Dan McCartney – Chairman Ted Wahl – President, Chief Operating Officer and Director Matt McKee – Vice President-Strategy and Head-Investor Relations.

A.J. Rice – UBS Chad Vanacore – Stifel Nick Hiller – William Blair Sean Dodge – Jefferies Toby Wann – Obsidian Research Group.

Good day, ladies and gentlemen, and welcome to the Healthcare Services Group Q1 2016 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, today’s conference call is being recorded.

The matters discussed on today’s conference call include forward-looking statements about the business prospects of Healthcare Services Group, Inc. within the meanings 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.

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’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 the recent results or those projected in the forward-looking statements are included in our earnings press release issued prior to this call and then 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. I would now like to turn the conference over to Chairman, Dan McCartney. Please go ahead..

Okay. Thank you, Candiz, and good morning, everybody. I’m with Ted Wahl and Matt McKee, and we all appreciate you guys joining us for today’s conference call. We released our first quarter results yesterday after the close, and we’ll be filing our 10-Q the week of April 18. And with that, I’ll turn the call over to Ted for further discussion..

Thank you, Dan, and good morning everyone.

It was during the fourth quarter of 2014 and first quarter of 2015 that we accelerated our expansion which does make the Q1-Q1 comparisons the most difficult of the year, but we continue to grow the top-line around the targeted range with revenues for the quarter up over 8% to $385 million, Housekeeping and Laundry grew at 5%, Dining and Nutrition was up 14% for the quarter.

Earnings from operations increased 20% in Q1 to over $29 million. Both revenues and earnings from ops were company records.

Overall, the districts and regions have done a good job of opening the new business we added during the first quarter, not only in minimizing inefficiencies, but more importantly developing strong working relationships with our new facility level customers.

As that new business matures, we would expect ongoing margin improvement as our focus shifts towards managing the departments and servicing the client base.

For the balance of 2016, we’ll continue our selective expansion, controlling our growth rate to ensure that our managerial wherewithal facility execution and financial performance are in line with what we committed to our customers. 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. So, net income for the quarter increased to $18.6 million, or $0.26 per share, compared to $15.5 million and $0.22 per share in Q1 of 2015. Both net income and earnings per share were company records for the quarter. Direct cost of services came in at 85.8%, so continue to be under 86%.

And obviously going forward our goal continues to be to manage direct cost under 86% moving our way on a consistent basis toward 85% direct cost of services. SG&A was reported at 6.6% for the quarter, but after adjusting for $300,000 change in deferred comps investment accounts that are held for and by our management people; our actual SG&A was 6.7%.

We would expect our normalized SG&A to continue to be in that 7% range going forward with the ongoing opportunity to garner some modest efficiencies in SG&A. Investment income for the quarter was reported at $2,000, but again after adjusting for that $300,000 change in deferred comp, our actual investment income was about $0.5 million.

As we have previously discussed in last quarter’s call, at the end of 2015, the Congress did reauthorized and extend through 2019 the Worker Opportunity Tax Credit program. So our effective tax rate for the quarter was 37%.

And for the balance of 2016, we expect our effective tax rate to be in that 37% range inclusive of that Worker Opportunity Tax Credit benefit. We continue to manage the balance sheet conservatively and at the end of the quarter had over $100 million of cash and marketable securities and a current ratio of four to one.

Accounts receivable remained in good shape below our targeted DSO of 60 days. In conjunction with the release yesterday, the board of directors approved and increased the dividend to $0.1825 per share, split adjusted and payable on June 24.

The cash flow and cash balances for the quarter more than support it 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.

This will be our 52nd consecutive cash dividend payment since the program was instituted in 2003, and its now the 51st consecutive quarter that we’ve increased the dividend payment over the previous quarter. And that’s a 13-year period now that includes four 3-for-2 stock splits.

So with those opening remarks we’d now like to open up the call for questions..

Thank you. [Operator Instruction] and our first question comes from A.J. Rice of UBS. Your line is now open..

Yes thanks. Hi everybody..

Good morning A.J..

Good morning..

When we look at the lines of business the housekeeping and linens was up about 5% year to year and dietary up 12% you mentioned that that’s your toughest comp in the first quarter.

Can you may be just talk about how you see the growth in those segments progressing over the rest of the year will they step gradually up or do you see it bouncing back quicker to more of those target ranges strictly to housekeeping and linens?.

I think it will happen more evenly over the balance of the year and you know A.J. as I opened up the call with, we’ve always tried to be more selective in our expansion making sure we have the management capacity to not only operate the facilities but also to ensure client satisfaction.

Some times we don’t spend enough time talking about how critical retention is to our topline growth in the near term but more importantly to our growth that is going to happen three years down the line our existing client base access our reference list and more than nine out of every ten of our new opportunities come from the existing customer in some form or fashion.

So for the balance of the year our focus will continue to be around focusing on the quality and the quantity of the management pipeline, which is a district by district region by region exercise.

Because more than anything else the pace at which we are able to develop management talent specifically at that the MIT and department head level is the gaining factor on how quickly we can grow.

Having said that I would say as far as the bolus of new business that we’ve added during the first quarter, other than the southwest divisions, which opened up about a third of the new facilities during Q1 the buildings were really pretty evenly distributed across the both the divisions as well as the segments.

So we would expect more normal course of business type growth for the balance of the year especially in those areas that have impacted by the expansion and that is what should put us in and around that double digit top line range for 2016 and moving ahead towards 2017 as well..

Okay, there has been a little bit of press on the whole issue of minimum wage particularly in California and New York we are actually trying to move to $15. Can you just remind us I know a lot of your contracts are sort of pass through.

How do you look at that is that a potential positive for you is it sort of a neutral because you just don’t have to go out and hire the people and what kind of indication are you getting from nursing homes about having to respond to those increases in minimum wage?.

I mean for us A.J. it is treated as a traditional pass through cost. So from a contract administration perspective the adjustments are pretty straight forward. Really the difference for us as it relates to the minimum wage specifically is more form over substance and rather than the local market forces driving the inflationary pressures.

And the administrator planning for or reacting to a tight or a slack labor market in states like California and New York the wage pass throughs would be determined by government mandate. But financially it is a really a cost neutral proposition for us since the contract pass throughs are margin preservation not margin expansion tools.

And look this isn’t a new dynamic for us either. We’ve dealt with minimum wage increases for years as a company.

And as far as some of the anecdotal feedback we’ve heard from our client partners it is more around the amount of the proposed increases specifically in New York and California rather than the mechanics behind it, where in the past minimum wage hikes would typically have a ripple effect on the entire wage scale.

Under the current proposals that ripple impact may not be economically feasible in many facilities, which as a derivative impact could affect their ability to attract and retain talented license staff that could promote greater wage parity, which could result in employ morale issues.

All of those are argumented I believe they are valid arguments against minimum wage increases and typical arguments you would expect to hear from the provider side but it remains kind of to be seen what will ultimately happen. But that is somewhat of the preliminary albeit anecdotal concerns we’ve heard from our clients..

Okay and then my last question.

It seem to be some head line discussion about increased pressure on nursing homes roll out of the RAC audits, may be some of the bundle payment initiatives can you just may be give us an update on what you are seeing in terms of the credit quality of your customers and trends along that line?.

As far as the overall health of the client base we haven’t seen anything on a macro level that would be cause for concern. As you know A.J. we’ve always managed the credit on a facility by facility client by client basis rather than in the aggregate knowing good operators, good managers are going to thrive in difficult reimbursement times.

And poor operators will struggle even what may be perceived as a stable reimbursement environment. But I would say today we mange the credit as tightly as we have at any point in time in the company’s history.

We have actually have left or reduced services in more facilities for credit related reasons over the past five years and we have the first 35 years of the company combined.

We won’t leave the company in alert, but when necessary we’ll give back the largest component of the contract, the payroll and in dining the food purchasing component until they get back on their fiscal feet in which case we’re more than happy to transition back the full services.

But typically once those types of discussions or negotiations commence, it’s a pretty significant incentive to live, for the client to live up to it’s payment terms or at least agree to workout that were both amenable to that allows us to stay full service in the facilities.

And just to point even some financial context around the topic, if you look back historically, we’ve written off less than one half of 1% of our receivables in large part because of our collection strategy and our general approach to the customer base, but also because the providers could face obligation, they use the reimbursed funds for their stated purpose.

So we’ll continue to manage the credit on an individualized basis and that gives us the flexibility to custom craft our collection strategy depending on the facts and circumstances on the ground.

But overall, nothing on a macro basis that would give us cause for concern, although we certainly do hear again more anecdotal client-by-client, group-by-group some of the feedback around bundled payments, RAC audits and some of the other issues to assure that Medicare and the government is kind of pushing their way..

Okay, all right. Thanks a lot..

Thank you, A.J..

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

Hi, good morning all..

Hey, good morning, Chad..

Good morning, Chad..

So you mentioned ongoing margin improvement, should we expect that in direct cost for the year, or it sounds like G&A probably is where it is, or would go up a little bit? I mean how should we think about that?.

I mean for us Chad, G&A, it certainly came in strongly this quarter, but for us – so we can consistently demonstrate that we can get that SG&A under 7%, I mean 7% remains, I think for us a realistic target, given the fact that we are committed as a company to continue our investments in clinical support and expanding appropriately our human resources function and continuing to develop a best-in-class legal department here at the corporate office.

So for all those reasons, I would expect SG&A to continue in and around that 7% range.

But certainly on a cost of services side of the ledger, we think there’s opportunities and we’ve already seen the benefits of the captive vehicle and it’s hard to say as we sit here now that it’s sort of business as usual with the captive, having seen the benefits come through in the fourth quarter and now just as expected here in the first quarter as well to the tune of about $1.5 million benefit in the cost of services line.

But more importantly in the larger opportunity for us continues to be the under utilization of our middle management structure, specifically in the dining segment. As you recall, the district managers in our scheme of things should be overseeing 10 facilities to 12 facilities.

And in dining, they’re still really only averaging about nine facilities or so. The regional managers should oversee four to six districts, and in dining, they are currently only overseeing about four districts per region right now.

So as we continue to selectively expand our client base in the dining segment, those middle managers will become more full utilized and then ultimately that margin structure of dining should mere that of housekeeping and laundry.

So there still is, call it, 250 or so basis point opportunity in that segment, which ultimately works us as a company from where we are presently and historically down to an 85% cost of service company..

Okay. And then you mentioned captive insurance, you received about $1.5 million cost benefits in the quarter.

Should we expect that to tick up slightly next quarter or you think $1.5 million is about where it should be?.

I would expect in the near term, certainly in next quarter we would expect in and around that $1.5 million Chad. Certainly looking beyond that, there are opportunities for that number to increase, but the purpose is at next quarter, I think it’s a safe estimation that it would be in and around that same level..

And then just one last one, on the tax rate, I think last quarter you had expected somewhere between 36% and 37% tax rate. Now we’re looking at towards the higher end of that.

Has anything changed there or what’s driving that?.

Yes, it’s really just, I guess the one kind of being, an entity that’s taxed – fully taxed that the both Federal and state income tax rates is when you start to drive pre-tax income your tax rate increases.

So it’s really just that, both at the Federal level and some of the states that we operate in that were being taxed at the higher end of the graduated scale, which pushes that tax rate closer to 37% rather than 36%.

Again NovaSys stole valuable program for us in an absolute dollars, that program will grow alongside the size of the company, the size of our employee base, but as pre-tax earnings grow as well, then our effective tax rate will raise, albeit modestly and incrementally it will continue to raise.

But we would expect 37% certainly for the balance of 2016..

All right. Thanks that’s it from me..

Thanks, Chad..

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

Hey, good morning. This is Nick Hiller in for Ryan Daniels. Thanks for taking my questions..

Good morning, Nick..

Good morning.

About how actually are the full quarterly run rate from that $70 million in your business that you won was recognized in revenue during Q1?.

So we saw a little bit more than two-thirds of that recognized in the first quarter, Nick and certainly in the second quarter we’ll see the full run rate of the new business adds..

Okay.

And then I know you said that the gaining factor for growth is development of regional and divisional management is there anything you can do there to increase that pipeline of talent?.

No Nick, I mean certainly we wish we could and we continue to look for innovative ways to do just that. But for us getting resumés has never been an issue and hiring folks into our management training program has never been the issue. We’ve certainly always demonstrated the ability to get the appropriate number of candidates into that program.

But it’s been getting them through that program that remains a challenge given the fact that we’re committed to really a hands on apprenticeship type training model really a 90-day training program, the first 30 days of which is you will be performing the blue-collar tasks that you ultimately be managing.

We need to make sure that they are comfortable in a nursing home setting which is certainly not for everyone.

And managing our caliber of employees which are blue-collar certainly lower on wage scale than they might be otherwise used to interacting with and it’s a difficult and demanding client base, not to mention that our whole model is based on efficiency.

So we need them to be 100% certain that they know how long it takes to perform each and every one of those tasks. So we’ve not had success, Nick, in recruiting mid-level managers from other service companies, and trying to give them a crash course in our way of doing things and acclimating to our customer base.

So we’re more convinced than ever that the training and development has to happen in the field, at the facilities, in that very hands-on fashion that’s because of that that we lose two out of three of those management candidates in the first two weeks of that training program.

So as much as we’ve tried alternatives whether it’s recruiting mid-level managers, or accelerating the training program, or even trying to conduct training in more of a class room type setting, none of those models have been successful to-date, not to say that we don’t continue to look for innovative ways to increase the success rate at which candidates make it through the training program, but nothing on the horizon that would enable us to do that.

So having said that we continue to remain committed to that promotion from within model that we’ve always adhere to.

So this is such that certainly the demand for the services is greater than what we’re able to service but we have to grow in a fashion that enables us to stick to the management development mandates and more importantly, to Ted’s earlier point, keep that client base satisfied, keep the retention levels as higher, higher than they ever have been historically, because that is the base from which we continue to grow the business..

Okay, thanks. So it’s helpful color and then I just had two quick modeling questions.

First, could you provide a rough update on the client cup between your two divisions and then has there been any material change in client retention over the last quarter or two?.

As far as the facility count it’s over 3,800 facilities in housekeeping and over 1,000 in dining, Nick..

Yes..

And then retention rates have historically been greater than 90% we’ve been trending closer to 95% than we have to 90% the past 90 days, although that’s something we work as Matt said awfully hard at, there’s a lot of factors that go into play with managing that client retention.

And similar to how we described other aspects of the business until we demonstrate we can do it on a consistent basis then we’d be reluctant to say that’s the new norm because much of at least a significant portion of the retention and really where we are most at risk is new client introductions or client transitions where new administrator comes into a facility, doesn’t have the benefit of seeing the before and after of having worked with Healthcare Services Group he or she may have their own Environmental Services Director or Culinary Director from their prior operation and they bring that candidate in.

We’re better at reselling that individual today than we’ve been in the past, but that’s still where we are most-at-risk..

Okay, great. Thanks. That’s it from me..

Okay, Nick..

Thanks Nick..

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

Good morning, thanks..

Good morning, Sean..

Hi, Sean..

Matt, you mentioned the possibility of more savings from the captive at some point, what would be driver there is it rolling in something like major medical, or is it improving claims experience or there are other sources or opportunities that you were to find to there..

It’s really we are continuing to drive the underlying performance within the mix of claimants that we have from indemnity to medical only, which is really the crux of the programmatic enhancements that we made. All of the work we’ve done in the past five years centered around reducing the scope and severity of a given claim.

So that’s where the additional – that’s where the majority of the additional opportunity would come from. Now over the past five years we’ve been successful in shifting that mix from what was one-third, two-third, one-third indemnity, two-third medical only to 15:85, 15% indemnity, 85% medical only.

And the difference between the two types of claims on a fully-developed basis is $30,000 plus. So that’s really where the opportunity longer term would come from..

How does your approach there maybe differ from what Zurich was doing? Are you guys just a little bit more diligent or little bit more proactive in trying to get that shift over, is there some other kind of secret that you found that’s allowing you to drive better experience?.

It’s really a complete overhaul of our Property and Casualty programs that we began five years ago. The claim-ex of which was dropping both the worker’s comp and general liability programs into a captive insurance subsidiary.

But we introduced nurse case management which was a proactive, caregiving nurse to respond to the first – be the first responded to claimant, rather than a claims adjuster sitting in a cubical at a third-party insurance office. We introduced a third-party administrator in Gallagher Bassett and unbundled the programs.

And along with that, a national physicians’ panel, which proactively, and again, proactively manages the claims and is the first responder in terms of doc visits in caregiving to a claimant. So a series of adjustments over the years that again resulted in us being able to truly drive better claims experience..

Very good, big thanks. And then lastly on DSOs, you guys have been in the low 50s for a little while now.

Should we expect this to be the new norm or with you maintaining that the targeted 60s, is there some expectation that those drift higher over time?.

Yes. I think DSOs been pretty stable the past few years in the 55-day range, which I think Matt mentioned during his opening remarks below the target of 60 days.

Quarter-to-quarter fluctuations shown upward or downward a couple of days that’s driven as much by timing of when we collect the payments at the end of any given month or quarter, how successful we are in getting paid the last day or the last week of the month rather than the first day or the first week of the following month.

There’s nothing noteworthy in DSO. We would call it out if there were, so we would expect. And there’s no reason for us to expect it wouldn’t be in and around the range, it’s been at the past few years..

Very good. Thanks again guys..

Thanks..

Thanks, Sean..

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

Hey good morning guys.

Just could you kind of quickly detail any cost impact on cost of services due to kind of the inefficiencies as you ramp up this new bolus of business, and maybe any impact that had on the quarter and kind of how that should shake-out going forward?.

Yes. There was that impact, Toby. As you know we’ve talked about previously that when we’re at our most inefficient is when we’re starting a new relationship with the prospective client.

Because of the fact that we do go in and rather than tear up the existing schedule that’s been on the wall and put in our new systems with new staffing levels, day one, we do allow those employees to work through that existing schedule while we simultaneously work with them to understand which employees want to work, who wants to buy into our model and make sure that we can really, most efficiently implement our systems into that new facility.

So given all of that really, we’re absorbing the inefficiencies and inheriting the inefficiencies that that new client had prior to our entering into facilities.

So it’s typically for us a 30 to 60 day timeframe to be able to get in, do our due diligence, and then really fully implement our systems to be at or better than how we’ve budgeted that facility to run. So there was about a 20 to 30 basis point. I’d call it impact on margins in the first quarter as a result of those new business ads.

As we sit here today looking at those new facilities, there’s nothing that suggests that they will not fall within kind of our historical 30 to 60 day timeframe as to us getting our systems implement and then getting the facilities on budget.

So there was an impact in Q1, June of about 20 to 30 basis points, about $1 million of an impact, Toby, that as I mentioned. We would expect to be cleaned up within kind of the normal historical timeframe that we’ve targeted..

Okay. Thanks so much..

Thanks, Toby..

Thank you. And this concludes our question-and-answer session for today. I’d like to turn the conference back over to Mr. Wahl for closing remarks..

Before we wrap up, Matt was going to review our conference schedule over the next few months so..

Yes. Just quickly, we will be at the UBS Global Healthcare Conference on the 24 of May. That will be at the Grand Hyatt in New York. We’re going to be going to present at the Jefferies 2016 Global Healthcare Conference. That’s on the 7 of June, also at the Grand Hyatt in New York.

And then the Citi 2016 Small and Mid Cap Conference, which is the 9 of June and that will be at the Lotte New York Palace in New York as well. Hopefully, we’ll see some of you there. Thanks..

Thank you, Matt. And I guess overall the demand for our services continues to be greater than what we’re capable of managing. And with the regulatory and reimbursement uncertainty facing the healthcare provider community that demand should only increase in the years ahead.

The pace at which we’re able to develop management talent continues to be both the rate limiting factor on our growth, as well as our most significant organizational opportunity, which is why hands-on coaching and training district-by-district, region-by-region remains our highest priority in the year ahead.

We’ll look to keep our direct costs below 86%, and work our way closer to 85% direct cost of services.

With the primary drivers of that margin improvement being the dining and nutrition, districts and regions managing the right complement at facilities, as well as our property and casualty, and employee health and welfare programs being managed out of the captive.

We expect our normalized SG&A to be about 7% going forward, excluding any deferred comp impact, but remain committed to ongoing investment in our clinical dietitian, HR and legal functions. As we move through 2016, and what is our 40th year of business, we continue to operate in a recession-proof market niche.

The demographic trends have been and continue to be in our favor. We’re in an unprecedented cost containment environment that’s really increased the demand for outsourcing services of all kinds including ours. 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 manage 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 all of us at Healthcare Services Group, we wanted to thank you for participating today and have a great rest of the week everyone..

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