Description

The Bancorp Inc. (TBBK) is a first mover in the health savings account (HSA) market, which will likely grow from almost nothing currently to $100+ billion by 2010. TBBK could be a ten-bagger in six or seven years if things go right (and maybe up only 100% if they don’t).

This is an idea that I began researching last summer after I personally got my own HSA account with TBBK. Since then, HSAs have obviously become much more prominent in the popular press. It is my belief that the growth of HSAs cannot be underestimated, as they represent a realistic way to solve America’s healthcare problems.

As just one quick example, I will demonstrate why HSAs will become category killers of the health insurance world. My fiancé is a nurse and her pay-stub is itemized. She gets $35 taken out of every monthly paycheck; her employer also spends about $300 in health insurance for her every month. Not including co-pays, $4,000 is being spent every year on her health insurance. She is young and healthy (not to mention good-looking) and probably consumes less than $700 a year in actual healthcare services that the insurance pays for. It will be a no-brainer when her employer gives her the choice of two health benefits options:

A) keep her current compensation/benefits scheme or;
B) have her employer contribute $2,700 to an HSA account in her name (the current annual HSA contribution limit is $2,700 for individuals and $5,450 for families), eliminate the $35 per month she gets cut out of her pay check, and buy her high deductible health insurance which will cost about $700 per year for a $3,000 deductible.

Option B is a winning situation for both parties. Her employer spends $3,500 on her health care benefits ($2,700 + $700) vs. the current $3,600 that it spends under option A. My fiancé benefits in several ways. First, she keeps the $35 per month that is taken out of her paycheck, which translates to roughly $400 a year. Second, she might consume $700 in healthcare in a normal year, leaving $2,000 left over in her HSA account (which is entirely hers and is transportable if she takes a new job). That puts $2,400 in her pocket every year in a normal year. In a disaster year, where she is diagnosed with a serious disease or gets into a major accident, the most she spends is the $3,000 deductible limit, which is only $300 more than what is contributed to her HSA account. But if we add back the $400 that isn’t taken directly out of her monthly paycheck, she still makes $100 more money than under Option A, even in a disaster year. To repeat, it is a no-brainer: versus her current compensation/ benefits, she can save $2,400 in most years and $100 in a really disastrous (and likely rare) year.

And there are other benefits to HSAs, like doctors reducing their consultation fees when they know you are paying them directly (as has happened with me). Obviously, there will be variations in how much employers contribute to the HSA accounts and how high the deductibles are, but the savings will be significant in the vast majority of scenarios. The growth of HSAs will be exponential for the next several years. www.hsainsider.com and www.ehealthinsurance.com are good resources for more information.


--Few Small, Publicly-Traded HSA Players.
Surprisingly, there are few small publicly traded companies that are levered to the growth of HSAs. HSA Bank would have been the best pure-play, but they were acquired last March by Webster Financial, a large Connecticut bank that is currently disliked by Wall Street because of other issues. Wells Fargo, JP Morgan, and US Bancorp are also going to be big players in the HSA world, but they are simply too big. There are other small and promising HSA administrators, but most of them are private. TBBK is the most levered HSA name I have come across, and even then TBBK isn’t primarily an HSA company (yet).


--The Bancorp, Inc.--
(FBR, Sandler O’Neill, and Stifel Nicholas all have decent initiation reports, so I will keep this brief.) Based, in Wilmington, DE, TBBK was founded in 1999 by banking veteran Betsy Cohen, who previously founded Jefferson Bank in 1974, grew it to be Philadelphia’s largest local bank, and subsequently sold it to Hudson United in 1999. TBBK has two businesses—the Philadelphia Private Bank (PPB), a very fast growing regional bank with no branches (inspired by its birth at the height of the Internet bubble), and Affinity Banking, which provides private label banking services to non-bank institutions.

--Philadelphia Private Bank--
PPB, which generates the majority of TBBK’s revenue, has grown loans from a standing start in 1999 to almost $700M currently. This success has been driven by its low cost structure and Ms. Cohen’s ability to attract seasoned lenders to leave larger and more bureaucratic banks. Asset quality is pristine, with NPAs at 0.08% of total assets, among the best in the banking world. Commercially oriented loans make up 82% of the total, with consumer loans and residential mortgages making up the balance. Substantially all of the loans are originated within the Philadelphia-Wilmington MSA. While the 60% loan growth they posted in 2005 is not sustainable, this business is still relatively small and should be able to easily grow loans at 20%+ for the next few years given the significant market share of large and lumbering out-of-state banks such as Bank of America, Wachovia, JP Morgan, Citi, TD BankNorth (recently acquired Hudson United which I bet Cohen will be able to scavenger for many former colleagues discontented with TD BNK), and SOV (just sold out to Santander and is engaged in a nasty PR war). Almost without exception, across the country, small, well-run banks have been able to steal meaningful market share from large banks, particularly those that have recently made big acquisitions. Comments on the Q4/05 conference call indicate that the pipeline of new business remains very robust.

--Affinity Banking--
Affinity Banking provides non-branded banking operations (mostly checking and deposit services) to organizations such as wealth managers (like Pennsylvania-based SEI), health insurance providers (like Blue Shield of Pennsylvania—this is where the HSA play comes in), merchant processor collectives (who aggregate store-owners to provide them with debit-card/credit-card/payment services—TBBK calls them ISOs), and universities (like Drexel University). These organizations are attracted to TBBK because it allows them to present one simple brand (their own) to the end customer. TBBK provides private label services to 23 wealth managers, 200 merchant processors, and 31 health insurance providers. TBBK doesn’t yet break out the profitability of Affinity Banking (it may start doing so in 2006), but it currently provides $160M of TBBK’s total $673M deposit base (24%). Merchant processor deposits are just over $100M; healthcare (HSA) deposits are $27M; and wealth management deposits make up the remaining roughly $30M (of which SEI provides the majority).

TBBK also just announced another significant partnership with Advanta (ticker: ADVNB; $1B market cap company that provides business credit cards to 900K customers) in which TBBK will provide private-label checking/deposit services to Advanta’s credit card users. This partnership rolls out in February and could be a substantial source of new business over the next couple of years.

Clearly, TBBK’s affinity banking product is valuable and is attracting a wide variety of customers that include SEI, Advanta, and many of the country’s large health insurance companies.


--The HSA Opportunity--
TBBK currently has $27M in HSA deposits, up from $13M in Q3/05. This represents 7% of TBBK’s total transaction deposits and 3% of total assets—i.e. it is still a very small part of TBBK. On the Q4/05 conference call, however, they indicated that account growth volume has continued to stay much stronger than expected. (Sign-ups for HSAs will be seasonally skewed to Q4 and Q1 as employers wait until the new calendar year to add new options to their benefits.) While the language on the call was fairly conservative, the reading between the lines tells me that Q1 and Q2 HSA account and deposit growth will likely remain very strong. They are targeting a quadrupling of accounts to 100,000 by the end of 2006, up from only 25,000 currently, and only 14,500 at the end of the third quarter.

To get a sense of the ultimate opportunity, TBBK’s 31 health insurance partners (this will likely grow) presently have 20 million customers, most of whom still have traditional non-HSA insurance. Now many of these insurers do not have exclusive agreements with TBBK, but some do and others have designated TBBK as the preferred HSA administrator. Additionally, TBBK’s designation as one of five HSA administrators (including Wells Fargo, UnitedHealth, HSA Bank, and Sterling HSA) for ehealthinsurance, the nation’s largest online health insurance broker, indicates to me that TBBK is on an even footing with some of the largest names in the financial services world. TBBK’s recent success in growing accounts clearly indicates they are offering value and gaining serious traction.

While the following is pure speculation, it is possible that TBBK could have one million accounts in five years, with an average account balance of roughly $2,000, and total deposits of $2 billion. If we apply a conservative 1.5% ROA to these very valuable deposits, we are looking at $30M in earnings from the HSA business alone. Putting a 15 multiple on these earnings adds $450M in market value alone, or about $32/share. In a more optimistic scenario, accounts could be 1.5 million, with average balances of $3,000 (GWB is pushing for larger annual contribution limits), which would translate to $4.5B of deposits, $67.5M in earnings, $1 billion in market value, and $70 per share. Once the exponential account growth rate slows, the average account balances should build up relatively quickly (new accounts have lower balances) and the increasing scale could lead to a nice expansion of the ROA. In 10 years, we could see 2 million accounts with average balances of $6,000, totaling $12B in deposits. A 2.00% ROA would translate to $240M in earnings. With a 15 PE multiple, we are looking at 3.6B in market value or $240 per share—just from the HSA business alone. Of course, this is all speculation, but it is not entirely fantasy.

While the growth in HSAs will encourage new players to enter the field, I think the last 18 months that TBBK has spent cultivating its HSA relationships, along with its corporate philosophy of low cost, low ego (i.e. private label, affinity branding) and high technology will also prove to be sustainable competitive advantages.


--Recent Results--

TBBK reports an excellent fourth quarter of $0.19 in EPS, beating the $0.16 consensus and meeting the high end. (Only two analysts cover the stock.)

-Valuable low-cost transaction deposits grew 8.3% un-annualized from Q3 while loans grew 8.2%.
-The net interest margin (or NIM, which is basically the difference between what it earns on its loans and what it pays on deposits) came in at 4.75%, well above the October guidance of 4.20-4.54%. Because of some one-timers, the 4.77% NIM of Q3/05 wasn’t sustainable, but the NIM is up sharply from the 4.05% of a year ago. This is a genuine and sustainable improvement.
-Revenue grew 9.2% from Q3/05, or 37% annualized. YOY revenue was up 75%.
-Op/ex grew 5.8% from Q3/05, or 23% annualized. YOY op/ex was up only 32%.
-Operating income grew 17% from Q3, or 68% annualized. YOY is up 450%.
-Diluted share count did increase from 13.4M in Q3/05 to 14.1M in Q4, but this was related to a one-time preferred stock conversion.
-HSA deposits grew from $14M in Q3 to $27M and should stay strong through Q1 and Q2 2006. They commented that HSA account growth volume remains stronger than expected.

Last quarter, they noted that Q3 is somewhat seasonally weak, but I think the above numbers indicate that TBBK can realistically grow annual revenue at 30%+ and earnings at 50%+. And with HSAs coming fully on-line in 2006 and 2007, we could potentially see a couple of years of 100% earnings growth.


--Valuation--
-TBBK just earned $0.19. I think it can earn $0.21, $0.23, $0.25, and $0.28 over the next four quarters, putting 2006 EPS at $0.97 (versus the current high of $0.90). This would represent growth of 100% over 2005. (The current 2006 consensus estimate for TBBK is $0.76, but FBR’s $0.63 figure is stale.)
-With a $0.30 quarterly run-rate of EPS heading into 2007, TBBK could easily earn $1.40 in ‘07. A 20 PE—conservative for 40%+ earnings growth— equals $28 per share, up 50% from the current price.
-Tangible book value per share is currently $9.80. If they earn $0.97 this year, it will be $10.77 next year. $1.40 in 2007 EPS on book per share of $10.77 translates into a 13% ROE that is improving rapidly (it was only 8% in Q4/05). I think 2.5 times this future book value is quite reasonable—translating into $27 per share, or up 45%.
-Insiders owns 17% of the stock, of which CEO and founder Betsy Cohen owns 7%.(Goldman Sachs and Wellington each own 9%.) They have a lot of skin in the game.
-This stock could quite easily get swept up in emerging HSA hype, pushing it much higher.
-While Cohen has surrounded herself with many younger executives, she is now 65 years old. I don’t think she will sell TBBK anytime soon, but she obviously had no trouble selling her bank before.
-The valuation at 20 times earnings may seem relatively pricey, especially if you are used to looking at banks and financial services companies. The stock has also been somewhat volatile. I think $19 is a very good entry price and $18 or below is an excellent opportunity to add more. After TBBK reported a great Q3/05 and the stock went no where, CEO Betsy Cohen bought 25K more shares at $16, which clearly proved to be a great investment.


--Other Possible HSA Plays--
Assurant (AIZ) is a $6B market cap specialized insurance company that offers HSAs. They are well-run and the health insurance segment represents about 1/3 of their revenue. They had a solid 2005 (but a mildly disappointing Q4/05), with core EPS up 33% over 2004. They currently trade at roughly12 times 2006 EPS, which could be understated given their exposure HSAs.

Tower Financial (TOFC) is a $70M market cap bank, based in Fort Wayne, Indiana. They have an HSA guru who has been giving lectures around the state, which earned TOFC the mandate as the HSA administrator for all employees of the Indiana state government (and they are partnering with Wellpoint). This is a huge win for TOFC (and the CFO tells me that they have had conversations with various county officials as well as state officials from Ohio and Michigan), but there are other concerns (credit quality) in TOFC’s core banking business that worry me.

Leesport Financial (FLPB) is a $125M market cap bank based in Wyomissing, PA. It is the banking partner of First HSA, a privately owned HSA administrator, also based in PA. They were recently featured in an article in the magazine, US Banker. It is still predominantly a traditional regional bank, but FLPB currently trades at a very reasonable 12.9 times 2006 EPS consensus of $1.86. Given that they just earned $0.47 in Q4/05, the $1.86 seems too conservative. (In early 2005, they did close a problematic acquisition that turned out to have some hidden bad loans. It led to reduced earnings and the resignation of the CEO.) Although they have a new CEO and Q4/05 results were good, it looks like there is still some over-hang on the shares. At under 13 times 2006 EPS and with some leverage to HSAs, FLPB has good upside.

While TBBK has a much higher valuation than these other names, it also has the best positioning, a fairly unique operating model, a veteran CEO with significant ownership, and the most potential earnings leverage.

Catalyst

Emerging HSA hype
Continued good results