WAGEWORKS INC (WAGE) WAGE S W
April 24, 2017 - 3:15pm EST by
ka8104
2017 2018
Price: 74.00 EPS 1.68 1.81
Shares Out. (in M): 37 P/E 44x 41x
Market Cap (in $M): 2,745 P/FCF 44x 41x
Net Debt (in $M): 175 EBIT 87 96
TEV ($): 2,920 TEV/EBIT 34x 31x
Borrow Cost: General Collateral

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Description

Thesis Summary

 

  • WAGE has built a nice, high margin business providing stable contracted fee-for-service outsourced employee benefit administration to large and mid-sized companies; the largest of these services is the administration of Flexible Spending Accounts (FSAs) wherein WAGE is the market leader and has been rolling up the industry for the last decade

  • FSAs have been around for 30+ years which as a whole is a mature and now likely shrinking market with a structural headwind due the emergence and rapid growth of Health Spending Accounts (HSAs); as further described herein, the business models are also importantly different, for administering FSA accounts, a provider like WAGE is paid a flat per employee per month fee; on the HSA side, it is more of a checking + 401k account that builds value over time and more of the economics to come from float income

  • HSAs are a far superior product for reasons further described herein and as employers increasingly adopt HSAs, they directly cannibalize FSA accounts as (i) employees are prohibited by law from having both a HSA and a FSA and (ii) people who have/use/understand their FSA account have a high propensity to switch most quickly

  • Although the company pitches itself and the sell-side views WAGE as a “HSA play” and way to ride that trend, WAGE’s HSA business is very small (~5% of revenues and 2% market share) while FSAs are 50%+ of revenues  

  • Unlike in the FSA market, WAGE is a small player and late mover with low 2% market share in HSAs and more importantly has a structurally disadvantaged business vs. its key competitors/market leaders:

    • Health Plans:  UNH is vertically integrated and the largest HSA provider via its sub called Optum Bank, Aetna is integrated as well via its sub called Payflex; Cigna is aligned with WBS and Anthem is aligned with HQY and also white-labels Alegus software

    • Non-bank custodians:  Health Equity (HQY) is the largest, they are the key industry channel partner and market share leader with robust technology, customer support and interface; their strategy is also to grow accounts and emphasize NIM/float income at the expense of admin fee for service income (which they have disclosed goes down 5-15% per year); it is also interesting that Founder and former CEO of WAGE, left to run HQY as their CEO and has little to no interest in the FSA business

    • Banks/Asset Managers:  Webster (WBS) is actually the largest bank player via its sub HSA Bank which was a first mover; others like BofA also in the business that view HSA balances as a deposit source; asset managers like Fidelity in the business as they see HSAs like 401k and are in asset gathering mode

    • WAGE is none of the above and must compete on price/fee for service vs. (i) health plans who are primary providers offering HSAs as a bundled services to both share in the economics as well as keep a stickier customer (ii) banks/custodians using low/no fees as a loss leader to gather assets/make Net Interest Margin (NIM); WAGE rather has a custodial partnership with Bank of New York (BK) where until 2017 has not participated in any NIM and doesn’t control the accounts (leading to issues described below)

  • The HSA channel to market is more difficult than FSA and is already full with large health plans having captive units or preferred partnerships and the large consultants/brokers (AON, MSH, WLTW, etc.) already aligned with preferred partnerships of which WAGE is not a major player

  • Majority of Fortune 500/1000 already has a HSA provider, those RFPs are done and switching is rare; being an incumbent FSA provider is not an advantage and WAGE as demonstrated/proven in the survey work below is a share loser

  • Organic Growth is overstated as the company counts “Channel Partnership” deals as organic even though they consist of large payments to other companies to take over books of business. FSA participation growth has also benefitted from a limited rollover provision tailwind that is now in late innings

  • Valuation: >6x Revenue, >21x Adjusted EBITDA and >44x Adjusted Earnings (adjusted to conform to mgmt presentation which adds back huge stock-based-comp charge, multiples much higher without), given the recent growth rates, the HSA halo (further boosted post-election) and sell-side support of a relatively underfollowed stock (despite $2.9B market cap)

 

FSA / HSA Background

At the core, both FSAs and HSAs are accounts that allow employers reduce healthcare costs.   There is tons of info on HSAs, how they work, etc. all over the internet and many already know about them so will keep this brief.

 

In the 1960s, health care inflation caused many employers to institute annual deductibles and coinsurance. These moves effectively doubled the healthcare cost for the average employee on an after-tax basis. In response, the IRS created the FSA in the 1970s to help reduce some of these costs by allowing employees to use some pre-tax dollars to pay for their healthcare expenses.  Over the last 40 years, FSAs gained popularity among employers and today the vast majority of employers offer this as a benefit. While nearly all employers offer the FSA today, adoption among employees is much lower at around 25%. The core issue with the FSA is that if you don’t use it, you lose it the next year and as a result, many employees dislike this uncertainty.  Dealing with an FSA is also a cumbersome process if need to gather receipts, etc.

 

Today, there is a similar issue in the health care system and the response by employers is to introduce High Deductible Health Plans (HDHP).  This effectively shifts costs to the consumer, forces consumers to be smarter about using the health care system, and ultimately lowers costs for everyone.

To help offset this expense, the government created the HSA account --  the law is you can only have an HSA account in conjunction with a HDHP.  

 

Unlike a FSA, the money that you put into an HSA is yours and rolls over year to year.  It is similarly tax-advantaged, has better limits and provisions and can be used for both spending (annual healthcare costs, deductibles, co-pays, etc.) as well as saving, for bigger healthcare related costs (withdrawable tax free for qualified medical expenses) as well as for retirement (many use/view as an additional savings account on top of your 401k and IRA).  Today, we are in the early stages of (i) getting employers to offer HDHPs, (ii) pushing employees to choose HDHP options and (iii) getting employees with HDHPs to open an HSA.  The last key point here is that individuals with HSAs cannot open up a general purpose FSA as the IRS wants to limit the tax benefits.  Individuals are only able to open up a “Limited Purpose FSA” that only basically covers vision and dental but it is extremely uncommon for people to have both. Thus, HSA growth directly cannibalizes the FSA market.

 

There are a number of differences between FSAs and HSAs laid out on the following chart. Despite the value proposition being significantly better, HSAs have yet to reach a similar level of popularity due to the FSA having a 30yr head start. The points to call out are: (i) you can rollover your entire balance within a HSA but not FSA, (ii) many more employers will match or seed a HSA every year, (iii) annual pre-tax contribution limit is higher on the HSA side.

 

 

 

Business Model

WAGE’s Healthcare segment business model is easy to understand:

  • FSA:  contracts with employers to administer the accounts and move around the money, for this get a flat fee of ~$3-$4 per employee per month and (ii) 50c-$1 per employee per month of interchange revenue (receive a share of the payment process as employees are issued debit cards used to pay for qualified FSA expenditures)

  • HSA:  paid in the same manner on the HSA side (admin fee + interchange) except as mentioned above, WAGEs competitors who own banks (WBS, BAC, UNH) or custodians (HQY) make additional float / Net Interest Margin (NIM) income on cash in customer accounts (i.e. the bank/custodian will use the cash to make loans or term deposits longer on the curve and only share a portion with the HSA account holder); as mentioned above this is a key point as the competition is advantaged and is economics are/will be more in the float than the fees; for example, when rates were higher, HQY used to charge ZERO admin flat fees and even today, once you get above a minimum cash balance in your HQY HSA account, there are ZERO fees; furthermore, HQY and other banks/custodians often will share the admin fee with the channel who sold/sourced the accounts – these factors combined is what drives HQY’s disclosed 5-15% annual decline in monthly charged account admin fees: “what we did say on our last call was that the 14% or 15% decrease in unit economics or unit pricing on service revenues that we had last year that that would decrease back in more lower levels that we had previously guided on and more in like the 5% to 10% range. So we expect that that will happen.”

  • Other:  includes the smaller Health Reimbursement Accounts (HRAs) business which also faces headwinds

Historically the business has been sticky with renewal rates of 95%+ as once you have an administrator that does a decent job, there is little reason to switch.  The company also administers Commuter and COBRA benefits and part of the bull case is that they can cross-sell these services amongst customers for higher wallet share (management says that 2/3 of their clients only use 1 out of their 4-5 products offered).   Will demonstrate below that the retention rate is rapidly changing as the shift to HSAs occurs and cross-selling disparate services doesn’t seem to matter.


The Bull Case

1.  As an incumbent in the FSA market, WAGE has a significant advantage in cross-selling into the HSA market

2.  The rise of HSAs is helpful for WAGE’s growth rates

3.   WAGE has been able to grow double digits and despite the FSA market maturing, historical growth rates can continue both organically and via M&A

 

The Bear Case

1.  Being an incumbent in the FSA market is not an advantage to win the HSA contract at RFP

In speaking with industry experts and channel participants from the large HR consultants/brokers, repeatedly heard anecdotally that WAGE was losing these RFPs despite being the incumbent.  To gain further conviction, built a bottoms-up market survey through publically available open enrollment documents on the internet.  In total thus far, were able to gather 184 data points out of mostly Fortune 500 companies (WAGE frequently mentions their share within this group and has stated that 2/3 of Healthcare revenue is from the top 100-200 employers they contract with).  The full results of the study are in the Appendix, here are the highlights.

 

Of the 184, WAGE provides FSA administration to 48 companies. 40 of those (83%) already have a HSA administrator but WAGE lost 29 of those accounts even as the incumbent (~75% loss rate). This was surprising in the context of the legacy 95% retention rate that drives the multiple in this stock. Conversely, there are ZERO cases of WAGE winning the HSA business when they were not the FSA incumbent.  Although HSA specialists don’t explicitly fight for the FSA business as it is not attractive long term, they actually are MORE successful than WAGE at cross-selling both solutions, winning both the FSA and HSA business ~50% of the time.  Believe this can be attributable to (i) WAGE being viewed as low value-add administrator versus a high-value partner and (ii) it is easy to do FSA if you can do HSA but not the reverse and you are seeing HSA specialists take share. Lastly, although HSAs are viewed as a “blue sky” opportunity, employer penetration within the Fortune 1000) is already very high, i.e. the RFPs have occurred and WAGE has already lost the market share land grab.

 

WAGE WAS FSA INCUMBENT BUT LOST THE HSA BUSINESS

HSA SPECIALISTS CAN CROSS SELL BETTER THAN WAGE