Good morning. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Healthcare Services Group, Inc. 2021 Fourth Quarter Earnings Call. The matters discussed on today's conference call include forward-looking statements about the business prospects of Healthcare Services Group, Inc..

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 Inc.'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. [Operator Instructions].

Thank you. Ted Wahl, Chief Executive Officer, you may begin. .

Great. Thank you, Chris, and Good morning, everyone. Matt McKee and I appreciate you joining us today. We released our fourth quarter results this morning and plan on filing our 10-K by the end of next week. Our Q4 results reflect continued margin pressures resulting from workforce availability, inflation, and supply chain disruption.

And while the current operating environment has pressured our profitability, we are taking decisive action to ensure we have a durable, scalable business model that will enable us to deliver sustainable, profitable growth over the long term..

one, get billing increases from our customers to capture past cost increases; and two, amend our service agreements for both current and prospective customers, so future cost increases are passed through in a way that is automatic and real time..

We expect these service agreement modifications to be completed throughout the first half of 2022 with the goal of exiting the year with cost of services in line with our historical target of 86%.

During the quarter, as we were actively engaging with our customers to modify our service agreements, we continued to take a longer-term view in staffing and supplying our client facilities to get the job done, even though in many cases, our service agreements had not yet been modified to adjust for the inflation experienced during the second half of 2021..

If that meant incurring overtime hours, introducing special employee bonuses or increasing wage rates and premium pay, that's what we did. We did this while we were actively engaging with our customers to modify our service agreements. We did this to maintain client satisfaction, systems adherence and compliance.

We did this because it best positions us to collaborate with our clients and modify our service agreements in a way that is mutually beneficial and durable over the long term..

Bottoms-up client-by-client action that will be long-lasting as opposed to top-down unilateral action that would be short-lived.

Although the extraordinary cost that we incurred without a corresponding billing increase had a significant impact on our Q4 financial results, we believe this is a temporary challenge that will be resolved in 2022 by our service agreement modification efforts..

We are encouraged that we've seen relative stability in industry census since August as operators have worked through the clinical challenges of both the Delta and Omicron strains.

Having managed through those challenges, we are cautiously optimistic that the availability of staff improves, labor market pressure stabilizes, and operators are able to build back their census in the year ahead..

We will continue to monitor industry recovery and remain confident that despite these near-term headwinds, the long-term growth outlook for the company remains strong, given our market leadership, efficient operating model and the attractive demographics..

So with those introductory comments, I'll turn the call over to Matt for a more detailed discussion on the quarter. .

Thanks, Ted. Good morning, everyone. Revenue for the quarter was $420.4 million with housekeeping & laundry and dining & nutrition segment revenues of $200 million and $220.4 million, respectively. Direct cost of services was reported at $377.2 million or 89.7%, and was impacted by increases in labor and supply costs.

Again, we expect the service agreement modifications that Ted described in his opening remarks to be completed throughout the first half of 2022, with the goal of exiting the year with cost of services in line with its historical target of 86%..

Housekeeping & Laundry, and Dining & Nutrition segment margins were 5.7% and 2.1%, respectively. Selling, general and administrative was reported at $44.3 million. After adjusting for the $2.7 million increase in deferred compensation, actual SG&A was $41.6 million. And SG&A was impacted by $2 million of nonrecurring items.

In the year ahead, the company expects SG&A between 8.5% to 9.5%, with the opportunity for ongoing efficiencies. .

Investment and other income for the quarter was reported at $2.7 million, but again, after adjusting for the $2.6 million change in deferred compensation, actual investment income was about $100,000..

The company reported an effective tax rate of 25.8% for the year. The fourth quarter tax rate was impacted by lower income before taxes and other discrete items, and the company expected a 2022 tax rate of 24% to 26%..

Net income for the quarter came in at $2.1 million and earnings were $0.03 per share. Cash flow from operations for the quarter was $31.3 (sic) [ 31. 4 ] million and was impacted by a $3.9 million increase in the accrued payroll, including the impact of .5 or $22.1 million of Cares Act deferred payroll tax repayment.

The DSO for the quarter was 64 days. .

Also, we would point out that the Q1 payroll accrual is 5 days, and that compares to 13 days in Q4, and 4 days that we had in 2021 during the corresponding period. But the payroll accrual only relates to timing, and the impact ultimately washes out through the full year..

We're pleased with the ongoing strength of the balance sheet and the ability to support the business while continuing to return capital to the HCSG shareholders. We announced that the Board of Directors approved an increase in the dividend to $0.21125 per share, payable on March 25, 2022. The cash balance is 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 free cash flow and ultimately maximize return to shareholders. This will mark the 75th consecutive cash dividend payment since the program was instituted in 2003, and the 74th consecutive quarterly increase.

That's now a 19-year period that's included 4 3-for-2 stock splits. Additionally, the company repurchased $16.1 million of its common stock pursuant to its previous authorization during the quarter. .

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

[Operator Instructions] Our first question is from Andy Wittmann with Baird. .

I guess, Ted, I wanted to start with just trying to understand the status of the discussions with your clients regarding these renegotiations. I think historically, you guys have always tried to get reasonable price that was in the terms of how you've always done things.

But this idea of amending the contract or really the business model to automatically pass through these inflationary items is clearly different from the past..

Is it your expectation that effectively all of your customers will move to this? And what do your early discussions regarding terms like that today indicate to you about your success in achieving that?.

The early indicators are positive, and we would expect to show some progress in Q1 to that end. Andy, our expectations, yes, are that our value proposition remains, right? The costs that we're incurring are no different than what the clients are experiencing with their own similarly situated workforce, and they clearly understand our position..

I think the challenge with the model, the fixed price model in this environment is not the fact that we're unable to get increases.

It's that even if we're able to secure increases for past wage inflation, it doesn't necessarily account for the potential for future inflation in a timely basis, given the environment and the uncertainty of the environment..

So our expectation is, in some cases or many cases, it's a simple sitting down with the customer working through an agreement on the past inflation, and then putting in quarterly triggers similar to what we have in food, and that served the company well for years. So it's not foreign to the client for that -- to have that type of mechanism in place..

And then there's others that it's a more holistic conversation that could involve maybe a cost -- something along the lines of a cost transparency model where it's a more open and airy type of relationship, whether that's cost plus or a version of that. There's no one size fits all.

This doesn't affect all of our customers, but there's many that it does..

So again, our expectation is that we're going to have a very high success rate, and it's a matter of doing the work. And as you can imagine, there's a variety of different approaches you could have, top down, bottoms up.

We decided early and often during Q4, bottoms up, recognizing every single one of our clients' unique set of circumstances was the right approach, also consistent with our past approach.

And while that may require a bit more patience and I'll say, investment on our part in the current state, we think it's going to have a very positive long-lasting effect. And really set us up well going forward, because aside from our existing business, this also relates to new business prospective customers that we're going to be engaging with.

And this resonates very -- our value proposition resonates very well in the current environment..

The same pressures we're experiencing in our business are all the more reasons why the demand for the services are increasing and are as strong as they've ever been. So I think we will continue to prioritize this exercise that we're going through with our customers. And again, expect that to be completed mid-year.

And exit the year with a direct cost of services line consistent with our 86% historical target. .

Matt, just maybe a follow-up for you regarding the staffing levels that you're currently seeing in the facilities where you are involved.

Can you just give us some context maybe about the progression of the number of open positions you have today versus maybe normal staffing, which would have probably been actually a few years ago now, versus 6 months? Is it getting better? Is it getting worse? Where are you on the open positions curve today?.

Yes, I would say we're seeing modest improvement, Andy. Some of our data are actually encouraging. They're not yet kind of bearing out in the form of actual hires or replacement per se.

But when we look at some of our data with respect to the inbound applications that we're receiving and then our new hires relative to terminations, a bucket that for us constitutes either somebody voluntarily exiting or us terminating their employment, but just any separation from the company, if it's maybe a bit too early to call them trends, but I would say that the recent data are certainly encouraging..

And it really sort of relates to the fact that we've been consistent throughout in innovating and developing recruiting and retention strategies to better attract and retain employees at all levels. That, of course, applies to our management development program.

But likewise, felt more acutely in recent months for sure at the line staff level, and that's encompassed promoting our purpose, vision, and values through every level of the organization, but leveraging our existing recruiting platforms, streamlining our onboarding process..

We've talked about previously repurposing and deploying some resources to high need facilities, and to other geographies, and developing employee engagement initiatives, and then ultimately as a component of that, introducing employee incentive and referral programs..

And again, without speaking specifically to a trend per se, we've seen that the number of employees who are being infected, and the impact of the Omicron variant, has decreased significantly over the past couple of weeks.

And that's certainly indicative of a more favorable environment to be able to get bodies in to fill positions at the facility level. .

Our next question is from Tao Qiu with Stifel. .

Ted and Matt. Just a quick question on the margin. And if you look at incremental margin this quarter in terms of expense increases sequentially, certainly the growth has been slowing from the last quarter.

Just wondering what's your kind of margin outlook for the next few quarters, understanding that you're going through these contract negotiations?.

We expect to see some progress beginning next quarter. And ideally, it would be a stair step, Tao, throughout the year, right, where we're exiting the year back at that 86% or better. There's probably going to be some fits and starts along the way.

I think part of our strategy here is to allow enough time and space to not get the quickest deal done, to get the right deal done for the long-term relationship..

So we expect to see progress beginning next quarter. And I think we'll have a more clear outlook on the rest of the year as far as the cadence of margin recovery when we talk in a couple of months. .

Got you.

Is it fair to say that the inflationary environment in the fourth quarter is slightly better sequentially than the third quarter? Or do you think that it's still pretty acute right now?.

Yes. I'd say Q4 relative to Q3 was similar, meaning a similar type of intensification, specifically on the labor side. We did see some of the food inflationary pressures stabilize a bit between Q3 and Q4, but we saw the labor inflationary pressures further intensify..

Too early to tell, year-to-date, where we are. But that's again why with this modification of our service agreements, we're not only going to make sure we secure increases for our past cost increases to get the billing rate correct at the moment in time.

But it's also equally as important to make sure the go-forward is taken care of and that the adjustments are done on a more real-time basis, whether that's tying it to a third-party index, or if it's using our own data that we have internally or the client's data for their similarly situated employees.

So that hopefully adds a little color to the types of conversations and engagement we're having. .

Got you. I appreciate that. Any update on the Genesis contract? I know that you talked about the pricing coming back first quarter 2022 and the terms will probably reverse at the end of the year.

Any update there?.

No, other than, as we previously called out, the pricing modification sunsetted at the end of 2021. So that returns back to its historical rate heading into the year effective January. And then as you highlighted, the AR modifications will begin to reduce throughout the year, and that will sunset at the end of 2022. .

Okay. Got you.

Maybe one last one, maybe I missed this when you talk about it, what's the operating cash flow for this quarter?.

From a cash flow perspective, we were north of $30 million. .

[ It was 1.40 million ]. .

Our next question is from Sean Dodge with RBC Capital. .

Maybe, Ted, going back to one of your earlier comments. On the labor challenges, is there a seasonal pressure that hit you in the fourth quarter too, with the hourly workforce? I'd imagine you're all probably competing with Amazon and UPS and all the retail that are staffing up and operating premiums around the holidays.

Now that we're through that, does that help things get sequentially better in the first quarter?.

I'd say it should, like it's in a theoretical sense, Sean, that would be the case. I think you have to look at it. One is Matt pointed to some of the January data that are suggesting some stabilization and some actually improvement on our front. So that would add some credibility to your question and your thinking on it.

I think the one thing that is yet to bear out is the niche within the niche, right? The health care labor market is, kind of has its own pressures outside of, say, the non-health care-related labor..

And then even within long term on post-acute care, I think it's seeing a different type of impact than the broader health care market. So that's why I'm a little reluctant to latch onto your silver lining there to some of the labor pressures that we saw in Q4. And there's so many moving parts between Delta, Omicron.

And not just the impact -- that had less of an impact from a clinical sense on the industry, it had a significant impact on staffing with quarantining requirements..

So there is optimism for a variety of reasons, one of which you pointed out. But again, still too early to tell if 1 or 2 months does not a trend make. .

Sure. Okay. Fair enough. And I guess now with the plan for getting cost of sales back in order.

What are your -- I guess, where are you now on new manager development? Are you back out recruiting and training again? What are your thoughts around when you might start adding new facilities?.

Yes, absolutely, Sean. And I would say, not dissimilar to our typical strategy. That's really the managerial needs assessment occurs at the local levels, right? And that's, of course, primarily to ensure that we have the management capacity to effectively manage the existing portfolio.

But just as importantly, in this environment, given the increasing demand for the services that Ted noted, to ensure that we've got the requisite managerial wherewithal to be able to think about onboarding new business opportunities..

So there are -- as is always the case, some geographies that are further ahead in that exercise than others. But without a doubt, this is a conversation that's happening throughout the company, to number one, continue to stabilize the operating environment in the face of some of the remaining challenges that are presenting as a result of COVID.

But the optimistic view is certainly that we continue to drive recruiting efforts and managerial development efforts with an eye toward future growth opportunities..

And as I said, for all the reasons that we talked about previously, suggestive of modest but suggestive of industry recovery, we're definitely beginning to think about getting back into growth mode. And obviously, the management development is a significant component of that. .

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

Nick Spiekhout on for Ryan. I guess to start, just a clarifying one on those new contract structures.

Would those be eliminating the current, I think you said, 90-day lag that most of your contracts have, such that it would be much more immediate to where increases in input costs would be mitigated within the quarter?.

Well, the reason for that 90-day lag on -- if you're speaking specifically to the food component of our dietary contracts is really just a function of administratively, not on our end, of when the data are published by the requisite government agencies..

So I think that's just a simple matter of when it's published. As soon as it's published, it's provided to the client and then we're adjusting the following quarter. So that's not really where the impact is being felt most acutely.

If we had a similar, and again, there is no one size fits all, but if we had a similar type of adjustment even with the 90-day lag on the wage piece, we'd still be in a much better -- we'd be in a much better spot..

Now there are different variations to that. [ If we [Technical difficulty] try to ] implement a monthly adjustment, and the customer is open to that, that's something we would consider as well. But again, we want this to be long-lasting and durable. So we're not in a race -- not racing to try to get kind of the quickest deal done that we possibly can.

We're building this for the next 4.5 decades, quite frankly. .

Okay. Great. And then, I guess, so you're planning on kind of second half being through most of that.

When did these kind of negotiations start? And I guess how far along are you in that kind of rollout between your total kind of facility base?.

Yes, they've been ongoing really throughout beginning as early as kind of the beginning of Q4 and have been ongoing since then, with the continued inflation, right, it's not a matter of inflation happened and it's over. It continues to evolve. So those conversations have continued to evolve as well..

As you highlighted, we should -- we expect all of the, I guess, agreements and conclusions with our clients to be reached by midyear. And then our goal is to exit the year, exit 2022 kind of with a run rate of 86% or better cost of services, which would be in line with our historical target. .

And just to sort of put a finer point on that, we've had initial -- at least initial meetings with every one of our client groups at this point. So as Ted mentioned, there's not a unilateral approach. It is client by client, the efforts that are undertaken. It's not a one-size-fits-all solution per se, but all of the conversations have been initiated.

And then it's just going to take some time to come to agreement..

And of course, that will be a moving target to a degree as to the timing of the closure of these, but we're confident that by midyear, we'll have some clarity and some conclusion, and be able to move forward and ultimately see the effects run through the results of the business. .

Great, thanks for the color. And then I guess just really quick on the labor side of things.

Is this -- are you guys seeing this as more of an issue on recruiting new employees or more on kind of maintaining your current workforce such that you're making it more enticing for them to stay on versus go somewhere else type of a thing?.

It's more the former than the latter. I wouldn't be dismissive to suggest that we assume all of our employees will want to stay with us. But we talked about some of the employee engagement initiatives that we've initiated over the course of the past few years.

And there is an element of kind of that emotional connection that employees establish to the facility..

Now that doesn't run in perpetuity when it's substantially challenged, and there have been challenges, but we're definitely finding that the availability of labor on the new hire front has been far greater a challenge than retaining our longer-established employees. .

Our next question is from Brian Tanquilut with Jefferies. .

Jack Slevin on for Brian. I guess I want to start and just make sure I understand sort of the puts and takes as we bridge to year-end and sort of what's happening in the industry versus the outlook with these contracts..

So I think if you're looking to adjust the contracts, we're sort of looking at industry data, occupancy has flattened off in the fourth quarter and is still sort of 10% below pre-COVID levels. You've got clinical staffing shortages that are at their highest levels we've seen, and significant wage inflation and wage pressure there for your clients..

And so kind of piecing those 2 things together with the step-up that you're expecting to get adjusted into your contracts, I guess I'm just wondering, is there a risk or how you're thinking about what needs to happen from an occupancy standpoint to stave off risk that you'll need to do more on the price concession side as we move through 2021?.

Yes, Jack, I would say, clearly, census is not a panacea, but it is a significant component if you think about the financial makeup for any one of our particular customers at the facility level.

I would say that the fact that you noted that census has plateaued a bit, that's a major win, right? If you think about the clinical impact that both Delta could have had on the industry and then on the heels of Delta add the Omicron variant.

But the reality is that going back from about the 2nd week of August, we've been above 72% occupancy on an average national level throughout the industry, and to have maintained that to this point is a big win from a clinical perspective.

That's likewise in the face of the clinical staffing shortages that you noted, the forced quarantines that have been required for infected individuals down to the frontline staff level..

So that's, in our view, a fairly significant accomplishment. So we're starting at a level that's significantly more favorable than where we stood at this point last year with respect to expectation for an ongoing census improvement. So you're correct in noting that the clinical staffing shortages will have an impact on census.

But we are -- again, there are some data that are encouraging, not only internal health care services group data, but some of the external anecdotes that we're beginning to hear from customers and industry groups..

So there is an expectation that even if it's modest, we do begin to see that uptick in census and that bodes well from a financial perspective for our industry end market.

And we'll be getting out [Technical difficulty ] an assessment that we make in analyzing the performance of a current partner of ours and likewise, looking out to future growth opportunities with prospective customers. .

Got it. That's helpful. And then last one for me. Just if you look at the cash flow from operations number is really strong in the quarter relative to sort of a pressured P&L.

I guess, can you just walk through in a little more detail what's going on there or what's driving that?.

And then talk about how we should be thinking about cash flow as we move into 2022. .

Well, we -- our goal always is to collect what we bill. And in the fourth quarter, we had strong cash collections. So I think we were $6 million or $7 million to the positive of what we billed. So that was a strong year.

I think when you look at cash, the outlook for the year, maybe just taking it -- looking at Q1, I know we do have the -- Matt highlighted it in his opening remarks, the change in the payroll accrual to 8 days..

So we would expect that alone to result in cash outflow for Q1. So without going through, say, a cash flow model for the year, I think what we can confidently say is our goal remains to collect what we bill.

There will be quarter-to-quarter timing differences, depending on the payroll accrual, which is the biggest driver or fluctuation driver of changes from any one given quarter. And again, our goal is to collect what we bill. .

Our next question is from Mitra Ramgopal with Sidoti. .

First, just on the top line. Last year, you had announced a pretty nice business addition on the food services side. I know you mentioned you're in talks in terms of bringing on new business. Just curious in terms of how optimistic you are given the environment right now that we might be getting some positive announcements on that front in 2022. .

I would say with all of the unknowns and ongoing uncertainty, and the variables that we've spoken about in the current environment, we'd be reluctant to sort of project or forecast too specifically on growth opportunities. But that doesn't mean that there are not opportunities for growth or that we won't grow.

We don't have necessarily specific visibility to next quarter or the quarter beyond that..

So we wouldn't really guide on expectations per se, but we continue to be confident around our capabilities to deliver long-term growth. And as I said, we are increasingly optimistic about pulling forward some of these growth opportunities that have presented themselves..

In light of increased access now to facilities that the pent-up demand that's been in our pipeline, more -- I'd say more imminent, I would say, would be opportunities to expand partnerships with existing [ EVS ] customers to include dining services, and then all of the above, of course, layered against the backdrop of that assessment of the financial health of any prospect..

And that remains a little bit tricky with the state of the industry recovery that we've talked about.

And I guess all of this kind of brings us back that, all the more reason why the changes to our service agreement structure are so important, to really make sure that we're creating the most durable value proposition and model and that it's a sellable model going forward. .

Okay. And on the SG&A side, I think you're expecting 8.5% to 9.5% this year. I guess, pre-COVID typically saw SG&A maybe 7.5%, 8% on the high end. Should we expect any -- I know you hinted at some potential efficiencies that you might be able to realize.

But is this sort of the new normal as we look at SG&A?.

Yes. I think certainly with where revenue sits today. Again, there's a fixed and a variable portion of SG&A. The majority of SG&A is payroll related.

But yes, we would expect that range to continue until we ramp up revenue over the next 12, 18, 24 months in a way that Matt kind of just highlighted, but that will be scalable to a degree, but there will be some incremental costs as we grow the top line as well. .

Okay. And then finally, just I think you mentioned there was about $2 million of nonrecurring costs in the quarter. If you maybe can provide some color on that, and going forward, if there are any more onetime items that need to be cleaned up maybe in 1Q. .

Yes, they were -- one was -- there was about $1 million. It was just an adjustment to one of our amortization schedules that we had, like a catch-up adjustment. The other $1 million was related to a state tax related education credit, the other side of which you see in the tax rate.

So that's an annual program that we participate in, where you see the expense in SG&A, and then the corresponding 90% credit in taxes. .

Our next question is from Andy Wittmann with Baird. .

There is 2 from accounting. So I just noticed that your goodwill and your intangibles are up actually a pretty decent amount in the fourth quarter over the third quarter level.

Matt, is that the amortization schedule that Ted just mentioned, or is there something else that went into your intangibles?.

No. So that's unrelated to the adjustment that Ted just referred to. Actually, during Q4, we acquired a small food service company. They're focused in the education space. They do about $3 million -- $30 million or so annualized in sales. And what we liked about them, Andy, is they've got really a great product and in our view, a scalable model.

So obviously, a small acquisition, but we view that along with our environmental services opportunity and that education niche as a nice complement to our longer-term growth strategy as a company. .

Okay. That makes sense. Glad I asked. Okay. So then, Ted, just I want to, I guess, ask on the, I guess, the balance sheets of your customers. There's been plenty of federal money over the last couple of years through various programs as you well know.

You guys and your customers had to pay back the payroll tax deferral, that's kind of a knock against everyone's balance sheet, including yours a little bit..

I was just wondering, I mean you guys haven't seen any material DSO write-offs here. We'll obviously look at the Q and get a little bit more detail. And obviously, you've changed your processes a lot over the last several years even before COVID.

But I guess I wanted to check in with you about the credit quality of where your customers sit today?.

And anything you can tell us about the level of federal funding that is helping or maybe not helping enough from your seat?.

Well, just maybe starting with your final point, I think at the federal level, there's really -- there's really not a lot that appears to be on the come. There are some positive puts and takes at the state level.

You have some states that -- and that's really where the -- at least at the association level, that's where the engagements -- our efforts are focused, is with the state opportunities rather than at the federal level..

You made a comment, Andy, that we changed our processes. And I would point to the weekly payment initiative that we launched a couple of years ago is certainly helping -- giving us the ability to navigate not just through the COVID environment, but in a post-COVID world.

If we were sitting here a couple of years ago, we would be talking about very few if any of our clients that were paying us at a frequency of greater than monthly. Here we are today, we have over 60% of our customers that are paying us at a frequency greater than monthly. The vast majority of those are weekly..

So that aside from all the other -- the quantitative data that we are able to glean from our clients, whether it's census-related or otherwise. That, more than anything, allows us to stay one step closer to our customers and monitor their behaviors and then be able to react quicker..

So while there's no guarantees, I think we're very well positioned. If there is some strain in the year ahead as the federal money dries up, and the census continues to recover, we're going to be able to -- and we'll continue to be disciplined in our decision making. And again, that's something we'll monitor closely. .

Our next question is from A.J. Rice with Credit Suisse. .

Maybe just to try to drill down on the expectation around -- first of all, on margin improvement in the first quarter. It sounds like some of that's a reworking some terms on the agreement.

Maybe can you talk a little bit about that? I mean I know you've shown some margin improvement is sort of from time to time when you've held operating income constant, but given a revenue concession to the -- as you've had -- need less workers because the census has been down..

How much is that type of thing versus some other concessions that might be a more sustainable benefit? Can you give us a little more color on how you're going to get that margin improvement in the first quarter?.

Yes. I would say directionally, the expectation is for improvement, A.J. As we've noted, we'd be hard-pressed to sort of quantify that at least for the Q1 impact.

But it is -- the expectation is that those improvements are driven by really more substantial and durable adjustments to the contract structure, right, the service agreements rather than any sort of nuance that may occur in kind of the ups and downs of staffing relative to census within the 4 walls of a facility. .

Okay. Last quarter, there was the discussion about the fact that the nursing homes were choosing not to raise rates to really adequately cover their hour -- some of the customers' hourly workers, and therefore you had to unilaterally do that because your pass-through sort of requires them to raise rates for their existing hourly..

Have you -- how is that now trending as you go into the first quarter? Is that getting better? Is it getting worse? Is it about the same as you saw in the fourth -- in the third quarter and fourth quarter?.

Yes. I would say relatively comparable, A.J., Q4 to Q3. And the reality is that given the dynamics of the labor environment, we have been making those adjustments in relative real time.

And that's been the challenge, right? The disconnect between when the customer would make an adjustment to the wage scale at the facility, that would have historically triggered the adjustment that we would then pass through. That's not been the case..

We've had to be much more nimble in adjusting in real time to be able to adequately staff the facility. So I would say that the environment, generally speaking, in that regard, comparable from Q3 into Q4, if not a bit worse in Q4. .

Okay. Okay. There's been several high-profile renegotiations with some skilled nursing operators.

I don't know whether any of those are your customers, but when that type of activity is happening, where they're being asked for rent concessions and so forth and the [ REITs ] agreed to that, do you typically -- do they sort of bring all the vendors, including you, into the table to discuss that? Are these being done one-off between the REIT and the operator?.

In just about every situation, and we are familiar with some of the groups that you alluded to, but it's typically directly between REIT and their tenant rather than anything that filters through to other -- the rest of the vendor community. .

Okay. And just a couple quick more. The 72% occupancy rate that you're quoting is sort of steady.

Is that something where that's good enough for the -- as long as it stays steady? You'd say the vast majority of your underlying customers can operate at that? Or is there a requirement that it rebounds to get to sort of a sustainable level where their operating cash flow is sufficient to cover their needs..

Any comment on how much of a rebound we need to have to sort of get the industry to a sustainable level? I know the government can potentially step in and help, but absent that, how much occupancy rebound do we really need to see, do you think?.

Ultimately, A.J., I think the general consensus is that occupancy needs to be in and around 80% for the industry.

Now there is significant variability -- you know this better than anyone -- between, say, New York, what New York needs and versus what Texas needs, picking 2 extremes of, New York's need to be north of 90%, Texas needs to be in the high 60s, low 70s..

So it's all state by state, area by area. But overall, that 80% is really the touchstone. Now if you look at optimistically, if you look at what happened between January and June of 2021, the industry was recovering.

Albeit slowly, but about 0.2% per week once they bottomed out at 67% in January, through June, and that's how -- that was the pathway to 72%..

Matt mentioned it in some of his remarks earlier, but when you think about the impact of Delta and Omicron, and the fact that the industry kind of held the clinical line, I think, is a real positive.

So with some of the, I said cautious optimism we have around staffing in the year ahead, and specifically looking at it through a client or provider prism, as their staffing stabilizes and they're able to have adequate nursing staff, there is a demand for the provider services. .

So we're, again, cautiously optimistic that we should see census begin to rebound in the coming months. And there's no reason why the end of year targeting that 80% would not be I don't know if that's a base case or somewhere between the best case and a base case, but it's not wholly unreasonable to expect 80% by the end of the year for the industry.

And that's where ultimately, longer term, as you said, absent any sort of federal intervention, the industry needs to be healthy, to be healthy and self-sustaining. .

Okay. Maybe one final question. On the, obviously a big part of Healthcare Service Group's story for years has been the dividend, the gradual increase in the dividend. I know pre-pandemic, the discussion was roughly 90% payout ratio. You have a very strong balance sheet..

So obviously, if you view this as short-term, you could borrow theoretically, if you needed to, to cover the dividend for even a year or so.

But what's the thinking about that dividend relative to the current run rate of earnings, where you're not -- if you're not covering the dividend, how long would that happen to be -- have to be before you would revisit to think about that -- changing the long-term trajectory?.

Yes. Well, and you pointed to our balance sheet, and I appreciate that. For the quarter, really, the cash balances as well as the cash flow certainly supported. I think more broadly, though, to your question, organic growth and internal investment, A.J., remain the #1 priority in terms of capital allocation for the Board, followed by the dividend..

There's no payout ratio per se. And I know we've talked about, consistency and sustainability have really been the guidepost more than a payout ratio. We'll continue to evaluate quarter-to-quarter just like we always have. But again, the dividend remains of the highest priority, right after organic growth and internal investment. .

We have no further questions at this time. I'll turn the call back to the presenters. .

Okay. Great. Thank you. In the quarter ahead, we will continue to prioritize engaging with our customers to modify our service agreements to adjust for the extraordinary inflation experienced during the second half of 2021, as well as to account for future inflation on a more real-time basis..

We expect these service agreement modifications to be completed throughout the first half of 2022 with the goal of exiting the year with cost of services in line with our historical target of 86%. We will also continue to execute operationally with an eye towards opportunistic growth.

Above all, we remain committed to making decisions that best position us to deliver long-term shareholder value..

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

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect..