Dan McCartney - Chairman Ted Wahl - President and CEO Matt McKee - VP and Marketing Director.

AJ Rice - UBS Michael Gallo - CL King Ryan Daniels - William Blair Toby Wann - Obsidian Research Group Sean Dodge - Jefferies Chad Vanacore - Stifel.

Good day, ladies and gentlemen and welcome to the Healthcare Services Group 2015 Second Quarter Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time.

[Operator Instructions] The matters discussed on today's conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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. As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances.

Healthcare Services Group’s actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors.

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 its forward-looking statements whether as a result of such changes, new information, subsequent events, or otherwise. I would now like to turn the call over to Dan McCartney, Chairman. Sir, please ahead..

Okay thank you Kelley and thank you everybody, good morning. Thank you for joining us. I'm with Ted Wahl and Matt McKee and again we appreciate everybody joining us for this conference call for the second quarter.

We released our second quarter results last night after the close and will be filing our 10-Q sometime next week, and with that I'd like to introduce Ted for a discussion on the second quarter results..

Thank you, Dan. Revenues for the second quarter increased over 11% to 355.4 million. Year-to-date revenues were up about 13% to 710.6 million. Housekeeping and laundry grew at nearly 8% for the quarter. Dining and nutrition was up about 19%. Earnings from operations increased over 22% in Q2 to 26 million bringing the year-to-date total to 51 million.

Both revenues and earnings from ops for the three and six month periods were company records.

We continue to expect double-digit top-line growth for the year with housekeeping and laundry at the lower end of our targeted range and dining and nutrition likely exceeding that range as even with the Q4 and Q1 expansion, the dining segment continues to have an underutilized district and regional management structure, as well as a smaller base from which to grow.

The division successfully transitioned the new business we added over the past nine months and now have shifted their focus towards managing the departments and servicing the clients. As that new business matures, we would expect ongoing margin improvement while at the same time continuing to give proper attention to our legacy customers.

As we discussed on prior calls, we expect to transition our workers' comp and certain employee health and welfare programs into the Captive insurance subsidiary during the third quarter.

These programs will add to the general liability coverage that's already included as part of the Captive, as well as allow for greater efficiency in the management of the claims, reduced costs, and provide much needed flexibility for our facility level, health, and welfare plans to meet the requirements of the Affordable Care Act which took effect January 1st.

With that abbreviated overview, I'll turn the call over to Matt for a more detailed discussion on the quarter..

Thanks Ted, good morning everyone. Net income for the quarter increased to 16.3 million or $0.23 per share compared to 13.9 million or $0.20 per share in the second quarter of 2014. Both net income and earnings per share were company records. Direct cost of services came in at 85.6%, so 40 basis points below our target of 86%.

Going forward, our goal is to continue to manage direct costs under 86% on a consistent basis and obviously work our way closer to 85% direct cost of services. SG&A was reported at 7.1% for the quarter with essentially no impact from the deferred compensation investment accounts that are held by and for our management people.

So we expect normalized SG&A to continue to be in the 7% range going forward with the ongoing opportunity to garner some additional modest efficiency there. Investment income for the quarter was reported at 240,000, again no impact from the change in deferred comp investment accounts.

Our effective tax rate for the quarter was 38%, depending on the timing of the WOTC reauthorization in the year ahead. Our rate will likely be between 36% and 38% for the remainder of 2015.

Continue to manage the balance sheet conservatively, at the end of the second quarter had over $97 million of cash and marketable securities and a current ratio of 3 to 1. Accounts receivable remained in good shape, below our DSO target of 60 days.

And as we announced yesterday in conjunction with our earnings release, the Board has approved an increase in the dividend to $0.17875 per share, split-adjusted and payable on the 25th of September.

Cash flow and cash balances for the quarter more than supported and with the dividend tax rate in place for the foreseeable future, the cash dividend program continues to be the most tax efficient way to get the value and free cash flow back to the shareholders.

It's going to be the 49th consecutive cash dividend since the program was instituted in 2003 after the change in tax law, and it’s the 48th consecutive quarter we increased the dividend payment over the previous quarter. That's a 13-year period that included four, three for two splits.

With those opening remarks Dan, Ted and I would like to open the call for questions..

Thank you. [Operator Instruction] Our first question comes from the line of AJ Rice of UBS. Your line is now open..

First off just maybe to ask, you had a nice step up in your cash position from first quarter to second quarter.

You mentioned receivables, how much of that was sort of working capital to management versus just timing on when the close of the quarter occurred?.

Yes, it was a combination of both AJ, I mean you saw we had about $25 million positive swing in our cash balances, and about $15 million of that increase was just the timing of the payroll accrual from one quarter to the next. And the balance of that was largely driven by the improvement in DSO and better cash management..

And as that cash balance builds, I mean you guys have been obviously very steady in increasing dividends for a long time.

Is that cash balance something that you feel like you need to maintain or when you look at perhaps you need to step up the dividend even faster or something else as that continues to build?.

I think as far as the dividend, it’s something that the Board evaluates on an ongoing basis, and certainly if earnings and cash flow and to your point cash balanced continue to grow at a rate faster than the dividend, then increasing dividend would warrant some serious consideration.

Our plan as it stands today is to finalize the Captive related re-org which includes capitalizing or funding the subsidiary with $60 million to $70 million during the third quarter. And then after six months or so of operating, the Captive will evaluate what makes the most sense in terms of the capital allocation for 2016..

And then switching gears for a bit, obviously the economy from the employment standpoint seems to be picking up a little traction here for the last year.

So, have you seen your client’s long-term care facilities begin to push up a little bit? The rate increases, the wage increases with their hourly workers yet, or is that still about the same as it was say a year ago?.

Yes AJ, when we kind of look at the industry and obviously I know you raised the question because that’s the trigger that increases our contract’s prices, but really the long-term care industry has always had to sort of respond more sensitively to wage increases relative to other blue-collar type employment companies.

So we haven’t really seen any changes, and it's rare that we would see macro-level economic or employment data really have an impact on our clients, obviously in extreme examples you'll see it, but over the past year, it's been a pretty steady state for us seeing the typical increases.

There are clients who are passing along to their blue-collar employees which in turn causes the pass through cause [ph] in our contract price increases..

And my final I'll finish up. You had said that you thought at least the business you brought on by year-end this fall is the big business that might by the time you exit in the second quarter will largely be your baggage target margin.

Is that what you’ve seen or is that you still have some of the margin improvement in front of you from the rollout of business this late last year?.

The majority of the business is well within our targeted margin range. As is always the case, we have some outliers to the positive and to the negative, and they are the ones we are working through. But overall, I think the business is online, and we think as that business continues to mature, there is some ongoing margin opportunity as well..

Thank you. And our next question comes from the line of Michael Gallo of CL King. Your line is now open..

I guess with the business now digested that you added to Q4 and Q1 substantially on budget, how should we think about the acceleration starting to really ramp back up on the sequential housekeeping addition? And then also I know it’s been lumpier with a lot of larger business kind of coming in at one shot.

I was wondering if you see more potential large lumps coming in here over the next six to 12 months..

I think in the near-term we continue to plan for double-digit revenue growth for the balance of the year. And our efforts are going to be focused on building the top-line momentum which as has always been the case is fueled by our management development efforts over the next six months as we prepare for 2016.

I think to take a step back Mike I would say the demand for the services is as great as it's ever been.

But the rate limiting factor on our ability to add new facilities and this again has always been the case is developing the next wave of management candidates, and each district and region is at a different stage in terms of the quality and quantity of their management pipelines.

And it's really that pipeline if you will that determines how quickly we can grow and access the accelerator in some quarters and years the decelerator of our growth rate. So it's driven from the bottom up in the training center by training center type of wave rather than through some corporate dictated plan being sent out to the field.

So we're comfortable that as the new contracts were initiated over the past nine months, the divisions continue to focus on the management development functions.

But a substantial amount really s year’s worth of managerial resources have been assigned to the new business that we've added over the past few quarters, which is why again the back half of '15 is going to be focused on digesting that bolus of new business and replenishing the management pipelines..

Though it sounds like it'll still probably be a little bit before you get back to the historical sequential or is it sort of [Multiple Speakers]?.

No, I think sequentially quarter-to-quarter you'll see a build up but it will be incremental as it's been historically..

And then just a follow-up question on the Captive, can you just walk us through what kind of still needs to happen from a re-org and regulatory, to sort of what are some of the hoops left that you still have to jump through before we get funded before you start to see developments?.

Yes, the Captive is on track. We will have it completed by end of the third quarter, there's really no additional regulatory hoops for us to jump through. So it will be completed again by the end of the third quarter.

It's just the a matter now to administratively and from a back-office perspective transferring the employees to their designated entities, funding the Captive, funding really the subsidiaries and then ultimately funding the Captive is the order of events but we're still expecting $6 million to $8 million of annualized savings and that could prove to be conservative depending on how things evolve as well as the 20 or so million dollar cash benefit as a result of the accelerated tax deduction from capitalizing the entity..

And in terms of the will we get to that full run-rate by the fourth quarter or…?.

We should be trending towards that run-rate by the end of the year Mike, and then I would expect in 2016 that is when you will really see the full benefit but there is going to be a transitory period during Q3, during Q4 we would expect the pro rata share of that benefit to drop to the bottom-line and then heading into 2016 our expectation is we're going to realize the full benefit of what we expected..

And I guess you'll see that really start to show up in the gross margin line, so I guess kind of….

That is exactly right..

…walk us through the numbers the '14 four, assuming you can hold that, you talked about some opportunities maybe to still prove that little bit on the new business, I guess that would move your direct costs closer to 85 once we get the full funding at the Captive, is that reasonable?.

I think the two drivers of our margin improvement over the next couple of years as we've said for quite some time are going to be the dining and nutrition districts and regions managing the right complement of facilities because even after the Q4 and Q1 expansion, we still have an underutilized district and regional network in dining relative to housekeeping and laundry, as well as the tailwind that the Captive insurance vehicle is going to provide so working our way closer to 85% and consistently managing it towards that number is what our objectives are.

And if you look back historically over the past at least six or 12 months that's exactly what we've done..

And then just final question I’d always felt that the G&A come down nicely, sequentially. I know you've talked in the past about a lot of things you've done to really enhance your ability to take on a lot of additional business in terms of the G&A structure.

Is there any reason as we kind of go forward and you start to layer in, you attain a layer in that double-digit top-line growth, why you shouldn't be able to keep SG&A in the $25 million, $26 million even $27 million range.

What should actually bring us the level as a percentage of sales sort of down below 7% as we assume double-digit growth continues?.

No there's nothing specific that I could identify as to why we couldn't continue to manage it in that 7% range going forward, I think if you look over the next year, you mentioned 25 million to 27 million, I think that's a fair modeling assumption if you're using that and kind of calculate the percentage that gets you to 7% or so, which is where we ran SG&A the past six quarters, if your question Mike is, do we have scale going forward, I think the answer would be we do but until we demonstrate that we're going to run it consistently under 7%, I wouldn't model it like that..

Yes, I know my question is more about, is there anything additional you need to add that you can foresee above and beyond that you need to kind of bring on the next wave of growth do you feel like you have what you need in place for the next 12, 18, 24 months from G&A perspective?.

We do yes..

Thank you. And our next question comes from the line of Ryan Daniels of William Blair. Your line is now open..

Let me start we another quick follow-up on the Captive, Ted you mentioned you'll fund that with 60 million to 70 million, is that cash just from an accounting standpoint that will sit on your balance sheet still on just a restricted cash account or how'll that work?.

Yes, it'll be a mix of cash debt that we've drawdown from our extended line of credit and then letters of credit. That's part of what's being finalized over the next 60 days..

And then any -- you discussed this briefly but any final re-org cost, I know you had some one-time expenses earlier, so maybe that's all accrued but anything we should be aware of in Q3 as we actually go through the launch?.

Nothing, no additional cost related to the Captive that we anticipate Ryan..

Okay, perfect. And then I don't know if this has been in your statings but I'm curious with the novel entities you've structured for the Captive.

Are there any potential tax benefits that you could see manifest from that you know state-level taxes or is that in your estimate at this point?.

It's not included in our estimates but there is an opportunity for us and this is more of a 2016-2017 opportunity to more efficiently determine and allocate our state income taxes so you know from some of the preliminary modeling we've done we think there's about 100 to 200 basis point opportunity just on the state income tax side.

And again that's not baked into our assumptions but that's something we see as an opportunity over the next couple of years..

Okay, perfect that's helpful, and then just….

And actually why, I know we've emphasized kind of the near-term financial opportunities but I think a more compelling and longer term benefit of the Captive is that it establishes a platform for what is our third largest spend and provides us with significant operational and administrative flexibility not just for the program design of our property and casualty in health and welfare programs but for a variety of other initiatives that we're going to be able to take advantage of for years to come.

It's really the flexibility that I think is the long-term play..

Yes, that makes sense.

Okay then final one for you guys, just from a macro standpoint obviously a lot of change is going on in the reimbursing environment with bundling hips and knees and value-based purchasing and things that probably could trickle down into the client base that you serve and I'm curious if you're hearing any discussions in the field about that accelerating demand to outsource so these entities can focus more on core competencies and patient care, is that still you're not resonating enough in the market to kind of show up on your income statement yet?.

No I think for us Ryan, it's really again and the macro level I guess sort of uncertainty as it relates to reimbursement has always been a benefit to outsourcing services of all kinds including ours.

So we've certainly I think and it's more we see more general uncertainty than kind of stalwart planning moving forward with a firm plan to definitively outsource service X, Y and Z and focus on certain core functions.

So, for us I think the trends to outsourcing continue to be in our favor and certainly work to the benefit of all outsourcing companies, but I think your premises is spot on in that the operators want to focus on their core competencies and continue to look to outsource any function that make sense from a financial and operational perspective.

So that trend I think continues. I don't know that there's any increased urgency as it relates to reimbursement uncertainty but we're certainly continue to be the beneficiaries of that trend in general..

Thank you. And our next question comes from the line of Toby Wann of Obsidian Research Group. Your line is now open..

Yes hi good morning guys, congratulations on the quarter.

Just quickly, one housekeeping item, a number of housekeeping and also dining and nutrition facilities under management at the end of the quarter?.

Pretty consistent with where it was the past 90 days Toby, we're at around 3,800 housekeeping and about a 1,000 dining and nutrition facilities..

And then I know you spoke to it a little bit earlier in the call about the capacity, just kind of refresh us where you stand capacity wise or in dining and nutrition in terms of number of facilities per district region, that sort of thing if you would?.

Toby when you look at sort of on a rolled up basis it's still fairly comparable in that the district managers who should be overseeing 10 to 12 facilities are still in that eight or nine range on average and the regional managers who should be overseeing four to six districts are still typically overseeing maybe four, it was three to four, now probably closer to four on average.

The good news and just to reiterate is that when we look at sort of the maturation of the dining services division starting in the Mid Atlantic working our way to the Northeast, then to the Southeast, and Mid West and then the Far West.

In the Mid Atlantic and the Northeast we have fully functioning and fully utilized district managers and regional managers in the dining segment. So we know the model works and we know we can get there. Now is it a nice clean quarter-over-quarter linear Excel Spreadsheet exercise, no it's not. We wish it was.

But we fully expect that that model that is in place in the Mid Atlantic and the Northeast divisions will continue to grow and expand to the other divisions that I mentioned and that's just going to be a gradual stepwise approach but certainly the opportunity to more fully utilize those folks remains and that is as Ted alluded to earlier the greatest margin opportunity for the company..

Okay I appreciate that, I specially appreciate the commentary about linear growth..

Thank you. And our next question comes from the line of Sean Dodge of Jefferies. Your line is now open..

Thanks, good morning. You guys had previously mentioned potentially adding major medical into the Captive. What are your thoughts on the timing of that and would that require a material amount of incremental funding..

It wouldn't and that's why that's not part of the initial phase-in that would be more of a 2016 consideration as well but that would be more of a fund as you go process rather than an initial funding requirement..

Okay, what percentage of your client base roughly is made up of non-for profit operators?.

It really mirrors the market and it’s more driven by a state-by-state, you have some states like Minnesota that have the higher percentage of non-for profits and as a result a higher percentage of our customer base in Minnesota is non-for profit so it really mirrors that the market and it’s just driven by what the state allocation is..

Okay, and if you look across the entire United States and is the entire non-for profits in this market addressable for you and what I'm getting at is are there any structural or behavioral differences you need to non-for profit guys that keep you from fully penetrating that side of the market like you would the for profit guys?.

Not any longer Sean if you go back 10 or even 15 years ago the non-for profits really sort of operated in a vacuum and had no real concern for sort of financial efficiencies within the management of their facilities.

With changing reimbursement and reimbursement uncertainty that sort of paradigm has completely shifted so that now even the most well funded non-for profits are typically concerned not only with managing overall in an efficient way financially. But also to Ryan Daniels’ question and comment earlier to really kind of focusing on their core competency.

So just as we've seen with the for profit sector the non-for profits maybe a little bit of a slower evolution toward demanding outsourced services and certainly demanding the management of housekeeping and dinning services in an outsourced fashion.

And certainly accelerated over the past few years but to your basic question there is really nothing fundamentally that differs among the management of for profit or non-for profit facilities.

From our perspective really what defines a proper target for us from housekeeping and laundry perspective remains the size and scope of the facilities being sufficient to bear the cost of having a full time on site manger to manage the housekeeping and laundry department.

So there is not typically a for profit non-for profit threshold even necessarily a bed size threshold. But it really the facilities being able to bear the cost of having a full time on site dedicated housekeeping manager..

Thank you. And our next question comes from the line of Chad Vanacore of Stifel. Your line is now open..

So can you give us an update on your promissory note receivable balance and then tell us a little bit about your collection experience throughout the quarter?.

The details around the promissory noted will be in the Q but it's going to be consistent with or better than I guess where we were last quarter.

But again from a promissory note perspective we've always looked at that as a tactic in an overall collection strategy and without sounding glib if we could have all of our receivables in the form of a promissory note we would because a typical accounts receivable for us is an unsecured amount that is due from a client versus a promissory note which typically comes with a security interest which is and legally bonding documents.

Our preferences would have been to have as much and we're more proactive in approaching our clients today and engaging them in promissory note discussions than we had been in the past. So I think from a promissory note perspective it should be in line with last quarter as far as the absolute amounts that we have.

But that’s really been our focus and our approach that we've taken historically..

And it looks like in your new credit line you borrowed 85 million to fund the Captive insurance.

Tell me should we expect the year to carry that balance for a while or is that in terms of letter of credit?.

Yes we don’t have any drawdowns on the credit line as of the balance sheet date Chad..

And then one last question so you mentioned taxes for the year and you expect 36% to 38% is that ex the WOTC credit?.

Yes I mean the most recent indication from the House Ways and Means Committee suggests that the tax extenders legislation is in early fall priority which would be a significant improvement over the past two years. I don’t know what early fall priority means in Washington DC province but we'll see how that plays out.

So I think our tax rate would be 36% to 38% depending on the timing of the extenders legislation 36% being if the WOTC on an annualized basis is in fact reauthorized before the end of the year and I think 38% if it's not reauthorized until 2016..

And early fall probably means early spring...?.

Ryan said it so maybe a little more reliable than others..

All right gentleman thanks for your time today..

Thank you. And I'm showing no further questions at this time. I would like to turn the call over to Ted Wahl President and CEO for closing remarks..

Thank you and before you wrap it up I know Matt wanted to review our conference schedule for the next few months, so Matt?.

Yes we will be participating in several conferences upcoming including the CL King 13th Annual Best Idea Conference. That will be on 10th of September at the Omni Berkshire Place in New York City. And then also the 6th Annual Credit Suisse SMID Conference, which will be on the 16th of September and that’s at the Waldorf Astoria also in New York City.

So look forward to seeing some of you folks at those conferences.

Ted?.

Thanks Matt. Well as we look towards the next 12 months we expect to continue to expand our client base both in housekeeping and laundry and dinning and nutrition within our historical targets.

The Q4 and Q1 expansion efforts do provide us with a good platform for the back half of the year not only maintain our growth rate but also the margin improvement that we've demonstrated during the first half of 2015.

The demand for our services has never been greater as our customer base and really the provider community at large continues to pay significant uncertainty in both the regulatory and reimbursement environments even with this stepped up demand we remain committed to controlled expansion.

The rate limiting factor on our growth continues to be the pace at which we are able to develop field-based management personnel, particularly at the MIT account and district manager levels.

The focus on teaching and training our management people from orientation through maturation will be our highest priority over the next 12 to 24 months using all available forms and mediums including on the job training, classroom settings and leveraging technology to its fullest extent.

We will look to keep direct cost below 86% and work our way closer to 85% direct cost of services.

The primary drivers of that margin improvement will be the dining and nutrition, districts and regions managing the right complement of facilities and the transition of our workers’ comp and employee health and welfare programs into the Captive insurance subsidiary during the third quarter.

Again the Captive vehicle will provide significant flexibility financial, operationally and administratively in the near-term and for years to come. We expect our normalized SG&A to be about 7% or so excluding any deferred comp impact but remain committed to ongoing investment in our HR and legal functions.

With the advertorial regulatory environment emanating from DC our subject matter experts have been valuable resources for our management team in the field and allow us to more proactively navigate a highly regulated litigious industry in which we operate.

Our effective tax rates should continue to be in the 36% to 38% range for the balance of '15 as I just talked about depending on the timing of the tax extenders reauthorization and overall we continue to operate in unprecedented cost-containment environment and that's increased the demand for outsourcing services of all kinds.

We have the most talented management team that we've had in the history of the organization and we have the financial wherewithal to grow the business as fast as our ability to managing it. Ours is an execution business and our ability to execute is what will drive our success in the months and years ahead.

So on behalf of Dan, Matt and really all of us at Healthcare Services Group I again wanted to thank Kelley for hosting the call today and thank you to everyone for participating..

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day..