Good day, ladies and gentlemen, and welcome to the Healthcare Services Group, Inc. 2017 Second Quarter Conference Call. [Operator Instructions].

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 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 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 Ted Wahl, President and CEO. Please go ahead. .

Thank you, Ayeila. And Ayeila, thank you for your counsel in advance of the call. I know you suggested that the results just speak for themselves. And that in this case, silence would be golden. But because of the demand from our many stakeholders to want to have a conversation today, we're going to go in that direction. But good morning, everyone.

Matt McKee and I 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 24. .

Revenues for the quarter increased over 21% to $471 million. Earlier this year, we called out anticipated new business adds of over $160 million. And we were able to exceed that expectation by accelerating our expansion with a large multistate operator.

As part of that expansion effort, we leveraged the customers' operational expertise, purchasing platforms, technology and talented employee base in a very meaningful way, right from the outset of the relationship. .

There are multiple aspects to the expansion that all worked together. Operations in clinical, pricing and credit as well as the acquisition of certain assets like inventory equipment and some additional operating wherewithal.

The synergies this opportunity creates allow us to successfully transition the new service agreements as well as further enhance our service offerings to existing and future customers. .

The provider community's emphasis around core competencies, especially in this era of value-based purchasing, continues to increase the demand for outsourcing services really of all kinds, including ours, that not only allow operators to focus on patient care and patient mix, which is the lifeblood of their business, rather than the support services that tend to drain their already limited resources.

This increased demand will represent significant opportunities for us in the years ahead, which is why people development, from the newest employee to the most experienced of leader, remains our highest priority. .

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 revenues of $471 million for the quarter, that includes housekeeping and laundry, which increased 2% to $243 million, and dining and nutrition, which grew over 50% to $228 million. Net income for the quarter increased to $22.6 million or $0.30 per share.

And direct cost of service for the quarter came in at 86.5%, which is about 0.5% or so above our target of 86%. And that's due to the inefficiencies that we inherited as part of that new business expansion that Ted referred to in his opening remarks.

And going forward, our goal remains to manage those direct costs under 86% on a consistent basis and ultimately to continue to work our way closer to 85% direct cost of services. .

SG&A was reported at 6.8% for the quarter. But after adjusting for the $1.2 million change in the deferred compensation investment accounts that are held for and by our management people, our actual SG&A was 6.5%. Now we expect SG&A to continue to be at or below the 7% range going forward.

And there are some ongoing opportunities to garner additional modest efficiencies. Investment income for the quarter was reported at $1.5 million. But again, after adjusting for that $1.2 million change in deferred compensation, actual investment income was around $300,000. .

Our effective tax rate for the quarter was 32%, which includes about a 2% impact related to FASB's required change in share-based payment accounting. Now we expect our effective tax rate for the remainder of 2017 to be in the 35% range, excluding any share-based payment accounting impact.

And we'll continue to maximize the tax credit programs inclusive of WOTC. We continue to manage the balance sheet conservatively, and at the end of the first quarter, had over $77 million of cash and marketable securities and a current ratio of greater than 3:1. Receivables remained in good shape and DSO was at 65 days. .

And as we announced yesterday, the Board of Directors approved an increase in the dividend to 88 -- or to $0.18875 per share. And that's payable on September 22.

And with the dividend and tax rate in place for this foreseeable future, cash dividend program continues to be the most tax-efficient way to get the value in the free cash flow back to the shareholders. This will now be the 57th consecutive cash dividend payment since the program was initiated in 2003 after the change in tax law.

And it's the 56th consecutive quarter that we've increased the dividend payment over the previous quarter. That's now a 14-year period that's included 4 3-for-2 stock splits. .

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

[Operator Instructions] Our first question is from Michael Gallo with CL King. .

My question, Ted and Matt, is just on the housekeeping linen/laundry side, I mean, exceptionally strong quarter in the dietary segment.

How should we think about the kind of the growth rate of that on a go-forward basis? And did you kind of slow that down intentionally, given just the large amount of business that you're absorbing? And how should we think about that segment of the business getting back to its historic growth rates?.

Yes. Thanks, Mike. And as you can imagine, the expansion was all hands on deck. We had significant involvement from housekeeping personnel as well as our district and regional management people to corporate office in a very targeted and strategic way.

But from a housekeeping perspective as well as dining, many of the additional or incremental adds that we had planned for the second quarter had been pushed out into the back half of the year. But ultimately, when we look out over the next 3 to 5 years, we continue to see housekeeping as a mid-single-digit-type growth segment.

We'll have quarters and years where it's going to be in the double digits, Mike. We'll have quarters and years where it's more in line with where it's been the past couple of years. But ebbs and flows and lumpiness aside, that's how we see it play out over the next 5 years.

The governing factor on that growth being our ability to develop management people. And again, it's done locally, not done topside with maps and pushpins. Each and every district and region is at a different stage of development with respect to the management pipeline, quality and quantity. So that's going to act as the driver.

But certainly, the demand for both services, housekeeping and laundry, continues to be more than what we're capable of managing. .

Okay, great. And then just a follow-up question, I mean, obviously the labor markets have gotten tighter. You're bringing on a tremendous amount of business in spite of that.

So I was wondering, have you seen any constraint in any markets? Because if anything, you're probably adding more business today than you ever were before in an environment where theoretically labor, which has been the gating factor, is tighter than it ever was before.

So I was wondering if you can give us some thoughts on what you're seeing and just your comfort in being able to get the people you need to manage all this business. .

Yes, Mike. Certainly, that applies. But it's really more market-specific as those dynamics play out. And that's sort of the beauty of the intentionally-designed model of having the recruiting, the hiring, the training and development efforts all executed locally. So in any given market, there may be challenges that they face.

But those folks that are managing that recruiting and management development function are able to leverage whatever avenues they find best to be able to find talent and bring them onboard.

So certainly, challenges in some markets, but if we were going to try to have a centralized recruiting, training and development function and health care university here in Philadelphia or in Chicago, that would certainly be a much more challenging task.

But by asking each district essentially through their district training manager to effectively develop 2 or 3 successful candidates through the management training program each and every year, it's much more manageable in that way.

So from a management perspective, Mike, we're really not seeing any challenges different than what we've seen historically. We're typically able to garner candidates regardless of the overall employment environment.

The challenge for us, as you know, Mike, has always been in not hiring these folks but in getting them through that rigorous 90-day training program, which is inclusive of the first 30 days being a very hands-on training program with mops in hands, scrubbing pots and pans, the true blue-collar tasks that we'll ultimately be managing.

And 2/3 of the candidates don't make it through that program. So it's really that being the gating factor, that the challenges of that management development training program, much more so than identifying and ultimately hiring candidates into that program.

Now if you look at sort of the line staff level of employees, that's really again a market-specific proposition and really a facility-specific proposition in the fact that the client does set and determine the conditions of employment at that facility and specifically as it relates to hiring, establishes the hiring wages at the facility.

So if in a specific facility environment we're having difficulty hiring employees into the entry-level housekeeping pot washer, dishwasher, dietary aide-type positions, that's when the case where we would have recourse through the client and they're more than likely seeing that same challenge and hiring similarly situated blue-collar employees, they would most likely have to adjust those wages in order to be competitive to get bodies into the facility.

And as that wage increases at the facility level, we execute our pass-through clause into our contracts and through that mechanism have always been able to work in conjunction with the client, maintain the margins of the facility and still maintain the headcount that's necessary to operate the operations in the specific departments that we're managing and overseeing.

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Our next question is from Sean Dodge with Jefferies. .

This part of the expansion with the large multistate operator, Ted, you mentioned acquiring some assets.

Can you give us some more specifics on what you all bought and how much you paid for them?.

the customer systems, process, technology and really a highly engaged employee mix in a very intimate type of way right from the jump.

Now you know just with the familiarity with the company, as part of any expansion or new facility add, we're always inheriting, acquiring, leveraging some level of systems, process, any technology a would-be customer may have, obviously the workforce.

But the reality is there isn't much to garner typically, which is why we're being brought in, in the first place.

I think what made this opportunity atypical was not only the size and the sophistication as well as the cultural similarities, which made it easier for it from a transitional perspective, but that there's real value in the personnel and the synergies that we've identified, the purchasing and procurement, operations, finance, even administration, that we believe will benefit both organizations going forward.

I think from a pure "What did we acquire," the reality is there's multiple aspects to its expansion that worked in harmony with one another, Sean.

Ops and clinical, pricing and credit, I talked about some of them at the outset of the call, certainly the purchase of things like inventory equipment and technology, which allowed us to seamlessly transition the service and facilities.

So to try to carve out or highlight individual pieces of the expansion, it's just not meaningful because ultimately there are all parts of it whereas the service agreements really represent the whole. .

Sure, okay. And then can you give us a sense of the timing of the implementations in the quarter? What I'm trying to understand is how representative the incremental revenue in the quarter is of the true run rate. .

Yes, really, Sean, from a run rate perspective, we did start the bulk of the business in the early stages of second quarter. So from a run rate perspective, more than 80% of that new business added in the past few months is reflected here in the second quarter.

And the majority of any other planned new business was really pushed out to the back half of the year. So we'll expect to see the full run rate in the third quarter. .

Our next question is from Ryan Daniels with William Blair. .

This is Nick Hiller in for Ryan Daniels. I was just wondering if you could talk about kind of the time frame to bring some of the new business you rolled out onto budget and how we should think about cost of services as a percentage of sales over the course of the year.

And I know 80%-plus of the new business with the large multistate operators is dining-related.

Is that easier or harder to get on budget versus the core linen and laundry and housekeeping?.

It's really all the same. And it's not about just getting something on budget. For us, it's about holistically managing the relationship, managing customer satisfaction levels, implementing systems, procedures.

In the case of the large multistate operator, there's some opportunity to take some of their best practices and integrate them into our company. So it's a holistic approach that we take. But from a timing perspective, it really shouldn't be any different than what we've seen historically.

But as you layer in and look at the back half of the year, we would expect to see some incremental margin improvement between Q2 and Q3, and then some additional incremental improvement between Q3 and Q4. And then ultimately, by 2018, we would expect the margins to be similar or mirror right around where we've been at the past few quarters. .

Okay. And then I know DSO has ticked up again to around 65 this quarter, kind of continues the trend.

Is there any nuance there to point out with the new business that you added?.

When you think about DSO fluctuations or trends year-over-year, are more or less driven by mix. We're in an industry that ebbs and flows between consolidation, fragmentation, acquisition, divestiture, we're in a constant state of, so Kindred being the latest example of ownership changes. And in many cases, we are the only constant at the facility.

So as we work with new operators, terms and conditions change, pricing, service levels, credit terms. So there's a variety of reasons not necessarily good or bad as to why DSO may increase.

And that's why we always highlight DSO as not being a very valuable metric or indicator on how successful we are on executing on our credit and collection strategy.

That being said, this past quarter with the state fiscal year-end and budget issues in California and Massachusetts, which are typically what we see this time of year, Illinois being a high-profile state, impacted DSO this quarter as well as the other dynamic being just a mismatch of the complete AR balance from the new business that we brought on during the second quarter compared to the something less than the full run rate of revenue, which just distorts the DSO calculation, but nothing material or noteworthy beyond that.

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Our next question is from Chad Vanacore with Stifel. .

So I'm just going to delve into the new contract adds probably again.

So can you give us some more details around the size, the type of contract and breakdown by geography, if you could?.

Yes, I'm not sure exactly what you mean by size, Chad.

But if you think about, I guess, kind of the growth coming from multiple customers throughout the quarter, and that's inclusive of independent operators, independent facilities, some state-based groups, and then of course, multiple multistate operators, we've certainly called out the bulk of the growth coming in dining and nutrition and the bulk of that with one specific multistate operator.

If you look at kind of that growth specifically, geographically it is disproportionately contained in the Mid-Atlantic and the Northeast divisions.

More than half of that new business coming in, in those 2 divisions specifically, which presents both positive and negative, right? If you think about we've talked about a facility add not being a facility add necessarily when you factor in the geographical considerations, mostly as it relates to the employee wages and benefits as the driver in contract price.

So the Northeast and the Mid-Atlantic typically have much higher wage scales, a greater preponderance of union facilities. So the top line impact is certainly greater in those geographies.

The flip side of that, if you think about specifically from a dining management perspective, those happen to be, of course, the 2 more mature divisions of the dining segment, which have the more fully utilized middle management structure of district and regional managers.

So the challenge that, that presented in this expansion is that not only did we have to make sure that we were capable of managing this new business at the facility level, we did have to build out correspondingly additional district and regional management capacity to be able to absorb these into our dining management structure, whereas if you think about the other parts of the country, from a dining middle management perspective, they remain as yet underutilized so those parts of the country where we're not only able to more aggressively layer in to that business, but that business does have more of an impact on margin as well.

.

All right.

And is it -- am I thinking it in the right way if I think it's more like 80% dining and 20% housekeeping? Or is it all dining?.

Yes, the majority of it was dining and more than 80% of it.

There was some housekeeping activity at the end of the quarter, but we ended up -- again, most of the housekeeping transitions that were either scheduled or planned for the second quarter, the first half of the year for that matter, have been pushed out, along with multiple dining opportunities.

And for us, we're going to evaluate again the management capacity, quality and quantity of the pipeline relative to the significant undertaking. And that will determine the transition of additional services.

But we're committed to really making sure we dedicate the resources required to deliver the customer experience and ultimately the commitments we made to the employees as part of this transition. .

Yes.

Are there any guidepost that we should be thinking about in terms of if you're trying to manage how much business you're taking on in any given period? Any guidepost we should think about into how you're making those decisions?.

It's really dependent on our management capacity. I know the large multistate operator we called out and we're having a conversation about has some nuances to it relative to that.

But the reality is that the management training program and our commitment to promotion from within continues to be the tie that binds the company and is a critical part of fostering the culture.

One of the things really that made this attractive is foundational things that lead to the culture as well, whether it's integrity, collaboration, empowerment through individual ownership and accountability. For us, passion and perseverance -- values like that, that are also deep within our culture and present similarities between the 2 companies.

So as far as the training and the indoctrination of the employees and the kind of similarities between the 2 companies, especially of a large multistate operator, that will be more custom-crafted. And it's more about ensuring alignment of culture as opposed to subject matter training.

But again, going forward, Chad, this opportunity notwithstanding, the management training program is really going to be the governor on the growth. And that's always been the case. .

All right. And then Ted, right upfront, you said that you had acquired some assets from one of these clients of yours. Can you go into a little more detail what those assets were? And it looks like goodwill and intangibles jumped up about $30 million sequentially.

Can you talk through what that was and why?.

I mean, as part of any expansion or new facility add, we're always -- as I mentioned earlier, we're always acquiring or leveraging some level of systems process, technology, workforce. As I mentioned earlier, there just isn't much to garner typically, which is why we're being brought in the first place.

But this, more because of the size of the opportunity and what they were able to bring to the table created synergies between the 2 organizations. And we look at it holistically. The service agreements again are the whole.

Each of the parts, whether it's pricing, operations, clinical, you can go right on down the gamut, it's all -- it all feeds right into the service agreement piece. So to call out separate pieces or parts of it, it's just not meaningful because it's all about the service agreements.

And putting us as well as the client in the best position possible to transition and manage those service agreements. No different than what we do in a typical one-off facility.

It's just again the difference here is that we value it in a different type of way because of the expertise that we perceive that they have that was complementary to our company. .

Our next question is from A.J. Rice with UBS. .

A few questions, if I could ask. So it looked like the cash balance was down sequentially as obviously you're buying equipment and good -- some intellectual property, et cetera. Can we -- how much cash actually changed hands? Again, I'm assuming it's to that multistate provider that you actually paid them for some of this stuff.

Are you willing to disclose how much you actually paid?.

No, we don't talk about specific arrangement with the customers for all the obvious reasons. But as we said earlier, there were certain assets we acquired to transition effectively and then ultimately service the new contracts as well as scale as a company going forward across our entire base of dining and nutrition contracts.

But as I said earlier, A.J., it's all in the lead-up to putting us in the best position to craft the service agreements that worked for both the customer as well as us. .

But if we look at that cash balance, the sequential decline, obviously you've got the dividend, but you had your cash flow generation in the quarter. The principal -- there's no other reason that it declined other than the fact that this new business. .

No, there was -- the payroll cutoff was an over $15 million swing. It's not on the face of this balance sheet, but you'll see that in the detailed balance sheet in the Q. So the payroll cutoff was upwards of $15 million.

And then the payroll funding, right, the mismatch between the collections for the quarter and the payroll funding from us to the bolus of new business, the $250 million plus. So there was a lot of moving parts in addition to the dividend that resulted in the cash balance decreasing.

But as we've seen before, that cash balance will swing quarter-to-quarter, year-over-year, largely dependent on payroll accrual and DSO. And then obviously, to the extent there's any cash outlay or CapEx related to new business startups, that could impact it as well. .

Right. I guess, working capital, too. Is -- it sounds like there must be some personnel beyond just the hourly workers, which you often move over -- or when somebody that's been in-sourced goes outsourced. It sounds like there must be people that were involved in purchasing, people that were involved in management responsibilities that you've taken on.

Any sense of how many additional headcounts you took on and sort of -- you're taking on to corporate level for this maybe as part of the transaction?.

The majority of the increase in SG&A relates to the employee and employee-related costs that were part of the Q2 expansion, not even specific to the large multistate operators but just the entire group of facilities that we brought on. And that's consistent with what we said before, A.J.

We're absolutely committed to ongoing investment, clinical dietitians, HR, really all of the support functions. And that commitment to reinvesting in the business, whether it's human capital, technology or otherwise, it remains in place. .

Okay.

And then I just want to confirm, but in terms of the management infrastructure, which you've always talked about the advantages of having homegrown, you're not bringing in a bunch of people that are -- or did you bring in people that are sort of in that management infrastructure on the day-to-day operations to ramp this business up? Do you follow what I'm saying?.

Yes.

And A.J., I think if you think about the size and scope, if we're talking specifically about the multistate operator here, as you can imagine, with them having hundreds of facilities under management from a dining perspective, they did have an operational structure that was beyond simply the facility level, as you can imagine, right? So in the part of the dialogue that's been ongoing for more than a year, not only did we have a view into the facility-level management talent but additionally, the managers that were in the system both clinically and operationally beyond the facility level to multi-facility management roles.

And throughout that dialogue, we got to know those folks and gain a certain comfort and ultimately confidence that not only would they fit into our organization, but they would bring additional operational expertise that we could ultimately leverage for the betterment of the organization and create value.

So absolutely, that has been part of the transition. And as Ted alluded to, from a cultural perspective, really a great fit.

But not to completely abandon our training, our systems, our policies and procedures, there will be a more gradual indoctrination and introduction to the shared company culture that ultimately we'll be creating here as a result of this expansion. .

Okay. So some -- there were some people that were effectively brought over that were the equivalent of your maybe district managers or... .

A.J., just to be clear, that's always the case. When we're transitioning with an operator, whether it's an independent and it happens to be more facility-based, once you get into the greater than 5- to 10-facility realm, there is some infrastructure in place, and we're always inheriting, acquiring or bringing onboard.

Whether they transition over or not, that's the question mark in most cases. Here, we found tremendous value in and many talented employees that we believe have a bright future with the company and are going to be an important part of what we're looking to do going forward.

But as far as the transition and bringing onboard people other than the size, this is fairly standard. This is how we do it, right? We always talk about inheriting employees at various levels, depending on the size of the company, and then acclimating them to our company and vice versa and then moving forward. .

Okay. And I guess I'm just trying to figure the bolus of new business. When you think about your structure, you have 10 divisions.

Would you say that 2 or 3 divisions were really impacted by this and the others are out there still adding clients in just the normal course? Or does it really pretty much affect the entire company?.

That's a good question, A.J. And as we talked about it earlier, really 2 of the operating divisions were overburdened with this specific expansion here in the second quarter, those being the Mid-Atlantic and the Northeast divisions.

So certainly, we would expect very minimal, if any growth, in those divisions for the balance of this year, especially as they're focused on bringing these facilities on board implementing our systems, and as Ted mentioned previously, really ensuring an overall positive customer experience, which is certainly a huge part of our focus.

And clearly, as a result of that, the budgets will come in line, and we'll see the margin contribution that we expect from those facilities. Beyond that though, there was -- just given the scale of the second quarter expansion, each and every division was impacted.

So every division has been stretched, certainly not to the extent that the Mid-Atlantic and the Northeast have been, but every operating division has been stretched with this most recent expansion. Now having said that there, it should be -- that business as usual.

And in those other parts of the country, they should be continuing to develop management personnel and able to layer in additional business opportunities throughout the balance of the year that most likely got pushed off due to this expansion. Because as Ted said in his opening comments, this truly was an all hands on deck proposition.

As you can imagine, the growth that we did bring on in the second quarter here has been a significant impact to not only the dining operating structure but additionally corporate personnel and frankly for -- and in sort of a unique way, many of our housekeeping and laundry leaders. .

Right. Okay, my last question. So this case, you said it's 50% growth and it doesn't fully reflect the run rate, is a little bit more incremental tail to the run rate on the dining side.

Does this put you in any new kind of category in terms of your purchasing power versus where you were at in terms of your purchases of food and so forth? Can we think about that in any way down the road? Once you get the operating structure margin where you want it to be, do you pick up anything on the buying power?.

Yes. That was one of the attractive features that we thought could be leveraged going forward. .

Any sense of how much of an impact? What is the purchasing of food in terms of total cost -- percent of cost or percent of revenue... .

It's more -- it's not kind of monolithic you're at x amount of items, it's more the specific line item that you're purchasing. So again, relative to state prison -- state or national prison systems or international food service companies, $300 million of food purchasing may not sound like a lot.

But when you get down to the line item, specific needs of the long term of post-acute care community, that's where opportunities present themselves. So selectively, that's where we see the opportunity. But we're not prepared to quantify any efficiencies going forward. But yes, we do view that as an opportunity. .

And I am showing no further questions. I would now like to turn the call back to Ted Wahl for any further remarks. .

Thank you, Ayeila. And as the company makes its mark in what is our fifth decade of operations, the HCSG family is poised to begin a journey on which we will fully realize together our company's purpose, vision and values.

Enhanced employment -- employee engagement, consistent systems supplementation and adherence and increased customer satisfaction will drive the fulfillment of our vision of becoming the choice for our customers. That is our pathway to delivering sustainable, profitable growth over the long term.

As we look to continue our positive momentum, the demographic trends have been and continue to be in our favor. We're in an unprecedented cost containment environment that's increased the demand for outsourcing services of all kinds, including ours. We have the most talented management team 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 to come. So on behalf of Matt and really all of us at Healthcare Services Group, I wanted to thank Ayeila for hosting the call today.

And thank you again to everyone for participating. .

Ladies and gentlemen, thank you for participating in today's conference. You may all disconnect. Everyone, have a good day..