Healthequity, Inc. Q1 FY2020 Earnings Call

Welcome to HealthEquity's First Quarter of Fiscal 2020 Earnings Call. Please note that this event is being recorded. Go ahead Mr. Putnam. Thank you, Jimmy. And good afternoon everyone. Welcome to HealthEquity's first quarter earnings conference call. With me today, we have Jon Kessler, President and CEO; Steve Neeleman, Founder and Vice Chair; Darcy Mott, our Executive Vice President and CFO. Before I turn the call over to Jon, I would like to remind those that are listening, that there is a copy of today's earnings release, an accompanying financial information posted on our Investor Relations website. We also claim safe harbor concerning these forward-looking statements included in today's earnings release and that will be made during this conference call. They include predictions, expectations, estimates, and other information that might be considered forward-looking. Throughout today's discussion we will present some important factors relating to our business which could affect those forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from statements made today. As a result, we caution you against placing undue reliance on these forward-looking statements. We encourage you to review the discussion of these factors and other risks that may affect our future results or the market price of our stock detailed in our Annual Report on Form 10-K filed with the SEC in March 2019, along with any other subsequent periodic reports filed with the SEC. We are not obligating ourselves to revise or update these forward-looking statements in light of new information or future events. With all that out of the way, I'll turn the call over to Mr. Jon Kessler.

Thank you, Richard, and thanks everyone for joining us on this lovely late spring day here in Utah for our first quarter 2020 earnings call. I will speak to Q1 operating results of key performance metrics. Our celebrity spokesperson Darcy Mott will provide a more detailed review of our financial results and update our guidance. He is our CFO as well. And then Steve Neeleman will join us during the Q&A. Looking first to the four key metrics that drive our business. HealthEquity continued the trend of outperformance on year-over-year measures of profitability and custodial assets, on top of robust revenue and HSA member growth. Revenues of $87.1 million were up 25% year-over-year, adjusted EBITDA of $38.9 million was up an even larger 31% year-over-year. HSA members at quarter's end reached $4.1 million, up 17% year-over-year and custodial assets at quarter's end grew to $8.3 billion, up an even larger 21% from a year ago. Custodial, interchange, and service fees all exceeded our expectations. Strong gross margins resulted from a team effort to finish the annual busy season as well as it began in Q4. Adjusted EBITDA margins expanded by more than 230 basis points year-over-year to 45% and all of that occurred notwithstanding the ramping up of the investment program that Steve detailed on our last call. The sales team also got off to a strong start. HealthEquity opened 89,000 new HSAs in the quarter. Custodial assets increased by $223 million, or more than three times the growth seen in the comparable period a year ago. That was the result of increased contributions as well as market gains. Invested assets grew 42% compared to last year. The number of HSA members investing was up 32%. Although there was no portfolio acquisition activity in Q1, the pipeline of smaller portfolio acquisitions regained some health with the softening of the macro interest rate environment and we hope to have good results over the rest of the year. HealthEquity continues to substantially outpace the market, our largest competitors, and all of this adds up to a terrific start to FY '20. Our focus on partnership, the proprietary technology that enables it, and our Purple service culture are what makes HealthEquity unique relative to our largest competitors. Q1 featured several interesting examples of the power of technology-enabled partnership and the Purple service model. The team went live with the first integrated 401(k) HSA clients under our new retirement record keeper partnerships. We saw strong year-over-year renewals and wins among employer clients associated with our health plan partners and we grew custodial margins despite the softer rate environment, thanks in part to the strength of our relationships with a dozen depository partners. The investment and consumer-directed benefits capabilities that Steve has talked about in the past, also saw promising early results during the quarter. HealthEquity grew its FSA HRA business by 4% year-over-year, which we believe is ahead of the market and was essentially all taken from competitors and sold its first COBRA clients in partnership with benefits brokers and advisors seeking a single HSA-centric consumer-directed solution for their clients and members. To achieve our investment goals faster and to go further, HealthEquity also during the quarter proposed to acquire WageWorks, a leading provider of FSA, HRA, COBRA, commuter benefits, and other consumer-directed benefits services to employers. We continue to evaluate this and other alternatives to accelerate our progress in connecting health and wealth. Now let's return to the strong performance during the quarter upon which Darcy is here to shed brighter light.

Thanks, Jon. I will discuss our results on both a GAAP and a non-GAAP basis. A reconciliation of non-GAAP results that we discuss here to the nearest GAAP measurement is provided in the press release that was published earlier today. I will first review our first quarter financial results for fiscal 2020 and then I'll provide an update to our guidance for the full fiscal 2020. Revenue for the first quarter grew 25% year-over-year to $87.1 million. Breaking down the revenue into our three categories, we continue to see growth in each of service, custodial, and interchange revenue during the quarter. Service revenue grew 8% year-over-year to $26.8 million in the first quarter. Consistent with the strategy we have outlined over the last five years, service revenue as a percent of total revenue declined to 31% in the quarter down from 36% of total revenue in the first quarter last year. As custodial revenue has become more predominant, service revenue growth was attributable to a 17% year-over-year increase in average HSAs during the quarter, partially offset by an 8% decrease in service revenue per average HSA. Remember, HSA service fees are paid primarily by employers on behalf of their employees, and by bringing these down over time, we deliver more value to our employer and network partners. Custodial revenue was $42 million in the first quarter, representing an increase of 48% year-over-year. The increase was the result of the 21% growth in average custodial assets and a higher annualized interest rate yield on average custodial cash assets of 2.53% during the quarter compared to 2.04% in Q1 last year. Interchange revenue grew 10% in the first quarter to $18.3 million compared to $16.6 million in the first quarter last year. Interchange revenue benefited from the 17% year-over-year increase in average HSAs in the quarter, compared to the first quarter last year, offset by a decrease in spend per average HSA. Gross profit for the first quarter was $57.8 million compared to $44 million in the prior year, increasing the gross margin level to 66% in the quarter from 63% in the first quarter last year. The higher gross margin was the result of the increasing mix to custodial revenue and a higher yield on custodial cash assets. Operating expenses were $30.1 million or 35% of revenue compared to $23.8 million or 34% of revenue in the first quarter last year. Income from operations was $27.7 million in the first quarter, generating an income from operations margin of 32% during the quarter. We expect that as the investments in sales, technology, and development that were discussed in our March fourth quarter conference call continue to ramp up through the year, operating margins will be lower through the rest of fiscal 2020. We generated net income of $41.8 million for the first quarter of fiscal 2020 compared to $22.6 million in the prior year. Our GAAP diluted EPS for the first quarter of fiscal 2020 was $0.65 per share compared to $0.36 for the prior year. Excluding stock compensation net of tax, the tax impact of stock option exercises, and the equity investment adjustment, our non-GAAP net income and net income per share for the first quarter of fiscal 2020 were $26.2 million and $0.41 per share. Our non-GAAP adjusted EBITDA for the quarter increased 31% to $38.9 million compared to $29.6 million in the prior year. Adjusted EBITDA margin in the quarter was 45%. Turning to guidance for fiscal 2020, based on where we ended the first quarter of fiscal 2020, we are raising our revenue guidance for fiscal 2020 to a range between $339 million and $345 million. We expect non-GAAP net income to be between $83 million and $87 million, non-GAAP diluted net income per share between $1.28 and $1.34 per share, and adjusted EBITDA between $135 million and $140 million. The non-GAAP outlook for fiscal 2020 includes a projected statutory income tax rate of approximately 24%.

Thanks to team Purple and our partners for a quarter in which you stayed focused and once again exceeded expectations. I want to close by mentioning that on June 19, we will briefly celebrate five years as a public company by ringing the NASDAQ opening bell, and then we turn our focus forward. We'll host an Investor Day from 10:00 AM to 1:00 PM again also on the 19th at the NASDAQ market site in Times Square. If you would like to join us and have not done so already, please get in touch with Richard through our Investor Relations site. The entire HealthEquity leadership team, Steve, Ted, Darcy, and I all hope to see all of you there. With that let's take some questions.

Our first question comes from Jamie Stockton with Wells Fargo. Your line is now open.

I guess maybe the first one on the yield, because I know there'll be a lot of focus there. Darcy, the yield curve is obviously well inverted right now or at least part of it. Can you talk about as we kind of think about the cash that you're likely to put toward next year? Would you guys come in from a duration standpoint or a maturity standpoint on how long you're putting the cash to work to maybe enhance the yield that you would be getting versus the historical kind of three-year-ish timeframe you've used? And if you did that, do you think you could get the same kind of let's say premium over where a comparable treasury is with a jumbo CD or with the partners not being willing to give you the same level of premium for a shorter duration?

Yes. Good question, Jamie. And we've talked about this before. Our approach to the placement of funds and the duration and the yields has been fairly consistent. We don't actually try to maximize the yield necessarily. What we're trying to do is deliver consistency and predictability and to manage the laddering off of custodial assets. Generally, we've followed this practice of - at the beginning of the year we're generally at about a three-year duration and then it works its way down to closer to two years throughout the year. We don't want to be caught in one year with a whole bunch of expirations and be limited to whatever the rates are at that particular point in time. We have a great deal of confidence that that strategy has worked well for us in the past. It gives us a great deal of predictability, not only for revenues, but also on yields and on duration. We like the laddering effect and it's very easy for us to manage through that.

And maybe just as my follow-up. On the investments that you guys are making this year from a growth standpoint, I think you kind of quantified it as $30 million, half of that capital investments, half of that expenses this year. How does the WageWorks situation impact that? Or has it impacted it at all? Because presumably some of those investments were probably going into solutions that might ultimately end up being duplicative. If you could just talk about that, that would be great.

Yes. Thanks, Jamie. This is Jon. As far as what we've done to date, the offer to acquire WageWorks has not affected either the pace or the nature of our investments at all. And that's by design; we want our teams to be working actively. We are learning a lot from the investments we're making and the activities in the market. So to date, there's been no real impact, and I would not expect it until and unless there were a transaction more definitively. We continue with our investment program.

And our next question comes from Sandy Draper with SunTrust. Your line is now open.

I guess the first question, I'm not sure how much you can answer it. It's around the WageWorks situation. Now there is no maybe specific update, but can you just - are there sort of next steps? Or is it - are you just waiting to hear back? Any type of update as to sort of what the next steps are and at what point do you just - it's an investment and you figure out what to do with the stock? Just that would be helpful.

Well, it's probably useful to just reiterate the steps that have occurred to date. We made our proposal on April 11th. The proposal entered the public domain, and both companies responded quickly to that by issuing confirmatory press releases. We indicated here that prior to April 11, we had built this position. That was one piece, but by no means the only piece of an effort over the course of a number of months to approach our overall strategic objectives. So we'll have to see what happens; I don't have really anything else to update you on in terms of the company's response or potential next steps. I will say that in making the investments that we made, we answered two questions. The first question was did the investment support our strategic objectives, and we concluded that it did. The second question was whether it was a good investment. We carefully assessed that and concluded that it was. So that's where we are.

And I guess maybe just a follow-up and more operational instant here, I think you said you got your first 401(k) joint, wasn't clear that maybe you also did some - I'm sure it's commuter benefits or COBRA. I'm just trying to get the update on what parts of the platform are fully operational, which are sort of coming down the pipe over maybe the next 12 to 18 months, and just get an update in terms of that product strategy. That would be great.

The way we're approaching it is to get to market as quickly as we can and learn. We were very pleased to have not only our first sales with our 401(k) partnerships but actually to be in market with product operating with those partners. Does the product today have every feature that it eventually will? I don't think so, because we will learn what customers really like and what helps them grow savings. By the same token, we also made our first sales of COBRA product, and we are pleased to be in market from both selling and product perspectives. This is going to be a multi-year process, and we think that the way to do that is through a more agile product approach.

I'm in the spirit of my reputation apparently. I'm going to try and load up several questions into my two question allocation.

We loosen the reins just a little bit and here we go.

Why are you referring to Darcy as your celebrity spokesman? I think that's what investors really want to know.

The reason for that is that, as you may know, Darcy is now a sports celebrity, and I'll encourage folks who are not aware of that to watch more ESPN. He's done a fantastic job of representing the company in his sporting endeavors.

In the spirit of that answer, maybe I know you started to answer this question.

I actually think that as I recall, a member of Raymond James leadership joined the PGA Tour. But I don't want to...

Can you circle back, talk about Vanguard, Principal, nationwide? And give us sort of an update on those initiatives?

Yes. We are pleased with this from two perspectives. We're pleased with the sales pipeline and the level of engagement between our teams. We had a great experience a few weeks ago where many of us were together at an event that supports some deep research behind these saving strategies. It was great to see firms working together to help employees grow their savings as quickly as possible.

Thank you for that answer, Jon. And I wanted to follow up just around the HSA members. So I'm looking at the total number increased 17%. That has only increased 13%, and what I was struck by is the sequential change in actives versus a sequential change in HSA members.

Yes, the first quarter is one where we see a lot of different things occurring. We didn't see as many new HSAs come in, but those that did as well as those that remained saw substantial growth in assets, which was reflected in both market growth and contributions. We feel good that we continue to outpace the market.

Maybe I guess while we have you on - in a public forum here, could you talk about your thinking around sort of potential revenue cost synergies from WageWorks?

We have not commented publicly on synergies; it's probably best just to hold off on that until we feel comfortable. We felt in making the proposal there were significant short-term synergies. The objective from our perspective is to grow our HSA market share and help Americans connect health and wealth, not primarily about cost savings.

How comfortable would you be taking that debt ratio up?

First of all, we recognize this is a business that has highly predictable and stable cash flow. If we were to incur debt, it would likely be for assets that have similarly stable and predictable free cash flow. We don’t believe in an ideal debt ratio; it depends on the attractiveness of the investments relative to stable cash flows.

On a per HSA basis that has been occurring regularly. We do see some seasonality associated with spending patterns. We'd like to think that many people are becoming educated about the importance of spending wisely with their HSA, but it's not solely a rate issue. It's a function of individual circumstances.

We heard examples of clients who are controlling their overall spending effectively, which can reduce costs for the company. There are opportunities here for us that where we can have real win-win that also increase our revenue line.

Two questions for me. One on the technology investments. Can you update us on where you are in the cycle and what we should expect to see through the year? And the second one maybe for Steve, just what your thoughts are on Medicare for all?

It's early in the cycle. The investment program is beginning to ramp up, but as our guidance implies, there's a little more ramp to come over the course of the year. Steve, do you want to address Medicare for All?

We have spent time educating both sides of the aisle regarding health savings accounts. Medicare is not what it used to be, and there's significant out-of-pocket spending. Regardless of the plan type, every American should have health savings accounts to manage out-of-pocket spending. We'll discuss this in our Investor Day.

Can you walk us through the differing end markets that you've got to participate in?

Historically, we have relied on our network partners for enterprise customers. What’s changed is an increase in our footprint with employers and brokers. Our RFP activity reveals that almost half included non-HSA services which reflects our growing presence.

You have some HRA and FSA capabilities, correct? What are the puts and takes when you try to fit your platform?

We added the ability to serve customers who weren’t connected to our health plan partners, which is new capability for us. We will continue to invest in these products as part of our core HSA offering.

Can you talk about how the current selling season is progressing versus last year?

We remain excited about this season. We've announced wins in the COBRA market and partnerships with record keepers. We've started our direct sales function and are pleased with the outcomes.

It's early in the cycle. We're off to a good start similar to last year. Everything we see indicates we have a positive opportunity ahead. We’re trying to execute strong in Q1, Q2, and Q3.

Operating margins will be lower throughout the year as we ramp up the pace of our investments.

Thank you. And I'm showing no further questions in the queue at this time. I'd like to turn the call back over to Jon Kessler for any closing remarks.

Thank you to the team. This is likely the largest amount by which we have ever raised revenue guidance in a quarter. We express increasing optimism with each passing quarter and feel very optimistic about where we are as a business. The credit truly goes to the team and the work they have accomplished.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude your program and you may all disconnect. Everyone have a great day.