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New Moon
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HealthEquity: An Over 20% Grower for Years to Come

A combination of a mini ADP, a mini bank with no credit risk and a mini Visa that has been growing the bottom line for several years

November 21, 2019 | About:

HealthEquity Inc. (NASDAQ:HQY) is a gem. Not only can the company more than triple its highly profitable revenue stream at industry maturity, but it has a terrific business. Think of it as a combination of a mini Automatic Data Processing (NASDAQ:ADP), a mini bank with no credit risk and a mini Visa (NYSE:V). The stock is down 40% from its high, so the valuation has become reasonable. This company has been, and probably will be, growing its bottom line at over 20% for a few years.


What is the biggest problem in the U.S.?

No doubt the cost of health care is at top of the list. Approximately 18% of U.S. gross domestic product is spent in health care versus peer countries at about 10%. Anything that can help reduce the cost without sacrificing the quality of health care is worth investing in. HealthEquity is a company that does just that.

The health care system in the United States is somewhat strange. Doctors, rather than consumers, give orders on what products and services to use. The health care networks, rather than consumers, pay for the products and services. The consumers pay annual health care insurance premiums, but don’t know exactly what they buy. As a result, we see people buying an expensive branded drug when a good generic version of the same drug is available for half the price. They also don’t compare prices between blood work done at a hospital and the same test done at Labcorp. According to a 2017 report, wasteful spending in health care could amount to as much as 35%.

Health savings accounts, or HSAs, attached to a high deductible health plan changes that. When a consumer pays for what he buys out of his HSA account balance, he searches for the best value in the market place, which will help to bring down the overall costs of health care and reduces wasteful spending. The health care networks experience lower cost inflation. The insured and their employers pay lower premiums. According to a 2018 Kaiser Family Foundation survey, HSAs save $1,700 in annual health insurance premiums on average. In addition, consumers can save and accumulate pre-tax money in their HSA accounts. This money will become part of their wealth over time if they are careful with it. No wonder health savings accounts are growing fast.

HealthEquity is the second-largest HSA administrator after UnitedHealth’s (NYSE:UNH) Optum Bank with a 15% market share. The other two major players are Webster Bank’s HSA bank and Fidelity. The major competitors of HealthEquity are health plans, banks, financial services companies and pharmacy benefit managers.

Source: Company presentation.

HealthEquity can more than triple its HSA revenue at industry maturity

The health savings account industry has high and sustainable growth. According to HealthEquity's  management, the industry currently has about 26 million accounts with $60 billion in custodian assets and would grow into maturity to 50 to 60 million accounts with $600 billion to $1 trillion in assets. The most noticeable growth will be from the assets being managed. If HealthEquity kept its 13% market share, it would have over $1 billion in  revenue, three times what it has currently.

Source: Investors’ day presentation, September 2019.

But HealthEquity is not just keeping up with industry growth. It is exceeding it. HSA is unique in that it is the only big standalone company focused on HSAs. Some of them don’t have health care expertise and its smaller competitors are too small to effectively compete. As a result, the company has been taking market share.

Source: investors’ day repsentation, September 2019.

HealthEquity has a terrific business

HealthEquity makes money in three ways. First, it makes money from employers or health care networks for servicing HSA accounts. This business is somewhat like what ADP does (i.e., helping to manage human resources for corporate clients). Second, it earns interest and fees on HSA balances. Currently this is mainly a spread business. HealthEquity pays short-term interest rates on deposits in HSA accounts and invests in longer-term FDIC-insured bank deposits. At the moment, HSA custodian assets have about three years’ maturity earning 2.5%. If the members direct HSA to investments rather than cash, HealthEquity places the money at financial service firms such as Vanguard and makes about a 40 basis point fee. Third, it collects interchange fees when its HSA member uses the debit cards tied to their accounts. You can view HealthEquity as a three-in-one business: a smaller version of ADP, a bank with no credit risk and a mini-version of Visa. All three have sticky, recurring and stable revenue.

HealthEquity is growing rapidly. From 2015 to 2019, the company's revenue increased at a compounded annual growth rate of 34%, along with growth in members and total custodian assets.

This is a great business. In fiscal year 2019, which ended last January, the company’s gross margin was 63%, operating margin was 17% and Ebitda margin was 41%. The return on invested capital was 67%. The company had no debt and was generating very healthy cash flows. These numbers are not only among the best across all industries, but also trending up, showing the significant operating leverage.

HealthEquity's stock is 40% from its high

There are two reasons for the underperformance.

First, the stock is viewed by some as having a high political risk. With some Democratic presidential candidates proposing Medicare for All, some investors think that HSA will be gone if the policy is implemented. 

Another reason for the underperformance could be the acquisition of WageWorks Inc. (NYSE:WAGE). HealthEquity announced its acquisition of WageWorks in April, when it was a $4 billion market cap company spending $2 billion to buy a company with revenue almost double its own. The combined company has a floating debt rate of $1.2 billion and net debt to Ebitda of 4.9 times. This increased uncertainty. In addition, WageWorks had some accounting issues and also lost some accounts.

WageWorks was founded about the same time as HealthEquity. It is a consumer-directed benefit manager managing flexible spending accounts, health care reimbursement accounts, HSAs, commuter benefits and Cobra. It offers a broader range of services than HealthEquity, but is less profitable. This is not surprising as the main source of WageWorks' revenue is lower-margin account service fees. WageWorks services 7.9 million corporate employees, much more than HealthEquity’s 4 million accounts. But it only has 700,000 HSA accounts.

The acquisition makes sense strategically. First, HealthEquity acquires a full suite of CBD services overnight. Second, it provides significant cross-selling opportunities. Third, it doubles HeathEquity’s scale in the business for which scale is the key to profitability.

As the market was paying HealthEquity’s HSA business for about $1,000 per member and WageWorks itself is a scalable and profitable business, the acquisition price of $250 per member does not look unreasonable. If HealthEquity can covert 50% of the non-HSA WageWork members to HSA, it doubles its highly profitable business. In addition, HealthEquity can now gain more clients by offering a more comprehensive suite of CBD services.

Valuation becomes reasonable. Start accumulating at this time of certainty

I estimate that the normalized non-GAAP earnings per share for the combined company is about $1.90 without short-term synergies. On a normalized basis, the non-GAAP earnings are about $2.30 per share with short-term synergier excluding one-time integration costs.

Historically, HealthEquity is a consistent 10 to 15 times enterprise value-sales business.

WageWorks, on the other hand, was significantly de-rated due to the accounting scandal. I don't believe WageWorks reached its full potential since its initial public offering in 2007. It grew through acquisitions, but didn’t really integrate the multiple platforms it gained. The latest acquisition of ADP’s CBD business brought on a dispute with the Office of Personal Management, which caused the accounting issue.

It is not a secret that today’s market is at an all-time high in almost all measures, especially for quality companies with high growth. Without judgement of the “right” enterprise value-sales multiple for the businesses, I assume that the historical valuation of the last four to five years reflect fair valuations of the two companies in relation to the market.

I will now consider three scenarios: without synergy, with short-term synergy and cross-selling success. In the third scenario, I assume 50% of the WageWorks non-HSA members get health savings accounts in the medium term at $50 per account revenue, 30% lower than HealthEquity’s existing members. On the valuation side, I considered three cases. The results are shown in the following table. I think the risk and reward is balanced to the positive.

My advice is to start a small position today and add whenever there is an opportunity and political headlines get worse. This is a long-term investment in a great emerging business with a deep moat and scale advantage.

What keeps me up at night

Political risk is high. The stock can move with news headlines. Ultimately, I believe the political risk will abate. Medicare for seniors has not been working very well. How can we have confidence that Medicare for All will work?

There are uncertainties with the integration of WageWorks, but the risk should be manageable. HealthEquity CEO Jon Kessler is the founder of WageWorks. While he left the company in 2007, he knows the business and its current management very well.

Leverage is high, but the business has strong profitability and growing cash flow. Deleverage should be quick.

Although health savings account deposits are sticky, a spike in short-term interest rates will be negative to HealthEquity’s profitability.

Disclosure: No positions.

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