Ted Wahl - President & CEO Matt McKee - Vice President of Strategy.

AJ Rice - UBS Nick Hiller - William Blair Sean Dodge - Jefferies Seth Canetto - Stifel Michael Gallo - CL King.

Good day ladies and gentleman and welcome to the Healthcare Services Group 2016 second-quarter conference call. [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 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.

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 factors that could cause forward, that could cause future results to materially different 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 to 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 Mr. Ted Wahl, President and CEO. Please go ahead, sir..

Thank you, Candace, and good morning, everyone. Matt McKee and I very much appreciate all of you joining us for today's conference call. We released our second-quarter results yesterday after the close and plan on filing our 10-Q the week of July 18.

We have very strong top line momentum heading into the back half of the year and if we're successful in meeting our management development and client retention goals, then the next six to nine months should look similar to the first half of the year in terms of revenue growth. For the second quarter, revenues were up about 9% to 387 million.

Housekeeping & Laundry grew at 5%. Dining & Nutrition was up 16% for the quarter. Earnings from operations increased 12% in Q2 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 half of the year, working through the inevitable start-up challenges and establishing relationships with our new facility level customers.

Although some of the facility transitions were at the higher end of our historical range, in terms of the time it takes to implement our systems, procedures and staffing patterns, as of June, our operational programs were fully implemented.

We would expect ongoing margin improvement during the back half of the year, as our focus shifts from transitioning the recently added business to managing the departments and most importantly, servicing the clients.

For the balance of 2016, we will 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 will 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 18.7 million, or $0.26 per share. And that compares to 16.2 million or $0.23 per share in the second quarter of 2015. Both net income and earnings per share were Company records. Direct cost of services came in at 85.9%, which is right around our target of 86%.

And as Ted alluded to, some of the new facilities took longer to get on budget than originally anticipated, which impacted direct costs for the quarter. Now as of June, substantially all of that new business that we opened in the first quarter is on budget.

So going forward, our goal is to continue to manage direct costs under 86% on a consistent basis and then work our way closer to 85% direct cost of services.

SG&A was reported at 6.6% for the quarter but after adjusting for the $500,000 change in deferred comp investment accounts that are held for and by our management people, our actual SG&A was 6.5%. We would expect our normalized SG&A to continue to be at or below 7% going forward with the ongoing opportunity to garner some modest efficiencies.

Investment income for the quarter was reported at about $1 million but again, after adjusting for that $500,000 change in deferred comp, our actual investment income was about $0.5 million.

Now as we've previously discussed, at the end of 2015, Congress reauthorized and extended through 2019, the Worker Opportunity Tax Credit Program, or WOTC, so our effective tax rate for Q2 was 37%. For the balance of this year, we expect our effective tax rate to be in the 37% range and that is inclusive of the WOTC benefit.

We continue to manage the balance sheet conservatively and at the end of the second quarter, we had over 100 million of cash and marketable securities and a current ratio of 4:1; and accounts receivable remain in good shape, right around 60 days.

In conjunction with yesterday's earnings release, the Board of Directors approved and increased the dividend to $0.18375 per share, split adjusted and payable on the September 23, 2016.

The cash flow and cash balances for the quarter support it and with the dividend tax rate in place for this 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 the 53rd consecutive cash dividend payment since the program was instituted in 2003 and it's the 52nd consecutive quarter that we increased the dividend payment over the previous quarter. That's a 13-year period now that includes four 3-for-2 stock splits.

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

Thank you. [Operator Instructions] And our first question comes from AJ Rice of UBS. Your line is now open..

Thanks. Hello, everybody. A couple questions, if I could ask. So you're now -- I'm assuming the captive insurance subsidiary is having impact.

Can you describe how that impacted your results in the quarter?.

[Indiscernible] It's like we said before.

It's fully implemented and it's really being managed now in a normal course of business type of way but we expect that entity to contribute with based on all of the programmatic enhancements we've made over the past three years, really, to contribute about 6 million or so towards the direct cost line on an annualized basis.

So on a quarterly basis it should be in and around 1.5 million a quarter..

Okay.

And any comments about cash flow trends in the quarter? What you saw in those and so forth?.

I think the details will be in the Q but cash flow from operations for the quarter was over 10 million and we're always going to have those quarter to quarter fluctuations, AJ, depending on, really, the timing of the payroll cutoff and fluctuations or changes to our DSO, but over any year or set of years, the best proxy for free cash flow for us is net income..

Okay, and then maybe a bigger picture question to end on, there's been a lot written about some of the pressures nursing homes are facing, both reimbursement, direct audits, et cetera, and also some commentary about tightening labor cost out there.

Are you, I guess on the one hand, what are you seeing in terms of your, any developments in your customer base? Are you seeing any change? And then second, in terms of wage increases, which I know passed through for you and actually could be a little bit of a positive, but are you seeing any of that start to trickle through or not?.

Well, I think it's your, the, your first question as far as the overall health of our client base, we really have not seen as it relates to us, at least anything on a macro level, that would be cause for concern. But again, we've always managed to credit on a facility by facility, really customer by customer basis rather than in the aggregate.

And again, specifically, as it relates to us and just to put some financial context around it, if you look back historically, we've written off less than one half of 1% of our receivables, in part because of our collection strategy and approach knowing that the last thing a customer wants to hear is that we're giving them back the payroll, but also because of the providers' good faith obligation to really use the reimbursed funds for its stated purpose.

Once those types of workout or negotiations begin, it's a pretty big incentive for the customer to live up to its payment terms or at least agree to a workout that we're amenable to.

I think as far as minimum wage, AJ, we have seen some inflationary related pressures, particularly in states that have adopted minimum wage initiatives like California, New York, Washington state. But as you suggested, it's really no different than how we handle any pass through increase.

Because we match the wage rates, we mirror the benefits and recognize seniority at each facility, any changes to the conditions of employment contractually, whether it be minimum wage as you pointed out, even health and welfare in the case of ACA, think about commodity costs related increases in food, union related, DOL exempt minimum salary threshold.

Whatever it may be, they all trigger our pass through clause in the contract and we increase the billing accordingly. You suggested it would be good for us, it's really not a margin enhancement tool; more than anything else, it's just a margin preservation tool and that's how we view it and in fairness, that's how the customer views it as well..

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

Hi, this is Nick Hiller in for Ryan Daniels. Thanks for taking my questions..

Hey, Nick. Good morning..

Good morning. You always talk about the development of management as a key hurdle.

Has it gotten tougher over the last 12 months, given the improvement in employment picture to recruit? And has that cost any wage pressure at the management level?.

No, Nick, for us, I think we talked about this last quarter as well. And for us, it's really a situation that remains unchanged, certainly one that we keep our eye on.

As we've discussed previously, the rate limiting factor on our growth as a Company has always been and it continues to be our ability to not only hire and train but really develop through our management training program, the next wave of managers who will allow us to expand with our client base to manage facilities at that facility level.

So for us, it's a very important function and it's one that happens locally, so in given markets we'll have different strategies where we've seen success targeting specific employee pools or through different avenues. But if you look at it really on a macro level, nothing has really changed, as we see it, in the way of management development.

And that's really historically been the case that the overall employment environment may have an impact on the types of resumes that we see, but getting the quantity of resumes that we need in order to hire the number of folks that we need to get into that training and development program has not been an issue.

And really, from our perspective, while it remains the most important function for us as an organization, we've not seen any outside impetus or trends that are having either a positive or a negative impact on that function for us..

Okay, great. Thanks and then maybe just a broader end market question.

With things like bundles and ACOs out there, I mean, has that increasing demand as post-acute clients really need to refocus their operations and maybe prepare for a tougher environment ahead?.

Absolutely. There's any number of pressures, some of which you just alluded to, Nick, that are really pressuring the provider community and in an industry that, really frankly, has never been overly generously reimbursed and the provider community has always had to manage their financials as efficiently as possible.

But to your point, Nick, whereas outsourcing had historically been a decision that they would make as a want, their preference being to outsource certain functions that were either outside direct patient care or viewed as not a core competency or core function of the provider community, it's increasingly becoming a need.

And as the providers continue to get pressured, whether its reimbursement uncertainty or any of the other factors that you outlined, Nick, it really is becoming a need for them to manage their operations as efficiently as is possible from a financial perspective.

And the one way to gain not only financial efficiencies but cost certainty is to outsource as many functions as they can. So I would say, certainly, we've seen an uptick in outsourcing of all services, including ours.

So it absolutely represents an opportunity for us and other companies like ours that provide similar services in the provider community..

Okay, thanks. And then I just had two quick housekeeping type of questions.

Has there been any change in the retention stats across either of your business lines? And then do you have any update to the general facility count for Housekeeping & Nutrition and in Dining?.

Retention has been in line the past couple of quarters with that historical target of greater than 90% and nothing substantially different in the facility counts than what it has been before, since our last update. Thanks Nick..

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

You guys recently launched an initiative to streamline some of the administrative tasks that your district managers have to deal with.

Can you talk about some of the early results or feedback you're getting on that program and maybe what the longer-term goals of that initiative were?.

Yes, it's really an internal initiative and we're referring to it as the DM Refresh, the District Manager Refresh, the primary goal of which, Sean, is to really refocus our efforts around this idea of operational excellence, essentially maximizing the amount of time we spend, but more importantly the quality of the visits at the facility level.

If you look back and think about the investments we've made in technology the past few years, whether it be biometric time keeping, the mobile app technology and even more recently the CRM system and our on-boarding programs, all create efficiency, enhanced visibility, and ultimately drive accountability, which has really been the focus of the Company over the past three years.

And I think more recently, as the field has become more proficient in utilizing technology not just as a processing tool, but really as a hands-on management tool, to your point, we had been able to reduce the administrative burden and again, refocus our operational team on systems implementation and adherence.

So I would say as far as no note, as far as financially, the impact, there's no noteworthy financial investment or near-term ROI. We anticipate we're going to measure our success based on quality assurance metrics as well as employee satisfaction metrics, both of which will benefit the Company over the long-term..

I think, Sean, just as far as anecdotally, early returns and what we're hearing both from our employees and the client base has been very positively received, although as Ted said, it's going to be more soft measurement in the near term, but from where we sit, it's been a successful program to date..

Very good. The, so your SG&A performance is really good again. You guys mentioned in the past, planning investments in things like clinical dietitians, HR and legal.

Have these investments begun and the efficiencies you're getting and the operational leverage are just more than enough to offset them? Or have they not started yet and we should expect G&A to begin trending more towards the 7% target as those spends ramp?.

I think it's more the former than the latter, Sean, and, at or below 7%.

If we're looking at SG&A as a percentage of sales or revenues, it's a fair modeling assumption for normalized SG&A, although as you said, I know the past few quarters it has been certainly below the 7% and the dollar spend being at the lower end of that $25 million to $27 million range that we look at internally.

But our reluctance would be until we demonstrate we can manage it consistently at those levels, to say, this quarter is the new norm going forward.

There's nothing specifically planned that should result in a significant jump in SG&A but again, until we demonstrate otherwise on a consistent basis, at or below 7% and from a dollar perspective, that $25 million to $27 million range is how we think about it..

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

Hey, good morning, it's Seth Canetto on for Chad.

How are you guys?.

Good morning, Seth..

First question, just, have you guys accounted for anything different? I know you have the insurance captive I think that's going in the direct cost bucket. I guess, has anything [indiscernible]..

Primarily, that is correct, yes.

Excuse me, Seth?.

No, I'm just saying, it just didn't, it seemed like the expected savings,$1.5 million a quarter, that the direct cost seemed to tick up.

Is there something else going on or how should we be thinking about it?.

Well, they really have, if you look at it, it's really the direct costs have really been managed consistently under 86%, which has been our historical target and as we said before, more driven by the underutilized middle management structure in Dining & Nutrition services relative to Housekeeping & Laundry.

That will be the catalyst as we work our way closer to 85% direct cost of services. But the past few quarters in Q1 and Q2 with the new business pressures and some of the start-up challenges we've talked about, that's really why maybe direct cost is closer to 86% than it is to 85.5% or 85.6%.

But the efficiencies in the, as a result of the captive, and really, the programmatic enhancements we've made in the insurance programs are reflected primarily in direct cost, some modest efficiencies as a result of it reflected in SG&A but the majority of it is reflected in direct cost..

All right, great.

And then just understanding that Healthcare Services controls the growth from time to time in order to maintain higher retention and good client relationships, can you guys provide an update, really, on just how we should be thinking about revenue growth in the back half of the year? Should we be looking for 9% or 11%, or how should we be thinking about that?.

I would just -- not to rephrase your question but it's not time to time that we are conscious of our management development efforts, that truly is the sole driver of our ability to execute on our growth strategy as a Company.

Our new business pipeline, which is strong going into the back half of the year, is really the result of executing not only on our management development strategy, but also on our client retention metrics and adhering to the policies and procedures we have at the facility level to ensure satisfaction.

But we do have a full pipeline heading into the back half of year and if we execute properly, we believe the next six to nine months should look and feel similar to the first half of the year in terms of new business, which would put us in and around that high single, low double-digit range for the year..

All right, great and then just last question. I think you guys mentioned that Housekeeping grew 5% and Dining grew 16%.

Can you give any color on the margin performance within those segments? And just go over the typical ranges for those?.

The segment information will be in the Q, but we would expect both Housekeeping & Laundry as well as Dining & Nutrition to be at the higher end of the historical ranges in terms of margins..

Is that around 12% range for Housekeeping?.

Historically, from a segment perspective, we really look at it because of the corporate elimination cost, our total Company margins are between 14% and 15%, as you know. And when you look at it on a segment level, Housekeeping, at the higher end of the range would be in that 9.5% to 10% range in Housekeeping and in Dining it would be north of 6%.

But again, the Q will be filed next week..

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

Just a question, I know you probably slowed down some of the additions given that it took a little longer to get some of the business on budget. When do you think you will be ready to start to ramp that up? I know you mentioned that the business is now on budget.

Does that start to ramp back up and you take and you are ready to take the next chunk of business you think in Q3, Q4 assuming things continue to go how they are going now? Or does it take longer before you start to ramp the additions back up again?.

No, you are right, Mike.

And as you alluded to when we talked about the first quarter add that we did bring on, there was a group of facilities that were originally scheduled to open as a part of that first quarter roll-out that we decided to push back a few months to devote the necessary time and resources to be able to implement our operational programs into that first wave of new business that we brought on in Q1.

And frankly, some of those adds in Q1 were challenging openings and took longer to get on budget than what we anticipated. So that's why number one, you see a bit of the margin compression that bled from Q1 into Q2 to the tune of about 20 bps to 30 bps of margin pressure and as Ted stated.

And we reiterated in our opening comments as of June, all that new business that we opened in Q1 is now on budget. So if you think about, number one, the group of facilities that we pushed out from anticipated Q1 opening, we are, in the present quarter, in Q3, bringing all those facilities on board and launching them.

And as Ted alluded to, really look at, for us, that group aside, normal course of business throughout the third and fourth quarters for us as we continue to replenish the management development function and continue to add new business.

So the group that we did push out in Q1 will be opened here in the third quarter and outside of that, as I said, normal course of business with respect to management development and corresponding new business adds..

Okay, great. And then, Matt, I know the DSOs ticked up a few days. Can you give us just some further color on what you see on the DSO side? Thanks..

Sure. Obviously, Mike, DSOs are a metric for us and, really, frankly, it's just that, a metric. And we don't really pay as much attention to it as maybe the external audience does. It's not necessarily a great indicator as to how successful we are in executing our cash collection strategy but with a little bit of an uptick.

The majority of that was really just timing of collections. Were we paid in the last week of the current month or did it bleed into the first week of the following month and really, that includes some of the payment delays in states like California and Massachusetts that have a fiscal year ending in June.

They tend to run out of cash at the end of their fiscal year. And ultimately, issue essentially IOUs to their payees. Now typically, that evens itself out in the back half of the year and that's what we expect to happen in this year as well.

But really, the balance of that DSO relates to the new business that we brought on so for really, for us, nothing noteworthy with respect to DSOs. It still continues to, as Ted mentioned, manage the collections not only customer by customer but, really, facility by facility..

Thank you. That concludes our question-and-answer session for today. I'd like to turn the conference back over to Mr. Wahl for any closing comments..

Thank you, Candace. Historically, the want for our types of services has always been strong, but with the regulatory and reimbursement headwinds facing the provider community more than ever the need for our types of services is greater than what we're capable of managing. We would anticipate that need only increasing in the years ahead.

The biggest constraint on our growth continues to be our ability to manage, to develop management people.

Although we've had success in adopting technology and minimizing the administrative burden placed on our district and regional teams, there is no shortcut to training the next wave of management people which is why management development remains our highest priority in the year ahead.

We'll look to keep direct costs 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 to Dining districts and regions managing the right complement of facilities as well as our Property & Casualty and Employee Health & Welfare programs being managed out of the captive.

We expect our normalized SG&A to be at or below 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 really operating in an unprecedented cost containment environment that's only increased the demand for outsourcing services of all kinds, including ours. We have the most talented, ambitious management team we've had in the history of the Company.

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 to come.

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

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..