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spk01: Hello, everyone, and welcome to the conference. Please note, today's conference is being recorded. I'd now like to turn the call over to Richard Putnam. Please go ahead.
spk09: Thank you, Rocco. Hello, everyone. Welcome to HealthEquity's second quarter of fiscal year 2024 earnings call. My name is Richard Putnam, investor relations for HealthEquity. Joining me today on the call is John Kessler, president and CEO, Dr. Steve Nealeman, vice chair and founder of the company, the company's CFO, Tyson Murdoch, and its soon-to-be CFO, James Lucania. Before I turn the call over to John, I have two important reminders. A press release announcing the financial results for our second quarter of fiscal 2024 was issued after the market closed this afternoon. These financial results include the contributions from our wholly-owned subsidiaries and accounts that they administer. The press release also includes definitions of certain non-GAAP financial measures that we will reference today. A copy of today's press release, including reconciliations of these non-GAAP measures with comparable GAAP measures and a recording of this webcast can be found on our investor relations website, which is ir.healthequity.com. Second, our comments and responses to your questions today reflect Management's view as of today, September 5th, 2023, and will contain forward-looking statements as defined by the SEC, which include predictions, expectations, estimates, or other information that might be considered forward-looking. There are many important factors relating to our business which could affect the forward-looking statements made today. These forward-looking statements are subject to risk and uncertainties that may cause the actual results to differ materially from statements made here today. We caution against placing undue reliance on these forward-looking statements, and we also encourage you to review the discussion of these factors and other risks that may affect our future results or the market price of our stock, as they are detailed in our latest annual report on Form 10-K and subsequent periodic reports filed with the SEC. We assume no obligation to revise or update these forward-looking statements in light of new information or future events. One more note before turning this over to John, with Jim now on board, we have rescheduled our Draper Investor Day to February 22nd. We're hoping for another great year of snow for those who want to ski on the greatest snow on earth, and we hope you all will join us either in person or virtually. Over to you, John.
spk12: Okay. Hi, everyone, and thank you for joining us. I will discuss Q2 key metrics and management's view of current conditions, and Tyson will touch on Q2 results before detailing our raised guidance for fiscal 24. And Steve is here for Q&A. In Q2, the team delivered double-digit year-over-year growth in revenue, which was plus 18%, and adjusted EBITDA, which was plus 31%. HSA assets grew 13% and HSA members grew 9%. Total accounts grew 3%, muted by the previously discussed change in COBRA methodology. Health equity ended Q2 with 8.2 million HSA members, 23.2 billion in HSA assets, and 15 million total accounts. The team added 156,000 new HSA members in its fiscal second quarter, which is healthy but down from the record-setting Q2 last year. As in Q1, comparison to last year's blistering job growth and high turnover, as well as fewer HSA transfers from small banks, were offset by robust new logo growth driven by an expanded network partner footprint and HR departments seeking out win-wins. The team also added $883 million in HSA assets in Q2. I wanted to say a whopping $883, but I wasn't allowed to, so I didn't say that. That's compared to a $272 million increase in the year-ago period, which would not be as whopping, reflecting not only count growth but also balance growth. Despite inflation, average HSA balances at health equity grew both sequentially and year-over-year, in part due to investments. 11% more of our HSA members became investors year over year, helping to drive up invested assets by 23%. Remarkably, invested assets now account for 40% of HSA assets. We continue to see more members choose enhanced rates for their HSA cash, leading to higher for longer custodial yields and, we believe, less cyclicality in the future. Interest rates in Q2 also gave a boost to variable rate HSA cash and CDB client health funds. While custodial fee growth drove Q2 performance, the team also delivered modest progress on service fees, the bulk of which come from ancillary CDB administration products. Service revenue rose 3% year over year in line with total accounts. Service costs grew just 2% year over year and declined sequentially by more than $4 million. As we discussed last quarter, rapid improvement in service tech continues to drive more interactions to chat and automated responses. The run out of remaining tailwinds from the COVID-19 national emergency may obscure a bit the progress that we're making when we get to the second half, but we see the results we've delivered here in Q2 as well as in the first quarter as evidence of positive trajectory on service revenue and margin. Finally, interchange revenue. which resumed its seasonal pattern as expected with strengthened Q1 followed by a more subdued performance in Q2. We think the HSA market Health Equity now leads can grow by about 10% annually for years to come, thanks to steady account growth and faster asset growth as accounts mature, which in turn expands margin opportunity. Team Purple can extend its long record of outperformance by doing what it did well in this second quarter. Before turning the call over, I would like to publicly thank Mr. Tyson Ty Murdock for his unwavering service to health equity's mission, vision, and values over the past five and a half years. And in particular, for focusing his team on a strong finish and a smooth transition over these past few months. Tyson's a class act, and you would do well to keep an eye out for the opportunity in whatever he chooses to do next. As Richard noted at the top of the call, Jim Lucania, who will take over as CFO effective tomorrow, is with us today. Jim will be active on the conference circuit this fall, beginning tomorrow, actually. And, of course, will preside at Health Equities Investor Day in Utah in February, as Richard mentioned. Tyson.
spk02: All right. Thank you, John, for those kind comments. All right, I'll highlight our second quarter GAAP and non-GAAP financial results. A reconciliation of GAAP measures to non-GAAP measures is found in today's press release. Second quarter revenue increased 18% year-over-year. Service revenue was $105.7 million, up 3% year-over-year. Custodial revenue grew 51% to $98.9 million in the second quarter, and the annualized interest rate yield on HSA cash was 237 basis points. Interchange revenue grew 4% to $38.9 million. Gross profit as a percentage of revenue was 62% in the second quarter of this year versus 57% in the year-ago period. This is the highest gross margin quarter since we acquired WageWorks four years ago. Net income for the second quarter was $10.6 million or $0.12 per share on a GAAP EPS basis. Our non-GAAP net income was $45.6 million for the second quarter, and non-GAAP net income per share was $0.53 per share compared to $0.33 per share last year. While higher interest rates increased custodial yields and generated interest income, they also increased the rate of interest we pay on the remaining $287 million term loan A to a stated rate of 6.9%. Adjusted EBITDA for the quarter was $88.1 million, and adjusted EBITDA as a percentage of revenue was 36%, a more than 360 basis point improvement over last year. For the first six months of fiscal 24, revenue was $488 million, up 18% compared to the first six months of last year. Gap net income was $14.7 million, or $0.17 per diluted share. And non-GAAP net income was $88.4 million, or $0.02 per diluted share, up 74% compared to the same period last year. And adjusted EBITDA was $174.7 million, up 39% from the prior year, resulting in adjusted EBITDA as a percentage of revenue of 36% for the first half of this fiscal year. Turning to the balance sheet, as of July 31, 2023, cash accorded was $290 million, boosted by a record $77 million of cash generated from operations in Q2, and $109 million year-to-date. The company had $874 million of debt outstanding net of issuance costs, and we continue to have an undrawn $1 billion line of credit available. For fiscal 24, we're raising guidance and now expect the following. Revenue in a range between $980 and $990 million. GAAP net income to be in a range of $19 to $24 million. And we expect non-GAAP net income to be between $171 and $179 million, resulting in non-GAAP diluted net income between $1.97 and $2.06 per share, based upon an estimated 87 million shares outstanding for the year. We expect adjusted EBITDA to be between $338 and $348 million. Our $5 million midpoint revenue increase is primarily based on revised expectations for the average yield on HSA cash to approximately 240 basis points for fiscal 24. As a reminder, we base interest rate assumptions embedded in guidance on an analysis of forward-looking market indicators, such as the secured overnight financing rate and mid-duration treasury forward curves and Fed funds futures. These are, of course, subject to change. Our expectations are tempered somewhat by the anticipated impact of the end of the national emergency period that John referenced in his remarks on service revenue. Average crediting rates our HSA members receive on HSA cash remain flat sequentially, and the crediting rates our HSA members receive are determined in accordance with the formula described in our custodial agreements with them. We continue to expect these rates will rise as overall interest rates remain elevated and have included in our guidance a five basis point increase by the end of fiscal 24. Our guidance also reflects the expectation of higher average interest rates on health equities variable rate debt versus last year, partially offset by the reduced amount of variable rate debt outstanding. And then we assume their projected statutory non-GAAP income tax rate of approximately 25% and a diluted share count of $87 million, which now includes common share equivalents as we anticipate positive GAAP-bent income this year. As we have discussed, moving to positive GAAP-bent income impacts our GAAP tax rate strangely this year. Discrete tax items may also impact the calculated tax rate on a low level of pre-tax income. Based on our current full-year guidance, we expect roughly a 50% gap tax rate for fiscal 2024. As we have done in recent reporting periods, our full fiscal 2024 guidance includes a reconciliation of gap to the non-gap metrics provided in earnings release, and a definition of all such items is included at the end of the earnings release. In addition, while the amortization of acquired intangibles is being excluded from non-gap net income, the revenue generated from those acquired intangible assets is not excluded. My time serving our members, our teammates, and investors over the last five and a half years has been a real pleasure. We made a lot of progress, and I'm confident the team will continue the course as I move into my next opportunity. And with that, we know you have a number of questions, so let's go right to our operator for Q&A. Thank you.
spk01: Thank you, sir. If you'd like to ask a question, please press star then 1. If your question has already been addressed and you'd like to remove yourself from the queue, please press star then 2. Today's first question comes from Greg Peters in Raymond James. Please go ahead.
spk05: Good afternoon, everyone. I guess before I begin with my question, Tyson, I'd also like to congratulate you on your service in health equity. It certainly helped accomplish some challenging times. John, in your prepared remarks, you mentioned something about sustaining a 10% growth, and I was just curious about your perspective of the macro environment from a competitive standpoint. We're seeing numbers from Duveneer and others suggest that some are having some success, maybe as much success in growing shares as you are, while others are not. Just an updated view on how the market looks to you today.
spk12: Well, I think if you sort of think about where the market is, you have two factors that ultimately drive revenue growth, which is the first thing that as investors we care about. The first is account growth, and the second is asset growth. Account growth, in my view, if I look at it on a multi-year basis, will kind of be in the high single digits, and asset growth will be in the teens. Revenue growth is typically somewhere between the two, I think, and I don't really see any reason for much change in that view, you know, based if I'm trying to ask the question over multiple years. And then, look, our job is to outperform the market in terms of assets, accounts, et cetera, and then to do a better job, the best job we possibly can, and hopefully a better job than others at generating both revenue and profitability from doing so.
spk05: All right. My follow-up detail question is on free cash flow. Nice improvement on a year-over-year basis. It looks like the gap between adjusted EBITDA and free cash flow is narrowing. Maybe you can just update us on how you're looking at free cash flow for the balance of this year, and are there any headwinds that we should be thinking about with free cash flow as we think out beyond this year?
spk12: Maybe, Tyson, would you mind starting with regard to the sort of balance of this year question? Anything particular that is, I think the quest, the gist of the question is, was there some jump forward or the like?
spk02: No. I mean, I think this is to be expected as the custodial revenue increases with the very high margin and cash generation capability. that it's going to accelerate that cash. And as you see the positive gap in income come in, it's overcome now all the amortization from the wage works and other deals that are in there. So the business is starting to purr on that generation of custodial cash. And I'd expect that to continue going forward. Of course, there's things in there like we're going to start to pay taxes. So you got wires going out for taxes. You can see that in there. And And other than that, I think the other things that are in there, like property and plant equipment purchases and just what we spend on tech and things like that, there isn't huge changes in there that would cause other things to occur. So it's going to continue to move up.
spk00: And, you know, Greg, as far as use of cash,
spk12: First of all, it's worth noting that if we do nothing over the course of multiple years here, and it's not too many, the free cash flow is basically going to eliminate our leverage. We're very comfortable with current leverage, and I don't want anyone to take my statement as suggesting otherwise, but that's probably not what's going to happen, meaning we probably will want to look at using that cash and or we will want to look at using that cash as we have in recent quarters and from my perspective in terms of order of cash utilization you know there's portfolio transactions that we like because they are reliable ROI and then we've paid down a little bit of our term a I would expect that that where portfolio transactions aren't available or where it makes sense At some point, we'll continue to do that. And then it's worth noting that within the current envelope, we've committed to investing in organic innovation. And you're starting to see pieces of that come through. You will see more pieces of it come through. And it's, I think, helpful when we get a question, as I'm sure we will later, about T&D expense and the like, that we're able to do that within the envelope we have and ultimately while bringing T&D expenses a percentage of revenue down over time.
spk05: Got it. Thank you for the answers.
spk12: Thanks, Greg. Have a safe flight. Thank you. Enjoy Rio.
spk01: Thank you. And our next question today comes from Stan Bernstein with Wells Fargo.
spk15: Please go ahead. He can't deny that he's going to Rio.
spk14: Thanks for taking my questions.
spk15: Hey, Stan.
spk14: How's it going? You're not going to Rio. On a personal... Not yet, not yet, although I'd like to. But I would like to say on a personal note, Tyson, it's been a pleasure working with you. Maybe a couple of questions. First one on your sales pipeline, any changes in the RFP volumes you're seeing, any changes in your win rates, or perhaps what employers are looking for?
spk12: Yeah, probably the most notable thing we've seen, Stan, this year is – I mean, let me back up and say generally the commentary I would give on account growth is that on the one hand, and similar to what we said in the first quarter, on the one hand, you've got the sort of less tailwind from a macro perspective, new job creation and so forth. And then on the other hand, we are seeing higher – new account onboarding, and then more importantly, the sort of pipeline and start work for fiscal Q4 calendar January build. And the source of that build is, so that's all providing a bit of an offset. And I think when I look at the pipeline, what's interesting this year is for the first time since the pandemic, The enterprise pipeline has been very robust, and I'm not prone to give answers without data. One answer that is given is, okay, people now have the space to make changes that they weren't willing to make. That's certainly possible, but in any event, it is worth noting that I think the biggest thing I would note that's different is the volume of enterprise deals that we are seeing and, you know, that are turning out not to be just price checks or whatever, where we're able to win business away from competitors as well as greenfield business.
spk14: Got it. That's helpful. And then one more. On custodial assets, can we get an update on the current mix of assets that are in enhanced yields, and where do you expect that mix will be 12 months from now?
spk12: So we've given guidance for the – guidance is maybe the wrong word. We've said that – See, I listen. I pay attention. Richard's giving me a face. This is what I get for being here. So we said that we'll hit about 30% by the end of the year, and I think we'll end up doing a little better than that. It is true that, you know, at this point, one of the limiting factors that we're working with is, you know, the timing of roll-off of our deposit contracts and the like that are also a barrier as well as, you know, appropriate education of consumers. So I guess I would say that, in general, the enhanced rates program is moving at or above the pace we have discussed, and we think that, you know, the end result of this is going to be both a higher, for lack of a better term, neutral rate as well as ultimately less cyclicality because of the features that we've been able to design into this product. And so I'm really excited about where we're headed with it. I'm excited to have Jim take a look at it and see where he can add and improve, and we'll have more to say about it as we go in the next couple of quarters.
spk14: Awesome. Thanks, Dan. Thanks so much.
spk12: Thank you, sir.
spk14: See you tomorrow.
spk01: Thank you. And our next question today comes from Glenn Santangelo with Jefferies. Please go ahead.
spk08: Oh, yeah. Thanks, and good evening. Hey, just two quick ones from me. You know, John, I was kind of curious if you can give us any update on the average duration of the portfolio and if that's changing at all with this enhanced rates product, because I think as most of us are probably aware, I mean, and you are, three years ago today, the 10-year was sitting at 65, 70 basis points, right? So you're getting ready to do – a replacement kind of coming up here in a few months, and I was kind of curious if you could help us in any way think about the waterfall, and then I just had a follow-up on margins.
spk12: Yeah, I'm going to give you a lot of words that I'm not sure are going to answer the question you asked, okay, so let me just, let me copy. In general, we have not made any change with regard to the, fundamentally with regard to the approach we take to to the duration of our cash portfolio? I think that's fundamentally what you're asking. That is to say, and by cash, in particular, I mean our deposit portfolio. We deploy, the actual contracts that are deployed are four or five year contracts, and when you kind of swizzle in the fact that there's variable rate cash and there's money above the minimums and whatnot, you're really talking about duration historically, and by duration here, I mean liquidity-related duration that's around three years. Now, so I think the premise is right. There are a couple things that, and I think generally the premise that your question, I think, suggests that you have, Glenn, which is that over the next couple of years here, there's a lot of cash that will be running out of deposit contracts, and particularly to the extent, well, I mean, even if it were placed in new deposit contracts, but particularly the extent it's placed in enhanced rates, right, is going to produce a nice bump here, and that will include, you know, all of the COVID-era cash. So, you know, you think about, and that includes both the natural runoffs, but also the kind of roughly five-year single placement associated with the timing of the wage conversions in calendar 2020, I believe. I may have that wrong. 20 or 21, one of the two. There is a lot of opportunity here. We think it was absolutely the right time to be looking at whether the deposit instruments were really serving our needs and those of our members. I think we've made the right choice in pursuing this mechanism. Look, the result is going to be under any reasonable economic scenario or any plausible economic scenario at the moment is going to be that it's not just that cyclically we're going to see higher profits. It's that on an ongoing basis, we're going to see higher profits from the custodial line, and that seems good.
spk08: Right. I mean, just to use your words, John, I mean, you said there's a bump coming, and I just want to make sure I'm correct in thinking there is a bump coming, even if you don't want to size it today, because when we go back and we look at those you know, those COVID, you know, sort of cash rates. I mean, it's pretty clear there's a big bump coming.
spk12: Yeah. I mean, you, you, as you well know, Glenn, when I think people got a little ahead of their skis at the beginning of calendar 23, um, and, and, and, and maybe, and so I want to be thoughtful about not creating an even, you know, a bigger, um, you crash on your skis, you yard sale, but, um, but, uh, uh, uh, But I think – but the premise is correct, and I think it will be sizable.
spk08: All right. And maybe, Tyson, just one quick one on the margins. I mean, you know, the EBITDA, you know, was up – adjusted EBITDA was up 360 basis points year over year. And, you know, I know, you know, there was some member and balance growth and the improvement in the custodial yields, obviously, and some technology benefits. But I was wondering if you could just real quickly – Sort of unpack that to help us think about what's really driving that better EBITDA, you know, when you think about those three contributors. Thanks.
spk02: Yeah, I mean, it is the custodial revenue obviously falling down to the model, and we knew that would drive it. And like we've talked about, you go back to history and, you know, way back, and we did hit a 40% EBITDA margin in one of the quarters in the middle of the summer like this one. And so we're moving back towards that as that moves up. But I do think that we've been very thoughtful about how we've managed the controllable costs. And when I say that, I mean, you know, not something like stock confidence, which is, which we, you know, we benchmark just fine with all of our peers, but it does get added back into Diva. What I'm talking about is what our executives work on every single day. And we're very thoughtful about how we build budgets and who we hire and how much we improve compensation and those type of things. And so I think that's just a matter of the seriousness with which the team takes that. And that's why we're able to raise our EBITDA guidance by five along the top line. Normally, you see it as a percentage of that top line raise. So it's just being thoughtful about those efficiencies. I do think that it's also true that there's efficiencies to be gained that have been gained on the service cost line item. And that's, again, where a lot of the executives are working on that. And I think we've set ourselves up for longer-term success there as well. And it will start to show. And so I think those are some of the things that are sort of showing through on that. And I think we'll continue to get the benefit of the enhanced rate program pushing down through there as well, like we've been talking about. So that will continue for some time.
spk08: Awesome. Thanks, and best of luck, Tyson.
spk02: Thank you, Glenn.
spk01: Thank you. And our next question today comes from Sean Dodge at RBC Capital Markets. Please go ahead.
spk06: Yeah, thanks. Good afternoon. Maybe just going back to the enhanced product, and just to further clarify how those work, I know, John, you said you placed cash in those for five years, but you've also said before they're designed to produce more smoothness and yields over time so does that mean should we think about these being more like a variable rate product or is that smoothness coming more from the fact that these are layered in over the course of the year not all happening in lumps around the january time frame and and so as these roll uh kind of on their five-year ladders it's happening more intra-year instead of in january and that's where the smoothness is coming from maybe just to help clarify that
spk12: The answer is there are really three sources of this, and we thought quite a bit about this as we worked through these products. The first is the second point you mentioned, that is to say the fact that money, when you do cash, I'm sorry, I keep saying cash. When you do deposits, like you strike the deal and you send all the money, and that's it. Here, you do have the ability to layer money in, you know, kind of for lack of a better term, dollar cost average in and out. And so that does really help. And at some point, we're not gonna be talking about, if we have our way, we're not gonna be talking about tremendous uncertainty on this topic when we announce the December quarter and the like, and I'm sure you'll all look forward to that, as we will. The second factor is that the variable cash that we need to maintain, liquidity, is built into the instrument. So in the bank instruments, right, Yeah, they have a min and a max, but fundamentally, they still work like term deposits. We have separate cash today, about $500 million or about 3.5% of our total HSA cash that is in purely variable rate instruments. We need to have it there because that protects us against any liquidity issues. The liquidity is built into the contract, and so that's very helpful in terms of eliminating situations where you have, as occurred in March of 2020, very rapid changes in government policy and the like that produce big changes and particularly downward in variable rates. And then the third factor, which I guess we'll get into a little bit more, I'm sure this will be on the agenda, when we get to Investor Day, but is some stuff that is internal, I'll just say internal to the contracts, that is just really designed to some extent to provide a little bit of trade-off between rate and non-cyclicality. We really recognize that it's not in the interest of our investors, nor is it valuable in terms of managing the business for investors for people to start thinking about these dollars as anything other than what in the end they really are, which is fees. When we're fully exposed to deposit products, as we have been, though we've done everything in our power within that world to try and minimize that cyclicality, there's still, particularly when you're close to profound, there's quite a bit of it. That's the third factor, and again, we'll, I'm sure, go into details at some point. But take all these together, and it's not that there aren't going to be ups and downs. There are. But it should be the case, A, that the more money that goes into these products, the higher the neutral rate will be, and second, the less variability there will be with short-term changes in interest rates.
spk06: Okay, and then you said the goal is to transition 10%, give or take, of the deposits to these. It sounds like you're tracking at or slightly better than that. Is that still the way we should be thinking about that over the longer term, or are there opportunities out there at some point to start to accelerate how quickly you transition cash into the enhanced products?
spk12: Unless we can tell you otherwise, that's the way you should think about it.
spk06: Got it. Okay. Thanks again.
spk12: Thanks, Sean.
spk01: Thank you. And our next question today comes from Scott Schoenhaus with Stevens. Please go ahead.
spk00: Hi, guys. Can you hear me?
spk09: Hi, Scott.
spk14: Hi, Scott. Hi, guys. So congrats in Tyson. It is also a pleasure working with you. Good luck in your next adventure. So most of my questions have been asked. I just wanted to drill on the service fee side. How much of that was driven, the growth driven by, I think you talked last quarter about slightly raised fees versus the underlying improvement in, like, commuter, et cetera? If you could break out any differentiation, that would be great.
spk12: Well, if you look at it, service fees, particularly if you take the – If you look at it, service fees, I believe, grew slightly faster than accounts, than total accounts. It's a little tricky because most service fees come from CDBs and the like. I would say that the bigger issue here was volume driven. And we are starting to see some of the rate increases that we put out there and talked about in the first quarter start to come through in actual collected revenues and the like. But I think you're going to see a little more of that particularly as we get into the beginning of fiscal 25 as a critical factor. Of course, we also hope that volumes are up as well. But I think for the moment what you're seeing is a little more volume driven. on the top line.
spk05: Great. That's great, Paul.
spk14: Thanks, John. And then just on the balance sheet, $290 million plus of cash, anything changing in the M&A environment versus 90 days ago?
spk12: Thanks, Scott. We commented 90 days ago that we felt like kind of given the proximity to the deposit crisis on the bank side that Deals weren't likely, and that's why we went ahead and, if you recall, back at the end of April, we did a partial pay down on our Term A. We sort of just did the math, and it made sense. But I should say Tyson did the math, and then he showed it to me, and I said no like five times, and he kept showing it to me, and he was right. But... I think that with a little bit of distance from that, we are seeing a little bit of thaw. You've seen some transactions announced primarily in areas where the HSA is a piece of the business but not the whole of the business. Those generally aren't transactions that we're going to do at this point. You've seen a few of those. In truth, the fact that things like the move to enhance rates, the increased investment that we're making and presumably others who want to be competitive will make too, all those factors raise barriers to staying in the market. I do think that it's possible that over the next while you will see one or two of the larger players, I don't think the very top of the bracket, but in that area break free, and we're pleased to be in a position to be ready to do those transactions. The nice thing about them, as you know, is that from a shareholder perspective, we've done a number of these. We know we don't need any kind of banker multiple magic to make them work. We look at the IRR, and if the IRR works, we can do it. From a cash flow and leverage perspective, these portfolio-type transactions you know, start cash flowing on day one. And, you know, you're not having to muck around with, you know, synergies and all that we've dealt with in other transactions, but not in this type. So I guess I would say that's just a long way to say I think it's incrementally a little bit better. But I think particularly on the smaller transactions, you know, the like just plain old bank transfers that occur, a little less, still less of those. I think The small banks got a pretty good scare, and I think they're still pretty scared.
spk09: Thanks, Scott. Thank you.
spk01: Thanks. And our next question today comes from Alan Lutz with Bank of America. Please go ahead.
spk04: Good evening, and thanks for taking the questions. I guess one for Tyson. As we look at the custodial revenue, and I went back and looked at custodial revenue really since the IPO, and it's It goes up basically every quarter. Only in fiscal 21 did it really ever dip. But I guess I wanted to talk about the components of the about $4.5 million increase sequentially in custodial revenue in the quarter. Can you just talk about what were some of the drivers of that? And then should we see some of those sequential drivers impact revenue going from 2Q to 3Q this year?
spk05: Thanks.
spk04: Thanks.
spk02: Yeah, I mean, we have some deposits that occur in the middle of the year, which are smaller, Alan, so we make adjustments there. And as we feed money into enhanced rates as well, kind of operating, we've got to make sure we operate between the min and the max of the deposits on the FDIC side, but we can start to, you know, continue to feed dollars into the enhanced rate program. You see that start to accelerate as well. And so, as John said, we're a little ahead of schedule on our goals there, too. So that's part of the story. We've also continued to do a little bit better on how we monetize client health funds against the rate environment that's currently available to us. And so we make a little bit of improvement there. And I give credit. We got a new treasurer in there who's making improvements and looking for ways to squeeze more dimes and nickels out of this. And clearly he's doing a good job. And so it's kind of all those things amalgamated together.
spk12: Thanks, Tyson. If you're doing a year-on-year comparison, this is where I'm doing Richard's bidding, and I expect that to be noted, since I don't mostly do what Richard tells me to do. Looking for a compliment? Something. I'm just looking for acknowledgement, that's all. You know, occasional positive reinforcement. Last year... Two things happened that I think you're not going to see this year. And they happened in tandem. One is obviously rates took off, variable rates took off from zero. So the variable component was, in percentage terms, was a big boost that we didn't see coming at the beginning of the year. Or I should say, certainly wasn't there at the beginning of the year. And then second, and tied to that, we began this effort that Tyson referenced about generating custodial income from the CDB side of the business. And, you know, that was a lot of work over the course of a couple of years since the WageWorks transaction, because that's where most of that CDB, the CDB funds come from. And yet, you know, there wasn't a real hurry to start it up because marginal rates were, you know, you won't have that same ramp this year. So if someone's doing a year-on-year comparison, I think the better way to do that is to look at, you can look at where things are now, you can add whatever cash you think you can add to the current pile and take our rate guidance for what it is, and you'll have a pretty good view of what things are gonna be for the rest of the year. The rate guidance obviously implies about 10 basis points higher in the second half, and so the math's not that hard to do.
spk09: Very well done, John.
spk12: Thank you. Finally. Now I can dive in.
spk04: Thanks, John. One quick one, one quick last one. So, John, you talked about new logo growth and expanded network partner footprint is kind of supporting that. the growth for health equity. And then you talked about a 10% market growth rate. I guess as you think about some of the wins you're seeing this year, new logo growth, if I'm a prospective customer, what is the impetus to change or to switch vendors this year? Is there something different that's driving more customers to switch or is it just kind of more of the same? Thanks.
spk12: I think, and now we're getting into the realm of, like, speculation informed by data, which is the most dangerous kind, but I think there's two things that are happening, and I would invite Steve to comment on this as well. You know, the first is that I do think it's probably fair to say that there are some HR departments that are coming out of the pandemic, and in particular, coming out of in a period where they've already now seen one year of inflation and its impact on the wage side, but they didn't see as much of an impact on the benefit side until this year, and now they're seeing it, so there's a little more attention being paid to benefits design and do I have the right vendor mix to optimize what I'm trying to do on the benefit side, and I think we're a great partner in that environment. And then I think the second factor is that that it's becoming somewhat clear who's in this thing to win it. And I think the number of firms that are really there to do that is somewhat smaller than it was. But maybe Steve, as I say, Steve spends more time in airplanes than I do almost doing anything. So you're as qualified as I to speak to what's going on out there.
spk16: I think John nailed it. Alan, you know, if you just go back to the history, right, we did the wage deal right before COVID and COVID hit everyone and look, it took us a while to get everything lined up and integrated and getting the teams working together and regaining, frankly, trust from brokers and consultants and large employers and things like that that we could execute with the much bigger company, you know, going from 900 health equity teammates to 3,500 teammates after the acquisition to really be able to nail it. And I think we've regained a lot of that trust back. And whether it's a trust of a HR professional that knows that to make a big, it's a big deal, right, to move 5, 10,000 or even 500 or 1,000 of their folks over, they have to close the accounts, they have to reopen new ones, everything. They have to be pretty sure that they're going to the right solution. And so, I mean, I think the great thing about health equity is that our services has always been highly regarded. We were able to do a lot of these integrations and things like that. And now I think if you really talk to the market, talk to the consultants, talk to large employers, talk to small employers, midsize, and of course all of our health plan partners, they really believe that we're hitting our stride from the service perspective, which makes it a lot easier to make those kind of changes when you don't need to worry about just systems not working and things like that. So I think we're very well positioned. And then more macro, John already spoke to the fact that when you're just trying to hire people and you're dealing with great resignation and great transfer and all that other stuff, and now it's a little bit more of a rhythm to people's benefits, now's a good time to kind of say, all right, time to start looking at where we can really drive some deeper adoption of health savings accounts and things like that. And they know that we're the proven leader in that space of really helping their workforce embrace health savings accounts.
spk11: Thanks, Alan.
spk16: Thank you.
spk01: Thank you. And our next question today comes from George Hill with Deutsche Bank. Please go ahead.
spk10: Yeah. Good evening, guys, and thanks for taking the question. And Tyson, I'll echo the positive sentiments and great working with you. I guess, John, two quick ones for me, and I'll try to keep it brief. First, as you talked about the enterprise pipeline being robust, I don't know if there's any way you can quantify that or throw some numbers around it and kind of what's the strategy to gain share as we go through the upcoming selling season. And then I'll pause and come back with the second one.
spk12: Yeah, I got out of the game of giving sales pipeline numbers, and I'm not going to get back into it. That's two, two in one day. But let me say from a strategy perspective briefly, this isn't rocket science. We're the market leader across this bundle, and we're good people, and we have – If you were, you know, we're not going to like throw up NPS numbers and the like, but if you were to look at that data, you would see that where I think others have been a little more challenged over the last year or two. Particularly this last year, the team just busted its butt and delivered a, and I'm not using this word lightly, a remarkable open enrollment season. And if you think about the way enterprise works, a lot of those enterprise deals start during the – they kind of start – the sales cycle starts at the end of the prior year. And people can do things, like they can call your call center in January and see how long the wait is and see whether people are harried or not and all those kind of things. And so those things matter. And then lastly, George, I'll say from a strategy perspective – We are, and we are showing our clients where we are spending on, I'm cashing in my chips here, Richard, on the tech side. And people are seeing what we're doing. It's not like, we're not, as you know, we do press releases for features or clients. That's not what we do, right? But folks who are looking at our roadmap, who are looking what comes out every month or so, who are looking, and you'll see some of this over the course of the next six months, but there's really neat and interesting stuff going on, and what it basically just conveys is that, again, back to another comment, that we're at a place that relative to some of our competitors and certainly relative to other segments, we're very fortunate to be in a place where we can invest at a time where investing in the infrastructure, in the technology, in feature function, in product actually matters versus a period where there's not that much new happening. And so I think the enterprise that really gets to pay attention to that, whereas the small groups kind of don't, they're seeing that. And I think you're going to see it, too, over the course of the next year or so.
spk10: Okay. That's helpful. And I think I knew you weren't going to give me an answer to the pipeline question, so I have a follow-up, which I also appreciate. I'm not sure that you'll give me an answer to, but given that we talked about kind of the average, well, I know that the company historically is not, you guys don't think of yourself as in the business of prognosticating rates. However, people in my business are in the business of prognosticating rates. And given where we are in the rate cycle, do you guys ever think about proactively trying to extend duration? Because I imagine a lot of people in my business, if we're looking out three years, we probably think the next rate move is down versus up. So just kind of like, is there anything that you guys are seeing in the rate environment that kind of makes you want to change the way that you guys think about how you kind of put that custodial cash to work and duration and timing?
spk12: Yeah, so I'm going to give you an answer that is only slightly different than I've given to this question before, but the slight's probably relevant. Let me first say the answer we generally give is that from the perspective of the instrument's and the duration of the instruments in which we have invested, quote-unquote, in the HSA cash world, we've not, exactly as you say, we've not been prognosticators and we've tried to generally hold aggregate duration for liquidity in that kind of three-, four-year range. I will say one of the benefits of the enhanced rates product, one of the features that allows us to have some trade off around this is that we can meet our liquidity needs while the instruments in the portfolio are somewhat longer term instruments. While that wasn't particularly designed with a moment like this one in mind, a practical effect of it is to the extent that we're placing funds whether it's at the end of the last cycle or in this cycle and towards the end of this cycle, not by cycle, I mean year and so forth, we're going to be locking in, in that context, higher yields on those placements for an extended period of time. And so I do believe Again, I want to be thoughtful and cautious in saying that, first of all, when managing the company and expenses, we think about neutral rates because spending into a ... Honestly, we're not actually at neutral yet, if you think about it, but I do think there is a practical effect of the way we're doing this is that it is going to produce more benefit from this cycle than we've seen from prior cycles or than we would see if we were just, you know, using our same deposit instruments that we have in the past. Thanks, George.
spk10: That was relevant and helpful. Thank you.
spk05: Yes, sir.
spk01: And our next question today comes from Mark Macron with Baird. Please go ahead.
spk03: Mr. Macron. Yeah. Hey, first of all.
spk11: You don't want macaroon or macaroni.
spk03: We're really getting into the off-tangent, aren't we? We are. Hey, Tyson, it's been a pleasure working with you. In terms of the serious questions, just on the yield, you know, moving up so much on the cash, was that partially just due to the enhanced yield product just becoming a bigger portion of the overall deal because obviously Fed funds doesn't fully explain it. So I just wanted to 100% clarify that.
spk12: Yes. In addition, I would say during this period to the extent we had any bank placements and they would have been small. We've talked about before that the bank placement market is very favorable right now.
spk03: Great. And then if we take a look at investments, I mean 23% growth in terms of the investments they're obviously there's been an impact with regards to the overall market, but what are you seeing just in terms of the, the, uh, the behavior of the holders? Are they, are they starting to chase, you know, additional yield even through like, you know, intermediate bond products or anything along that line? Are you seeing any sort of movement from that perspective and how should we think about that?
spk12: Yeah. Thank you for asking that question, Mark. Um, we, we, um, Our portfolio offering does include things like ultra-short bond funds that kind of behave in the same manner as money market, but I think don't fuzz the distinction between insured by the federal government and not insured by the federal government. And so as sometimes you see with some of what our other folks in the marketplace might do, I don't think they intend to, but it's the practical effect. So, and those funds have been quite popular. So, I do think there's an element of this that is investor, that is member saying, you know what, I'd like to get more yield than I can get on cash. I know I'm not going to do anything with it. Let me put it in, you know, at least today, tomorrow. I'm willing to give up the clarity of, you and I'll put it in some of these products. I think there's some of that. I also think that every day there's an article in the paper that you can decide what the motivation is, but it's like, yeah, those 5% CD yields are great, but it still doesn't beat the stock market over the long term. And so there's some of that too. But I think it's probably fair to say that there's an element, and that's a win from our perspective, in that, well, sure, on that incremental dollar, you know, we might earn more if it were sitting in cash. You know, that's a customer that's going to be more sticky. We're giving them the product they want. We try to guide them to exactly the product that they're asking for. If they're getting capital A advice from us, that's part of the discussion. I mean, it's, I just think at the end of the day, and it, you know, while the rates we pay on cash are determined from a formula, Nonetheless, it's probably the availability of those products in part that has allowed not just us but the broader industry to kind of keep a lid on custodial expense. And so I guess I sort of think that's a win. That's how I think about it. Thanks, Mark.
spk06: Thanks.
spk12: Thank you, Mark.
spk01: And our next question today comes from David Larson at BTIG. Please go ahead.
spk07: Hi, congrats on a good quarter, and Tyson, it was great working with you. I thought you did a great job guiding the company through a very, very tough cycle. Can you maybe just talk about either John or Tyson, the revenue delta on interchange, 1Q versus 2Q, it's obviously down about 13%, and just any more clarity around the COBRA impact, and if you can describe what exactly that was, that would be very helpful. Thank you.
spk12: Tyson, you want to hit part A of that?
spk02: Yeah, on the interchange, David, I mean, that's just the normal seasonality. So we've got people essentially spending, you know, as they've loaded up the HSA accounts in the first part of the year, they're going to spend more. And then as we move into the summer months, you know, they're going to spend less as they're not – They're not home spending, actually. And so we always get that seasonality through. So you'll see a Q1 high point. You'll see a Q2, Q3 softer point. And then as we move into Q4, you've got the use it or lose it, and you've got kind of the remaining funds on those CDB accounts that get used up. And so you see a stronger Q4, and that's why you see that. And so that seasonality is a little funny in history, so it is hard to decipher that because – the COVID effect over, you know, quarters that are in history now, it doesn't look as smooth as just that seasonality I explained. So that's kind of one thing. And then, John, you're going to hit the Cobra side of it. Oh, go for it.
spk11: You're on a roll.
spk02: Yeah, and on the Cobra side of it, that's just, again, we've got, we've mentioned in the script a little bit of the legislative effect of that. And so with regards to FSA and Cobra, this has been That's been tough to forecast all the way through having the national emergency legislation out there. And with regards to COBRA, just the fact that people don't have the optionality to go into COBRA multi-year after exiting a job, that changes how we essentially drive revenue off of. of the different communications that we make to them, and also just the number of people that sign up, given the, I think, even the broader strength in the economy that maybe wasn't expected. So those are kind of the things that kind of push those things around.
spk07: Okay, great. And then I think what I'm hearing also is that in terms of like the risk of a recession or the risk of a slowdown next year, you're not seeing any of that in terms of demand. In fact, it's kind of the exact opposite. There's lots of demand. You're sending up a bunch of clients. Is that right?
spk12: I mean, I don't know that our clients in the human resources department are experts at predicting recessions, but, um, um, but I, I think people are, um, I think it's probably fair to say that, that, um, um, What's happening out there is that people are anticipating tighter conditions. Whether that's a recession or not, I don't know. But the effect of anticipating tighter conditions is that they're attentive to plan design and win-wins and things like that that we talked about earlier in the call. But in terms of when I look at the account numbers that change as a result of you know, that are a function just of new job ads and the like. I mean, our data are moving in tandem with the national data at this point. So I think there's nothing that would surprise you there.
spk07: Okay. And then I think you basically renegotiate your contracts every three years with your clients, which I think would imply that the yields that drive custodial revenue should continue to increase through next year, right? Yes.
spk12: Yeah, I would refer back to the answer on that one to, I think it was Glenn that asked a similar question. But just to say, our duration is three, but our bigger contracts, the deposit contracts themselves, you know, maybe four or five years. So you're going to see quite a few of these come through over the next couple of years. And also during, obviously, the last few years have been quite a bit of growth. So you need to, if you look at this, You need to go back to your reference year versus dividing today by that number.
spk07: Okay. And when you say you'll see quite a few of these in a favorable manner, I think is what you were saying, right?
spk12: Yes. Yeah. Yeah.
spk07: Okay. Okay. And then just lastly for me, your service gross margin. obviously showed some pretty good improvement. It got as high as, like, I think 38% in 2Q of 22. How high can your service gross margin trend to?
spk12: You know, we've talked about this in the past. I'm not able to make, like, long-run predictions. What I will say is we're targeting the total margin, and particularly as we reduce the cyclicality of the other components, you know, I think that makes a ton of sense. So I, I, um, but, but I do think we have some room to grow from here. I mean, um, we ought to be able over time to get this number back into the thirties. It may take us a little while, but the drivers of that are going to be, you know, first of all, particularly growth in the CDB businesses that, that are profitable. And then secondly, um, the, the, the underlying HSA account growth. And then third is going to be service tech, um, you know, where, where we can bring costs down and, um, we've delivered a little bit of that in this quarter and a little bit of last quarter. And, heck, we do a little of that each quarter. And at the end of this, we'll have a software business. I don't know. I'm just kidding. That won't be true. But it is an opportunity.
spk01: Thanks, man.
spk12: Thanks so much. Appreciate it. Thanks, David.
spk01: And our next question comes from Sandy Draper at Guggenheim.
spk13: Please go ahead. Thanks so much. Not a lot left to ask. So first I'll just say – We'll also echo Tyson. It's been a pleasure working with you. Hopefully we'll get to cross paths at some point in the future. I guess the first question, you know, if I just do the simple math of looking at the cash per account, it's down a touch. You know, I know that's just a one-day comparison last quarter to this quarter. Just trying to think, because you have much more visibility, and this sort of ties to what you were saying, John, about the investments. Is there any notable change in behavior you're seeing in the now versus maybe the past couple years about the desire for people to pay themselves back versus put the money in and not reimburse themselves? That would be the first question.
spk12: Now I have to ask how many there are going to be because, you know, after – I'm just glad Greg's already off the line to hear all these, like, eight-parters. No, I'm kidding, but here goes. Look, I think, first of all, you know, it is worth noting that if you look at total assets – for the quarter, this was actually a record growth period X Q4s. I mean, you're talking about close to a billion dollars in asset growth over the course of a single quarter, and that's really good. Also, if I break it down, and I think that the short answer here is gonna be that I don't think there's been very much difference other than the, as we talked about in an earlier question, you know, the increased interest in investment, no pun intended. Because if you look at Q2 contributions, they're up year over year exactly as you would expect. And it's just that the transfers from cash to investments were way up. And I think that just reflects, you know, it ultimately reflects a better market backdrop. I mean... you know, if I look at the same period a year ago, the S&P was off 13%. And during this period, you know, it was plus about the same number, a little bit more. And so, you know, better market backdrop and all that kind of stuff. But the underlying contribution behavior, which is I think really the thing you would care about, was kind of about the same. Spend was seasonally pretty much what we expected, so I don't think it's any fundamental change in spend behavior.
spk13: Okay, great. And then if Steve hasn't gotten bored and dropped off, maybe a quick one for him. You commented on the environment around sales, but Steve, you're our man on the ground in D.C. Anything coming out that you're hearing coming out of D.C., whether it's regarding Medicare, potential bigger step-ups and potential ability for people to invest or save in HSAs, anything new out of DC or is it really nothing's going on there right now? Thanks.
spk16: No, thanks. Thanks, Sandy. And I think on this very day, there's nothing going on in DC, but they are coming back. You know, we continue to have some fantastic discussions. And I think what, what kind of is different is that now these are more by bipartisan and we're just kind of focusing on what do Americans need and, and, you know, whether it's loosening up a little bit on some of the qualifying attributes around the high-deductible plan. And you've been around long enough, and thank you for all your support over the years, to remember that, you know, there was a lot of lack of clarity around things like preventative care, right? And that was actually clarified under the Trump administration that allowed people that started paying for more medications, first dollar and things like that, and still have a high-level plan, that helped. And so that was not only the help that they introduced it, but then the Biden administration has been very supportive of those, and they haven't changed that at all. So now when you look at, especially the large employers, and then plans are offered by health plans, and you look at their benefit design, you know, they are covering things like high blood pressure meds and diabetic meds and stuff like that as allowed by regulation. So I think that has actually plowed a little bit of the ground that we're trying to do, which is to say, all right, we all agree that every American needs what we would refer to as a custodial account, one that can work with any plan, obviously with the high deductible plan, we know that as the HSA, but are there other mechanisms to try and do that? And so, look, I I just, I'm, I'm encouraged by the bipartisan nature of the discussions. Uh, and despite everything that everyone sees when they turn on, you know, they're given a news station and how they think it's so torn apart. I haven't seen that when I've talked to Democrats and Republicans in Congress. And so we are hopeful that we'll continue to see some, um, what we refer to as HSA or other type of account expansion. allowing just more Americans to have the benefits of one of these portable, personally owned, investable accounts and what kind of plan they have. And so that's what we've been focused on. It's just saying, how can we expand that? But yeah, I mean, let's, you know, thanks for the question. I believe we're continuing to make progress and, you know, we're hopeful that certainly before the next presidential election, you know, there will be some bills introduced that can continue to expand the benefit. So we will make sure that as legislators make these decisions and they start to disseminate that information out, then we will pass it along. But it's just a constant educational game. Thanks, Andrew. And thank you for your musical talents over the years, too. I really appreciate your musical talents. Thanks.
spk01: Thank you. Ladies and gentlemen, this concludes our question and answer session. I'd like to turn the conference back over to John Kessler for closing remarks.
spk12: So, appreciate everyone and the kind comments for Tyson. For all he takes our teasing really well, always has, and is going to be genuinely missed within the organization. But, like, I think this is not going to be the last time most of you on this call will see Mr. Murdoch or hear Mr. Murdoch, and certainly will not be the last time I hear or see him. And, you know, we'll see how this Lucania guy does. But one way to find out is to book your flights now for February 22, 2024. This is big time. This is all, like, I mean, we're talking about Broadway College.
spk16: type stuff actually I have no idea but I do know that it will be yes I want to interject one thing on that so look we think we'll have a good winter and we would love to not only guide you through our business but maybe do some mountain guiding and maybe we can bring Tyson back to help us be one of the guys That's true. I felt the same, Tyson, as well. Tyson, thank you. You've been a wonderful teammate, and thank you for everything you've done for health equity.
spk05: Thanks, everybody. I really appreciate it. Thank you.
spk15: All right. That's it.
spk12: We'll see you all in December and some of you before then, and then, of course, in February. Thank you.
spk01: Bye.
spk12: Thank you, everybody.
spk01: This concludes today's conference call. Thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.
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