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Edited Transcript of HCSG earnings conference call or presentation 12-Feb-20 1:30pm GMT

Q4 2019 Healthcare Services Group Inc Earnings Call

BENSALEM Feb 19, 2020 (Thomson StreetEvents) -- Edited Transcript of Healthcare Services Group Inc earnings conference call or presentation Wednesday, February 12, 2020 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Matthew J. McKee

Healthcare Services Group, Inc. - Chief Communications Officer

* Theodore Wahl

Healthcare Services Group, Inc. - President, CEO & Director

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Conference Call Participants

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* Albert J. William Rice

Crédit Suisse AG, Research Division - Research Analyst

* Andrew John Wittmann

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Chad Christopher Vanacore

Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst

* Jason Michael Plagman

Jefferies LLC, Research Division - VP

* Lalishwar Mitra Ramgopal

Sidoti & Company, LLC - Healthcare Sell Side Analyst

* Ryan Scott Daniels

William Blair & Company L.L.C., Research Division - Partner & Healthcare Analyst

* Sean Wilfred Dodge

RBC Capital Markets, Research Division - Analyst

* William Sutherland

The Benchmark Company, LLC, Research Division - Senior Equity Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the HCSG Q4 Earnings Call. (Operator Instructions) I would now like to hand the conference over to Ted Wahl, President and CEO.

The matters discussed on today's conference call include forward-looking statements about the business prospects of Healthcare Services Group, Inc., within the meaning of the Private Securities Litigation Form -- Reform Act of 1995. 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'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 the 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, including the SEC's ongoing investigation. There can be no assurance that the SEC or another regulatory body will not make further regulatory inquiries or pursue further action that could result in significant cost and expenses, including potential sanctions or penalties as well as distraction to management. The ongoing SEC investigation and/or any related litigation could adversely affect or cause variability in our financial results. 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.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [2]

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Thank you, Sharon, and good morning, everyone. Matt McKee and I appreciate all of you joining us for today's conference call. We released our fourth quarter results yesterday, along with announcing the Board-approved increase in our dividend after market close. We also plan on filing our 10-K by the end of next week.

During the quarter, we continued to take actions that position the company for long-term growth. We delivered solid facility-level outcomes as we continue to prioritize managing the base business, assigning account managers to new opportunities and maintaining discipline in our credit-related decisions. In 2020, we will maintain our focus on these near-term priorities as the industry continues to work its way through the latter stages of this challenging cycle and transitions to the Patient Driven Payment Model.

Our longer-term growth outlook remains positive as we believe there is great opportunity for continued expansion as the demand for our services remain strong with significant whitespace to drive long-term growth. We remain committed to returning capital to shareholders as evidenced by our stable and growing dividend, and we'll continue to capture growth opportunities to create value for all stakeholders.

With that abbreviated overview, I'll turn the call over to Matt for a more detailed discussion on the quarter.

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [3]

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Thanks, Ted, and good morning, everyone. Revenue for the fourth quarter was $447 million with Dining & Nutrition at $224.9 million and Housekeeping & Laundry segment revenues reported at $222.1 million. Net income for the quarter came in at $18.9 million, and EPS was $0.25 per share.

Direct cost of services is reported at 86.5% with Housekeeping & Laundry and Dining & Nutrition segment margins reported at 9.5% and 4.1%, respectively. The temporary cost increase relates to approximately $4 million of payroll for account managers who've transitioned out of a facility that we're no longer servicing as well as some costs related to starting up new business during the quarter. We expect that -- this cost impact to decrease as account managers continue to be assigned to new facilities at which they're budgeted and the new business additions operate on budget.

Direct costs also included an approximately $2 million benefit primarily related to favorable workers' compensation loss development trends as we continue to successfully execute on its strategy of reducing claim frequency, scope and severity. Overall, our near-term goal is to manage direct costs at 86%, excluding the temporary investments in management capacity and any new business start-up inefficiencies that may occur.

SG&A was reported at $36.8 million or 8.2%. After adjusting for the $2.4 million change in deferred compensation, actual SG&A was $34.4 million or 7.7%. And during the quarter, SG&A was impacted by approximately $1.5 million of legal and professional fees related to the previously announced SEC matter. The company expects SG&A to approximate 7.5% in the year ahead, excluding any SEC-related costs, and there's an ongoing opportunity to garner additional efficiencies. Other income for the quarter was reported at $2.5 million, but again, after adjusting for the $2.4 million change in deferred comp, actual investment income was around $100,000.

We reported an effective tax rate of 27% and 24.1% for the fourth quarter and the year, respectively. The fourth quarter and the 2019 tax rates were impacted by a reduction in the Worker Opportunity Tax Credit program credits primarily due to the fact that there's historically low unemployment rates and the resulting decrease in WOTC-eligible new hires. And we expect our tax rate for 2020 to be in the 24% to 26% range, including WOTC.

To the balance sheet. At the end of the fourth quarter, we had over $118 million of cash and marketable securities and a current ratio of better than 3:1. Cash flow from operations for the quarter was $13.4 million, inclusive of the $17.7 million decrease in accrued payroll, and cash flow was $93.6 million for the year. DSO for the quarter was reported at 70 days, consistent with our previous quarter.

And it's worth noting that we continued to make progress in converting customers to a weekly payment model as we now have around 60% of our customers paying us with the frequency greater than monthly. And as we've discussed previously, in that conversion, both parties collaborate on a solution that works for both sides. For instance, in the fourth quarter, as part of converting one of our customers to weekly payments, we rolled a portion of their receivable into a promissory note with a 3-year term.

And I just want to reiterate the ultimate benefit of this strategy is better allowing us to collect what we bill and to reduce the rollover impact of a missed payment. And because we have called this out previously, we did want to talk to the timing of the payroll and the impact of the payroll accruals. So we wanted to point out that the 2020 payroll accruals will have a bit of a different cadence than we've seen in the past 2 years: the first quarter will have the highest payroll accrual of 17 days; Q2 will be 10 days; Q3, only 4 days; and then Q4, 12 days. And that compares to 15, 8, 16 and 10 days that we had in 2019 during corresponding periods. But of course, the payroll accrual only relates to the timing, and the impact ultimately washes out through the full year.

As we announced yesterday, the Board of Directors approved an increase in the dividend to $0.20125 per share payable on March 27. The cash flows and 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 the shareholders. This will mark the 67th consecutive cash dividend payment since the program was instituted in 2003. We're proud that it's now the 66th consecutive quarter that we've increased the dividend payment over the previous quarter, now a 17-year period that's included four 3-for-2 stock splits.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) First question comes from Andrew Wittmann with Baird.

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Andrew John Wittmann, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [2]

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Where am I going to start? Let's start just trying to understand the quarter a little bit better, then we'll talk a little bit more about what you guys are seeing in the marketplace. I guess Ted or Matt, on the workers' compensation, $2 million benefit to the quarter, I wanted to understand -- I mean is this the actuarial adjustment that you guys have to do, I guess, annually? And is this for in-period, as in 2019? Or is this a prior period adjustment that drove that? I just want to understand the source of the accounting-related benefit here that you got in the quarter.

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [3]

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So you're exactly right, Andy. This is a component of the annual actuarial review. That is part of the captive insurance subsidiary. So typically, during the fourth quarter of each year, we now have that complete actuarial review, which does 2 things: it trues up the accrual that we had made in the previous year; and then it also establishes the rate at which we accrue as a percentage of payroll for the upcoming year. So that $2 million adjustment relates to the 2019 accrual, and it's a true-up of that accrual based on the experience and development in claims that we've seen through that period. And then the actuarial report also then will trigger the upcoming percentage of payroll that will accrue for 2020 here and then have that year-end adjustment as needed as well.

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Andrew John Wittmann, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [4]

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Okay, that's helpful. And then I guess the other thing I wanted to understand here a little bit more detail was on the $4 million that you called out related to access manager as well as start-up costs. Could you just break that into the 2 components? I guess that is -- the total of that is down sequentially from last quarter. So I just wanted to understand the pace at which you see this improving. I mean you did mention that, over the course of 2020, you expect that those will get better absorbed. Is it going to take the entirety of 2020, do you think? Or what's the best way, the proper way to think about those costs and those costs getting absorbed with new revenue in 2020?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [5]

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Yes. So you called out the $4 million, Andy, and the split, as roughly $3.5 million-or-so, relates to management costs, management salaries that we continue to carry and then about $0.5 million related to inefficiencies that come with starting the new business that we did in the quarter. So the anticipation is that we'll continue to selectively, and with a very disciplined approach, find new business opportunities and obviously, assigning the managers to new business opportunities at which they're budgeted has the impact of not only the top line implications, but from a cost perspective, having those folks budgeted is beneficial to the company.

But we're going to -- the emphasis will be on caution and discipline. So I would allow ourselves likely the balance of 2020 to fully assign those folks. We continue to have a customer base that's working their way through the tail end of some industry challenges. We're still not even 6 months into the transition to PDPM. So as far as the customer priorities, we'll consider that as well with respect to onboarding new business. So I think expectation would be first half of the year, continued caution. We'll selectively find opportunities to place those managers into new opportunities. If our view and assessment becomes more beneficial or more positive, then there's an opportunity perhaps to pull some opportunities forward. But I would expect that the bulk of real business additions come more in the back half of the year. So I think fair to assume that every opportunity for us to reallocate those managers to new business opportunities, full expectation to do so within 2020 but would likely allow ourselves the full year to do so.

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Andrew John Wittmann, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [6]

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Okay, great. And then I guess my final question here was just around some of the WOTC commentary. It's an interesting dynamic that, with the low unemployment, the groups that are able to be WOTC-ed, if you will, if I could make a verb there, they're just -- it sounds like they're just not as available as maybe they used to be. Is that really what the dynamic is here? It seems like a pretty big change in your tax rate. So I just wanted to try to gauge your level of confidence that this is going to be the hiring environment and the impact of that tax rate around 25%.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [7]

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Yes. I think barring some significant change in the macroeconomic environment and unemployment rate, we would expect in this tight labor environment that there's just less employees that are receiving some of the governmental assistance that typically drives a WOTC-eligible -- WOTC eligibility, so it's that straightforward. So yes, we're comfortable with the rate that we're guiding towards that 24% to 26% range, Andy, but again, almost exclusively driven by just fewer eligible WOTC employees within the hiring pool.

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Operator [8]

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Next question comes from Sean Dodge with RBC Capital Markets.

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Sean Wilfred Dodge, RBC Capital Markets, Research Division - Analyst [9]

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Maybe going back to the spare managers for a moment, the roughly $3.5 million of elevated payroll costs you're carrying there. Is the expectation that all of those managers are going to be placed in net new facilities? Or are there going to be some proportion of those that are used to backfill open spots or things like upgrading underperformers?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [10]

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It'll be an all-of-the-above strategy, Sean, where obviously, the single most desirable option is to place a freed-up manager into a newly minted account or to backfill for an existing manager who's being placed into a new account. But like any other cycle, any other time, it's a fairly dynamic business where there's always opportunities, both with new customers as well as within existing customer facilities. So a portion of the managers will be reassigned to backfill or to replace existing management, strengthen the bench, so to speak, and then others will be assigned to new opportunities as they present themselves. And still, others are being used to further strengthen specific areas, whether it be as an assistant manager or as a supplement project work in a given area that's required. So all-of-the-above strategy.

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Sean Wilfred Dodge, RBC Capital Markets, Research Division - Analyst [11]

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Okay. And then as we think about margins over the coming year, you'll get lift in gross margins as these spare managers are deployed. Ted, in your prepared remarks, it sounded like there could be some other cost levers or efficiencies you may be able to garner outside of those spare managers over the course of the year that give you a little bit of lift there.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [12]

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Yes. I think it'll be levering SG&A primarily. As we grow the top line, a significant portion of our SG&A is fixed. So that's really the other, I'd say, near-term margin lever in addition to deploying some of the excess management capacity that we currently are carrying.

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Operator [13]

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Next question comes from Jason Plagman with Jefferies.

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Jason Michael Plagman, Jefferies LLC, Research Division - VP [14]

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I just wanted to ask about the timing of the clients you added in Q4, whether that was towards the beginning of the quarter or

(technical difficulty)

carryover impact in Q1? And then just kind of the growth trajectory or your thinking given your kind of cautious and disciplined approach for 2020, how should we be kind of pacing the sequential growth in revenue throughout 2020?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [15]

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Yes. I'm having a little bit of difficulty hearing you there, Jason, but I think I've got the questions, the first of which is about the timing of the new business that we onboarded in the fourth quarter, nearly all of which was in the early parts of the quarter, so there'll be very over -- very little, rather, carryover impact in Q1. Nearly all of the revenue impact of the new business that we onboarded in the fourth quarter was recognized in that quarter.

And as to kind of the 2020 growth prospects, which I think was the second part of your question, obviously, having exited quite a bit of business for various reasons in 2019, you set up some challenging comps with respect to year-over-year revenue, so the expectation is, I think, probably generally speaking, to think more of a flattish to slightly increased growth trajectory of the early parts of 2020 and then the opportunity sequentially to step up from there.

So I think all told, when you look at 2020 compared to 2019, a comparable year would be a successful year with respect to replacing the business that we exited in 2019. So if we saw 2020 revenue is slightly down or even with 2019 revenues, I think that would mean that, not only have we done the right things in execution, but that we're feeling a lot more comfortable about the state of the industry.

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Jason Michael Plagman, Jefferies LLC, Research Division - VP [16]

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Got it. And wanted to ask about the bad debt accrual you called out, that adjustment for accounting-related reasons. My math would say that should be about a $30 million to $40 million incremental accrual that you'll be taking in Q1. Is that accurate?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [17]

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Yes, that's a fair range.

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Jason Michael Plagman, Jefferies LLC, Research Division - VP [18]

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Got it. And will that impact the go-forward quarterly accrual as you move forward for what you're allow -- accruing for allowance for bad debt going forward? Or can you just walk through if that'll have an impact on the revenue going forward?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [19]

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Yes. I think as far as the go-forward bad debt expense impact, I think Jason, if we continue to meet our goal of collecting what we bill week in and week out, then we'll likely have a very stable if not decreasing bad debt expense levels, likely more in line with what we saw the past 3 quarters or the last 3 quarters in 2019. To the extent there's accounts rolling over in the aging buckets or if there's a specific event like a customer restructuring, then we would likely see elevated bad debt expense levels. But again, our goal in the year ahead is to collect what we bill week in and week out.

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Jason Michael Plagman, Jefferies LLC, Research Division - VP [20]

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Got it. And last one from me. I just wanted to make sure we understood the moving parts around investment income in Q4. So did your treatment of the deferred compensation change? And if so, what changed for where that was hitting in the income statement in Q4 versus prior quarters?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [21]

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No. In fact, deferred comp has been treated in the same manner really since its inception over a decade ago. So it's -- again, just to remind all of our shareholder partners what -- that deferred compensation represents investments that are held by and for our management people. And the deferred compensation adjustment that takes place each and every quarter is the market -- mark-to-market for the non-HCSG stock portion of those investments. And the way that's reflected in our P&L is that to the extent the mark-to-market is made upward, then it represents an increase in our SG&A costs as well as an increase in investment income, like we saw this past quarter. To the extent there's a downward adjustment in that mark-to-market, then the inverse would be true. It would be reflected as a decrease in SG&A costs and a corresponding decrease in investment income. There's no net impact on earnings, but that's why we call it out the way we do each and every quarter.

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Jason Michael Plagman, Jefferies LLC, Research Division - VP [22]

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Okay. I think that's helpful. I was just -- there was a footnote in the press release on -- mentioning previously recorded as revenue and related costs and cost of services, so I can follow up...

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [23]

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That actually, just -- yes, got you. That relates to our captive insurance subsidiary and voluntary health and welfare benefits that the captive insurance administered -- that the captive insurance subsidiary administers on behalf of the company to its employees unrelated to deferred compensation, correct.

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Operator [24]

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Next question comes from Ryan Daniels with William Blair.

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Ryan Scott Daniels, William Blair & Company L.L.C., Research Division - Partner & Healthcare Analyst [25]

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Just one question for me this morning. I'm curious, Ted, for your state of the industry. I noticed for the first time in a while, you commented in the press release about the new payment models and the rate update and increasing occupancy. So I'm curious what you're seeing both on the reimbursement front and how it's impacting your client base and stability. And then also on the occupancy front, if there's something notable that you're seeing in the space that gives you more comfort to state that?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [26]

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Thank you, Ryan. I think -- well, just specifically, PDPM, I mean it's still the early stages obviously, 5 months in. But the initial certainly reimbursement data as well as the initial feedback from the operators is generally positive that revenue trends have been neutral to slightly favorable as expected. And there's been some modest rehab cost savings that have been realized, again as expected. So overall, specific to PDPM, both from the limited data -- there's not a ton of data out there, but from the data as well as from our customers and just the general operator community, we continue to hear both positive expectations and experiences.

Again, I caution that we're only 5 months into the transition, but certainly, so far, so good. I think even beyond that though, overall, we definitely see industry fundamentals continue to improve. Longer-term demographic trends aside, which as we all know are extraordinarily favorable, the data we're seeing are encouraging. You mentioned occupancy trends. Since the end of 2018, we continued to see, each of the past 3 quarters, a stable, if not improving occupancy environment, both as a result perhaps of the tip of the baby boom sphere entering the long-term care continuum but also from the reduced supply that's in the marketplace today from, let's say, some of the hard work that's been done the past decade or so in the space as well as the reimbursement programs improving: PDPM, I mentioned; the 2.5% Medicare increase, which also took place October 1.

So again, we're seeing these improvements and I think hearing the positive sentiment firsthand within our customer base. But again, we're not out of the woods yet. We have to remain disciplined in our decision-making, especially when it comes to credit-related matters. And Ryan, we're going to continue to apply that discipline when we're evaluating both existing customers as well as new business opportunities. But overall, I do believe we're in the latter stages of this -- what has been, by all accounts, a difficult cycle.

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Operator [27]

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Next question comes from Mitra Ramgopal with Sidoti.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [28]

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Just one question for me. I know the focus is also on improving efficiencies and driving margins. And I was just hoping to get some color in terms of the promotion of Andy to COO and maybe some of the changes we should expect as a result of that.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [29]

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Yes. Well, look, Andy has been -- I'll start with the comments around Andy, but he's certainly been a great contributor to the company in many respects over the past decade as a leader in risk management and human resources, operational excellence and, most recently, leading the day-to-day field-based operations over the past 6 months or so. So his promotion to Chief Operating Officer, his well-deserved promotion is really a natural progression of his leadership within the organization. I would also add that he's demonstrated a pretty remarkable level of capacity and expertise in each and every one of those roles. And maybe most importantly, Mitra, he's always helped lead and deliver strong results. So we're certainly excited about the possibilities of his expanded role.

But the reality is the hard work still has to happen in the 4 walls of every facility. Our business is oriented around the facilities and our success is determined by the outcomes in the facility, which is led by local leadership. And it gets back to the same kind of 4 critical aspects of the business: delivering on customer satisfaction, budget versus actual, systems implementation and compliance objectives. And that is a 7-day-a-week, 365-day-a-year exercise.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [30]

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Okay. And then just a quick follow-up regarding the -- I think you've converted about 60% now of your customers to the advance or accelerated payment model. How much, I don't know, in terms of the remaining customers and potentially how those conversations are going and kind of where you see yourself by the end of 2020 on that front?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [31]

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Yes. We've not thrown down a marker, Mitra, as far as a specific quantitative objective, although the 2 major components as we see it are, number one, that weekly payment structure absolutely being the default position with new customers. So that's definitely a stance that we've taken. And we're holding firm to that as we think about new business opportunities coming onboard here in 2020. Now as we think about onboarding new customers and new facilities, that dynamic in and of itself with the commitment to the weekly payments will have an impact of lifting that overall percentage. And then the other bucket would be with existing customers of ours. Obviously, as we've discussed previously, this was a strategy that was somewhat borne out of necessity. And the customers that we converted in the early stages of the strategy were those where there was either the greatest concern or the greatest opportunity.

So we've moved through those as we look at the balance of our customers within the customer portfolio. There's less urgency, short of a specific catalyst or a significant change in their financial conditions. We'll more selectively and opportunistically look to convert those folks. So there's nothing that is a fundamental obstacle to ultimately continuing to drive that number upward, which we'll do, as I said, as a result of onboarding new customers and selectively converting within the existing customer base.

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Operator [32]

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Next question comes from Bill Sutherland with The Benchmark Company.

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William Sutherland, The Benchmark Company, LLC, Research Division - Senior Equity Analyst [33]

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I'm thinking about as you move back into more of a growth mode here and just looking at the incredibly low unemployment situation, how are you thinking about the challenges of the salary churn and whether that might impact direct costs in some way that is a little more than normal?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [34]

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Well, it's interesting, Bill. As you sort of frame out the question and relate it to growth, the typical gating factor on our ability to grow the company is in management capacity. We find ourselves in somewhat of a unique situation relative to the company's history and now having management capacity at our avail and spread fairly well geographically throughout the country. So those are local assessments as to the qualification of pipeline opportunities and making sure that we have the corresponding availability of managers to place into those new business opportunities. So as it relates to the overall labor environment, we find ourselves with managers ready to go. As we've discussed previously, they are being put to productive purposes as we sit here. But to have that flexibility to place them into new facilities, new business opportunities as they arise is certainly advantageous to us.

The other component from a labor perspective is the line staff employees, our associates that are the housekeepers, the pot washers, the dishwashers. And the benefit that we face in that regard is that the customer, in fact, controls the conditions of employment at the facility specifically as it relates to starting wages, the timing and amount of any wage increases and the adjustments to benefits. And the component of cost savings that we bring in the value prop is that we can typically operate more efficiently so we can do more with fewer bodies. So and as much as there's an opportunity for us to potentially reduce the cost of a prospective customer but, at a minimum, certainly better contain their costs, that's viewed very favorably. And as you can imagine, that's a significant driver of the increase that we're seeing in the demand for our services and the continued buildout of our sales pipeline.

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William Sutherland, The Benchmark Company, LLC, Research Division - Senior Equity Analyst [35]

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Right. So even with your existing facilities where I assume hourly employees just going to be a little hard to get, at least on the incremental side, you're actually freeing up, in most cases, some of those hourly people when you take on new business, so some offset there.

And then finally, the -- on the cash front, which is going in the right direction, I know you're committed to the dividend. Is the Board possibly going to start to think about any other capital direction, such as buyback?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [36]

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Look, it's -- that specifically is something we certainly discuss each and every quarter. I know we've had conversations about just that on calls like this in the past. The Board's thinking around capital allocation continues to be the same as it was previously that, first and foremost, in terms of capital allocation, organic growth is the priority beyond that with really consistency and sustainability as the guidepost, which leads us to the first commitment after organic growth being the dividend.

So certainly with continued strong cash flow and cash generation, Bill, you could foresee a scenario where either the dividend has increased or a buyback could make sense. But I would not anticipate anything in the year ahead specific to either one of those scenarios. However, it is something we discuss each and every quarter.

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Operator [37]

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(Operator Instructions) We have a question from Chad Vanacore with Stifel.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [38]

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Can you hear me?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [39]

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Yes, we've got you now.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [40]

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Okay, got it. All right. So thinking about the new business that you won in the quarter, what was characteristic of those accounts? And how do they compare to the accounts that you lost in the quarter?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [41]

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Could you be more specific, Chad? I'm not sure exactly what you mean when you talk about...

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [42]

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So are these local players, regional players, national players? What made them want to outsource to you rather than insource? And how does that compare with the accounts that you lost?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [43]

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So I would say that this -- the growth that we had were with a couple of smaller regional-type players. There was one player that kind of skewed to the larger side relative to the business that we did onboard in the quarter, but it was really a number of different regional chains, pretty fairly distributed geographically. And a pretty nice split, likewise, between housekeeping and dining. So really kind of the -- just like we talked about the business that we onboarded in the third quarter. It's really kind of the optimal sort of mix that you'd like to see with respect to geography, customer type and split of services.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [44]

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All right. And I'm assuming that, when you say split of services, you're providing both services to most of those accounts?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [45]

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Correct.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [46]

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Okay. And then just thinking about the write-down for doubtful account that you expect in the first quarter. Can you give us some more details on the amount? And then how did you go about evaluating the collectibility and then determining impairment? So what we're getting out is -- what would trigger further writeoffs?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [47]

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Yes. Well, just to be very clear, Chad, it wasn't a writeoff. This was driven by a new FASB standard that was -- that required us and all public filers to adopt beginning January 1. And that adoption changes the AR, allowance reserving methodology from what was with us and most public filers an incurred loss model to what now is an expected loss approach.

So I think there was 2 components to it: one is that initial -- I guess you're referring to the initial reserve, not writeoff. Initial reserve adjustment was developed based on a 7-year look-back period analyzing agings and collection experience, writeoff percentages, litigation and restructuring actions; also considering industry and macroeconomic considerations. Now obviously, using a 7-year look back meant that 2018 and Q1 of '19 bad debt levels, which were clearly elevated relative to the past 4 decades of the company's experience, had a disproportionate impact in determining that initial reserve. But that aside, that was the methodology for determining the initial reserve, which again, is -- increases the reserve and then has a corresponding tax-affected reduction to equity.

I think beyond that, I mentioned earlier, as far as the go-forward bad debt expense impact, it's very simple. If we continue to meet our goal of collecting what we bill, which is, in fact, our expectation, then we should have certainly a stable if not decreasing -- bad debt levels certainly in line or maybe more favorable than what we saw the past 3 quarters. If we have eroding experience or challenged accounts that are rolling over from one bucket to another, then we would have -- or if there's a specific customer-related event that we have to specifically identify, then we would likely have elevated bad debt levels.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [48]

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All right. On the flip side of that, you had a $2 million benefit from workers' comp in the quarter. Is that a continuing benefit that you're going to continue to book in subsequent quarters? Or is that a onetime benefit?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [49]

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So that relates to the adjustment looking back on the 2019 period, Chad. So we reserved the accrual based on a percentage of payroll that comes at the recommendation of the actuary based on their annual review. So that $2 million adjustment relates back to 2019 and prior year experience. And now we'll make an adjustment in the percentage of payroll that we've reserved for 2020. We'll go through that same actuarial assessment at the end of this year to determine did we appropriately accrue, did we accrue enough or not enough and make those adjustments. So the expectation is that, as we gain further experience in the captive, the predictability from an actuarial perspective gets tighter and tighter, and you've all seen the end of year adjustments continue to diminish.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [50]

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All right. So that's an unusual true-up that happens at the end of the year. We shouldn't expect that benefit going forward.

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [51]

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Not necessarily as a benefit, no. There will be a true-up, but like I said, can't predict whether it's to the good or to the bad. And certainly, expectation is that, that should be continuing to decline.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [52]

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Okay. And then just thinking about cash flow in the quarter. It was pretty solid. Talk us through how you expect cash flow to go. Are there any reversals in terms of use of -- or source of net working capital that we should expect? How should we expect 2020 to look?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [53]

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Yes. Well, I would say -- not to take issue with your solid word, I would say cash flow, when you really take a step back in what arguably is the most challenging environment the industry has ever experienced, maybe rivaled by the late '90s and the Balanced Budget Act time frame, I would suggest that record cash flows -- not even close. I mean record cash flows for this year and certainly on the heels of a record cash flow from prior year is certainly a great accomplishment for the company and a direct testament to not only the mindset that has been instilled here, the collaboration with our customers and the partnership that we have with our customers and then, ultimately, the strategy that we developed vis-à-vis the weekly payment initiatives. So I think all of that puts us in a very good position to be able to execute in a consistent way moving forward on our cash collection strategy week in and week out.

From an expectation perspective in the year ahead, Chad, I think pointing more towards that $80 million target, and that is lower than the $94 million that we had in 2019. But the reason for, I think, maybe the conservative baseline that we have in the year ahead would be more oriented towards the fact that we want to maintain flexibility. And I know Matt talked about some of the opportunities both in his opening remarks as well as in some of the Q&A around weekly payment conversions. We want to maintain that flexibility where, when there's a mutually beneficial opportunity with a particular customer, to convert them to a weekly payer, which is -- which we hold in high regard from a sustainability of relationship and scalability of the company's model perspective. There may be an opportunity with that customer to collaborate. And if they're, in fact, paying January services that are due at the end of February today, maybe it's in the best interest of us and them that they pay January services 4x in March. So they get some sort of additional cash flow benefit. That does create a temporary dyssynergy, if you will, relative to DSO and cash flow. But again, we believe that certainly puts us in the best position from a long-term sustainability of that customer relationship.

So those are the types of discussions and conversations we're having right now. And that's why our outlook for the year ahead is in and around $80 million.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [54]

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All right. And then just thinking about one key aspect of this. We're expecting a slow top line growth in the year. And then -- so that margin becomes an important aspect of [restoring] specifically direct cost. So can you give us some idea of what the upside to your direct cost is and maybe some risk to that in 2020?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [55]

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Yes. I think the goal -- the stated goal remains, Chad, and that's to get direct costs to 86%. The pathway to that is really by the end of the year primarily driven by the growth. Just exactly as you call out, it's the growth, but it's in placing the managers into facilities at which they're budgeted. There tends to be a little bit of a put-and-take with respect to growth. And that -- and obviously, as we're able to assign those managers to new facilities, that's beneficial. There tends to be corresponding margin pressure, though. As we inherit the inefficiencies of a new facility and a new operation, it does take us some time to get those new facilities on-budget. So I would say that expectation is to return to 86% cost of services but likely, given the dynamics I just described, allowing ourselves till the end of the year to accomplish that.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [56]

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Okay. So some progression through the year, but it's difficult just given the limited top line growth to deploy those managers any faster?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [57]

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I think that's fair.

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Operator [58]

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The last question comes from A.J. Rice with Credit Suisse.

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Albert J. William Rice, Crédit Suisse AG, Research Division - Research Analyst [59]

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Just a couple things. Do you have the margins by the 2 segments? I know you said you'd hope to get to 14% overall gross margin by the end of the year but when you normalize for the unusual items, look at dining and the housekeeping did in the fourth quarter.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [60]

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Yes. The margin -- well, the margins for the segments for the quarter are 9.5% in housekeeping and 4.1% in dining. Now the way that relates back to the -- that relates to the company, total company margins in that -- that's directly off of our operating statements, which has a fixed payroll, a fixed workers' comp burden, a fixed general liability burden, et cetera. So there's some eliminations between those segment-level margins and the total company margin that's reported on the external results.

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Albert J. William Rice, Crédit Suisse AG, Research Division - Research Analyst [61]

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So to get to the 14%, where are you at as you exit 2019 and on a relative basis, would you say, again, eliminating the unusual items?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [62]

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Yes. I wouldn't be able to guesstimate that on this call, A.J., in terms of where we're at. What I can say is the pathway for us to work our way back to 14% margins are pretty clear in that as we reallocate and reassign the excess management costs that we have, that'll have a direct and natural lift both to the segment-level margins and the corresponding total company margins proportionately.

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [63]

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And I'd say the visibility that we do have, A.J., is in the base business, right? And from our perspective, the base business is performing to budgetary expectations. So the challenge, as Ted said, in kind of giving you a specific answer to your question on this call is if you look at the impact of some of the onetime or at least nonrecurring costs that we faced in the year, whether it was bad debt or excess management costs or start-up costs, those will always be a factor and should have, as we've talked about, a diminishing impact on the 2020 results and beyond. But as we look at the base business, which is the most important and controllable factor for us, we're doing a really good job. And that's going to be the most important driver of us achieving that 86%.

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Albert J. William Rice, Crédit Suisse AG, Research Division - Research Analyst [64]

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Okay. I know you made the comment that, with the strong economy, you're able to still get the management talent you need and that, obviously, you got the pass-through aspect of your contract for the hourly workers. But I know that the contracts do reset up if you're seeing wage inflation. So is the rate of increase overall in the contracted rates moving up? Or is it still sort of steady with what we're seeing?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [65]

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It's customer-specific, A.J., and the reason we call that out is that, in some facilities, if there's -- if it's a union environment and there's a collective bargaining agreement, that'll have a prescribed -- specifically prescribed wage increase. Whereas, other nonunion facilities, it's dependent upon the customers' assessment to respond to the labor market conditions. And the benefit from where we sit is that they need to respond to the same labor market conditions that we do. They're essentially hiring from the same pool of would-be employees that we are. For us to hire into the housekeeping, laundry and dining departments, you're typically talking about the same caliber of candidate that the customer would hire into their activities, maintenance and often CNA departments.

So it really is in the hands of the customer. We'll certainly advise them, and we'll share the experience that we're seeing with respect to the facility-specific challenges in onboarding new employees. If we think the starting wage is too low or the challenge in keeping employees in the department if there is a requirement for a wage increase to remain competitive in a particular market. So it's a conversation with the customer but ultimately lies in the hand of that customer specific to the facility.

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Albert J. William Rice, Crédit Suisse AG, Research Division - Research Analyst [66]

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I guess I was sort of thinking more in terms of your rate increases on your contracts. You've been running 2% to 3%. And now because the hourly wages on average are going up 4%, 5%, that also affects the portion that you retain as profits and has a positive impact on that. Is -- are you seeing any of that yet or not really?

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Matthew J. McKee, Healthcare Services Group, Inc. - Chief Communications Officer [67]

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Relative to historical norms, it may be a bit elevated in the aggregate, A.J., but it's not significant to the point of really moving the needle.

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Albert J. William Rice, Crédit Suisse AG, Research Division - Research Analyst [68]

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Okay. And then I guess just to go back finally to your comment about -- you're still looking at the portfolio and all. Do you see either because of -- I guess there's always the expectation that, with this new PDPM in the skilled nursing area, there'll be some winners and some losers. Any sense -- I mean do you feel like the bulk of the pruning is done? Or are you -- is there still a number of facilities that you're watching? And can you say with confidence you do expect to see net additions overall to the customer base in 2020?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [69]

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Yes. I would say the latter, that we do expect to see net additions in 2020. Having said that, when you talk about pruning, if a partnership is trending in the wrong direction, A.J., and we don't believe it's in the best interest of the company, we have to reserve the right and maintain committed to being able to make that decision. That may be painful in the short term but best positions us for the long term. So nothing imminent. And again, we've done quite a bit of pruning over the past 18 months, contract restructurings and otherwise. So for us, we feel good about where we're at. And Matt talked about that growth cadence where we do think of a more flattish first half of the year with maybe more modest sequential growth in the back half of the year.

Having said all of that, and you mentioned PDPM, if we start to see the initial favorable trends within PDPM specifically continue, that would certainly give us a higher degree of confidence of maybe pulling in some expected growth opportunities back half of this year, first half of 2021, maybe into the first half of 2020. So that's the way we're thinking about certainly the current environment and our near-term growth prospects relative to that environment.

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Operator [70]

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And at this time, I will turn the call over to Mr. Ted Wahl.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [71]

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Great. Thank you, Sharon. We look forward to starting 2020 off strong and laying the groundwork for the rest of the year. Industry fundamentals continue to improve with the positive impact of the PDPM and 2.4% Medicare increase, both of which took effect October 1 of last year, along with more favorable occupancy trends.

Over the course of 2020, we will continue to prioritize managing the base business, assigning account managers to new opportunities and maintaining discipline in credit-related decisions. We will also remain committed to taking actions that best position us to take advantage of the growth opportunity that lies ahead and deliver shareholder value over the long term.

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

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Operator [72]

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