust for the impact of the change in payroll accrual, but since it will still be included in our reported cash flow from operations, we would point out that the Q4 payroll accrual is 15 days. That compares to the 7 days that we had in the third quarter of 2023, and 14 days that we had in the fourth quarter of 2022. 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.

Operator (participant)

At this time, I would like to remind everyone, in order to ask a question, press Star, then the number one on your telephone keypad. Your first question comes from a line of Sean Dodge from RBC Capital Markets. Your line is open.

Sean Dodge (Equity Research Analyst)

Yep, thanks. Good morning. Maybe just starting with the impact of the two restructurings. Ted, you said some of the facilities were divested, but you signed contracts with the new operators. Did either of those new agreements contribute any revenue in the quarter? I just—I'm just looking for a little bit of help squaring that with the revenue and the adjusted revenue you reported. Should we think about the $424 million of adjusted revenue numbers? Is that kind of the jumping-off point into Q4?

Ted Wahl (President and CEO)

It is, Sean, and really, that in terms of the impact on restructurings, there was no other than the way it was accounted for as a temporary one-time step down in revenue, you know, in terms of the go-forward, we believe that there's going to be more opportunity because divestiture of facilities was a large part of the restructuring activities of both of these groups. So they provide us new operators and, you know, smaller, nimbler organizations to grow within the future. And that's why we expect, going forward from a revenue and earnings perspective, it to be neutral, a neutral to positive event.

Sean Dodge (Equity Research Analyst)

... Okay, great. And then on the guidance for the cash from operations for the second half of the year, the $35 million-$45 million, is that an adjusted number or would that be GAAP? And then maybe if you could just walk us through the visibility you have into that, what gave you the confidence to raise that range by the $15 million?

Ted Wahl (President and CEO)

That's to be consistent with how we presented it last quarter and the quarter before, in terms of our second half of the year expectations. We're just presenting and sharing a GAAP number, so that's our revised range has moved from $20 million-$30 million to $35 million-$45 million. And in terms of our conviction around that number, I think it's a function of what we've talked about before. While the industry is still recovering, it hasn't fully recovered. We talked about coming into the year, even on the heels of a strong Q4 last year, we expected some fits and starts on the collections front, especially in the beginning of the year, which is why we provided more modest cash flow estimates for the first half of the year.

But during the third quarter, you know, and really starting in the second quarter with May and June, we continued that strong momentum and, you know, this quarter collected over 98% of what we billed. And I mentioned it in the opening remarks, but the modest shortfall was really related to some of the startups we had intra-quarter. So we have positive momentum heading into Q4. And, you know, visibility, Sean. Visibility is a big thing in any business, including ours. So I think the signals that, you know, Matt and I are trying to send to our investors and all of our stakeholders is we're continuing to gain visibility into our future performance, and that's what gives us conviction.

Sean Dodge (Equity Research Analyst)

Okay, great. Thanks again, and congratulations on the progress on the quarter.

Ted Wahl (President and CEO)

No, I appreciate it, Sean.

Operator (participant)

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

Andy Wittmann (Managing Director and Senior Research Analyst)

Oh, great. Good morning, gentlemen. Appreciate you taking the time for my question here. And, I guess, Matt, maybe I wanted to just dig into the $21.3, the item here in the reconciliation, just to get a little bit more color. It seems like there's two factors here. It looks like there's some of the revenue recognition that you talked to in the prior question, but there's also a component that's just, I guess, I'd just call it kind of bad debt write-downs, judging from the footnote. Can you just tell me how much of the $21.7 was-- What would be, I guess, considered the bad debt write-down?

Ted Wahl (President and CEO)

Sean, I think, and this is Ted speaking. About $12.5 would have impacted the top line with the balance impacting bad debt, and that's just a function of the way the accounting guidance works. There was still a partial ongoing relationship with the smaller, much leaner operation that the existing customer is organized. So because they're still an existing customer, that's accounted for as a one-time revenue step-down in the quarter. And then conversely, the other restructuring has been divested in full to two separate operators, and because that's a former customer, that's accounted for as bad debt. So it's just, it's just geography in terms of the P&L, but the same impact, non-cash, one-time from our perspective. Legacy issue.

Andy Wittmann (Managing Director and Senior Research Analyst)

Got it. So then I, I guess the question is, from a process point of view, given that you've got about $9 million of kind of bad debt, is, is this—is this idea of adjusted revenue that's going to add back some of the bad debt unique to the circumstances this quarter? Or should we expect that this is a metric that you're going to re-report on an ongoing basis?

Ted Wahl (President and CEO)

We would believe it's going to be circumstance driven. I would expect in most, if not just about... In most quarters, it would be a 0 in terms of the adjusted revenue. But we at least wanted to introduce that possibility because, again, the accounting rules for revenue are pretty clear. I believe it's ASC 606, that if you're in a negotiation and you're accepting getting paid less on what you had previously billed, and that's with an existing customer that you continue to provide some level of services to, then you're expected to record that adjustment as a reduction to revenue rather than bad debt expense.

So to the extent an incident like that or an action like that happens in the future, we would account for it in accordance with the guidance, but otherwise, we wouldn't expect it to be a recurring theme moving forward.

Andy Wittmann (Managing Director and Senior Research Analyst)

Okay, that makes sense. And then maybe, Ted, just one other one here, just on the increased cash flow guidance here. Was there... I mean, we heard your answer before to the prior question about the visibility and the confidence since May, and that all makes sense. Was there an item here collecting on a past, maybe bad debt that happened in the quarter or that's expected to happen in the balance of the year, that gives you some of this confidence for this increase?

Ted Wahl (President and CEO)

No, it's really the, you know, the intra-quarter collections and billings that gives us the confidence. And with that said, we continue to work on our, you know, with our customers on plans, whether they're in hand and, you know, promissory notes we talked about before as an important tactic in our overall collection strategy, which can add a degree of tailwind to it. But there was nothing specific to this quarter or notable that would have been unusual. It was largely intra-quarter, collecting what we bill, and again, a function of our strategy working, the increased payment frequency, the proactive use of promissory notes, and then discipline in our decision-making, coupled with, and perhaps even more importantly, Andy, the recovering environment.

You know, every quarter that goes by, you know, census, occupancy continues to recover, and, you know, the state-based reimbursement benefits are starting to take hold. October is the, you know, the first month that, you know, the 4% CMS increase would be realized. So you have a confluence of events that I think environmentally make for a stronger, a strengthening industry.

Andy Wittmann (Managing Director and Senior Research Analyst)

Okay. That's all really helpful perspective. Thank you, Ted. Have a good day.

Ted Wahl (President and CEO)

Thanks, Andy.

Operator (participant)

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

Jack Senft (Equity Research Associate)

Yeah. Hey, guys. This is Jack Senft on for Ryan Daniels. Thanks for taking my question. In terms of margins, it looks like both the housekeeping and laundry, and then dining and nutrition segments decreased from last quarter on an adjusted basis. Is there anything to call out here that caused this decrease? Was it anything to do with restructurings or possibly just even attributed to seasonality? Just curious if you can kind of double-click on that. Thanks.

Ted Wahl (President and CEO)

Yeah, more the latter than the former, Jack. You know, there's always gonna be some movement you know, month to month, quarter to quarter, depending on timing of new business ads or exit, management development ramp-ups, operational execution, and other considerations that are happening really each and every day as a part of our business within our field-based operations. You know, year to date, our adjusted segment margins are 8.8% and 5.6%, and we'd expect to track in and around those levels for 2024, again, with a degree of that quarter-to-quarter variability.

Overall, we continue to have positive operational trends related to customer experience, system adherence, regulatory compliance, and budget discipline, all of which are near-term margin drivers, which is why we remain confident in our overall ability to continue to manage adjusted cost of services in that 86% range that we've targeted.

Jack Senft (Equity Research Associate)

Okay, perfect. Thanks. And then just a quick follow-up, too. In your prepared remarks, I think you noted that the sales pipeline was ramping up nicely, which obviously correlates really well with you guys entering this growth mode phase. Just curious if you can dive a bit deeper on the sales pipeline and if you can kind of touch on and just, like, in terms of what you're seeing, in terms of demand and, you know, as you kind of head into 2024.

Ted Wahl (President and CEO)

Yeah, we appreciate that question because, as we've discussed previously, our value proposition continues to resonate, you know, more strongly than it ever has, even historically. So the demand for the services is absolutely there, and not to suggest that increased demand necessarily yields an increased growth rate, but certainly to have greater demand allows us to be that much more, you know, selective in determining with whom we would like to establish new partnerships and, in many instances, expand our existing relationships. So the demand for the services is certainly strong. You know, we've built an organization on both the sales side of our field-based organization and also within our operations to develop the management pipeline, such that we have the management capacity to be able to onboard new facilities, all of which are operating at full capacity right now.

So, you know, the demand, we do anticipate will turn into new business growth and new business opportunities. So given that, we did talk about, you know, our expectation for the second half of the year to demonstrate top-line growth sequential relative to the first half of the year and, you know, expect that growth trajectory to continue into 2024, such that we have every expectation that we see year-over-year growth 2024 compared to this year.

Jack Senft (Equity Research Associate)

Yeah. Awesome. Thanks, guys.

Operator (participant)

Your next question comes from a line of Brian Tanquilut from Jefferies. Your line is open. Brian, your line is open. And there are no further questions at this time. I will turn the call back over to Ted Wahl for some final closing remarks.

Ted Wahl (President and CEO)

Okay, great. Thank you, Rob. As we look ahead, we remain confident in our ability to control the controllables, realistic about the 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 shareholders. So on behalf of Matt and all of us at Healthcare Services Group, I wanted to again thank Rob for hosting the call today, and thank you again, everyone, for joining.

Operator (participant)

This concludes today's conference call. Thank you for your participation. You may now disconnect.