HEALTHEQUITY, INC. 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 the anticipated synergies and other benefits of our Acquisition of WageWorks, health savings accounts and other tax advantaged consumer-directed benefits, tax and other regulatory changes, market opportunity, our future financial and operating results, investment and acquisition 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 and other acquisitions, 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 in this Quarterly Report on Form 10-Q, and in our other reports filed with theSEC . 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. Consumers use our platforms to manage their
tax-advantaged health savings accounts ("HSAs") and other consumer-directed
benefits ("CDBs") offered by employers, including flexible spending accounts and
health reimbursement arrangements ("FSAs" and "HRAs"), Consolidated Omnibus
Budget Reconciliation Act ("COBRA") administration, commuter and other benefits,
compare treatment options and pricing, evaluate and pay healthcare bills,
receive personalized benefit information, access remote and telemedicine
benefits, earn wellness incentives, and receive investment advice to grow their
tax-advantaged healthcare savings.
The core of our offerings is the HSA, a financial account through which
consumers spend and save long-term for healthcare expenses on a tax-advantaged
basis. As of October 31, 2019 , we administered 5.0 million HSAs, with balances
totaling $10.5 billion , which we call HSA Assets. Also, as of October 31, 2019 ,
we administered 7.5 million complementary CDBs. We refer to the sum of HSAs and
CDBs on our platforms as Total Accounts, of which we had 12.5 million as of
October 31, 2019 .
We reach consumers primarily through relationships with their employers, whom we
call Clients. We reach Clients primarily through a sales force that calls on
Clients directly, relationships with benefits brokers and advisors, and
integrated partnerships with a network of health plans, benefits administrators
and retirement plan recordkeepers, which we call Network Partners .
We have grown our share of the growing HSA market from 4% in 2010 to 17% in
2019, including by 3% as a result of the Acquisition of WageWorks. Today we are
the largest HSA provider by accounts, second largest by assets, and, we believe,
the largest provider of other CDBs. We seek to differentiate ourselves through
our proprietary technology, product breadth, ecosystem connectivity and
service-driven culture. Our proprietary technology is designed to help consumers
optimize the value of their HSAs and other CDBs, as they gain confidence and
skill in their management of financial responsibility for lifetime healthcare.
Our ability to engage consumers is enhanced by our platforms' capacity to
securely share data bidirectionally with others in the health, benefits and
retirement ecosystems, whom we call Ecosystem Partners . Our commuter
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benefits offering also leverages connectivity to an ecosystem of mass transit, ride hailing and parking providers. These strengths reflect our "DEEP Purple" culture of remarkable service to customers and teammates, achieved by driving excellence, ethics, and process into everything we do. We earn revenue primarily from three sources: service, custodial and interchange. We earn service revenue mainly from fees paid by Clients on a recurring per-account per-month basis. We earn custodial revenue mainly from HSA Assets held at our members' direction in federally insured cash deposits, insurance contracts or mutual funds, and from investment of CDB Client pre-funding amounts. We earn interchange revenue mainly from fees paid by merchants on payments that our members make using our physical payment cards and virtual platforms. See "Key components of our results of operations" for additional information on our sources of revenue. Acquisition of WageWorks OnAugust 30, 2019 , we completed the Acquisition of WageWorks and paid approximately$2.0 billion in cash to WageWorks stockholders, financed through net borrowings of approximately$1.22 billion under a new term loan facility and approximately$816.9 million of cash on hand. The Acquisition is expected to increase the number of our employer opportunities, the conversion of these opportunities to Clients, and value of the Clients in generating members, HSA Assets and complementary CDBs.WageWorks' strength of selling to employers directly and through health benefits brokers and advisors complements our distribution throughNetwork Partners . Together these channels produce 79% of new HSAs according to Devenir. WithWageWorks' CDB capabilities, we can provide employers with a single partner for both HSAs and other CDBs, which is preferred by the vast majority of employers, according to research conducted for us byAite Group . For Clients who partner with us in this way, we believe we can produce more value by encouraging both CDB participants to contribute to HSAs and HSA-only members to take advantage of tax savings by increasing their account balances in other CDBs. Accordingly, we believe that current Clients represent a significant opportunity. The Acquisition has significantly increased the number of our Total Accounts, HSA Assets, Client-held funds, Adjusted EBITDA, total revenue, total cost of revenue, operating expenses, and other financial results, and we expect that it will continue to do so. Key factors affecting our performance We believe that our future performance will be 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" included in this Quarterly Report on Form 10-Q and our other reports filed with theSEC . WageWorks integration OnAugust 30, 2019 , we completed the Acquisition of WageWorks. We are now pursuing a multi-year integration effort that we expect will produce long-term cost savings and revenue synergies. We have identified near-term opportunities, estimated to be approximately$50 million in annualized ongoing net synergies to be achieved by the end of fiscal 2021. Furthermore, we anticipate generating revenue synergies over the longer-term as our combined distribution channels and existing client base take advantage of the broader platform and service offerings and as we continue to drive Member engagement. We estimate non-recurring costs to achieve these synergies of approximately$80 million to$100 million realized within 24 to 36 months of the closing of the Acquisition, resulting from investment in technology platforms, back-office systems and platform integration, as well as rationalization of cost of operations. Structural change inU.S. health insurance We derive revenue primarily from healthcare-related saving and spending by consumers in theU.S. , which are driven by changes in the broader healthcare industry, including the structure of health insurance. The average premium for employer-sponsored health insurance has risen by 22% since 2014 and 54% since 2009, resulting in increased participation in HSA-qualified health plans and HSAs and increased consumer cost-sharing in health insurance more generally. We believe that continued growth in healthcare costs and related factors will spur continued growth in HSA-qualified health plans and HSAs and may encourage policy changes making HSAs or similar vehicles available to new populations such as individuals in Medicare. However, the timing and impact of these and other developments inU.S. healthcare are uncertain. Moreover, changes in healthcare policy, such as "Medicare for all" plans, could materially and adversely affect our business in ways that are difficult to predict. -25-
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Trends inU.S. tax law Tax law has a profound impact on our business. Our offerings to members,Clients and Network Partners consist primarily of services enabled, mandated or advantaged by provisions ofU.S. tax law and regulations. We believe that the present direction ofU.S. tax policy is favorable to our business, as evidenced for example by recent regulatory action and bipartisan policy proposals to expand the availability of HSAs. However, changes in tax policy are speculative, and may affect our business in ways that are difficult to predict. Our client base Our business model is based on a B2B2C distribution strategy, meaning that we attractClients and Network Partners to reach consumers to increase the number of our members with HSA accounts and complementary CDBs. We believe our current Clients represent a significant opportunity for us, as fewer than 5% presently partner with us for both HSAs and our complementary CDB offerings. Broad distribution footprint We believe we have a diverse distribution footprint to attract newClients and Network Partners . Our sales force calls on enterprise, commercial and regional employers in industries across theU.S. , as well as potentialNetwork Partners from among health plans, benefits administrators and retirement plan record keepers. Together these channels produce 79% of new HSAs according to Devenir. Product breadth We are the largest custodian and administrator of HSAs (by number of accounts), as well as a market-share leader in each of the major categories of complementary CDBs, including FSAs and HSAs, COBRA and commuter benefits administration. Our Clients and their benefits advisors increasingly seek HSA providers that can deliver an integrated offering of HSAs and complementary CDBs. WithWageWorks' CDB capabilities, we can provide employers with a single partner for both HSAs and complementary CDBs, which is preferred by the vast majority of employers, according to research conducted for us byAite Group . We believe that the combination of HSA and complementary CDB offerings significantly strengthens our value proposition to employers, health benefits brokers and consultants, andNetwork Partners as a leading single-source provider, Our proprietary technology platform We believe that innovations incorporated in our technology that enable consumers to make healthcare saving and spending decisions and maximize the value of their tax-advantaged benefits differentiate us from our competitors and drive our growth. We plan to build on these innovations by combining our HSA platform withWageWorks' complementary CDB offerings, giving us a full suite of CDB products, and adding to our solutions set and leadership position within the HSA sector. We intend to continue to invest in our technology development to enhance our platform's capabilities and infrastructure. For example, we are making significant investments in our platform's architecture and related platform infrastructure to improve our transaction processing capabilities and support continued account and transaction growth, as well as in data-driven personalized engagement to help our members spend less, save more and build wealth for retirement. Our "DEEP Purple" service culture The successful healthcare consumer needs education and guidance delivered by people as well as technology. We believe that our "DEEP Purple" culture which we define as Driving Excellence, Ethics, and Process while providing remarkable service, is a significant factor in our ability to attract and retain customers and to address nimbly, opportunities in the rapidly changing healthcare sector. We make significant efforts to promote and foster DEEP 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. Interest rates As a non-bank custodian, we contract with federally insured banks, credit unions, and insurance company partners, whom we collectively callDepository Partners , to hold custodial cash assets on behalf of our members. We earn a material portion of our total revenue from interest rates offered to us by these partners (approximately 40% in the nine months endedOctober 31, 2019 ). The lengths of our agreements withDepository Partners range from zero to five years and may have fixed or variable interest rate terms. The terms of new and renewing agreements may be impacted by the then-prevailing interest rate environment, which in turn is driven by macroeconomic factors and government policies over which we have no control. Such factors, and the response of our competitors to them, also determine the amount of interest retained by our members. We believe that diversification ofDepository Partners , varied contract terms and other factors reduce our exposure to short-term fluctuations in prevailing -26-
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interest rates and mitigate the short-term impact of sustained increases or declines in prevailing interest rates on our custodial revenue. Over longer periods, sustained shifts in prevailing interest rates affect the amount of custodial revenue we can realize on custodial assets and the interest retained by our members. Our competition and industry Our direct competitors are HSA custodians and other CDB providers. Many of these are 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 (including well-known mutual fund companies such as Fidelity and health insurers such asUnited Health Group's Optum) 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. OurNetwork Partners may also choose to offer competitive 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 environment Federal law and regulations, including the Affordable Care Act, the Internal Revenue Code, theEmployee Retirement Income Security Act and Department of Labor regulations, and public health regulations that govern the provision of health insurance and provide the tax advantages associated with our products, play a pivotal role in determining our market opportunity. Privacy and data security-related laws such as the Health Insurance Portability and Accountability Act, 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, or the Advisers Act, theUSA PATRIOT Act, anti-money laundering laws, 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. For example, our subsidiaryHealthEquity Trust Company is regulated by theWyoming Division of Banking , and several states are considering, or have already passed, new privacy regulations that can affect our business. 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. Our acquisition strategy We have a successful history of acquiring HSA portfolios from competitors who have chosen to exit the industry and complementary assets and businesses that strengthen our platform. We seek to continue this growth strategy and are regularly engaged in evaluating different opportunities. We have developed an internal capability to source, evaluate and integrate acquisitions. We intend to continue to thoughtfully pursue acquisitions of complementary assets and businesses that we believe will strengthen our platform. -27-
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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. Total Accounts The following table sets forth our HSAs, CDBs, and Total Accounts as of and for the periods indicated: (in thousands, except percentages) October 31, 2019 October 31, 2018 % Change January 31, 2019 HSAs 5,031 3,677 37 % 3,994 Average HSAs - Year-to-date 4,296 3,540 21 % 3,608 Average HSAs - Quarter-to-date 4,743 3,642 30 % 3,813 New HSAs - Year-to-date 1,113 338 229 % 679 New HSAs - Quarter-to-date 898 119 655 % 341 Active HSAs 4,115 2,972 38 % 3,241 HSAs with investments 197 153 29 % 163 CDBs 7,504 598 1,155 % 572 Total Accounts 12,535 4,275 193 % 4,566 Average Total Accounts - Year-to-date 6,482 4,125 57 % 4,194 Average Total Accounts - Quarter-to-date 9,970 4,239 135 % 4,402 The number of our HSAs and CDBs are key metrics because our revenue is driven by the amount we earn from them. The number of our HSAs increased by approximately 1.4 million, or 37%, fromOctober 31, 2018 toOctober 31, 2019 , primarily driven by the Acquisition of WageWorks and other HSA portfolio acquisitions, which contributed approximately 757,000 HSAs. The remainder of the increase was due to further penetration into existingNetwork Partners and the addition of newNetwork Partners . The number of our CDBs increased by approximately 6.9 million, or 1,155%, fromOctober 31, 2018 toOctober 31, 2019 , primarily driven by the Acquisition of WageWorks. HSAs are individually owned portable healthcare accounts. As HSA members transition between employers or health plans, they may no longer be enrolled in an HDHP that qualifies them to continue to make contributions to their HSA. If these HSA members deplete their custodial balance, we may consider the corresponding HSA no longer an Active HSA. We define an Active HSA as an HSA that (i) is associated with a Network Partner or a Client, in each case as of the end of the applicable period; or (ii) has held a custodial balance at any point during the previous twelve month period. Active HSAs increased 38% from 3.0 million as ofOctober 31, 2018 to 4.1 million as ofOctober 31, 2019 . HSA Assets The following table sets forth our HSA Assets as of and for the periods indicated: (in millions, except percentages) October 31, 2019 October 31, 2018 % Change January 31, 2019 HealthEquity HSA cash (custodial revenue) (1) $ 6,578 $ 5,583 18 % $ 6,428 WageWorks HSA cash (custodial revenue) (2) 986 - n/a - WageWorks HSA cash (no custodial revenue) (3) 381 - n/a - Total HSA cash 7,945 5,583 42 % 6,428 HealthEquity HSA investments (custodial revenue) (1) 2,188 1,507 45 % 1,670 WageWorks HSA investments (no custodial revenue) (3) 326 - n/a - Total HSA investments 2,514 1,507 67 % 1,670 Total HSA Assets 10,459 7,090 48 % 8,098 Average daily HealthEquity HSA cash - Year-to-date 6,435 5,503 17 % 5,586 Average daily HealthEquity HSA cash - Quarter-to-date $ 6,493 $ 5,551 17 % $ 5,837
(1) HSA Assets administered by
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Our HSA Assets, which are our HSA members' assets for which we are the custodian or administrator, or for which we generate custodial revenue, consist of the following components: (i) cash deposits, which are deposits with ourDepository Partners , (ii) custodial cash deposits invested in an annuity contract with our insurance company partner, and (iii) investments in mutual funds through our custodial investment fund partners. Measuring our HSA Assets is important because our custodial revenue is directly affected by average daily custodial balances for HSA Assets that are revenue generating. Our Total HSA Assets increased by$3.4 billion , or 48%, fromOctober 31, 2018 toOctober 31, 2019 , primarily driven by the Acquisition of WageWorks and other HSA portfolio acquisitions, which added$1.7 billion in HSA Assets. The remaining$1.7 billion increase was due to additional HSA Assets from our existing HSA members and new HSA Assets from our new HSA members. Importantly, our HSA investment assets increased by$1.0 billion , or 67%, fromOctober 31, 2018 toOctober 31, 2019 , reflecting the Acquisition of WageWorks and our strategy to help our HSA members build wealth and invest for retirement. Client-held funds (in millions, except percentages) October 31, 2019 October 31, 2018 % Change January 31, 2019 Client-held funds (custodial revenue) (1) $ 670 $ - n/a $ - Average daily Client-held funds - Year-to-date $ 268 $ - n/a $ - Average daily Client-held funds - Quarter-to-date $ 500 $ - n/a $ - (1) Client-held funds that generate custodial revenue Our Client-held funds are interest earning deposits from which we generate custodial revenue. These deposits are amounts remitted by Clients and held by us on their behalf to pre-fund and facilitate administration of our other CDBs. These deposits are held withDepository Partners . The amount of our Client-held funds is important because our custodial revenue is affected by average daily Client-held fund balances. Our total Client-held funds increased by$670.0 million fromOctober 31, 2018 toOctober 31, 2019 , primarily driven by the Acquisition of WageWorks. Adjusted EBITDA We define Adjusted EBITDA, which is a non-GAAP financial metric, as adjusted earnings before interest, taxes, depreciation and amortization, amortization of acquired intangible assets, stock-based compensation expense, merger integration expenses, acquisition costs, gains and losses on marketable equity securities, and certain other non-operating items. We believe that Adjusted EBITDA provides useful information to investors and analysts in understanding and evaluating our operating results in the same manner as our management and our board of directors because it reflects operating profitability before consideration of non-operating expenses and non-cash expenses, and serves as a basis for comparison against other companies in our industry. The following table presents a reconciliation of net income (loss), the most comparable GAAP financial measure, to Adjusted EBITDA for each of the periods indicated: Three months ended October 31, Nine months ended October 31, (in thousands) 2019 2018 2019 2018 Net income (loss)$ (21,334 ) $ 15,686 $ 39,854 $ 60,780 Interest income (2,046 ) (358 ) (5,273 ) (919 ) Interest expense 10,225 68 10,355 204 Income tax provision (benefit) (9,918 ) 1,745 3,908 (1,322 ) Depreciation and amortization 6,203 3,092 12,940 9,060 Amortization of acquired intangible assets 13,051 1,490 16,036 4,438 Stock-based compensation expense 8,222 5,734 21,840 15,461 Merger integration expenses (1) 17,675 - 20,459 - Acquisition costs (2) 32,932 849 40,712 1,074 Gain on marketable equity securities (285 ) - (27,570 ) - Other (3) 824 1,360 1,854 2,318 Adjusted EBITDA $ 55,549$ 29,666 $ 135,115 $ 91,094
(1) Includes
post-Acquisition merger integration activities.
(2) Includes
Acquisition-related cash and equity accelerations.
(3) For the three months ended
other costs of
contract of
software development of
amortization of
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incremental costs to obtain a contract of
Three months ended Nine months ended October
October 31, 31,
(in thousands, except
percentages) 2019 2018 $ Change % Change 2019 2018 $ Change % Change
Adjusted EBITDA $ 55,549 $ 29,666 $ 25,883 87 % $ 135,115 $ 91,094 $ 44,021 48 %
As a percentage of
revenue 35 % 42 % 41 % 43 %
Our Adjusted EBITDA increased by $25.9 million , or 87%, from $29.7 million for
the three months ended October 31, 2018 to $55.5 million for the three months
ended October 31, 2019 . The increase in Adjusted EBITDA was driven by the
overall growth of our business, including a 123% increase in total revenue,
primarily due to the inclusion of WageWorks' financial results following the
Acquisition.
Our Adjusted EBITDA increased by $44.0 million , or 48%, from $91.1 million for
the nine months ended October 31, 2018 to $135.1 million for the nine months
ended October 31, 2019 . The increase in Adjusted EBITDA was driven by the
overall growth of our business, including a 56% increase in total revenue,
primarily due to the inclusion of WageWorks' financial results following the
Acquisition
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.
Key components of our results of operations
Acquisition of WageWorks
As the Acquisition closed on August 30, 2019 , only two months of WageWorks'
results of operations are included in our consolidated results of operations.
Accordingly, the results of operations attributable to WageWorks may not be
directly comparable to WageWorks' results of operations reported by WageWorks
prior to the Acquisition.
Revenue
We generate revenue from three primary sources: service revenue, custodial
revenue, and interchange revenue.
Service revenue. We earn service revenue from the fees we charge our Network
Partners, Clients and members for the administration services we provide in
connection with the HSAs and other CDBs we offer. With respect to our Network
Partners , our fees are generally based on a fixed tiered structure for the
duration of our agreement with the relevant Network Partner and are paid to us
on a monthly basis. We recognize revenue on a monthly basis as services are
rendered to our Members and Clients.
Custodial revenue. We earn custodial revenue, an increasing component of our
overall revenue, primarily from our HSA Assets deposited with our Depository
Partners and with our insurance company partner, Client-held funds deposited
with our Depository Partners , and recordkeeping fees we earn in respect of
mutual funds in which our members invest. We deposit the HSA custodial cash with
our Depository 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 Depository Partner, and
(iii) have minimum and maximum required deposit balances. We deposit the
Client-held funds with our Depository Partners in interest-bearing, demand
deposit accounts that have a floating interest rate and no set term or duration.
We earn custodial revenue on the HSA Assets and Client-held funds that is based
on the interest rates offered to us by these Depository 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 earn a recordkeeping fee, calculated as a percentage of custodial
investments.
Interchange revenue. We earn interchange revenue each time one of our Members
uses one of our payment cards to make a qualified purchase. This revenue is
collected each time a Member "swipes" our payment card to pay expenses. We
recognize interchange revenue monthly based on reports received from third
parties, namely, the card-issuing banks and card processors.
Cost of revenue
Cost of revenue includes costs related to servicing Member accounts, managing
Client and Network Partner relationships and processing reimbursement claims.
Expenditures include personnel-related costs, depreciation, amortization,
stock-based compensation, common expense allocations (such as office rent,
supplies, and other overhead expenses), new member and participant supplies, and
other operating costs related to servicing our
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members. Other components of cost of revenue include interest retained by members on custodial cash and interchange costs incurred in connection with processing card transactions for our members. Service costs. Service costs include the servicing costs described above. Additionally, for new accounts, we incur on-boarding costs associated with the new accounts, such as new member welcome kits, the cost associated with issuance of new payment cards and costs of marketing materials that we produce for ourNetwork Partners . Custodial costs. Custodial costs are comprised of interest retained by our HSA members and fees we pay to banking consultants whom we use to help secure agreements with ourDepository Partners . Interest retained by HSA members is calculated on a tiered basis. The interest rates retained by HSA members can change based on a formula or upon required notice. Interchange costs. Interchange costs are comprised of costs we incur in connection with processing payment transactions initiated by our members. Due to the substantiation requirement on FSA/HRA-linked payment card transactions, payment card costs are higher for FSA/HRA card transactions. In addition to fixed per card fees, we are assessed additional transaction costs determined by the amount of the transaction. Gross profit and gross margin Our gross profit is our total revenue minus our total cost of revenue, 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 interest rates, the amount we charge our partners and members, how many services we deliver per account, and payment processing costs per account. 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. Technology and development. Technology and development expenses include personnel and related expenses for software engineering, information technology, product development, and security. Technology and development expenses also include 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. General and administrative. General and administrative expenses include personnel and related expenses of, and professional fees incurred by our executive, finance, legal, internal audit, compliance, and people departments. They also include depreciation, amortization, stock-based compensation and common expense allocations. Amortization of acquired intangible assets. Amortization of acquired intangible assets results primarily from intangible assets acquired in connection with business combinations. The assets include acquired customer relationships, acquired developed technology, and acquired trade names and trademarks, which we amortize over the assets' estimated useful lives, estimated to be 10-15 years, 2-5 years, and 3 years, respectively. We also acquired intangible HSA portfolios from third-party custodians. We amortize these assets over the assets' estimated useful life of 15 years. We evaluate our acquired intangible assets for impairment annually, or at a triggering event. Merger integration. Merger integration expenses include personnel and related expenses, including severance, professional fees, and technology-related expenses directly related to the integration activities to merge operations as a result of the Acquisition. Interest expense Interest expense consists of interest expense and amortization of financing costs associated with our Credit Agreement. Other expense, net Other expense, net, primarily consists of acquisition costs and non-income-based taxes, less interest income earned on corporate cash. Income tax provision We are subject to federal and state income taxes inthe United States based on a calendar tax year which 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 -31-
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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 ofOctober 31, 2019 , we have recorded a net deferred tax liability. 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 current taxable income, reversing taxable temporary differences, and forecasted profitability, no valuation allowance was required as ofOctober 31, 2019 for most of our deferred tax assets. However, we recorded a valuation allowance of$0.2 million as ofOctober 31, 2019 and$0.1 million as ofJanuary 31, 2019 . The increase in valuation allowance recorded is a result of state tax credits that are not expected to be utilized before they expire. Comparison of the three and nine months endedOctober 31, 2019 and 2018 We incurred a net loss of$21.3 million during the three months endedOctober 31, 2019 , compared to net income of$15.7 million during the three months endedOctober 31, 2018 , and net income of$39.9 million for the nine months endedOctober 31, 2019 , compared to net income of$60.8 million for the nine months endedOctober 31, 2018 , due to the factors described below. The net loss during the three months endedOctober 31, 2019 includes$38.5 million , net of tax, of acquisition and merger integration expenses in connection with the Acquisition of WageWorks. The following table sets forth our revenue for the periods indicated: Three months ended October 31, Nine months ended October 31, (in thousands, except percentages) 2019 2018 $ Change % Change 2019 2018 $ Change % Change Service revenue$ 87,620 $ 25,041 $ 62,579 250 %$ 140,710 $ 74,797 $ 65,913 88 % Custodial revenue 46,972 31,564 15,408 49 % 132,538 90,713 41,825 46 %
Interchange
revenue 22,526 13,890 8,636 62 % 57,545 45,956 11,589 25 % Total revenue$ 157,118 $ 70,495 $ 86,623 123 %$ 330,793 $ 211,466 $ 119,327 56 % Service revenue The$62.6 million , or 250%, increase in service revenue from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was primarily due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$61.0 million of the increase. The remainder of the increase resulted from the increase in the number of HSAs, partially offset by lower service revenue per average HSA. The$65.9 million , or 88%, increase in service revenue from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was primarily due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$61.0 million of the increase. The remainder of the increase resulted from an increase in the number of HSAs, partially offset by lower service revenue per average HSA. The number of our HSAs increased by approximately 1.4 million, or 37%, fromOctober 31, 2018 toOctober 31, 2019 , primarily due to approximately 757,000 acquired HSAs. The remainder of the increase was due to HSA portfolio acquisitions and further penetration into existingNetwork Partners and the addition of newNetwork Partners . Service revenue as a percentage of our total revenue increased primarily due to the inclusion ofWageWorks' financial results, whose total revenue is comprised primarily of service revenue, following the Acquisition. Custodial revenue The$15.4 million , or 49%, increase in custodial revenue from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was primarily due to an increase in the yield on average HealthEquity HSA cash assets from 2.14% for the three months endedOctober 31, 2018 to 2.48% and an increase in average daily HealthEquity HSA cash assets of$0.9 billion , or 17%. The inclusion ofWageWorks' financial results following the Acquisition contributed$3.7 million of custodial revenue during the period. The$41.8 million , or 46%, increase in custodial revenue from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was primarily due to an increase in the yield on average HealthEquity HSA cash assets from 2.10% for the nine months endedOctober 31, 2018 to 2.52% and an increase in average daily HealthEquity HSA cash assets of$0.9 billion , or 17%. The inclusion ofWageWorks' financial results following the Acquisition contributed$3.7 million of custodial revenue during the period. -32-
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Custodial revenue as a percentage of our total revenue decreased primarily due to the inclusion ofWageWorks' financial results following the Acquisition, which has relatively little custodial revenue. Interchange revenue The$8.6 million , or 62%, increase in interchange revenue from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was primarily due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$7.4 million of the increase. The remainder of the increase resulted from an overall increase in the number of average HSAs, partially offset by lower card spend per average HSA. The$11.6 million , or 25%, increase in interchange revenue from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was primarily due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$7.4 million of the increase. The remainder of the increase was as a result of an overall increase in the number of average HSAs, partially offset by lower card spend per average HSA. Total revenue Total revenue increased by$86.6 million , or 123%, and$119.3 million , or 56%, from the three and nine months endedOctober 31, 2018 to the three and nine months endedOctober 31, 2019 , due to the impact of the WageWorks acquisition and related realized net synergies, which contributed$72.1 million . Cost of revenue The following table sets forth our cost of revenue for the periods indicated: (in Three months ended October Nine months ended thousands, 31, October 31, except percentages) 2019 2018 $ Change % Change 2019 2018 $ Change % Change Service costs$ 52,278 $ 17,562 $ 34,716 198 %$ 92,672 $ 52,808 $ 39,864 75 % Custodial costs 4,384 3,551 833 23 % 12,716 10,492 2,224 21 % Interchange costs 4,421 3,565 856 24 % 13,177 11,418 1,759 15 % Total cost of revenue$ 61,083 $ 24,678 $ 36,405 148 %$ 118,565 $ 74,718 $ 43,847 59 % Service costs The$34.7 million , or 198%, increase in service costs from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$32.0 million of the increase. The remainder of the increase resulted from the higher volume of accounts being serviced, including$1.6 million due to hiring additional personnel to implement and support our newNetwork Partners and HSAs, increases in stock-based compensation expense of$0.6 million , and increases in other expenses of$0.5 million . The$39.9 million , or 75%, increase in service costs from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$32.0 million of the increase. The remainder of the increase resulted from the higher volume of accounts being serviced, including a$3.5 million increase due to the hiring of additional personnel to implement and support our newNetwork Partners and HSAs, increases in activation and processing costs of$1.6 million , increases in stock-based compensation expense of$1.3 million , and increases in other expenses of$1.5 million . Custodial costs The$0.8 million , or 23%, increase in custodial costs from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was due to an increase in average daily HealthEquity HSA cash assets, which increased from$5.6 billion for the three months endedOctober 31, 2018 to$6.5 billion for the three months endedOctober 31, 2019 . Custodial interest costs on average HealthEquity HSA cash assets decreased slightly from 0.24% for the three months endedOctober 31, 2018 to 0.23% for the three months endedOctober 31, 2019 . The$2.2 million , or 21%, increase in custodial costs from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was due to an increase in average daily HealthEquity HSA cash assets, which increased from$5.5 billion for the nine months endedOctober 31, 2018 to$6.4 billion for the nine months endedOctober 31, 2019 . Custodial interest costs on average HealthEquity HSA cash assets decreased slightly from 0.24% for the nine months endedOctober 31, 2018 to 0.23% for the nine months endedOctober 31, 2019 . -33-
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Interchange costs The$0.9 million , or 24%, and$1.8 million , or 15%, increase in interchange costs for the three and nine months endedOctober 31, 2018 compared to the three and nine months endedOctober 31, 2019 was due to an overall increase in average Total Accounts, partially offset by decreased card spend per average Total Accounts. In addition, the inclusion ofWageWorks' results contributed$0.5 million to the increase. Cost of revenue As we continue to add Total Accounts, we expect that our cost of revenue will increase in dollar amount to support ourNetwork Partners , Clients, and members. Cost of revenue will continue to be affected by a number of different factors, including our ability to scale our service delivery, Network Partner implementation and account management functions. Operating expenses The following table sets forth our operating expenses for the periods indicated: Three months ended October Nine months ended (in thousands, 31, October 31, except percentages) 2019 2018 $ Change % Change 2019 2018 $ Change % Change Sales and marketing$ 12,654 $ 7,502 $ 5,152 69 %$ 30,015 $ 21,605 $ 8,410 39 % Technology and development 23,511 8,678 14,833 171 % 46,061 25,055 21,006 84 % General and administrative 19,222 9,161 10,061 110 % 37,193 24,561 12,632 51 % Amortization of acquired intangible assets 13,051 1,490 11,561 776 % 16,036 4,438 11,598 261 % Merger integration 17,675 - 17,675 n/a 20,459 - 20,459 n/a Total operating expenses$ 86,113 $ 26,831 $ 59,282 221 %$ 149,764 $ 75,659 $ 74,105 98 % Sales and marketing The$5.2 million , or 69%, increase in sales and marketing expense from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$3.5 million of the increase. The remainder of the increase was as a result of increased staffing of$0.9 million , increases in other expenses of$0.5 million , and higher stock-based compensation expense of$0.3 million . The$8.4 million , or 39%, increase in sales and marketing expense from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$3.5 million of the increase. The remainder of the increase was as a result of increased staffing of$3.2 million , higher stock-based compensation expense of$0.8 million , and increases in other expenses of$0.9 million . Technology and development The$14.8 million , or 171%, increase in technology and development expense from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$10.5 million of the increase. The remainder of the increase was as a result of increased personnel-related expense of$2.3 million , increases in professional fees of$2.0 million , increased stock-based compensation expense of$0.8 million , increases in amortization and depreciation of$0.3 million , and other increases of$0.9 million , which were partially offset by increases in capitalized development of$2.0 million . The$21.0 million , or 84%, increase in technology and development expense from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$10.5 million of the increase. The remainder of the increase was as a result of increased personnel-related expense of$6.3 million , increases in professional fees of$5.4 million , increases in stock-based compensation expense of$1.9 million , increases in amortization and depreciation of$0.8 million , and other increases of$1.7 million , which were partially offset by increases in capitalized development of$5.6 million . General and administrative The$10.1 million , or 110%, increase in general and administrative expense from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$9.2 million of the increase. The remainder of the increase was as a result of increases in stock-based compensation expense of$0.8 million . -34-
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The$12.6 million , or 51%, increase in general and administrative expense from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was due to the inclusion ofWageWorks' financial results following the Acquisition, which contributed$9.2 million of the increase. The remainder of the increase was as a result of increased personnel-related expense of$0.8 million , increases in stock-based compensation expense of$2.3 million , and increases in other expenses of$0.3 million . Amortization of acquired intangible assets The$11.6 million increase in amortization of acquired intangible assets for the three and nine months endedOctober 31, 2019 was a result of the acquired identified intangible assets due to the Acquisition of WageWorks. Merger integration The$17.7 million and$20.5 million in merger integration expense for the three and nine months endedOctober 31, 2019 was due to integration activities directly related to the Acquisition. We expect merger integration expenses to continue for the next 24 to 36 months following the closing of the Acquisition onAugust 30, 2019 . Interest expense The increase in interest expense for the three and nine months endedOctober 31, 2019 was due to the$1.25 billion borrowed under the Term Loan Facility to finance the Acquisition. Other expense, net The change in other expense, net from the three months endedOctober 31, 2018 to the three months endedOctober 31, 2019 was primarily due to acquisition costs of$32.9 million , partially offset by interest income of$2.0 million and a gain of$0.3 million in connection with the cancellation of our equity investment in WageWorks. The change in other expense, net from the nine months endedOctober 31, 2018 to the nine months endedOctober 31, 2019 was primarily due to acquisition costs of$40.7 million , partially offset by a gain of$27.6 million in connection with the cancellation of our equity investment in WageWorks, as well as interest income on corporate cash of$5.3 million , respectively. Income tax provision (benefit) Income tax benefit for the three months endedOctober 31, 2019 was$9.9 million and income tax provision for the nine months endedOctober 31, 2019 was$3.9 million as compared to an income tax provision of$1.7 million and an income tax benefit of$1.3 million for the three and nine months endedOctober 31, 2018 , respectively. The decrease in the tax provision for the three months endedOctober 31, 2019 was$11.6 million compared to the three months endedOctober 31, 2018 . The increase in the tax provision for the nine months endedOctober 31, 2019 compared to the nine months endedOctober 31, 2018 was$5.2 million . The change in the three and nine months endedOctober 31, 2019 and 2018 was primarily due to a gain in connection with our equity investment in WageWorks that will not be realized for income tax purposes offset by a decrease in excess tax benefits from stock-based compensation expense and certain costs incurred in connection with the Acquisition of WageWorks that are not deductible for income tax purposes. Our effective income tax rate for the three and nine months endedOctober 31, 2019 was a benefit of 31.7% and an expense of 8.9%, compared to a provision of 10.0% and a benefit of 2.2% for the three and nine months endedOctober 31, 2018 . The 21.7 percentage point change for the three months endedOctober 31, 2019 compared to the three months endedOctober 31, 2018 is primarily due to a gain in connection with our equity investment in WageWorks that will not be realized for income tax purposes offset by a decrease in excess tax benefits from stock-based compensation expense and certain costs incurred in connection with the Acquisition of WageWorks that are not deductible for income tax purposes. The 11.1 percentage point increase for the nine months endedOctober 31, 2019 compared to the nine months endedOctober 31, 2018 is primarily due to a decrease in excess tax benefits from stock-based compensation expense recognized in the provision for income taxes. 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 existingNetwork Partners bring us new HSAs and CDBs beginning in January of each year concurrent with the start of many employers' benefit plan years. Before we realize any revenue from these new accounts, we incur costs related to implementing and supporting our newNetwork Partners and new accounts. These costs of services relate to activating accounts and hiring additional staff, including seasonal help to support our member support center. These expenses begin to ramp up during our third fiscal quarter with the majority of expenses incurred in our fourth fiscal quarter. -35-
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Liquidity and capital resources Cash and cash equivalents overview In connection with the closing of the Acquisition onAugust 30, 2019 , we entered into a new credit facility withWells Fargo Bank, N.A ., which includes a$350.0 million revolving credit facility. As ofOctober 31, 2019 , our principal source of liquidity was our current cash and cash equivalents balances, collections from our service, custodial and interchange revenue activities, and availability under the revolving credit facility. 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 ofOctober 31, 2019 andJanuary 31, 2019 , cash and cash equivalents were$174.6 million and$361.5 million , respectively. Capital resources We have a "shelf" registration statement on Form S-3 on file with theSEC . This shelf registration statement, which includes a base prospectus, allows us at any time to offer any combination of securities described in the prospectus in one or more offerings. Unless otherwise specified in a prospectus supplement accompanying the base prospectus, we would use the net proceeds from the sale of any securities offered pursuant to the shelf registration statement for general corporate purposes, including, but not limited to, working capital, sales and marketing activities, general and administrative matters and capital expenditures, and if opportunities arise, for the acquisition of, or investment in, assets, technologies, solutions or businesses that complement our business. Pending such uses, we may invest the net proceeds in interest-bearing securities. In addition, we may conduct concurrent or other financings at any time. OnJuly 12, 2019 , the Company closed a follow-on public offering of 7,762,500 shares of common stock at a public offering price of$61.00 per share, less the underwriters' discount. The Company received net proceeds of approximately$458.5 million after deducting underwriting discounts and commissions of approximately$14.1 million and other offering expenses payable by the Company of approximately$0.9 million . In connection with the closing of the Acquisition onAugust 30, 2019 , the Company entered into a new$1.6 billion Credit Agreement, consisting of (i) a five-year senior secured term loan A facility in the aggregate principal amount of$1.25 billion , the net proceeds of which were used by the Company to finance the Acquisition and related transactions, and (ii) a five-year senior secured revolving credit facility in an aggregate principal amount of up to$350.0 million , which may be used for working capital and general corporate purposes, including the financing of acquisitions and other investments. For a description of the terms of the Credit Agreement, refer to Note 9-Indebtedness. We were in compliance with all covenants under the Credit Agreement as ofOctober 31, 2019 . Use of cash FromFebruary 1, 2019 toApril 4, 2019 , we acquired approximately 1.6 million shares of common stock of WageWorks for$53.8 million in open market purchases. OnAugust 30, 2019 , the Acquisition closed and we paid approximately$2.0 billion in cash to WageWorks stockholders, which was funded with net borrowings of approximately$1.22 billion , after deducting lender fees of approximately$30.5 million , under the above term loan, and$816.9 million of cash on hand. Capital expenditures for the nine months endedOctober 31, 2019 and 2018 were$22.4 million and$10.8 million , respectively. We expect our capital expenditures to increase for the remainder of the year endingJanuary 31, 2020 as we continue to devote capital expenditures to improve the architecture and functionality of our technology platforms. Costs to improve the architecture of our technology platforms include computer hardware, personnel and related costs for software engineering and outsourced software engineering services. In addition, we plan to devote further resources to leasehold improvements and furniture and fixtures for our office space. We believe our existing cash and cash equivalents 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 financing is required, we may not be able to raise it on favorable terms, if at all. -36-
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The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods:
Nine months ended October 31,
(in thousands) 2019 2018
Net cash provided by operating activities $ 74,070 $ 80,785
Net cash used in investing activities (1,715,393 ) (12,588 )
Net cash provided by financing activities 1,454,405 21,338
Increase (decrease) in cash and cash equivalents (186,918 )
89,535
Beginning cash and cash equivalents 361,475
199,472
Ending cash and cash equivalents$ 174,557
Cash flows provided by operating activities. Net cash provided by operating activities during the nine months endedOctober 31, 2019 resulted primarily from our net income of$39.9 million , adjusted for the exclusion of non-cash items totaling$34.6 million , which included a$27.6 million gain on marketable equity securities,$28.8 million of depreciation and amortization expense,$31.2 million of stock-based compensation expense, and other non-cash items totaling$2.2 million , as well as the effect of changes in working capital and other carrying balances that resulted in cash outflows of$0.4 million . Net cash provided by operating activities during the nine months endedOctober 31, 2018 resulted primarily from our net income of$60.8 million , adjusted for the exclusion of non-cash items totaling$29.8 million , which included$13.5 million of depreciation and amortization expense,$15.5 million of stock-based compensation expense, and other non-cash items totaling$0.8 million , as well as the effect of changes in working capital and other carrying balances that resulted in cash outflows of$9.7 million . Cash flows used in investing activities. Net cash used in investing activities for the nine months endedOctober 31, 2019 was primarily the result of the Acquisition of WageWorks for$1.63 billion , net of cash acquired, purchases of marketable equity securities of$53.8 million . We also continued development of our proprietary system and other software necessary to support our continued account growth. Purchases of software and capitalized software development costs for the nine months endedOctober 31, 2019 were$17.2 million , compared to purchases of software and capitalized software development costs of$7.4 million for the nine months endedOctober 31, 2018 . Our purchases of property and equipment increased from$3.5 million for the nine months endedOctober 31, 2018 to$5.2 million for the nine months endedOctober 31, 2019 , primarily as a result of increases in computer hardware. In addition, during the nine months endedOctober 31, 2019 , purchases of intangible member assets resulted in cash outflows of$9.1 million , compared to$1.2 million for the nine months endedOctober 31, 2018 . Cash flows provided by financing activities. Cash flow provided by financing activities during the nine months endedOctober 31, 2019 resulted primarily from net borrowings of$1.22 billion , our follow-on offering where we received net proceeds of$458.9 million from the sale of 7,762,500 shares of our common stock, and the exercise of stock options of$7.3 million , compared to$21.3 million for the nine months endedOctober 31, 2018 . These items were offset by$231.0 million of cash used to settle Client-held funds obligations. Contractual obligations The following table describes our contractual obligations for long-term debt obligations, future minimum lease payments, and other contractual payments as ofOctober 31, 2019 : Fiscal year ending January Less than 1-3 3-5 More than 31, (in thousands) 1 year years years 5 years Total Long-term debt obligations (1) 31,250 125,000 1,093,750 - 1,250,000 Interest on long-term debt 51,867 97,246 77,809 - obligations (2) 226,922 Operating lease obligations 11,130 28,420 20,437 60,250 (3) 120,237 Other contractual 10,268 13,215 2,664 101 26,248 obligations (4) Total$ 104,515 $ 263,881 $ 1,194,660 $ 60,351 $ 1,623,407 (1) As ofOctober 31, 2019 , maximum total borrowings under the Revolving Credit Facility is$350.0 million with a base interest rate determined in accordance with the Credit Agreement terms (see Note 8-Indebtedness). The debt maturity date isAugust 31, 2024 . As ofOctober 31, 2019 , our outstanding principal of$1.25 billion is presented net of debt issuance costs on our consolidated balance sheets. The debt issuance costs are not included in the table above. (2) Estimated interest payments assume the interest rate applicable as ofOctober 31, 2019 of 4.12% per annum on a$1.25 billion outstanding principal amount. -37-
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(3) We lease office space, data storage facilities, and other leases under non-cancelable operating leases expiring at various dates through 2030. (4) Other contractual obligations consist of processing services agreements, telephony services, immaterial capital leases, and other contractual commitments. Off-balance sheet arrangements During the three months endedOctober 31, 2019 and 2018, other than outstanding letters of credit issued under our Revolving Credit Facility, we do not have any off-balance sheet arrangements. The majority of the standby letters of credit expire in one year. However, in the ordinary course of business, we will continue to renew or modify the terms of the letters of credit to support business requirements. The letters of credit are contingent liabilities, supported by our revolving credit facility, and are not reflected on our condensed consolidated balance sheets. 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 unaudited 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 consolidated financial statements and in Note 1 to our audited consolidated financial statements contained in our Annual Report on Form 10-K for the year endedJanuary 31, 2019 . Other than the adoption of ASU 2016-02 and related subsequent amendments, Leases, updates to our Investment policies, and client held funds described in Note 1 of the accompanying unaudited condensed consolidated financial statements, there have been no significant or material changes in our critical accounting policies during the nine months endedOctober 31, 2019 , 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 Annual Report on Form 10-K for the year endedJanuary 31, 2019 . Recent accounting pronouncements See Note 1. Summary of business and significant accounting policies within the interim financial statements included in this Form 10-Q for further discussion. Item 3. Qualitative and quantitative disclosures about market risk Market risk Concentration of market risk. We derive a substantial portion of our revenue from providing services to tax-advantaged healthcare account holders. A significant downturn in this market or changes in state and/or federal laws impacting the preferential tax treatment of healthcare accounts such as HSAs could have a material adverse effect on our results of operations. During the three months endedOctober 31, 2019 , no one customer accounted for greater than 10% of our total revenue. We monitor market and regulatory changes regularly and make adjustments to our business if necessary. Inflation. Inflationary factors may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of expenses as a percentage of revenue if our revenue does not correspondingly increase with inflation. Concentration of credit risk Financial instruments, which potentially subject us to concentrations of credit risk, consist primarily of cash and cash equivalents. We maintain our cash and cash equivalents in bank and other depository accounts, which frequently may exceed federally insured limits. Our cash and cash equivalents as ofOctober 31, 2019 were$174.6 million , of which$2.3 million was covered by federal depository insurance. We have not experienced any material losses in such accounts and believe we are not exposed to any significant credit risk with respect to our cash and cash equivalents. Our accounts receivable balance as ofOctober 31, 2019 was$66.6 million . We have not experienced any significant write-offs to our accounts receivable and believe that we are not exposed to significant -38-
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credit risk with respect to our accounts receivable. We continue to monitor our credit risk and place our cash, cash equivalents, and marketable securities with reputable financial institutions. Interest rate risk HSA Assets and Client-held funds. As ofOctober 31, 2019 , we had HSA Assets of approximately$10.5 billion and Client-held funds of$670.0 million . We have entered into depository agreements with financial institutions for our HSA Assets and Client-held funds. The contracted interest rates were negotiated at the time the depository agreements were executed. A significant reduction in prevailing market interest rates may make it difficult for us to continue to place custodial deposits at the current contracted rates. Cash and cash equivalents. We consider all highly liquid investments purchased with an original maturity of three months or less to be unrestricted cash equivalents. Our unrestricted cash and cash equivalents are held in institutions in theU.S. and include deposits in a money market account that is unrestricted as to withdrawal or use. As ofOctober 31, 2019 , we had unrestricted cash and cash equivalents of$174.6 million . Due to the short-term nature of these instruments, we believe that we do not have any material exposure to changes in the fair value of our cash and cash equivalents as a result of changes in interest rates. Credit agreement. AtOctober 31, 2019 , we had$1.25 billion outstanding under our Term Loan Facility and no amounts drawn under our Revolving Credit Facility. Our overall interest rate sensitivity under these credit facilities is primarily influenced by any amounts borrowed and the prevailing interest rates on these instruments. The interest rate on our Term Loan Credit Facility and Revolving Credit Facility is variable and was 4.12 percent atOctober 31, 2019 . Accordingly, we may incur additional expense if interest rates increase in future periods. For example, a one percent increase in the interest rate on the amount outstanding under our credit facilities atOctober 31, 2019 would result in approximately$12.6 million of additional interest expense over the next 12 months. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as ofOctober 31, 2019 , the end of the period covered by this Quarterly Report on Form 10-Q. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act means controls and other procedures of a company that are designed to provide reasonable assurance that the information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in theSEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on such evaluation, and subject to the below exclusion, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level. In accordance with interpretive guidance issued bySEC staff, companies are allowed to exclude acquired businesses from the assessment of internal control over financial reporting during the first year after completion of an acquisition and from the assessment of disclosure controls and procedures to the extent subsumed in such internal control over financial reporting. In accordance with this guidance, as the Company acquired WageWorks onAugust 30, 2019 , management's evaluation and conclusion as to the effectiveness of the Company's disclosure controls and procedures as ofOctober 31, 2019 excluded the portion of disclosure controls and procedures that are subsumed by internal control over financial reporting of WageWorks.WageWorks' assets and revenues represented approximately 13%, excluding the effects of purchase accounting, and approximately 46% of the Company's consolidated total assets and consolidated total revenues, respectively, as of and for the fiscal quarter endedOctober 31, 2019 . -39-
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Material Weaknesses in Internal Control over Financial Reporting related to the WageWorks Acquisition The Company completed the Acquisition of WageWorks onAugust 30, 2019 , and we are currently evaluating the impact of the Acquisition on our internal control over financial reporting. WageWorks management had assessed the effectiveness of its internal control over financial reporting as ofDecember 31, 2018 . Based on the results of that evaluation, WageWorks management concluded that its internal control over financial reporting as ofDecember 31, 2018 was not effective due to the existence of the material weaknesses in internal control over financial reporting described below. Control Environment, Risk Assessment, Control Activities, Information and Communication and Monitoring It was concluded that there was an inadequate open flow, transparency, communication and dissemination of relevant and pertinent information from former WageWorks senior management concerning a complex transaction with the federal government that contributed to an ineffective control environment driven by the tone at the top. WageWorks management's failure to timely communicate all pertinent information resulted in an environment which led to errors in the financial statements. Based on the assessment of control environment, it was noted that WageWorks did not maintain effective internal control over financial reporting related to the following areas: control environment, risk assessment, control activities information and communication and monitoring: • WageWorks did not have processes and controls to ensure there were
adequate mechanisms and oversight to ensure accountability for the
performance of internal control over financial reporting responsibilities
and to ensure corrective actions were appropriately prioritized and
implemented in a timely manner.
• WageWorks did not effectively execute a strategy to attract, develop and
retain a sufficient complement of qualified resources with an appropriate
level of knowledge, experience, and training in certain areas important to
financial reporting.
• There was not an adequate assessment of changes in risks by management
that could significantly impact internal control over financial reporting
or an adequate determination and prioritization of how those risks should
be managed.
• WageWorks did not have adequate management oversight of accounting and
financial reporting activities in implementing certain accounting
practices to conform to its policies and GAAP.
• WageWorks did not have adequate management oversight around completeness
and accuracy of data material to financial reporting.
• There was a lack of robust, established and documented accounting policies
and insufficiently detailed procedures to put these policies into
effective action.
• Wageworks was not focused on a commitment to competency as it relates to
creating priorities, allocating adequate resources and establishing cross
functional procedures around managing complex contracts and non-routine
transactions as well as managing change and attracting, developing and
retaining qualified resources.
These deficiencies in WageWorks' internal control over financial reporting
contributed to the following identified material weaknesses:
A. Accounting Close and Financial Reporting
WageWorks had inadequate or ineffective senior accounting leadership and
corresponding process level and monitoring controls in the area of accounting
close and financial reporting specifically, but not exclusively, around the
review of account reconciliations, account estimates and related cut-off, and
monitoring of the accounting close cycle and some areas of related sub-processes
such as equity. WageWorks also did not have effective business processes and
controls to conduct an effective review of manual data feeds into journal
entries for platforms which were not integrated with the main enterprise
resource planning system.
WageWorks did not have robust, established and documented accounting policies
that were implemented effectively, which led to adjustments in areas such as,
but not exclusive to, impairment of internally developed software (IDS) and
unclaimed liability. As a result of these adjustments, the accounts related to
amortization of IDS, fixed assets, and operating expenses as they relate to
interest and penalties were impacted.
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WageWorks also did not have a robust process around managing change and corresponding assessment and implementation of accounting policies. Furthermore, it also resulted in the delayed assessment and design of controls for the timely implementation of controls around Accounting Standard 606 (ASC 606) for Revenue Recognition, which was effectiveJanuary 2018 . These gaps resulted in several adjustments in the WageWorks financial statements as of the fiscal year endedDecember 31, 2018 . B. Contract to Cash Process WageWorks did not have effective controls around the contract-to-cash life cycle. The root cause of these gaps were due to inadequate or ineffective process level controls around billing set-up during customer implementation, managing change to existing customer billing terms and conditions, timely termination of customers, implementing complex and/or non-standard billing arrangements which require manual intervention or manual controls for billing to customers, processing timely adjustments, lack of robust, established and documented policies to assess collectability and reserve for revenue, bad debts and accounts receivable, and availability of customer contracts. These gaps resulted in several adjustments in revenue, accounts receivable, and accounts receivable reserves in the WageWorks financial statement as of the fiscal year endedDecember 31, 2018 . C. Risk Assessment and Management of Change WageWorks did not maintain an effective risk assessment and monitoring process to manage the expansion of its business. Hence, there were inadequate and ineffective business and financial reporting control activities associated with change and growth in the business. Among other areas, the assessment of the control environment and the design of manual controls around financial system implementations was not performed adequately. As a result, WageWorks did not properly estimate, reserve and record certain transactions that resulted in errors in the WageWorks financial statements as of the fiscal year endedDecember 31, 2018 . D. Review of New, Unusual or Significant Transactions and Contracts WageWorks did not have adequate risk assessment controls to continuously formally assess the financial reporting risks associated with executing new, significant or unusual transactions, contracts or business initiatives. As a result, WageWorks did not adequately identify and analyze changes in the business and hence implement effective process level controls and monitoring controls that were responsive to these changes and aligned with financial reporting objectives. This failure to identify and analyze changes occurred in connection with the integration of acquisitions and the monitoring and recording of certain revenues associated with a complex government contract. As a result, WageWorks did not properly account for certain transactions including revenue and customer obligation accounts, which resulted in errors in the WageWorks financial statements as of the fiscal year endedDecember 31, 2018 . E. Manual Reconciliations of High-Volume Standard Transactions WageWorks did not have effective business processes and controls as well as resources with adequate training and support to conduct an effective review of manual reconciliations including the complex data feeds into the reconciliations of high-volume standard transactions. This resulted in several errors mainly to balance sheet classifications around accounts receivable, customer obligations and other related accounts as ofDecember 31, 2018 . F. Information Technology General Controls (ITGC) WageWorks did not have effective controls related to information technology general controls (ITGCs) in the areas of logical access and change-management over certain information technology (IT) systems that supported its financial reporting processes.WageWorks' business process controls (automated and manual) that are dependent on the affected ITGCs were also deemed ineffective because they could have been adversely impacted. WageWorks believed that these control deficiencies were a result of IT control processes having an inadequate risk-assessment process to identify and assess changes in business environment which would impact IT environments related to internal control over financial reporting. Hence, the control design, implementation, and documentation were not enhanced to adapt to the changing business environment. There was also insufficient training of IT personnel on how to design and implement ITGCs. In addition to the material weaknesses noted above, WageWorks management identified several significant deficiencies and other deficiencies. These deficiencies relate to several areas that are partially rooted in the weaknesses in the internal control environment documented above. -41-
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These material weaknesses and other deficiencies could result in a misstatement of the aforementioned account balances or disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. We are assessing plans to evaluate and remediate the material weaknesses outlined above. Changes in Internal Control Over Financial Reporting The Acquisition of WageWorks is considered a change in the Company's internal control over financial reporting. There were no other changes in the Company's internal control over financial reporting during the fiscal quarter endedOctober 31, 2019 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. -42-
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