I am recommending Healthcare Services Group (“HCSG” or the “Company”) as a short.  Management’s longer-term expectations for growth are too ambitious, the Company’s quality of earnings is poor, and the business of primarily serving the long-term care industry comes with derivative risks from Medicare and Medicaid reimbursement programs.

As noted in the Company’s risk factors, “Management believes the historical price increases of our Common Stock reflect high market expectations for our future operating results.”  Trading at less than a 2% current FCF yield, ~25x LTM EBITDA, and more than 25x consensus 2015E EPS (over 40x LTM EPS), the stock is “priced for perfection”.  Even when applying HCSG’s best year generating FCF (at a 5.3% conversion rate of revenue), the stock is trading at less than a 3% equity FCF yield.  For context, HCSG’s closest publicly-traded U.S. peers are ABM Industries and Aramark; those companies are trading at a FCF yield of ~5-6%, a LTM EBITDA multiple of 10-11x, and a forward year P/E of 15-17x.  Furthermore, I believe, and perhaps management agrees as inferred from their noted risk factor, that even if the Company were to achieve its long-term performance objectives of 10-15% in annual revenue growth and an 8% operating margin, the stock would be over-valued.  At 12x LTM EBITDA (more than any of the comps including Compass, Sodexho, CTAS, UNF, and GK), HCSG would be trading at ~$14, an implied dividend yield of 5%.  Although I am not asserting such downside, especially in the current yield environment, the context should reinforce how expensive HCSG’s stock is on both an absolute and relative basis.  At 15x, HCSG would be trading at ~$17.50, an implied dividend yield of 4%.    

Management promotes the Company’s consistency for raising its dividend, having done so in 44 consecutive quarters; however, in each of the past five years, the Company’s dividend has been a payout ratio of at least 100% and in only two of the past five years did HCSG generate more FCF than its dividend.  In 2013, HCSG paid dividends totaling $46.7M but generated FCF of only $28.4M.  In spite of the moderating level of dividend growth and especially in the current “chase for yield” market, I believe that a large proportion of HCSG investors have stuck with the stock because of the consistent increase in the Company’s dividend.  When the yield curve steepens, that would be one catalyst to re-rate HCSG, and with only ~2.5% dividend yield that is highly reliant on Medicare and Medicaid reimbursement funding rates, there is an inadequate level of downside protection for those who are long HCSG at the current price. 

Founded in 1976 and providing its services to over 3,000 facilities in 48 states, the Company generates revenue from three sources:  Housekeeping (47%), Dining & Nutrition (34%), and Laundry & Linen (19%).  On a CAGR basis from 2011-2013, Housekeeping grew ~8%, Dining & Nutrition grew ~29%, and Laundry & Linen grew ~7%.  It should be noted that this does not reflect organic growth since the calculation is not pro forma for the acquisition of Platinum Health Services completed mid-July 2013.  A financial summary of the Company’s historical performance is shown below.

Clients span the spectrum of nursing homes, retirement complexes, rehabilitation centers, and hospitals.  Management believes the Company is the largest provider of its services to the long-term care industry in the United States.  Skilled nursing facilities are the Company’s primary client segment; hospitals comprise ~10% of HCSG’s client facility mix.  The hospital market segment is more competitive with larger companies like Aramark and Crothall focusing on it. 

HCSG’s retention rate with its clients is 90%.  Although 90% sounds impressive, note that competitor Crothall has a retention rate of 98%.  Agreements with clients are typically for just one year, cancelable by either party upon 30 to 90 days’ notice after the initial 90-day period.  During the first quarter of 2013, two clients modified their service arrangements with the Company which caused the Company to miss its revenue and profit objectives.  The absence of longer-term contracts renders the Company’s business model to be vulnerable to sudden changes sought after by HCSG’s clients.  As noted by management, the Company finds itself most at risk when changes are made in the facility administrator/decision-maker and when there are changes in the nursing home corporate ownership. 

Although the Company does not directly participate in any government reimbursement programs, HCSG’s clients’ reimbursements are directly affected by any legislation and regulations relating to Medicare and Medicaid reimbursement programs.  This derivative risk could create several headwinds for HCSG to confront in the years ahead.

The Company is organized around two reportable segments:  Housekeeping and Dietary.  Housekeeping consists of the managing of the client’s housekeeping department which is principally responsible for the cleaning, disinfecting and sanitizing of patient rooms and common areas of a client’s facility, as well as the laundering and processing of the personal clothing belonging to the facility’s patients.  Also within this segment is the responsibility for laundering and processing of the bed linens, uniforms and other assorted linen items utilized by a client facility.  The Dietary segment, founded in 1997, consists of managing the client’s dietary department which is principally responsible for food purchasing, meal preparation and providing dietitian consulting professional services, including the development of a menu that meets the patient’s dietary needs.  The operating margin for Housekeeping declined from 9.7% in 2011 to 9.1% in 2013; the operating margin for Dietary services increased from 5.0% in 2011 to 5.5% in 2013.  In the most recent quarter, the Housekeeping segment generated an operating margin of 8.5% (down 50 basis points from the prior year period), and the Dietary segment generated an operating margin of 6.0% (up 10 basis points from the prior year period). 

The Company, which primarily targets skilled nursing facilities with over 100 beds (there were 7,870 such facilities in the U.S. in 2012; 958 of the 7,870 had over 200 beds), has relationships with the majority of national chains.  Management estimates that 35-40% of its facility agreements are with a national chain but service agreements are typically negotiated at the individual facility level.  From 2011-2013, the number of facilities served by HCSG was relatively flat, but did increase by over 30% from 2009-2013.  There are no customers comprising over 10% of revenue but two customers which each represent 7% of total Company revenue. 

Management’s strategy is to bundle its housekeeping, laundry, and dietary services.  Most of the Company’s housekeeping clients also receive laundry services from HCSG.  There is recent improvement at executing this strategy with dietary services as evidenced by the more than 25% of HCSG’s customer facilities taking dietary services in 2013, up from approximately 15% in 2009.  By outsourcing, the client’s average savings are estimated by HCSG management at 10%.  Management claims that savings from outsourcing are achieved from better productivity and purchasing efficiencies under HCSG’s domain but discussions with former employees highlight that a significant amount of client savings are derived from lower wages. 

Healthcare facilities nationwide are searching for ways to cut costs and operate more efficiently.  Housekeeping and facility operations/maintenance services remain among the top outsourcing categories in healthcare.  According to an outsourcing survey conducted by Modern Healthcare in 2012,  linen/scrubs is the most outsourced service by hospitals, housekeeping was the second-highest category based on the number of facilities served, and food service contractors enjoyed the largest percentage increase (55%) in the number of facilities served.  According to the textile services industry’s premier trade publication, American Laundry News, the wave of outsourcing and shared-service, mega-plants has made the healthcare on-premise laundry an endangered species.  The Chief Operating Officer of the Chesapeake Regional Medical Center said, “While not top-of-mind for most, laundry is an area representing 1-3% in overall operating costs.”  HCSG management highlights the secular growth prospects for increased outsourcing in their presentation slide that portrays less than 25% of hospitals outsourcing housekeeping and laundry, and less than 20% of long term/post-acute care facilities outsourcing housekeeping and laundry.  While housekeeping and laundry represents 3-6% of total expenditures, the larger category for cost savings is dining and nutrition which represents 6-12% of total expenditures.  There is more outsourcing of dining and nutrition among hospitals, at almost 30%; however, it is less than 5% across long term/post-acute care facilities.  There is no disputing that outsourcing by healthcare facilities of services, like those provided by HCSG, will continue and grow; however, I assert that the quality of such growth derived by HCSG will be sub-optimal.

Management maintains an ambitious expectation of revenue growth ranging from 10-15%.  They envision that housekeeping and laundry will grow at the lower-end of the range and dining at the higher-end of the range.  As described earlier, in the past two years, housekeeping grew at ~8% and laundry grew at ~7% but the figures during the second half of 2013 benefitted from the inclusion of Platinum Health Services which was acquired on July 12, 2013.  There is no disclosure of results for Platinum and pro forma results are not presented; the acquisition was not deemed significant to the Company’s operating results pursuant to Regulation S-X for the three months and years ended December 2013 and 2012.  Based on management’s expectation that the Platinum transaction, for which HCSG paid ~$47M, would add more than $60M in annualized revenue, I assume that Platinum contributed $27.5M to HCSG’s results during the second half of 2013.  Therefore the organic growth rate for the overall Housekeeping segment (including maintenance services), on a CAGR basis, over the past two years ending 2013 was less than 6%.  Furthermore, on a more recent basis comparing the first half of 2014 to the first half of 2013 and applying the similar adjustment for Platinum, organic growth was less than 4% in the Housekeeping segment.  This is far below management’s expectation of 10-15%.  On a headline basis, overall top-line growth during the first half of 2014 was over 15% but less than 10% when adjusted for Platinum.  I am not asserting that HCSG will miss their 10-15% top-line objective this year but I am asserting that the notion of that level of growth being sustainable is overly ambitious and the stock might discount such expectations at the current valuation.  For context, note that Aramark’s healthcare segment revenue declined by almost 1% during the first nine months of its current fiscal year.  Consensus estimates for top-line growth at HCSG in 2014 and 2015 are currently 13% and 12%, respectively.

It’s important to consider that some growth might be derived through adverse selection (i.e., facility clients that competitors don’t want at that price and those terms).  In fact, one competitor that focuses on the hospital segment chooses to avoid the skilled nursing facility segment where HCSG focuses its resources because that competitor deems the nursing home segment to be a “marginal opportunity given smaller scale of each facility and less desirable customer set from a credit standpoint.”  Assuming the Company achieves its top-line objectives on a consistent basis over the long-term, I assert that the quality of growth is likely to be poor as HCSG confronts challenging issues from both its clients and its employees. 

Although there might be some operating leverage to be gained from improved utilization of the regional and district management structure, the ongoing reimbursement pressures across HCSG’s client landscape will likely compromise the Company’s ability to improve its pricing or demand better payment terms.  In fact, the likely scenario is that both pricing and payment terms deteriorate as regulatory and budgetary issues grow across the healthcare sector.  The business of primarily serving the long-term care industry comes with derivative risks from Medicare and Medicaid reimbursement programs.  The Company is highly reliant on reimbursement funding rates.

In July 2011, the Centers for Medicare and Medicaid Services (“CMS”) issued a final rule that reduced Medicare payments to nursing centers by over 11%.   Although Medicare’s 2% average increase for skilled nursing providers in fiscal year 2015 is the most attractive in recent years, a few states have indicated it is possible they will run out of cash to pay Medicaid providers, including nursing homes.  Medicaid is jointly funded by state and federal governments and is the nation’s largest payer of nursing home bills.  According to a recent study by the American Health Care Association, the cost of nursing home care exceeded Medicaid reimbursement by ~$8B.  According to the Massachusetts Senior Care Association, several nursing homes in Massachusetts have gone out of business this year and scores more are on the edge of shutting down since half of the remaining nursing homes are operating “in the red”. 

Nursing facilities are struggling to find ways to reduce expenses to cover the gap between the cost of care and Medicaid reimbursement.  HCSG management will highlight this as being favorable to them because it drives outsourcing as clients turn to the Company’s services seeking efficiencies.  I contend that such growth might be attractive in the short-term and assist management at accomplishing its lofty top-line objectives but with this growth comes adverse selection as many of these clients will be difficult on several fronts:  the margin available to HCSG, payment terms, and these struggling facilities are likely candidates for bad debt.

Management is of course aware of the numerous struggles across its client landscape and the CEO highlights such struggles as a key enabling factor to HCSG’s success by capitalizing on the increased need for outsourced services.  Although the CEO will point to revenue growth as a sign of ongoing success, I believe the cash flow statement is a better determinant.  From 2009-2013, revenue CAGR was 13.5% but across this time period the Company’s FCF declined at a CAGR of ~6%. 

This is not a capital-intensive business; total capital expenditures incurred represents less than 50 basis points of total revenue generated in the past five years.  The challenge is with accounts receivables which is perhaps not surprising given the underlying client credits.  During 2013, operating activities’ cash flows decreased by $63M which was mostly as a result of ~$55M of increases in accounts and notes receivables.  To maneuver around their working capital challenge pertaining to receivables, management offset the outflow by increasing payable and accrued expenses. 

Although management speaks confidently about DSOs being below 60 days, there is some questionable issues with that calculation since the Company moves dated “receivables” to “notes receivables”, some listed as a current asset (though combined with accounts receivables) and some listed as a noncurrent asset.  As evidence of the poor quality of earnings, note that at year-end 2013, the Company’s receivables (inclusive of current note receivables) grew by ~35% from the prior year.  This compares to less than 7% of revenue growth generated in 2013.  Management will highlight part of the issue being the acquisition of Platinum in mid-July but that begs the question for why would the Company pay almost $50M for $60M of revenue if the acquired receivables would be a challenge.  Demonstrating further collectability challenge, the Company’s noncurrent note receivables grew by over 200% by year-end 2013.  Overall note receivables grew by 50% in 2013 to over $16M.  Given the landscape, the growth in account and note receivables, I question the Company’s bad debt provision (as a percent of revenue) being just 20 basis points in each of the past two years, down from 30 basis points in the prior three years 2009-2011. 

Any negative changes to its clients’ reimbursements could negatively impact the Company’s results.  The client industry landscape challenges are driving an urge to merge across HCSG’s client landscape.  The most recent example is the announced merger of Genesis Healthcare and Skilled Healthcare in a combination of more than 500 facilities nationwide.  Less than a month ago, Brookdale Senior Living and Emeritus Corp closed their merger.  The consolidation trend across HCSG’s client landscape is likely to bolster the balance of power that the larger clients have when negotiating with HCSG or its competitors in pursuit of the efficiencies that were contemplated as part of the transaction process.  For example, in the recently announced skilled nursing facility combination, Genesis and Skilled Healthcare forecasted that 40% of their projected synergies will be derived from “vendor repricing and contract consolidation”.   

Management cites its biggest limiting factor in capitalizing upon the secular growth opportunities available to the Company is the recruitment, training, and retention of management talent.  At the end of 2013, over 40,000 people were employed by HCSG, almost 20% of which were characterized as management, office support, and supervisory personnel.  Since corporate management seemed challenge to bolster their management talent while employment trends were weaker during the past five years, I question whether this “limiting factor” will be easily resolved in the current improving employment environment.  More relevant perhaps is labor relations with the Company’s approximate 32,000 hourly employees.  Although not mentioned much by senior management, I think a key ingredient to HCSG’s ongoing success resides in the day-to-day execution by the Company’s hourly employees.

If employee relations are not great, then labor issues might serve as an impediment to profitable growth.  HCSG’s business model is labor-intensive and poor execution in the field can marginalize performance.  Within the Housekeeping segment, labor costs represent over 80% of segment revenue; within the Dietary segment, labor costs represent over 50% of segment revenue.  Almost 20% of all hourly employees are unionized.  Although management considers the relationship with its employees to be “good”, their perspective is extremely inconsistent with my primary research findings which highlighted a pattern of discontent, a lack of adequate training, and some questionable integrity.  At the hourly level, this is a low paying job and therefore one might expect hearing lots of complaints but the primary research takeaways are consistent with numerous negative reviews available on Glassdoor and other websites.  For context, on Glassdoor, HCSG received an overall rating of just 2.0; this compares poorly with selected peers (median and average of 3) which each scored higher than HCSG with the exception of Angelica.  Other peers used in this comparison are Aramark, Compass Group subsidiary Crothall, ABM Industries, Mission Linen, Alsco, Sodexo USA, Cintas, G&K Services, Unifirst, and UGL Unico.  As evidence of selected labor relation challenges, a set of lawsuits from hourly employees against the Company was recently settled at a $0.13 per share charge to the Company. 

The objective of management to achieve an operating margin of 8% will be challenging.  The primary area of top-line growth is more likely to be derived from the Dietary/Dining segment which generated an operating margin of just 5.4% last year versus 9.1% in Housekeeping.  Although a benefit of increased top-line growth in Dining might be an improving margin, as evidenced at 6% in the most recent quarter, the business of executing Dietary/Dining is more complex and industry experts ascribe a low likelihood that HCSG will be able to improve margin substantially from the current level when the Company’s primary client mix is skilled nursing facilities.  Moreover, issues of Obamacare and minimum wage legislation loom as headwinds against HCSG improving its margin.  During 2014, in at least thirteen of the forty-eight states where HCSG conducts business, the minimum wage increased.  Although the Company can sometimes mitigate wage increases with pass-through provisions, this is not always the case and is not as relevant when contractual arrangements are so short-term and/or easily cancelable. 

Among the biggest challenges to the short case is the more than 15 days to cover.  Since I don’t have comprehensive sell-side research access, I cannot adequately assert the extent of the issues I highlighted being well-documented by the research analyst community.  That said, I will infer from the high short interest that my perspective is not necessarily a variant view.  However, that does not deter me from shorting HCSG and advocating it to you.  In light of the high short interest, I am sensitive to that risk component of being short and of course size the HCSG short accordingly.  Since HCSG has typically traded on the more expensive spectrum, one might question why that is likely to change anytime soon.  I view the recent earnings miss and subsequent price action as a potential inflection point in the stock breaking down which could drive additional investor selling (i.e., what makes a short work) as future quarterly results elevate continued deterioration and/or challenges relative to lofty market expectations.  At this valuation, on an absolute and relative basis, the bar for results is high.  The quality of earnings is poor and that eventually catches up with a Company’s stock.  Recent quarterly calls have evidenced an increasing level of inquiries pertaining to the rising level of receivables.  To the extent the trend of poor cash flow conversion continues as I envision, those analyst inquiries might drive downgrades and more importantly selling by existing investors.  The best shorts are often made subsequent to the first break in the stock and it’s possible that the 8% decline over the five days pursuant to HCSG’s last earnings (posted after-market on July 8th) versus the gain in the S&P by 50 basis points was the first crack in what some might say has been HCSG “armor”.  Since HCSG’s earnings on July 8^th, the stock is down 8% versus the S&P up almost 2%.  I anticipate more alpha will be generated in the months ahead; it might require patience though in light of the crowded nature of this short.

Selected Catalysts

Modified service arrangement by significant client(s) compels management to reset expectations lower 

Quality of earnings continue to deteriorate

Budgetary challenges across numerous states elevates reimbursement challenges across nursing home industry

Rising yield curve compresses perceived attraction of HCSG’s 2.5% dividend yield