HealthEquity: A Unique Play On Healthcare Spending

Originally published 11/6/2018 on seekingalpha.com

Summary

HealthEquity is currently the only public pure-play HSA platform and offers investors a unique way to participate in the growing HSA market.
With a strong record of growth and profitability, the core business shows no signs of slowing down.
Shares look fully valued currently, but offer significant growth opportunities over the next several years.

In 2002, Stephen Neeleman and David Hall launched HealthEquity (HQY) to introduce consumer-driven healthcare back into the marketplace. Since then, consumer-driven healthcare has exploded into a multi-billion-dollar industry as rising healthcare costs have driven a need for consumers to find new ways to afford healthcare. HealthEquity, as a leading HSA platform, provides a means for investors to participate in this growing HSA market. Shares look fully valued after an incredible run this year, but there is significant growth potential as the company executes on its long-term vision.

Consumer Driven Healthcare

Consumer-driven healthcare refers to a type of health insurance plans that allows its members to use products such as health savings accounts (NYSE:HSA), health reimbursement accounts (HRA), and Flexible Spending Accounts (NYSEARCA:FSA) to pay for routine healthcare expenses, while also using a high deductible insurance plan to mitigate catastrophic medical expenses. These high deductible insurance policies are typically lower in cost, and the user pays medical claims out of a pre-tax pre-funded spending account, often with a debit card provided by a bank or insurance plan. Users can rollover and invest any unused balances for future use.

Pre-funded accounts provide consumers more flexibility and control when paying for medical expenses and can offer an alternative to traditional health insurance plans. In addition, HSAs can augment a traditional health insurance plan by providing savings for non-covered medical expenses. Several studies have shown that consumers using these plans are also more cost-sensitive and request only the treatment they need, as well as having a higher adherence to treatment regimes.

In 2003, one year after the founding of HealthEquity, consumer-driven healthcare received a large boost when federal legislation allowed those plans to become tax-advantaged. This allowed consumer-driven healthcare plans to take on a role analogous to an IRA or 401(k) by providing tax-advantaged contributions solely for the use of medical expenses not covered by health insurance. Healthcare Savings Accounts became the most efficient vehicle to take advantage of these tax incentives and are the prevalent choice in new accounts. As healthcare costs continue to increase, it is likely that non-traditional plans that offer more flexibility will become increasingly popular for consumers to plan and save for medical expenses.

The HSA Platform

Most consumer HSA and HRA insurance plans are offered by traditional health insurance providers. Since HSAs can have a rolling balance, most of the monetization of these plans comes from the custodial assets. The HSA market is currently around $51 billion in custodial assets spread across 23 million accounts. However, this market is estimated to grow to more than $500 billion over the next few decades. Even then, that would likely be spread across 50-60 million accounts, a small percentage of the several hundred million health insurance policies that exist today in the United States.

HealthEquity offers a “one-stop shop” platform for consumers and businesses to access their HSAs, compare different treatment options and pricing, pay healthcare bills, receive personalized information, and make investment decisions. This allows consumers to take care of almost all the different aspects related to their healthcare expenses in one convenient location and creates a sticky user base for HealthEquity.

HealthEquity’s platform creates a lucrative business as approximately 80% of revenue comes from high-margin service and custodial fees, and the remainder coming from interchange fees. This has allowed HealthEquity to significantly scale the business as custodial assets have quintupled since 2014, and EBITDA has grown by more than 700%. With the business already earning mid-20% operating margins on a revenue base of only a few hundred million, and earnings forecasted to grow by more than 30% annually over the next few years, there is a tremendous opportunity for growth.

Looking to the Future

Jon Kessler currently leads the team at HealthEquity, after taking the reins from Stephen Neeleman in 2014. A veteran of Wageworks (WAGE), and member of HealthEquity's board since 2009, Jon has been instrumental in leading the firm on its growth path. Dr. Neeleman continues to serve in an advisory role, and with the firm successfully being successfully led by its new management team, HealthEquity looks ready to continue to execute on its vision of being a leader in the HSA space.

HealthEquity has steadily been growing its HSA market share from just 4% of custodial assets in 2011 to more than 14% in 2018, ranking second in the marketplace behind UnitedHealth (UNH). HealthEquity has differentiated itself from its peers by being focused on the technology platform of HSA plans, allowing consumers to access a full suite of options and plan integrations. This compares to UnitedHealth whose HSA plans only integrate into their branded health insurance plans. Third place, Webster Financial (WBS), offers a full range of financial products outside of HSAs and lacks the focus that HealthEquity can offer. This has coincided with HSAs increasing penetration from 9% of the marketplace in 2011 to 19% today. 83% of employers have yet to offer an HSA, creating significant room for opportunity.

The main growth in HealthEquity’s business will come from rising custodial asset balances. On average, HealthEquity’s HSAs have a balance of just under $2,000 and are only 3.5 years old. Just 3.6% of those accounts have investment balances. While individuals are likely to not contribute HSAs anywhere close to the amount that they will for their 401k, there is still an opportunity for most balances to reach the $8,000-$10,000 range. When looking at HealthEquity’s breakdown of account balances by age, the oldest accounts from 2005 and 2006 already have balances in excess of $7,000 on average. Even though HSAs are used to fund expected medical expenses (short to mid-term expenses), current rules allow any funds held after the age of 65 to be withdrawn at the long-term tax rate, like a 401k. This creates an incentive for individuals to max out their HSA when possible as any unused savings can be withdrawn to fund their retirement after passing the age threshold.

Valuation

HealthEquity trades at a premium valuation, 22x sales and 65x 2019 estimates. For a firm growing sales at approximately 35% per annum over the last 5 years, this valuation is still higher than many peers growing at a similar pace, such as many of the Software-As-A-Service companies. However, due to HealthEquity's profitability and industry dynamics, the current valuation is reasonable.

Sales are projected to grow in the mid-20% over the next several years, and given the significant runway ahead for growing penetration of HSAs, I think that those numbers can be sustained for a significant period of time. In addition, it is important to remember that HealthEquity has been profitable since its IPO, with net margins at 24% and climbing. To give a sense of how much margins can grow, over the past two years, for every 10% growth in sales, that has been accompanied by an approximate 1% growth in net margin. This gives a blended growth rate for earnings that is much higher than the top-line sales growth.

Over a longer time horizon, net margins will likely cap out around 30-35%, similar to that of other highly-scaled software firms, which offer the most comparable business model. Over the next 5 years, it will be possible for HealthEquity to grow earnings in excess of 30% a year, even if sales are still in the mid-20% range. Paying a 65x multiple is rich, but definitely reasonable given that HealthEquity will likely be able to sustain its growth in earnings for the foreseeable future.

Finally, I think that HealthEquity warrants a small premium of its own for being the only pure-play public firm focusing on HSAs. The other two main competitors, UnitedHealth and Webster, have a broad set of operations, of which HSAs make up only a small piece. HealthEquity warrants a premium valuation due to being the most highly levered to the favorable industry dynamics.

Risks to the Thesis

One of the aspects that has troubled me about HealthEquity is the firm’s shareholder dilution. The firm has increased the float by about 7% a year, with most coming from share-based compensation, however they also recently filed a mixed-shelf offering in September 2018. The share-based compensation is likely due to the need to attract and retain top talent, and as the share price has accelerated over the past few years, this amount of dilution is likely to remain constant.

The company’s recently announced offering is the first since the firm’s IPO in 2014. While the size is unknown, the firm still had approximately 1.5 million shares available to be sold under placement from an S-3 filing in 2015. Even if the full 1.5 million shares are sold, that would represent an approximate 2.5% dilution based on 62 million shares outstanding.

The biggest potential risk to HealthEquity is any damage that could befall its HSA platform. While the company has continued to take market share and increase margins, increased competition could hurt HealthEquity’s core business.

Pushback will likely come from HealthEquity's two largest competitors, UnitedHealth and Webster Financial, as they seek to stabilize and take market share where possible. The HSA market is so fragmented though that all three firms could continue to grow their respective share over the next several years. Smaller players are likely to get steadily pushed out as it becomes harder to compete on the platform accessibility and fees. HealthEquity has an impressive track record, and with the favorable industry dynamics, the firm could continue to do well even if competition heats up.

Conclusion

HealthEquity runs a great business by providing a platform for individuals and business to utilize Health Spending Accounts. With forecasted increases in healthcare spending, tax-advantaged health plan accounts offer a great way for individuals to plan and adjust to rising medical expenses.

Shares trade at a premium, and the firm has an issue of shareholder dilution, but those risks are more than made up for the high-quality business you would be investing in. With the business continuing to grow leaps and bounds, shares look to have further upside.

Disclosure: I am/we are long HQY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.