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Edited Transcript of HCSG earnings conference call or presentation 1-May-19 12:30pm GMT

Q1 2019 Healthcare Services Group Inc Earnings Call

BENSALEM May 7, 2019 (Thomson StreetEvents) -- Edited Transcript of Healthcare Services Group Inc earnings conference call or presentation Wednesday, May 1, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Matthew J. McKee

Healthcare Services Group, Inc. - VP of Strategy

* Theodore Wahl

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

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Conference Call Participants

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* Andrew John Wittmann

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

* Caleb Benjamin Harris

Crédit Suisse AG, Research Division - Research Analyst

* Chad Christopher Vanacore

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

* Jacob K. Johnson

Stephens Inc., Research Division - Senior Research Associate

* Lalishwar Mitra Ramgopal

Sidoti & Company, LLC - Healthcare Sell Side Analyst

* Nicholas Mark Hiller

William Blair & Company L.L.C., Research Division - Associate

* Sean Wilfred Dodge

Jefferies LLC, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Healthcare Services Group, Inc. 2019 First Quarter Conference Call. (Operator Instructions)

As a reminder, this conference call may be recorded. 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 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 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 other regulatory body will not make further regulatory inquiries or pursue further actions 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're 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.

I would now like to introduce your host for today's conference, Mr. Ted Wahl, President and CEO. Mr. Wahl, you may begin.

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

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Great. Thank you, Josh. And good morning, everyone. Matt McKee and I appreciate all of you for joining today's conference call. We released our first quarter results yesterday after the close and plan on filing our 10-Q by the end of the week.

Before I get started, I did want to recognize that over the past year or so, the industry's cycle, along with other events, has certainly led to a few interesting quarters and less consistent external results than what those that know the company well have become accustomed to over the years.

But at its core, beyond some of the recent noise, is a consistent maybe even boring business, a word that many of our shareholders have used to describe the company over the years with, and a compelling growth story, that simple -- that has simple and time-tested goals: To hire good people that we can train and develop; to stick to our facility level operating systems; to provide our customers with a great experience; to grow the company from a satisfied client base; and to promote from within the very same people we hire, train and develop to support our continuous growth.

That is the virtuous cycle that we're creating. That is our business. And that is our future.

This past quarter was eventful yet very productive. Eventful in that the industry continued to work through a challenging cycle that has negatively impacted some of our customers, leading in some cases to restructurings or payment issues that required us to increase AR reserves, which impacts reported earnings, or reduce services, which creates a temporary step-down in revenue growth.

We saw some of these dynamics play out in Q1 and Q4 of last year as well.

The quarter was productive in that our management team and field-based leaders demonstrated expertise and significant capability in proactively managing these difficult situations as well as innovation in identifying solutions to set up the company for future success. For example, we've now transitioned over 55% of our customers to an increased payment frequency model, up from 40% as of December and essentially, none as recently as 2 years ago. The quarter was eventful in that we completed a comprehensive internal investigation into the matters related to the SEC inquiry and that the completion of that investigation filed our 10-K with an unqualified opinion from our external auditors. The investigation was conducted by a nationally renowned law firm and supported by a Big 4 accounting firm's forensic practice. As it relates to the SEC matter, we have and will continue to fully cooperate with the SEC. And since this matter remains open, we'll not really be commenting any further beyond that.

The quarter was productive in that we successfully completed the implementation of the workday ERP financial module, a cloud-based financial and accounting platform that is scalable for our future growth and allows for best-in-class finance and accounting processes, controls, as well as enhanced visibility into our -- into key operational areas like purchasing and procurement.

This implementation required a great deal of planning and preparation to ensure successful transition. I could not be more proud of the project leaders in the finance and accounting team for all of their dedication and commitment to this important project. Thank you for all your work, team.

During the quarter, we continued to make progress on our near-term priorities of implementing and adhering to our facility level operating systems highlighted by Q1 normalized cost of services, returning to its historical levels of below 86%, with segment margins coming in at 11.6% in housekeeping and 6.3% in dining.

Strengthening customer payment terms and conditions as I described earlier with the weekly payment conversions and growing the management pipeline as we continue to increase the quality and quantity of management candidates in both segments and across the majority of divisions.

As far as revenue for the balance of '19, we'll continue to build out the management pipeline and expect a relatively flat second quarter with modest sequential growth in the second half of the year as we selectively add new business and replace some of the recent revenue step-downs.

In 2020 and beyond, we fully expect to return to our historical growth profile. And as industry fundamentals improve and we're starting to see the early signs of that happening now, we'll be very well positioned to execute on our growth strategy. Our longer-term outlook over the next 3 to 5 years is very positive, as the opportunity for continued expansion is as great as it's ever been.

The demand for our services remain strong, and there's enough white space to more than support the next decade's worth of growth with over 23,000 facilities in our target market, and less than 18% of those facilities outsourcing housekeeping and laundry, less than 8% outsourcing Dining & Nutrition.

On the cost side for the rest of the year, excluding any unusual items, our expectation is that direct cost of services be below 86%, that SG&A approximate 7% and that our tax rate be in the 21% to 23% range, including WOTC but excluding other discrete items.

In terms of the balance sheet, and more specifically AR and our cash conversion cycle, for the rest of the year, after adjusting for the normal quarterly fluctuations in the payroll accrual, we would expect operating cash flow to mirror net income as our goal remains to collect what we bill, each and every, now, week and month, and then ultimately improve DSO.

As far as capital allocation, second only to organic growth in terms of priority, the board remains deeply committed to the cash dividend program. And although there is no formal payout ratio, consistency of payment and sustainability over the long term are always front and center in the Board's thinking, as are strong leanings towards conservative working capital and overall balance sheet management, evidenced by our 3:1 current ratio. Longer term, growth in earnings and cash flow will most certainly create additional capital allocation opportunities, including continued investment in organic growth, whether it be new facility adds, ongoing company expansion or internal investments like we saw on the formation and funding of the captive, further increases in the dividend or even selective share buybacks. But in the near term, the board continues to be of the view that organic growth and the cash dividend after 64 consecutive payments since the program's inception and 63 consecutive quarters of payment increases over the previous quarter remains the most consistent and sustainable way to create shareholder value over the long term.

So with that 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. - VP of Strategy [3]

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Thanks, Ted. Good morning, everyone.

Before I get into the detail, I wanted to mention some of the ongoing benefits of our new ERP Platform.

The capabilities of the ERP now allow us to assign certain facility-related cost to the facility specifically, so those cost that were previously included as part of SG&A are now included in cost of services. Some examples are pre-employment screening, hiring and onboarding costs and hardware and software costs and then certain field-based costs that are outside of the facilities like district manager costs, that were previously included in cost of service are now in SG&A.

The net impact of this adjustment is negligible from a reporting perspective, but it does provide us with a clearer sightline on the true operating performance at the facility level. Another change worth noting is that the company, through our captive subsidiary, offers discounted voluntary benefits, including limited medical, short-term disability and term life insurance to our employees.

Historically, the premiums were recorded as revenue and the related expenses as cost of services but are now included as part of other income and other expenses.

So revenues for the first quarter were down about $19 million sequentially to $476 million. Housekeeping and laundry revenues were down about $5 million to $233 million, Dining & Nutrition revenues decreased $14 million and came in at around $243 million.

The decrease in housekeeping & laundry revenues was primarily related to us canceling service agreements with a privately held California-based operator over payment-related concerns, and the majority of that revenue step-down is reflected in the current quarter. The decrease in the Dining & Nutrition revenue was primarily related to the previously announced fourth quarter contract modifications with Genesis HealthCare.

The contract changes decreased Dining & Nutrition segment revenues and related food purchases by about $20 million per quarter with about 1/3 of that impact being reflected in the fourth quarter of 2018 and the full run rate now being reflected in the current quarter. Net income for the quarter came in at $19.2 million and earnings per share was $0.12 per share.

Direct cost of services is reported at 89.7%, above our target of 86%, with housekeeping and dining segment margins estimated at 11.6% and 6.3% respectively. Direct costs included about $18 million of increased AR reserves, the majority of which relates to the out-of-court restructuring of a privately held Northeast-based operator as well as that previously discussed California customer that we left due to payment-related concerns.

Although the timing and amounts of recovery are unknown at this point, we do believe that we're well positioned to pursue outstanding claims related to these matters. Direct cost for the quarter was also impacted by about $3 million of increased payroll cost related to our continued investment in the management training ramp-up. As we have talked about in the past couple of quarters, we expected to see additional management-trainee related investment as we've ramped up our recruiting and training efforts over the past few months. We expect this stepped-up investment to continue through the first half of the year, but we'll continue to have a heightened focus on management development throughout the year. And beyond that our expectation is that the management development function will return to its normal cadence without the stop-start dynamic that we've seeing bear out, starting in 2017 through the present.

And overall, our near-term goal is to manage direct cost of services below 86% in the year ahead.

SG&A was reported at 8.6% for the quarter. There was about a $3.4 million impact from the change in deferred compensation, investment accounts that are held for and by our management people. So our actual SG&A was 7.9%. Now SG&A was also impacted by about $6 million of legal and professional fees related to the SEC matter, the majority of which related to the internal investigation that was completed in mid-March.

And we expect SG&A of around 7% the year ahead, excluding any onetime or non-recurring items.

Investment income for the quarter was reported at $4.2 million. But after adjusting for that $3.4 million change in differed comps, actual investment income was around $800,000.

Our effective tax rate in Q1 was 23%, and we expect our tax rate for the rest of the year to be in that 21% to 23% range, including WOTC but excluding other discrete items that impacted the 2018 tax rate.

Over to the balance sheet. At the end of the fourth quarter, we had $107 million of cash and marketable securities and a current ratio of 3:1. Cash flow from operations for the quarter came in at $18 million and that was favorably impacted by the $16 million increase in accrued payroll. DSO came in at around 68 days, net of the reserve increase, so that's up about 5 days from last quarter. Now about 3 days of that increase related to payments due from customers at the end of March that were ultimately received in early April and the balance of that DSO change was related to weekly payment transitions during the quarter and that's moving from that end of month payment schedule to the weekly payments schedule that Ted talked about. And given the importance of that weekly payment initiative to us and since it's still a fairly new area of discussion, I wanted to just take a moment and go through a bit more detail as to the how and why those customer transitions to weekly payments during Q1 impacted the DSO calculation. And I thought the easiest way to do that would be to go through an example.

So in an ideal situation, we're able to convert a customer to weekly payment without that conversion increasing the float, or our DSO. And to illustrate that point, if the customer would have previously paid February services in a monthly payment at the end of March, we would propose that they now pay the first week of February services at the end of the first week of March, the second week of services during the second week of March, et cetera. So there's no impact on their receivable balance as of the end of March.

Now of course, we'd love to have them pay the first week of February services at the end of the first week of February, but that's a different conversation. But an example that illustrates us gaining benefits of the weekly payments but in a way that could slightly increase DSO is that same scenario of February services due at the end of March. But in this example, if the customer is unable to accommodate our payment request, we may agree that they may pay the first week of February services at the end of the 3rd week of March, the second week of February services at the end of March, and then carry over into the first 2 weeks of April. So the full February balance would now be paid in full after the second week of April.

So relative to a normal monthly billing, we're collecting half a little early and half a little late. So if you're looking at a weighted average DSO, it's neutral for the company. But if you're looking at a moment in time, and specifically the end of the quarter, you're going to show a 2-week increase in the DSO for that particular customer. And over the -- overall, and over the long term, weekly payments actually enhance the overall customer experience, it better aligns with the timing of their payrolls as well as reimbursements, and of course, it provides us with a consistent screen -- stream of operating cash -- consistent stream of operating cash flow during the quarter -- I'm sorry, during the month. And significantly increases our visibility into a customer's financial health and commitment to our partnership, and over time will led to a stable and ultimately favorable DSO trend, since weekly payments reduce both the amount as well as the likelihood of an AR balance rolling over and growing from one month to the next.

As was announced yesterday, the Board of Directors has approved an increase in the dividend to $0.1975 per share payable on June 28. The cash flows and cash balances support it, and as Ted mentioned in his remarks, the dividend remains the most consistent and sustainable way to deliver value and free cash flow to the shareholders.

With this marking our 64th consecutive cash dividend payments since the program was instituted in 2003 after the change in tax law and now the 63rd conservative quarter that we've increased the dividend payment over the previous quarter, a 16-year period that now includes 4, 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) Our first question comes from A.J. Rice with Crédit Suisse.

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Caleb Benjamin Harris, Crédit Suisse AG, Research Division - Research Analyst [2]

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This is Caleb Harris on for A.J.

Let me first just ask, we've had a few surprises over the past 5 quarters. Are there any other specific discussions you're having with customers that might result in a restructuring or termination in the near term?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [3]

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No. None that we're aware of now, but as you know, being familiar with the company and anyone familiar with the industry knows, and this isn't unique to just the current industry cycle, there's times where things go well until they don't. And we do have visibility into our customers. A big part of increasing that visibility, as Matt described in detail with the weekly payment initiative, is getting 4 looks at a customer's commitment to the partnership. And it's like a 4:1 increase over the monthly payment. So that will provide further visibility to get out in front of issues prior to them arising. But when you mentioned the surprising quarters or a few of the surprises, much of them, Caleb, when you talk about Q1 of last year and even this current quarter, their legacy matters. It's what happened oftentimes, years ago, with customers that we worked with in some cases for decades, with AR balances that we've carried for years. So we believe we're absolutely on the right track in increasing that visibility and reconfirming the customer's commitment by increasing payment frequency.

But again, getting back to your original question, sitting here today there is no dialogue we're having with customers or no -- nothing above and beyond what would normally take place that we would expect to arise next quarter or at any other point in time this year.

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Caleb Benjamin Harris, Crédit Suisse AG, Research Division - Research Analyst [4]

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Okay. And just thinking back to the first quarter last year where the was the $35 million write-off and then the situation in the fourth quarter of last year. When you're trying to collect on some of that, how long does that typically take? And on some of these recent issues, have you collected some of those amounts that you've written off? Or is that still an ongoing process?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [5]

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It's very customer- and very situation-specific. So if you have an in-court restructuring, right, that's relatively perfunctory, relative to whatever that specific case has for all the unsecured creditors and depending on how we're being treated with payroll and payroll-related costs specifically. But that's administered by a U.S. trustee and overseen by the court, right.

So that's one type of situation. Out-of-court restructurings typically are resolved sooner since it's a collaborative and cooperative process, generally. And then litigation or litigious situations, oftentimes end in some form of settlement before -- not necessarily at the courtroom steps but prior to.

And then there's just the normal course, out-of-court -- out-of-court workouts where you're working with the customer in a somewhat cooperative way to try to maximize an outcome for everybody, for the company, but also maybe there's a way to maintain and grow the relationship. So it just depends on the situations. I think relative to the first quarter, which is what you asked about, one was an out-of-court restructuring. So that is -- there's no additional monies coming in from that. About half of it was the multistate operator that we've worked with for years and agreed to an out-of-court restructuring and we continue to service that provider. The other one, well-publicized, Oriana, is in the process of being finalized, if not finalized at the courts, within the bankruptcy court now. So there will be a payout, a modest payout to the unsecureds, but timing is still uncertain relative to that.

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Caleb Benjamin Harris, Crédit Suisse AG, Research Division - Research Analyst [6]

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Okay. And just one more quick one on the cash flow. Obviously, it is about $2 million or so, excluding the payroll. What do you think you'll be at by the end of the year on cash flow? Do you think it's going to look pretty similar to the profile last year?

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

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Yes. That's what we would expect. Again, I think this quarter was atypical, because we did have the weekly payment conversions that impacted DSO. We had about 3 or 4 days that were March payments, payments that were due at the end of March, which were received in early April. All the more reason why we are working with our customers to convert them to a higher-frequency payment design because when someone is paying monthly, it just takes a missed day or 2 and then you end up having some DSO variability. And more importantly for the company, temporary cash flow variability, which we obviously had the balance sheet to support, but that's not the ideal. But yes, we would expect cash flow, moving forward, to look -- look like it did from the following 3 -- the Q2, Q3 and Q4 of last year. I think we ended up with over $80 million of cash flow last year. So that'd be a fair number to have out there.

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Operator [8]

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And our next question comes from Andrew Wittman of Baird.

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Andrew John Wittmann, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [9]

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Great. Yes. I'm just going to ask some more questions on the cash flow as well. I guess, just to get a little context here. The $18 million in total that you talked about that was reserved in the quarter, were these uncovered as a result of these presumably more detailed conversations you're having with all of your customers as a result of the cash payment terms? Or is this kind of normal course of business? And I guess the reason why I ask that question is because you went from 40% last year, 40% at the end of last year, 55% here today. Clearly, there is 45% more to go and I got to think that by the time you're done with all these more detailed discussions about how and when your customers will pay you, you'll probably have an even better level of confidence with the status of those outstanding receivables. So I guess my question is, we heard you before, you said you're not expecting any more and obviously that's the case, otherwise you would have had to reflect that in the -- in your numbers, but as you go through the remaining 45%, won't you have more confidence at the end of all that than even you do even today?

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

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Yes. I'd say just to unpack your question a little bit, Andy, if you think about the makeup of the $18 million from this quarter, the majority of it, right, I mean 2/3 of it was with the Northeast customer, more specifically, New England, and that's that 13-year client for whom we're providing both housekeeping and dining services. So we're really looking at legacy AR balance, which represents about 90 days of AR. And mid-year last year, we did move them to the weekly payments, but then just a few weeks ago they came to us and told us of their intention to restructure and asked us to play a part in that process. So we're still very early days there. Can't handicap how long that will take or ultimately what our recovery will look like, but we feel like we reserved appropriately. And unless our view of the situation or their intentions change, we'll continue providing services and billing them weekly.

The California situation is a little bit different. They're a housekeeping only customer for a number of years, and we did start to have concerns about their intention to pay us, and we started to do that dance we've talked about previously with some payments being a couple days late and then payments being a little bit light. And we did initiate the conversation with them about moving to weekly payments and about building out a more secured structure on the payment commitment, and we weren't able to come to an agreement and felt that it was best to sever the relationship altogether rather than face the possibility of further exposure. So in that situation, it was to a degree precipitated by that conversation regarding weekly payments and really that uncovering our view of how they ultimately intended to treat the relationship by the partnership and ultimately their payment obligations.

So in terms of recovery in that situation, it could go a couple of ways. One could be a good recovery of the amount owed, given that we believe they are and on relatively firm financial footing. The other could be that we're paid in full and could actually see ourselves working back into all of those facilities. That's, of course, assuming we can work out a mutually beneficial payment schedule and make sure that we've got a firm commitment on their intentions to pay us.

So ultimately, Andy, to the second component of your question, we are absolutely confident that weekly payment structure with our customers, the conversations that, that precipitate, the visibility that, that gives us and ultimately, the swiftness with which we can respond or react to a missed customer payment on that weekly schedule as opposed to monthly, very well better positions us going forward.

We've talked about that strategy being born out of necessity, right, the first folks that we moved to the weekly payment structure where those that we felt we needed to. The second tranche, if you will, would be some of the low hanging fruit; customers that we believed would be receptive to that conversation and that's enabled us to move pretty swiftly in moving from essentially 0% to 55% of our customers over a 2-year period now paying us with a frequency greater than monthly. The rest will most likely take a bit longer to move, right. I mean we've really covered our top 10 customers, all of whom are now paying us with a frequency greater than monthly. So when you get into the smaller regional customers, some of the onesie, twosie, more independent-type facilities, there's more conversations that are involved that will likely to take a bit longer to move the needle there. But it is absolutely a strategy that we're committed to as a company. Do we ever get to 100%? Not sure, but at a minimum, we can guarantee that by virtue of this now being the default position with new customer contractual relationships and that continued work that we'll put in with the current customers who have not yet moved to that structure, we will absolutely see that 55% continue to grow. And again, can't overemphasize the benefit that comes to the company as a result of that.

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [11]

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I just want to underscore one more point here, because we are a customer-centric company, and all of our strategy is oriented around how we are providing an extraordinary service and experience to that customer. And the weekly payment design, once it's folded in and implemented as part of the routine moving forward, it actually increases and enhances the customer experience.

And I say that for a couple of reasons. One, and Matt mentioned this in his opening remarks, but it does align much more favorably and -- with their reimbursement receipts, which are intra-month. It also is consistent with how they're funding and then ultimately paying their payroll expenses. And I think maybe most importantly, and you can imagine this from a relationship perspective, there's not a scramble the last 2 or 3 days of a month, and then the unpleasant conversations the following 2 or 3 days about collecting money or why you paid or why you missed. Because they just -- it's just part of what happens, every week and there's not that slipping and sliding or that debate or that discussion. So really this was, in some respects, born out of the customer experience and the focus on customer experience. And obviously, there's a lot of other benefits to the organization, financially and otherwise. I just want to emphasize that so it doesn't get lost on everyone as to who is the real beneficiary here. We view it as a long-term solution that enhances the customer experience as well as the company's experience.

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Andrew John Wittmann, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [12]

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Got it. That's helpful. I just wanted to go through some of the mechanics as well here on the cash flow. Ted, you kind of endorsed this year's free cash flow looking like last year's in the $80 million range. Your underlying net income is above that, somewhere in the $115 million, $120 million, run rate if you look at the income statement. So there's a delta there.

So I guess the expectation then is that the DSOs, because of the timing, the methodology that you described earlier, the reported DSOs will be the drain on cash or the Delta between free cash flow and net income. Is that what investors should be expecting as this year unfolds, is that the way we calculate, we understand that the weighted average DSOs are unchanged but the way most people calculate it, that will actually increase as the year goes on as you move to more frequent payments? And will that be the Delta between the free cash flow of around $80 million versus the underlying earnings power on the income statement of $115 million, $120 million, $125 million, somewhere in there?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [13]

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Yes. So a couple of different part of your question. One is that the Delta between earnings and cash flow for the year is going to be more of a function of the Q1 outcome, right?

For the rest of the year, and just to be clear, converting customers to weekly payments is not necessarily a drag on DSO. It's only in a specific situation like Matt described when it's a customer that is in good standing or reaching a collaborative outcome. To your point, weighted average DSO is consistent but it does result in a drag for that customer specifically on DSO. But as Matt mentioned, all of our top 10 -- most of our largest customer groups are now on a payment frequency greater than monthly; weekly, trimonthly, something along those lines. So the likelihood of a particular customer or multiple customers impacting DSO unfavorably where it rises to the level of this call and it's something that's over -- that's noteworthy, is unlikely. So as we continue to work through the weekly payment initiative, we would not envision that being a prominent conversation in terms of why DSO increased. It's possible, but we don't envision that having an impact -- a meaningful impact on DSO in the coming months.

So I think getting back to your question about what investors should expect, they should expect us to collect what we bill in Q2, Q3 and Q4 and that would result in free cash flow from operations resembling for the year what last year did.

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Andrew John Wittmann, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [14]

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Okay. Super helpful. Last question for me. You mentioned on the script, Ted, about potentially even buyback, I think is what you said or something to that effect. What would it take? What do you need to see for that to become a new arrow in your quiver?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [15]

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Yes. I mentioned that and I appreciate you bringing that up. And I wanted to go through capital allocation and really on the heels of yesterday's board meeting and it's an active conversation we're always having that, after organic growth, the priority remains the dividend. We've gotten over the years, many questions about what about buybacks, what about other capital allocations. Why aren't you strategies: Why aren't you more acquisitive. And I wanted to make sure that everyone who's on this call understood the company's position, the Board's position as far as capital allocation, that deeply committed to organic growth, and then after that it's the dividend. And over the near term, that is going to continue to be based on where we are today, the primary means by which we return excess cash to shareholders. Now at some point in the future, right, with growth in earnings, which we fully expect and growth in cash flow, which we fully expect, that's going to create additional capital allocation opportunities that could be an additional internal investment.

And I mentioned the captive, Andy, because let's not forget, we invested -- we've $80 million committed to the captive insurance subsidiary that has provided all sorts of benefits from the company, current. And we expect future and perhaps increases to the dividend, which would be the next logical place for us to look for additional capital allocation opportunities beyond internal investment and organic growth.

I mentioned buybacks because we do have still 1.5 million shares authorized on the last authorization, but it has not been -- it just hasn't been historically a focus area for the board over the past decade or so. So I can't tell you here what it would take to have that be a focus area, but I can tell you as a priority in the near term, deeply committed to organic growth with the next priority being continued dividend payments and continued dividend increases with consistency of payment and sustainability over the long term being the guidepost.

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Operator [16]

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And our next question comes from Jacob Johnson of Stephens.

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Jacob K. Johnson, Stephens Inc., Research Division - Senior Research Associate [17]

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I guess first question on revenue growth. Looks like it's going to be flattish in 2Q, sequentially, and then picking up in the third and fourth quarter. Is that just because muted additions, as you build up the management pipeline? Or could we see sort of you add accelerating new business but perhaps offset by some additional customer exits for contractual adjustments?

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [18]

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I would say more of the former, Jacob. For us it really is, when we look at our sales pipeline, it's literally more robust than it's ever been.

The most significant component of our growth outlook remains management capacity and more specifically, that management development function. And since mid-year of last year, we've invested heavily in replenishing that training and development pipeline. We've deployed some of those new managers into new facility starts here in Q1; we'll continue to do that through the balance of the year. That would likely result in sequentially increasing the number of new facility adds, but we'll obviously need to replace that reduced revenue that we've talked about before we begin to show net revenue growth. Just as you sort of outlined, realistically looking at flattish Q1 to Q2 from a revenue perspective but then it's really as those managers in training fully develop, having graduated the program, ideally getting some degree of an assignment, working as an assistant manager in the facility and then ultimately being placed into their own facility to manage really more in the back half of the year. So I would say that the limitations in growth, the rate-limiting factor on growth continue to be that management development, fully expect to see a more significant ramp of available managers for us in the back half of the year. And then very much positioning ourselves, as Ted mentioned, with heading into 2020 getting back to kind of normal growth cadence.

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Jacob K. Johnson, Stephens Inc., Research Division - Senior Research Associate [19]

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And maybe following up on that. You've been telling some of these expenses related to the management pipeline. Can you just talk about why these -- you're calling these out right now? What's different about them versus historical management pipeline development? And then why should that normalize in 2020?

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [20]

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Yes. I'm glad you asked that question, because it is important for folks to understand that management development: that recruiting, the training, the developing of managers through our internally executed training and development program, those costs are typically baked into the cake, right. I mean that is typically an ongoing and continuous effort that's executed throughout the company, throughout the country with each of those respective areas being at a different part of that virtuous cycle at any given time.

The reason we're seeing a more pronounced increase now is because of, frankly, the more pronounced slowdown, if not total stop in those recruiting and training efforts as we onboarded the significant business that we did in 2017 with a continued focus on implementing operational systems and ultimately getting that business on budget through the first half of 2018. So while it wasn't a complete stop and start, there was very much a grinding slowdown in our recruiting, training and hiring efforts through that operational startup and transitional phase that was essentially reramped in midyear of last year.

So that's why we're calling it out, that relative to what would be those normal levels that are baked into the cake, we did see elevated training levels in fourth quarter, continued elevated levels here in Q1 that will likely taper through the balance of this year and then get back into the normal cadence in 2020, really as a function of just, as I said, that continuation of that continuously operating and continuously flowing virtuous cycle that's executed locally, down to the district level and that being management development, assessment of management capacity and then ultimately that feeding business development.

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Operator [21]

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Our next question comes from Ryan Daniels of William Blair.

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Nicholas Mark Hiller, William Blair & Company L.L.C., Research Division - Associate [22]

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This is Nick speaking on for Ryan. Just to start off, I guess, how much of visibility do you have into the operational issues of your clients to get outside of simply them not paying promptly? In other words, do your local site managers have the ability to flag clients as a risk in advance of collection issues given that they're on the ground at the actual facilities?

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

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Yes. And in fact, the design of the company allows that to have them very fluidly between the financial services leadership and team that we have out of our home office and that are in constant communication with all of our field-based leaders as well as some of the local leaders to garner all of the intelligence that the boots on the ground are able to get, whether or not there's pressures with other vendors at the facility level, high administrator turnover, low census that's growing lower, or regulatory issues. You can imagine all the information we're able to get from our local teams. And that's absolutely part of the evaluation we're making.

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Nicholas Mark Hiller, William Blair & Company L.L.C., Research Division - Associate [24]

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Got you. And so did the fact that the one client kind of restructured out of court, does that have anything to do with maybe catching you off guard? And if clients kind of do that in the future, is it a little bit hard to see then because they're kind of doing it out of court? Or is that kind of irrelevant to that?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [25]

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Yes. It just depends on the customer and the situation. Sometimes it happens quickly, sometimes it's more of a death by a thousand cuts for a provider. They're all different. Sometimes it's -- the catalyst could be a change in not Medicare but Medicaid reimbursement or reimbursement issues that they're having, a regulatory matter at a facility that results in a different type of settlement or exposure than what the provider was thinking. So again, there is no -- I wish I could tell you that, hey, here's the standard situation that we're faced with and here's the playbook. It really is situational. And that's why the communication that we have between the office, our local folks as well as the customer are so important.

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Nicholas Mark Hiller, William Blair & Company L.L.C., Research Division - Associate [26]

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Got you. Okay. And then I guess the last one on the new Workday solution. I know you talked about a couple of the main operational benefits you'll see internally. Is there any financial benefits you kind of hope to achieve with the new Workday solution? Or is it more kind of like an internal operations base?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [27]

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It's more the lateral, though we do have greater visibility into certainly purchasing and procurement and a true facility level sightline into performance. So that will help with decision-making as any level of enhanced visibility does. But nothing tangible or nothing specific that we would call out in terms of financial upside from what we had. It was really an investment that the company made to set us up for many, many years of growth to come.

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Operator [28]

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And our next question comes from Chad Vanacore of Stifel.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [29]

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All right. So you transitioned 55% of your clients to an accelerated payment program. What's the ultimate target for the percent of client base that you'd like to transition to more accelerated payments by the end of the year? And assuming you do transition to your targets and DSOs stabilize, are there other levers you can pull to improve DSOs through the year? Or is it more an expectation of a reversion to the mean?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [30]

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Yes. I think probably to answer the last part, I would say if anything, it would be more of a reversion to the mean. Although, I will say the new business that we're bringing on board are all coming on board with some form of higher-frequency payments, typically weekly, and that creates -- as we layer on new business that will have a natural effect of bringing down the DSO, because you won't see that quarter-to-quarter variability with one full month rolling over.

The other part of your question, Chad, in terms of what's the ultimate goal or expectations for the rest of the year. I think Matt touched on this, but all of our largest customer groups have more or less been converted. So now we're -- we've had the ones that were triggered, the customers that were triggered by a catalyst, an event that resulted in us approaching them with the conversation about weekly payments. There's another subset of customers that was more of a collaboration, long-term customers, great relationships, we're able to have those types of conversations and come with a mutually agreeable outcome -- come up with a mutually agreeable outcome. And then now we're moving more to some of the state-based groups, some of the local independent operators, which will be probably a slower step up. So there'll be a slower step up to the actual percentage in terms of penetration. But again, as we layer on new customers with a weekly payment frequency as well as ongoing efforts around existing customers, you'll see that continue to rise throughout the year. But I don't have a -- we don't have a hard, fast number that we're striving for. It's more about the quality of the conversions and the rationale behind the conversions more than it is trying to get to a certain number or percentage.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [31]

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All right. So more of an evolution than a revolution from here? Am I right?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [32]

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From this point forward, I think that's a good word to describe it as. It will be evolving from here, but it is our policy moving forward. So it's just with existing customers. There's some long-term relationships where everything is working, they're obviously deprioritized in terms of candidates for a weekly payment conversation.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [33]

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Okay. Then just moving on, direct cost. They've been running consistently above 86% since second quarter 2017. Prior to that, you're actually running much better than that. What do you have to do to get that below the 86%? And I recognize that this quarter there is a bunch of unusual items, and you can add back some of that and get close to that 86%. But what you have to do to get back below there?

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [34]

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Well, we think we are there from a core operating performance perspective, Chad. I would say this was our strongest underlying performance from a result's perspective. We've had many strong underlying performances, but as far as it being reflected in the results, since the second quarter of 2017, when we were for the year -- for the -- certainly, I think 10 consecutive quarters or couple of years leading up to that, we were consistently below that 86% cost of services.

So we have 11.6% housekeeping, 6.3% dining margins, which from a segment perspective were as strong as we've had together in quite some time. So I think we continue to stay the course and implement and stick to our systems, provide the customer with a great experience. And when you look at where we're at as of this quarter, from an underlying performance perspective, we were below 86%.

So yes, of course, with the increase in the AR reserves and some of the training cost Matt referenced, that pressured the reported number. But again, underlying performance, we believe we're back in that pre-Q2 of '17 space, from an operating perspective.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [35]

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All right. And then just one more for me. What does the pipeline for growth look like near term, as far as what's the demand that's built up in your pipeline? And then what's the excess capacity that you currently have given that you're exiting some facilities and you've increased the management pipeline? So how many facilities could you roll out to today, if you needed to?

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [36]

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Yes. I'd say, Chad, we typically don't talk about number of facility additions or even numbers of managers in the training pipeline. It's such a localized effort, right. You talk about exiting facilities, and of the kind of meaningful exits in Q1 they were pretty well contained within that California marketplace. So you can be sure the operators in California, in conjunction with our sales team, they're absolutely exploring how to best and when to most efficiently deploy those folks into new business opportunities. To bring that up to a larger level of the complexion of the current pipeline, without a doubt there remains a significant slant toward dining opportunities, right. I mean you're talking about still having less than 40% penetration and providing dining services to our existing and current housekeeping customer base.

We continue to develop, expand and evolve our reputation as a culinary provider that we cannot only better contain their costs and typically save them money versus their current spend from a dining perspective but to enhance the culinary offering, to increase the overall service offering at the facility, which in the current competitive landscape is absolutely meaningful to our current customers. Now obviously, as Ted alluded to, the controlled component of growth relates to the current operating landscape for our customers and making sure that we appropriately and realistically assess where they are before we make that determination to significantly expand the partnership in adding dining services to the mix. Because as you're aware, on a same-store basis, generally speaking, the value of the dining contract is double that of housekeeping. So we've got to do the work. We have to make sure that we're appropriately validating and vetting the customers with whom we'd like to expand. And there's a process that's involved in that. But there's no shortage of housekeeping and laundry opportunities as well. We've -- I think folks have perhaps lost sight of that all hands on deck nature of the Genesis expansion in that we had a housekeeping and laundry personnel a bit unique to the norm and absolutely beneficially to the company but involved in a hands-on way in helping to facilitate this transition and implement our operational systems given that they had expertise in being involved in those facilities for years in advance of the dining transition; that they know the administrators very well, that they've got relationships with the other department heads within the facility. So housekeeping and laundry, we do believe that given the ramp-up in the management development focused specifically within housekeeping and laundry, there are opportunities to not only redeploy those managers that you alluded to in the California from that business that we've exited, but likewise looking out over the housekeeping and laundry pipeline. Again, you've got to do the work. You have to validate that the new prospective customer is one that we feel comfortable to initiate a relationship and a partnership with, but absolutely every opportunity for us to continue to get back into growth mode in the housekeeping segment in addition to dining.

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Chad Christopher Vanacore, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [37]

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All right. If I were to come to you today with a couple of hundred facilities that I wanted services for, could you do that today?

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [38]

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I'd have to validate, Chad, whether you are a good payer and you're open to that weekly payment structure, right?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [39]

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But it would depend on where the facilities were and how they fit into the management development capacity -- the management capacity that we have in a particular area. Because some areas would be able to handle that type of transition. If not turnkey, certainly over a 3-, 6-month type of rollout. Others would have to -- we'd have to have an outlook that's beyond that. But it would just depend on the area. Overall, the company, if it -- if we were able to pick and choose where those couple hundred facilities were, Chad, then yes, we would be able to accommodate it, but it would depend on where they were located.

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Operator [40]

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And our next question comes from Sean Dodge of Jefferies.

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Sean Wilfred Dodge, Jefferies LLC, Research Division - Equity Analyst [41]

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Maybe staying on revenue for a moment, Ted. It feels like your broader commentary around growth, you're pushing out the time limit a bit on when you expect to return to a more normal cadence.

I guess is it simply because of the incremental service cancellation you had in California this quarter and you had to do a little bit more backfilling now to get back to growth? Or do you have situations where you had line of sight on some opportunities but the timing shifted on you?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [42]

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I think it's more -- it's a common -- well it's not the latter. I think primarily it's, and hopefully it's not -- I'm not trying to shift it necessarily, but if anything now that were -- now that the quarter's in the books and we have a clear sightline on what the run rate would be heading into Q2, we want to come out and be clear about what our expectations are for the second quarter, but back half of the year, we're still expecting sequential growth, Sean. And to the extent that maybe the tone and tenor is a little more tempered, it's only because, as you alluded to, we had some of the recent revenue step-downs, certainly with the California customer but also wanted to make sure everyone understood as far as the contract restructuring, as that folds into the new year, we're replacing at least the revenue. In some cases, obviously, it didn't impact the profitability or the margins but certainly the revenue. So it was more to try to create clarity around what we're thinking for the second quarter, how the opportunities that are being considered would be folded in during the second half of the year. Of course, without the precision of the week or the month that they may hit. And then as you mentioned, second, moving into 2020, fully expect to be returning to our historical growth profile, when you're comparing Q1 of '20 to Q1 of '19.

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Sean Wilfred Dodge, Jefferies LLC, Research Division - Equity Analyst [43]

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Okay. And I just want to understand a little bit better when you guys talk about the $3 million of elevated payroll costs related to the training of new managers, is there any portion of that, that is nonrecurring? Or is this just payroll cost of carrying an elevated number of managers that haven't been deployed yet? But as they are putting it on facilities, the costs don't go away, necessarily. It just gets absorbed with the incremental revenue it generates?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [44]

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That's exactly right, Sean. So this is basically elevated payroll, additional overhead that's not yet -- that's not budgeted for in sort of the typical model. So these folks, to your point, would be those costs would continue. But as you're adding new business and adding a new facility in which that individual's compensation would be budgeted, it just slides into the mix.

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Sean Wilfred Dodge, Jefferies LLC, Research Division - Equity Analyst [45]

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Okay. Got it. And then a quick last one for me, Ted. You said you can't really comment on the SEC matter, but I know you guys were working to be proactive and get a chance to present the findings of your interval review to them. Can you tell us if that's happened? Or is that still expected to happen?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [46]

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Yes. I think to your point, we can't really get into much detail other than to say, which we've talked about in the past, we are fully cooperating and obviously we're hopeful for a swift and successful outcome. And yes, we did successfully complete the internal investigation in mid-March. But the conversations, the dialogue with the SEC is active and ongoing and will continue to be. But it's one of those things when we're asked about a timetable or potential evolution of the matter it's really -- there's not a straight line, right. There's stops and starts. And we're ready, willing and able to continue to move as quickly or as slowly as the staff would like us to. And again, continuing to fully cooperate.

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Operator [47]

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And our next question comes from Mitra Ramgopal of Sidoti.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [48]

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I'm just wondering, just from an industry outlook, if given the tight labor market, obviously some wage inflation, et cetera, if you're seeing more calls in terms of operators looking to outsource their business to you?

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Matthew J. McKee, Healthcare Services Group, Inc. - VP of Strategy [49]

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Yes. I think, Mitra, if you kind of bundle up the previous commentary with respect to that pipeline, that pipeline has absolutely been fed more by incoming prospective customer inquiries than us sitting around or having sales folks make cold calls and try to attend industry functions or blanket the countryside with direct mailing sales brochures. So that is absolutely a component. If you think about the value proposition that we can generally deliver a better qualitative outcomes from an operational perspective, from a regulatory perspective, certainly from a financial perspective, we're at a minimum better containing their costs, if not reducing them, relative to what they would otherwise be able to do on their own.

So in the current operating environment in which you have kind of reimbursement uncertainty, although there is increased clarity on that front, the challenges that operators have faced in filling beds from an occupancy perspective and some of the capital structure and financial pressures that they faced, the value proposition that we offer is increasingly compelling. So the short answer to your question, absolutely, given all of the above, the demand for the services continues to grow.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [50]

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And I would just add, Mitch, from an industry-wide perspective, when you look, and I mentioned earlier that fundamentals are clearly improving and the data are clear that the fundamentals are improving. You think about industry-wide occupancy trends, the demo change between the baby bust, giving way to the baby boom, every month, every year that goes by, that's a favorable tailwind for the industry. They have more experience now in managing Medicare Advantage and the nuances with that program and the impact on occupancy. You have lease cost pressures that I think are subsiding. A lot of the work that needed to be done around leases has happened. We certainly saw that manifest itself more specifically in Q1 of last year, but that's happened and continues to happen, but most about has happened from our perspective throughout the industry.

You talked about and brought up labor inflation with CMS having a 2.5% increase for the providers, that will be the second year in a row there is at least a partial offset to the labor inflationary environment. And then Matt mentioned the payment model, PDPM, which is certainly a more predictable and sustainable reimbursement framework moving forward. So it's not that the industry still does not have its set of challenges. I mean it's -- but it has been a disproportionately difficult couple of years for the industry, because you had a variety of these factors and forces coming together almost at the same time but the -- I think as the fundamentals improve and some of these trends continue to gain traction, you're going to see increasing stabilization. And I think that'll be reflected certainly within the provider community results and their financial health.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [51]

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Okay. And then just a quick follow-up on the industry and the financial health. Obviously, you're clearly working with your customers. And I'm just wondering, as you look at your noncustomers or the operators out there if you're hearing or seeing any increased incidents in terms of operators having a difficult time financially?

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [52]

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No. I think I would only say that comparatively to 12 months ago or 18 months ago, it's the anecdotally that type of -- those type of incidences is waning. Those types of incidents are waning, meaning if anything we're hearing less both within our customer base and then certainly industry-wide. Because, as I said, a lot of -- the trends are improving and a lot of the work, specifically around lease costs and some of the challenges between having an affordable lease payment with an environment with declining occupancy, has been worked through with the REITs, the landlords and other stakeholders in the space.

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Operator [53]

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And I'm not showing any further questions at this time. I would now like to turn the call back over to Ted Wahl for any further remarks.

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Theodore Wahl, Healthcare Services Group, Inc. - President, CEO & Director [54]

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Well, thank you, Josh. And as we look ahead to the rest of the year in what is our 43rd year of business, the company's underlying fundamentals are as strong as ever. Our leadership and management team, our business model and visibility we have into that business performance, learning platforms, key operating trends around systems implementations, customer experience, employee engagement and margins, a rock solid balance sheet, the strong demand for the services and the significant growth opportunity that lies ahead for the company, our employees and all of our stakeholders.

It's exciting to imagine all the future possibilities and know that our future begins with our great people going beyond and living out our purpose, exemplifying our values and fulfilling our vision. Our purpose, vision and values are the company's touchstone and it's our pathway to delivering sustainable and profitable growth over the long term. So on behalf of Matt and all of us at Healthcare Services Group, I wanted to thank you, Josh, for hosting the call today and thank everyone again for participating.

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Operator [55]

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Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. And you may all disconnect. Everyone, have a wonderful day.