If you can reliably reduce costs for healthcare facilities, you're going to be quite popular. To that end, Healthcare Services Group (Nasdaq:HCSG) has indeed built a very appealing and scalable business in providing housekeeping, linen/laundry and dining services to healthcare facilities. While this company has a pretty compelling dividend story, the valuation is a bit confounding.

SEE: Countries With The Highest Healthcare Spending.

Cost Challenges Bite into First Quarter Results
Although Healthcare Services did well on the top line, cost control proved to be a more challenging situation. Revenue rose 25%, as the company continues to see solid performance in its core housekeeping/laundry services, but also impressive growth from dietary services, as more clients add these services.

Part of the profitability issue, then, is amortizing the cost of the growing dietary business. The company has to make certain commitments in terms of management infrastructure to roll out this business, but there is a lag in building up enough customers to absorb that overhead.

Consequently, the company's cost of services rose 26%, dropping gross margin nearly a point. Operating income was up just 4%, as that increased cost of services chewed up incremental profitability.

SEE: What Health Insurance Covers.

A Wall Street Love Story?
Although the company's profits were well below sell-side expectations (though few analysts follow this stock), the Street doesn't seem to care. Investors seem sold on the idea that Healthcare Services needs time to build the dietary business, but once it reaches critical mass the profit growth will be significant.

Certainly there is an appealing growth angle to this company. HCSG already provides housekeeping and laundry services to about 2,900 facilities, with 600 of them also using the company's dietary services (nearly doubling in the past year). Lest you think HCSG is close to market saturation, remember that there are nearly 7,000 hospitals in North America and more than 23,000 nursing homes, long-term care facilities and other potential customers.

A Good Model, but Could It Be Better?
Healthcare Services runs an admittedly appealing model - essentially taking over the management of the facility's housekeeping, laundry and dietary needs. The company largely uses the existing infrastructure in place and indexes its labor costs to the costs of the facility's other unskilled workers. Consequently, this is a business where the company can earn a fairly predictable margin without large capital commitments.

I wonder if the model can get even better. Now, there's nothing wrong with the housekeeping model and it works along similar lines as Ecolab (NYSE:ECL) (and Ecolab is a competitor in some healthcare settings). I do wonder about the laundry/linen service, though. While the company uses the facility's own equipment (or will install some in certain cases), could there be better cost leverage from an outsourced, centralized model like that used by Cintas (Nasdaq:CTAS) or Aramark?

The Bottom Line
One of the simultaneous challenges and opportunities for this company is the fact that companies like HCA (NYSE:HCA) and Kindred Healthcare (NYSE:KND) are actually a little unusual in the industry. A lot of the hospital industry and most of the nursing home industry is still run by small "mom-and-pop" operators and that not only increases the service costs, but also makes them more vulnerable to ongoing cuts in Medicare and Medicaid reimbursement (if facilities take in less revenue, there's less available money for service providers like Healthcare Services).

Frankly I'm flummoxed by the valuation Healthcare Services Group gets. While the 35 straight quarters of dividend growth is indeed very laudable, even mid-teens compound free cash flow growth over the next decade isn't enough to come close to the current stock price. My fear, then, is that investors are paying too much for that dividend growth and the expectation that HCSG will profit from the graying of America.

SEE: Healthcare Funds: Give Your Portfolio A Booster Shot.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.
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