HEALTHCARE SERVICES GROUP INC quarterly report, Q2 FY2014

Healthcare Services Group, Inc. — Q2 2014 Form 10-Q

Reporting period: Three and six months ended June 30, 2014, compared with the same periods in 2013. The company manages housekeeping, laundry, linen, facility maintenance and dietary services for healthcare facilities, primarily long-term-care providers. It served more than 3,000 facilities in 48 states; results are reported in Housekeeping and Dietary segments.

Financial performance

Metric	Q2 2014	Q2 2013	Six months 2014	Six months 2013
Revenue	$319.3 million	$273.6 million	$631.5 million	$547.5 million
Income before taxes	$22.0 million	$19.9 million	$45.2 million	$38.8 million
Net income	$13.9 million	$12.9 million	$28.6 million	$27.9 million
Diluted EPS	$0.20	$0.19	$0.40	$0.40
Operating cash flow	Not presented quarterly	$14.8 million	$14.0 million

Q2 revenue rose 16.7% and net income rose 7.6%; six-month revenue rose 15.3%, while net income increased 2.4%. Revenue growth reflected new Housekeeping clients, the Platinum acquisition, and expanded Dietary service at existing clients.
Q2 net margin declined to 4.4% from 4.8%; six-month net margin declined to 4.6% from 5.1%. Q2 pretax margin was 6.9%, versus 7.3%; six-month pretax margin improved to 7.2% from 7.1%.
Costs of services increased faster than revenue in Q2: 17.6% versus 16.7%; the cost ratio rose to 86.4% from 85.7%. For six months, the ratio increased to 86.0% from 85.8%. Housekeeping labor inefficiencies and higher Dietary supplies weighed on costs; Dietary labor efficiency and workers’ compensation/general liability claims experience provided offsets.
The effective tax rate was approximately 37% for the first half, versus 28% a year earlier. Management attributed the increase primarily to tax credits recognized in 2013, including Work Opportunity Tax Credits; the WOTC had expired again as of December 31, 2013. The company estimated a 37% full-year 2014 rate, versus 29% in 2013.

Liquidity, balance sheet and capital allocation

At June 30, cash and cash equivalents were $57.3 million, marketable securities $11.1 million, and working capital $223.9 million. Cash plus marketable securities totaled $68.4 million, down from $75.6 million at December 31, 2013. Current ratio was 3.3, versus 3.1.
Operating cash flow of $14.8 million was below net income, principally reflecting a $16.7 million increase in receivables and other working-capital outflows. Investing activities used $2.2 million; financing activities used $19.5 million, including $24.3 million of dividends. Cash declined $6.9 million during the half.
No borrowings were outstanding on the $125 million demand credit facility. A $51.5 million insurance-related standby letter of credit reduced availability; the filing does not state a separate net availability figure. The company reported covenant compliance; funded debt/EBITDA was 0.64 against a maximum of 3.00.
Accounts and notes receivable, net, were $205.2 million, up from $189.1 million; the doubtful-account allowance rose to $4.8 million from $3.9 million. Net promissory notes from clients were $18.9 million, up from $16.1 million. The company paid quarterly dividends and declared a subsequent $0.17375-per-share dividend for September 2014.
There was no material conventional debt outstanding. Accrued insurance claims totaled $26.9 million current and long-term combined.

Changes, outlook and material items

Housekeeping revenue increased 15.0% in Q2 and 12.0% for the half; Dietary revenue increased 20.1% and 22.3%, respectively. Dietary growth was primarily from serving more existing Housekeeping clients.
The 2013 Platinum acquisition had total consideration of $50.8 million, including $5.0 million cash, stock and contingent stock consideration. The purchase-price allocation was finalized in Q2 2014, adding $4.3 million to goodwill. The filing says the first eligible contingent milestone—300,000 shares—was expected to be paid in Q3 2014; up to 705,000 shares may be issued through 2016 if targets are met.
Management expected segment revenue mix to remain approximately 66% Housekeeping and 34% Dietary for the remainder of 2014. It expected Dietary growth chiefly from existing Housekeeping clients and Housekeeping growth chiefly from new clients. Planned second-half capital expenditures were approximately $2.5–$4.0 million; management said available cash, operating cash flow and the credit line should fund operations and anticipated growth.
Risks include client payment delays, bankruptcy and collection disputes; client dependence on Medicare, Medicaid and other reimbursement; labor and supply cost inflation; and workers’ compensation and general-liability claims. The company noted several clients individually represented at least 3% of revenue, with two as high as 7%. It also faces possible state and local tax disputes and ordinary-course legal and employment claims; management did not expect known matters to materially harm financial position or results, while noting outcomes are uncertain.
The company reported no material change in annual-report risk factors, no material off-balance-sheet arrangements apart from the standby letter of credit, and no control deficiencies identified in its evaluation. The 2014-09 revenue-recognition standard was not expected to have a material impact.

Investor verification priorities

Track receivable aging, client-specific exposures, bad-debt provisions and collection of the $18.9 million in client promissory notes.
Assess whether revenue growth can translate into improved margins, particularly given Housekeeping labor inefficiencies and Dietary supply costs.
Monitor the elevated tax rate and any renewal or replacement of expired tax credits.
Verify Platinum milestone achievement, share issuance and integration-related contribution to growth.
Review client concentration and the potential effects of Medicare/Medicaid reimbursement changes on customers’ ability to pay.
Monitor insurance claim development, credit-facility availability after letters of credit, and dividend funding relative to operating cash flow.