Good day, ladies and gentlemen, and welcome to the Healthcare Services Group Third Quarter 2016 Earnings Call. [Operator Instructions] As a reminder, today's call is being recorded..

The matters discussed on today's conference call include forward-looking statements about the business prospects of Healthcare Services Group 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 assumption 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 differ materially 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 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 Chief Executive Officer. Please go ahead, sir. .

Okay, thank you, Kaylee. And good morning, everyone. Matt McKee and I appreciate all of you joining us for today's conference call..

We released our third quarter results yesterday after the close and plan on filing our 10-Q the week of October 24..

Overall, we have very strong new business momentum heading into next year. And if we're successful in meeting our client retention and management development goals, then 2017 should look similar to 2016 in terms of top line growth. .

For the third quarter, revenues were up 9% to $393 million. Housekeeping and laundry grew at 5%. Dining and nutrition was up 16% for the quarter. Earnings from operations increased 13% in Q3 to over $30 million. Both revenues and earnings from ops were company records..

As we've discussed previously, the Department of Labor's minimum salary threshold rule takes effect in December of this year.

Similar to other facility level adjustments for operational systems and staffing patterns, wage inflation, commodity prices, or health insurance like in the case of ObamaCare, our clients understand and support our mutually agreed-upon approach to these types of matters, which is why we don't expect any operational or financial impact related to the rule change.

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As we enter the fourth quarter, the districts and regions have fully transitioned the new business added over the past 9 months and shifted their focus to managing the departments and, more importantly, developing the next wave of management people to service our existing client base and support our future expansion efforts.

And although each area is at a different stage in the management development process, overall our management pipeline is in good shape as we prepare for the year ahead..

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

Thanks, Ted. And good morning, everyone..

Net income for the quarter increased to $19.7 million or $0.27 per share, and that compares to $17.1 million or $0.24 per share for the same quarter, third quarter of 2015. Both net income and earnings per share were company records..

Direct cost of services came in at 85.6%, again below our target of 86%. And going forward, our goal is to continue to manage direct costs under that 86% level on a consistent basis and really work our way closer to 85% direct cost of services. .

SG&A was reported at 6.9% for the quarter, but after adjusting for the $900,000 change in the deferred compensation investment accounts that are held for and by our management people, the actual SG&A was 6.7%.

We would expect our normalized SG&A to continue to be at or below that 7% range going forward and really still have the ongoing opportunity to garner additional modest efficiencies..

Investment income for the quarter was reported at $1.4 million, but again, after adjusting that $900,000 change in deferred comp, our actual investment income was about $0.5 million..

And as we talked about previously, at the end of 2015, Congress reauthorized and extended through 2019 the worker opportunity tax credit program. And we continue to expect our effective tax rate for the year to be in that 37% range, and that's inclusive of that WOTC, the WOTC benefit..

Continued to manage the balance sheet conservatively and, at the end of the third quarter, had over $100 million of cash and marketable securities and a current ratio of nearly 4:1..

Our accounts receivable remain in good shape, right around 60 days.

And we have and will continue to be proactive with customers to strengthen our position as it relates to accounts receivable, specifically, when we cross-sell Dining & Nutrition Services, by requiring promissory notes when a secured position or other financial guarantee makes sense for the relationship..

Now, in conjunction with yesterday's earning release, the Board of Directors approved an increase in the dividend to $0.1850 per share, split adjusted, and that'll be payable on the 23rd of December in 2016.

The cash flow and cash balances for the quarter 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 our shareholders.

This will be the 54th consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law, and it's now the 53rd consecutive quarter that we've increased the dividend payment over the previous quarter. Now, that's a 14-year period that included 4 3-for-2 stock splits..

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

[Operator Instructions] Our first question comes from the line of Ryan Daniels with William Blair. .

Ted, let me start with one for you. You mentioned in your prepared comments that if the retention stays the same or trends on par with what you've been seeing, you could return to -- or should stabilize at a similar growth rate in '17.

Yes, I know historically you guys have talked about more of a 10% to 15% growth, so I'm curious if, given the size of the organization, we should be considering more of a high single, low double digit as a sustainable longer-term top line rate. .

Yes, I think it's overall, Ryan, we start with the fact that the demand for the services is as strong as it's ever been. There is significant pent-up demand as we head into 2017.

As you suggested, if we execute properly, specifically on the management development side but also with respect to customer retention, then '17 should look similar to this year in terms of new business, but the demand for the services has really always been there.

The rate-limiting factor for our growth continues to be our ability to develop the next wave of management people. And here we are 4 decades in, and we still have not found a management development shortcut in that promotion-from-within model.

Specifically as it relates to client retention, we've always been able to maintain a greater than 90% client retention rate really since the company's inception. And actually, over the past few quarters, it's ticked up closer to 95% than it has been to 90%.

And when you think about where we're most at risk, and it's been that way historically, it's when an administrator, a director of nursing in some of the smaller chains, maybe a principal changes jobs or takes on a new endeavor. And they don't have the benefit of seeing the before-and-after picture financially, operationally or otherwise.

They may have a preference to bring in their own activities director, maybe their own maintenance director, even a housekeeping and laundry manager.

Today, especially in situations where we're providing both services, housekeeping and dining, that individual is much less inclined to unravel what could be upwards of 20% of their management and cost structure, which is why, especially in those situations where we're providing both services, we become #11 on their top 10 list.

And that's why we've seen that customer retention rate continue to tick up. And it's higher in where we provide both services rather than the standalone.

So we're stickier, which is crucial for us as we look towards future growth opportunities because, still the case, more than 9 out of 10 of every one of our new business opportunities can be traced back to an existing customer in some form or fashion.

And that's what we expect to be the case going forward, but that sweet spot for us where we can best manage kind of the upwardly mobile opportunities for our management candidates as well as the client satisfaction levels that are critical to that future growth is probably that high single-digit growth rate.

We'll have quarters and years going forward where we're growing faster than that, where we reach double digits. That's not necessarily good for us because it does begin to pressure our management structure.

And as I said, we have to be disproportionately conscientious, at least relative to other service companies, in how we manage that customer satisfaction level. .

Okay, very helpful color. And then as my follow-up, maybe one for Matt. You talked a little bit about the DSOs. I know that's been ticking up pretty consistently, and I don't know if there's any more color there.

I think last quarter, you said there were some timing issues in California and Massachusetts that would be resolved, but it still appears to be going up a little bit, so any major changes in the end market there?.

No, I wouldn't say, Ryan, that on kind of a macro level there's any major changes. There are still sort of the inevitable delays that our customers face with respect to the timing of reimbursement that they receive in certain states.

But for us, the DSO, the majority of it is just timing with respect to payments received from our clients, where we paid the last week of the current month or the first week of the following month.

And we've talked about it previously, but overall, DSO as a metric, at least for us, is not a great indicator as to how successful we are in executing on our cash collection strategy. And it's not that we don't monitor it or pay attention to it, but there will be those inevitable quarter-to-quarter fluctuations aside.

But more than anything, we judge our customers' credit worthiness by whether or not they live up to the credit terms that we've agreed to. So we don't manage the collections really on a top-down manner or look at things in the aggregate. It really is not only a customer-by-customer but even facility-by-facility exercise.

And we know that through many different cycles of the overall kind of reimbursement and financial environment, good operators will find ways to thrive in what are perceived as challenging times; and poor operators will manage to struggle even in times that are considered more stable or even favorable.

So we'll continue to manage on an individualized basis and custom-craft our collection strategy, depending on the facts and circumstances that we're hearing down to the facility level; and continue to explore the usage of all of the collection tools that are in our toolbox. .

Our next question comes from the line of Chad Vanacore with Stifel. .

So one of the things I noticed about this quarter is that OpEx is actually a lot better than expected. And it looked like it was mostly related to direct costs.

Can you give some idea what's actually driving that?.

Yes. I mean it was -- you're right, Chad. And it was really kind of the combination of 2 factors. The captive, not as much the vehicle but really the programmatic enhancements that feed through the captive by way of work comp experience, we continue to see the benefits there as we've expected.

And secondarily, we were able to sort of button up the budgetary and expense-related costs from some of the new startups that we brought onboard in the first and second quarters.

And as we talked about previously, we not only sort of slowed down some of the additional growth opportunities from that initial bolus of business that we took on in the first and second quarters, but we did have some sort of slowdown in getting some of those facilities on budget for a variety of reasons.

So the combination of the benefit, the continued benefit, from the captive; and now having significantly buttoned up the new business to being on budget is really what drove the cost-of-services improvement there. .

So Matt, at this point, you -- do you think all that new business that you brought onboard in the first half of the year, it looks like it's on budget and then it's going to perform to your margin specs?.

Yes, absolutely, Chad. Not only is it all fully folded in on a full run rate basis now but absolutely on budget at this point as we sit here. .

All right. And then one of the other things that I noticed about the quarter is tax rate was actually lower than we expected, and yet you had guided toward 37% tax rate for the year. This quarter, it looked like it's 150 basis points below that.

Are we expecting some kind of tax change in the fourth quarter? Or should we expect that maybe tax is coming in a little bit lower?.

It's really just the timing of the tax credits on a quarter-to-quarter basis that affect the provision, but we would expect that for the year it to end up in and around 36.5%, so not too far off of that 37% we've estimated. .

All right. And then I'm not sure if you covered this in Ryan's prior question, but DSOs were a bit elevated following the second quarter.

Do we expect that to get down to a normalized rate soon? Or is this a new normal up here?.

Yes, I wouldn't describe it as a new normal necessarily, but Matt talked about the timing that drives the majority of our DSO, as far as fluctuations quarter-to-quarter. It's also mix of customer, what the negotiation or the terms of each arrangement we make are.

It's just not a great metric for us in terms of whether we're executing on our cash collection strategy successfully. And again, as Matt said, it's not that we don't monitor it or pay attention to it, but we don't judge the creditworthiness of our customer by their DSO standing.

We have some highly creditworthy customers that are at the very -- at the highest end of our comfort level in terms of credit. And we have some that are on biweekly payment terms that we're nervous as hell about, so it really varies customer by customer rather than some topside financial metric that we're focused on. .

Our next question comes from the line of Andy Wittmann with Robert W. Baird. .

So just given the impact that the DOL overtime rules have, we thought we'd get you a bit more on record on this one and talk about -- I mean I heard your comments that you're not expecting a major impact to your financials, but just drilling into that.

Are there steps that you need to take to make sure that it doesn't have a impact on your financials? In other words, are there mitigation steps that have to be in place by December 1? And are they in place? And how many employees, if you don't mind, could this potentially affect for you?.

Yes, whatever changes or adjustments have been made are done at the local level and they're changes in form rather than substance. But just to take a step back, Andy. This has been out there as a highly likely possibility for over 2 years. The rule's been finalized since May, so at least from our perspective, this is relatively old news.

No -- and as you said and we reiterated in our opening comments, we don't expect there to be any operational or financial impact related to the rule change. But on some level, all of our managers have been impacted by the process, whether it's administratively or from a client contact perspective.

But to the extent there's facilities that are impacted by the change; or any other facility related matter, whether it be staffing pattern related, minimum wage, union contracts, most recently ObamaCare, it's really handled at that local level between the administrator and the district manager.

We have over 50,000 employees, nearly all of whom are hourly. And this is what we do. We're a labor management company. I think if we've demonstrated anything over the past 4 decades, it's that we know how to manage labor, whether it be hourly labor or salaried labor.

And ultimately, because we're the employer of record, we control what our managers are paid, whether that pay takes, again, the form of an hourly or salary payment. .

Okay, that's helpful. And then I just wanted to kind of take your temperature on the build-out of food. Clearly, it's obviously been growing faster than the housekeeping segment for a while.

Ted, I guess I'm kind of just curious as to your updated thoughts on how long do you think that it takes for that business to get to scale, where you could see the margins be more in line with the housekeeping segment and how that's progressing clearly pretty well given the top line.

But just kind of your thoughts about what the future looks like for that margin's progress to unfold. .

Yes, Andy, I think you're correct, obviously, in pointing out that the top line growth in dining, at least relative to housekeeping, has been more accelerated.

And always want to point out that that's not due to any increased demand but really, just due to that underutilized middle management structure that you called out us still having in the dining segment.

And as we continue to expand the dining business, it really -- there's -- it's an operational exercise as to sort of filling in that underutilized structure. And it varies regionally as well.

So if you think about our more mature operating divisions in the dining segment, the Mid-Atlantic and the Northeast divisions, they are more fully utilized where you have district managers overseeing 12 facilities; you've got regional managers overseeing 6 districts.

Compare that to the less-mature segment divisions, the Southeast, Midwest, out to the Far West, where you're still significantly underutilized and on a rolled-up basis, the district managers in dining are averaging 8 facilities overall, 4 districts per region.

So if we're adding facilities in the Mid-Atlantic and the Northeast divisions, we need to simultaneously expand and build out the district and regional structure, whereas obviously in the underutilized areas, we can more aggressively add the facilities because the gating factor there is just our ability to develop facility level managers through the training program and not have to simultaneously develop and promote new district and regional managers.

Now, having said that, it is still an operational exercise; so out in those underutilized areas, there still are district managers overseeing 5 or 6 facilities and doing a great job. And when we layer-in even 2 more facilities, never mind 7 more, they may fall flat and not be able to perform. Now we don't cut them loose.

There's still a spot in that organization for them, but it's not as a district manager. Our model doesn't support in perpetuity those 5- and 6-facility districts, nor the 3- or 4-district regions. So it's crucial for us that the model does apply.

We've seen that they are out in those more mature divisions within the segment, but it is an operational exercise. We wish we could just look at a spreadsheet and say, "Hey, this district manager only has 7 facilities. Let's give her 5 more, and we're fully utilized." That would be great and clean. That's not the reality.

The reality is that it continues to be sort of an up-down stepwise exercise. And as we sit here, it's probably realistically still 18- to 24-month exercise. I think if we revisited this issue in 24 months and weren't a heck of a lot closer to having the dining margins on par with housekeeping, I think it's safe to say we would be disappointed. .

Our next question comes from the line of A.J. Rice with UBS. .

This is actually Jailendra Singh filling-in for A.J. Rice. So a few questions, if I can ask. First, just one clarification on the business rollout which got pushed from Q2 to Q3. Did you get the full benefit in Q3? Or do you expect some incremental sequential pickup from Q3 to Q4? Just trying to understand the timing of the rollout in the quarter. .

It wasn't implemented on July 1, if that's your question. It was implemented during the quarter, so of course, we'll get some additional top line run rate benefit. But again, we're not in a static state as an organization. We're constantly growing the business and increasing our footprint. .

Okay.

And can you remind us the -- was that business more housekeeping, dietary, like even split? Or it's more skewed towards one or other, like housekeeping or dietary?.

A mix of both. .

Okay. And then thanks for the color on the margin gap between housekeeping and dietary.

On that similar line, would you expect any margin improvement in your housekeeping business right now? Or do you think that business is already hitting your target and it's more of closing the gap between dietary and housekeeping?.

As much, Jailendra, as we can look at the housekeeping business and think that there are pressure points that we can identify to sort of improve down at the facility level; or rolled up, I mean, some of our district-level systems, I think, at this point, we sort of are what our records says we are.

We don't see any significant increases there on the come, so I would expect that housekeeping sort of continues in steady state historical levels. It's really the dining segment where the opportunity exists from a margin perspective. .

Our next question comes from the line of Sean Dodge with Jefferies. .

So Matt, maybe going back to the underutilization and the dining structure.

Which regions are you guys having most problems optimizing currently? And is it something structurally slightly different about those regions that's making it more difficult? Or is it just the way simply that demand has materialized?.

It's really actually neither of those points, Sean. It really just relates to sort of the maturity of the divisions.

And if you go back to even kind of the start of the company back in the mid-'70s, we started our operations in South Jersey, which was -- at that time would have been the Mid-Atlantic division; and then grew up to the Northeast; then down to the Southeast; then the Midwest and the Far West.

So just following that trajectory, you can understand that client relationships that we have really sort of follow that exact same track, so the longer-lasting relationships that we have with our clients really kind of follow similarly geographically.

So you can imagine, when we started the dining services division, having had the longest relationships in the Mid-Atlantic and the Northeast, that's where it made sense for us to initiate and ultimately expand our dining growth.

So we had the combination of longer-lasting relationships coupled with more experienced management teams from a dining perspective, so I would suggest that the reason that the dining has followed some sort of geographic trends is more related to the maturity of both relationships and the management team, much more so than demand or flaws in execution.

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Okay, makes sense. So staying on dining.

As that division continues to scale higher, how much room is left to squeeze savings out of the way you buy food or your input or your food costs?.

I would say that's an opportunity on the come that we're not really factoring into any of our estimates or any of our goals and objectives in terms of executing on the dining growth strategy.

But as we become a more astute purchaser and being able to be even more selective in our "all of the above" strategy that we have with respect to dining, the more concentration we have in specific line items that we purchase, then obviously, the more leverage we have with that manufacturer negotiating favorable deviated pricing.

So that is an opportunity, Sean, as you pointed out, but it's not something today that we're factoring in per se. .

Our next question comes from the line of Mitra Ramgopal with Sidoti. .

I'm just trying to get a sense if you're seeing any change in the competitive landscape as you try to win new contracts or even retain the existing ones, if you're still really dealing with the mom-and-pops or the third-party players that are coming into the space. .

Yes, it's really -- to the extent there's competition, it's at the lower end, that kind of inner city, Medicaid-based facility where maybe we'll run into a local janitorial company or a local catering company that has a footprint in that given market.

And at the higher end, if we're looking at a 50-acre CCRC-type campus, maybe we'll run into 1 of the big 3 service companies, Sodexo, Aramark or Compass. But more than 9 out of every 10 of the opportunities we look at, Mitra, it's really either us or the in-house operation. That has been the case and that continues to be the case.

There's plenty of room for competition within the market. There has been for 4 decades, but as we've demonstrated over time, we've been effective in kind of being able to deliver high-quality services in a cost-effective manner. And in this environment, I think that's a very much appreciated value proposition. .

And again, on the acquisition side, I assume the strategy is continuing to grow the business organically, no need to look outside of that. .

Yes, absolutely, Mitra. And it's for 2 reasons. Number one, as Ted just outlined, there really aren't attractive or viable acquisition targets out there, and that's a good thing from our perspective.

And secondarily, we certainly believe that the investment that we've made in establishing the national organization that we have in place, both in the housekeeping segment and in the dining segment, really positions us to be able to continue to grow organically.

So for those reasons, there's really no acquisition candidates on the horizon, nor is there any need for that.

As I said, the model, really from our perspective, the growth is a top-down exercise that initiates at the district level that Ted talked about kind of that balance in the beginning the call, that we need to add new business to be able to incent and motivate our management people. And that's our most valued resource.

We've got to be able to provide for them a path for career upward mobility and advancement, which is what attracts them to our company to begin with, but we have to balance that obviously at the local level with continued customer satisfaction and retention. So for all of those reasons, acquisitions are not a part of our growth strategy.

And we are fully confident that we can continue to grow organically. .

Thank you. And I am showing no further questions at this time. I'd like to turn the call back to Mr. Wahl for closing remarks. .

Thank you, Kaylee. And as we round the final turn in what is our 40th year of business, the demand for our services has never been greater. Our customer base and really the provider community at large continues to face significant uncertainty in both the regulatory and reimbursement environments.

Even with this increased demand, we remain committed to selective expansion so as to ensure accountability around systems implementation and adherence, budgetary compliance, people development and client satisfaction. .

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

We have had success in adopting technology and reducing the administrative burden placed on our district and regional teams, but there is no shortcut to training the next wave of management people, which is why management development remains our highest priority in the years ahead..

As we look to finish strong in 2016, 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 Matt and really all of us at Healthcare Services Group, I wanted to thank Kaylee for hosting today's call. And thank you again 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..