HealthEquity (HQY), as an innovative pure-play provider of tax-advantaged health accounts and related technology-enabled services, is perfectly positioned to capitalize on the secular shift to greater consumer responsibility for healthcare costs. HQY’s cloud-based platform empowers consumers to access their tax-advantaged health savings, compare treatment options and pricing, evaluate and pay healthcare bills, receive personalized benefit and clinical information, earn wellness incentives, and make educated investment choices to grow their tax-advantaged healthcare savings. Any health plan or banking institution can be integrated into the HQY platform to be the independent and trusted partner that enables consumers to manage, save and spend their healthcare savings. The platform has high functionality and flexibility and is favorably differentiated from those of competitors. For example, HQY is able to easily integrate third-party applications into its platform, offering consumers access to services such as price transparency, benefits enrollment, population health, wellness, analytics, and health insurance and investment services. Importantly, HQY legally became a “non-bank” custodian of health savings accounts (HSAs) in 2006. This allows HQY to host actual HSA cash and investments, as well offer financial advice. HQY is gaining share in HSA members and assets under management (AUM), driving the strong historical growth and lucrative long-term outlook for the company. I think HQY can continue to generate a ~20% revenue CAGR over the mid/long term. My $60 price target is based on a 10-year DCF analysis and implies 33.7x my FY2019 adjusted EBITDA estimate of ~$102M.
The US healthcare market is the largest and most expensive in the world. According to a February 2017 CMS report, total health spending is projected to have reached nearly $3.4 trillion for 2016, a 4.8-percent increase from 2015. Further, CMS expects national health expenditure growth to average 5.6 percent annually over 2016-2025. US employers bear a substantial amount of this financial burden, currently paying over three quarters of their employees’ health costs and are projected to have paid almost $700 billion in healthcare costs in 2016 (per CMS). Approximately 95% of these employers are self-insured, meaning they pay the healthcare bill, not an entity such as an MCO. Employers have responded to annual health insurance premiums, rising faster than the rate of inflation, by shifting costs onto employees through benefit designs such as high-deductible health plans (HDHPs). To help cover out-of-pocket expenses not covered by a health plan, some employers offer HDHPs that are paired with an account that allows enrollees to use tax-preferred savings to pay plan cost sharing and other out-of-pocket medical expenses, commonly Health Reimbursement Arrangements (HRAs) and Health Savings Accounts (HSAs). Among firms offering health benefits, 5% offer an HDHP/HRA and 24% offer an HSA-qualified HDHP. The percentage of covered employees enrolled in an HSA-qualified HDHP increased from 15% in 2015 to 19% in 2016. As evident from the figure below, HSA-qualified plans continue to outpace HDHP/HRAs (10-year CAGR of 18% for HSA-qualified plans vs. 5% for HDHP/HRAs).
A health savings account (HSA) is a triple-tax advantaged savings account that is only available to individuals enrolled in qualified high deductible health plans (single coverage deductible between $1,300 and $6,550; family coverage deductible between $2,600 and $13,100). Despite the higher deductibles, these plans have monthly premiums which are significantly lower than those of traditional health plans. The premium savings can then be deposited into an HSA on a pre-tax basis – up to $3,400 per year under single coverage and up to $6,750 for family coverage for 2017 (these increase to $3,450 and $6,900, respectively, for 2018). Further, individuals over the age of 55 can make a “catch-up” (additional) contribution annually. Contributions accumulate tax-free, and the money in an HSA rolls over year to year and grows if it is not spent (unlike an FSA). The HSA completely belongs to the individual and, in contrast to an FSA and HRA, can be transferred between employers with no tax implications. Withdrawals from the HSA are tax free for qualified medical, prescription drug, dental, and vision expenses for both in-network and out-of-network providers. A 20% penalty is applied if money is withdrawn from the HSA account before age 65. However, no penalty is applied if money is withdrawn from the HSA after age 65, although the withdrawal will be taxed if it is not used for a qualified medical expense. Individuals enrolled in Medicare (starting at age 65) are ineligible to make HSA contributions, but the penalty-free HSA withdrawals can be used to pay for Medicare premiums tax-free (other than Medigap).
The Trump administrations plans for healthcare policy reform aim to control healthcare costs and empower individuals to consume medical care more efficiently. Reform under the leadership and guidance of Tom Price (Secretary of the Department of Health and Human Services (HHS)) and Seema Verma (Head of the Centers for Medicare and Medicaid Services (CMS)) may lead to several outcomes which would expand the uses and eligible member base of the HSA, directly benefiting HSA account administrators and custodians such as HQY. These potential products of reform include: 1) expanding the definition of an HSA-qualified health plan by lowering the current deductible requirements; 2) expanding the applicability of the HSA by increasing the amount that one can contribute to an HSA (to fully cover deductibles) and by broadening the types of purchases that can be made using HSA funds (e.g., over the counter products); 3) expanding HSA contribution eligibility to Medicare beneficiaries; and 4) expanding the HSA to Medicaid beneficiaries (Seema Verma helped former Indiana Governor and current Vice President Mike Pence to design “Healthy Indiana 2.0,” which requires certain Medicaid beneficiaries to pay into an HSA account with high deductibles).
HSA Market Landscape
According to a report published in August 2017 by Devenir Research (a leader in HSA market research), there are over 21M HSA accounts for total AUM of approximately $42.7 billion. These findings represent year over year increases of 23% and 16% for HSA assets and AUM, respectively. Once the value of an individual’s HSA account reaches a certain threshold, the funds can be invested. An HSA investment account usually offers investment options such as mutual funds, stocks, and bonds. Total industry HSA investment assets reached $5.5 billion in 2016, increasing by 29% from the prior year. HSA investment assets reached an estimated $6.8 billion as of June 30, 2017, an increase of 44% year over year. Devenir expects HSA investment assets to continue to grow in popularity, reaching $9.4 billion in 2018. Devenir projects that HSA assets in investments will represent 16% of total HSA assets in 2017 and 17% in 2018. The percentage of total HSA assets made up by investment assets grows each year, see following figure.
As of April 30, 2017, HSA investment AUM represented 15% of HQY’s total AUM. Growth in HSA investment assets is beneficial to HQY as the company’s custodial and interchange (“card”) revenue streams are driven by growth in AUM. HQY can generate significant additional profitability from existing HSA member’s AUM because recurring custodial revenue is based on the value of its AUM. As account balances increase, HQY benefits from increasing custodial revenue with minimal incremental cost. HQY reports that, among accounts that are open for five or more years, HSA investment accounts have an average balance of five times more than that of the accounts that do not invest. For example, the average cash balance of HSA accounts that do not invest is about $3,685 versus $19,661 for members that use their HSAs as an investment vehicle. HQY is focused on helping its members grow their HSA savings through its regulated investment advisory subsidiary, HealthEquity Advisors. HQY has added automated, proprietary logic to the platform that identifies HSA members who are most likely to benefit from investing. HQY can then engage these members across multiple touch points, including in the member service center, the website, email alerts, and onsite member education. In the short term, the percentage of funds that are invested is still modest, and the percent of members who invest is even more modest. However, these percentages are growing, and HQY will look to accelerate this growth by educating members about the long-term benefits of the HSA.
Of the 19% of Americans under 65 years old who are in an HSA-qualified health plan, HQY reports that only ~75% use an HSA. Total HSA AUM has increased at a +20% CAGR for the last several years, and HQY projects this market could reach $600B – $1T and 50-60M HSA accounts at maturity, representing about $5-6B in market wide revenue. HQY currently estimates that it holds the #2 ranking in HSA accounts with a 13% market share, and the #3 ranking in custodial assets with a 12% market share. As of April 30, 2017, HQY had 2.8M HSAs and $5.2B in AUM, year-over-year growth of 26% and 28%, respectively. Most impressive is the fact that HQY’s current investment AUM ($773M) has grown an outstanding 58% year over year.
The HSA space is dominated by the three market leaders: HQY, OptumBank (part of UnitedHealth Group (UNH)), and Webster Bank (part of Webster Financial Corporation (WBS)). HQY has advantages over UNH and WBS due to its combination of an in-house cloud-based platform (UNH outsources its technology platform) and its pure-play approach and experience with healthcare consumerism (WBS lacks this unique, singular focus as a bank). The remaining market share is highly fragmented, with over 2,000 banks and insurance companies offering HSA services. These smaller competitors once made up a larger portion of the market, but many have chosen to exit the industry due to their underestimating of the demands of HSA holders, healthcare issues (e.g., HIPAA), and the complexities of healthcare consumerism (e.g., employee communication, integration with broader employer benefit offerings). For this reason, these smaller HSA custodians are potential acquisition candidates for the larger players looking for incremental, albeit inorganic, growth.
Founded in 2002 and granted legal status as a non-bank custodian in 2006, HQY has over a decade of experience interacting with HSA account holders and channel partners. Central to the company’s edge is its in-house cloud-based technology platform, which aligns with the new healthcare environment that rewards consumer engagement and fosters an integrated consumer experience. The platform, accessible on desktop and mobile devices, enables consumers to conduct their HSA spending and savings activities over the Internet (with the HealthEquity Visa debit card), including depositing funds, comparing medical options, paying bills, receiving personalized benefit and clinical information, and making investment decisions. This supports the HQY bull case because HSA members (and assets) are drawn towards custodians who can best engage consumers to make smarter healthcare spending and saving decisions. HQY engages with its members through 24/7/365 live support and education. According to company reports, during HQY’s fiscal year 2017, its platform experienced 30.4M logons, and on average, every month 24% of its members signed into the platform. Most of HQY’s competitors only offer simple checking accounts and no consumer engagement or support services. HQY also has over 2,300 distinct integrations with health plans, pharmacy benefit managers, employers, and other benefits provider systems, allowing HQY to seamlessly incorporate personal health information, clinical insight and individually tailored strategies into the consumer experience. HQY is also expanding its network of partners, which currently consists of 87 health plans and 34,000 employers (584 large employers). This wide network allows HQY to serve its current consumer base of 4.7M, with the potential of reaching one-third of the under age 65 privately insured population (according to the 2017 10-K). The HQY platform is fully configurable, with the flexibility to create a unique solution for each Network Partner. HQY currently has over 1,300 unique partners configurations in use. For example, HQY can offer employers customizable dashboards to give the employer visibility to HSA balances, employee logons, first time logons, page views, and other data that HR and finance administrators would likely find valuable. The following figure indicates some of the unique features offered by the company’s mobile app.
HQY has also created many innovations to its platform to enhance their consumers’ engagement with their healthcare spending. For example, HSA Store helps members understand what expenses are currently eligible for HSA funds and what expenses are not. This helps members understand how they can manage their healthcare costs through current HSA regulations. Further, HQY’s Balance Booster makes HSA funds available before they are contributed to the account. This allows members to pay for qualified expenses with tax-free money before the HSA balance has time to grow, eliminating any concern over not having enough saved in the HSA for immediate costs. Perhaps most important, is HQY’s regulated investment advisory subsidiary, HealthEquity Advisors (see figure below). This tool can be accessed through the member portal, allowing users to choose between two service levels (auto-pilot and GPS) to receive investment advice and continuing oversight. The auto-pilot service level manages an individual’s money based on their personal risk profile, while the GPS service level gives the user an option to manage their funds on their own while constantly receiving the advice of an expert. HQY also offers a “self-driven” option which grants the consumer full control of their HSA without the benefit of any personalized guidance offered with the Advisor tool. However, a member can only begin to invest HSA assets in after reaching a certain investment threshold (typically $2,000). HealthEquity offers the Investor Choice fund lineup of low cost mutual funds which provides flexibility for members to reflect their investment philosophies and strategies. The fund has a monthly investment administration fee and a mutual fund expense ratio, but there are no trading costs, commissions or fund minimums. HQY leverages its Advisor subsidiary and investment fund options to educate members on the benefits of investing, expecting that these members will subsequently invest their assets with HQY.
For the fiscal year ending 1/31/18 (FY2018), I forecast revenue of ~$225M, a ~26% annual increase, and I believe annual sales growth greater than 20% is achievable for the foreseeable future. HQY’s revenue is reported as three separate components: 1) service; 2) custodial; and 3) interchange. These revenue channels are recurring in nature, providing strong visibility into HQY’s future business. Each of the three revenue categories is directly driven by the number of HSA members that HQY adds, and the ability of these members to increase their HSA’s AUM and their use of HSA funds for healthcare spending (typically via the HealthEquity Visa debit card). I forecast year-over-year growth in HSA members and AUM of ~40% and ~28%, respectively, in fiscal year 2018 (to 3.3M members and $6.4B in AUM; $987M of which in investments).
Service revenue: I model service revenue growing ~16% in FY2018 (40% of total revenue) from an increase in HSA members, despite declining ~5% annually on a per member basis. HQY generates service revenue by providing monthly account services on its platform, primarily through multi-year contracts with Network Partners that are usually three to five years in duration. The service fees are generally based on a fixed tiered structure for the length of the agreement with the Network Partner. The unit economics behind the service revenue are reflected by HQY’s volume-based pricing strategy. HQY incents its partners to bring in more volume, and if the partner is successful the service fee tier will decrease. This explains why service revenue is declining per member and, as a percentage of total revenue, now only 40%.
Custodial revenue: I believe custodial revenue will grow 39% in FY2018 (~37% of total revenue), with gross margins of ~84%, driven by increasing account balances and elevated investment activity by HQY HSA members. HQY’s custodial revenue is generated based off the interest rate spread on its custodial assets (cash AUM). HQY’s current annualized interest rate yield on custodial cash assets is approximately 1.72%, and it pays its members roughly 30 bps annually, implying a spread of around 140 bps. As a result, HQY will benefit in a rising interest rate environment due to widening long-short spreads. As the figure below indicates, HSA account balances increase substantially with age. This is especially true if the member is investing, which can be done if the account cash balance is above a certain threshold. For HQY HSAs open for five or more years, the average cash balance of HQY members who do invest is $5,444, and the average investment balance of these accounts is $14,217. The total cash investment balance of $19,661 trumps the average cash balance of a +5-year old HSA cash balance of a member who does not invest ($3,685). HQY can generate significant additional profitability from these growing accounts with minimal incremental cost, as the gross margins of an account increase with age. According to HQY, a six-year old account can have a gross margin 1,200 bps higher than a one-year old account (see figure below). As accounts age and members invest their HSA funds, the share of total revenue made up by custodial revenue will continue to grow. The company cites that its retention rate is over 95% and that 98% of its HSA members have yet to invest.
Interchange revenue: I forecast interchange revenue to grow ~26% in FY2018 (~23% of total revenue) and ~3% annually on a per member basis, as members continue to spend using the HQY debit card. Interchange revenue (formerly known as “card” revenue) is composed of transaction fees from merchants (the card-issuing bank and the card processor). HQY receives a small transaction fee from the merchant each time the member spends money out of the HSA using the debit card to make a qualified purchase. The HQY platform enables the use of debit cards and electronic payments because of the integrated claims the company receives for most health plans.
As the revenue mix (see figure above) continues to shift in favor of custodial revenue (primarily due to increasing account balances through investing) and away from service revenue, gross margins will increase as the higher margin custodial segment will account for a larger piece of the total revenue pie. I believe that total gross margins can well exceed 60% in the near/mid-term due to these beneficial revenue mix dynamics. Incremental upside will stem from growing economies of scale and interest rate expansion. Furthermore, as investment cash AUM increases, other metrics of profitability, such as EBITDA and earnings, will follow. For FY2018, I model adjusted EBITDA of ~$80M and adj. EPS of $0.70, year-over-year increases of 19% and 27%, respectively.
HQY reports its results for the quarter ending 7/31/17 (2Q18) after market close on Tuesday, September 5, 2017. I expect total revenue of $55.4M (year-over-year growth of ~25%). I see GAAP EPS of $0.14 and adjusted (non-GAAP) EPS of $0.17. I project adj. EBITDA of ~$21.5M (~10% y/y growth).
With respect to HSA sales-specific metrics, I forecast ~2.9 members as of 7/31/17 (24% y/y growth) and ~78.5K members with investments (49% y/y growth). I also project approximately $5.4B in total AUM, consisting of $4.5B in cash AUM (+24% y/y) and ~$813M in investment AUM (y/y growth of 50%). Members and AUM at my forecasted levels will lead to continued growth in revenue, and the steep ramp in investment AUM will continue the trend toward higher custodial revenue and subsequently higher margins.
HQY’s guidance for FY2018, as stated in its June 2017 Investor Presentation, is for revenues of $222-227M vs. my $225M estimate. FY2018 net income expectations are $33-37M vs. my $35M estimate. Adjusted (non-GAAP) EBITDA for FY2018 is expected in a range of $78-83M vs. my $80M estimate. Adjusted net income is forecasted as $38-42M vs. my $43M estimate. Adj. EPS is seen at $0.62-0.67 for FY2018, assuming 62M shares (vs. ~61.4M for the quarter ended 4/30/17), vs. my $0.70 estimate.
I rate HQY as a Buy with a price target of $60 based on my 10-year DCF analysis, implying ~40% upside over the most recent price at last market close. I have used a discount rate of 6.4% (using CAPM) and a terminal growth rate of 3.5%. I assume gross margins of 64%, in addition to operating margins of 37% (consistent with recent company history). I also assume D&A, changes in working capital, and capex will make up 6%, 0.4%, and 6% of revenue, respectively (consistent with historical trends).
I have included Bear/Base/Bull scenarios in my analysis, yielding fair value estimates of $33/$60/$164. My base case assumes HSA members and AUM grow ~5-6% sequentially, on average, while my Bear and Bull scenarios assume sequential growth of ~1% and ~22%, respectively. I have similarly adjusted my cost assumptions for each scenario. My price target of $60 implies ~33.7x my FY2019 adjusted EBITDA estimate ($101.6M) vs. current ~25x, and ~12.4x my FY19 revenue estimate ($276M) vs. current ~9.3x. Although there is no direct trading comparison for HQY, I believe this valuation is appropriate for a company gaining market share due to competitive differentiation and management’s commitment to a high-growth area of healthcare. The political backdrop, although not critical to the base thesis, creates the possibility of accelerated growth for the HSA market in addition to HQY’s ability to scale its platform into other areas of digital health and HCIT, such as telemedicine and population health. Using its cash-rich balance sheet (~195M in cash and zero debt as of April 30, 2017), HQY is capable of using acquisitions to grow its HSA members and assets (such as its partnership with First Interstate BancSystem for all current and future First Interstate HSA clients) and expand into other areas of healthcare (such as integrating 401((k))) services with HSAs through the BenefitGuard acquisition). HQY has historically traded at a premium, and I fully expect to see the valuation expand with more clarity on the future of healthcare policy later in 2017.
Shares of HQY have risen 143% since the company’s IPO in late July 2014. This appreciation is likely due to a favorable stock market and political climate, as well as management’s tendency to incrementally raise guidance and outperform expectations. Further, due to the fact that HQY’s custodial revenue stream is boosted by higher interest rates, HQY shares have likely been aided by the general anticipation of higher interest rates in the near/mid-term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
HealthEquity: Empowering Healthcare Consumers And Building Savings For Tomorrow – HealthEquity (NASDAQ:HQY)