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

Sean Dodge - Jefferies Ryan Daniels - William Blair Michael Gallo - CL King Andrew Wittman - Robert W. Baird A. J. Rice - Credit Suisse Chad Vanacore - Stifel Bill Sutherland - The Benchmark Company.

The matters discussed on today's conference call will 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 believe, expect, anticipate, plans, will, goal, may, intense, assume or similar expressions. Forward-looking statements reflect management's current expectation as of the date of this conference call, and involves certain risks and uncertainties.

The forward-looking statements are based on the 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 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 forward-looking statements, whether as a result of such changes, new information, subsequent events or otherwise. Good day, ladies and gentlemen. And welcome to the Healthcare Services Group Inc. 2018 Second Quarter Conference Call.

At this time, all participants are in a listen-only mode. Later we will conduct the question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder this conference is being recorded. I would now like to introduce your host for today's conference Ted Wahl, President and CEO. You may begin..

Thank you, GG, and good morning, everyone. Matt McKee and I all appreciate you joining us today for the conference call. We released our second quarter results yesterday after the close and plan on filing our 10-Q the week of July 30th.

The healthcare industry continues to face regulatory challenges and reimbursement uncertainties but in our view, a bit less so than a year ago.

Many providers have expressed cautious optimism about CMS’s proposed reimbursement system, the patient driven payment model and the possibility of PDPM being a meaningful step towards a more predictable and sustainable reimbursement framework for the future.

The 2.4% market basket update which takes effect October 1st, is also a recent and positive development. And will go a long way in offsetting some of the inflationary pressures that many operators continue to experience. And a lot of the hard work that needed to be done around operator debt loads and rental rates has happened over the past year or so.

There are certainly more work to be done on this front, but again, a good amount of the heavy lifting has already happened. We entered the second half of 2018 having digested the new business brought on during the prior year and over the next couple of quarters, we'll look to selectively expand and continue to replenish the management pipeline.

So we're prepared for the next wave of growth in 2019 and beyond. As those facilities recently brought on budget continue to mature throughout the rest of the year, we would expect ongoing margin improvement with the goal of exiting 2018 at 14% gross margins with the full improvement being reflected in Q1 of 2019.

Cash collections and cash flow is also an area that's received a great deal of attention and focus inside and outside the company, and deservedly so especially in light of some of the stress the industry has experienced as of late.

We have more personnel and process capability in this area than ever before and continue to focus on enhancing visibility into our customers' business performance and strengthening payment terms and conditions.

Over the next 12 to 18 months, our goal remains to collect what we build and we continue to expect operating cash flow to approximate net income over that time period. So 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. Obviously as we're lapping the expansion that we undertook in the second quarter of 2018 we faced more challenging year-over-year comps this quarter-end and for the balance of 2018.

But having said that, revenues for the quarter were up 7% to $504 million, housekeeping and laundry was up 1% to $246 million and dining and nutrition grew at 13% coming in at $258 million. Net income for the quarter was $25.8 million and earnings per share came in at $0.35 per share.

Direct cost of services is reported at 86.9%, which remains higher than our target of 86%. Now the segment margins will be in the Q, but we'd expect housekeeping to be in line with last quarter and the dining segment margins to show some modest improvement compared to the first quarter.

Now as reflected in our cost of services, some of that improvement was offset, and that was primarily by the timing and mix of premium payments related to our insurance programs. We expect these costs to even out over the rest of the year as is the norm.

And as Ted mentioned in his opening remarks, our near-term goal remain to manage direct cost back to 86% by year’s end and ultimately continue working our way closer to 85% direct cost of services, which remains an opportunity for us. SG&A was reported at 6.8% for the quarter.

There was about a $900,000 impact from the change in the deferred compensation investment accounts held for and by our management people, so the actual SG&A was right around 6.6%. And we'd expect SG&A to continue to be below 7% going forward, with the ongoing opportunity to garner additional modest efficiencies.

Investment income for the quarter was reported at $1.3 million, but again after adjusting for the $900,000 change in deferred comp actual investment income was around $400,000. Our effective tax rate for the quarter was 22.5% and we expect our rate to be in and around this range for the rest of 2018.

That's excluding the share based payment accounting impact. To the balance sheet, at the end of the first quarter we had $88 million of cash and marketable securities and at current ratio of 3 to 1. DSO was around 62 days and cash flow from operations came in at $3.5 million compared to $24 million in Q1.

And just wanted to unpack a little bit the major contributors to that number, it was primarily due to the $20 million decrease in the payroll accrual. And just so it’s clear, the payroll accrual is simply related to the cutoff of our payroll period relative to the end of the quarter. And that evens out over the course of the year.

But just for some added color, the third quarter accrual will more closely mirror that, which we saw in the first quarter. And our Q4 payroll accrual will look a lot more like the second quarter.

And as to the DSO the day increase also contributed to the cash flow and really that increase was mostly related to Massachusetts and California state budget delays, which is not uncommon. As we announced yesterday, the Board of Directors approved an increase in the dividend to $0.19375 per share that will be payable on September 28th.

The year-to-date cash flows and accounts cash balances supported and with the dividend tax rate in place for the foreseeable future, the cash dividend program continues to be the most tax efficient way to get the value and free cash flow back to the shareholders.

This is now the 61st consecutive cash dividend payment since the program was instituted in 2003 after the change in tax law and it’s now the 60th consecutive quarter that we’ve increased the dividend payment over the previous quarter now 15 year period that included four, three-for-two stock splits.

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

[Operator Instructions] And our first question is from Sean Dodge from Jeffries. Your line is now open..

Good morning. Thanks for taking the question. .

Good morning, Sean..

So on margins they were pretty flat sequentially given the ongoing work around Genesis, can you talk about why we didn’t see any improvement there? And then now that you have all of the facilities that were added in 2017 on budget where are you guys running at on gross margins right now? This finally getting those on budget put you well on your way ahead of where you were in the second quarter as far as kind of tracking back towards this 14% target exiting the year?.

Yes, I think just Sean as far as if you’re looking at it sequentially every quarter, every month as you can imagine there is a lot of different cost within cost of services that increase or decrease in any given time period.

And I think we highlighted insurance and insurance is as being one of them depending and that really depends on what is our employee mix at any given moment in time, what’s the timing of payments on premiums or premium true ups now typically that normalizes over the course of any given year, but again if you’re looking at it sequentially quarter-over-quarter at a vacuum it probably impacted cost of services by about 20 or 30 basis points.

So I think when you look at -- there would have been modest margin improvement had it not been for that and now that we’ve really delivered on what our expectations were heading into July with respect to the Q2 and really the 2017 business we would expect to see ongoing margin improvement throughout the rest of the year, but what we’re targeting really just to share what we’re thinking internally is really end of the year by December to be back at 14% margins knowing like in any systems integration and there’s always the adherence part, there’s always the quarter-to-quarter fluctuations.

But for us it’s all about end of the year being at 14% margins and coming into the first quarter of 2019 in that 14% or better world that we were in pre-Q2 of 2017. That’s our thinking on margins and how we see the rest of the year playing out. .

And then the path from here to there, Ted, you mentioned some systems integration is it going to be pretty linear or are there things that are going to cause maybe more of a stair step like result in savings?.

We would expect if we’re looking Q2 to Q3 and then Q3 to Q4, Sean, I’d be disappointed if we didn’t see incremental margin improvement I’ll put it that way.

But since it is an operational exercise the stair step rather than the linear one, we feel most comfortable looking at it over a six month period and isolating how we’re progressing in any given week or month. .

Got it, okay. And then, the healthier end market certainly been a concern, it sounds like you’re incrementally positive there.

Can you update us on activity during the quarter were there any more meaningful client reorganizations write-downs reserving of accounts receivable that you had to do subsequent to the two we discussed last quarter?.

No there weren’t and -- but you’re right I think the industry sentiment seems to be one of cautious optimism as I mentioned in my opening remarks and I think PDPM has generally been well received although it’s way too early to tell.

It certainly simplifies or has the possibility of simplifying reimbursement I think it’s -- as it’s written out reduces payment buckets or categories by 80%.

And there’s all sorts of administrative easing that take place along with that, which would make the operators and the provider community more efficient and allow them to operate in a linear type of overhead model. So I think that’s a benefit.

And the market basket increase was certainly a pleasant surprise I think the community was expecting one, but this was as high of a market basket increase as we’ve had in quite some time and -- but I think to your point Sean, continues to be internally for us irrespective of the industry and the environment, high area of focus for us.

We have great people in this function, we have the process and the capability, we're constantly innovating with individual customers as well as on the whole around how we can better position ourselves, how we can strengthen the partnerships with our customers for the long haul, because we don't plan on going anywhere.

This is -- we're in no rush in terms of doing the right thing. So I think it's been a collaborative exercise in many instances with our customers. And I think again, that's generally been well received once all of us understand our positions. And I would only add to that in addition to the work we're doing internally.

We've also spent a lot of time in conversations with our shareholders and as a Board on how we can further increase visibility into this area going forward. And one of the plans we have is to include -- there is a schedule in our 10-K, which is the allowance for doubtful account schedule.

It's in the MD&A and it's been traditionally included on an annual basis. We're looking to include that as part of our Q filings going forward.

And that'll give all of us a common platform to have real meaningful conversations and about how we're thinking about the environment, how we're thinking about exposures and opportunities, and it just gives us a common platform. So I think that's a good opportunity as well going forward from the visibility and transparency perspective..

Okay, that's great. Thanks again..

Thanks, Sean..

Thank you. Our next question is from Ryan Daniels from William Blair. Your line is now open..

Good morning, guys. Thanks for the question. You talk a lot about the strength in the sales pipeline and end market demand. I'm curious if you could speak to the pipeline for management talent given the current labor market.

And if that is a perhaps growth bottleneck at all, or if you feel pretty good about your recruiting position at this point?.

Yes, thanks for the question, Ryan. Really, for us, we go to great lengths to have our partners understand not only the importance of that management training and development pipeline, but the mechanics of it. In other words, emphasizing the fact that all of our recruiting and the training and development happens locally.

We don't have healthcare university that resides in Chicago, where -- or here in Bensalem. So for us, it is very much a localized exercise.

Having said that, certainly the great expansion efforts that we undertook as a company in 2017 involve not only our dining management folks, but likewise our housekeeping management personnel who help to broker the introductions at the facility level and further facilitate the introduction of our operations and systems into the facilities as well.

Recognizing that they certainly had very well established relationships with the administrator and other department heads at the facility in addition to knowing the building and having that impact in that conversion that we undertook last year.

So if you look out company wide, there are certainly pockets where we are further along in that management development continuum, if you will. But total company if you look, it's been severely depleted.

Now, how does our ability to recruit managers correspond to the overall labor environment? We've generally been pretty well buffered against those dynamics, Ryan.

And the reason for that is that management candidates who come to Healthcare Services Group are attracted to the upward mobility the career development pathway that we can offer them, rather than being attracted to a market premium wage that they're going to be paid as a management training candidate relative to another comparable type position that they may be able to get at another company.

So the individual who's looking at opportunities and weighing out the sale, well, I'd be paid $2,000 less annually to be a management trainee with Healthcare Services Group rather than being a shift supervisor at a big box store. This isn't the job for me. Well, if that’s their view than this probably isn't the opportunity for them.

We far prefer the candidate who looks at the opportunity with Healthcare Services Group, and in their mind says, yes, sure, maybe I'll make $2,000 less per year as a management training candidate.

But that's going to be short lived, because I know that I'll make it through I’ll be signed to be an account manager, ideally get promoted to a larger facility and greater responsibility and greater comp and then continue on that pathway of developing their career.

So they're looking much more so at the career opportunity and corresponding comp opportunity, much more so than just the moment in time entry level position. So that that dynamic has certainly served us well, number one.

And most importantly our ability to attract high caliber talent that would otherwise not be attracted to this industry or more specifically the types of work that we perform. And then secondarily buffers us against some of those labor market dynamics that you alluded to..

Okay, thank you for that.

And then as we look forward how should we think about the growth in the two segments, I know anniversaring the Genesis food services that growth was slow I am curious if there is more of a focus on house-keeping you kind of ramping up that core business, especially as I’d say are tends to be a higher margin business given the management scale you have there already.

So any more of a balance going forward or is it going to continue to have more skew towards food?.

Yes, I think it will just naturally skew towards food in the sense that it’s the opportunity is just from a dollar value perspective is twice that of house-keeping and laundry coupled with the fact that it’s a cross-sell primarily for us still today.

I mean, were more than 60% of our existing customer base is not currently utilizing our services in dining. So they’ve already surpassed the first two hurdles is A, am I open to outsourcing; and B, is HCSG a viable partner in that endeavor.

So I think it will naturally skew towards food, but to your point and just building off of what Matt just talked about with management development being one of the highest it’s always -- it’s the lifeblood of the company, it’s always a priority.

But in light of now the 2017 business being adjusted the all hands on that nature and leveraging any and all resources available kind of passing the focus turns now towards replenishing that pipeline, building out that pipeline, which is why selective expansion really in both segments for the balance of the year.

But looking towards 2019 with a build out pipeline, quality and quantity I would just also add that that’s really a local endeavor that’s not max and push-ins in the corporate office and HCSG training taking place at Chicago University that continues to be done by our trading managers at the facility level in conjunction with our district leadership.

So -- but that really will be the lift to housekeeping growth and we would expect as we’ve expected -- as we talked down the past right in the normal environment without the comps quarter-over-quarter that mid-single-digit type growth in housekeeping over the next few years and in dining we continue to expect that mid-teens -- low to mid-teens type growth..

Okay, that’s helpful. And then just last one very quickly, I know you’ve highlighted in the past the potential to maybe sell initially into the private pay senior housing space on the food side as there’s enough scale there now, can you give us a little bit of an update of that status and outlook? Thanks guys. .

Yes, thanks, Ryan. And you’re correct, we’ve absolutely spoken about senior living as a longer term opportunity for dining services specifically. Those type of facilities assisted living, independent living facilities generally not attractive candidates for our housekeeping and laundry services.

Given the fact that there is a more ambulatory resident population, lower acuity levels they’re typically cleaning their own apartments and doing their own personal laundry. And those facilities tend toward more of a universal aid model rather than having a dedicated carved out housekeeping and laundry department with the housekeeping manager.

And for us a facility needs to be able to support having a full time on-site housekeeping manager in order to be an attractive candidate for our services. But certainly with respect to dining they would be absolutely ideal candidates for our services.

The question that was in our heads, as we thought about that opportunity was always do you make that platform product or do you acquire it. And that was a debate that we had internally recognizing that there was really no rush to get into that market. But certainly the Genesis partnership has added additional clarity to that opportunity for us.

And by that I mean really the Genesis team brought a heck of a lot of culinary expertise and a product that was specifically designed to service that sort of short term rehab and senior living environment. So that is a product that we believe that we can leverage, we can scale.

So rather than looking at senior living as a longer term opportunity perhaps the Genesis capabilities in that product could be scaled to more of a mid-term or even near-term opportunity for us now, number one.

The pipeline of business opportunities within our existing customer base as Ted just mentioned that cross-sell opportunity is absolutely far in a way our number one priority and the ultimately low hanging fruit for us as a company.

Beyond that, you've got the remaining facilities that comprise our 23,000 facility addressable market for housekeeping services. And we’ve certainly built a reputation there through the four decades that we've been in operation. But beyond that again, definitely a longer term opportunity for dining services in that senior living market.

And for us, it would be a methodical and selective expansion. We wouldn't expect to have kind of a product launch or a new division launch and make some sort of splashy entry [ph].

The reality is that there is plenty of opportunity for us in the smaller more regional type facilities that really align more closely with the existing skilled nursing facilities that we're servicing.

And often times there is that kind of crossover ownership of a regional operator who owns a dozen or so skilled nursing facilities and maybe three or four assisted living facilities as well.

So plenty of opportunities to leverage those relationships, and most likely our existing operational structure albeit with a different facility-specific culinary offering to service that market. So tremendous opportunity for us as we look out to the future..

Okay, thanks guys. I appreciate the color. .

Hey, thanks, Ryan. .

Thank you. Our next question is from Michael Gallo from CL King. Your line is now open. .

Hi, good morning. .

Good morning, Mike. .

Ted and Matt, I know you talked about getting back to kind of 14% plus gross margins by the end of the year.

But I was wondering as we look longer term more structural basis, is there anything you see about the mix of food service or the business that you added last year? Do you think we're eventually getting closer to 15%? And also if you can update us on the recent rollout of the onboarding software, what percentage of facilities have that in place? And then what kind of benefits you expect to see.

And whether you're seeing all -- any of those yet or whether you expect that to come. Thanks..

Sure, thanks, Mike. As far as the dining margin and how that will impact the total company gross margins. We were -- as we sit here today, we are very confident in the opportunity that exist for that segment specifically and that as a driver toward returning total company gross margins back to 14%.

And ultimately that opportunity to continue to drive towards 15% total company gross margins. And the primary driver remains the same. That being the under-utilized middle management structure that continues to exist in dining services recognizing that at this point it's really very specific geographically based opportunity.

Given the fact that in our Mid-Atlantic and Northeast divisions, we really do have the district managers in dining overseeing the appropriate number of facilities and the regional level directors of operations overseeing the appropriate number of districts.

It's just that in the Southeast and Midwest and the Far West those middle management positions remain significantly underutilized. So that's the primary driver of that dining services segment opportunity that as we continue to drive that full utilization of the middle management structure.

We absolutely have confident that we can drive toward at a minimum the 14% gross margins and certainly beyond that. There is nothing structural in any of the new business that we on boarded nor in the dining business in general that would preclude us from that further margin opportunity for the company..

And Mike, I would only remind everyone to that. It may when Matt went through the fact that we still have this underutilized middle management structure. Again I would just remind everyone that the vast majority of the 2017 new business adds were in that Northeast and Mid-Atlantic footprint. So we didn't garner that incremental operating leverage.

Now if it were in the Southeast, the Midwest the Far West than we would have had additional and more immediate margin expansion. But that dynamic continues to be the case as Matt said, going forward where that's the opportunity for us not just to work towards 14%, but really the pathway to 15%. .

And then Mike, as to your question on electronic onboarding program continue to see tremendous degree of success of that really positive feedback from our managers in the field, as far as the utilization of that platform.

Because it is state-specific and custom crafted toward the state-specific onboarding requirements, it has been more of a phased approach as we sit here today.

We're in probably three quarters of the states in which we operate and the balance would be those states that we have kind of more state-specific requirement that need to be embedded into that platform, but absolutely no hurdles or impediments that will preclude us from ultimately rolling that platform out to all of our facilities.

So again tremendous feedback that we’ve gotten, very positive at the facility level as far as freeing up our managers and certainly from a compliance perspective to make sure that all of those applications are complete and that from a documentation perspective we’ve got everything now stored electronically in the clouds that we can access that information any time readily available.

.

It is too early to kind of quantify of what kind of longer term impact do you expect from that. And sort of as a follow up to that we kind of scan in documents and the like kind of all your existing employees' overtime.

Or is it really just as the new employees get on boarded they’re all kind of going in a digital environment?.

Right now Mike Phase 1 is definitely focused on onboarding new employees, that’s been the priority.

In some of the geographies in which the onboarding has been rolled out for a longer period of time, they have kind of advanced the ball to not include scanning and uploading current employee information so that that can now reside in a central repository electronically in the cloud readily accessible.

So that’s been the move there, but definitely the priority for us has been to rollout the platform to each of the geographies that have not yet had that program rolled out.

And as far as quantifying an ROI Mike, it’s really more qualitatively that we’ll see some benefits and that’s definitely in freeing up our managers most importantly rather than having to sort of coach a new employee through what could be a 125 page onboarding paper packet of information to doddle the eyes and cross all the tees [ph], fill out the state-specific requirements and forms, abuse registry tracks, check background screening, etcetera that manager can now be out on the floor coaching and managing the facility -- employees in the facility, managing our quality assurance programs, interacting with the customer.

So that’s definitely been the most significant benefit not the one that we’re easily able to quantify, but certainly at least anecdotally the feedback we’ve gotten nothing, but positive and had served that end in freeing up our managers much more..

Yes, I was just wondering again sort of as a follow-up to that whether you’ll be able to kind of -- as you free that up whether you will be able to kind of fold more facilities longer term into an individual manager?.

It really -- Mike the benefit really exist at the facility level. The district manager who is overseeing multiple facilities is really generally speaking not much involved in that onboarding process at the facility level that’s much more managed by our facility level account manager.

So that’s where the benefit in freeing up their additional capacity to do more within the facility is a benefit.

But if that function had been one that was served by the district manager that’s where you may see the impact of allowing them to oversee additional facilities because that function is really a facility specific function, you wouldn’t get that kind of multi-facility benefit..

Thank you..

Thank you, Mike..

Thank you. Our next question is from Andrew Wittman from Baird. Your line is now open..

Great, thanks. Good morning, guys. .

Good morning, Andy..

I wanted to dig into the housekeeping margins you said they were kind of flat sequentially, last quarter were really grew there 11.7% and just as I was looking back over the last three years, I mean, it was average closer to like 9.5%.

So I guess the question is why are the margins so high today and how sustainable is that maybe even in the near-term over the balance of the year?.

I think the most significant impact on the housekeeping margins has been that management pipeline, that management trainee role that we talked about before with those resources being allocated in a different type of way to the growth we’ve taken on over the past 12 months as we’ve talked about earlier in the call.

So that’s been -- that’s had a meaningful impact on it. And the other part, I think that maybe we don’t spend enough time talking about is, is we are managing it, we believe more effectively than maybe in years past.

And that’s largely due to the increase visibility we’ve had and continue to have as a company and I would just point to the biometric time clock as one example of that where we’re able to -- it actually evolved from when we first rolled it out, it was more of a compliance tool and then it was a timekeeping device.

And then it became a way for us to on a real time basis actively manage payroll on it, day-to-day, week-to-week, which is required. And that's how we've been able to ensure that the cookie cutter does not go [ph] as we continue to expand.

We have as much if not more visibility into what's happening at the facility level today as we did two decades ago, which may sound counterintuitive considering the size of the company today relative to that time. But technology has been the primary reason for that. And again, I think the biometric time clock among other enhancements is Exhibit A..

That's interesting.

So just as you look at -- if you look at the balance of the year and really better growth in 2019, is this the right housekeeping margin you think for the next couple of quarters?.

We think it will begin to come back down to earth Andy, as we're -- again as we're building out the management depth. I think it'll continue to be at or perhaps better than historical highs for really the second reason I pointed to. But for us, we would expect housekeeping to return back to historical levels.

But at the higher end, if not maybe setting the new historical trend, but that decrease will be more than offset by what we expect to be the continued increase in the dining and nutrition margins. .

Okay. .

But you better believe we’re going to continue to try to maintain those margins, Andy. We're not conceding anything, we're going to continue to focus to identify technology, and further efficiencies as Ted alluded to..

Yes, for sure. Okay, super helpful. And then I guess my last question here is around just looking at your kind of credit quality of the customer base and you guys kind of mentioned, obviously coming on last quarter, that's something you had to scrutinize a little bit more that something you'd be looking at more closely.

I guess, advancing three months here Ted, what have you done to look at your customer base credit quality receivables that you have, the timeliness with which they're paying you, in order to effect change on a going forward basis? I'm just kind of curious for an update more than anything on that line..

Yes, I would say the single most significant impact around increasing our visibility, which we view as the key in any relationship has been around advancing or accelerating payment terms.

So moving a customer that was historically on a monthly payment to a biweekly payment and then opportunistically advancing those on biweekly payments to weekly payments. Because when we have a higher frequency of payments, it allows us to engage in conversation when there's a shortfall or there's a mess, rather than waiting until the end of a month.

So that that I would say, has been more impactful over the last 12 months than any other single thing we've done. And again, that's not a new concept, but we've been much more focused on engaging and I’d say collaborating because a lot of those conversations, Andy, they're not do this or helps with our customers.

I mean, we're partners, we're in this for the long-term with them. So it's a collaboration around, hey, how can we strengthen the partnership? How can we create that neutral space for that win-win where it's better for you? Maybe it aligns better with your cash flow customer; maybe it aligns better with your Medicare or Medicaid payments.

So they're the types of conversations we're having on an ongoing basis. But that has been significant. If you looked at where we were a year ago and where we are today, there has been a meaningful shift in increasing the frequency of payments across our entire cross section of customers.

And we talked about it before, but also the ongoing movement towards, when it make sense, specifically with the dining and nutrition cross sale, but also outside of that, engaging in conversations about promissory notes, which again from a strengthening terms and conditions perspective, that certainly accomplishes that because it's a legally binding document that when we're allies is the indebtedness.

So you're already over the first hurdle with the workout that the indebtedness or the amount owed is agreed upon in writing. So that short circuit and you sort of workout conversations by a significant amount of time.

And then all the other benefits that come along with that like cross guarantees, personal guarantees, security interest, like in interest bearing component. So they've been two of the areas we focused on.

And then obviously system and process internally, and from a human capital perspective, they'll having the right cross-section of leaders here with different subject matter expertise, as well as I mentioned technology earlier making sure we have the right technology in place to be able to evaluate the metrics so we can react in a meaningful way when it warrants that..

Okay, good. Thank you for the update, that's all I have for now. .

Hey, thank you, Andy. .

Thank you. Our next question is from A. J. Rice from Credit Suisse. Your line is now open. .

Thanks. Hi, Ryan. .

Good morning, AJ. .

To go back to the comments about cash flow on there seems to be amount of focus on that. So I think if I have got the numbers right, year-to-date you're looking at about $27 million, $28 million of cash flow from operations.

As you layout the payroll dynamics, it sounds like the second half is going to mirror the first half pretty much and your DSOs sitting at around 62 last quarter 61.

What has to change or how do you move from where you're at now to get a -- I mean I think net income this year depending on whether or not you still have the charge in is probably run somewhere in the $80 million to $100 million range.

How -- what has to change from where we're at today to where we're at by year-end to get to that net income includes cash flow which is your target [ph]. .

I think you mentioned two of the most significant ones. But in a world where we're collecting what we built with a 30-day lag that would drive DSO into, it would stabilize and drive DSO downward AJ; so just by virtue of collecting what we built each and every month.

So that would be one tailwind to that cash flow, which we've done historically that's our goal going forward. And then the other one you mentioned is the margin improvement that will naturally provide a lift for cash flow.

So they would be the two biggest components that we'll talk about certainly every quarter when we're all together and we're evaluating each and every week on how we're performing and how that impacts the cash flow of the company..

So what would be a reasonable target for DSOs then? If it’s running 61-62 now I think..

Yes we think, where we are at right now, we would expect -- we expect a stable DSO-type environment, again we had this past quarter. It was actually a strong quarter in terms of cash collections. And we looked at it.

You look at it both from the more significant customers and then you have to look at it how many at the local level what were the payments like. So you're looking at kind of bedding [ph] average as well as slugging percentage if you will. And you're measuring it in a variety of different ways. But overall, we had a very strong quarter.

It was unfortunate that Massachusetts budget was not signed on to. But again that would have been an additional $5 million or $6 million. And then obviously with the increased margins and then an additional -- some other opportunities that certainly are there to make in-roads into some of the slippage that happened over the past 12 months.

So that's what we're focusing on, but I think a reasonable target to think of is the starting point would be the first half of the year. And then depending how some of these other factors impact at least the back half of the year could be $10 million to $20 million more compared to the first half of the year.

But again it just depends on as I said, the collecting what we build, which we'll talk about as well as the margin expansion that we're hoping to have incrementally, but really targeting the end of the year in terms of that 14% and then running into 2019. .

Okay. Then looking at the sequential operating income, I think you were down $1 million or so. If you -- I think we would have thought you've been up a little bit maybe up $1 million $1.5 million.

I know you highlighted I mean, it sounds like the margins in the two businesses were pretty much we don't have specifics yet, but it sounds like they were pretty on track. You mentioned this premium, extra premium payment, it sound like there might also be a little higher accrual for bad debt.

I guess is that true, and if it's true, are you accruing a little higher level now post what happened with the charge in the first quarter of bad debt going forward and maybe give us the split on that?.

Yes, I’d say sequentially it was a very modest increase AJ regarding the bad debt expense and that was -- there is -- that will vary quarter-to-quarter. I wouldn’t say it as a reaction to Q1, but we’re certainly -- we continue to scrutinize and evaluate each and every account and what our expectations are going forward.

I talked about where I mentioned earlier the enhanced disclosures and transparency that we’re going to include in the queue so we have a platform to have this type of conversation in a very qualitative way.

But I’d say the other -- when you look at it quarter-over-quarter it was second quarter-second quarter that’s where your point is spot on that it was about $1 million or so higher Q2 to Q2.

So again I wouldn’t say that’s the new norm, but to have some modestly higher bad debt expense as well as timing of health and welfare in any other quarter, it wouldn’t even rise at the level of this conversation because we’re typically not talking about a quarterly swing of 20 basis points or 30 basis points in direct cost of services.

And counting it one way or the other because we’re looking at this over a 6, 12, 18 months period. It’s a continuing for us, it’s certainly not a quarter-to-quarter business, but that was all.

We try to provide a little bit more color because we knew it was a high area of focus for certainly for us and we knew it would be a point of conversation for today. So wanted to provide as much color to cost of services as possible..

Okay.

And when I look at the growth last year second quarter, this year second quarter dining is up 13%, is that I mean, I think, a lot of the new business came on at the beginning of last year’s second quarter so you anniversaried it, but is that 13% sort of the run rate for dining or is that a benefit from further add-ons that happened over maybe in the course of the quarter last year now you’re getting….

It’s primarily run -- there is some sequential step up, but it’s primarily it was more modest I think it may have been $3 million or so quarter-over-quarter AJ. So it’s mostly run rate and carry-over from 2017..

Okay. So then as we look at the back half of the year it sounds like you’re looking to do some additions, but you’re not back to normal additions but you have some tailwind at dining.

So it will be even if you don’t add a lot of new accounts, you’re going to get some benefit from there or is that really revert down to maybe a low to mid-single-digit absent any new accounts?.

Yes, I think -- yes there is tailwind, I guess, if you’re thinking of sequential improvement quarter-over-quarter is being a tailwind, I would just say without -- the comps -- we added $65 million of business in the second quarter of last year. So when we start talking about percentage comps obviously it’s somewhat distorted.

So what would it look like next year at this time, I would -- and what does this mean for the back half of the year. I think you touched on this idea of selective expansion. So, yes, it doesn’t mean that we’re not going to grow in either housekeeping or dining for the balance of the year it’s just going to be selective.

We’re going to be focusing as a priority on building out the management pipeline and then opportunistically taking on customers and taking on new business that aligns with our management development efforts and our management depth.

And then going into next year we’ll be in a position to grow more in line with where we’ve been historically and then without getting again compared percentage-to-percentage versus an unusually high growth 2017 year. But we would expect that normal course of single-digits housekeeping and laundry and low mid-single-digits dining.

But that’s how we’re thinking about it here..

Low to mid-single-digit or low to mid-double-digit percentage?.

Double-digits, I'm sorry if I misspoke there. Yes, low to middle-double-digits in dining. .

Right. And then -- so that just sort of takes me to my last question, last issue to bring up, I mean, years ago you guys just talked about 10% to 15% top-line growth, 15% to 20% earnings growth. It seemed like in the last few years that obviously the base got a lot bigger. You sort of move that to 8% to 12% and maybe mid-teens earnings growth.

Obviously the last few quarters have disrupted that.

When you come out the other end of this in 2019 and beyond, what do you -- do you have a view? I mean, sort of the 8% to 12% and mid-teens still a reasonable long-term annual earnings growth target or is it something different than that you think?.

We believe it is. That it's if we are looking out over the next three years and again without exiting out the comps as I talked about earlier, but over any three to five year period.

When we look at the pipeline, the demand for the services, the management capability and capacity that we expect to have certainly double-digit type revenue growth you said 8% to 12%, but whether it's high single-digits or low double-digits overall.

And by segment, housekeeping we'd expect to be in that mid-single-digit range and dining and nutrition in the low to mid-double-digit. And I think to your point AJ, as you pointed out, that would deliver mid-teens type earnings growth, because we continue to have that under-levered middle management structure.

That would be the primary driver of earnings growing at an accelerated rate relative to top-line growth..

Okay, thanks a lot. .

Great. Thank you, AJ. .

Thank you. Our next question is from Chad Vanacore from Stifel. Your line is now open. .

Hey, good morning, Ted and Matt. .

Hey, Chad. Good morning. .

So one thing that stuck out to me, revenues were fairly flat in the quarter sequentially.

Can you go a little more detailed on why that top-line growth was slower? And then what trend we should expect for the year on overall top-line?.

I think like we talked about Chad, it's really -- we can't grow the business we can't add facilities unless we have the management capacity to do so.

And certainly that's a localized effort, but if you look at it from total company you certainly lagging in that management development function companywide as we sit here talking about that virtue of cycle that we've referenced in the past, that being primary function and most important being management development.

And specifically developing new managers through our training and development program rather than focusing on kind of the management development, which is related to promoting and developing account managers to be multi-facility managers to become district managers and developing district managers to become regional directors of operations.

So certainly, that entry level management position in which we're lagging currently, and we're not able to add facilities unless we've got that management capacity specifically a well-trained and developed manager to be able to place in as an account manager at that facility.

So that's been the primary drag on the top-line opportunities if you will, Chad. And certainly we are committed to delivering a tremendous customer experience to driving that high-degree of customer satisfaction ultimately customer retention.

And for all those reasons as has always been the case, we're committed to that internal training and development of our managers not leading with our chin and trying to put managers out before they're ready to deliver that high-degree of customer experience.

So that's where we are right now and certainly there are other areas in the country that are further along that continuum of having managers in the queue. And they'll be able to add new business in a more accelerated basis relative to others.

But total companywide, we're certainly, if you have to characterize us as where we are in that continuum of that virtue of cycle definitely leaning more heavily toward management development, which then leads into management capacity and that ultimately that primes us to enter the sort of business development portion of that cycle..

Right now what's constraining that management development pipeline? And then what can you do to affect that so that you get more employees through that pipeline?.

Yes, it's a good question, Chad. And really it just comes down to the management folks who are tasked with you think about within the district structure.

There is a district training manager who is tasked with screening resumes, conducting interviews, hiring folks, and ultimately helping to shepherd them through the training program, which is delivered at additional facilities.

There are account managers who would be bringing a candidate through that 90-day training program within their facility all the while maintaining the customer relationship, delivering the operational and quality performance and managing the other lines staff employees at the facility and hitting their budgetary targets.

So when you have such significant expansion, those facility level training managers, and the district training managers get pulled into additional expansion related opportunities and other operational issues, more so than focusing on that recruiting effort to interviewing and shepherding those folks through the training program.

We wish that wasn't the case. We wish that we could continue to be all things to all people, in that regard. But the reality is when you have that significant type of expansion it really is an all hands on that exercise.

And because of that, those folks who would otherwise be focused on that management development of recruiting the training function has been pulled into help facilitate systems implementation, operational and qualitative issues, and helping to manage the clients both existing and newer clients that we expanded with in 2017..

All right. And another question just on cash flows, you mentioned a $20 million decline in payroll accrual. So that's a significant change versus historical and a cash use.

Was that because you’ve cut some contracts and handed those employees back to the operators? Or is that something else going on there?.

No, and just Matt touched on it in the opening remarks, Chad, I think when we -- the payroll accrual it's always been something we've talked about, it even that over the course of the year and it's strictly related to the timing of when the pay period closes, when that pay period is funded.

And then how many days between those two -- those -- the close and the funding are left for the remainder of the quarter that have not either been -- that are either unpaid or not funded. And then that becomes our payroll accrual, which is why there's always variability in any given year or in any given quarter rather.

But over the course of the year that evens out. And that's why we've spent a lot of -- which is good and we will continue to do so spend a lot of time and Matt called out what the payroll accrual would look like in the third quarter, in the fourth quarter, just to give everybody some visibility into the impact that has.

But that's really not related to underlying cash flow and cash generation. That's just fluctuations that happened that over the course of a year, it's a net zero impact. It's just the quarter-to-quarter fluctuations.

What we're focused on internally, we'll communicate, we'll speak about the impact of the payroll accrual, but we're focused on cash generation vis-à-vis cash collection from customers, vis-à-vis margin expansion, as well as obviously other opportunities we have with respect to cash flow.

So that -- hopefully that clarifies a little bit, I know the conversation around the payroll accrual. But again it evens itself out over the course of any given year..

Okay. I'm just looking at it because it looks abnormally large and it's the use of cash. .

We have about -- we accrue roughly $3 million a day of payroll. So if a quarter ends with seven days accrued, the accrual is $20 million, if it ends up being $15 million accrued than the accrual ends up being $35 million. So, it’s just were $30 million.

It just depends on how much we have in payroll at the end of a give -- we don't control it we just have a biweekly payroll that each and every other week is paid and then at the end of the quarter whatever is unpaid is accrued..

Alright.

So fair to say you think it evens out throughout the year?.

It does even out. It's been there for decades. So, no changes, there is no impact to the underlying business related to the fluctuation in payroll..

Alright. And then just one more on cash flow, So, DSO picked up sequentially by about a day.

How is that impacting cash flow and then what steps are you taking to improve that cash collection process? I know, earlier you said basically tightening your payables timing?.

Yes, for us Chad, with respect to the impact on cash flow, you can think about a day of billing being around $5.5 million. So when you have an increase in DSO of eight day, that's a negative $5.5 million impact on cash that we otherwise would have had.

And really this quarter, that day increase and as Ted talked through some of the enhancements and the focus that we're placing in the credit and collection functions. And we've been very pleased with the progress that we've had in that regard.

Although there remain additional opportunity that increase in DSO was primarily related to Massachusetts specifically, California not unlike in past years had a delay in approving their fiscal year budget as well, but we were actually able to collect nearly all of the monies owed in California, we did have an impact in Massachusetts though.

And not uncommonly they’ve not yet approved their fiscal year 2019 budget that created a lag in reimbursement payment that the operators receive from the state now understanding that that’s the norm.

The operators of the Massachusetts tend to sort of brace themselves and manage their cash outflows much more conservatively at the tail end of the fiscal year obviously prioritizing payroll until that new budget is approved.

So we’ve been in close communication with our clients in Massachusetts and indications are that the legislature will pass their budget shortly, operators will be made whole, our customers will be able to catch us up. So we’ve got a pretty high degree of confidence in that trend reversing itself quickly.

Outside of Massachusetts there was really not any noteworthy shift in our DSO. And we do as I said believe that there remains opportunity to selectively improve the credit in the payment terms with certain customers of ours, all of which would have a positive impact on DSO and cash flow..

All right thanks for taking the questions..

Hey, thank you, Chad..

Thank you. Our next question is from Bill Sutherland from The Benchmark Company. Your line is now open..

Hey guys. I think I'm good all questions asked and addressed. Thank you..

Hey, thanks, Bill..

At this time, I'm showing no further questions. I would like to turn the call back over to Ted Wahl, President and CEO for closing remarks..

Alright, great thank you. And it’s incredibly exciting to imagine all of the possibilities that await and know that our future really does begin with our great people going beyond and living out our purpose, exemplifying our values and fulfilling the company’s vision. That is our pathway to ensuring sustainable, profitable growth over the long term.

As we enter the second half of 2018 the company’s underlying fundamentals are strong and there is more demand for the services than we can manage. We continue to operate in a recession proof market niche and the demographic trends have been and continue to be in our favor.

We’re in a strong 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 company and we have the financial wherewithal to grow the business as best as our ability to manage it.

It’s for all of those reasons we know our best days lie ahead of us. So on behalf of Matt and all of us at Healthcare Services Group I wanted to thank GG for hosting the call today and thank you again to everyone for participating..

Ladies and gentlemen thank you for your participation in today’s conference. This concludes the program, you may now disconnect..