Good day, ladies and gentlemen, and welcome to the Healthcare Services Group, Inc. 2017 Third 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, go, may, intends, assume or similar expressions. Forward-looking statements reflect management's current expectations as of the day of this conference call and involve certain risks and uncertainties.

The forward-looking statements are based on assumption that we have made light in our -- of our industry experience and our perceptions of historical trends, current conditions, expected future developments or other factors that, we believe, are appropriate under the circumstances.

As with any projection or forecast, they are inherently susceptible to uncertainty and changes and 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 may 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 call over to Ted Wahl, President and CEO. Please go ahead. .

Thank you, Ayela, 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 the 23rd. .

I know these calls tend to be more focused on the financial aspects of our business, but I did want to especially call out the efforts of our operations teams, as it relates to hurricanes Harvey and Irma. Our hearts go out to all of those impacted by the storms.

And we were deeply saddened to witness the devastation caused throughout the greater Houston area and Florida. But the humanity, bravery and generosity that our employees demonstrated in the lead-up, during and in the aftermath of those terrible storms was beyond inspiring.

On behalf of the entire HCSG family, I'd again like to honor all of our Texas and Florida teammates for truly going beyond in the most special type of way..

As we look towards 2018, the demand for our services is as strong as ever. The demand will present significant opportunities for our company, as we have positioned ourselves as a strategic partner of the healthcare provider community.

It's incredibly exciting to imagine the future possibilities and know that our future begins with our people, going beyond and living out our purpose, exemplifying our values and fulfilling the company's vision. That is our pathway to delivering extraordinary outcomes and ensuring sustainable, profitable growth over the long term..

So with that context, I'll turn the call over to Matt for a more detailed discussion on our Q3 results. .

Thanks, Ted, and good morning, everyone. Revenues for the quarter were up 25% to $491 million, housekeeping and laundry increased 3% to $247 million, and dining and nutrition grew close to 60%, coming in at $244 million. So we've reached the point of relative parity between the segments now from a revenue perspective..

Net income for the quarter increased to $23.5 million, or $0.31 per share. Book net income and earnings per share for the quarter were company records.

Direct cost of services for the quarter came in at 86.9%, above our target of 86%, due to the more deliberate approach we've taken in implementing our systems at the facilities from the second quarter expansion, coupled with the inefficiencies we inherited as part of the new business adds that we've brought on board in the third quarter. .

Going forward, our near-term goal remains to manage direct cost back under 86% on a consistent basis and, ultimately, to continue working our way closer to 85% direct cost of services beyond that..

SG&A was reported at 6.7% for the quarter, but after adjusting for the $1.1 million change in the deferred compensation investment accounts that are held for and by our management people, our actual SG&A was 6.5%. We would expect SG&A to continue to be below 7% going forward..

Investment income for the quarter was reported at $1.4 million, but again, after adjusting for the $1.1 million change in deferred comp, actual investment income was around $300,000..

Our effective tax rate for Q3 was 29%, which includes about $1 million or so impact related to the FASB required change in share-based payment accounting.

We expect our effective tax rate over the next year or so to be in that 35% range, excluding the share-based payment accounting impact and also excluding the possibility of tax reform, of which, based on the current proposal, we would be a significant beneficiary..

To the balance sheet. At the end of the third quarter, we had over $81 million in cash and marketable securities. Current ratio better than 3:1 with DSO coming in right around 70 days. .

And as we announced yesterday, the Board of Directors approved an increase in the dividend to $0.19 per share payable on December 22. .

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 the shareholders.

It will be the 58th consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law. And it's now the 57th consecutive quarter we increased the dividend payment over the previous quarter. That's a 14-year period that includes 4 3-for-2 stock splits..

So 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 Associates. .

Just a couple of quick questions.

First, how do you feel about -- a lot of business brought out on the second quarter and some more incrementally started here in the third quarter, how do you feel about having absorbed that bolus of business and getting the business to where it needs to be in terms of adding the next chunk of business? And I guess, as an adjunct to that, where do you -- how do you see the pipeline over the next 12 to 24 months?.

Yes. I think Matt mentioned in his opening remarks. But Mike, to your question and to his point, we've taken a more deliberate approach in getting the facilities from the Q2 expansion on budget.

And again, due to the relative complexity of those integrations as well as the scale and some of the union-related procedural delays with one of the multistate operator groups we expanded with, about half of the facilities are in geographies with a more significant union presence.

So just by their very nature, the integration is more procedural in nature. And then on top of that, we added a significant number of facilities in the third quarter and inherited the efficiencies of those operations. And as we've discussed previously, that's nearly always results in margin compression.

So I think from an integration and, really, the implementation of our systems and procedures, I think if we've demonstrated anything over the past 4 decades, it's that we'll know how to get the facilities on budget. And we're pretty confident that we'll show some incremental improvement during the fourth quarter.

And then we would expect margins to begin to normalize. And that's really a byproduct of our systems being implemented during 2018.

In terms of the balance of the year into 2018, I think, whether or not we continue to grow at the pace we have or it's tempered down or it's further accelerated, all depends on where we're at in terms of management capacity, the quality and the quantity of the management pipelines and really [Audio Gap] area, even district-by-district assessment that's [Audio Gap] ongoing basis and in a very bottoms-up type of way.

And looking back over the history of the company, that has truly been the one constant for us, from the formative stages right on through the present state, people development. And we emphasized the management and training level may be disproportionately, but it's really at all levels is the ultimate governor on our growth.

And that's why it continues to be the highest priority for us as a company. .

Okay. Great. And then quick follow-up question. I was wondering where you stand in rolling out that digital onboarding. .

Yes, Mike. As you know, that's been sort of an incremental project just to make sure that we have the capabilities to support each of the geographies. So we're about halfway through that rollout.

So If you think about 10 operating divisions that has been fully rolled out to about half of those divisions and, really, we're kind of accelerating the back end of that. So the goal is to have the remaining divisions with the electronic onboarding capabilities by the end of this year, if not certainly by the first quarter of 2018.

But everything is progressing really exactly as planned. So we're excited about that opportunity.

And it certainly has freed up our on-site managers to do much more operationally focused tasks and servicing the customer as they should be, much more so than pushing paper with the numerous applicants that they're typically processing through at the facility level. .

That's exactly right. All -- that initiative and, really, any initiative we push out from corporate in collaboration with the field-based operators is all about allowing our operators to focus on systems implementation and adherence, employee engagement and customer experience.

They're really the metrics that we want to focus on as a company, not processing and administrative work. .

And as a follow-up to that.

Do you think that's helping you perhaps grow at a faster rate than you had in the past? Perhaps, do you have more management time to focus on this stuff? Or is that a factor you just can't measure yet?.

We wouldn't expect it to have an impact, Mike, on sort of the throughput in the management training program or even the management development, in general.

The 2 impacts that we primarily would expect to see and have really seen to date more qualitatively than anything would be the managers being better trained and better prepared to move on to the next role, whatever that role might be, whether it's moving through the training program and becoming a facility-based manager or whether it's a facility-based manager moving on to a larger opportunity or a facility-based manager moving into multi-facility management responsibilities.

That's certainly the one output that we've seen as a result of being able to utilize technology to better develop and train our folks for the next position that they'll be moving onto. The secondary benefit certainly would be from a client experience perspective.

Our clients don't want us administratively focused on pushing paper, whether that's with respect to regulatory compliance or hiring new employees.

So from that perspective, certainly, as much as we can utilize technology to free up our managers and line staff employees, as Ted alluded to, to better focus on systems implementation, we do see a direct correlation to the overall client experience, which, ultimately, ideally, leads to greater client satisfaction and, ultimately, has a positive impact on client retention, which, as we've talked about historically, is a crucial part of everything that we do in keeping that client base highly satisfied to be able to retain the business year-over-year, so that we're not out there trying to outsell our mistakes and we have that solid foundation from which to grow because, as we've talked about previously, nearly all of our new growth can be traced in one way or another to the existing client base.

.

Our next question is from Sean Dodge with Jefferies. .

Just going back to gross margins and the impact of the new implementation, I just want to understand a little better how union facilities differ from those that are non-union. I would have thought that natural attrition or turnover alone should be high enough to wind down the employee headcount in the union facility.

So you've -- you shouldn't have to actively reduce headcount and can avoid some of the regulatory [indiscernible].

Is that not the case? Or can you just clarify for me what I'm missing there?.

It's really the same dynamic with respect to sort of that natural attrition and reducing headcount, although, Sean, what differs in a union environment is really more procedural requirements in notifying the union of any and all changes that we propose to make within the departments that we manage.

We need to notify the union in writing of our intention to exercise management rights. And then anything from changing a job title to changing a job routine to clearly changing the schedule as it's posted on the wall with respect to how many bodies we need during any given shift or on any given day, we need to give the union notification.

And they'll almost always require that we honor the schedule that's posted on the wall, which is similar to how we would operate in a nonunion environment, the caveat being that the typical facility in a nonunion environment will have a 2-week, maybe a 4-week schedule posted on the wall, whereas in a union environment, it's typically a 4-week, sometimes even a 6-week schedule that's posted on the wall.

So it's really just, again, more procedural in nature that tends to be a drag and more of a delay.

But the reality is that operating in the union environment, in many regards, with respect to our operations is ultimately simpler and more straightforward in the sense that the collective bargaining agreement very clearly outlines the sort of work rules that the employees must honor, and the employees in that environment know that collective bargaining agreement and those associated work rules like the back of their hands.

So it does make the management of those employees in that environment typically more straightforward. But from a initiation of their relationship perspective, there are more, just again, what we would describe as procedural delays. We can get any facility on budget.

We just know that when we go into a union-based facility, we need to allow for sort of that longer period to allow for that natural attrition and headcount to occur. .

And Sean, just more specific to the second quarter expansion, I've referenced that earlier, that there was about half the facilities of that large multistate operator we expanded with, specifically that operated in the union environment. But it's really 2/3 of the wages, 2/3 of the cost associated with that contract.

So it has disproportionate impact and has a higher level of margin compression in what otherwise would've happened for the reasons Matt outlined. .

Okay, that's helpful. And then in the press release, there was mention of litigation [ you're -- in to ] collect payments.

Is there anything additional you can add there? Any background on the situation or how much money you're trying to collect?.

I think that's just standard safe harbor language that we have at the end of -- as part of the press release, Sean. There's nothing specific in our press release other than that, which we've had before. Thank you. .

Our next question is from Andrew Wittmann with Baird. .

Great. I wanted to ask a little bit about the sequential uptick in the revenue and just maybe if you could give us a little bit of a detail. The revenue up $20 million sequentially.

How much of that was just -- you find -- you guys finally being able to get some of the business started that was sold at for Q2, part of that bolus of business that was sold in 2Q but had to wait, just given the size and the wins there versus what I would call a different sale that started in the quarter that contributed to the revenue growth?.

Andy, there's about half of the -- just to break it down into the segment level, about half of the dining and nutrition growth in the third quarter was related to carryover run rate from the second quarter, which, is, I believe, the heart of your question. And the other half is really new business-related.

So if you think about the $16 million or so step-up in dining, $8 million of that was carryover run rate. The other $8 million or so was new business we added over the past few months.

And really, for housekeeping and laundry, just about that entire step-up was related to new business that we added during the third quarter, which, again, represented some of the opportunities we alluded to previously that we pushed out as a result of that all-hands-on-deck expansion during the first half of the year, where we did leverage much of our housekeeping and laundry as well as our corporate infrastructure to help support that significant integration.

.

Got it. That's helpful. So basically, $8 million was kind of new, new in dining, plus a little bit more in housekeeping gets you about a [ $50 ] million of new business that you started in the quarter. .

That's exactly right. .

Okay. And then just on the DSO, looks like by our calculation, up about 6 days year-over-year. I'm wondering if your mix towards more dining is a factor in that.

Or what we can attribute the increase in DSO to?.

That's -- it's a number of dynamics, Andy, that contribute to the change in the DSO number, whether that's quarter-to-quarter, year-to-year or sets of years, really. Those fluctuations are largely driven by customer mix. And certainly, the segment has an impact on that.

But really, it's an industry that ebbs and flows between consolidation, fragmentation, acquisition, divestitures as we work with new operators, whether that's expanding additional services or adding new facilities from an acquisition perspective, terms and conditions change, pricing, service levels, credit terms, et cetera.

So that's why DSO, really, as a standalone metric is not a great indicator as to how successful we are in executing on our credit and collection strategy. Now this past quarter, you had, similar to last quarter, the timing of the new business as we just talked about, adding about $15 million in new business.

And that has an impact on the DSO calculation, right, between a complete AR balance, but something less than the full run rate of revenue. But again, as we've discussed, we don't manage collections from a top-down approach or in the aggregate. It really is not only a customer-by-customer but really, a facility-by-facility exercise.

Knowing that in what could be defined as challenging times, good operators will survive and even thrive. And in even more favorable times, poor operators will find a way to get themselves in trouble. So for us, it really is very much a bottoms-up approach and really focusing at the facility level. .

And Andy, just to underscore Matt's point, really, it's not that we sit here and don't pay attention to it. But it's more about cash flow and cash flow management than it is a qualitative assessment. 60 days for us is not necessarily good. 80 days wouldn't necessarily be bad. We're -- it's not that we're agnostic or indifferent toward 70 days.

I know we've discussed this quite a bit over the past few years, especially the past year. But look, there's -- with the overall movement in healthcare towards value-based purchasing, along with bundling initiatives, RAC audits, I mentioned on previous calls the requirements of participation.

The industry, overall, has certainly felt a heightened sense of uncertainty and that's further amplified with continued census pressure. And what we've continued to see is the ongoing trend of decoupling the real estate from the operations, or said another way, the equity from the operations of the healthcare facility.

So for us, all of that uncertainty, regulatory and reimbursement-wise, has the effect of increasing the demand for our services since part of our value proposition is we're providing operational and financial certainty to about 20% of the facility's cost structure.

So it's a tremendous opportunity for us to be able to grow the company and continue to expand our footprint.

And quite honestly, it also presents a great opportunity for us to further strengthen all aspects of our customer relationships, with both existing customers and prospective customers, because we're able to engage not just the customer as we traditionally refer to them as, the facility or the bricks and sticks, but the lenders, the landlords, and we're able to find that neutral space.

So all of our interests are aligned in maybe a different type of way than they were before. But Matt referenced the challenging environment. And there's been -- you could argue for the past 40 years, there's been some form of a challenging environment.

But we're not going to bat 1,000, right? We enter every relationship with our eyes wide open as to the various possibilities. What's the best case? What's the worst case? What's our base case? And I can assure you and everyone else, we would not be in any of these relationships if we did not believe it was in the company's best long-term interest.

So having said that, there are customers we have relationships now that we may end up in a workout situation with. We may end up in litigation, to Sean's question, although that wasn't part of something we disclosed, or in a bankruptcy. God knows, after 40 years of doing this, we're all too familiar with every single scenario.

But I think -- and getting back to the company's balance sheet and our receivable balance, we are built to last. We're going to withstand and have withstood good times and bad times in the industry. And I agree with the way Matt kind of wrapped up his commentary on DSO.

At the end of the day, for us, it's a facility-by-facility assessment, qualitatively driven, regardless of size or scale. Good operators will find a way to succeed during the challenging times. And bad operators or poor operators are going to struggle even in a stable environment. .

Our next question is from Chad Vanacore with Stifel. .

So what kind of impact are you expecting from hurricanes in Florida and Texas? Would you anticipate booking extra revenues in 3Q from cleanup? Or on the flip side of that, would you be taking a hit from not collecting revenues from closed communities?.

Chad, there's no noteworthy financial impact, per se, for us. I know for other companies, it's been significant.

But again, I think the stories of heroism that have come out of Texas and Florida, really, from the associate level right on through our leadership team are a source of incredible pride for our company and something the entire organization has drawn significant energy from.

And I will tell you, over the past month, we've tried to figure out ways to give some of that special energy back to our teams because, again, it has been inspiring to be part of what they've done. .

Yes. I would just add, Chad, that from a financial perspective, certainly, in some of those geographies more localized, there were some temporal impacts from financial outlays. But we would be -- we would expect to be kept whole as a result of that. There might be some delays in reimbursements.

What we would rather talk about, though, would certainly be countless examples of employees exceeding our clients' expectations in managing through those hurricanes.

I mean, renting cars, trucks, trailers and even boats to transport supplies to affected client facilities, assisting in evacuating residents from impacted facilities or even helping to manage the influx of residents being temporarily housed at neighboring facilities.

We had managers and line staff employees spending multiple nights sleeping at a facility to ensure that the residents were cared for, traveling miles on foot, sometimes through floodwaters to make their way to the facility. So we're tremendously proud of the way our teams managed the impact of the storms.

And it certainly served to further cement our client relationships and allows us to demonstrate to our clients how seriously we take those relationships. And ultimately, the responsibility and, really, the honor that we have in caring for their residents.

So I think much more than any financial impact, either positively or negatively, the opportunity for our teams to demonstrate their value and for Healthcare Services Group to really cement the relationship that we have and the reputation that we've earned out in the industry with our clients and those relationships is certainly a huge positive that we've been thrilled to be able to witness throughout these devastating tragedies.

.

All right. So no noteworthy changes, no financial impact you're anticipating. .

No, nothing material. .

Nothing we'd expect, no. .

Was there anything -- just thinking about your pipeline, is there anything left in the pipeline to close from those new contracts that you announced back in 1Q? Or have they all been integrated as this point?.

At this point, Chad, you're talking about kind of the second quarter significant expansion with the multistate operator, those are -- that opportunity is pretty well exhausted. There may be surprisingly a bit different than the typical model. There may be some additional housekeeping and laundry opportunities with that client.

But from the way we look at it, that's a pretty mature relationship at this point as far as the opportunity goes. .

All right. Got it.

And then just thinking about it, because your call service were elevated because you've added all those new contracts, what kind of timing should we expect till they normalize?.

I guess, Chad, it's a tough question. If you think about it in a couple different buckets, right, kind of sticking with those facilities that we added in the second quarter, we talked about kind of the more deliberate approach that we've taken in integrating those facilities, given some of the complexities of that integration.

We talked about kind of a union dynamic. But then also from a management perspective, it's been a more deliberate approach to integrating those facilities. So they are exactly on pace. They -- we continue to see improvement there. September was the best month out of the quarter. So we'll expect to continue to see improvement there.

And ultimately, those facilities that we specifically expanded with in the second quarter should be, really, largely on budget by the end of this year, certainly by the start of 2018. With respect to the other facilities that we brought on board in the third quarter in both dining and housekeeping, very much business as usual.

Really, no -- nothing to speak of in any of those facilities that would suggest that they would leak outside of our standard. Housekeeping and laundry, 30 to 60 days expectation to be on budget. Dining, a bit longer, perhaps more of the 60- to 90-day range.

But certainly, from the business that we've brought on in the third quarter and what we envision coming on board most likely here in the fourth quarter, very much business as usual. No considerations outside the norm with respect to getting our systems implemented and ultimately getting those facilities on budget. .

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

This is Nick Hiller in for Ryan Daniels.

Most of my questions have been asked already, but on DSOs, I mean, how should investors think about that -- the accounts receivable trending over the next quarter or 2?.

It should be in and around 70 days, as it's been the past couple quarters. But now, again, to Matt's earlier point and to the conversation we've been having the last couple quarters, it -- trending upward or downward is not necessarily a positive or a negative sign. It's really the qualitative assessment that we look to as a company.

And Nick, just to take a step back, we've written off less than 1/2 of 1% of the company's billings since the inception of the organization. So at various times, through reimbursement and regulatory history, it's been slower pay or faster pay. But we've always been successful in executing ultimately on our collection strategy.

And I -- we believe that will continue to be the case going forward. .

Okay. Great.

And then looking at direct cost, was that [ opposite ] percentage of sales for both your housekeeping and food services segments?.

No. The segment margins will be in the Q, Nick. They've not yet been finalized. But I'd expect housekeeping and laundry really to be at the upper end of kind of the historical range. And then dining and nutrition, certainly much more impacted by the expansion. So we'd expect the dining and nutrition margins to be at the lower end of the historical range.

.

Okay.

And then sorry if I missed this earlier, but what was your cash from operating activities for the quarter?.

That will be in the Q as well. But it'll -- it will be somewhere in and around $10 million. We don't really look at it quarter-to-quarter because depending on the timing of the payroll cutoff, Matt referenced earlier in one of his conversations the amount of new business that we start in a given quarter can impact cash flow from operations.

So there's a lot of different -- as well as DSO, which you referenced earlier. So there's a lot of different components that really determine cash flow.

But over this -- over the course of any year, or even more kind of appropriately any given set of years, that's really the net income is the best proxy for cash flow from operations for us as a company. I think if you go from 2012 through 2015, they mirror one another.

And that's what we would expect, again, going forward adjusted for some of those fluctuations quarter-to-quarter or even at times, year-to-year, depending on the cutoff of those items. .

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

Thank you. And as we make our 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. As we look to continue our positive momentum, the demographic trends have 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 all of us at Healthcare Services Group, I wanted to again thank Ayela for hosting the call today, and thank you again to everyone for participating in our conversation. .

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