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 our ability to integrate acquired businesses, the impact of the COVID-19 pandemic and resulting societal and economic changes on the Company, the anticipated synergies and other benefits of acquired businesses and any future acquisitions, health savings accounts and other tax-advantaged consumer-directed benefits, tax and other regulatory changes, market opportunity, our future financial and operating results, our investment and acquisition strategy, our 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 our Annual Report on Form 10-K for the fiscal year endedJanuary 31, 2022 , this Quarterly Report on Form 10-Q, and 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 providing technology-enabled services that empower consumers to make healthcare saving and spending decisions. We use our innovative technology to manage consumers' 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"), and to administer Consolidated Omnibus Budget Reconciliation Act ("COBRA"), commuter and other benefits. As part of our services, we and our subsidiaries provide consumers with healthcare bill evaluation and payment processing services, personalized benefit information, including information on treatment options and comparative pricing, access to remote and telemedicine benefits, the ability to earn wellness incentives, and 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 ofApril 30, 2022 , we administered 7.4 million HSAs, with balances totaling$20.3 billion , which we call HSA Assets, as well as 7.1 million complementary CDBs. We refer to the aggregate number of HSAs and other CDBs that we administer as Total Accounts, of which we had 14.5 million as ofApril 30, 2022 . We reach consumers primarily through relationships with their employers, which we call Clients. We reach Clients primarily through relationships with benefits brokers and advisors, integrated partnerships with a network of health plans, benefits administrators, benefits brokers and consultants, and retirement plan recordkeepers, which we callNetwork Partners , and a sales force that calls on Clients directly. We have increased our share of the growing HSA market from 4% inDecember 2010 to 18% as ofDecember 2021 , measured by HSA Assets. According to Devenir, we are the largest HSA provider by accounts and second largest by assets as ofDecember 2021 . In addition, we believe we are the largest provider of other CDBs. We seek to differentiate ourselves through our proprietary technology, product breadth, ecosystem connectivity, and service- -17-
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driven culture. Our proprietary technology allows us to help consumers optimize the value of their HSAs and other CDBs and gain confidence and skills in managing their healthcare costs as part of their financial security.
Our ability to assist consumers is enhanced by our capacity to securely share data in both directions with others in the health, benefits, and retirement ecosystems. Our commuter 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 Client-held funds. We earn interchange revenue mainly from fees paid by merchants on payments that our members make using our physical payment cards and on our virtual payment system. See "Key components of our results of operations" for additional information on our sources of revenue, including the adverse impacts caused by the COVID-19 pandemic and resulting societal and economic changes.
Recent acquisitions
Luum acquisition. InMarch 2021 , we bolstered our commuter offering by acquiring 100% of the outstanding capital stock ofFort Effect Corp , d/b/a Luum (the "Luum Acquisition"). The aggregate purchase price for the acquisition consisted of$56.2 million in cash. Luum provides employers with various commuter services, including access to real-time commute data, to help them design and implement flexible return-to-office and hybrid-workplace strategies and benefits. Fifth Third Bank HSA portfolio acquisition. InSeptember 2021 , we acquired theFifth Third Bank , National Association ("Fifth Third") HSA portfolio, which consisted of$490.0 million of HSA Assets held in approximately 160,000 HSAs in exchange for a purchase price of$60.8 million in cash. Further acquisition. InNovember 2021 , we acquired the Further business (other than Further's voluntary employee beneficiary association business), a leading provider of HSA and other CDB administration services, with approximately 580,000 HSAs and$1.9 billion of HSA Assets, for$455 million in cash (the "Further Acquisition"). We expect merger integration expenses attributable to the Further Acquisition totaling approximately$55 million to be incurred over a period of approximately three years from the acquisition date. HealthSavings HSA portfolio acquisition. InMarch 2022 , we acquired theHealth Savings Administrators, L.L.C. ("HealthSavings") HSA portfolio, which consisted of$1.3 billion of HSA Assets held in approximately 87,000 HSAs in exchange for a purchase price of$60 million in cash.
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 also "Results of operations - Revenue" for information relating to the COVID-19 pandemic and resulting societal and economic changes, and also the section entitled "Risk factors" included in our Annual Report on Form 10-K for the fiscal year endedJanuary 31, 2022 , this Quarterly Report on Form 10-Q, and our other reports filed with theSEC .
Our acquisition and integration strategy
We have historically acquired HSA portfolios and businesses that strengthen our service offerings. We plan to continue this growth strategy and are regularly engaged in evaluating different opportunities. We have developed an internal capability to source, evaluate, and integrate acquired HSA portfolios. Our success depends in part on our ability to successfully integrate acquired businesses and HSA portfolios with our business in an efficient and effective manner and to realize anticipated synergies.
Structural change in
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 2016 and 47% since 2011, 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 -18-
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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.
Trends in
Tax law has a profound impact on our business. Our offerings to members, Clients, andNetwork Partners consist primarily of services enabled, mandated, or advantaged by provisions ofU.S. tax law and regulations. 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, whereby we work withNetwork Partners and Clients to reach consumers to increase the number of our members with HSA accounts and complementary CDBs. We believe that there are significant opportunities to expand the scope of services that we provide to our current Clients. Broad distribution footprint We believe we have a diverse distribution footprint to attract newClients and Network Partners . Our sales force calls on enterprise and regional employers in industries across theU.S. , as well as potentialNetwork Partners from among health plans, benefits administrators, and retirement plan record keepers.
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 HRAs, 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. With our 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
We believe that innovations incorporated in our technology, which enable us to better assist 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. Our full suite of CDB offerings complements our HSA solution and enhances our leadership position within the HSA sector. We intend to continue to invest in our technology development to enhance our capabilities and infrastructure, while maintaining a focus on data security and the privacy of our customers' data. For example, we are making significant investments in the architecture and infrastructure of the technology that we use to provide our services 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 by 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, our members' custodial HSA cash assets are held by either our federally insured bank and credit union partners, which we collectively call ourDepository Partners (our "Basic Rates" offering), pursuant to contractual arrangements we have with theseDepository Partners , or by our insurance company partners through group annuity contracts or other similar arrangements (our "Enhanced Rates" offering). We earn a material portion of our total revenue from interest paid to us by these partners.
The lengths of our agreements with
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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.
HSA members who place their HSA cash into our Enhanced Rates offering receive a higher yield compared to our Basic Rates offering. An increase in the percentage of HSA cash held in our Enhanced Rates offering also positively impacts our custodial revenues, as we generally receive a higher yield on HSA cash held by our insurance company partners compared to cash held by ourDepository Partners . As with ourDepository Partners , yields paid by our insurance company partners may be impacted by the 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 and insurance company partners, varied contract terms, and other factors reduce our exposure to short-term fluctuations in prevailing 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.
Although interest rates have increased, we expect our custodial revenue to
continue to be adversely affected by the interest rate cuts by the
Interest on our term loan facility changes frequently due to variable interest rate terms, and as a result, our interest expense is expected to fluctuate based on changes in prevailing interest rates.
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 benefits administration services are not a core business. Some of our direct competitors (including healthcare service companies such asUnited Health Group's Optum,Webster Bank , and well-known retail investment companies, such asFidelity Investments ) are in a position to devote more resources to the development, sale, and support of their products and services than we have at our disposal. Our other CDB administration competitors include health insurance carriers, human resources consultants and outsourcers, payroll providers, national CDB specialists, regional third-party administrators, and commercial banks. In addition, numerous indirect competitors, including benefits administration 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. As a result of the COVID-19 pandemic, we have seen a significant decline in the use of commuter benefits due to many of our members working from home, which has negatively impacted both our interchange revenue and service revenue, and this "work from home" trend, or hybrid work environments, may continue indefinitely.
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 services, 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. Various states also have laws and regulations that impose additional restrictions on our collection, storage, and use of personally identifiable information. Privacy regulation in particular has become a priority issue in many states, includingCalifornia , which in 2018 enacted the California Consumer Privacy Act broadly regulatingCalifornia residents' personal information and providingCalifornia residents with various rights to access and control their data, and the new California Privacy Rights Act. We have also seen an increase in regulatory changes related to our services due to government responses to the COVID-19 pandemic and may continue to see additional regulatory changes. 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. -20- -------------------------------------------------------------------------------- Table of Contents OnFebruary 18, 2022 ,President Biden formally continued the National Emergency Concerning COVID-19, which tolls certain deadlines related to COBRA and other CDBs and increases the complexity of properly administering these programs. Each national emergency declaration generally lasts for one year unless the President announces an earlier termination.
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) April 30, 2022 April 30, 2021 % Change January 31, 2022 HSAs 7,359 5,846 26 % 7,207 New HSAs from sales - Quarter-to-date 159 115 38 % 472 New HSAs from sales - Year-to-date 159 115 38 % 918 New HSAs from acquisitions - Year-to-date 90 - n/a 740 HSAs with investments 506 371 36 % 455 CDBs 7,095 6,986 2 % 7,192 Total Accounts 14,454 12,832 13 % 14,399 Average Total Accounts - Quarter-to-date 14,427 12,870 12 % 14,326 Average Total Accounts - Year-to-date 14,427 12,870 12 % 13,450 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 1.5 million, or 26%, fromApril 30, 2021 toApril 30, 2022 , primarily driven by new HSAs from sales, HSAs acquired through the Further Acquisition, the Fifth Third acquisition, the HealthSavings acquisition, and other HSA portfolio acquisitions. The number of our CDBs increased by 0.1 million, or 2%, fromApril 30, 2021 toApril 30, 2022 , primarily driven by CDBs acquired through the Further Acquisition, partially offset by a decrease in FSA accounts and COBRA accounts. HSA Assets
The following table sets forth HSA Assets as of and for the periods indicated: (in millions, except percentages)
April 30, 2022 April 30, 2021 % Change January 31, 2022
HSA cash $ 12,935 $ 10,026 29 % $ 12,943
HSA investments 7,330 4,987 47 % 6,675
Total HSA Assets 20,265 15,013 35 % 19,618
Average daily HSA cash - Year-to-date 12,910 10,051 28 % 10,579
Average daily HSA cash - Quarter-to-date 12,910 10,051 28 % 12,118
HSA Assets includes our HSA members' custodial assets, which consists of the
following components: (i) HSA cash, which includes cash deposits held by our
Depository Partners and our insurance company partners, and (ii) HSA investments
in mutual funds through our custodial investment fund partners. Measuring HSA
Assets is important because our custodial revenue is directly affected by
average daily custodial balances for HSA Assets that are revenue generating.
HSA cash increased by
HSA investments increased by
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Total HSA Assets increased by$5.3 billion , or 35%, fromApril 30, 2021 toApril 30, 2022 , due primarily to HSA Assets transferred to us as part of the Further Acquisition, the Fifth Third acquisition, the HealthSavings acquisition, and other HSA portfolio acquisitions, and net HSA contributions from new and existing HSA members. Client-held funds (in millions, except percentages) April 30, 2022 April 30, 2021 % Change January 31, 2022 Client-held funds $ 872 $ 903 (3) % $ 897 Average daily Client-held funds - Year-to-date 865 899 (4) % 842 Average daily Client-held funds - Quarter-to-date 865 899 (4) % 822 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 CDBs. We deposit the Client-held funds with ourDepository Partners in interest-bearing, demand deposit accounts that have a floating interest rate and no set term or duration. Client-held funds fluctuate depending on the timing of funding and spending of CDB balances and the number of CDBs we administer.
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 equity securities, amortization of incremental costs to obtain a contract, costs associated with unused office space, 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 loss, the most comparable GAAP financial measure, to Adjusted EBITDA for the periods indicated:
Three months ended April 30,
(in thousands) 2022 2021
Net loss $ (13,639) $ (2,615)
Interest income (52) (408)
Interest expense 10,461 6,689
Income tax benefit (4,412) (3,451)
Depreciation and amortization 15,788 11,954
Amortization of acquired intangible assets 23,698 19,814
Stock-based compensation expense 13,986 12,799
Merger integration expenses 9,294 8,807
Acquisition costs (1) 6 5,939
Amortization of incremental costs to obtain a contract 1,067 1,272
Costs associated with unused office space 1,294 -
Other 844 (1,826)
Adjusted EBITDA $ 58,335 $ 58,974 (1)For the three months ended
The following table further sets forth our Adjusted EBITDA as a percentage of revenue:
Three months ended April 30,
(in thousands, except percentages) 2022 2021 $ Change % Change
Adjusted EBITDA $ 58,335 $ 58,974 $ (639) (1) %
As a percentage of revenue 28 % 32 %
Our Adjusted EBITDA decreased by $0.6 million , less than 1%, from $59.0 million
for the three months ended April 30, 2021 to $58.3 million for the three months
ended April 30, 2022 , primarily due to increases in personnel and related costs,
largely offset by an increase in total revenue.
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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
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 ourNetwork Partners and Clients, our fees are generally based on a fixed tiered structure for the duration of the relevant service agreement 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 primarily from HSA Assets held by ourDepository Partners or our insurance company partners, recordkeeping fees we earn in respect of mutual funds in which our members invest, and Client-held funds deposited with ourDepository Partners . HSA cash held by ourDepository Partners is held pursuant to contracts that (i) typically have terms ranging from three to five years, (ii) provide for a fixed or variable interest rate payable on the average daily cash balances held by the relevant Depository Partner, and (iii) have minimum and maximum required balances. HSA cash held by our insurance company partners is held in group annuity contracts or similar arrangements. Client-held funds held by ourDepository Partners are held in interest-bearing, demand deposit accounts that have a floating interest rate and no set term or duration. We earn custodial revenue on HSA Assets and Client-held funds that is based on the interest rates offered to us by theseDepository Partners and insurance company 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 from which 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 physical payment cards or virtual platforms to make a 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 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 members. Other components of cost of revenue include interest retained by members on HSA 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, in respect of HSA cash with yield, 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 ourNetwork Partners , Clients, and members, the mix of our sources of revenue, how many services we deliver per account, and payment processing costs per account. -23-
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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 development and delivery, licensed software, information technology, data management, product, 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, corporate development, 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 7-15 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, legal expenses, and facilities and technology expenses directly related to integration activities to merge operations as a result of acquisitions.
Interest expense
Interest expense primarily consists of accrued interest expense and amortization of deferred financing costs associated with our long-term debt. Interest on our term loan facility changes frequently due to variable interest rate terms, and as a result, our interest expense is expected to fluctuate based on changes in prevailing interest rates. Other expense, net
Other expense, net, consists of acquisition costs, interest income earned on corporate cash and other miscellaneous income and expense.
Income tax benefit
We are subject to federal and state income taxes inthe United States based on aJanuary 31 fiscal year end. 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. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. As ofApril 30, 2022 , we have recorded a valuation allowance on certain state deferred tax assets and maintained an overall net federal and state deferred tax liability on our condensed consolidated balance sheet. -24-
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Comparison of the three months ended
Revenue
The following table sets forth our revenue for the periods indicated:
Three months ended April 30,
(in thousands, except percentages) 2022 2021 $ Change % Change Service revenue$ 104,348 $ 102,534 $ 1,814 2 % Custodial revenue 59,365 46,978 12,387 26 % Interchange revenue 41,966 34,690 7,276 21 % Total revenue$ 205,679 $ 184,202 $ 21,477 12 % Service revenue. The$1.8 million , or 2%, increase in service revenue from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was primarily due to new revenue from acquired businesses and HSA portfolios, and new HSAs from sales, partially offset by lower average service fees per account. Custodial revenue. The$12.4 million , or 26%, increase in custodial revenue from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was primarily due to the$2.9 billion , or 28%, increase in the year-over-year average daily balance of HSA cash. The increase was partially offset by a decrease in average annualized yield from 1.79% for the three months endedApril 30, 2021 to 1.69% for the three months endedApril 30, 2022 , which was due in part to HSA cash that was placed with ourDepository Partners following the interest rate cuts made by theFederal Reserve at the beginning of the COVID-19 pandemic, and by transfers from HSA cash to HSA investments. Interchange revenue. The$7.3 million , or 21%, increase in interchange revenue from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was primarily due to an increase in accounts and increased spend per account. Total revenue. Total revenue increased$21.5 million , or 12%, from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 due to the increases in service, custodial, and interchange revenues described above. Impact of COVID-19. Our business has been adversely affected by the COVID-19 pandemic, and we expect that it will continue to be adversely affected by related societal and economic changes. Although interest rates have increased from their pandemic lows, a majority of our members' HSA cash is deposited with ourDepository Partners pursuant to contracts that have fixed interest rate terms, typically ranging from three to five years, which reduces the short-term impact of an increase or decline in prevailing interest rates on our custodial revenue. As a result, the yield we currently receive from ourDepository Partners and insurance company partners remains significantly below the levels seen before the pandemic. Our financial results related to certain of our products have also been adversely affected, such as commuter benefits, due to many of our members working from home during the outbreak, and the "work from home" trend, or hybrid work environments, may continue indefinitely. In particular, the increased spread of COVID-19 in early 2022 and the associated decisions by employers to delay return-to-office plans for their employees further delayed the recovery of use of these commuter benefits. During the initial stages of the COVID-19 pandemic, and during subsequent increases in COVID-19 cases, we saw a negative impact on our members' spend on healthcare, which negatively impacted both our interchange revenue and service revenue. Our compliance with proposed COVID-19 vaccine mandates has resulted in, and could continue to result in, increased team member attrition, absenteeism, and associated costs. We may be unable to meet our service level commitments to our Clients as a result of disruptions to our work force and disruptions to third-party contracts that we rely on to provide our services. The extent to which the COVID-19 pandemic and any longer lasting impacts on the usage of our services will continue to negatively impact our business remains highly uncertain and as a result may have a material adverse impact on our business and financial results. -25-
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Cost of revenue
The following table sets forth our cost of revenue for the periods indicated:
Three months ended April 30,
(in thousands, except percentages) 2022 2021 $ Change % Change Service costs$ 80,874 $ 70,632 $ 10,242 15 % Custodial costs 6,641 5,009 1,632 33 % Interchange costs 6,991 5,445 1,546 28 % Total cost of revenue$ 94,506 $ 81,086 $ 13,420 17 % Service costs. The$10.2 million , or 15%, increase in service costs from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was primarily due to the inclusion of Further's results of operations and an increase in personnel costs to support the increase in average Total Accounts. Custodial costs. The$1.6 million , or 33%, increase in custodial costs from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was due to an increase in the average daily balance of HSA cash, which increased from$10.1 billion for the three months endedApril 30, 2021 to$12.9 billion for the three months endedApril 30, 2022 and an associated increase in interest retained by HSA members, partially offset by a lower average annualized rate of interest retained by HSA members on HSA cash, which decreased from 0.18% for the three months endedApril 30, 2021 to 0.16% for the three months endedApril 30, 2022 . Interchange costs. The$1.5 million , or 28%, increase in interchange costs from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was due to an increase in accounts and increased spend per account. Total 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. On an annual basis, we expect our cost of revenue to continue to increase as a percentage of our total revenue, primarily due to the inclusion of a full year of Further's results of operations and expected increases in stock-based compensation. 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, account management functions, realized synergies, and the impact of the COVID-19 pandemic.
Operating expenses
The following table sets forth our operating expenses for the periods indicated:
Three months ended April 30,
(in thousands, except percentages) 2022 2021 $ Change % Change
Sales and marketing $ 16,560 $ 14,086 $ 2,474 18 %
Technology and development 45,183 35,469 9,714 27 %
General and administrative 23,727 20,687 3,040 15 %
Amortization of acquired intangible
assets 23,698 19,814 3,884 20 %
Merger integration 9,294 8,807 487 6 %
Total operating expenses $ 118,462 $ 98,863 $ 19,599 20 %
Sales and marketing. The $2.5 million , or 18%, increase in sales and marketing
expense from the three months ended April 30, 2021 to the three months ended
April 30, 2022 was primarily due to the inclusion of Further's results of
operations, an increase in marketing expenses from increased staffing and
marketing collateral costs, and increases in team member and partner
commissions.
We expect our sales and marketing expenses to increase for the foreseeable
future as we focus on our cross-selling program and marketing campaigns. On an
annual basis, we expect our sales and marketing expenses to continue to increase
as a percentage of our total revenue, primarily due to the inclusion of a full
year of Further's results of operations and expected increases in stock-based
compensation. However, 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. The
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of Further's results of operations and increases in amortization, stock-based compensation, and personnel-related expenses.
We expect our technology and development expenses to increase for the foreseeable future as we continue to invest in the development and security of our proprietary technology. On an annual basis, we expect our technology and development expenses to continue to increase as a percentage of our total revenue, primarily due to the inclusion of a full year of Further's results of operations, expected increases in stock-based compensation, and our growth initiatives. 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. The$3.0 million , or 15%, increase in general and administrative expense from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was primarily due to the inclusion of Further's results of operations and increases in personnel-related expenses and stock-based compensation. We expect our general and administrative expenses to increase for the foreseeable future due to the additional demands on our legal, compliance, and accounting functions that we incur as we continue to grow our business. On an annual basis, we expect our general and administrative expenses to increase as a percentage of our total revenue, primarily due to the inclusion of a full year of Further's results of operations, expected increases in stock-based compensation, and our growth initiatives. 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. The$3.9 million , or 20%, increase in amortization of acquired intangible assets from the three months endedApril 30, 2021 to the three months endedApril 30, 2022 was primarily due to the inclusion of amortization related to identified intangible assets acquired through the Further Acquisition commencingNovember 1, 2021 and the Luum Acquisition commencingMarch 8, 2021 . The remainder of the increase was due to amortization of acquired HSA portfolios, including the Fifth Third and HealthSavings HSA portfolios. Merger integration. The$9.3 million in merger integration expense for the three months endedApril 30, 2022 was primarily due to personnel and related expenses, including expenses incurred in conjunction with the migration of accounts, professional fees, and technology-related expenses directly related to the Further Acquisition and certain ongoing merger integration expenses related to the acquisition of our wholly owned subsidiaryWageWorks, Inc. ("WageWorks"), including ongoing lease expense related toWageWorks offices that have been permanently closed, less any related sublease income, professional fees associated with the remediation of remaining material weaknesses in internal control over financial reporting, and costs associated with remaining platform migrations. We expect merger integration expenses attributable to the Further Acquisition totaling approximately$55 million to be incurred over a period of approximately three years from the acquisition date.
Interest expense
The$10.5 million in interest expense for the three months endedApril 30, 2022 consisted primarily of interest accrued on our long-term debt and amortization of debt discount and issuance costs. On an annual basis, we expect interest expense to increase, primarily from the inclusion of a full year of interest expense we will incur on the$600.0 million aggregate principal amount of the Notes, which were issued inOctober 2021 , and due to the impact of increased interest rates on our term loan facility, which had an outstanding principal balance of$347.8 million as ofApril 30, 2022 . The interest rate on our term loan facility and Revolving Credit Facility is variable and, accordingly, we may incur additional expense if interest rates increase in future periods.
Other expense, net
The$3.3 million decrease in other expense, net, from$3.6 million during the three months endedApril 30, 2021 to$0.3 million during the three months endedApril 30, 2022 was primarily due to a$5.9 million decrease in acquisition costs, partially offset by a$2.6 million decrease in interest and other income, net. Income tax benefit For the three months endedApril 30, 2022 and 2021, we recorded an income tax benefit of$4.4 million and$3.5 million , respectively. The increase in income tax benefit was primarily the result of increased pre-tax book loss and a corresponding increase in benefit for state income taxes, partially offset by an increase in nondeductible executive compensation and a decrease in excess tax benefits on stock-based compensation and research and development tax credits. -27-
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Seasonality
Seasonal concentration of our growth combined with our recurring revenue model create seasonal variation in our results of operations. Revenue results are seasonally impacted due to ancillary service fees, timing of HSA contributions, and timing of card spend. Cost of revenue is seasonally impacted as 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.
Liquidity and capital resources
Cash and cash equivalents overview
Our principal sources of liquidity are our current cash and cash equivalents balances, collections from our service, custodial, and interchange revenue activities, and availability under our Revolving Credit Facility (as defined below). 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, principal and interest payments on our long-term debt, and capital expenditures.
As of
Capital resources
We maintain a "shelf" registration statement on Form S-3 on file with theSEC . A 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, capital expenditures, and repayment of indebtedness, 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. Our credit agreement includes a five-year senior secured revolving credit facility (the "Revolving Credit Facility"), in an aggregate principal amount of up to$1.0 billion , 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 8-Indebtedness. As ofApril 30, 2022 , there were no amounts outstanding under the Revolving Credit Facility. We were in compliance with all covenants under the credit agreement as ofApril 30, 2022 , and for the period then ended.
Use of cash
On
Capital expenditures for the three months endedApril 30, 2022 and 2021 were$14.8 million and$18.0 million , respectively. We expect to continue our current level of increased capital expenditures for the remainder of the fiscal year endingJanuary 31, 2023 as we continue to devote a significant amount of our capital expenditures to improving the architecture and functionality of our proprietary systems. Costs to improve the architecture of our proprietary systems include computer hardware, personnel and related costs for software engineering and outsourced software engineering services. We believe our existing cash, cash equivalents, and Revolving Credit Facility 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. -28-
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The following table shows our cash flows from operating activities, investing activities, and financing activities for the stated periods:
Three months ended April 30,
(in thousands) 2022 2021
Net cash provided by operating activities $ 7,077 $ 30,918
Net cash used in investing activities (74,203) (67,801)
Net cash provided by financing activities 2,959 444,853
Increase (decrease) in cash and cash equivalents (64,167) 407,970
Beginning cash and cash equivalents 225,414 328,803
Ending cash and cash equivalents $ 161,247 Cash flows from operating activities. Net cash provided by operating activities during the three months endedApril 30, 2022 resulted from a net loss of$13.6 million , plus depreciation and amortization expense of$39.5 million , stock-based compensation expense of$14.0 million , and amortization of debt discount and issuance costs of$0.8 million , partially offset by other non-cash items and working capital changes totaling$33.6 million . Net cash provided by operating activities during the three months endedApril 30, 2021 resulted from a net loss of$2.6 million , plus depreciation and amortization expense of$31.8 million , stock-based compensation expense of$12.8 million , and amortization of debt issuance costs of$1.2 million , partially offset by other non-cash items and working capital changes totaling$12.3 million . Cash flows from investing activities. Cash used in investing activities for the three months endedApril 30, 2022 resulted from$59.4 million in acquisitions of intangible member assets,$13.6 million in software and capitalized software development, and$1.2 million in purchases of property and equipment.
Cash used in investing activities for the three months ended
Cash flows from financing activities. Net cash provided by financing activities during the three months endedApril 30, 2022 resulted from$2.3 million received in the settlement of Client-held funds obligations, net, and the exercise of stock options of$2.8 million . These items were partially offset by$2.2 million of principal payments on our long-term debt. Net cash provided by financing activities during the three months endedApril 30, 2021 resulted from$456.6 million of net proceeds from our follow-on public offering of 5,750,000 shares of common stock and the exercise of stock options of$4.2 million . These items were partially offset by$15.6 million of principal payments on our long-term debt and$0.4 million used in the settlement of Client-held funds obligation, net.
Contractual obligations
See Note 6-Commitments and contingencies for information about our contractual obligations.
Off-balance sheet arrangements
As ofApril 30, 2022 , other than outstanding letters of credit issued under our Revolving Credit Facility, we did not have any off-balance sheet arrangements. The majority of the standby letters of credit expire within 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.
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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 fiscal year endedJanuary 31, 2022 . There have been no significant or material changes in our critical accounting policies during the three months endedApril 30, 2022 , 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 fiscal year endedJanuary 31, 2022 .
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.
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