Health Care Services Group Is a Possible Triple Bagger

Healthcare Services Group Inc. (HCSG, Financial) is a third-party provider of services, including housekeeping, dining, nutrition planning and laundry, to health care providers such as hospitals, nursing homes and senior living centers across the U.S.

At 52.9%, the Dietary segment is slightly larger than the Housekeeping business.

Looking at the 10-year price chart, I notice the stock is down about 74% from its high, which it reached in 2017. This is surprising given the general growth of the health care sector in the U.S.; one would think that a company providing essential services would do quite well.



Healthcare Services Group has run into problems following the Covid-19 pandemic as nursing homes and senior living centers have been financially stretched and unable to expand their use of its services. Prior to the pandemic, the industry was overbuilt as it was anticipating a tsunami of retiring baby boomers stretching into the 2030s. However, when the pandemic hit, senior living centers saw occupancy levels drop, and fewer new residents were moving in, so the company's business suffered. Then, starting in 2021, inflationary pressures got bad, squeezing its operating margins. The acute labor shortage and wage inflation is putting even more pressure on margins by pushing up labor costs. However the power of the aging demographics should reassert itself eventually.

Aside from labor costs, the lack of available workers constricts Healthcare Services Group’s ability to expand. Additionally, higher prices for food and cleaning supplies has shrunk margins for the company’s core services as prices charged to customers do not make up for cost increases. As a result, the company is working to modify its existing contracts to adjust for the effects of inflation. In other words, they are raising their prices in an attempt to return closer to their previous operating margins. Looking at the financials, it appears the company's profitability, as measured by the operating margin, started to falter around 2017-18, briefly recovered in 2020, but then fell badly in the aftermath of the pandemic.

This has led to a compression of price multiples investors have been willing to pay for the company's stock. This compression is seen most clearly seen in the price-sales ratio, which has plummeted from around 1.80 in 2016 to less than 0.60 currently.

In spite of its income statement and growth problems, Healthcare Services Group has maintained an excellent balance sheet with very little debt, as shown in the chart below. This leads me to be believe the company has the platform to execute a turnaround and bounce back as business normalizes.

My view of a turnaround is supported by the fact core free cash flow remains at a good level. Core free cash flow, represented by the orange line in the chart below, is free cash flow without changes in working capital. Because Healthcare Services Grouop is a services provider, its working capital can bounce around quite dramatically as it depends on a fluctuating workforce to manage demand. There is ususally a lag between incurring costs and cash collection.



The company's management team noted that despite near-term inflationary headwinds, the long-term growth outlook remains strong given its market leadership, efficient operating model and appealing demographics. Further, the stock is attractively valued based on several metrics. Healthcare Services Group also recently cut its dividend and is deploying capital to buy back its deeply discounted stock. This looks like a sensible strategy to me. The stock went up when the dividend cut was announced as the market was anticipating that it was not sustainable.

As Healthcare Services Group works on getting its operating margins in order, its price-sales ratio should start to normalize. Therefore, I believe all the ingredients are there for a turnaround. Now the focus will be on how effectively management executes its plan.

The profit numbers from the latest quarter (see below) are quite encouraging. Note the large jump in the operating income and margin. If this trend continues, it will prove the turnaround efforts have been effective.

Conclusion

Contending with inflation and labor shortages, the nursing home and senior living industry is currently between a rock and a hard place. However, relief may be in sight given the expected recession later this year or early next year. That should in theory cut down inflation and reduce labor shortages.

Healthcare Services Group historically has traded at much higher price multiples. Looking at the company's Ebitda, Ebit and enterprise value data over the last 10 years (shown in the table below), a reasonable case can be made that the stock could double or even triple if the company can revert to the median. Given its solid balance sheet, I think there is a strong likelihood this will happen. Once earnings start to go up, the market is likely to re-rate the multiple it is giving the stock. The demographic tailwinds should also reassert itself and increase the retirement home's occupancy.