On Thursday, after the markets closed, Healthcare Services Group (HCSG) reported somewhat noisy third quarter 2014 results, as the company proactively decided to move its healthcare and workers’ compensation insurance plans into a captive insurance subsidiary. As part of the process, the company was required to project current/future claims out over the next 15 to 17 years, and was required to record a roughly $37 million non-cash charge to establish the captive entity.
The move to a captive insurance plan will provide a tax shield for the company, thus affording the organization a roughly $20 million cash flow benefit upon full funding of the captive; moreover, management believes the formation of the captive will be accretive to EPS in 2015 and beyond. Thus, despite the noise associated with the transaction, we view it favorably, as both cash flows and earnings will be enhanced by the transaction. Management commented that operating expenses and SG&A expense would have fallen in line with expectations in the absence of the above-mentioned transaction, which would yield $0.22 in estimated pro forma EPS. However, top-line growth of 7.2% marked a deceleration from the first half of the year, as the anniversary of the Platinum acquisition created a more difficult comparison; overall sales registered at $320.1 million, or roughly 3% shy of the consensus forecast.
Still, we expect sales momentum to return in the fourth quarter, as the company disclosed roughly $120 million in net new annualized sales during the period. Lastly, days’ sales outstanding ticked down approximately two days, which we view favorably. The company also declared a cash dividend of $0.175, marking its 46th consecutive cash dividend payment and 45th consecutive increase. Thus, we were pleased with the results and newsales momentum, despite the noise associated with the insurance restructuring and the weaker-than-anticipated third-quarter sales.
We maintain our Outperform rating on HCSG shares, although at about 27 times our 2015 EPS forecast we acknowledge that shares are not inexpensive and therefore expect that share price performance is more likely to be driven by consistent earnings growth versus further multiple expansion. Still, the company’s cash-based recurring-revenue business model is unique in the broader healthcare landscape, and shares could offer investors refuge from any return of market volatility. We therefore continue to see HCSG as a core holding and would be more aggressive with purchases on any pullbacks.