August 11, 2017 - 3:43pm EST by
2017 2018
Price: 46.14 EPS 0.66 0.85
Shares Out. (in M): 60 P/E 70.2 54.2
Market Cap (in $M): 2,767 P/FCF 0 0
Net Debt (in $M): -196 EBIT 52 70
TEV ($): 2,572 TEV/EBIT 50.0 36.6
Borrow Cost: Available 0-15% cost

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HealthEquity, Inc. (NasdaqGS:HQY, “HealthEquity” or the “Company”) is a short. The Company is one of the largest custodians of health savings accounts (“HSAs”) and is the largest HSA custodian that is not part of a bank or insurance company. An HSA is a tax-advantaged medical savings account available to taxpayers in the U.S. who are enrolled in a high-deductible health plan (“HDHP”). The funds contributed to an account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (“FSA”), HSA funds roll over and accumulate year to year if they are not spent (see ka8104’s discussion of the benefits of HSAs over FSAs in his write-up of WageWorks).

HSAs are owned by the individual, which distinguishes them from Health Reimbursement Arrangements (“HRAs”) that are an alternate tax-deductible source of funds paired with either standard health plans or HDHPs. Unlike a 401k plan, each family can have just one HSA account. HSAs have been around since 2004. They can be used to pay for qualified medical expenses at any time without having to pay federal taxes or penalty. Withdrawals can occur for non-medical expenses but are penalized if taken before retirement age. The annual contribution limit is currently $3,400 for individuals and $6,750 for families.

Morningstar recently put out a very good report on the HSA industry titled “2017 Health Savings Account Landscape” which we will refer to several times in our write-up. Their report is the most detailed analysis we have seen to date on the various players in the HSA space.

HealthEquity currently has 2.8 million HSA members, or approximately 13% market share in the fast growing HSA space, which currently has approximately 20-22 million HSA accounts.  The industry has grown rapidly over the last several years as more people switch to high deductible health plans, some of which are eligible for HSAs. HQY’s HSA member counts have grown from 968,000 in 2013 to 1.4 million in 2014, 2.1 million in 2015, and 2.8 million today (some of the growth has been due to acquisitions). Management estimates market maturity will result in 50-60 million HSA accounts, which at 13% market share would imply HQY would be the custodian for 6.5-7.8 million HSA accounts.  HQY’s custodial assets have grown from $1.6 billion in 2013 to $2.4 billion in 2014, $3.7 billion in 2015, and $5.2 billion today. Total industry custodial assets were $37.0 billion at the end of 2016 and are expected to grow to $44.5 billion at the end of 2017 and $53.2 billion at the end of 2018 per Devenir. HQY’s average account balance is ~$1,850, which bulls expect to significantly grow over time, which we disagree with and which is central to our short thesis.

The bull thesis is built around the thinking that despite HQY being very expensive (the Company currently trades at 9x forward sales, 25x forward EBITDA and 54x forward earnings), the share price is justified given the attractive growth prospects of the broader HSA market and HQY’s market leading position within it. While we don’t disagree that the number of HSA accounts will continue to grow (we agree with analysts that member count will likely double over the next five years to 40 million accounts), our variant thesis comes from the fact that we don’t believe the average account balance will climb to nearly as high levels as the market predicts. HQY’s sales and earnings are tied to both (a) number of HSA accounts and (b) average account balance. Furthermore, we believe analysts are focusing too much on the demand side of the equation, and not enough on the supply side. We believe the barriers to entry in this industry are fairly modest and as new entrants come into the market, pressure on HQY’s fees charged to its account holders will increase, hurting HQY’s profitability.

We believe HQY’s fair value is $20.00 per share, representing 56% downside from the current price of $46.14.

Below is a summary of HQY’s three segments (a) service, (b) custodial and (c) interchange, along with our forecast for each segment’s sales and gross profits over the next five years.

Service Segment

HQY earns service revenue from annual account maintenance fees charged to the holders of its HSA accounts. Fees are generally based on a fixed tiered structure and are paid on a monthly basis. In 2016 HQY charged an average account fee of $33. This is down 14% from prior year of $38.5, which itself was down 8% from prior year of $42. Account fees are ongoing and are not one-time opening fees. Management expects fees per account to decline 6-8% per year going forward as larger account balances get a pricing discount. We believe on top of the 6-8% decline there will be further declines due to fee pressure from increasing competition, and we have assumed in our model that average service revenue per member declines 10% each year over the next five years. As demonstrated in the Morningstar report, HQY charges among the highest account maintenance fees, with several competitors not charging any account maintenance fees. We have assumed member counts grow 18% in 2017, 16% in 2018, 14% in 2019, 12% in 2020, and 10% in 2021. This results in service revenue growing from $77 million in 2016 to $98 million in 2021.

The primary cost of revenue for this segment is servicing member accounts. Service COGS per account has declined consistently from $27.4 in 2014 to $24.6 in 2015 to $22.2 in 2016. We believe COGS per account will decline 3% per year over the next five years, resulting in service COGS increasing from $52 million in 2016 to $87 million in 2021.

As a result, we expect gross profit for this segment to decline from $25 million in 2016 (33% gross margin) to $11 million in 2021 (11% gross margin). In comparison, analysts have margins for this segment increasing over the next several years.

Custodial Segment

This is what we would call the crown jewel segment of the business given it’s the highest margin segment. HQY earns custodial revenue from its custodial assets deposited with FDIC-insured custodial bank partners. As a non-bank custodian, HQY deposits its cash custodial assets with its various bank partners pursuant to contracts that (i) have terms that range from three to five years, (ii) provide for a fixed or variable interest rate payable on the average daily cash balances deposited with the relevant bank partner, and (iii) have minimum and maximum required deposit balances. The Company earns custodial revenue on its cash custodial assets that is based on the interest rates offered to HQY by these bank partners. Furthermore, once a member’s HSA cash balance reaches a certain threshold, the member is able to invest his or her HSA assets in mutual funds through HQY’s custodial investment partner, allowing the Company to receive a recordkeeping fee related to such investment custodial assets (however, currently the majority of HQY’s accounts have no investment assets). In the most recent quarter, HQY generated an average annual yield on its custodial assets of 1.72%, compared to 1.55% the prior year.

Custodial costs primarily consist of interest HQY pays to its members on a tiered basis (larger account balances receive greater interest).  In the most recent quarter, HQY paid its members an average annual interest rate of 0.26%, compared to 0.27% a year ago.

HQY’s spread is calculated by subtracting 0.26% from 1.72%, resulting in 1.46%, or a very high 85% gross margin. In this segment the Company generated $60 million in revenue last year and $50 million of gross profit. Assuming HQY earns an average yield of 2.35% in 2021 and pays account holders 0.34% in interest,  HQY will generate $221 million in custodial revenue and $189 million in custodial gross profit in 2021, up significantly from today.

The Morningstar report has a very telling Exhibit 10, which simulates how a $2,000 initial investment in an HSA account with the various providers would change over the course of a year, assuming no further investment. Taking interest income earned on the $2,000 and deducting the annual maintenance fee resulted in an ending balance that was less than the initial $2,000 for the majority of providers, given interest rates are currently very low and the annual maintenance fees charged are generally quite high. Out of the 10 providers, Health Equity ranked second bottom (its $2,000 account balance decreased to $1,955). In our view, this is indicative that for HealthEquity to be more competitive, it will either have to lower its account maintenance fees or offer account holders greater interest, both of which will hurt the Company’s profitability.

In its summary, the Morningstar report ranks HealthEquity as the third to last HSA provider out of a total of 10 HSA providers with respect to spending plans, implying the majority of competitors offer more attractive plans. That said, we acknowledge Morningstar ranked HealthEquity as having the number one investment plan, but note that the majority of HSA assets are held in cash, not investments, although this could change in the future.

One risk to our short thesis is that interest rates increase faster than we anticipate. To hedge this risk, we would suggest going long a financial name such as BAC which would benefit from rising rates.

Interchange Segment

HQY earns interchange revenue each time one of its members uses one of the Company’s payment cards to make a qualified purchase. HQY earns approximately $18 in interchange revenue per account per year, which has been increasing ~4% over the last two years. We forecast interchange revenue per member to increase to $22 in 2021, resulting in interchange revenue increasing from $42 million last year to $109 million in 2021.

Interchange costs are comprised of costs HQY incurs in connection with processing payment transactions by its members. Interchange COGS per member has been declining and was $4.4 last year. In our model, we forecast this cost declining 2.5% each year to $3.9 in 2021, resulting in interchange COGS increasing from $10 million in 2016 to $20 million in 2021, and gross profit increasing from $31 million in 2016 (75% gross margin) to $89 million (82% gross margin) in 2021.

Three Segments Combined

In our model, for HQY as a whole we forecast $427 million in sales in 2021, up from $178 million in 2016. We forecast gross profit of $289 million in 2021, up from $106 million in 2016, and Adjusted EBITDA of $184 million in 2021 versus $63 million in 2016. The service, custodial and interchange segments accounted for 24%, 47%, and 29% of the Company’s gross profit in 2016, respectively. In our model, we forecast service, custodial and interchange segments to account for 4%, 65%, and 31% of the Company’s gross profit in 2021, respectively.

We expect EPS to increase from $0.44 in 2016 to $1.25 in 2021. Our EPS forecast in 2018 (the latest consensus estimate we have) is about 20% below the street.  Looking forward from 2021, we expect account growth to still be positive but more limited given we think by 2021 the market will have experienced quite a bit of penetration. We believe in 2021, the bull thesis will be less about account growth and more about growth in average assets per account. We disagree with this view for a couple of reasons. It may make sense to take a step back and analyze the 401k market. At its beginnings the 401k market, much like the HSA market today, experienced tremendous growth in member counts and then reached a steady state maturity after which time the growth of accounts increased roughly in line with population growth. However, average assets per account continued to climb as people contributed more and more to their 401ks. It’s important to note that unlike the HSA market, the majority of 401k holders do not withdraw from their 401ks until after they retire. This allows people’s average account balances to dramatically rise over time, which allows 401k custodians to generate greater and greater profits despite the overall number of 401ks no longer growing very fast. In contrast, we believe that the majority of HSA holders will spend their funds on qualified medical expenses each year, and that a greater and greater amount of funds will be spent each year due to high healthcare inflation (currently ~6%). Therefore, we believe average account balances will not grow significantly in the HSA market over time like they have in the 401k market, even if regulations get passed to allow HSA members to contribute more to their accounts each year (few HSA members max out their accounts as it is).


In light of the above analysis, we believe that a more than appropriate P/E multiple to apply to our 2021 EPS estimate of $1.25 is 25x, which we believe is appropriate for a company that, while being high margin and cash generative with no leverage (at the moment), will have more muted growth prospects once the number of HSA accounts approaches maturity. We additionally think 25x is more than a fair multiple for a company that, while having a market leading position, operates in a highly competitive industry with modest barriers to entry and regulatory risk (although for now HSAs have bipartisan support). Therefore, applying our 25x multiple to our 2021 EPS estimate of $1.25 results in a fair value of $31.30 in 2021, or approximately $20.00 discounted back to today, implying 56% downside relative to the current share price of $46.14.

Key risks include (a) M&A risk (HQY is the only pure-play public HSA custodian), which we believe is mitigated by the Company's expensive valuation and (b) rising rates (can be hedged by going long a financial name like BAC).

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Catalysts include future earnings announcements (new member growth, service revenue per account and average account balance will be particularly important to monitor), existing competitors lowering their fees in order to gain share, and additional competition entering the market.

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