Healthcare Services Group Inc

NASDAQ:HCSG

Earnings Call Transcript 2024-Q1

[Operator]

Hello. Welcome to Healthcare Services Group 2024 First Quarter Earnings Conference Call. The matters discussed on today's conference call include forward-looking statements about the business prospects of Healthcare Services Group, Inc.

For Healthcare Services Group Inc.'s most recent forward-looking statement notice, please refer to the press release issued this morning, which can be found on our website, www.hcsg.com. Actual results may differ materially from those expressed or implied as a result of various risks, uncertainties and important factors, including those discussed in the Risk Factors MD&A and other sections of the annual report on Form 10-K and the Healthcare Services Group Inc. other SEC filings.

And as indicated in our most recent forward-looking statement notice, additionally, management will be discussing certain non-GAAP financial measures. A reconciliation of these items to U.S. GAAP can be found in this morning's press release.

I'd now like to hand over the conference to the President and CEO, Ted Wahl; and Chief Communication Officer, Matt McKee. Please go ahead.

[Theodore Wahl, executive]

Thank you, and good morning, everyone. Matt McKee and I appreciate you joining us today. We released our first quarter results this morning and plan on filing our 10-Q by the end of the week.

Today, in my opening remarks, I'll first discuss our Q1 financial highlights and key accomplishments, including the change health care disruption and the temporary impact it had on our customers, cash collections and cash flow. I'll then share our perspective on the latest industry trends and developments. And then lastly, I'll provide an update on our Q2 priorities and outlook for the rest of the year. I'll then turn the call over to Matt for a more detailed discussion on the quarter. So with that overview, I'd like to now discuss our Q1 financial highlights and key accomplishments.

Our team delivered strong first quarter results, building on our positive momentum in 2023. For the 3 months ended March 31, 2024, we reported revenue of $423.4 million in line with expectations. Net income and diluted EPS of $15.3 million and $0.21, adjusted net income and adjusted diluted EPS of $16.5 million and $0.22 and adjusted EBITDA of $28.9 million, a 10.7% increase over Q1 of 2023.

During the quarter, we managed adjusted cost of services under 86% and continue to grow our new business and manager and training pipelines. We remain confident that we will deliver on our goal of year-over-year growth in 2024 with the majority of those new business adds expected in the second half of the year.

On the cash collections front, Q1 has historically been our most challenging quarter, especially on the heels of Q4, which typically sees our strongest collections. The first quarter seasonality is anticipated and accounted for in our cash flow forecasting. However, what was unanticipated was the February Change Healthcare cyberattack. The resulting disruption had a far-reaching impact across the healthcare landscape and affected the claim submissions and billing activities of long-term and post-acute care providers, many of whom are HCSG customers.

In spite of these first quarter headwinds anticipated or otherwise, we achieved 95% cash collections and would have met our first quarter cash flow estimates, if not for the change healthcare issue. While this event was disruptive during the quarter, we are confident that the impact on our customers is temporary. We expect to make up for any cash collection delays in the months ahead, which is why we're reiterating our previously shared 2024 cash flow range of $40 million to $55 million.

I'd like to now share our perspective on the latest industry trends and developments. Industry fundamentals continue to trend positively, highlighted by a slow but steady increase in workforce availability with the industry adding nearly 100,000 jobs since the beginning of 2023. At the current pace, the sector's workforce will match the $1.6 million pre-pandemic employee levels by the end of 2025. Rising occupancy, which now sits at 79%, [ 12 ] points higher than the January 2021 low and just 1% under pre-pandemic levels and a stable reimbursement environment, which includes CMS' recently proposed 4.1% increase in Medicare rates for fiscal year 2025 as well as continued positive reimbursement trends at the state level.

Reimbursement rates are especially important at this stage of the recovery and helping to offset the increased cost of doing business driven by persistent inflation and the higher cost of capital. On the regulatory front, CMS published its final minimum staffing rule earlier this week. There is a growing list of stakeholders opposed to the rule, including healthcare industry leaders, trade associations like ACA, MedPAC members and a bipartisan group of legislators, including nearly every R and a growing number of these.

The reason for their opposition include the unfunded nature of the mandate, the one-size-fits-all approach, the apparent disregard for the realities of present and future nursing availability and the near certainty that if implemented, the rule would lead to facility closures and ultimately reduce access to care, especially in rural areas.

We believe it's highly likely the rule will not be implemented or will undergo significant revision during the extended phase-in period, especially given the inevitability of litigation and potential for legislation or administration change.

As far as our outlook for Q2 and the second half of 2024, our top 3 priorities continue to be as follows: the first is managing adjusted cost of service is in line with our target of 86%. We do not take operational execution for granted but have full faith in the ability of our operators to deliver the services on budget. It took a considerable amount of work in 2022 to modify our contracts to better capture wage inflation and cost increases in our pricing on a closer to real-time basis. Those contract enhancements along with recent positive trends in customer experience, systems adherence, regulatory compliance and budget discipline provides strong operating momentum heading into the second quarter. We expect Q2 adjusted cost of services to be at or below 86%.

Our second priority is delivering year-over-year growth by executing on our organic growth strategy through hiring, training and developing future management candidates, converting opportunities from our sales pipeline into new business adds and retaining our existing facility business. We estimate a Q2 adjusted revenue range of $420 million to $430 million and remain confident that we will deliver on our goal of year-over-year growth in 2024, with the majority of those new business adds expected in the second half of the year.

The third priority is collecting what we bill. We view cash collections as a lagging indicator of industry recovery. While our recent trends have improved compared to 2022 and the first half of 2023 and if not for the change healthcare disruption, we would have met our Q1 cash flow estimates. This remains an area of opportunity for the company in 2024. We continue to expect some choppiness throughout the year ahead but anticipate our cash collections gaining strength throughout 2024 and further still into 2025.

We estimate a Q2 adjusted cash flow range of $5 million to $15 million and reiterate our previously shared 2024 adjusted cash flow range of $40 million to $55 million. As we round the turn of what has been a prolonged recovery for the industry, the company's underlying fundamentals are stronger than ever, and we remain focused on executing on our strategic priorities to drive growth and deliver meaningful shareholder value in the year ahead. So with those introductory comments, I'll turn the call over to Matt for a more detailed discussion on the quarter.

[Matthew McKee, executive]

Thanks, Ted, and good morning, everyone. Revenue was $423.4 million, in line with the company's expectations of $420 million to $430 million. The company estimates Q2 revenue in the range of $420 million to $430 million. Housekeeping and Laundry and Dining & Nutrition segment revenues were $190.5 million and $232.9 million, respectively. Housekeeping & Laundry and Dining & Nutrition segment margins were 9.7% and 7.6%, respectively.

Cost of services was $358.9 million. Adjusted cost of services was $357.3 million or 84.4%. The company's goal is to continue to manage adjusted cost of services in the 86% range. SG&A was $46.9 million. Adjusted SG&A was $42.8 million or 10.1%. The company's goal continues to be achieving adjusted SG&A in the 8.5% to 9.5% range.

Net income and diluted earnings per share were $15.3 million and $0.21, respectively. Adjusted net income and adjusted diluted earnings per share were $16.5 million and $0.22, respectively. Adjusted EBITDA was $28.9 million or 6.8%. This is a 10.7% increase over Q1 of 2023. Q1 cash flow and adjusted cash flow used in operations were $26 million and $9.2 million, respectively. DSO for the quarter was 88 days.

Also as part of our adjusted results, we adjust for the impact of the change in the payroll accrual, but since it will still be included in our reported cash flow from operations, we would point out that the Q2 payroll accrual is 15 days. That compares to the 8 days in the first quarter of 2024 and the 13 days that we had in Q2 of 2023. But again, the payroll accrual only relates to quarter-to-quarter timing. So with those opening remarks, we'd now like to open up the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Bill Sutherland from the Benchmark Company.

[William Sutherland, analyst]

Nice print. Ted, can you comment on client retention in the quarter? Just curious about if you had to offset the exits and maybe -- and in that light, what the new adds were in the quarter?

[Theodore Wahl, executive]

From a retention perspective, Bill, our retention was greater than 90%, which is, as you know, our expectation is we're always aspiring for something greater than that, but we were in those levels and expect that to continue to trend along those lines. And from an adds perspective, again, modest adds, which offset some of the exits we had. But by and large, again, looking ahead, we expect to have additional facility adds and really begin to ramp up our new business additions in the second half of the year.

[William Sutherland, analyst]

So the cadence would adds to expect would kind of build in the back half of the year as far as new adds?

[Theodore Wahl, executive]

Yes, we would expect the top line to look and feel similar to what it has been -- what it was in Q1 into Q2 and then again, expect some step-ups in the back half of the year, which we'll be able to share in more detail on our next call.

[William Sutherland, analyst]

Okay. And you adjusted SG&A at 10.1%, it's outside the range. Is there anything in particular there?

[Theodore Wahl, executive]

Well, when we made our -- when we balanced our capital allocation strategy, we talked about making new and sustained investments along the lines that are organic growth drivers and certainly highlighted that as part of our shift in strategy. I think specifically, in Q1, and these have been in process now for well over a year, but we continue to have investments in employee engagement and experience, which we're in the midst of a company-wide initiative to drive retention and satisfaction among our employees.

So we've increased marketing and branding positioning investments, which we view critical for the future for both external as well as internal stakeholders, and our goal is to move this from a neutral to a strength and then ongoing tech investments. I think most recently, this past quarter, we had facility level investments in Chromebook and tablets, specifically in our dining department.

So we're going to continue to make those investments. Again, they're central to our organic growth strategy as well as our retention and customer satisfaction and employee retention drivers. And then we've also seen some increases in T&E expense like a lot of businesses just with overall activity and inflation. But longer term, as we lever that top line, Bill, we expect to see the SG&A as a percentage of growth -- as a percentage of revenue, rather come back in line with our target. So we're committed to maintaining our target. It's just more of a timing issue than anything else.

[Operator]

Next question comes from Sean Dodge from RBC Capital Markets.

[Sean Dodge, analyst]

Ted, you said cash collections in Q1, typically seasonally weak, but certainly impacted by the change outage. How much of a drag do you think change was in the quarter? Are there any bookends you can give us around some quantification there?

[Theodore Wahl, executive]

Yes. The change disruption, Sean, affected about half of our customers in some form or fashion. And then obviously, depending on the scale of the relationship that our client had with change as well as their claims and billing volumes and even alternative capabilities with -- of certain of those customers, some were affected more than others. Some that were the larger groups, especially that were equipped with greater back-office support, we're able to offset at least in part the impact by processing manual claims.

Many of our customers -- actually, the majority of the affected customers did apply for CMS' accelerated and advanced payments program, but we're not expecting that supplemental funding to really hit in the main until late April, early May. I think overall, when you think about the difference from forecasted cash flow to adjusted cash flow, we estimate anywhere from $12 million to $15 million being directly related to the change impact. And we were able to get different levels of granularity and validation from some customers more so than others, but that's what we estimate that impact to be.

[Sean Dodge, analyst]

Okay. And then you said it should only be temporary in some of the supplemental help impacting kind of hitting later in April. Are you seeing any signs of collections elsewhere? I guess so far to date in April.

[Theodore Wahl, executive]

In April, we're pacing right on with what our forecast was for the month. So we're, again, confident that the impact, as you mentioned, as we touched on in our opening remarks is temporary and expect to make up for any delays in the months ahead, which, again, is why we reiterated that '24 adjusted cash flow range of $40 million to $55 million.

[Sean Dodge, analyst]

Okay. Great. And then on cost of sales, so adjusted was 84.4% so you continue to manage that very well. Is there anything else to call out there that's onetime or more transient than helping right now? Or do you think you can kind of continue to operate well within this 86% range?

[Theodore Wahl, executive]

Yes. I know I touched on it in my opening remarks, but the contract enhancements from 2022 certainly are a key factor in providing the durability and as we see it, the sustainability of our cost of services line, but most importantly, really, Sean, it's the positive trends we see in customer experience, system adherence, regulatory compliance and budget discipline, which all the credit goes to our teammates that are leading the business in the field and their relationships with our customers and the impact they're able to have within the communities they're servicing. And that's really more than anything central to driving consistency of cost of services and ultimately, margins.

So yes, we are very confident in our ability to continue to manage adjusted cost of services at or below 86%. You've seen before, Sean, there's always going to be some month-to-month and quarter-to-quarter movement depending on the timing of new business adds or even exits occasionally, management development investments can impact that even the business mix. But by and large, it's about execution and the consistency of that execution.

[Operator]

Our next question comes from Andy Wittmann from Baird.

[Andrew J. Wittmann, analyst]

Lots of questions on the SG&A. I'm going to add another one too, just for a little bit of a clarification. Ted, you talked about near term, you're making these investments and those make sense. You talked about getting back to your targeted level in some period of time. You didn't talk about how that happens. Does that require offsets in the cost structure to get there? Or do you think that it's just going to be leverage from the revenue growth that you're expecting in the second half and beyond?

[Theodore Wahl, executive]

Leveraging the fixed portion of our SG&A more than anything else, Sean. And I would also be remiss if I didn't point out that it's not a coincidence that we're seeing our cost of services performance improve, while our SG&A perhaps offsets a portion of that, but we're still benefiting from the improvement in our cost of services. And one does directly relate to the other.

[Andrew J. Wittmann, analyst]

Okay. That makes sense. And then as it relates to that expected second half ramp in organic growth. I was hoping maybe you could just give us a little bit more detail and will be curious actually, if there's one of your particular segment that's expected to see more growth than the other. And really, just the visibility that you have into this -- are these contracts that are basically signed already and then just waiting for the transition to happen? Anything that you can give in terms of confidence as to why you feel like the second half is going to show that ramp. I think would be helpful for us.

[Matthew McKee, executive]

Yes, Andy, this is Matt. I'll take this one. And we described last quarter the fact that our ramp back to growth will likely not be a clean linear sequential step-up, but directionally we expect ongoing revenue uptick and certainly year-over-year revenue growth. And realistically, we expect to onboard more new business in the back half, as we mentioned previously as compared to the first half.

So that's sort of how we're thinking about it, having offered the revenue range expectation in Q2 of that $420 million to $430 million certainly suggests a first half compared to second half step-up in the back half of the year. We did on board, as Ted mentioned, a modest amount of new business in Q1. But more importantly, we're in the midst of prospect discussions that will amount to more meaningful adds in the back half and the coming quarters even beyond that.

So while we have improving visibility into the pipeline business that will convert likely this year, the timing of those adds obviously has an impact on our quarterly top line projections. So in as much as we lock in start dates and have a sense for increasing top line targets, we'll share those. But as it relates to the top line and Bill Sutherland asked about this, we'd be remiss if we didn't remind everyone that a component of top line growth is retaining our existing business.

And as we sit here, we don't foresee any significant exits on the horizon, but it's worth reiterating that we're still in the final stages of an ongoing industry recovery. Changes in facility operations or ownership can alter our view on a piece of business. And we have to remain nimble if we believe that it's in our best interest, both in the near term and the long term to exit a client group about whom we might have concerns.

But overall, Andy, net-net, we definitely have confidence in our ability to grow the top line year-over-year. The expectation would be that, that growth comes from not only greenfield housekeeping opportunities with new customers, but also the ongoing cross-sell of dining into the existing customer base. We talked last quarter about the benefits of that cross-sell in the sense that we've had an opportunity to really understand the intricacies from an operational perspective as to the dining operation within an existing piece of business, an existing facility with whom we partner on the Environmental Services side and we've established that track record of payment, which obviously, in this environment is more critical than ever.

So we do expect that the primary driver of growth will be organic growth within the long-term and post-acute care segment, our primary segment. But we remain committed to the education space as well. And we're sort of in the tail end of what would be described as the selling season in the education space. So we'll probably have greater visibility into growth opportunities in that segment in the coming months here as well.

[Andrew J. Wittmann, analyst]

I appreciate the detail on that answer. And then just my last question here has to be -- we have to talk about the minimum staffing requirement given that the way this is going to play out. So I guess, Ted, obviously, this isn't new. This has been something that's been proposed and talked about for a long time and at nauseam. Obviously now finalized and heard your comments about your challenges, administration change, all that, that makes sense.

What are -- when you're talking to your customers, I mean they have to do a degree of planning, assuming that this is going to get phased and I recognize it's 3 or 5 years and taking some time. But what are they telling you about how this can affect the way they interact with you or the propensity to stay on with you or sign up with you?

[Theodore Wahl, executive]

Yes, it's a great question, Andy. And I think broadly, not just this, but any sort of uncertainty that's introduced into the industry or the sector creates a demand for our services for no other reason because we provide certainty. Certainty is a central part of our value proposition. Peace of mind, cost certainty, operational certainty and being able to be that partner that allows the operator to focus on the lifeblood of their business, which is really patient care and patient mix.

So from that perspective, that's how we believe it could or would impact at least the demand for our services, but more poignantly before you even talk about the theoretical or the hypothetical that ever being implemented, we do believe that the rule will not be implemented or at a minimum, will undergo substantial revision during the phase-in period. And what I mentioned in the opening remarks, the inevitability of litigation and the growing number of political will for legislation and the possibility for administration change.

The reality is the provider community and most industry stakeholders, and you can include us as part of that stakeholder group do not view this as a serious or a sincere policy. Then provider community has seen serious policy in the past, and this is so far outside the realm of what's possible and the fact that it's unworkable and dated. I think Mark Parkinson has publicly referred to this, who's the Mark Parkinson, the President of AHCA, has referred to this as a 20th century solution to a 21st century problem. One is left with no choice but to really view the rule cynically through an election year's eyes as an attempt to cater to a specific constituency.

There's no funding, the required staff are simply not available and there's no plan or a pipeline that's being built to produce the number of RNs that's needed. So again, we're confident the rule will not be implemented or if it does, it will undergo significant change. So I appreciate the question. It's interesting to even speculate on it. But at this stage, it's just -- so there are so many hurdles for this to overcome. It's -- there has to be, to your point, at least a degree of thought put forth but the realities of it ever becoming overall are still, we believe, very slit.

[Operator]

Our next question comes from Ryan Daniels from William Blair.

[Unknown Analyst]

This is Jack on for Ryan Daniels. Most of my questions have been asked already. But first, just back on the cash flow expectations. I appreciate that you're reaffirming the $40 million to $55 million cash flow range. And I think you said second quarter cash flow is expected between $0 million and $15 million.

So I guess how should we think about this for the remainder of the year, though? Has the Change Healthcare makeup kind of included in the second quarter guidance? I guess I'm just trying to see if you expect to make up a good portion of the Change Healthcare impact in the second quarter. Maybe it sounds like it will trickle into third quarter too. Hoping I'm on the right track there.

[Theodore Wahl, executive]

Yes, $5 million to $15 million was what we mentioned for Q2. And then second half of the year would be $40 million to $50 million from a range perspective. So trickle is one way to describe it. We're working -- we're actively working on plans and outlining expectations with customers on making up the shortfall from Q1, that will be iterative. That will be over -- not just Q2, but over the course of the rest of the year in a TBD type of way. But again, that's what we reiterated the expectation that we're going to deliver on our range of $40 million to $55 million.

[Unknown Analyst]

Okay. Understood. And then just a quick follow-up, too. I think it's been a few quarters since you discussed the Education segment. Just kind of curious if this is an opportunity for second half of 2024 and into 2025. Can you just kind of talk about your expectations here? And then there are any recent updates on the education front.

[Matthew McKee, executive]

Yes. I would say we would certainly reiterate our commitment to the opportunity that exists in the education space. There is a bit of seasonality to that market with respect to selling and then obviously, the operations, which largely coincide with the academic year. So there'll be less of a first half dynamic in the education space in the way that we're speaking about the growth opportunity that exists in our core market, the long-term and post-acute care at least in 2024. So we would view that as more of the longer-term linear growth opportunity.

It still represents less than 5% of total company revenue. So with our firm commitment to the growth opportunity there with the compelling nature of the value proposition that we're able to offer in that space relative to the competitive environment, we do still feel very bullish about the opportunity that exists in the education space. So as that grows to be a more meaningful component of total company revenue, we would certainly begin to speak about that more specifically. But generally speaking, firm commitment and still very much a compelling opportunity.

[Operator]

Our next question comes from A.J. Rice from UBS.

[Unknown Analyst]

This M.J. on for A.J. I would like to ask about whether there seems to be an industry expectation that there's going to be higher ownership turnover at least in the SNF industry year-over-year in '24. Does that propose a significant risk to any of the retention of your businesses? And how would the company think about quantifying that?

[Matthew McKee, executive]

Yes. We've not yet seen sort of a significant step up in transactions within the space. Operator changes, ownership changes are certainly a normal course and expected component of our business. We deal with those very well. While theoretically, you're exactly right in the supposition that ownership changes would potentially put us at risk if there is an acquiring company that's coming into a facility that we currently operate, and they either are philosophically opposed to outsourcing or they choose not to specifically partner with Healthcare Services Group or from our perspective, we choose not to partner with them.

So that is definitely where we're most at risk. Ted reiterated our expectation that 90% client retention year-over-year remains the target. That's inclusive of any ownership or operator changes. I would point really to the flip side in the sense that typically when there are those owner or operator changes, we're the beneficiary of those acquisitions, right? I mean we would like to think relative to the end market, we're partnering with most of the strongest operators.

So those tend to be the folks who are expanding their holdings, expanding their portfolios and acquiring facilities. So assuming we've demonstrated the benefit of our partnership as they go along and increase their holdings, generally speaking, there's no guarantees or assurances but we're along for the ride, right? They recognize the benefits of our partnership when they're acquiring a facility, especially if it's a turnaround opportunity.

The last thing they want to prioritize is remedying the environmental service departments or rightsizing the dining departments and getting their food spend under control, all of those issues, which they can very easily of shift to Healthcare Services Group. So we would view any increase or uptick in a transactional environment to be beneficial for the company. But you're correct that we have to work hard, and we have to maintain the business that we currently have through the possibility of ownership or operator transitions.

[Unknown Analyst]

Great. Maybe just one follow-up. I know that you negotiated a lot of your contracts back in '22 to give it an annual inflation that's more tied to wage increases. Do you have a sense of what the underlying rate increases on the contracts are running, I assume it will be around maybe 3% to 5%? Is that the right way to think about it?

[Matthew McKee, executive]

Yes. Not as much of an annual increase, but the goal was to be able to capture inflationary increases on both the food, the supply and the wages in something closer to real time. So we really went out of our way to sort of mirror and mimic the parameters that were put in place in the dining agreements relative to food inflation, whereby those are generally captured and passed through on a quarterly basis, typically tied to CPI food at home.

So see that food at home for Q4 was 50 basis points -- I'm sorry, it was 50 basis points in Q4. We saw a little bit of a downward movement to 40 basis points in Q1. So that is the dynamic that's in play. On the food, we did attempt to mirror that with respect to wage inflation. So that was down from 1.5% in Q3 to 0.8% in Q4. So there's a little bit of a lag in the availability of those data. But that's generally where we're at.

We continue to see a slowdown in the inflation that disinflation, if you will. And the goal is, of course, related to all of the above inflationary increases to pass those through in as close to real time as possible.

[Operator]

As of right now, we don't have any pending questions. I'd now like to hand back over to the President and CEO, Ted Wahl. Thank you.

[Theodore Wahl, executive]

Okay. Thank you, Ellie. It's an incredibly exciting time for the company as we're rounding the turn of what has been a prolonged recovery for the industry. The challenges we navigated the past few years have further solidified our value proposition, the durability of our business model and our market-leading position. The company's underlying fundamentals are stronger than ever and with the industry at the beginning of a multi-decade demographic tailwind, we are very favorably positioned to capitalize on the opportunities ahead and deliver meaningful long-term shareholder value.

So on behalf of Matt and all of us at HCSG, I wanted to thank Ellie for hosting the call today, and thank you again to everyone for joining.

[Operator]

We'd like to thank everyone for attending today's call. We hope you have a wonderful day. Stay safe. You may now disconnect the discussion.