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HEALTHEQUITY INC - 10-Q - Management's discussion and analysis of financial condition and results of operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Statements that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements are often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "plan," "project," "seek," "should," "target," "will," "would" and similar expressions or variations intended to identify forward-looking statements. Such statements include, but are not limited to, statements concerning market opportunity, our future financial and operating results, investment strategy, sales and marketing strategy, management's plans, beliefs and objectives for future operations, technology and development, economic and industry trends or trend analysis, expectations about seasonality, opportunity for portfolio purchases, use of non-GAAP financial measures, operating expenses, anticipated income tax rates, capital expenditures, cash flows and liquidity. These statements are based on the beliefs and assumptions of our management based on information currently available to us. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included under Part II, Item 1A below. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such events. Overview We are a leader and an innovator in the high-growth category of technology-enabled services platforms that empower consumers to make healthcare saving and spending decisions. Our platform provides an ecosystem where consumers can access their tax-advantaged healthcare savings, compare treatment options and pricing, evaluate and pay healthcare bills, receive personalized benefit and clinical information, earn wellness incentives, and make educated investment choices to grow their tax-advantaged healthcare savings. The core of our ecosystem is the health savings account, or HSA, a financial account through which consumers spend and save long-term for healthcare on a tax-advantaged basis. We are the integrated HSA platform for 20 of the 50 largest health plans in the country, a number of which are among 28 Blue Cross and Blue Shield health plans in 26 states, and more than 25,000 employer clients, including industry leaders such as American Express Company, Dow Corning Corporation, eBay, Inc., Google, Inc., Intermountain Healthcare and Kohl's Corporation. Through our Network Partners, we have the potential to reach over 55 million consumers, representing approximately 30% of the under-age 65 privately insured population in the United States. Since our inception in 2002, we have been committed to developing technology solutions that empower healthcare consumers. In 2003, we began offering live 24/7/365 consumer support from health saving and spending experts. In 2005, we integrated HSAs with our first Health Plan Partner, and in 2006, we were authorized to act as an HSA custodian by the U.S. Department of the Treasury. In 2009, we integrated HSAs with multiple health plans of a single large employer, began delivering integrated wellness incentives through an HSA, and partnered with a private health insurance exchange as its preferred HSA partner. In 2011, we integrated HSAs, reimbursement arrangements, or RAs, and investment accounts on one website, and in 2013, we began delivering HSA-specific investment advice online. Our customers include individuals, employers of all sizes and health plans. We refer to our individual customers as our members, all of our health plan customers as our Health Plan Partners and our employer customers with more than 1,000 employees as our Employer Partners. Our Health Plan Partners and Employer Partners collectively constitute our Network Partners. We generate revenue primarily from three sources: account fees, custodial fees and card fees. We generate account fee revenue by providing monthly account services on our platform, primarily through multi-year contracts -17- -------------------------------------------------------------------------------- with our Network Partners that are typically three to five years in duration. We generate custodial fee revenue from interest we earn on cash assets under management, or AUM, deposited with our FDIC-insured custodial depository bank partners, and recordkeeping fees we earn from mutual funds in which our members invest on a self-directed basis. We also generate payment card fee revenue from interchange fees that we earn on payments that our members make using our physical and virtual payment cards. Key factors affecting our performance We believe that our performance and future success are driven by a number of factors, including those identified below. Each of these factors presents both significant opportunities and significant risks to our future performance. See the section entitled "Risk factors." Structural change in U.S. private health insurance Substantially all of our revenue is derived from healthcare-related saving and spending by consumers, which is impacted by changes affecting the broader healthcare industry. The healthcare industry has changed significantly in recent years, and we expect that significant changes will continue to occur that will result in increased participation in high deductible health plans that are eligible to be coupled with HSAs, or HSA Plans, and other consumer-centric health plans. In particular, we believe that the implementation of the Patient Protection and Affordable Care Act of 2010, or PPACA, over the remainder of this decade, continued growth in healthcare costs, and related factors will spur HSA Plan and HSA growth; however, the timing and impact of these and other developments in the healthcare industry are difficult to predict. Attracting and penetrating network partners We created our business model to take advantage of the changing dynamics of the U.S. private health insurance market. Our model is based on a business-to-business-to-consumer, or B2B2C, distribution strategy, meaning we rely on our Employer Partners and Health Plan Partners to reach potential members to increase the number of HSAs for which we serve as custodian, which we refer to of HSAs for which we serve as custodian, which we refer to as our HSA Members. Our success depends in large part on our ability to further penetrate our existing Network Partners by adding new members from these partners and adding new Network Partners. Our innovative technology platform We believe that innovations incorporated in our technology that enable consumers to make healthcare saving and spending decisions differentiate us from our competitors and drive our growth in revenue, HSA Members, Network Partners and AUM. Similarly, these innovations underpin our ability to provide a differentiated consumer experience in a cost-effective manner. For example, we are currently undertaking a significant update of our proprietary platform's architecture, which will allow us to decrease our maintenance spending and increase our budget for innovation initiatives. As part of this project, we are also investing in improvements in our transaction processing capabilities and related platform infrastructure to support continued account and transaction growth. We intend to continue to invest aggressively in our technology development to enhance our platform's capabilities and infrastructure. Our "Purple" culture The new healthcare consumer needs education and advice delivered by people as well as technology. We believe that our team-oriented customer-focused culture, which we call "Purple," is a significant factor in our ability to attract and retain customers and to nimbly address opportunities in the rapidly changing healthcare sector. We make significant efforts to promote and foster Purple within our workforce. We invest in and intend to continue to invest in human capital through technology-enabled training, career development and advancement opportunities. We regularly measure the success of these efforts, particularly in the context of rapid growth. Interest rates As a non-bank custodian, we contract with FDIC-insured custodial depository bank partners to hold cash AUM, and we generate a significant portion of our total revenue from fees we charge based on interest rates offered to us by these partners. These contracts are long-term, substantially reducing our exposure to short-term fluctuations in interest rates. A sustained decline in prevailing interest rates may negatively affect our business by reducing the size of the interest rate margins available to us and thus the size of the custodial fees we can charge our members. Conversely, a sustained increase in prevailing interest rates would present us with an opportunity to increase our interest rate margins. Changes in prevailing interest rates are driven by macroeconomic trends and government policies over which we have no control. -18- -------------------------------------------------------------------------------- Our competition and industry Our direct competitors are HSA custodians, of which there are over 2,200 currently competing in the market. These are primarily state or federally chartered banks and other financial institutions for which we believe technology-based healthcare services are not a core business. Certain of our direct competitors have chosen to exit the market despite increased demand for these services. This has created, and we believe will continue to create, opportunities for us to leverage our technology platform and capabilities to increase our market share. However, some of our direct competitors are in a position, should they choose, to devote more resources to the development, sale and support of their products and services than we have at our disposal. In addition, numerous indirect competitors, including benefits administration technology and service providers, partner with banks and other HSA custodians to compete with us. Our Health Plan Partners may also choose to offer technology-based healthcare services directly, as some health plans have done. Our success depends on our ability to predict and react quickly to these and other industry and competitive dynamics. Regulatory change Federal law and regulations, including the PPACA, IRS regulations, labor law and public health regulations that govern the provision of health insurance and are the foundation for tax-advantaged healthcare saving and spending through HSAs and RAs, play a pivotal role in determining our market opportunity. Privacy and data security-related laws such as Health Insurance Portability and Accountability Act of 1996, or HIPAA, and the Gramm-Leach-Bliley Act, laws governing the provision of investment advice to consumers, such as the Investment Advisers Act of 1940, and the Federal Deposit Insurance Act, all play a similar role in determining our competitive landscape. In addition, state-level regulations also have significant implications for our business in some cases. Our ability to predict and react quickly to relevant legal and regulatory trends and to correctly interpret their market and competitive implications is important to our success. Key financial and operating metrics Our management regularly reviews a number of key operating and financial metrics to evaluate our business, determine the allocation of our resources, make decisions regarding corporate strategies and evaluate forward-looking projections and trends affecting our business. We discuss certain of these key financial metrics, including revenue, below in the section entitled "-Key components of our results of operations." In addition, we utilize other key metrics as described below. HSA members The following table sets forth our HSA Members as of the periods indicated: July 31, 2014 July 31, 2013 % Change January 31, 2014 HSA Members 1,061,713 728,346 46 % 967,710 Average HSA Members 1,015,539 701,072 45 % 747,182 We define an HSA Member as an HSA for which we serve as custodian. Tracking the number of our HSA Members is critical because our account fee revenue is driven by the administrative fees we charge per account. The number of our HSA Members increased by approximately 333,000, or 46%, from July 31, 2013 to July 31, 2014, and by approximately 94,000, or 10%, from 967,710 as of January 31, 2014 to 1,061,713 as of July 31, 2014. The increase in the number of our HSA Members in these periods was driven by the addition of new Network Partners and further penetration into existing Network Partners. Assets under management The following table sets forth our AUM as of the periods indicated: (in thousands, except percentages) July 31, 2014 July 31, 2013 $ Change % Change January 31, 2014 Cash AUM $ 1,546,753 $ 1,129,490 $ 417,263 37 % $ 1,442,336 Investment AUM 237,831 134,417 103,414 77 % 182,614 Total AUM $ 1,784,584 $ 1,263,907 $ 520,677 41 % $ 1,624,950 Average daily cash AUM $ 1,480,075 $ 1,096,021 $ 384,054 35 % $ 1,137,825 -19--------------------------------------------------------------------------------- We define AUM as our custodial assets under management. Our AUM consists of two components: (1) cash AUM, or our members' HSA assets that are deposited with our FDIC-insured custodial depository bank partners; and (2) investment AUM, or our members' HSA assets that are invested in mutual funds through our custodial investment fund partner. Measuring our AUM is important because our custodial fee revenue is determined by the applicable account yields and average daily AUM balances. Our AUM increased by $520.7 million, or 41%, from $1.26 billion as of July 31, 2013 to $1.78 billion as of July 31, 2014. Our AUM increased by $159.6 million, or 10%, from $1.62 billion as of January 31, 2014 to $1.78 billion as of July 31, 2014. The increase in AUM in these periods was driven by additional AUM from our existing HSA Members and new AUM from new HSA Members added during the fiscal year. Adjusted EBITDA The following table sets forth our Adjusted EBITDA: Three months ended July 31, Six months ended July 31, (in thousands, except percentages) 2014 2013 $ Change % Change 2014 2013 $ Change % Change Adjusted EBITDA $ 6,866 $ 4,637 $ 2,229 48 % $ 13,671 $ 8,476 $ 5,195 61 % We define Adjusted EBITDA, which is a non-GAAP financial metric, as adjusted earnings before interest, taxes, depreciation and amortization and certain other non-cash statement of operations items. We believe that Adjusted EBITDA provides useful information to investors and analysts in understanding and evaluating our operating results in the same manner as our management and our board of directors because it reflects operating profitability before consideration of non-operating expenses and non-cash expenses, and serves as a basis for comparison against other companies in our industry. Our Adjusted EBITDA increased by $2.2 million, or 48%, from $4.6 million for the three months ended July 31, 2013 to $6.9 million for the three months ended July 31, 2014. The increase in Adjusted EBITDA was driven by the overall growth of our business, including a $1.5 million, or 40%, increase in income from operations. Our Adjusted EBITDA increased by $5.2 million, or 61%, from $8.5 million for the six months ended July 31, 2013 to $13.7 million for the six months ended July 31, 2014. The increase in Adjusted EBITDA was driven by the overall growth of our business, including a $4.0 million, or 61%, increase in income from operations. Our use of Adjusted EBITDA has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. The following table presents a reconciliation of net income and comprehensive income, the most comparable GAAP financial measure, to Adjusted EBITDA for each of the periods indicated: Three months ended July 31, Six months ended July 31, (in thousands) 2014 2013 2014 2013 Net income and comprehensive income $ 3,028 $ 2,222 $ 5,746 $ 3,972 Interest expense - 10 - 20 Income tax provision 2,004 1,351 3,947 2,444 Depreciation and amortization 983 600 1,825 1,171 Amortization of acquired intangible assets 409 409 818 818 Loss on revaluation of redeemable convertible preferred stock derivative liability - - 735 - Other (1) 442 45 600 51 Total adjustments $ 3,838 $ 2,415 $ 7,925 $ 4,504 Adjusted EBITDA $ 6,866 $ 4,637 $ 13,671 $ 8,476 (1) For the three and six months ended July 31, 2014 and 2013, Other consisted of interest income of $0, $(12), $0 and $(24), miscellaneous taxes of $39, $42, $132 and $44, and stock-based compensation expense of $403, $15, $468 and $31, respectively. -20--------------------------------------------------------------------------------- Key components of our results of operations Revenue The following table sets forth our revenue for the periods indicated: Three months ended July 31, Six months ended July 31, (in thousands, except percentages) 2014 2013 $ Change % Change 2014 2013 $ Change % Change Account fee revenue $ 10,548 $ 7,209 $ 3,339 46 % $ 20,936 $ 14,225 $ 6,711 47 % Custodial fee revenue 5,934 4,648 1,286 28 % 11,361 9,097 2,264 25 % Card fee revenue 4,233 3,014 1,219 40 % 8,531 6,076 2,455 40 % Other revenue 176 111 65 59 % 294 208 86 41 % Total revenue $ 20,891 $ 14,982 $ 5,909 39 % $ 41,122 $ 29,606 $ 11,516 39 % We generate revenue from three primary sources: account fees, custodial fees and card fees. We also generate other revenue, primarily from marketing materials that we produce for our Network Partners. Account fee revenue. We earn account fee revenue from the fees we charge our Network Partners, employer clients and individual members for the administration services we provide in connection with the Health Savings Accounts ("HSA") and Health Reimbursement Arrangements ("HRA") we offer. Our fees are generally fixed for the duration of our agreement with the relevant customer, which is typically three to five years, and are paid to us on a monthly basis. We recognize revenue on a monthly basis as services are rendered under our written service agreements. Custodial fee revenue. We earn custodial revenue from our AUM held in trust with our FDIC-insured custodial depository bank partners and our custodial investment partners. As a non-bank custodian, we deposit our cash AUM with our various bank partners pursuant to contracts that (i) have terms up to five years, (ii) provide for a fixed or variable interest rate payable on the average daily cash balances deposited with the relevant bank partner, and (iii) have minimum and maximum required deposit balances. We earn custodial fees on our cash AUM that are based on the interest rates offered to us by these bank partners. In addition, once a member's HSA cash balance reaches a certain threshold, the member is able to invest his or her HSA assets in mutual funds through our custodial investment partner. We receive a recordkeeping fee related to such investment AUM. Card fee revenue. We earn card fee revenue each time one of our members uses one of our payment cards to make a qualified purchase. These card fees are collected each time a member "swipes" our payment card to pay a healthcare-related expense. We recognize card fee revenue monthly based on reports received from third parties, namely, the card-issuing bank and the card processor. Cost of services Cost of services includes costs related to servicing member accounts, managing customer and partner relationships and processing reimbursement claims. Expenditures include personnel-related costs, depreciation, amortization, stock-based compensation, common expense allocations, and other operating costs related to servicing our members. Other components of cost of services include interest paid to members on cash AUM and card costs incurred in connection with processing card transactions for our members. Account costs. Account costs include the account servicing costs described above. Additionally, for new accounts, we incur on-boarding costs associated with the new accounts, such as new member welcome kits and the cost associated with issuance of new payment cards. Custodial costs. Custodial costs are comprised of interest we pay to our HSA Members and fees we pay to banking consultants whom we use to help secure agreements with our FDIC-insured custodial depository banking partners. We pay interest to HSA Members on a tiered basis. The interest rates we pay to HSA Members can be changed at any time upon required notice, typically 30 days. Card costs. Card costs are comprised of costs we incur in connection with processing payment card transactions initiated by our members. Due to the substantiation requirement on RA-linked payment card transactions, which is the requirement that we confirm each purchase involves a qualified medical expense as defined under applicable law, payment card costs are higher for RA card transactions. In addition to fixed per card fees, we are assessed additional transaction costs determined by the amount of the card transaction. Other costs. Other costs are comprised of costs of marketing materials that we produce for our Network Partners. -21- -------------------------------------------------------------------------------- Gross profit and gross margin Our gross profit is our total revenue minus our total cost of services, and our gross margin is our gross profit expressed as a percentage of our total revenue. Our gross margin has been and will continue to be affected by a number of factors, including the fees we charge per account, interest rates, how many services we deliver per account, and card processing costs per account. We expect our annual gross margin to remain relatively steady over the near term, although our gross margin could fluctuate from period to period depending on the interplay of these factors. Operating expenses Sales and marketing. Sales and marketing expenses consist primarily of personnel and related expenses for our sales and marketing staff, including sales commissions for our direct sales force, external agent/broker commission expenses, marketing expenses, depreciation, amortization, stock-based compensation, and common expense allocations. We expect our sales and marketing expenses to increase for the foreseeable future as we continue to increase the size of our sales and marketing organization and expand into new markets. However, we expect our sales and marketing expenses to decrease slightly as a percentage of our total revenue over the near term. Our sales and marketing expenses may fluctuate as a percentage of our total revenue from period to period due to the seasonality of our total revenue and the timing and extent of our sales and marketing expenses. Technology and development. Technology and development expenses include personnel and related expenses for software engineering, information technology, security and compliance, and product development. Technology and development expenses also include outsourced software engineering services, the costs of operating our on-demand technology infrastructure, depreciation, amortization of capitalized software development costs, stock-based compensation, and common expense allocations. We expect our technology and development expenses to increase for the foreseeable future as we continue to invest in the development of our proprietary system. We expect our technology and development expenses to increase as a percentage of our total revenue over the near term as a result of higher amortization costs related to our planned capital expenditures to improve the architecture of our proprietary system. Our technology and development expenses may fluctuate as a percentage of our total revenue from period to period due to the seasonality of our total revenue and the timing and extent of our technology and development expenses. General and administrative. General and administrative expenses include personnel and related expenses of, and professional fees incurred by, our executive, finance, legal, and people departments. They also include depreciation, amortization, stock-based compensation and common expense allocations. We expect our general and administrative expenses to increase for the foreseeable future due to the additional legal, accounting, insurance, investor relations and other costs that we will incur as a newly public company, as well as other costs associated with continuing to grow our business. However, we expect our general and administrative expenses to remain steady as a percentage of our total revenue over the near term. Our general and administrative expenses may fluctuate as a percentage of our total revenue from period to period due to the seasonality of our total revenue and the timing and extent of our general and administrative expenses. Amortization of acquired intangible assets. Amortization of acquired intangible assets results from our acquisition of intangible member assets. We acquired these intangible member assets from third-party custodians. We amortize these assets over the assets' estimated useful life of 15 years. We evaluate these assets for impairment each year. Other expense Other expense primarily consists of interest expense, loss on revaluation of warrants and loss on revaluation of our derivative liability associated with our series D-3 redeemable convertible preferred stock. We continued to record adjustments to the fair value of the derivative liability associated with our series D-3 redeemable convertible preferred stock until March 31, 2014, at which time the remeasurements ceased. As a result, during the six months ended July 31, 2014, we recorded a loss on revaluation of this derivative liability. However, as a result of our modifications of our series D-3 redeemable convertible preferred stock on March 31, 2014, we reclassified the aggregate fair value of the derivative liability associated with our series D-3 redeemable convertible preferred stock to additional paid-in capital and we ceased to record any related fair value adjustments. -22- -------------------------------------------------------------------------------- Income tax provision We are subject to federal and state income taxes in the United States based on a calendar tax year that differs from our fiscal year-end for financial reporting purposes. We use the asset and liability method to account for income taxes, under which current tax liabilities and assets are recognized for the estimated taxes payable or refundable on the tax returns for the current fiscal year. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, net operating loss carryforwards, and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. As of July 31, 2014, we remain in a net deferred tax liability position. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. Due to the positive evidence of taxable income coupled with forecasted profitability, no valuation allowance was required as of July 31, 2014. Results of operations The following table sets forth our results of operations for the specified periods. The period-to-period comparisons of results are not necessarily indicative of results for future periods. Three months ended July 31, Six months ended July 31, (in thousands) 2014 2013 2014 2013 Revenue Account fee revenue $ 10,548 $ 7,209 $ 20,936 $ 14,225 Custodial fee revenue 5,934 4,648 11,361 9,097 Card fee revenue 4,233 3,014 8,531 6,076 Other revenue 176 111 294 208 Total revenue 20,891 14,982 41,122 29,606 Cost of services Account costs 6,703 4,705 13,131 9,700 Custodial costs 1,006 910 1,944 1,879 Card costs 1,412 1,009 2,817 1,983 Other costs 1 15 2 42 Total cost of services 9,122 6,639 17,894 13,604 Gross profit 11,769 8,343 23,228 16,002 Operating expenses Sales and marketing 2,321 1,837 4,554 3,582 Technology and development 2,302 1,659 4,488 3,328 General and administrative 1,666 825 2,809 1,735 Amortization of acquired intangible assets 409 409 818 818 Total operating expenses 6,698 4,730 12,669 9,463 Income from operations 5,071 3,613 10,559 6,539 Other expense Interest expense - (10 ) - (20 ) Loss on revaluation of warrants - - (735 ) - Other expense, net (39 ) (30 ) (131 ) (103 ) Total other expense (39 ) (40 ) (866 ) (123 ) Income before income taxes 5,032 3,573 9,693 6,416 Income tax provision 2,004 1,351 3,947 2,444 Net income and comprehensive income $ 3,028 $ 2,222 $ 5,746 $ 3,972 -23---------------------------------------------------------------------------------The following table presents the components of our results of operations for the periods indicated as a percent of our total revenue: Three months ended July 31, Six months ended July 31, 2014 2013 2014 2013 Revenue Account fee revenue 51 % 48 % 51 % 48 % Custodial fee revenue 28 % 31 % 27 % 31 % Card fee revenue 20 % 20 % 21 % 20 % Other revenue 1 % 1 % 1 % 1 % Total revenue 100 % 100 % 100 % 100 % Cost of services Account costs 32 % 31 % 32 % 33 % Custodial costs 5 % 6 % 5 % 6 % Card costs 7 % 7 % 7 % 7 % Other costs - % - % - % - % Total cost of services 44 % 44 % 44 % 46 % Gross profit 56 % 56 % 56 % 54 % Operating expenses Sales and marketing 11 % 12 % 11 % 12 % Technology and development 11 % 11 % 11 % 11 % General and administrative 8 % 6 % 6 % 6 % Amortization of acquired intangible assets 2 % 3 % 2 % 3 % Total operating expenses 32 % 32 % 30 % 32 % Income from operations 24 % 24 % 26 % 22 % Other expense Interest expense - % - % - % - % Loss on revaluation of warrants - % - % (2 )% - % Other expense, net - % - % - % - % Total other expense - % - % (2 )% - % Income before income taxes 24 % 24 % 24 % 22 % Income tax provision 10 % 9 % 10 % 9 % Net income and comprehensive income 14 % 15 % 14 % 13 % Comparison of the three and six months ended July 31, 2014 and 2013 Account fee revenue The $3.3 million increase in account fee revenue for the three months ended July 31, 2014 as compared to the three months ended July 31, 2013 was primarily due to an increase in the number of our HSA Members. The $6.7 million increase in account fee revenue for the six months ended July 31, 2014 as compared to the six months ended July 31, 2013 was primarily due to an increase in the number of our HSA Members. The number of our HSA Members increased by approximately 333,000, or 46%, from July 31, 2013 to July 31, 2014. The growth in the number of our HSA Members from July 31, 2013 to July 31, 2014 was due to a combination of growth from our new and existing Network Partners. Custodial fee revenue The $1.3 million increase in custodial fee revenue from the three months ended July 31, 2013 to the three months ended July 31, 2014 was primarily due to an increase in average daily cash AUM of $395 million, or 36%, partially offset by a decrease in the yield on average cash AUM from 1.65% in the three months ended July 31, 2013 to 1.52% in the three months ended July 31, 2014. Custodial fees decreased in the three months ended July 31, 2014 -24- -------------------------------------------------------------------------------- as a percentage of our total revenue compared to the three months ended July 31, 2013, primarily due to lower-rate custodial depository agreements added in the three months ended July 31, 2014 to accommodate our growth in cash AUM. This had an adverse impact on our interest yield during the three months ended July 31, 2014 compared to the three months ended July 31, 2013. The $2.3 million increase in custodial fee revenue from the six months ended July 31, 2013 to the six months ended July 31, 2014 was primarily due to an increase in average daily cash AUM of $384.1 million, or 35%, partially offset by a decrease in the yield on average cash AUM from 1.66% in the six months ended July 31, 2013 to 1.50% in the six months ended July 31, 2014. Custodial fees decreased in the six months ended July 31, 2014 as a percentage of our total revenue compared to the six months ended July 31, 2013, primarily due to lower-rate custodial depository agreements added in the six months ended July 31, 2014 to accommodate our growth in cash AUM. This had an adverse impact on our interest yield during the six months ended July 31, 2014 compared to the three months ended July 31, 2013. Cash AUM per HSA Member of $1,457 as of July 31, 2014 was 6% lower than the cash AUM per HSA Member of $1,551 as of July 31, 2013. This was primarily due to new HSAs having lower average balances than those HSAs that have been open for multiple years. Investment AUM increases resulted from an increase in the number of our members choosing to move their HSA assets from cash balances to investment balances, along with market changes (positive or negative) in the particular investments chosen. Card fee revenue The $1.2 million increase in card fee revenue from the three months ended July 31, 2013 to the three months ended July 31, 2014 was due to an overall increase in the number of our HSA Members and card activity. In addition, we continued to see a trend toward more HSA spending through payment card transaction swipes and less by checks and ACH or electronic reimbursements, which increased our card fee revenue. The $2.5 million increase in card fee revenue from the six months ended July 31, 2013 to the six months ended July 31, 2014 was due to an overall increase in the number of our HSA Members and card activity. Other revenue Other revenue increased $65,000 and $86,000 from the three and six months ended July 31, 2013 to the three and six months ended July 31, 2014, respectively. The increases were the result of an increase in the amount of fees charged to our Network Partners for marketing materials. Cost of services The following table sets forth our cost of service for the periods indicated: Three months ended July 31, Six months ended July 31, (in thousands, except percentages) 2014 2013 $ Change % Change 2014 2013 $ Change % Change Account costs $ 6,703 $ 4,705 $ 1,998 42 % $ 13,131 $ 9,700 $ 3,431 35 % Custodial costs 1,006 910 96 11 % 1,944 1,879 65 3 % Card costs 1,412 1,009 403 40 % 2,817 1,983 834 42 % Other costs 1 15 (14 ) (93 )% 2 42 (40 ) (95 )% Total cost $ 9,122 $ 6,639 $ 2,483 37 % $ 17,894 $ 13,604 $ 4,290 32 % Account costs The $2.0 million increase in account costs from the three months ended July 31, 2013 to the three months ended July 31, 2014 was due to the higher volume of total accounts being serviced. The $2.0 million increase includes $1.4 million related to the hiring of additional personnel to implement and support our new Network Partners and HSA Members, activation and processing costs of $278,000 related to account and card activation as well as monthly processing of statements and other communications, information technology expenses of $134,000, depreciation and amortization of $100,000, stock compensation of $49,000 and $53,000 in other expenses. The $3.4 million increase includes $2.4 million related to the hiring of additional personnel to implement and support our new Network Partners and HSA Members, activation and processing costs of $632,000 related to account and card activation as well as monthly processing of statements and other communications, information technology expenses of $71,000, depreciation and amortization of $183,000, stock compensation of $65,000 and $29,000 in other expenses. -25- -------------------------------------------------------------------------------- Custodial costs Our custodial costs increased $96,000 from the three months ended July 31, 2013 compared to the three months ended July 31, 2014. Our custodial costs on average cash AUM decreased from 0.33% in the three months ended July 31, 2013 to 0.27% for the three months ended July 31, 2014, while average cash AUM increased from $1.10 billion during the three months ended July 31, 2013 to $1.50 billion during the three months ended July 31, 2014. Our custodial costs increased $65,000 from the six months ended July 31, 2013 compared to the six months ended July 31, 2014. Our custodial costs on average cash AUM decreased from 0.35% in the six months ended July 31, 2013 to 0.26% for the six months ended July 31, 2014, while average cash AUM increased from $1.09 billion during the six months ended July 31, 2013 to $1.48 billion during the three months ended July 31, 2014. Card costs Card costs increased $403,000, or 40%, during the three months ended July 31, 2014 compared to the three months ended July 31, 2013. Card costs increased $834,000, or 42%, during the six months ended July 31, 2014 compared to the six months ended July 31, 2013. The increases are a result of increases in card fee revenue and RA spend increasing as a percentage of total spend. As we continue to add HSA Members, our cost of services will increase in dollar amount to support our Network Partners and members. Cost of services will continue to be affected by a number of different factors, including our ability to implement new technology in our Member Education Center as well as scaling our Network Partner implementation and account management functions. Operating expenses The following table sets forth our operating expenses for the periods indicated: Three months ended July 31, Six months ended July 31, (in thousands, except percentages) 2014 2013 $ Change % Change 2014 2013 $ Change % Change Sales and marketing $ 2,321 $ 1,837 $ 484 26 % $ 4,554 $ 3,582 $ 972 27 % Technology and development 2,302 1,659 643 39 % 4,488 3,328 1,160 35 % General and administration 1,666 825 841 102 % 2,809 1,735 1,074 62 % Amortization of acquired intangible assets 409 409 - - % 818 818 - - % Total operating expenses $ 6,698 $ 4,730 $ 1,968 42 % $ 12,669 $ 9,463 $ 3,206 34 % Sales and marketing The $484,000 increase in sales and marketing expense from the three months ended July 31, 2013 compared to the three months ended July 31, 2014 primarily consisted of increased staffing and sales commissions of $286,000, stock compensation of $135,000, marketing expenses of $52,000 and travel and entertainment of $24,000. These increased expenses were partially offset by lower costs in other expenses of $13,000. The $972,000 increase in sales and marketing expense from the six months ended July 31, 2013 compared to the six months ended July 31, 2014 primarily consisted of increased staffing and sales commissions of $641,000, stock compensation of $135,000, travel and entertainment of $123,000, marketing expenses of $59,000 and other expenses of $14,000. We will continue to invest in sales and marketing by hiring additional personnel and promoting our brand through a variety of marketing and public relations activities. As a result, we expect our sales and marketing expenses to increase in future periods. Technology and development The $643,000 increase in technology and development expenses for the three months ended July 31, 2014 compared to the three months ended July 31, 2013 resulted primarily from hiring additional personnel, totaling $381,000, and professional fees of $696,000 related to the ongoing project to improve and optimize our proprietary technology platform. There were other expenses of $64,000, stock compensation of $48,000, amortization of $263,000, all of which were offset primarily by an increase in capitalized engineering of $809,000. -26- -------------------------------------------------------------------------------- The $1.2 million increase in technology and development expenses for the six months ended July 31, 2014 compared to the six months ended July 31, 2013 resulted primarily from hiring additional personnel, totaling $632,000, and professional fees of $968,000 related to the ongoing project to improve and optimize our proprietary technology platform. There were other expense increases related to stock compensation of $75,000, amortization of $424,000, and other expenses of $147,000 all of which were offset primarily by an increase in capitalized engineering of $1.1 million. We will continue to invest in our proprietary technology platform. The timing of development and enhancement projects, including whether they are capitalized or expensed, will significantly affect our technology and development expense both in dollar amount and as a percentage of revenue. General and administrative The $841,000 increase in general and administrative expenses for the three months ended July 31, 2014 compared to the three months ended July 31, 2013 was primarily attributable to increased personnel and professional fees of $663,000, stock compensation of $151,000 and other expenses of $27,000. The $1.1 million increase in general and administrative expenses for the six months ended July 31, 2014 compared to the six months ended July 31, 2013 was primarily attributable to increased personnel and professional fees of $860,000, stock compensation of $162,000 and other expenses of $52,000. As we continue to grow, we expect our general and administrative expenses to continue to increase in dollar amount as we expand general and administrative headcount to support our continued growth. Amortization of acquired intangible assets The amortization of acquired intangible assets was unchanged between the three months ended July 31, 2013 and the three months ended July 31, 2014 as no additional acquisitions occurred during the year ended January 31, 2014 or during the three months ended July 31, 2014. The amortization of acquired intangible assets was unchanged between the six months ended July 31, 2013 and the six months ended July 31, 2014 as no additional acquisitions occurred during the year ended January 31, 2014 or during the six months ended July 31, 2014. Other expense The following table sets forth our other expense for the periods indicated. Three months ended July 31, Six months ended July 31, (in thousands) 2014 2013 $ Change 2014 2013 $ Change Interest expense $ - $ (10 ) $ 10 $ - $ (20 ) $ 20 Loss on revaluation of redeemable convertible preferred stock derivative - - - (735 ) - (735 ) Other expense, net (39 ) (30 ) (9 ) (131 ) (103 ) (28 ) Other expense $ (39 ) $ (40 ) $ 1 $ (866 ) $ (123 ) $ (743 ) Loss on revaluation of redeemable convertible preferred stock derivative There were no adjustments to the fair market value of the series D-3 redeemable convertible stock during the three months ended July 31, 2014. The $735,000 loss during the six months ended July 31, 2014 relates to a revaluation of the fair market value of our derivative liability associated with our series D-3 redeemable convertible preferred stock. Due to the modification of our series D-3 redeemable convertible preferred stock in March 2014, there will be no further fair market value adjustments. Income tax provision Our effective tax rate for the three and six months ended July 31, 2014 was 39.8% and 40.7%, respectively, compared to 37.8% and 38.1% for the three and six months ended July 31, 2013, respectively. The 2.0 and 2.6 percentage point increase in the three and six months ended July 31, 2014 over the three and six months ended July 31, 2013 is primarily due to an increase in permanent tax items in relation to income before income taxes, expiration of the federal research and development tax credits as of December 31, 2013, and discrete tax items -27- -------------------------------------------------------------------------------- related to tax benefits on stock compensation expense on stock options vesting upon the Company's initial public offering offset by increases in federal and state tax rates during the three and six months ended July 31, 2014. Seasonality Seasonal concentration of our growth combined with our recurring revenue model create seasonal variation in our results of operations. A significant number of new and existing Network Partners bring new HSA Members beginning in January concurrent with the start of many employers' benefit plan years. Before we realize any revenue from these new HSA Members, we incur costs related to implementing and supporting our new Network Partners and new HSA Members. These costs of services relate to activating the account and the hiring of additional staff, including seasonal help to support our Member Education Center. These expenses begin to ramp up during our third fiscal quarter with the majority of expenses incurred in our fourth fiscal quarter. We also experience higher operating expenses in our fourth fiscal quarter due to sales commissions for new accounts activated in January. Liquidity and capital resources As of July 31, 2014, our principal source of liquidity was collections from our account, custodial and card fee revenue activities. We rely on cash provided by operating activities to meet our short-term liquidity requirements, which primarily relate to the payment of corporate payroll and other operating costs, and capital expenditures. As of July 31, 2014 and January 31, 2014, cash and cash equivalents totaled $20.9 million and $13.9 million, respectively. In August 2014, we consummated our IPO and received net proceeds of approximately $132.5 million from the issuance of 10,465,000 shares of common stock. Capital expenditures for the three and six months ended July 31, 2014 and 2013 were $2.4 million, $1.4 million, $4.6 million, and $2.4 million, respectively. We expect to continue our increased capital expenditures for the remainder of the year ending January 31, 2015 as we are devoting a significant amount of our capital expenditures to improve the architecture and functionality of our proprietary system. Costs to improve the architecture of our proprietary system include outsourced software engineering services, computer hardware, and personnel and related costs for software engineering. We believe our existing cash and cash equivalents, and the net proceeds from our IPO, will be sufficient to meet our operating and capital expenditure requirements for at least the next 12 months. To the extent these current and anticipated future sources of liquidity are insufficient to fund our future business activities and requirements we may need to raise additional funds through public or private equity or debt financing. In the event that additional financings is required, we may not be able to raise it on favorable terms, if at all. The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods: Six months ended July 31, (in thousands) 2014 2013 Net cash provided by operating activities $ 6,350 $ 7,124 Net cash used in investing activities (4,563 ) (2,400 ) Net cash provided by (used in) financing activities 5,182 (1,302 ) Increase in cash and cash equivalents 6,969 3,422 Beginning cash and cash equivalents 13,917 5,905 Ending cash and cash equivalents $ 20,886 $ 9,327 Cash flows provided by operating activities Net cash provided by operating activities during the six months ended July 31, 2014 resulted primarily from our net income of $5.7 million being adjusted for the following non-cash items: depreciation and amortization of $2.6 million and deferred income taxes of $1.8 million and a revaluation of our derivative liability associated with our series D-3 redeemable convertible preferred stock of $735,000, changes in stock-based compensation of $468,000, and changes in inventories and deferred rent totaling $64,000. These items were offset by changes in accrued compensation of $1.1 million and accounts payable of $1.9 million as well as accounts receivable of $582,000 and prepaid items and accrued liabilities totaling $1.5 million. -28- -------------------------------------------------------------------------------- Net cash provided by operating activities during the six months ended July 31, 2013 resulted primarily from our net income of $4.0 million being adjusted for the following non-cash items: depreciation and amortization of $2.0 million and deferred income taxes of $2.4 million, accrued liabilities of $709,000, deferred rent of $189,000, and other miscellaneous items totaling $59,000. These items were offset by changes in accrued compensation of $915,000, and accounts payable of $633,000 as well as accounts receivable of $290,000, and inventories, income taxes payable and prepaid items totaling $371,000. Cash flows used in investing activities Net cash used in investing activities for the six months ended July 31, 2014 was primarily the result of purchases of software and capitalized software development costs of $3.5 million. This compares to $1.6 million for the six months ended July 31, 2013. The increase can be primarily attributed to development of our proprietary system and other software necessary to support our continued account growth. We also increased our purchases of property and equipment from $773,000 during the six months ended July 31, 2013 to $1.0 million during the six months ended July 31, 2014. Cash flows provided by (used in) financing activities Cash flow provided by financing activities during the six months ended July 31, 2014 resulted from the exercising of stock options totaling $2.4 million, exercising of common stock warrants totaling $2.3 million and the associated tax benefits totaling $1.9 million. These items were offset by offering costs of $1.4 million in connection with the Company's initial public offering. Cash flow used in financing activities during the six months ended July 31, 2013 resulted primarily from the repayment of notes in the amount of $1.5 million, partially offset by the exercising of stock options in the amount of $198,000. Contractual obligations Except for the following amended lease agreement, there were no material changes outside the ordinary course of business to our contractual obligations since the filing of the Company's prospectus (dated July 30, 2014) filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933 on August 1, 2014. In March 2014, the Company modified its corporate office lease to expand its existing space for an additional commitment of $1.1 million over the term of the original lease. Off-balance sheet arrangements During the three and six months ended July 31, 2014 and 2013, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements. Critical accounting policies and significant management estimates Our management's discussion and analysis of financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable in the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. Our significant accounting policies are more fully described in Note 1 of the accompanying unaudited condensed financial statements and in Note 1 to our audited financial statements contained in our final prospectus (dated July 30, 2014) filed pursuant to Rule 424(b) on August 1, 2014 with the SEC. There have been no significant or material changes in our critical accounting policies during the three and six months ended July 31, 2014, as compared to those disclosed in "Management's discussion and analysis of financial condition and results of operations - Critical accounting policies and significant management estimates" in our final prospectus filed on August 1, 2014. -29--------------------------------------------------------------------------------- Recent accounting pronouncements On May 28, 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for our annual and interim reporting periods beginning February 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on the consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor determined the effect of the standard on the ongoing financial reporting. |