Description

Thesis Summary

• WAGE has built a nice, high margin business providing stable contracted fee-for-service outsourced employee benefit administration to large and mid-sized companies; the largest of these services is the administration of Flexible Spending Accounts (FSAs) wherein WAGE is the market leader and has been rolling up the industry for the last decade

• FSAs have been around for 30+ years which as a whole is a mature and now likely shrinking market with a structural headwind due the emergence and rapid growth of Health Spending Accounts (HSAs); as further described herein, the business models are also importantly different, for administering FSA accounts, a provider like WAGE is paid a flat per employee per month fee; on the HSA side, it is more of a checking + 401k account that builds value over time and more of the economics to come from float income

• HSAs are a far superior product for reasons further described herein and as employers increasingly adopt HSAs, they directly cannibalize FSA accounts as (i) employees are prohibited by law from having both a HSA and a FSA and (ii) people who have/use/understand their FSA account have a high propensity to switch most quickly

• Although the company pitches itself and the sell-side views WAGE as a “HSA play” and way to ride that trend, WAGE’s HSA business is very small (~5% of revenues and 2% market share) while FSAs are 50%+ of revenues  

• Unlike in the FSA market, WAGE is a small player and late mover with low 2% market share in HSAs and more importantly has a structurally disadvantaged business vs. its key competitors/market leaders:

• Health Plans:  UNH is vertically integrated and the largest HSA provider via its sub called Optum Bank, Aetna is integrated as well via its sub called Payflex; Cigna is aligned with WBS and Anthem is aligned with HQY and also white-labels Alegus software

• Non-bank custodians:  Health Equity (HQY) is the largest, they are the key industry channel partner and market share leader with robust technology, customer support and interface; their strategy is also to grow accounts and emphasize NIM/float income at the expense of admin fee for service income (which they have disclosed goes down 5-15% per year); it is also interesting that Founder and former CEO of WAGE, left to run HQY as their CEO and has little to no interest in the FSA business

• Banks/Asset Managers:  Webster (WBS) is actually the largest bank player via its sub HSA Bank which was a first mover; others like BofA also in the business that view HSA balances as a deposit source; asset managers like Fidelity in the business as they see HSAs like 401k and are in asset gathering mode

• WAGE is none of the above and must compete on price/fee for service vs. (i) health plans who are primary providers offering HSAs as a bundled services to both share in the economics as well as keep a stickier customer (ii) banks/custodians using low/no fees as a loss leader to gather assets/make Net Interest Margin (NIM); WAGE rather has a custodial partnership with Bank of New York (BK) where until 2017 has not participated in any NIM and doesn’t control the accounts (leading to issues described below)

• The HSA channel to market is more difficult than FSA and is already full with large health plans having captive units or preferred partnerships and the large consultants/brokers (AON, MSH, WLTW, etc.) already aligned with preferred partnerships of which WAGE is not a major player

• Majority of Fortune 500/1000 already has a HSA provider, those RFPs are done and switching is rare; being an incumbent FSA provider is not an advantage and WAGE as demonstrated/proven in the survey work below is a share loser

• Organic Growth is overstated as the company counts “Channel Partnership” deals as organic even though they consist of large payments to other companies to take over books of business. FSA participation growth has also benefitted from a limited rollover provision tailwind that is now in late innings

• Valuation: >6x Revenue, >21x Adjusted EBITDA and >44x Adjusted Earnings (adjusted to conform to mgmt presentation which adds back huge stock-based-comp charge, multiples much higher without), given the recent growth rates, the HSA halo (further boosted post-election) and sell-side support of a relatively underfollowed stock (despite $2.9B market cap)

FSA / HSA Background

At the core, both FSAs and HSAs are accounts that allow employers reduce healthcare costs.   There is tons of info on HSAs, how they work, etc. all over the internet and many already know about them so will keep this brief.

In the 1960s, health care inflation caused many employers to institute annual deductibles and coinsurance. These moves effectively doubled the healthcare cost for the average employee on an after-tax basis. In response, the IRS created the FSA in the 1970s to help reduce some of these costs by allowing employees to use some pre-tax dollars to pay for their healthcare expenses.  Over the last 40 years, FSAs gained popularity among employers and today the vast majority of employers offer this as a benefit. While nearly all employers offer the FSA today, adoption among employees is much lower at around 25%. The core issue with the FSA is that if you don’t use it, you lose it the next year and as a result, many employees dislike this uncertainty.  Dealing with an FSA is also a cumbersome process if need to gather receipts, etc.

Today, there is a similar issue in the health care system and the response by employers is to introduce High Deductible Health Plans (HDHP).  This effectively shifts costs to the consumer, forces consumers to be smarter about using the health care system, and ultimately lowers costs for everyone.

To help offset this expense, the government created the HSA account --  the law is you can only have an HSA account in conjunction with a HDHP.  

Unlike a FSA, the money that you put into an HSA is yours and rolls over year to year.  It is similarly tax-advantaged, has better limits and provisions and can be used for both spending (annual healthcare costs, deductibles, co-pays, etc.) as well as saving, for bigger healthcare related costs (withdrawable tax free for qualified medical expenses) as well as for retirement (many use/view as an additional savings account on top of your 401k and IRA).  Today, we are in the early stages of (i) getting employers to offer HDHPs, (ii) pushing employees to choose HDHP options and (iii) getting employees with HDHPs to open an HSA.  The last key point here is that individuals with HSAs cannot open up a general purpose FSA as the IRS wants to limit the tax benefits.  Individuals are only able to open up a “Limited Purpose FSA” that only basically covers vision and dental but it is extremely uncommon for people to have both. Thus, HSA growth directly cannibalizes the FSA market.

There are a number of differences between FSAs and HSAs laid out on the following chart. Despite the value proposition being significantly better, HSAs have yet to reach a similar level of popularity due to the FSA having a 30yr head start. The points to call out are: (i) you can rollover your entire balance within a HSA but not FSA, (ii) many more employers will match or seed a HSA every year, (iii) annual pre-tax contribution limit is higher on the HSA side.

Business Model

WAGE’s Healthcare segment business model is easy to understand:

• FSA:  contracts with employers to administer the accounts and move around the money, for this get a flat fee of ~$3-$4 per employee per month and (ii) 50c-$1 per employee per month of interchange revenue (receive a share of the payment process as employees are issued debit cards used to pay for qualified FSA expenditures)

• HSA:  paid in the same manner on the HSA side (admin fee + interchange) except as mentioned above, WAGEs competitors who own banks (WBS, BAC, UNH) or custodians (HQY) make additional float / Net Interest Margin (NIM) income on cash in customer accounts (i.e. the bank/custodian will use the cash to make loans or term deposits longer on the curve and only share a portion with the HSA account holder); as mentioned above this is a key point as the competition is advantaged and is economics are/will be more in the float than the fees; for example, when rates were higher, HQY used to charge ZERO admin flat fees and even today, once you get above a minimum cash balance in your HQY HSA account, there are ZERO fees; furthermore, HQY and other banks/custodians often will share the admin fee with the channel who sold/sourced the accounts – these factors combined is what drives HQY’s disclosed 5-15% annual decline in monthly charged account admin fees: “what we did say on our last call was that the 14% or 15% decrease in unit economics or unit pricing on service revenues that we had last year that that would decrease back in more lower levels that we had previously guided on and more in like the 5% to 10% range. So we expect that that will happen.”

• Other:  includes the smaller Health Reimbursement Accounts (HRAs) business which also faces headwinds

Historically the business has been sticky with renewal rates of 95%+ as once you have an administrator that does a decent job, there is little reason to switch.  The company also administers Commuter and COBRA benefits and part of the bull case is that they can cross-sell these services amongst customers for higher wallet share (management says that 2/3 of their clients only use 1 out of their 4-5 products offered).   Will demonstrate below that the retention rate is rapidly changing as the shift to HSAs occurs and cross-selling disparate services doesn’t seem to matter.

The Bull Case

1.  As an incumbent in the FSA market, WAGE has a significant advantage in cross-selling into the HSA market

2.  The rise of HSAs is helpful for WAGE’s growth rates

3.   WAGE has been able to grow double digits and despite the FSA market maturing, historical growth rates can continue both organically and via M&A

The Bear Case

1.  Being an incumbent in the FSA market is not an advantage to win the HSA contract at RFP

In speaking with industry experts and channel participants from the large HR consultants/brokers, repeatedly heard anecdotally that WAGE was losing these RFPs despite being the incumbent.  To gain further conviction, built a bottoms-up market survey through publically available open enrollment documents on the internet.  In total thus far, were able to gather 184 data points out of mostly Fortune 500 companies (WAGE frequently mentions their share within this group and has stated that 2/3 of Healthcare revenue is from the top 100-200 employers they contract with).  The full results of the study are in the Appendix, here are the highlights.

Of the 184, WAGE provides FSA administration to 48 companies. 40 of those (83%) already have a HSA administrator but WAGE lost 29 of those accounts even as the incumbent (~75% loss rate). This was surprising in the context of the legacy 95% retention rate that drives the multiple in this stock. Conversely, there are ZERO cases of WAGE winning the HSA business when they were not the FSA incumbent.  Although HSA specialists don’t explicitly fight for the FSA business as it is not attractive long term, they actually are MORE successful than WAGE at cross-selling both solutions, winning both the FSA and HSA business ~50% of the time.  Believe this can be attributable to (i) WAGE being viewed as low value-add administrator versus a high-value partner and (ii) it is easy to do FSA if you can do HSA but not the reverse and you are seeing HSA specialists take share. Lastly, although HSAs are viewed as a “blue sky” opportunity, employer penetration within the Fortune 1000) is already very high, i.e. the RFPs have occurred and WAGE has already lost the market share land grab.

WAGE WAS FSA INCUMBENT BUT LOST THE HSA BUSINESS

HSA SPECIALISTS CAN CROSS SELL BETTER THAN WAGE

2. The rise of HSAs is bad for FSAs and thus WAGE’s core business – FSAs may eventually go away

1. HSA is simply a better product for the consumer:  (i) you can put more money in, (ii) you get to keep the money that you put in, (iii) ~70% of employers will match or seed an HSA but not a FSA

2. It is a substitute good (i) you are prohibited from having a FSA if you have a HSA, (ii) you can opt to have a Limited Purpose FSA solely additional dental and vision, but only if you max out your HSA, a very rare use case, (iii) as HSAs continued huge growth, FSAs could eventually go away

3. Inferior Unit Economics:  WAGE makes $4-$5 per account per month  vs. $3-$4 per account per month for HSAs and the admin fee is trending down (~5-15% per year) as competition focused on gathering assets and NIM

4. WAGE is not a bank, a non-bank custodian or an asset manager, a competitive disadvantage as they can only make money from the admin fees and interchange

1. Banks and non-bank custodians can make a spread on deposits or invested asset; WAGE outsources this to BK as custodian and is just starting to get a small rev share however BK has reportedly started to charge extra custodial fees directly to HSA holders which has caused some real problems (see below)

2. As the industry matures, assets grow, and interest rates rise, more and more of the economics shift to NIM and allow for other players to further lower account fees and gain share/asset gather

3. It would not be surprising if account fees eventually go to $0 over the long term, when HSAs were first developed in a more normal rate environment admin fees were in fact $0

4. More and more HSAs are viewed as the 401ks of the health care world; competitors like Fidelity have also been gaining share

5. WAGE is not tied to a health plan, a competitive disadvantage; while the decision to choose an FSA administrator is one-off, the decision to choose an HSA administrator is directly tied to the medical plan; the problem for WAGE is that many of these medical plans have brought this administration in-house (i.e. UNH/Optum and Aetna/Payflex) or already have preferred partners and the RFPs have already been won

6. Evidence:  Devenir is an industry consultant and puts out good HSA related market data, per the most recent survey, as a % of total industry wide HSA AUM, WAGE has just a 2% AUM market share; this is vs. Optum, WBS and HQY at 20%, 14% and 12%, respectively

3.  Recent custodial mistep may drive continued market share losses on both HSA and FSA going forward

Learned that Bank of New York Mellon (WAGE’s custodial partner) began to charge all of WAGE’s customers a $2 / month fee as of October of 2016. This has caused a significant backlash and has caused a number of customers to switch to other administrators (FSA and HSA Admin fees are typically paid by the employer/opaque to the employee not deducted directly from an employee’s account which people detest).

More importantly however, many of these customers are ALSO switching their FSA business. These examples illustrate that the core FSA retention rates are coming under pressure as well. While historically, there is no reason to ever switch FSA administrators, HSAs have become the catalyst.

Here are a few of the losses:

In case can't read the above, here is what is says in red box and here are the links:

Fedex: "Plan administration change from WageWorks to HealthEquity for the following spending and savings accounts (Full Purpose FSA, Dependent Care FSA, Limited Purpose FSA, HSA, HRA); http://docdro.id/YhzyQCP

Leidos: "Partnering with a new Health Savings Account (HSA) and Flexible Spending Account (FSA) adminstrator: Health Equity... employees will have the opportunity to elect to transfer their current HSA balances from WageWorks to HealthEquity." https://www.leidos.com/benefitspd/whatsnew

WKU: "We have chosen to transfer our HSA Custodian to HealthEquity... You may recall a letter you received from WageWorks/BNY Mellon detailing new monthly account fees and new account transfer fees. The transition to HealthEquity will eliminate these new fees for HSA account holders." https://www.wku.edu/benefits/hsa/hsa_faq.pdf

4.  WAGE has been able to grow its healthcare segment double digits despite a maturing FSA market, driven by M&A, a one-time favorable regulatory change, and aggressive disclosure around “organic growth”

Given this backdrop, hard to see how WAGE will come close to management’s “guidance” of 9%-14% organic growth over the next 3 years. You have 35% of the business (commuter, COBRA, and other) that are not growth businesses and thus the healthcare segment will have to grow much faster than guidance.

It is helpful to analyze how quickly the healthcare business has grown over the last 3 years on an organic basis as a starting point for how the next three years might look. On a reported basis, WAGE has been able to grow healthcare business topline at a 13% CAGR over the last 3 years since 2010.

The company’s light disclosure makes it very hard to disaggregate growth but took an illustrative shot below. Color coded the growth based on quality: green is good, yellow is “one-time-ish”, and red is a headwind.  Believe that after making the proper adjustments, organic growth has been only MSD and slowing every year.

1. M&A:  the FSA rollup story is in the later innings as after the acquisition of ADP’s business last year (before this, WAGE did not do a deal for 2 years), there are very few scale players left to acquire.  In the HSA market, there is no scale player available.

2. FSA rollover impact is should be viewed as “one-time”

1. WAGE has successfully driven FSA penetration (the % of employees at a contracted client who actually open/use a FSA) from ~20% to ~30%; this is part of the bull case as many underwrite even further penetration

2. The notion that FSA penetration can continue to march higher while HSAs are growing is aggressive; more interestingly, what some fail to appreciate is that a large part of this penetration growth has been a result of regulation beginning in plan year 2014 that allowed for $500 within your FSA to roll over to the next year (i.e. used to be use it or lose it and then regulators allowed for a $500 annual rollover)

3. Based on management commentary, estimate that this has been a 3% tailwind but this tailwind is over; as of the last earnings call, said that at least 70% of employers and an even higher percentage of accounts have already taken advantage of this regulation “In situations on FSAs where we see employers taking advantage of the carry-over provision, those employers usually see a 10% to 15% increase in enrollments, and we've seen that to be pretty consistent over the last couple of years.”

4. Furthermore, as employers begin to push for HSAs over FSAs, are starting to see companies getting rid of this carryover election to their employees; “Beginning in 2017, Lowe’s will no longer offer a carryover balance to the next year.  Employees may carryover up to $500 from their 2016 healthcare FSA into 2017 but any unused funds at the end of 2017 will be forfeited.”

3. Aggressive disclosure categorizes M&A as organic

1. Wageworks often partners with other firms to resell their services, while most of these partnerships fit into the definition of organic growth, others were acquisitions of customer accounts and should be counted in M&A instead of organic growth

2. Due to lack of disclosure, it is hard to pinpoint the impact of this over 3 years but can walk through an example of their deal with Ceridian, a two-step transaction (Aflac was similar deal)

1. In 2013, WAGE purchased the FSA / HSA / HRA / Commuter customers for ~$15M; in 2015, WAGE purchased the COBRA customers for ~$20M

2. Both are disclosed in the 10K as “acquisition of client contracts” versus “business acquisitions” and WAGE considers this to be organic growth

4. Better Employment:  this part is just cyclical, as unemployment goes down and more people are working, more open these types of accounts

5. FSA market share gains: WAGE has done a solid job taking share within FSAs, not only through M&A but also through partnerships, and competitive takeaways, it is unclear how much more this can occur

1. In 2016, WAGE won the largest employer in the US (federal government Office of Personnel Management “OPM”) by undercutting the former incumbent ADP by 50% (they bought the rest of the ADP business thereafter)

2. This alone is a ~7% tailwind to healthcare organic growth in 2017 but no other new customer can be anywhere close to being a needle-mover

3. WAGE already has 335 of the Fortune 500 and 71 of the Fortune 100 as customers in at least one business line, the same metrics in 2011 were 122 of the Fortune 500 and 37 of the Fortune 100; they can begin to go down market but this will impact the margin profile and churn characteristics of the business

6. WAGE’s own HSA business is growing off a small base; for a company where HSAs are such a part of the bull case, it is very interesting that they do NOT even disclose basic HSA account metrics

7. HSA cannibalization of FSA, crux of the thesis as described at length herein

Conclusion

WAGE has several interesting elements in a short: (i) significant structural headwinds misunderstood by investors, (ii) primary research survey supporting a variant view, (iii) good risk / reward driven by high multiple and peak stock price and low 5% short interest, (iv) shorter-term catalysts in that 2H comps get very hard to show organic growth once they lap the Federal Government OPM organic win and the Ceridian and ADP deals, (v) longer term structural headwinds that will persist for years, (vi) light sell-side coverage, external IR and a management team that does not go to many conferences and in December started selling some of their stock.

The overarching thesis is straightforward.  The stock gets a big multiple because it’s viewed as having sticky, long term earnings stream from FSA fees and a growth driver tailwind in the HSA trend.  However, the FSA market as defined by total number of accounts is at best mature/flat and likely shrinking.  The pace of shrinking will accelerate as the shift to HSA occurs as it is a better substitute product.  The problem for WAGE is that they are losing the HSA RFPs as demonstrated. And lastly, HSAs have become the catalyst for clients to switch the FSA business as well.  

For each 100,000 FSA accounts they have, over time as more and more employers shift to HDHPs w/ attached HSAs, the economic headwind is a huge hole to overcome.  Even assuming they keep 25% of the business (which is well more than their market share): every 100,000 FSA accounts paying $4-$5 per month = 25,000 HSA accounts paying $3-$4 per month.

This medium-long term headwind will take time to show up in the numbers (depending on how quickly employees adopt or are pushed to adopt HDHP/HSAs by their employer) but as their weak position in HSAs and the cannibalization effect on FSA is better understood, believe the stock first loses its huge multiple (as earnings growth potential is re-rated) and ultimately earnings start to miss.  Even if the stock trades at a full 10x “Adjusted” EBITDA, this translates to a $35 stock, down ~50%.  If the FSA to HSA trend accelerates more quickly, believe the stock goes much lower.

Questions for the management team

Much of the misunderstanding around the stock has been due to lack the disclosure. If had three questions to ask the management team, would ask the following:

• How do you bridge to 9%-14% long term organic growth rates long term given the impact of cannibalization and your market share within HSA?

• Within your Fortune 500 customers, what has been your same store FSA account growth, excluding the impact of the rollover provision?

• What was your “up-for-renewal” revenue retention rate in 2016 within your FSA business and how many new HSA contracts did you win as the FSA incumbent?

Catalysts

• Continued losses of HSA RFPs and sell side coverage realizing this is occurring changes the narrative

• Lapping the Ceridian deal in 2Q17:  this could be the first time WAGE could miss their target organic growth range

• Lapping OPM Federal government win in 1Q18:  second shot at WAGE missing target growth ranges

Risks

• Continue to acquire in both the FSA and other smaller segments (COBRA and Commuter)

• Risk mitigated by the fact that they just bought ADP, the only deal of that size out there, however there are certainly more M&A and partnership deals they will do

• COBRA is a more cost intensive and less value added business, is also a very mature market; segment should do fine over time but not much left for them to buy and much/all of this segment’s growth is from M&A; similar comment on Commuter, smaller segment and should be fine and has better growth than COBRA but not much left for them to buy to move needle

• Continued execution within core FSA

• Organic market share gains not likely to move needle

• Won the largest employer in the US (federal government) last year and there is some runway to improve usage penetration from 15% closer to industry averages of 25% on a large employee base, but this is already in both management guidance and Street numbers

• Becoming a relevant player in HSA

• Many of the largest companies already have a HSA and have not selected WAGE

• No material size player for them to buy

• Can buy or become a custodian but this comes with cost, regulation, required capital support and necessary scale

• Legislation:  any headlines and/or actual laws surround increased limits in HSAs (there is bipartisan support for this and is likely at some point with or without repealing ACA) may also include FSAs and these headlines will support the stock

WAGE was FSA Incumbent but lost the HSA Business

Summary Numbers / Valuation Metrics

Notes:

• Adjusted EBITDA and Adjusted EPS include huge add-backs for Stock-Based Comp (SBC), without which the multiples would be even higher

• Cash on the balance sheet is overstated due to short term advances they receive in the FSA business, there is large offsetting balance sheet liability called “Customer Obligations” (shown net below)

Appendix – Company Survey

https://docs.google.com/spreadsheets/d/1hOTgbscxKzPv7izo-bW4atTElPBwihFPPDtQUe22KJo/edit?usp=sharing

Catalyst

• Continued losses of HSA RFPs and sell side coverage realizing this is occurring changes the narrative

• Lapping the Ceridian deal in 2Q17:  this could be the first time WAGE could miss their target organic growth range

• Lapping OPM Federal government win in 1Q18:  second shot at WAGE missing target growth ranges