I am recommending a long position in the common stock of Higher One Holdings (ONE).

Investment Highlights

Extremely predictable business—if Higher One were to fire all its sales people and never again sign up another new school, assuming they replicate last year’s retention ratio of 100%, revenues could still grow 37% from 2011’s $181mm to about $250mm just from growth in OneAccounts at existing schools. Over 95% of Higher One’s 2011 “Account Revenue” (80% of total) was generated from contracts signed in prior years. As a result we feel very confident that ONE will reach a certain level of growth in the coming years.

Small share of large market with a powerful hook to grow share—Higher One provides debit cards with the functionality of a bank account to about 2mm students out of a US student population of about 21mm. They think their addressable market is 17-18mm students and typically at a school where they have had a presence for 3-4 years they get 67-70% of the students using their cards. This represents an opportunity 6x their current business. Higher One’s leading product, OneDisburse, saves schools money and headaches, and provides access to the school’s students for Higher One’s debit cards, creating a favorable access point that competitors don’t have. ONE’s retention rate for schools using their services has been 98%+ since 2003.

High return on capital, high free cash flow production, and a debt-free balance sheet—ONE’s ROIC the last 3 years was 97%, 47%, and 31%. ROIC should be at least 30% for the foreseeable future. Normalized FCF excluding one-time CapEx should be $65-70mm in 2012, or 25-30% of revenues. The company has no debt and $51mm of cash and marketable securities on its balance sheet.

All-time low valuation—since its IPO on 6/16/10 ONE has traded at a median LTM GAAP P/E of 33x. Its low was reached on 2/29/12 at 27x. Currently it is trading at 28x LTM GAAP P/E and 18x the mid-point of 2012 guidance. This is fairly cheap for a company whose revenue is expected to grow at least 20% in 2012 and GAAP EPS at least 50% (non-GAAP EPS at least 20%), and sustainable 20%+ top line growth for years to come.

Company History

Higher One was founded in 2000 by three Yale undergraduates. Normally this would disqualify the company for investment purposes but we’ll make an exception in this case due to the high quality of the business.

With four rounds of VC money from 2000 through 2004 they raised about $38mm from Club Circle, North Hill, and Hanseatic; Lightyear Capital then essentially bought out some existing shareholders in 2008 at $4.58/share.

Lightyear still owns 14mm shares / 25% (current board member), Club Circle 3.4mm / 6%, North Hill is out, Hanseatic 2mm / 3.6% (current board member).

Higher One brought in an outside CEO, Dean Hatton, in early 2002—on January 12, 2012 the company announced his retirement which will occur on or before June 30, 2012. He will remain a member of the board. One of the 3 founders, Mark Volchek (34), who has been CFO and Chairman, will become CEO and step down from the Chairmanship. Of the three founders, two are still involved in the company, Volchek the incipient CEO, and Miles Lasater, COO. Both are on the board of directors.

Higher One went public at $12/share on 6/16/10. ONE sold 3.6mm primary shares for net proceeds of $37.8mm, and selling stockholders sold 6.8mm shares.

Business Description

Higher One sells its OneDisburse (OD) product to schools to get its foot in the door to enable it to sell debit cards linked to virtual bank accounts to students. About 50% of total company revenues are derived from non-profit 2-year community colleges and the students at those schools, and less than 5% of sales are from profit universities. The remaining 45% or so come from 4-year colleges and universities like the University of Louisville and the University of Hartford.

Higher One has four revenue segments:

Institution Revenue, 9% of 2011 total revenues

Higher One charges school clients for services in which money is being passed from the government via the school to the student in the form of a refund (OneDisburse) or from the student/parent to the school (CashNet): (i) an annual subscription fee based on the size of their student population; (ii) a per-transaction fee; or (iii) a combination of both. For certain payment transaction products, they also charge an implementation fee, which is deferred and recognized over the estimated client relationship period, which they currently estimate to be five years. OneDisburse is Higher One’s leading product that allows schools to outsource the refund disbursement process, and with it the burdens of regulatory compliance and data security. It saves schools money and the headaches of dealing with IT, regulatory, and data security functions that they would rather not have. OD is used at over 500 campuses with a total of 4.2mm students (what they call Signed School Enrollments, or SSEs).

Account Revenue, 79% of 2011 total revenues

OneAccount (OA) is Higher One’s debit card with the functionality of a bank account. There are 2mm active cards, defined as a card with a non-zero balance. As a percentage of SSEs at schools that use OD, the number of cards is 48%, essentially flat since 3Q10. Account Revenues are generated in two ways: 1) ONE is paid interchange when students use the Higher One issued prepaid Mastercard to buy goods and services. ONE partners with two banks, Urban Trust and Wright Express, to provide the accounts for students. ONE receives the interchange and in exchange the banks earn the net interest margin on account deposits. These banks have less than $10 billion in assets and as a result ONE earns interchange fees are exempted from the Durbin amendment cap. Last August ONE announced that its sole bank partner at the time, The Bancorp Bank, was terminating its agreement with the company on or before May 4, 2012. The stock fell from $19 to $16 and there was an overhang as ONE searched for a new bank partner. Investors worried that they would not be able to find another partner or if they did that the terms of the partnership would be significantly worse. Specifically, investors worried that ONE would have to share the interchange fees with the bank partner and lose all the float revenue—a fee charged to the banks on the average account balances (ONE calls this a “processing fee” and includes it in the Other Revenues segment). On 12/29/11 ONE announced a new partnership with the Urban Trust Bank (a $600mm Florida-based privately owned bank), and on 1/12/12 they announced another partnership with Wright Express Financial Services (a $1.5B Utah-based wholly owned subsidiary of WXS). The terms are better than investors expected in that ONE will continue to collect all interchange and some float revenues. They had to give up some of the float revenue earned in the past but with interest rates low for the foreseeable future this was a small price to pay. Most importantly they now have two bank partners locked in for the next five years (banks can terminate the agreement with 270 days written notice), which lowers the risk should either one fail or terminate the contract.

2) ONE earns account fees from non-Higher One ATM fees, non-sufficient funds fees, other banking services fees and convenience fees. Higher One generally has at least one ATM at each campus it serves. In 2011 OA revenue was about $78 / average account, down from about $85 in 2010 and $88 in 2009 due to the implementation of Regulation E in July 2010. Reg E limits the ability of financial institutions to assess an overdraft fee for paying ATM and one-time debit card transactions that overdraw a consumer’s account unless the consumer opts in to the institution’s payment of overdrafts for these services. ONE has not offered the opt in feature to OA holders for ATM or one-time debit card transactions and as a result their OA revenues / account declined. Historically this metric has been stable; I believe the implementation of Reg E has caused a one-time step-down in revenue per account. Currently ONE has introduced two new types of OneAccounts that should increase revenue per account over time. In aggregate the cost of a OneAccount is still very low to the student (“less than $50 on average”—the other ~$30 is from interchange and is not paid by the student) compared to a bank account (~$300), or even some other general purpose reloadable prepaid debit cards (~$100-200). Right now, with still low penetration of schools and OAs as a percentage of OD SSE, the biggest drivers of Account Revenue growth are 1) adding more schools and increasing SSE, and 2) adding more OAs at existing schools. The key number here is OAs per One Disburse SSE, which was 48% in 4Q11. This has been relatively stable since 3Q10 but the endpoint is to get the cards in as close to 100% of students’ hands as possible. Typically once Higher One has been providing cards to students at a particular campus for 3-4 years penetration is 67-70%.

Payment transaction Revenue, 10% of 2011 total revenues

ONE generates payment transaction revenue through convenience fees charged to students, parents or other payers who make online payments to schools through the SmartPay feature of ONE’s ePayment product (CashNet) using a credit or debit card. As this fee is assessed on a per transaction basis, growth in payment transaction revenue is primarily influenced by transaction volumes. ONE acquired the ePayment product when they purchased IDC (CashNet) in November 2009 for $27.5mm. At least one module (there are six in total) is currently being used on 350 campuses with a total of 2.6mm students.

At the time of the CashNet acquisition, there was a 6% overlap of students enrolled at institutions that used both Higher One and CashNet products and services. Overlap today is 13%. Higher One thinks they can get this overlap to at least 50% eventually.

Other Revenue, 2% of 2011 total revenues

Other revenue consists of two main components: a marketing incentive fee paid by MasterCard based on transaction volumes and new OneCard issuances, and processing fees paid by bank partners based on the total amount of deposits held in OneAccounts and prevailing interest rates.

Competition

Sellside analysts always ask about competition on earnings calls but ONE doesn’t seem to think very highly of their competitors. Either the company is right and competition is not a very significant factor in Higher One’s growth, or competition is more of a factor than they want us to believe and they downplay this aspect intentionally. A third possibility is that competition is more intense and significant to their future than they are aware; this isn’t as plausible an explanation in my opinion. Higher One has averaged greater than 98% retention with its school clients and had 100% retention in 2011. This is a pretty clear testament to customer satisfaction or at least switching costs. The sales process with schools often takes many months or even years, and once they convince a school CFO to use OneDisburse or CashNet they then have the ability to market their OneCards to students, which are well integrated with their services to the schools.

With interest rates low and with the Durbin amendment reducing interchange for banks with more than $10 billion in assets, regional banks such as US Bancorp and Wells Fargo (which are both listed in the 10-K as competitors) will make less money on student bank accounts. As a result competition from banks should be less than it has been in recent years. Higher One also lists Sallie Mae, Nelnet, PNC Financial Services Group, and TouchNet Information Systems, as competitors as they provide competitive payment software, products and services. I don’t have much to say about these competitors other than ONE has rarely had a competitive loss although there doesn’t seem to be anything about their products that cannot be emulated or copied. I think the key to their business model is that they become the school’s partner with their cost- and time-saving products—and this relationship ideally lasts forever—and then as a result they become the preferred financial partner for students at that school. For competitors wishing to market bank accounts/debit cards to students at an existing Higher One school it is not an impenetrable barrier to entry, but it is a difficult proposition when the students have an existing solution well integrated with the school’s payment processes. And for a competitor selling the processing products to the schools there are certainly switching costs and a lot of inertia that prevent schools from switching. For what it is worth, Higher One defines their competitive advantages in a slide in their recent presentation as: 1) Full suite of products, 2) Proprietary technology, 3) Convenient solutions for students, 4) Legal and regulatory knowledge, 5) Referrals from long standing clients.

Opportunity / How High is Up?

Right now there are about 21mm college students in the US. OD is deployed in schools with about 4.2mm students, or about 20%. Generally the company wins business from a “pen and paper” solution, like OpenTable, rather than from a competitor. The company estimates that 80-85% of those 21mm students attend schools that could use OD some day. OA penetration is currently at 48%. Once OAs have been available to a school for 3-4 years penetration reaches 67-70% at that school. Assume nominal pricing power for all fees including OA Revenues per OA. Operating leverage is a little uncertain as incremental EBIT margin over the last two years has been about 29%--equal to the 2011 operating margin. But as the company gets closer to fully penetrated the incremental margin should be substantially higher as the company will not need to spend additional G&A or S&M as they won’t be adding new schools nearly as rapidly as they are now. My estimate for the incremental margin in 2012 is 66%. So it is difficult to estimate the long-term margin potential but I believe it could approach 50%. In that scenario EPS could eventually grow from around $0.90 today to over $6.

Management

2012 Guidance

Revenue $215-230mm, +19-27%

GAAP EPS $0.80-0.90, +48-67%

Non-GAAP EPS $0.90-1.00, +19-32%

Management has a history of conservatism with their guidance:

2010

Initial Guidance Revenue $131-135mm, Actual result $145mm

Initial Guidance GAAP EPS $0.20-0.32, Actual result $0.44

Initial Guidance Non-GAAP EPS $0.48-0.52, Actual result $0.60

2011

Initial Guidance Revenue $172-180mm, Actual result $186mm (excluding $4.7mm reversal of certain insufficient funds fees charged over multiple years)

Initial Guidance GAAP EPS $0.39-0.56, Actual result $0.54

Initial Guidance Non-GAAP EPS $0.67-0.73, Actual result $0.76

Incoming CEO Volchek, COO Lasater, and outgoing CEO Hatton collectively own about 4mm shares, or about 7% of the company. They have each entered into 10b5-1 selling programs whereby they have sold some shares over the past year. Volchek has sold 150k and still owns 1.9mm; Lasater has sold 370k and owns 1.68mm; and Hatton has sold 733k and owns 365k. Two weeks ago they terminated their plans and replaced them with new ones where the limit price floors were set higher. I am not sure if that is a good sign but I don’t think it is a bad sign, and given their still large ownership stakes I conclude that they are still committed to the company and believe in its long-term prospects.

On 8/23/11 management announced a stock repurchase agreement for up to $40mm of shares, expiring on 9/7/12. Through 12/31/11 the company has bought $16.2mm of stock.

Why is the stock mispriced?

4^th quarter negative revenue surprise and 2012 revenue guidance reduced—ONE missed 4Q11 revenue expectations announced 2/7/12 by $5mm ($46.5mm vs. $51.4mm expected) despite reiterating guidance on 11/5/11 and cut 2012 revenue guidance from $227-237mm to $215-230mm (-4% at the midpoint). Higher One prides itself on its extremely predictable performance and this surprise has sown doubt in investors’ minds regarding that predictability. Furthermore, ONE couldn’t explain the reason for the revenue shortfall with much certainty. They think it is due to lower enrollments in their schools but have no direct evidence to verify this thesis. The thought process seems to be to eliminate other explanations: 1) refund size per OA was stable, down 1%, so it doesn’t appear that refunds per student are declining, 2) for students who received refunds behavior didn’t change so revenue per refund-receiving-OA did not decline, 3) the adoption rate, that is the rate at which students open new OneAccounts, did not change. After eliminating those explanations ONE determined that the most likely explanation is that total enrollment growth at ONE schools in aggregate declined, which led to fewer refunds than expected, which lowered both Institution revenues and more importantly Account revenues (80% of total revenue). Total revenues still grew 17% YoY in 4Q and 25% for the year but this follows 87% and 76% top line growth in the previous two years so it represents a big slowdown. Still, if the company’s explanation is the right one, the current price of around $15/share presents a great opportunity to buy a high quality company early in its lifecycle with still a small market share and therefore a long runway ahead of it, at a very reasonable 16-17x GAAP P/E.

Here is why this revenue miss presents an opportunity rather than a warning sign of further slowing to come: I don’t believe enrollment growth in higher education is in secular decline. If our population continues to grow at a similar pace, and more and more young people choose some kind of higher education whether it is community college, for profit, technical schools, or four year liberal arts, enrollment growth will continue at a similar pace as it has for the past 10 years (3.3% CAGR). But even if the pace does decline a little, the opportunity for ONE to grow its presence from 20% to 80-85% outweighs a minor decrease in enrollment growth rate. More concerning would be if one of the other three explanations had been the cause of the shortfall. If the size of the refund per OA were to decline, both OD revenue and revenue per OA would decline. And if OA behavior were to change, essentially meaning students use the card less, this would be very concerning. Finally, if the adoption rate for OAs were to decline that would probably be the most concerning as the investment thesis relies on OA/SSE increasing from 48% last quarter to 67-70% at maturity. As none of these three explanations is borne out by the evidence from 4Q11, the investment thesis appears to be intact.

Strong top line growth and Free cash flow generation

Growth metrics 2009/2010/2011/2012e

Revenue 76% / 87% / 25% / 27%

EBIT 123% / 83% / 26% / 64%

By the end of 1Q12 ONE will have spent about $47mm buying and renovating its new headquarters in New Haven, CT. Once that spending is completed CapEx will return to a more normal level of about $8mm per year. Backing out the one-time building CapEx, normalized FCF was about $36mm and I forecast $65-70mm in 2012, or a 7-7.5% FCF yield on today’s market cap. Generally I would not approve of a company spending more than 1 year’s FCF on its headquarters, but I think Higher One rightly felt that in order to compete with Silicon Valley and NYC startups for talent they had to create a work environment that is a selling point to counteract the downside of being in New Haven. And when factoring in $36mm of rebates, subsidies and credits, it will be cheaper to buy than to rent a comparable space.

Valuation

Return forecasts and estimated probabilities:

Base case: ONE eventually reaches 65% market share, 22% penetration with CashNet, nominal pricing power and low 40s% EBIT margin. In 10 years EPS will reach about $3.50 and the stock will hit $60 for a 10-year CAGR of almost 15%. Worth $21 today, p=50%.

Upside: ONE reaches 80% penetration with OD, 22% penetration with CashNet, nominal pricing power and eventually reaches 50% EBIT margins. In 10 years EPS will be about $6. At about $100 the stock would have a 10-year CAGR of 21%. Worth $36 today, p=30%.

Downside: ONE reaches 50% penetration with OD, 17% penetration with CashNet, but has little pricing power and EBIT margin reaches only 34% (3% lower than my forecast for 2012). In 10 years EPS is only about $1.50 which requires a price of $9, or about 10x this year’s GAAP EPS in order to give investors a return to match the cost of capital, p=20%.

Expected Value = $23, +50%

Base / Downside: 1 / 1

Upside / Downside: 2.3 / 1

Risks

• Change in the regulatory environment—if the Durbin amendment were abolished this could make offering debit cards to students more attractive for large banks, which would increase competition. Alternatively if the threshold for exemption from Durbin were lowered far below $10 billion this could lower ONE’s interchange revenues and profitability if they were not able to find bank partners with total assets below the lower threshold. In addition new regulation could further limit fees on out of network ATM usage and other account fees which would be extremely damaging to ONE’s core revenue stream.
• Competitors fight more fiercely for business—this could require ONE to lower prices and prevent margin expansion over time.
• US government decides to disburse funds directly to students rather than through schools—this seems remote as the administrative burden for the government would be immense, however it would be extremely detrimental to ONE’s business model.
• US government reduces the number of students eligible for federal loans—this is possible but unlikely as it would be very unpopular; depending on the decrease it could have a minimal to medium-sized impact on ONE.

• Execution over the next couple of quarters—if ONE meets or beats its 1Q12 guidance and appears to be on track to reach 2012 full year guidance the stock should move back up to $18 or so.
• ONE is a private equity takeout candidate—with a normalized FCF yield of about 7.5%, no debt, and expected operating profit growth of at least 30% for years to come this would seem to be an obvious private equity candidate . Current VC holders who own about 35% of the company will need to exit at some point but most likely don’t want to sell at the current price and realize they can’t sell big stakes without better liquidity and a sustainable upswing in the share price without it appearing to be a distressed sale. Distribution to LPs is potentially another option but a full sale to a private equity sponsor would be a cleaner exit.