Healthequity Inc (HQY) 2016 Q2 法說會逐字稿

Welcome to the HealthEquity second-quarter FY17 earnings conference call. Please note that this event is being recorded. I would now like to turn the conference over to Richard Putnam, Investor Relations. Go ahead, Mr. Putnam.

Thank you, Ronya. Good afternoon, everyone. We welcome you to HealthEquity's second quarter earnings conference call. My name is Richard Putnam, Investor Relations for HealthEquity. With me today we have Jon Kessler, our President and CEO, Darcy Mott, our Chief Financial Officer, and Brad Bennion, Senior Vice President of Product, participating with us on our call today.

Before I turn the call over to Jon, I'd like to remind you of a couple of things. First, a copy of today's earnings release and accompanying financial information can be accessed on our Investor Relations website, at IR.HealthEquity.com.

Secondly, we remind those listening to our call today that today's discussion will include forward-looking statements, including predictions, expectations, estimates and other information that might be considered forward-looking. Throughout today's discussion, we will present some important factors relating to our business which could affect those forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from statements made today.

As a result, we caution you against placing undue reliance on these forward-looking statements. We encourage you to review the discussion of these factors and other risks that may affect our future results or the market price of our stock detailed in our annual report on Form 10-K, filed with the SEC on March 31, 2016, along with any subsequent periodic or current reports. Finally, we are not obligating ourselves to revise or update these forward-looking statements in light of new information or future events. With those reminders out of the way, I'll turn the call over to Jon.

Thank you, Richard, and before we get fully into it, those of you who have participated in previous earnings calls will note that Richard's is a new voice to our team. Richard joined us over the summer, bringing with him more than 25 years of IR and Finance experience. Frode Jensen, who previously participated in these calls as EVP and General Counsel, announced his retirement over the summer, the first genuine HealthEquity retirement. He is gearing up to hit Utah's famous ski slopes full time, and Del Ladd has taken over the role of Executive Vice President and General Counsel. Del has been HealthEquity's Deputy General Counsel for the past roughly, six months, and prior to that built up a distinguished record at Willkie Farr and Gallagher in New York, including a wealth of SEC and corporate experience. So I'm hoping that others will, when they have the opportunity, please join me in welcoming Richard Putnam and in congratulating both Del and Frode on their career changes.

So with that, let me turn to our second quarter operating results. Darcy, Brad Bennion and I will each share some perspective and then we'll open up the phone line to answer your questions.

HealthEquity continued to deliver strong positive results for FY17, with substantial growth during Q2 in the four key metrics that drive our business, which are revenue, adjusted EBITDA, HSA members, and assets under management, or AUM.

Looking at each, the pace of revenue growth remained very strong, with revenues up 45% year-over-year in the second quarter, to $44.2 million. Adjusted EBITDA not only outgrew revenue as margins widened, but continued to accelerate its growth, increasing 66% year-over-year to set a record quarterly mark of $18.4 million, or 42% of revenue, compared to 36% of revenue in the prior year's second quarter. Likewise, HSA members grew 50% year-over-year to 2.3 million, versus 45% year-over-year growth in the comparable period a year ago. And total AUM grew an even larger 60% year-over-year, to more than $4.2 billion at the end of the quarter versus 47% year-over-year growth in the year ago period. Over the last 12 months alone, HealthEquity has grown AUM by $1.6 billion. So the top line continued the traffic growth on a much larger base and profitability accelerated, as did HSAs and AUM, as the team continues to form the base of a strong, profitable business for the long term.

Turning to sales. Consumers opened 84,998 new HealthEquity HSAs in the second quarter, which was up 21% year-over-year. HealthEquity members grew AUM by $115 million in Q2, up 31% year-over-year. Year-to-date, new HSA openings are up 27% and members have added 68% more AUM over the last six months than they did in the first six months of last year. This sales growth is on top of the HSAs and AUM that the team successfully transitioned from M&T Bank's platform during the first quarter. So the sales team's production continues to grow and accelerate on a year-over-year basis, which speaks to HQY's market leading competitive position.

Speaking of that, how are we doing versus market benchmarks? Devenir Research has published it mid -year calendar 2016 market estimates; and while there is a one month offset to HealthEquity's mid-year FY17, we can make reasonable comparisons. According to Devenir, HSAs and AUM marketwide grew 25% and 22% respectively in the 12 months ended June 30. Pretty healthy. Thanks to strong organic growth and aided by modest portfolio acquisitions, however, HealthEquity grew HSAs twice as fast and grew AUM nearly three times as fast, 60% versus 22% for the industry. So we've had a great start to the year.

Margins in our business are always tighter in the second half of the fiscal year, which Darcy will talk about in his remarks. We've got a lot of work to do, but the HealthEquity team members are very enthusiastic about the rest of the year.

At our Investor Day in June, I introduced Brad Bennion, Senior Vice President of Product and Corporate Development. Now Brad is a 10-year veteran of HealthEquity, 10 years this week, in fact. He's done just about everything there is to do at the Company. But what Brad really does best is to listen, synthesizing what he hears into actionable insights for the Company.

So I'd like to turn the call over to Brad for a few moments to share what he has been hearing from our partners, including those who participated in our Investor Day, who participated in our Key Partner Summit held in July, and from our voice of customer research and ongoing work in the field. Brad?

Thank you, Jon. At our Investor Day, which you can still listen to on our website, we talked about HealthEquity's conviction that while only about 14% of working Americans have HSAs today, eventually HSAs will become ubiquitous, as common as other retirement accounts, like 401(k)s and IRAs. They will be used not only for current healthcare spending, but for long-term healthcare saving and retirement planning, resulting in higher asset balances. HSA assets under management could, under that market scenario, reach between $600 billion and $1 trillion at market maturity, versus $30 billion today, according to Devenir.

When you spend your time listening to partners and consumers, as I do, you begin to understand why we are so convinced of this future. We invited a few of our partners to our Investor Day so that you could also hear of their enthusiasm. Intermountain Healthcare explained how enrollment in HSA plans has grown year after year, from zero to 60% of their 37,000-person workforce. During that period of time, utilization of medical and prescriptions by employees has not increased. Intermountain employees are seeking more preventive and well care than ever before. It is for this reason they expect to grow towards full replace, that is, making all of their health plan offerings HSA qualified plans in the future.

Eastman Chemical, a $10 billion global chemical company, is already there. They spoke at our Investor Day about the remarkable double benefit of lower spend today and growing employee health savings for retirement. We heard similar sentiments from participants in our Key Partner Summit in July. Suze Orman spoke from the consumer perspective powerfully about the key benefits of HSAs. First, lower insurance premiums. Second, lower net deductibles, taking into account employer contributions. And third, as she put it, the tax savings bonanza from contributing to an HSA as your first place to build savings.

What we hear from partners and from members is what convinces us that our vision of every American family having an HSA will eventually be achieved. We know our job is to lead the market as it grows, so we listen very carefully to the reasons customers partner with HealthEquity and their expectations of their HSA partner moving forward. Unlike our largest competitors, HealthEquity built and owns its platform and proprietary technology. This gives us a greater agility than our competitors. We can act on what we hear, do it quickly, and deliver value like no one else.

At the Investor Day, two regional health plan partners, Optima and Blue Cross Blue Shield of Michigan, shared how valuable this agility is. Both stated that they rely on our solution to help them compete in the marketplace. They pointed out that the flexibility to be able to offer HealthEquity as either a white label or a co-branded solution helps them win and retain business. Both of these partners appreciated the fact that HealthEquity has a full suite of health account solutions and that our platform helps expand and strengthen their product by integrating with their transparency, wellness, telemedicine, and other consumer facing solutions.

Let me give you a couple of examples of HealthEquity's ability to listen and act to meet the needs of an emerging market. The first example comes from an employer's focus group that reveals that the timing mismatch of health expenses versus HSA contributions was a barrier to pushing HSAs to employees living paycheck to paycheck. So we created Balance Booster, which automatically accelerates employer contributions based on medical bills incurred and transmitted through HealthEquity's ecosystem.

A second example comes from network partners asking during strategic product review sessions, how can we further create a seamless member experience and make our mobile application even more relevant to our membership? These strategic discussions presented an opportunity for us to leverage our open platform to not only allow key HSA data elements to display within the network partner's mobile application, but to seamlessly integrate via an app to app single sign on, allowing our network partners to take even greater advantage of the tremendous engagement created by our unique HSA experience.

As we have discussed, 26% of our members visit our platform every month, ultimately allowing our network partners to engage members in everything that we have to offer by meeting members where they are. This ability to respond to a fast growing market is something that only a company that owns its own platform can do.

We know a key to our ongoing success is our ability to evolve HealthEquity's platform as our partners see more growth and complexity in their HSA qualified population. The key to that evolution is an ongoing close and listening relationship with our partners and members. I will now turn the time over to Darcy to review our financial numbers for the quarter.

Thanks, Brad. Today I will discuss our results on both a GAAP and a non-GAAP basis. A reconciliation of non-GAAP results that we discuss here to their nearest GAAP measurement are provided in the press release that was published earlier today. We will first review our second quarter and year-to-date financial results of FY17, and then I'll update our guidance for the full FY17.

We had another strong quarter, adding to our first quarter to produce a record first half of the year. Overall, our revenue for the second quarter grew 45% year-over-year, to $44.2 million, with strong growth within each component of our revenue. Looking at the three components of revenue, we saw strong growth in each of service, custodial and interchange revenue; and the transition we have been discussing with you for some time from service fees paid by our partners and members to custodial and interchange revenue continued.

Service revenue grew 28% year-over-year, to $18.8 million for the second quarter. Service revenue as a percent of total revenue declined to 43% in the quarter, down from 48% of total revenue that it represented in the second quarter last year, as custodial and interchange revenue streams became more predominant. Service revenue growth was attributable to a 50% year-over-year increase in average HSAs during the quarter, partially offset by a 15% decrease in service revenue per average HSA.

As we discussed on our first quarter earnings call, the three primary reasons for the decrease in service revenue per average HSA are, first, we have historically and we will continue to operate tiered pricing approach of lower service fees per HSA for more volume of HSAs from our network partners, particularly when they come to us with higher balances. This tiered pricing approach to service fees is strategic to our business growth, and based upon our operating results, it is working well.

Second, service revenue includes revenue from flexible spending and health reimbursement arrangements, what we call RAs, which are complimentary to, but are not growing as rapidly as our HSAs. Our experience is in line with the industry data showing HSAs growing in popularity, while RAs are more or less flat. And third, acquired HSA portfolios typically have lower service revenues per HSA and contain a minimal amount, or no RAs.

Custodial revenue was $14.8 million for the second quarter, representing an increase of 64% year-over-year. The driving factor for this growth was a 60% growth in ending total AUM. The growth in total AUM was fueled through strong organic growth, along with acquisitions, HSA rollovers, and AUM transferring during the first half of FY17. Our annualized interest yield on cash AUM was 1.58% in the second quarter of FY17, compared to 1.56% in the prior year.

Interchange revenue for the second quarter was $10.6 million, representing an increase of 56% year-over-year. Interchange revenue also benefited from the 50% year-over-year growth in average HSAs in the quarter, compared to the second quarter last year.

Gross profit for the second quarter was $28.6 million, compared to $18.6 million in the prior year, for a gross margin of 65% in the quarter versus 61% in the prior year. This is directly attributable to two factors.

First, as we have discussed before, rising gross margins are the result of increasing custodial and interchange revenue from accounts we already have, a happy outcome that will only become more important as accounts mature and their balances grow. Second, our service delivery organization did an outstanding job during the quarter of taking advantage of the increased scale that account growth provides HealthEquity, while continuing to deliver the high quality purple service for which HealthEquity is known.

We don't typically spend a lot of time on these calls talking about G&A expense; however, G&A increased by $1 million, or 21% sequentially from Q1 to Q2. This was driven by a mix of one-time and recurring expenses, as we continue to provision the Company's risk management, compliance program and legal function. We believe it is strategically important for HealthEquity to understand and effectively manage challenges and identify opportunities resulting from the regulatory environment.

The recent adoption by the Department of Labor of an expanded definition of a fiduciary in the context of investment advice to include HSAs is one example. We have started to make expenditures that will help us fully comply with both the letter and spirit of the DOL's new rule, and we believe the result is a better offering and lower cost investing for HealthEquity members.

Income from operations was $12.7 million in the second quarter, an increase of 70% year-over-year and generated an operating margin of 29%, compared to 25% in the prior year. We generated net income of $8.2 million for the second quarter of FY17, compared to $4.4 million in the prior year.

Our GAAP diluted EPS for the second quarter of 2017 was $0.14 per share, compared to $0.08 in the prior year. Our non-GAAP adjusted EBITDA for the quarter increased 66%, to $18.4 million, compared to $11.1 million in the prior year. Adjusted EBITDA margin for the quarter was 42%, compared to 36% last year.

Combining our first and second quarters produced robust growth for the first six months of FY17. I won't take time to go into the same details that I did for the second quarter results, but I would like to call out a couple of highlights. First half revenue is up 46% compared to last year. Gross profit is up 54%. Operating profit grew by 68% in the first half of FY17; and operating margins were 29%, compared to 26% last year.

Turning to the balance sheet. As of July 31, 2016, we had $149.5 million of cash, cash equivalents and marketable securities, with no outstanding debt. We generated $15.5 million from operating cash flow during the first six months of FY17.

I now want to comment on our outlook for the full FY17. We have previously provided guidance on revenue, adjusted EBITDA and non-GAAP adjusted EPS. In order to more fully align ourselves with SEC guidelines, at this time and going forward, we will provide guidance on revenue, net income, GAAP EPS, and adjusted EBITDA.

There are three factors that I want to emphasize that we include in our analysis for FY17 guidance. One, it is still early, of course, and I would remind you that 70% to 75% of annual account openings historically occur in the fiscal second half, with the majority happening in fiscal Q4, with the start of many benefit plan years. Accordingly, our margins in the second half of the year are usually lower than the first half of the year. We experience seasonality in our cost of services in our third and fourth fiscal quarters, as we gear up to onboard these new customers.

We also accrue sales commissions as new accounts are open. In FY16, for example, we recorded approximately $5.9 million in additional service costs and $2.2 million in additional sales and marketing expense in the second half as compared to the first half of the year. A comparable phenomenon will occur this year, with the magnitude influenced by the results of the selling season currently underway.

Second, interchange revenue declined last year from Q2 to Q3, as HSA members met their deductibles and spent less. We anticipate that we will see a similar pattern this year, with a rebound in Q4. And as I mentioned earlier, we are also increasing investments in G&A to insure compliance with regulatory requirements.

Based on those three factors and our year-to-date results that we have recorded today, we now expect full year revenue between $174 million to $178 million, up from our prior guidance of $173 million to $177 million. Net income between $23 million and $25 million, GAAP diluted EPS between $0.38 and $0.42 per share, resulting in adjusted EBITDA between $59 million and $62 million, up from our prior guidance of $58 million to $60 million.

Our GAAP diluted EPS estimate is based on an estimated diluted weighted average shares outstanding of 60 million shares for the year. The outlook for the full FY17 assumes a projected effective income tax rate of approximately 36%. With that, I'll turn the call back over to Jon for some closing remarks.

Thank you, Mr. Mott. While this call focuses primarily on looking backwards, this is the time of year, right now, when our team in the field, which includes our sales leaders, our implementation specialists, our relationship managers, our open enrollment specialists, are really racking up the road miles; to win new relationships, expand exiting partnerships, and to make sure that HealthEquity delivers everything that it has sold.

And so I'd like to take a moment here to say thank you to all of these team members, as well as to the team members from our partners, for this effort and to their families for the support during this time of year. If the second half of the year is like the first, all that work will have been well worth it, giving more Americans the ability to build health savings.

And with that, operator, let's open it up for questions.

Thank you.

(Operator Instructions)

And our first question comes from the line of Peter Costa from Wells Fargo.

Hello. This is Polly [Sung on the line] for Peter. How are you?

Hello, Polly.

I was hoping to first dig in a little bit or get a better understanding of why you are changing your guidance basis to now include stock-based compensation?

Yes, Polly, thank you. There's been a lot of press about the fact that the SEC has requested people to give equal or more prominence to GAAP measurements than they do to non-GAAP measurements. And in fact, we did have our 10-K and our first quarter reviewed by the SEC and we got a comment letter. I think it's out there publicly available now. And one of the comments they had was not only to give equal prominence to historical -- the reconciliation between GAAP and non-GAAP measures, but also to do that in our business outlook.

And so as we looked at that and evaluated it, we felt like the only difference between our non-GAAP earnings and our GAAP earnings was the stock comp. And since we provided the stock comp as a reconciliation item between our net income and our adjusted EBITDA in this reconciliation, we felt that we would give you enough visibility into making that calculation and that we would just conform to the SEC's request, and then it made it easier just to go with GAAP. Net income, GAAP EPS, and then we'll still provide adjusted EBITDA as our only non-GAAP measure.

Okay. And just to be clear, you plan on providing the breakout for stock-based compensation going forward?

Exactly. I'm pretty sure there's a reconciliation in the earnings release itself, and we will continue to provide that breakout of that stock-based compensation.

Okay. And then my other question, I was hoping to dig a little bit deeper in your revenue per HSA account. I know the decline year over year, a lot of it is driven by service revenue and you went through the three items that really drove that decline. But for this quarter, it declined year over year as well as sequentially. I was hoping you could provide some color as to how much of it is driven by acquisitions versus the tiered pricing approach, and then the inclusion of RA accounts in that calculation?

In our first quarter, we talked about, I think that the year-over-year decline was maybe 14%. I think it's 15%. And at the time, we said that we expected that trend to continue out through the rest of this year, because of the base that we have and the accounts that are already in with their pricing in place.

The components of that, we haven't gone into a great deal of detail of what the different breakouts of that are. Going too far with that gets into our RA component and we're not ready to give pricing on that.

But the most significant item is the tiered pricing approach. The second most important aspect of that would be the RA component of the pricing model.

Okay, so acquisitions really did not play as big of a --?

They do, it's just (multiple speakers).

Yes, they would probably be third.

They're third. I think what Darcy is trying to do is -- the reason we don't break this out is, as a practical matter, if we were to do so, we're giving our competitors our fees.

Okay.

And our competitors aren't lining up to do that. So that's why we don't break it out. But I think what Darcy is trying to say, and trying to get to the gist of your question, if you look at the three factors, and you have them exactly right, the biggest one is around tiered pricing arrangements, et cetera, and then the second biggest one is around RA, and the third biggest one is the effect of the acquisition.

Okay. And then really my last question, and I'll let someone else speak, is your interchange revenue per HSA account is down from first quarter. I know that was high in the first quarter, but still a pretty high level versus what we were expecting. Should we think of that as a new normal or could it come down even more dramatically in Q3 to back to where, let's say, it was last year?

No. So last year, I think we stated that our first quarter is always our highest spend quarter for HSAs, and it's a little bit counterintuitive to the FSA mentality. In an HSA, because deductibles start over at the beginning of the plan year, on January 1, everybody is spending in that first quarter, as people reach their deductibles and then they go, so they're then insured at that point and they stop spending on their HSAs, then it starts to diminish further in the second quarter. And last year, we saw a particular decrease from Q2 to Q3 in total spend on the HSA platform, particularly.

And so then what happens in Q4 is it returns to maybe a normal level of Q3. But what you end up picking up is all of the new accounts that you get in Q4 pick up the total spend level. So that's why the interchange revenue pops back up in Q4.

Okay. But last year, in Q3, the decline that we saw, would you say that was abnormal?

At the time, we thought it was abnormal, because we hadn't seen the level of that occur in the prior year, and so I think we stated we're not ready to say this is a trend. We're now just being cautious that since we saw it last year, we're being cautious about that spend level in Q3.

Okay.

And if you delve deeper into it, Polly, what's happening here is that as you get into the, particularly into our fiscal third quarter, there are two factors. There are some seasonal factors in healthcare spending broadly, in terms of when -- you think about it, it's sort of the third quarter that some of the stuff that actually happened over the summer hits, and the summer is seasonally low in terms of actual incurrence of spend. So that's a factor.

And then as Darcy said, you obviously have people who start to hit their deductibles or if they had an FSA, they've run out. So if I return to your original question, which is, is Q2 the new normal, I think Darcy's prepared remarks made clear that we are not assuming Q2 is the new normal.

Okay. Thank you very much.

And our next question comes from the line of Stephanie Davis from JPMorgan.

Hello, guys. Thank you for taking my question.

Hello, Stephanie.

You've seen really strong top-line growth over the past few quarters, in spite of the decline in your monthly account maintenance fees. I know you've addressed this a bit, but is there a minimum level you would target for per-account fee revenue or is there a terminal situation where the revenue stream could go to zero and you'd focus more on the custodial and the interchange?

Well, it's a great question. Maybe a way to answer this is to step back and understand where these fees each come from. And it really, I think, shines a light on our strategy here.

The service fee bucket includes a number of things, but obviously its biggest piece is our monthly service fees that are pretty much paid by employers or by members themselves. And the other two buckets, that is interchange revenue and custodial revenue, are effectively paid, in one form or another, either by third parties or are paid indirectly. And so our view is that strategically, it's important for us to be pushing the envelope, as it were, on service fees, particularly since, at least it's our view that we as an organization have been doing, I suppose, as well as, and probably in some cases better than, the rest of our industry in driving and capturing for ourselves the other two components.

So the first point I'd make in response to your question is, you are right to cast this as a strategic effort on our part that is in part responsible for the growth we've seen. That having been said, and now this gets to the, does it go to zero point, we've deployed this strategically. At least, we think we have. And so it's not the case that we're out there saying, hey, anyone can have an HSA for free or for a dollar or whatever.

What is the case is that when we look at our partnerships, our network partnerships, meaning our large employer and health plan relationships, what we've tried to do is to use tiered pricing structures as an inducement to have our network partners really work with us to drive both HSA growth and AUM growth, which obviously is the goal at the end of the day. And it's working. And to some extent, what you see here is evidence that it is working.

What we're not going to do is simply say, well, it doesn't matter who you are, the fee is the same. Because that doesn't really make sense. It makes sense for us to deploy that as a resource that we can use to induce our best partners to do what they do well and what they can do well, which is to help us help members build their health savings. So that's kind of the way we look at it.

We don't really see this going to zero. If I were on a witness stand, I'd probably point out things like the fact that HSA account administrators still get paid flat fees at the beginning, on a per-month basis, and their balances are quite a lot higher than ours. But even if that weren't the case, I guess my basic view is, what you're seeing here is the result of a strategy. And the evidence that the strategy is on plan is that while we are executing it, we are still growing our margins at the bottom line, or EBITDA, or what have you, or gross margins, by substantial amounts.

And this is Darcy. Let me just add one thought to that. Back in the day when the Fed rate was at 5% or more, you had a lot of our competitors who were offering HSAs with no service revenue, or no service fee. Over time, as interest rates came down, they felt like, one, servicing these accounts that are just not your normal savings account, they actually have transactions in them month in and month out, that they actually do cost money to service.

And so not all HSAs are created equal, and we will choose to differentiate based on the behavior of the HSA itself. If they have a significant balance, we're going to offer a lower account fee. But an account that spends all their money, yes, we get interchange out of it. But if they have no custodial AUM, then servicing that account and taking care of it is more costly, so we will continue to differentiate.

All right. Thank you for the thorough answer, guys. I really appreciate it.

Sure.

And our next question comes from the line of Greg Peters from Raymond James.

Good afternoon, everyone. Thank you for hosting the call. I have to say, I like the sound of Frode's new job. I hope he has a big HSA balance to offset the risks associated with becoming a full-time skier.

Well, he is in retirement. So I don't think he's -- he's going to be on Medicare and he can't yet contribute, but we are working on that. So we are hoping that he won't spend it down very quickly. And he's a wise investor, so I don't think it will be the first thing he gets at.

Well, certainly with your growth, it's not a reportable event, that's for sure, if he starts drawing down on his balances.

We do miss the facial expressions he makes at your questions -- not just yours, Greg, but everyone's.

Right.

Frode gesticulates quite a bit, so we're missing that. We love Richard, but we're missing the gesticulation (laughter).

Got it. So I thought you provided some great color regarding the service fees, et cetera. I'd like to go back to some of the comments that were made in the prepared remarks section. I'm pretty sure that you guys have your own robo advisor embedded in the HealthEquity advisors.

We do.

You mentioned the increased costs associated with the DOL fiduciary rule. So I was wondering if you could provide a little more color about what's going on there? And then secondly, embedded in that, I'm wondering if the Consumer Financial Protection Bureau also has an oversight role on your Business and how that's coming into play as you think about things going forward?

So let me try and take those in turn. On DOL and the fiduciary rule broadly, let me say, and this may not be the most popular audience to make this point, but it's nonetheless our view is -- our view is that the fiduciary rule is a net positive for investors. And we think it's particularly a net positive for HealthEquity members.

Now, there are people who are saying, and probably will, the reducing the amount of investment advice that they offer to small balance account holders. We know a thing or two about small balance account holders. And we are absolutely not backing away from offering advice. Nor are we backing away from the position we've always taken, which is that when we select funds for our investment lineup, that we try to do so with care.

Instead, what we're doing is, from a compliance perspective, in addition to dotting our I's and crossing our T's and all that, and reviewing everything we do in this area to make sure that we feel comfortable with it, is we're, in the end we will be accelerating the movement that we already had under way towards lower cost fund lineups and fund lineups where all of the fees that HealthEquity receives are completely transparent. And the net result for our members is going to be lower investment costs, and that's good.

And you've seen some press from us on this over the course of the last, let's say, year or so, our index investment investor product that we introduced for individuals and now have expanded into small groups, offering Vanguard's institutional lineups, some of those kind of things. And that's going to continue. And, as I said before, we are going to continue to offer our robo advisor product for those who want it.

And so I guess my basic feeling is that while certainly there is some work we are doing on a one-time basis that is specifically related to the fiduciary rule, I think broadly, this is a positive for, I think, everyone involved, with the exception of folks who are going to take the view either that this is too complicated for them and/or that they want to deny that this is applicable to them. And I think there are those folks in the competitive environment who are either going to try and outsource it or somehow talk their way around it or whatever. And that, in our view, is not going to be a good outcome and it's not reflective of market leadership and that's not the way we're handling it.

So if that means we're spending a little more to get it right on day one, then so be it. But I really do believe at the end of the day, certainly as it relates to our marketplace, that ultimately this is a good protection for investors, and we're happy to embrace it and do exactly what we think both the letter and the spirit of the rule had in mind.

With respect to CFPB, we have to operate under the presumption that CFPB, at this point, given the breadth of its mandate, can do whatever it wants. I think anyone who would assume, who would make the statement, oh, CFPB doesn't apply to me is probably kidding themselves in any area of financial services. But at the same time, I'd say we would welcome the scrutiny to the industry broadly, because we feel like, a little bit, at least we try to be wearing the white hat on this, in terms of both transparency and disclosure and so forth. And we may not do it perfectly and I'm sure there will come some time when we find out there's something we've missed.

But without having any insight as to what's on CFPB's agenda beyond what they've published, none of which includes HSAs, we have to operate under the presumption that what we do is going to stand the harsh light of scrutiny. And we've tried to do that from day one. And in a funny way, Greg, I think it's actually pretty helpful in the sense, it's a little like trying to build a business when interest rates are low. If you assume from the outset that you have to make money and come by it honestly, then you build the business to do that.

So that's kind of where we are on it. And again, I don't mean to be beating my chest about it in any way. I'm sure there will come a day when we will find something we've missed, and we'll fix it as quickly as we can when we do. But our attitude is that we're going to embrace a regulatory environment that is aimed at protecting our members, because that's what we're trying to do, too.

Perfect. I have two other areas for questions. And your last comment there on interest rates is a good segue. It seems like the interest rates, the revenue that you're collecting, the rates seem to be ticking up a little bit in the last couple quarters, and that's in the face of big deposit growth or AUM growth on your side.

So perhaps you could -- and maybe this is where Darcy steps in and provides an outlook of what he sees in terms of bundled assets coming off previous deposit arrangements and renegotiating on new deals, et cetera, and where the current market appetite is for AUM. And then I'll ask one final question after that.

Yes, rates have ticked up very slightly, but sometimes that's just a mix of which depositories they're in. And as you know, we've tried to keep this pretty steady and stable, and be a fairly steady source.

The biggest change that we ever see is in our fourth quarter, that has potentially the impact. When we come into a new large inflow of cash AUM that will happen every January, that is the time when we have to go out and figure out where to place that money. And so we're pretty confident in the current year that we have homes for the growth that will occur in the remainder of the fiscal year until January.

And then in January, we'll enter into some new contracts with either existing depositories or new depositories, and it will be very rate sensitive to what the rates are at that time. And we have some latitude on duration, but we usually don't exercise a lot of -- we keep a pretty tight range on that. And so we really don't have anything to give on specific guidance at this time, but just knowing that the time when there is any dramatic change, or even any change, it will generally be, come out when we do our fourth-quarter release and we have visibility into that new block of cash and what we were able to place it at.

Okay.

I'd only add one thing to that, Greg, which is it's important to understand, and I think you do, but just to reiterate the point that when you talk about the rates to which we're pegged, and I think this is particularly important as you're in the neighborhood of the zero boundary here, you're really talking about a market for cash that's somewhat unique. And so for example, while obviously, broadly speaking, there's a correlation with things like 10-year T's or what not, over an extended period of time, that's not necessarily the case.

And particularly you do see divergence at the zero bound, in part because you see the same thing happening with loan rates, that is that banks don't take their loan rates to zero, because they can't. And therefore, there remains a healthy market for particularly mid-term money, which is mostly what we're about on this side of the Business.

And so I guess I would say, while obviously we all recognize that the markets broadly for money are in somewhat uncharted territory, we feel pretty good about, certainly as Darcy said, where we are with regard to the deployments we'll have to do in the current fiscal year, and we'll see how things look like next year. But based on the conversations that the team has with our existing depositories and would-be new ones, again, and given the unique nature of what we do, how long we've been doing it, the reputation we've established, and the technology that underlies it, in terms of being able to be predictable, we feel pretty good about it.

Great. Thank you for that color. And I noticed, the final one, I think I asked this of you last quarter, but I can't help myself. The cash and marketable security balance on your balance sheet continues to grow. Can you just give us an update on M&A, et cetera? And then I'll turn over the floor to someone else for questions.

Thank you. I think I just lost a bet there. There was a word that we thought you might use. In any event, so -- gentlemen's bet, though.

I know the word.

So look, I think first of all, as I think Steve Neeleman talked about -- was it Steve or was it you, Brad? One of them talked about it at our Investor Day. We look at our market for competitive M&A and see -- the way we look at it, we presented a little pie chart at the Investor Day -- roughly half the market, in our view, are not really in it for the long term. And so there's going to be plenty of opportunity for that kind of M&A.

And the reason I start there is because, as we've said before, while these deals are not going to be transformative, they offer IRR to the shareholders. And that's the way we approach them. So we're not going to price them up to rush them, but when they're there, we're going to look at them in terms of IRR, and if they make sense, we're going to do them.

And if they don't, by the way, we won't. We'll happily pass. Because we know who we're here to serve.

And so I don't think there's any shortage of opportunity there. There may be timing issues, but there's no shortage of opportunity.

When I get beyond that, and I think this is worth remembering, our field of view isn't limited to competitive M&A. And as Brad talked about a little bit, one of the things, the luxuries we have is the ability to listen to people who have already begun to go through this transition from a world where HSAs and high deductibles and the like are a minority to a place where they become the norm, and what products do they need and what stuff is important, and frankly, what stuff that you maybe thought was important is less important. And so there are capital deployment opportunities there, as well.

So I'm not remotely feeling like we're in a position where we won't have great places to deploy that money for high IRR for our shareholders. And if I were, we'd be giving it back to them.

Got it. Thank you.

And our next question comes from the line of Sandy Draper from SunTrust Robinson.

Thank you and good afternoon. A couple questions -- first, on the technology and development side, it's creeping up modestly, but not a lot. And I keep waiting for the mystery investments that were talked about last year that you guys are going to be talking about, that might start to ramp up.

I'm just trying to get a sense, I know you guys don't like to open up the kimono and say what you're doing, but do you feel -- are you doing those things now or are those still on the back burner? Just trying to think about, longer term, where technology spend is going to be trending.

Yes, we are continuing to push on that, Sandy, and we continue to try to, where we can, to accelerate the development. The one thing that happens in that, as you know, is that we capitalize some of that development and then put it into new product enhancements, and then we put it on the balance sheet and then we amortize that over three years, generally. So there's a little bit of lag.

Even if I started spending it wildly, the impact on the P&L, where you'd see it is in the amortization line within technology and development, and that has been growing. And so it's just a matter of the way it gets modeled out and you see it coming, and we expect that it will continue. We have not backed off on that at all.

Okay. Great. That's helpful. And then the second, I know, Jon, it's too early to make the calls on where the year's going to shape up in sales. But I'm curious, are the discussions you're having, especially from the customers, the questions they're asking or what they're pushing and poking you about, have they substantially changed from last year? Are there new areas of interest, new hot buttons, new things they're focused on, what can you deliver to us as our HSA provider? Is that changed or is it really the same type of questions and discussions that you had last year?

I'd normally start by offering Steve the opportunity to comment. He's, as I suggested many of our folks were, he's on the road. So I have Brad with me. And Brad's in the field as much as anyone. So I'm going to start, Brad, with you and then maybe I'll offer some commentary.

Sure. I think, by and large, the type of questions and requests that we're getting haven't changed dramatically. We're getting a lot, as organizations are looking to promote health savings accounts more and more, getting requests for more direct education and more touch points for better engagement. We're getting requests for things that will further improve the user experience, in terms of helping the members really plan for the future, as well as the shift from viewing these as spending accounts to being more savings accounts. So what tools are we bringing to bear to help them be able to make that shift from spenders to savers.

So those are some of the things that are coming out, I think, in the dialogue. But by and large, it's very similar to things that we heard last year.

Yes, I was just going to take off on this idea of savings versus spend, and label it long term versus short term. What I see in the new sales dialogues this year is an increased level of sophistication on the part of the employers and the like that this is not a 1-year strategy, that it's a 5- and 10-year strategy, and that a big part of the challenge is communicating that fact and the implications of that to team members.

And it really is a stretch because as you know, Sandy, so much of health benefits in particular is judged on the basis of 1 year, and then conversely, so much of retirement benefits is about what happens in this great beyond, where we're all retired and just luxuriating somewhere. And health savings is sort of in between those two.

And so I see a lot of interest in, for example, as Brad said, what level of sophistication are we bringing to that discussion and some, let's say, dissatisfaction with either the answer that is, well, we don't really do that, we outsource it, or alternatively, yes, we're all about retirement, let's talk about what happens at age 65. Because for most of these people with regard to health savings, that's not the first issue.

So we think we're in the right place in terms of helping to meet that need, and certainly, the response from our partners has been very positive on it. But I think that's probably the thing that I see as a trend that's likely to be out there that -- simply a way to look at it is it's an indicator that the partners are becoming more sophisticated about understanding how this is really going to pan out in a world where most people have these kinds of savings accounts and are being asked to manage their health savings in one form or another.

Great. That's really helpful. Appreciate it.

And our next question comes from the line of Mark Marcon from R.W. Baird.

Hello. Good afternoon. Congratulations on a great quarter.

We're going to call you Macon from now on.

Oh, thank you.

I think there's a country song in that. Go ahead.

With regards to the industry, we've seen a significant amount of consolidation over the last 12 months. I'm wondering, as we're in the heart of, or going into the heart of the selling season as it relates to acquiring new partners and expanding the relationships, what impact do you think the consolidation that we've seen thus far in the industry is going to have. And to what extent would the 50% that's not going to be part of the industry long term, to what extent does that help?

You know, I don't know, is the honest answer, Mark. I think the buyers out there are not as attuned to all the to's and fro's within the HSA industry as all of us are. And so I don't want to overstate any impact.

Certainly, it's true that if you look at those relationships that have been directly affected by these transactions, there are opportunities there, as we've talked about before. But I hesitate to say something like, oh, it would be nice for me to say, well, people see all this turmoil and they figure I better go with a leader. That would be great.

I just don't know that -- as you well know, our partners in the benefits arena are busy people. I read something yesterday that said that for the first time, the average number of benefits professionals, the ratio of benefits professionals to employees within the average American corporation has exceeded 1 to 1,000. I guess I did that back -- it's less than 1 to 1,000. So these are busy people, and I don't know that they're tracking all of the details of comings and goings within our industry. I think they're looking for leaders, looking for people to meet their concerns, and that's their primary concern.

Do you anticipate any increased aggressiveness from some of the players that have been acquiring greater portfolios within the space or enhancing their offering?

I don't know. They have earnings calls, too. I think the short answer, I can only tell you what we see, which is, what we see is much more about folks who don't do this all the time and maybe this isn't their sole priority, struggling sometimes to get the transition right. And I suspect that that's more of where the focus likely is at this point versus, okay, that's done with, now what should we do?

That's not meant to cast aspersion. It's a hard thing to do, and something we've been doing for a long time, and so we can feel good about it. And frankly, I think the results last quarter, to some extent, reflect that.

Some of the gross margin stuff that Darcy talked about, part of what's going on there is that's the tail of a very smooth M&T transition. If the M&T transition weren't smooth, then those costs would have shown up as more calls and more issues in the second quarter. But I suspect that people are much more focused on making, as they should be, on their side, on making sure that as best they can that their new customers have a good experience. Certainly, if we were in that position, that's what we'd be focused on.

Great. And then with regards to the monthly service fees, do we think the current slope of change on the monthly fees, that that's probably a good place to be, just assuming that interest rates don't change a lot and that we continue to see the increased tiering, et cetera?

I would say for the current year, that would certainly be true.

Okay. And, Darcy, what do you use as a benchmark in terms of thinking about the effective yield on the cash, given your current duration profile? What do you look towards in terms of giving you a sense for how that market's going?

One that we look at it is there's published 3-year CD rates. We usually get a little bit of a premium to what those rates are because of the stability of our depository base and the ease-of-use for our depository partners. And then we just look at 3- to 5-year ranges on rates and we're usually playing in that space.

Great. And then lastly, just as it relates to the DOL regs and potentially some changes on the CFPB, how should we think about the G&A ramp, have we gone through the majority of that or is there a significant further increase to come?

As we said, we have invested more. We had a pretty large sequential increase in G&A, and we're just saying that we think that that's staying there.

We don't think that it's going to keep expanding in significant -- we're just making those incremental investments. And some of them are -- we're using outside consultants to help us get this right. And so those are recurring.

So we don't see that there's going to be some huge expansion of that. We're just acknowledging the fact that we had a significant increase from Q1 to Q2 and that we think that will, not the growth, but the level will continue.

Great. Super. Thank you.

And our next question comes from the line of Randy Reece from Avondale Partners.

Afternoon.

Hello, Randy.

Cash AUM per member increased 7% year over year. I'm wondering how much of that came from acquisitions and wondering what the real trend is like? There's an -- optically, there's an uptrend. I'm wondering what would be reasonable expectations for future changes in cash AUM per member?

It really depends on account growth and the source of account growth. So what's going on underneath that is a number of counter currents. As you say, you've got new accounts that we have acquired from others. And as we've commented, they generally have slightly higher cash balances than native HealthEquity accounts, simply because, on average, they are older.

And then the second undercurrent you've got is the influx of brand new accounts. And as you well know, the new accounts start out with much lower balances. And then the third is the aging of existing accounts.

And I'm sympathetic with the challenge of trying to take all those things and put them into an average, but the real answer to your question is that there's a link between what you assume about account growth and what you assume about balance growth. If account growth, particularly brand new accounts, were to slow, then you would see, obviously you would see average account balances continue to rise pretty substantially.

Conversely, if account growth remains brisk, that will be less the case. And we do occasionally, we have occasionally reported on, and others have reported on, what the older accounts start to look like, that the balances do, the cash balances definitely creep up well above $2,000.

And so I guess I'd say generally, if you're trying to time it quarter to quarter, I don't know how to help. But if you think about it as a long term, there's this huge chunk of margin growth to the shareholders and benefit to the members that's locked into that existing account base.

You saw right through my trick. Okay. My second question is -- (multiple speakers).

Darcy looked at me and he's like, do you want to try?

Well, any kind of detail would have shed light on what your expectations were for account growth. Employment growth in the US is slower than it was in 2015. Do you think this has a meaningful effect on your Company's growth potential in the near future?

No. I mean, I don't know and no. I think the relative delta in employment growth -- first of all, I'd just rather have employment growth. Whether it's good or bad for our Company, it's another question. I'm not running for office or anything, but it would be a good thing. But the deltas are so modest relative to our aggregate growth rates that they're not going to meaningfully affect our numbers.

I do think that in a world where -- maybe a slightly different question that you might have asked is really about earnings growth. And broadly speaking, as we all know, corporate earnings growth has not been fantastic. And so I think that puts a premium, no pun intended, on every dollar of compensation expense being used efficiently.

And the point that I think was at our Investor Day, one of our partners made, I think it was Eastman, was pointing out that this is just a more efficient form of compensation than the alternatives, if you look at it over the long term, is to shift some of the costs to the margin, but then provide contributions to the account and get folks educated up on how to use it. And so I think there's a real opportunity for folks who are looking to squeeze win-wins out of every dollar of compensation expense, which, on average, for companies, comp is 40% of G&L, to look at this stuff. And I think that's what's happening.

And that's just a longer way to say, as we've said before, the math on HSAs and HSA products works. It may take people time to figure that out, but it works, and that's why the underlying market is growing.

You asked my other question for me, which was, if there's pressure on corporate margins, does that actually help the demand for the shift, not only to HSAs but to full conversion?

I think so. I do think, though, at the same time, to those with perhaps not quite as long of a telephoto lens, it also speaks to the benefits of having the flexibility on the pricing side on fees. While as we said before we're not going to use that flexibility where there's no value to our shareholders, the ability to go in, in a case where the client sees the long term and they say, oh, by the way, I'm ready to commit to that and I'm asking you to commit with me, and for us to give them everything we can on the fee side, it really becomes a win-win.

And all that is enabled by the fact that we try very, very hard to get our members doing the right thing. Doing the right thing means growing balances, and if they're going to spend money on healthcare, spending it through the platform. That's good for them. It's good for us, and we can transfer some of that benefit to our partners. And so that's kind of a nice virtuous cycle.

Thank you very much.

I hope. That sounded very good. And then I'm like, hmm, I don't know.

And our next question comes from the line of Alex Paris from Barrington Research.

Hello. Good afternoon, or good evening. This is Chris Howe sitting in for Alex Paris.

Hello, Chris.

Hello. Just had a few questions for you here. Would you be able to describe any trends you're seeing among new adopters? Or perhaps asked a different way, would you be able to provide color on certain demographics, industries, locations, a segment analysis of things that may be showing better acceleration than other parts of the market?

We don't typically provide too much breakdown in that regard, in part because we don't see what we're doing as an industry-specific phenomenon. But let me say this. I think what you're starting to see, or what you are seeing is, as this industry continues to grow, and we were sort of trumpeting our growth relative to Devenir and the market, but the market's still growing 20% plus. And so by definition, you are moving into, let's say, more mainstream pragmatic customers.

And what do pragmatic customers want? Pragmatic customers want to know that you're going to take care of their team members, they want to know about your service record, they want to know how long you've been in the business. They want to know things along those lines. They want to know what the investment lineup looks like and that they're going to be treated fairly and all that kind of stuff. They want to know that you're thinking about security.

And I think those are questions that work really to our benefit as a specialist within, not only within the benefits arena, not only within the tax-advantaged account, whatever arena, but really focused on the HSA. And there are other things we do, of course. But that kind of focus of the buyer on the nuts and bolts of delivery really is something that we relish.

And so I guess that's probably the biggest thing that I could say in answer to that. And where you see that is a lot more pre-buy security audits that are really in depth, as opposed to just the usual, we'll send our consultants out for 3 hours kind of stuff, that kind of thing. More evaluation of people actually asking questions about the investment lineups, which they really should and we wish more did, because we have great answers -- people asking the difference between someone like us, who's a custodian that's taking fiduciary responsibility, and someone who says, oh, I'm just the administrator. If you actually have a problem, you may have to go somewhere else. Those kinds of things.

So I think that's the biggest, if you want to call that a demographic change, demographic that we see. But broadly speaking, of course there are always going to be leading and laggard sectors.

We've talked before about the fact that, surprisingly, the healthcare sector, meaning hospital systems, physicians, et cetera, have been a great market for us and continue to be a great market for us. We offer some pretty unique and interesting solutions in that market. And you might not think of that as being the kind of market where this stuff would really take off. And then there are always going to be some laggards, too. But broadly, we see what's going on as more broad than sectoral.

Okay. Thank you for the color. That's helpful. And then I think you touched on it briefly on the last quarter call, in regard to max savers, whether it be pertaining to the absolute number, was there any positivity or anything measurable in the quarter that showed some growth among this space?

Brad, why don't you talk a little bit about what we're doing to try and encourage our folks along the saving point? I know you were probably not expecting to answer this one.

That's all right. So it's important to remember that to truly build health savings, you need to educate and engage the member. And at the heart of that engagement, it needs to be very personalized.

And so we're really focused on data analytics to understand this journey that our members -- and when I say members, that each individual member is going on. Because every individual member has a different journey. Some are very similar, but we're focused on using data and then using our platform to flex to meet their needs.

And in looking at the data, there's lots of opportunity for us to continue our mission of building health savings. There's lots of members that really probably should be contributing more than they are. And our vision and mission is to engage them in a way that is personalized and meaningful to them, to move them along that continuum of savings. And we're really focused on doing that through data analytics, leveraging our open platform to be able to flex to meet their needs and create that personalized experience.

Thank you. And one last one for me, perhaps this is not the time, but just wanted to get some overall view on when it would be appropriate to provide longer-term financial targets? I think in the past, you had mentioned some things about margin potential, just want to see where your stance is on that moving forward.

Yes, to date, we give fiscal year guidance from year to year. At the time of the IPO, we did give some broader growth targets for both the revenue and for adjusted EBITDA. And so we've been public just over 2 years now and we have exceeded both of those targets.

The revenue target was to grow from 25% to 35%, and the adjusted EBITDA was to grow from 35% to 45%. And on both accounts, we've exceeded those ranges. And so we're not really reiterating new longer-term guidance ranges, but that's the only that we've ever given in the past. We'll revisit that to see if we give anything in the future, but that's where we're at today.

We'll put some thought to it.

All right. Thank you for taking my questions. I appreciate it.

Thank you.

And I'm not showing any further questions at this time. I would now like to turn the call back to Mr. Kessler for any further remarks.

Well, thank you, everyone. Hope everyone had a great Labor Day and ready to get back to work, as we are. So see you in a few months. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a wonderful day.