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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 31, 2019
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number: 001-36568
 
 
 
HEALTHEQUITY, INC.
 
 
 
(Exact name of registrant as specified in its charter)
Delaware
 
7389
 
52-2383166
(State or other jurisdiction of
incorporation or organization)
 
(Primary Standard Industrial
Classification Code Number)
 
(I.R.S. Employer
Identification Number)
15 West Scenic Pointe Drive
Suite 100
Draper, Utah 84020
(Address of principal executive offices) (Zip code)

(801) 727-1000
(Registrant's telephone Number, including Area Code)
 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common stock, par value $0.0001 per share
HQY
The NASDAQ Global Select Market
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
 
 
Emerging growth Company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No

As of August 30, 2019, there were 70,621,252 shares of the registrant's common stock outstanding.
 


Table of Contents

HealthEquity, Inc. and subsidiaries
Form 10-Q quarterly report

Table of contents
 
 
Page
Part I. FINANCIAL INFORMATION
 
Item 1.
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
Part II. OTHER INFORMATION
 
Item 1.
Item 1A.
Item 2.
Item 6.
 
 



-2-


Part I. Financial information
Item 1. Financial statements

HealthEquity, Inc. and subsidiaries
Condensed consolidated balance sheets
(in thousands, except par value)
July 31, 2019


January 31, 2019

 
(unaudited)

 
 
Assets



Current assets



Cash and cash equivalents
$
815,160


$
361,475

Accounts receivable, net of allowance for doubtful accounts as of July 31, 2019 and January 31, 2019 of $105 and $125, respectively
27,357


25,668

Other current assets
10,999


7,534

Total current assets
853,516


394,677

Investments
81,839

 
709

Property and equipment, net
9,873


8,223

Operating lease right-of-use assets
36,716

 

Intangible assets, net
88,768


79,666

Goodwill
4,651


4,651

Deferred tax asset
666


1,677

Other assets
22,311


20,413

Total assets
$
1,098,340


$
510,016

Liabilities and stockholders’ equity



Current liabilities



Accounts payable
$
2,740


$
3,520

Accrued compensation
11,055


16,981

Accrued liabilities
19,392


8,552

Operating lease liabilities
3,954

 

Total current liabilities
37,141


29,053

Operating lease liabilities, non-current
35,660

 

Deferred tax liability
7,773


916

Other long-term liabilities
735


2,968

Total liabilities
81,309


32,937

Commitments and contingencies (see note 6)



Stockholders’ equity



Preferred stock, $0.0001 par value, 100,000 shares authorized, no shares issued and outstanding as of July 31, 2019 and January 31, 2019, respectively



Common stock, $0.0001 par value, 900,000 shares authorized, 70,603 and 62,446 shares issued and outstanding as of July 31, 2019 and January 31, 2019, respectively
7


6

Additional paid-in capital
783,986


305,223

Accumulated earnings
233,038


171,850

Total stockholders’ equity
1,017,031


477,079

Total liabilities and stockholders’ equity
$
1,098,340


$
510,016

See accompanying notes to condensed consolidated financial statements.


-3-


HealthEquity, Inc. and subsidiaries
Condensed consolidated statements of operations and
comprehensive income (unaudited)

(in thousands, except per share data)
Three months ended July 31,
 

Six months ended July 31,
 
2019


2018


2019


2018

Revenue:



 
 
 
 
Service revenue
$
26,282

 
$
24,935

 
$
53,090

 
$
49,756

Custodial revenue
43,614

 
30,715

 
85,566

 
59,149

Interchange revenue
16,727

 
15,417

 
35,019

 
32,066

Total revenue
86,623

 
71,067

 
173,675

 
140,971

Cost of revenue:
 
 
 
 

 
 
Service costs
19,745

 
17,199

 
40,394

 
35,246

Custodial costs
4,209

 
3,502

 
8,332

 
6,941

Interchange costs
4,229

 
3,791

 
8,756

 
7,853

Total cost of revenue
28,183

 
24,492

 
57,482

 
50,040

Gross profit
58,440

 
46,575

 
116,193

 
90,931

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
8,391

 
7,243

 
17,361

 
14,103

Technology and development
11,645

 
8,398

 
22,550

 
16,377

General and administrative
9,262

 
7,893

 
17,971

 
15,400

Amortization of acquired intangible assets
1,494

 
1,478

 
2,985

 
2,948

Merger integration
2,784

 

 
2,784

 

Total operating expenses
33,576

 
25,012

 
63,651

 
48,828

Income from operations
24,864

 
21,563

 
52,542

 
42,103

Other income (expense), net
(1,128
)
 
(75
)
 
22,472

 
(76
)
Income before income taxes
23,736

 
21,488

 
75,014

 
42,027

Income tax provision (benefit)
4,370

 
(1,029
)
 
13,826

 
(3,067
)
Net income and comprehensive income
$
19,366


$
22,517


$
61,188


$
45,094

Net income per share:



 
 
 
 
Basic
$
0.30

 
$
0.36

 
$
0.97

 
$
0.73

Diluted
$
0.30

 
$
0.36

 
$
0.94

 
$
0.72

Weighted-average number of shares used in computing net income per share:
 
 
 
 
 
 
 
Basic
64,220

 
61,880

 
63,289

 
61,531

Diluted
65,583

 
63,397

 
64,785

 
63,060

See accompanying notes to condensed consolidated financial statements.

-4-


HealthEquity, Inc. and subsidiaries
Condensed consolidated statements of stockholders’ equity (unaudited)

(in thousands)
Three months ended July 31,
 
 
Six months ended July 31,
 
2019

 
2018

 
2019

 
2018

Total stockholders' equity, beginning balances
$
529,299

 
$
396,974

 
$
477,079

 
$
346,274

 
 
 
 
 
 
 
 
Common stock:
 
 
 
 
 
 
 
Beginning balance
6

 
6

 
6

 
6

Issuance of common stock upon exercise of stock options, and for restricted stock

 

 

 

Issuance of common stock
1

 

 
1

 

Ending balance
7

 
6

 
7

 
6

Additional paid-in capital:
 
 
 
 
 
 
 
Beginning balance
315,621

 
276,440

 
305,223

 
261,237

Issuance of common stock upon exercise of stock options, and for restricted stock
2,281

 
7,640

 
6,651

 
18,604

Other issuance of common stock
458,494

 

 
458,494

 

Stock-based compensation
7,590

 
5,488

 
13,618

 
9,727

Ending balance
783,986

 
289,568

 
783,986

 
289,568

Accumulated comprehensive loss:
 
 
 
 
 
 
 
Beginning balance

 

 

 
(269
)
Cumulative effect from adoption of ASU 2016-01

 

 

 
269

Ending balance

 

 

 

Accumulated earnings:
 
 
 
 
 
 
 
Beginning balance
213,672

 
120,528

 
171,850

 
85,300

Net income
19,366

 
22,517

 
61,188

 
45,094

Cumulative effect from adoption of ASC 606

 

 

 
13,007

Cumulative effect from adoption of ASU 2016-01

 

 

 
(356
)
Ending balance
$
233,038

 
$
143,045

 
$
233,038

 
$
143,045

 
 
 
 
 
 
 
 
Total stockholders' equity, ending balances
$
1,017,031

 
$
432,619

 
$
1,017,031

 
$
432,619

See accompanying notes to condensed consolidated financial statements.


-5-


HealthEquity, Inc. and subsidiaries
Condensed consolidated statements of cash flows (unaudited)


Six months ended July 31,
 
(in thousands)
2019


2018

Cash flows from operating activities:



Net income
$
61,188


$
45,094

Adjustments to reconcile net income to net cash provided by operating activities:



Depreciation and amortization
9,722


8,916

Unrealized (gains) losses on marketable equity securities and other
(27,180
)

86

Deferred taxes
7,868


2,351

Stock-based compensation
13,618


9,727

Changes in operating assets and liabilities:





Accounts receivable
(1,689
)

(3,304
)
Other assets
(5,036
)

(6,921
)
Operating lease right-of-use assets
1,286

 

Accounts payable
(1,083
)

(837
)
Accrued compensation
(5,926
)

(2,826
)
Accrued liabilities and other current liabilities
4,942


56

Operating lease liabilities, non-current
(1,210
)
 

Other long-term liabilities
331


298

Net cash provided by operating activities
56,831


52,640

Cash flows from investing activities:



Purchases of intangible member assets
(1,736
)

(1,014
)
Purchases of marketable equity securities and other
(53,845
)

(368
)
Purchases of property and equipment
(3,492
)

(2,690
)
Purchases of software and capitalized software development costs
(9,518
)

(4,701
)
Net cash used in investing activities
(68,591
)

(8,773
)
Cash flows from financing activities:



Proceeds from follow-on equity offering, net of payments for offering costs
458,881

 

Proceeds from exercise of common stock options
6,564


18,469

Net cash provided by financing activities
465,445


18,469

Increase in cash and cash equivalents
453,685


62,336

Beginning cash and cash equivalents
361,475


199,472

Ending cash and cash equivalents
$
815,160


$
261,808

Supplemental cash flow data:
 
 
 
Interest expense paid in cash
$
101

 
$
101

Income taxes paid in cash, net of refunds received
9,119

 
554

Supplemental disclosures of non-cash investing and financing activities:



Purchases of property and equipment included in accounts payable or accrued liabilities at period end
$
3


$
14

Purchases of software and capitalized software development costs included in accounts payable or accrued liabilities at period end
487


175

Purchases of intangible member assets accrued during the period
6,500

 
181

Exercise of common stock options receivable
87


135

Follow-on equity offering costs accrued during the period
386

 

Debt issuance costs accrued during the period
345

 

See accompanying notes to condensed consolidated financial statements.

-6-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)



Note 1. Summary of business and significant accounting policies
Business
HealthEquity, Inc. was incorporated in the state of Delaware on September 18, 2002. The Company offers a full range of innovative solutions for managing health care accounts (Health Savings Accounts ("HSAs"), Health Reimbursement Arrangements, and Flexible Spending Accounts) for health plans, insurance companies, and third-party administrators.
Merger with WageWorks, Inc.
On June 26, 2019, HealthEquity, Inc. entered into an Agreement and Plan of Merger (the “Merger Agreement”) with WageWorks, Inc., a Delaware corporation (“WageWorks”), and a wholly owned subsidiary of HealthEquity, Inc. (“Merger Sub”), pursuant to which, on the terms and subject to the conditions therein, Merger Sub would merge with and into WageWorks (the “Merger”), with WageWorks surviving the Merger and becoming a wholly owned subsidiary of HealthEquity, Inc. On August 30, 2019, the Merger closed and HealthEquity, Inc. paid approximately $2.0 billion in cash to WageWorks stockholders.
The Merger is expected to give HealthEquity, Inc. access to more of the HSA market by expanding its direct distribution to employers and benefits advisors as a single source provider of HSAs and consumer-directed benefits ("CDBs"), including flexible spending accounts, health reimbursement arrangements, COBRA administration and commuter accounts.
Principles of consolidation
The condensed consolidated financial statements include the accounts of HealthEquity, Inc. and its wholly owned subsidiaries, HealthEquity Trust Company, HEQ Insurance Services, Inc., HealthEquity Advisors, LLC, and HealthEquity Retirement Services, LLC (collectively referred to as the "Company").
As of July 31, 2019, the Company held a 4% ownership interest in WageWorks. The Company measured the investment at fair value, and all unrealized gains on the investment were recognized in other income (expense), net in the condensed consolidated statements of operations and comprehensive income. The investment was valued at $81.1 million as of July 31, 2019 and is included in investments on the accompanying condensed consolidated balance sheet.
The Company has a 22% ownership interest in a limited partnership for investment in and the management of early stage companies in the healthcare industry; this partnership interest is accounted for using the equity method of accounting. The investment was approximately $0.2 million as of July 31, 2019 and is included in investments on the accompanying condensed consolidated balance sheet.
The Company has a 1% ownership interest in a limited partnership that engages in the development of technology-based financial healthcare products. The Company elected the measurement alternative for non-marketable equity investments to account for the investment. The investment was valued at $0.5 million as of July 31, 2019 and is included in investments on the accompanying condensed consolidated balance sheet.
Acquisitions of businesses are accounted for as business combinations, and accordingly, the results of operations of acquired businesses are included in the condensed consolidated financial statements from the date of acquisition. All significant intercompany balances and transactions have been eliminated.
Basis of presentation
The accompanying condensed consolidated financial statements as of July 31, 2019 and for the three and six months ended July 31, 2019 and 2018 are unaudited and have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP") and the applicable rules and regulations of the Securities and Exchange Commission ("SEC") regarding interim financial reporting. In the opinion of management, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for the interim periods. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company's Annual Report

-7-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 1. Summary of business and significant accounting policies (continued)

on Form 10-K for the year ended January 31, 2019. The fiscal year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.
Certain reclassifications have been made to prior year amounts to conform to the current year presentation.
For the three and six months ended July 31, 2019, the Company added a new expense line item (Merger integration) on the condensed consolidated statements of operations and comprehensive income, which includes professional fees and all other internal and external costs directly related to the integration activities as a result of the Merger.
Follow-on equity offering
On July 12, 2019, the Company closed a follow-on public offering of 7,762,500 shares of common stock at a public offering price of $61.00 per share, less the underwriters' discount. The Company received net proceeds of approximately $458.5 million after deducting underwriting discounts and commissions of approximately $14.1 million and other offering expenses payable by the Company of approximately $0.9 million.
Significant accounting policies
There have been no material changes in the Company’s significant accounting policies, other than the additions of the policies described below for leases and investments in equity securities, as compared to the significant accounting policies described in the Company’s Annual Report on Form 10-K for the year ended January 31, 2019.
Leases. The Company determines if a contract contains a lease at inception or any modification of the contract. A contract contains a lease if the contract conveys the right to control the use of an identified asset for a specified period in exchange for consideration. Control over the use of the identified asset means the lessee has both (a) the right to obtain substantially all of the economic benefits from the use of the asset and (b) the right to direct the use of the asset.
The Company has entered into various operating leases consisting of office space and data storage facilities with remaining lease terms of approximately 3 to 11 years, often with one or more Company options to renew. These renewal terms can extend the lease term from 3 to 10 years and are included in the lease term when it is reasonably certain that the Company will exercise the option. Leases with an expected term of 12 months or less at commencement are not accounted for on the balance sheet. All operating lease expense is recognized on a straight-line basis over the expected lease term. Certain leases also include obligations to pay for non-lease services, such as utilities and common area maintenance. The services are accounted for separately from lease components, and the Company allocates payments to the lease and other services components based on estimated stand-alone prices.
Operating lease right-of-use ("ROU") assets and liabilities are recognized based on the present value of future minimum lease payments over the expected lease term at commencement date. As the rate implicit in each lease is not readily determinable, management uses the Company’s incremental borrowing rate based on the information available at commencement date in determining the present value of future payments. The Company used its incremental borrowing rate on February 1, 2019 for all leases that commenced prior to that date.
Operating leases are included in operating lease right-of-use assets, operating lease liabilities and operating lease liabilities, non-current on the condensed consolidated balance sheets beginning February 1, 2019.
Investments. Marketable equity securities are strategic equity investments with readily determinable fair values and for which the Company does not have the ability to exercise significant influence are accounted for at fair value and are classified as investments on the condensed consolidated balance sheets. All gains and losses on these investments, realized and unrealized, are recognized in other income (expense), net in the condensed consolidated statements of operations and comprehensive income.
Non-marketable equity securities are strategic equity investments without readily determinable fair values and for which the Company does not have the ability to exercise significant influence are accounted for using the measurement alternative and are classified as investments on the condensed consolidated balance sheets. All gains and losses on these investments, realized and unrealized, are recognized in other income (expense), net on the condensed consolidated statements of operations and comprehensive income.

-8-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 1. Summary of business and significant accounting policies (continued)

Equity method investments are equity securities in investees the Company does not control but over which the Company has the ability to exercise significant influence. Equity-method investments are included in investments on the condensed consolidated balance sheets. The Company's share of the earnings or losses as reported by equity-method investees, amortization of basis differences, and related gains or losses, if any, are recognized in other income (expense), net on the condensed consolidated statements of operations and comprehensive income.
The Company assesses whether an other-than-temporary impairment loss on equity method investments and an impairment loss on non-marketable equity securities has occurred due to declines in fair value or other market conditions. If any impairment is considered other than temporary for equity method investments or impairment is identified for non-marketable equity securities, the Company will write down the investment to its fair value and record the corresponding charge through other income (expense), net in the condensed consolidated statements of operations and comprehensive income. See Note 3—Supplemental financial statement information for additional information.
Recent adopted accounting pronouncements
In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-02, Leases (codified as "ASC 842"), which requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous guidance. ASC 842 requires that a lessee recognize a liability to make lease payments (the lease liability) and a ROU asset representing its right to use the underlying asset for the lease term on the balance sheet.
The Company adopted ASC 842 on February 1, 2019 using the modified retrospective transition method with the adoption date as the date of initial application. Consequently, prior period balances and disclosures have not been restated. The Company has elected the package of practical expedients, which allows the Company not to reassess (1) whether any expired or existing contracts as of the adoption date contain a lease, (2) lease classification for any expired or existing leases as of the adoption date and (3) initial direct costs for any existing leases as of the adoption date. The adoption of ASC 842 on February 1, 2019 resulted in the recognition on the Company's condensed consolidated balance sheet of both operating lease liabilities of $40.6 million and ROU assets of $38.0 million, which equals the lease liabilities net of accrued rent previously recorded on its consolidated balance sheet under previous guidance. The adoption of ASC 842 did not have an impact on the Company's condensed consolidated statement of operations, stockholders’ equity and cash flows for the three and six-month period ended July 31, 2019.
Recent issued accounting pronouncements
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which requires financial assets measured at amortized cost be presented at the net amount expected to be collected. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. The Company does not plan to early adopt this ASU. As a result of the Merger, the Company is currently evaluating the potential effect of this ASU on the consolidated financial statements.
In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment, which removes step two from the goodwill impairment test. As a result, an entity should perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting units' fair value. This ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the timing of adoption; however, it does not believe this ASU will have a material impact on the Company's consolidated financial statements.
In August 2018, FASB issued ASU 2018-13, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which amends ASC 820, "Fair Value Measurement." ASU 2018-13 modifies the disclosure requirements for fair value measurements by removing, modifying and adding certain disclosures. This ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted. As a result of the Merger, the Company is currently evaluating the potential effect of this ASU on the consolidated financial statements.

-9-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 1. Summary of business and significant accounting policies (continued)

In August 2018, the FASB issued ASU 2018-15, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASU allows the capitalization of implementation costs incurred in a hosting arrangement. This ASU is effective for fiscal years beginning after December 15, 2019. As a result of the Merger, the Company is currently evaluating the potential effect of this ASU on the consolidated financial statements.
Note 2. Net income per share
The following table sets forth the computation of basic and diluted net income per share:
(in thousands, except per share data)
 
Three months ended July 31,
 
 
Six months ended July 31,
 
 
2019

 
2018

 
2019

 
2018

Numerator (basic and diluted):
 
 
 
 
 
 
 
 
Net income
 
$
19,366

 
$
22,517

 
$
61,188

 
$
45,094

Denominator (basic):
 
 
 
 
 
 
 
 
Weighted-average common shares outstanding
 
64,220

 
61,880

 
63,289

 
61,531

Denominator (diluted):
 
 
 
 
 
 
 
 
Weighted-average common shares outstanding
 
64,220

 
61,880

 
63,289

 
61,531

Weighted-average dilutive effect of stock options and restricted stock units
 
1,363

 
1,517

 
1,496

 
1,529

Diluted weighted-average common shares outstanding
 
65,583

 
63,397

 
64,785

 
63,060

Net income per share:
 
 
 
 
 
 
 
 
Basic
 
$
0.30

 
$
0.36

 
$
0.97

 
$
0.73

Diluted
 
$
0.30

 
$
0.36

 
$
0.94

 
$
0.72


For the three months ended July 31, 2019 and 2018, approximately 0.3 million and 0.1 million shares, respectively, attributable to stock options and restricted stock units were excluded from the calculation of diluted earnings per share as their inclusion would have been anti-dilutive.
For the six months ended July 31, 2019 and 2018, approximately 0.3 million and 0.1 million shares, respectively, attributable to stock options, restricted stock units were excluded from the calculation of diluted earnings per share as their inclusion would have been anti-dilutive.
Note 3. Supplemental financial statement information
Selected condensed consolidated balance sheet and condensed consolidated statement of operations and comprehensive income components consist of the following:
Property and equipment
Property and equipment consisted of the following as of July 31, 2019 and January 31, 2019:
(in thousands)
 
July 31, 2019

 
January 31, 2019

Leasehold improvements
 
$
4,288

 
$
3,583

Furniture and fixtures
 
5,201

 
4,476

Computer equipment
 
11,279

 
9,242

Property and equipment, gross
 
20,768

 
17,301

Accumulated depreciation
 
(10,895
)
 
(9,078
)
Property and equipment, net
 
$
9,873

 
$
8,223


Depreciation expense for the three months ended July 31, 2019 and 2018 was $1.0 million and $0.8 million, respectively, and $1.8 million and $1.7 million for the six months ended July 31, 2019 and 2018, respectively.

-10-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 3. Supplemental financial statement information (continued)

Investments
Investments consisted of the following equity investments as of July 31, 2019 and January 31, 2019:
(in thousands)
 
July 31, 2019

 
January 31, 2019

Marketable equity securities, at fair value
 
$
81,130

 
$

Non-marketable equity securities
 
500

 
500

Equity method investments
 
209

 
209

Total equity investments
 
$
81,839

 
$
709


Unrealized gain recognized during the six months ended July 31, 2019 for equity investments held as of July 31, 2019 was $27.3 million, which was attributable to an increase in fair value of WageWorks common stock. In connection with the closing of the Merger on August 30, 2019, the Company's investment in WageWorks common stock was canceled.
Other income (expense), net
Other income (expense), net, consisted of the following:
 
 
Three months ended July 31,
 
 
Six months ended July 31,
 
(in thousands)
 
2019

 
2018

 
2019

 
2018

Interest income, net
 
$
1,817

 
$
234

 
$
3,097

 
$
425

Unrealized gain on marketable equity securities
 
3,774

 

 
27,285

 

Acquisition costs
 
(6,596
)
 
(224
)
 
(7,780
)
 
(225
)
Other
 
(123
)
 
(85
)
 
(130
)
 
(276
)
Total other income (expense), net
 
$
(1,128
)
 
$
(75
)
 
$
22,472

 
$
(76
)

Note 4. Leases
The Company has entered into various non-cancelable operating lease agreements for office space and data storage facilities with remaining lease terms of approximately 3 to 11 years, often with one or more Company options to renew. These renewal terms can extend the lease term from 3 to 10 years and are included in the lease term when it is reasonably certain that the Company will exercise the option.
The components of operating lease costs, lease term and discount rate are as follows:
 
 
Three months ended

 
Six months ended

(in thousands, except for term and percentages)
 
July 31, 2019

 
July 31, 2019

Operating lease expense
 
$
1,086

 
$
2,160

 
 
 
 
 
Weighted average remaining lease term
 
11.24 years

Weighted average discount rate
 
4.37
%


-11-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 4. Leases (continued)

Maturities of operating lease liabilities as of July 31, 2019 were as follows:
Fiscal year ending January 31, (in thousands)
 
Operating leases

Remaining 2020
 
$
2,013

2021
 
4,105

2022
 
4,205

2023
 
4,233

2024
 
4,288

Thereafter
 
31,930

Total lease payments
 
50,774

Less imputed interest
 
(11,160
)
Present value of lease liabilities
 
$
39,614

 
 
 
Current
 
$
3,954

Non-current
 
35,660

Total lease liabilities
 
$
39,614


As of July 31, 2019, the Company had an additional operating lease for office space that has not yet commenced with undiscounted lease payments of $17.1 million. This operating lease will commence in fiscal year 2021 with a lease term of approximately 11 years.
Supplemental cash flow information related to the Company's operating leases was as follows:
 
 
Three months ended

 
Six months ended

(in thousands)
 
July 31, 2019

 
July 31, 2019

Cash paid for amounts included in the measurement of lease liabilities:
 
 
 
 
Operating cash flows from operating leases
 
$
852

 
$
1,829

ROU assets obtained in exchange for new operating lease obligations
 
$

 
$
199


Note 5. Intangible assets and goodwill
Intangible assets
During the three months ended July 31, 2019, the Company acquired the right to act as custodian of a portfolio of HSA Members for $6.5 million, which is expected to be paid in October 2019 upon conversion of the accounts to the Company's proprietary platform. The cost was recorded in accrued liabilities on the condensed consolidated balance sheet and allocated to acquired intangible member assets as of July 31, 2019. The Company has determined the acquired intangible member assets to have a useful life of 15 years. The assets will be amortized using the straight-line amortization method, which has been determined appropriate to reflect the pattern over which the economic benefits of existing member assets are realized.
During the three months ended July 31, 2019 and 2018, the Company capitalized software development costs of $4.0 million and $2.1 million, respectively, and $7.7 million and $4.2 million for the six months ended July 31, 2019 and 2018, respectively, related to significant enhancements and upgrades to its proprietary system.

-12-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 5. Intangible assets and goodwill (continued)


The gross carrying amount and associated accumulated amortization of intangible assets were as follows as of July 31, 2019 and January 31, 2019:
(in thousands)

July 31, 2019


January 31, 2019

Amortized intangible assets:

 
 
 
Capitalized software development costs

$
48,410

 
$
40,583

Software

6,430

 
4,252

Other intangible assets

2,882

 
2,882

Acquired intangible member assets

92,084

 
85,110

Intangible assets, gross

149,806

 
132,827

Accumulated amortization

(61,038
)
 
(53,161
)
Intangible assets, net

$
88,768

 
$
79,666


During the three months ended July 31, 2019 and 2018, the Company expensed a total of $3.8 million and $3.4 million, respectively, and $7.7 million and $6.6 million for the six months ended July 31, 2019 and 2018, respectively, in software development costs primarily related to the post-implementation and operation stages of its proprietary software.
Amortization expense for the three months ended July 31, 2019 and 2018 was $4.0 million and $3.5 million, respectively, and $7.9 million and $7.2 million for the six months ended July 31, 2019 and 2018, respectively.
Goodwill
There were no changes to the goodwill carrying value during the three and six months ended July 31, 2019 and 2018.
Note 6. Commitments and contingencies
The Company’s principal commitments consist of operating lease obligations for office space and data storage facilities, a processing services agreement with a vendor, and contractual commitments related to network infrastructure, equipment, and certain maintenance agreements under long-term, non-cancelable operating leases. These commitments as of January 31, 2019 are disclosed in the Company’s consolidated financial statements included in its Annual Report on Form 10-K for the year ended January 31, 2019, and except for the entry into the Merger Agreement with WageWorks, providing for the acquisition of WageWorks for approximately $2.0 billion in cash, did not change materially during the three and six months ended July 31, 2019.
Note 7. Indebtedness
On September 30, 2015, the Company entered into a credit facility (the "Prior Credit Agreement") that provided for a secured revolving credit facility in the aggregate principal amount of $100.0 million for a term of five years. No amounts were drawn under the Prior Credit Agreement as of July 31, 2019.
Borrowings under the Prior Credit Agreement bore interest equal to, at the Company's option, a) an adjusted LIBOR rate or b) a customary base rate, in each case with an applicable spread determined based on the Company's leverage ratio as of the most recent fiscal quarter. The applicable spread for borrowing under the Prior Credit Agreement ranged from 1.50% to 2.00% with respect to adjusted LIBOR rate borrowings and 0.50% to 1.00% with respect to customary base rate borrowings. The Company paid a commitment fee of 0.20% on the daily amount of the unused commitments under the Prior Credit Agreement in arrears at the end of each fiscal quarter.
The Company's material subsidiaries were required to guarantee the obligations of the Company under the Prior Credit Agreement. The obligations of the Company and the guarantors under the Prior Credit Agreement and the guarantees were secured by substantially all assets of the Company and the guarantors, subject to customary exclusions and exceptions.

Note 7. Indebtedness (continued)

-13-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

The Prior Credit Agreement required the Company to maintain a total leverage ratio of not more than 3.00 to 1.00 as of the end of each fiscal quarter and a minimum interest coverage ratio of at least 3.00 to 1.00 as of the end of each fiscal quarter. In addition, the Prior Credit Agreement included customary representations and warranties, affirmative and negative covenants, and events of default. The restrictive covenants included customary restrictions on the Company's ability to incur additional indebtedness; make investments, loans or advances; grant or incur liens on assets; engage in mergers, consolidations, liquidations or dissolutions; engage in transactions with affiliates; and make dividend payments. The Company was in compliance with these covenants as of July 31, 2019.
In connection with the closing of the Merger on August 30, 2019, the Company entered into a new $1.6 billion credit agreement (the "Credit Agreement"), which replaced the Prior Credit Agreement, consisting of (i) a five-year senior secured term loan A facility in the aggregate principal amount of $1.25 billion, the net proceeds of which were used by the Company to finance the Merger and related transactions, and (ii) a five-year senior secured revolving credit facility in an aggregate principal amount of up to $350 million. For a description of the terms of the Credit Agreement, refer to Note 11—Subsequent events of the Notes to condensed consolidated financial statements.
Note 8. Income taxes
The Company follows FASB Accounting Standards Codification 740-270, Income Taxes - Interim Reporting, for the computation and presentation of its interim period tax provision. Accordingly, management estimated the effective annual tax rate and applied this rate to the year-to-date pre-tax book income to determine the interim provision for income taxes. For the three and six months ended July 31, 2019, the Company recorded income tax expense of $4.4 million and $13.8 million, respectively. This resulted in an effective income tax expense rate of 18.4% for each of the three and six months ended July 31, 2019, compared with an effective income tax benefit rate of 4.8% and 7.3% for the three and six months ended July 31, 2018, respectively. For the three and six months ended July 31, 2019 and 2018, the net impact of discrete tax items caused a 4.8 and 4.6 percentage point decrease and a 27.0 and 29.5 percentage point decrease, respectively, to the effective income tax rate primarily due to the excess tax benefit on stock-based compensation expense recognized in the provision for income taxes in the condensed consolidated statements of operations and comprehensive income. The increase in the effective income tax rate from the same period last year is primarily due to a decrease in excess tax benefits on stock-based compensation expense recognized in the provision for income taxes relative to pre-tax book income.
As of July 31, 2019 and January 31, 2019, the Company’s total gross unrecognized tax benefit was $2.0 million and $1.7 million, respectively. Certain unrecognized tax benefits have been netted against their related deferred tax assets. As of July 31, 2019, an unrecognized tax benefit of $0.4 million was recorded. As of January 31, 2019, no unrecognized tax benefit had been recorded. If recognized, $1.9 million of the total gross unrecognized tax benefits would affect the Company's effective tax rate as of July 31, 2019.
The Company files income tax returns with U.S. federal and state taxing jurisdictions and is not currently under examination with any jurisdiction. The Company remains subject to examination by federal and various state taxing jurisdictions for tax years after 2003.
Note 9. Stock-based compensation
The following table shows a summary of stock-based compensation in the Company's condensed consolidated statements of operations and comprehensive income during the periods presented:


Three months ended July 31,
 
 
Six months ended July 31,
 
(in thousands)

2019


2018

 
2019

 
2018

Cost of revenue

$
1,010


$
807

 
$
1,869

 
$
1,220

Sales and marketing

1,158


891

 
2,166

 
1,596

Technology and development

1,930


1,300

 
3,429

 
2,291

General and administrative

3,492


2,490

 
6,154

 
4,620

Total stock-based compensation expense

$
7,590


$
5,488

 
$
13,618

 
$
9,727



-14-

Table of Contents

HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 9. Stock-based compensation (continued)


The following table shows stock-based compensation by award type:


Three months ended July 31,
 
 
Six months ended July 31,
 
(in thousands)

2019


2018

 
2019

 
2018

Stock options

$
1,727


$
1,983

 
$
3,510

 
$
3,747

Performance stock options



172

 

 
325

Restricted stock units

3,694


2,045

 
6,619

 
3,587

Performance restricted stock units

1,393


536

 
2,044

 
1,050

Restricted stock awards

164


171

 
327

 
226

Performance restricted stock awards

612


581

 
1,118

 
792

Total stock-based compensation expense

$
7,590


$
5,488

 
$
13,618

 
$
9,727


Stock options
The Company currently grants stock options under the 2014 Equity Incentive Plan (as amended and restated, the "Incentive Plan"), which provided for the issuance of stock options to the directors and team members of the Company to purchase up to an aggregate of 2.6 million shares of common stock.
In addition, under the Incentive Plan, the number of shares of common stock reserved for issuance under the Incentive Plan automatically increases on February 1 of each year, beginning as of February 1, 2015 and continuing through and including February 1, 2024, by 3% of the total number of shares of the Company’s capital stock outstanding on January 31 of the preceding fiscal year, or a lesser number of shares determined by the board of directors.
Under the terms of the Incentive Plan, the Company has the ability to grant incentive and nonqualified stock options. Incentive stock options may be granted only to Company team members. Nonqualified stock options may be granted to Company executive officers, other team members, directors and consultants. Such options are to be exercisable at prices, as determined by the board of directors, which must be equal to no less than the fair value of the Company's common stock at the date of the grant. Stock options granted under the Incentive Plan generally expire 10 years from the date of issuance, or are forfeited 90 days after termination of employment. Shares of common stock underlying stock options that are forfeited or that expire are returned to the Incentive Plan.
Valuation assumptions. The Company has adopted the provisions of Topic 718, which requires the measurement and recognition of compensation for all stock-based awards made to team members and directors, based on estimated fair values.
Under Topic 718, the Company uses the Black-Scholes option pricing model as the method of valuation for stock options. The determination of the fair value of stock-based awards on the date of grant is affected by the fair value of the stock as well as assumptions regarding a number of complex and subjective variables. The variables include, but are not limited to, 1) the expected life of the option, 2) the expected volatility of the fair value of the Company's common stock over the term of the award estimated by averaging the Company's historical volatility in addition to published volatilities of a relative peer group, 3) risk-free interest rate, and 4) expected dividends.
The key input assumptions that were utilized in the valuation of the stock options granted during the periods presented:
  

Three months ended July 31,
 
Six months ended July 31,
 
  

2019
 
2018
 
2019

 
2018

Expected dividend yield

*

*
 
%
 
%
Expected stock price volatility

*

*
 
35.98% - 36.53%

 
37.84
%
Risk-free interest rate

*

*
 
2.21% - 2.43%

 
2.52% - 2.68%

Expected life of options

*

*
 
4.95 - 5.09 years

 
5.17 - 6.25 years


* No stock options were granted during the three months ended July 31, 2019 and 2018.

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HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 9. Stock-based compensation (continued)


The Company historically used the "simplified" method to estimate the expected life of an option as determined under Staff Accounting Bulletin No. 110 due to limited option exercise history as a public company. Commencing February 1, 2019, the Company began estimating the expected life of an option using its own historical option exercise and termination data. Expected volatility is determined using weighted average volatility of the Company's historical common stock price in addition to published volatilities of publicly traded peer companies. The risk-free interest rate is determined by using published zero coupon rates on treasury notes for each grant date given the expected term on the options. The dividend yield of zero is based on the fact that the Company expects to invest cash in operations.
A summary of stock option activity is as follows:
  

Outstanding stock options
 
(in thousands, except for exercise prices and term)

Number of
options


Range of
exercise
prices

Weighted-
average
exercise
price


Weighted-
average
contractual
term
(in years)

Aggregate
intrinsic
value

Outstanding as of January 31, 2019

2,444


$0.10 - 82.39

$
27.37


6.74

$
85,971

Granted

108


$63.64 - 73.61

$
73.27





Exercised

(283
)

$0.10 - 44.53

$
23.49





Forfeited

(31
)

$24.36 - 44.53

$
30.96





Outstanding as of July 31, 2019

2,238


$0.10 - 82.39

$
30.03


6.45

$
116,288

Vested and expected to vest as of July 31, 2019

2,238




$
30.03


6.45

$
116,288

Exercisable as of July 31, 2019

1,429




$
22.14


5.75

$
85,503


The aggregate intrinsic value in the table above represents the difference between the estimated fair value of common stock and the exercise price of outstanding, in-the-money stock options.
As of July 31, 2019, the weighted-average vesting period of non-vested awards expected to vest is approximately 1.6 years; the amount of compensation expense the Company expects to recognize for stock options vesting in future periods is approximately $10.5 million.
Restricted stock units and restricted stock awards
The Company grants restricted stock units ("RSUs") and restricted stock awards ("RSAs") to certain team members, officers, and directors under the Incentive Plan. RSUs and RSAs vest upon service-based criteria and performance-based criteria. Generally, service-based RSUs and RSAs vest over a four-year period in equal annual installments commencing upon the first anniversary of the grant date. RSUs and RSAs are valued based on the current value of the Company's closing stock price on the date of grant less the present value of future expected dividends discounted at the risk-free interest rate.
Performance restricted stock units and awards. In March 2017, the Company awarded 146,964 performance-based RSUs ("PRSUs"). Vesting of the PRSUs is dependent upon the achievement of certain financial criteria and cliff vest on January 31, 2020. The Company records stock-based compensation related to PRSUs when it is considered probable that the performance conditions will be met. Issuance of the underlying shares occurs at vesting. The Company believes it is probable that the PRSUs will vest at least in part. The vesting of the PRSUs will ultimately range from 0% to 150% of the number of shares underlying the PRSU grant based on the level of achievement of the performance goals.
In March 2018, the Company awarded 227,760 performance-based RSAs ("PRSAs"). Vesting of the PRSAs is dependent upon the achievement of certain financial criteria and cliff vest on January 31, 2021. The Company records stock-based compensation related to PRSAs when it is considered probable that the performance conditions will be met. Issuance of the underlying shares occurred at the grant date. The Company believes it is probable that the PRSAs will vest at least in part. The vesting of the PRSAs will ultimately range from 0% to 200%

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HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 9. Stock-based compensation (continued)


based on the level of achievement of the performance goals. The PRSAs were issued at the 200% level of achievement. As the underlying shares were issued at grant date, they are subject to clawback based on actual Company performance.
In March 2019, the Company awarded 129,963 PRSUs. Vesting of the PRSUs is dependent upon the achievement of certain financial criteria and cliff vest on January 31, 2022. The Company records stock-based compensation related to PRSUs when it is considered probable that the performance conditions will be met. Issuance of the underlying shares occurs at vesting. The Company believes it is probable that the PRSUs will vest at least in part. The vesting of the PRSUs will ultimately range from 0% to 200% of the number of shares underlying the PRSU grant based on the level of achievement of the performance goals.
A summary of the RSU and RSA activity is as follows:


RSUs and PRSUs
 

RSAs and PRSAs
 
(in thousands, except weighted-average grant date fair value)

Shares


Weighted-average grant date fair value


Shares


Weighted-average grant date fair value

Outstanding as of January 31, 2019

647


$
55.18


256


$
61.93

Granted

527


70.84





Released

(122
)

54.49


(11
)

62.75

Forfeited

(42
)

55.77


(10
)

61.72

Outstanding as of July 31, 2019

1,010


$
63.41


235


$
61.91


For the six months ended July 31, 2019, the aggregate intrinsic value of RSUs and RSAs released was $8.8 million and $0.8 million, respectively. For the six months ended July 31, 2018, the aggregate intrinsic value of RSUs released was $4.6 million.
Total unrecorded stock-based compensation expense as of July 31, 2019 associated with RSUs and PRSUs was $52.1 million, which is expected to be recognized over a weighted-average period of 2.7 years. Total unrecorded stock-based compensation expense as of July 31, 2019 associated with RSAs and PRSAs was $5.4 million, which is expected to be recognized over a weighted-average period of 1.8 years.
Note 10. Fair value
Fair value measurements are made at a specific point in time, based on relevant market information. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. Accounting standards specify a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs have created the following fair value hierarchy:
Level 1—quoted prices in active markets for identical assets or liabilities;
Level 2—inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
Level 3—unobservable inputs based on the Company’s own assumptions.
Level 1 instruments are valued based on publicly available daily net asset values. Level 1 instruments consist primarily of marketable equity securities.





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HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 10. Fair value (continued)
The following table summarizes the assets measured at fair value on a recurring basis and indicates the level within the fair value hierarchy reflecting the valuation techniques utilized to determine fair value:


July 31, 2019
 
(in thousands)

Level 1


Level 2


Level 3

Other investments:







Marketable equity securities

$
81,130


$


$


The Company did not have any assets measured at fair value on a recurring basis as of January 31, 2019. The Company has classified cash and cash equivalents and marketable equity securities as Level 1 in the fair value hierarchy.
Note 11. Subsequent events
Merger with WageWorks
On August 30, 2019, the Company closed the Merger with WageWorks for $51.35 per share in cash, or approximately $2.0 billion in the aggregate. As a result of the Merger, the Company's investment in the common stock of WageWorks was canceled. In addition, the Company assumed and converted into Company equity awards approximately 0.5 million outstanding equity awards to WageWorks employees. The Company financed the cash transaction through a combination of $805.4 million cash on hand plus net borrowings of approximately $1.22 billion, after deducting lender fees of approximately $30.0 million, under the term loan facility described below.
New Credit Agreement
In connection with the closing of the Merger on August 30, 2019, the Company entered into a new $1.6 billion Credit Agreement, which replaced the Prior Credit Agreement, consisting of (i) a five-year senior secured term loan A facility in the aggregate principal amount of $1.25 billion, the net proceeds of which were used by the Company to finance the Merger and related transactions, and (ii) a five-year senior secured revolving credit facility in an aggregate principal amount of up to $350 million, which may be used for working capital and general corporate purposes, including the financing of acquisitions and other investments.
Subject to the terms and conditions set forth in the Credit Agreement (including obtaining additional commitments from one or more new or existing lenders), the Company may in the future incur additional loans or commitments under the Credit Agreement in an aggregate principal amount of up to $300 million, plus an additional amount so long as the Company's pro forma secured net leverage ratio would not exceed 3.85 to 1.00 as of the date such loans or commitments are incurred.
Borrowings under the Credit Agreement will bear interest at an annual rate equal to, at the option of the Company, either (i) LIBOR (adjusted for reserves) plus a margin ranging from 1.25% to 2.25% or (ii) an alternate base rate plus a margin ranging from 0.25% to 1.25%, with the applicable margin determined by reference to a leverage-based pricing grid set forth in the Credit Agreement.
The loans made under the term loan facility will amortize in equal quarterly installments in an aggregate annual amount equal to the following percentage of the original principal amount of the term loan facility: (i) 2.5% for the year commencing August 30, 2019; (ii) 5.0% for each of the years during the two-year period commencing August 30, 2020; (iii) 7.5% for the year commencing August 30, 2022; and (iv) 10.0% for the year commencing August 30, 2023.
The Credit Agreement contains customary affirmative and negative covenants, including covenants related to the following subjects: mergers, and sales of assets; limitations on the incurrence of certain liens; limitations on certain indebtedness; limitations on the ability to pay dividends; and certain affiliate transactions, in each case, subject to customary exceptions and “baskets.”
In addition, the Credit Agreement contains financial performance covenants, which require the Company to maintain (i) a maximum total net leverage ratio, measured as of the last day of each fiscal quarter, of no greater than 5.25 to 1.00, which steps down to (x) 5.00 to 1.00 beginning with the fiscal quarter ending July 31, 2020 and (y) 4.50 to

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HealthEquity, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)

Note 11. Subsequent events (continued)
1.00 beginning with the fiscal quarter ending July 31, 2021 (subject to a customary “acquisition holiday” provision that allows the maximum total net leverage ratio to increase to 5.00 to 1.00 for the four fiscal quarter period ending on or following the date of a permitted acquisition in excess of $100 million), and (ii) a minimum interest coverage ratio, measured as of the last day of each fiscal quarter, of no less than 3.00 to 1.00.
The obligations of the Company under the Credit Agreement are required to be unconditionally guaranteed by WageWorks and each of the Company's subsequently acquired or organized domestic subsidiaries and are secured by security interests in substantially all assets of the Company and the guarantors, in each case, subject to certain customary exceptions.






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Item 2. Management’s discussion and analysis of financial condition and results of operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Statements that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements are often identified by the use of words such as, but not limited to, “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “target,” “will,” “would” and similar expressions or variations intended to identify forward-looking statements. Such statements include, but are not limited to, statements concerning the anticipated benefits of the Merger with WageWorks, market opportunity, our future financial and operating results, investment and acquisition strategy, sales and marketing strategy, management’s plans, beliefs and objectives for future operations, technology and development, economic and industry trends or trend analysis, expectations about seasonality, opportunity for portfolio purchases and other acquisitions, use of non-GAAP financial measures, operating expenses, anticipated income tax rates, capital expenditures, cash flows and liquidity. These statements are based on the beliefs and assumptions of our management based on information currently available to us. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk factors” included in our Annual Report on Form 10-K for the year ended January 31, 2019, as updated by this Quarterly Report on Form 10-Q, and in our other reports filed with the SEC, and the WageWorks Annual Report on Form 10-K for the year ended December 31, 2018 and its other reports filed with the SEC. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such events.

Overview
We are a leader and an innovator in the high-growth category of technology-enabled services platforms that empower consumers to make healthcare saving and spending decisions. Our platform provides an ecosystem where consumers can access their tax-advantaged healthcare savings, compare treatment options and pricing, evaluate and pay healthcare bills, receive personalized benefit and clinical information, earn wellness incentives, and make educated investment choices to grow their tax-advantaged healthcare savings.
The core of our ecosystem is the HSA, a financial account through which consumers spend and save long-term for healthcare on a tax-advantaged basis. As of July 31, 2019, we were the integrated HSA platform for 141 Health Plan and Administrator Partners and over 45,000 employer clients. Our Health Plan and Administrator Partners and Employer Partners constitute our Network Partners.
Since our inception in 2002, we have been committed to developing technology solutions that empower healthcare consumers. We have a proprietary cloud-based technology platform, developed and refined during more than a decade of operations, which we believe is highly differentiated in the marketplace. Key platform differentiators include purpose-built technology that offers greater functionality and flexibility than the technologies used by our competitors, more than 3,000 data integrations with our Network Partner and other benefits provider systems, and configurability solutions with more than 1,700 uniquely tailored configurations serving our Network Partners. We work closely with our Network Partners to educate and provide personalized guidance regarding the benefits of HSAs and our other products.
We earn revenue primarily from three sources: service revenue, custodial revenue and interchange revenue. We earn service revenue by providing monthly account services on our platform, primarily through contracts with our Network Partners, and custodial agreements with individual members. We earn custodial revenue from custodial cash assets deposited with our federally-insured custodial depository partners and with our insurance company partner, and recordkeeping fees we earn in respect of mutual funds in which our members invest. We also earn interchange revenue from interchange fees that we earn on payments that our members make using our physical and virtual payment cards.

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Merger with WageWorks
On June 26, 2019, we entered into a Merger Agreement with WageWorks, and Merger Sub, pursuant to which, on the terms and subject to the conditions therein, Merger Sub would merge with and into WageWorks (the “Merger”), with WageWorks surviving the Merger and becoming a wholly owned subsidiary of HealthEquity. On August 30, 2019, the Merger closed and we paid approximately $2.0 billion in cash to WageWorks stockholders, financed through net borrowings of approximately $1.22 billion under our new term loan facility and approximately $805.4 million of cash on hand.
The Merger is expected to give us access to more of the fast-growing HSA market by expanding our direct distribution to employers and benefits advisors as a single source, premier provider of HSAs and complementary consumer-directed benefits ("CDBs"), including flexible spending accounts, health reimbursement arrangements, COBRA administration and commuter accounts. WageWorks' focus on member engagement and client service enables us to more fully meet the needs of employers, partners and a broader range of consumers along the continuum of health savings.
We expect that the Merger will significantly impact the number of our HSA Members, custodial and other HSA assets, Adjusted EBITDA, total revenue, total cost of revenue and operating expenses, and materially impact our other financial results.
Key factors affecting our performance
We believe that our performance and future success are driven by a number of factors, including our acquisition of WageWorks and those identified below. Each of these factors presents both significant opportunities and significant risks to our future performance. See the section entitled “Risk factors” included in our Annual Report on Form 10-K, as updated by this Quarterly Report on Form 10-Q and our other reports filed with the SEC.
Structural change in U.S. private health insurance
Substantially all of our revenue is derived from healthcare-related saving and spending by consumers in the United States, which is impacted by changes affecting the broader healthcare industry in the U.S. The healthcare industry has changed significantly in recent years, and we expect that significant changes will continue to occur that will result in increased participation in high deductible healthcare plans, or HDHPs, and other consumer-centric health plans. In particular, we believe that continued growth in healthcare costs, and related factors will spur HDHP and HSA growth; however, the timing and impact of these and other developments in the healthcare industry are difficult to predict, and changes in U.S. healthcare policy could adversely affect our business.
Attracting and penetrating network partners
We created our business model to take advantage of the changing dynamics of the U.S. private health insurance market. Our model is based on a B2B2C distribution strategy, meaning that we rely on our Employer Partners and Health Plan and Administrator Partners to reach potential members to increase the number of our HSA Members. Our success depends in large part on our ability to further penetrate our existing Network Partners by adding new HSA Members from these partners and adding new Network Partners.
Our innovative technology platform
We believe that innovations incorporated in our technology that enable consumers to make healthcare saving and spending decisions differentiate us from our competitors and drive our growth in revenue, HSA Members, Network Partners and custodial assets. Similarly, these innovations underpin our ability to provide a differentiated consumer experience in a cost-effective manner. We intend to continue to invest in our technology development to enhance our platform’s capabilities and infrastructure. For example, we are currently undertaking a significant update of our proprietary platform’s architecture, which will allow us to improve our transaction processing capabilities and related platform infrastructure to support continued account and transaction growth.
Broad product offering
Our Employer Partners and their benefits advisors increasingly seek HSA providers that can deliver an integrated offering of HSAs and complementary CDBs, including flexible spending accounts, health reimbursement arrangements, COBRA administration and commuter accounts.  We believe that the combination of our HSA platform with WageWorks' complementary CDB offerings as a result of the Merger will strengthen and broaden our product offerings, enabling us to better meet the needs of our clients and prospective clients. As a market-leading, single-source provider, we believe we will be better positioned to attract new Employer Partners as well as sell additional complementary services to our existing clients. 


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Our “DEEP Purple” culture
The new healthcare consumer needs education and guidance delivered by people as well as technology. We believe that our "DEEP Purple" culture which we define as driving excellence, ethics, and process while providing remarkable service, is a significant factor in our ability to attract and retain customers and to address nimbly, opportunities in the rapidly changing healthcare sector. We make significant efforts to promote and foster DEEP Purple within our workforce. We invest in and intend to continue to invest in human capital through technology-enabled training, career development and advancement opportunities.
Interest rates
As a non-bank custodian, we contract with federally-insured custodial depository partners and an insurance company partner to hold custodial cash assets on behalf of our members, and we earn a significant portion of our total revenue from interest rates offered to us by these partners. The contract terms range from three to five years and have either fixed or variable interest rates. As our custodial assets increase and existing agreements expire, we seek to enter into new contracts with federally-insured custodial depository partners, the terms of which are impacted by the then-prevailing interest rate environment. The diversification of deposits among partners and varied contract terms substantially reduces our exposure to short-term fluctuations in prevailing interest rates and mitigates the short-term impact of a sustained increase or decline in prevailing interest rates on our custodial revenue. A sustained decline in prevailing interest rates may negatively affect our business by reducing the size of the interest rate yield, or yield, available to us and thus the amount of the custodial revenue we can realize. Conversely, a sustained increase in prevailing interest rates without a corresponding increase in what we pay on our members' deposits can increase our yield over time. An increase in our yield would increase our custodial revenue as a percentage of total revenue. In addition, as our yield increases, we expect the spread to grow between the interest offered to us by our custodial depository partners and the interest retained by our members, thus increasing our profitability. However, we may be required to increase the interest retained by our members in a rising prevailing interest rate environment. Changes in prevailing interest rates are driven by macroeconomic trends and government policies over which we have no control.
Our competition and industry
Our direct competitors are HSA custodians. Many of these are state or federally chartered banks and other financial institutions for which we believe technology-based healthcare services are not a core business. Certain of our direct competitors have chosen to exit the market despite increased demand for these services. This has created, and we believe will continue to create, opportunities for us to leverage our technology platform and capabilities to increase our market share. However, some of our direct competitors (including well-known mutual fund companies such as Fidelity) are in a position, should they choose, to devote more resources to the development, sale and support of their products and services than we have at our disposal. In addition, numerous indirect competitors, including benefits administration technology and service providers, partner with banks and other HSA custodians to compete with us. Our Health Plan and Administrator Partners may also choose to offer technology-based healthcare services directly, as some health plans have done. Our success depends on our ability to predict and react quickly to these and other industry and competitive dynamics.
Regulatory environment
Federal law and regulations, including the Affordable Care Act, the Internal Revenue Code and IRS regulations, the Employee Retirement Income Security Act and Department of Labor regulations, and public health regulations that govern the provision of health insurance, 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, the USA 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 subsidiary HealthEquity Trust Company is regulated by the Wyoming Division of Banking, and several states are considering, or have already passed, new privacy regulations that can affect our business. Our ability to predict and react quickly to relevant legal and regulatory trends and to correctly interpret their market and competitive implications is important to our success.
Our acquisition strategy
We have a successful history of acquiring complementary assets and businesses that strengthen our platform, including our recent acquisition of WageWorks. We seek to continue this growth strategy and are regularly engaged in evaluating different opportunities. We have developed an internal capability to source, evaluate and integrate

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acquisitions that have created value for shareholders. We intend to continue to pursue acquisitions of complementary assets and businesses that we believe will strengthen our platform.
Key financial and operating metrics
Our management regularly reviews a number of key operating and financial metrics to evaluate our business, determine the allocation of our resources, make decisions regarding corporate strategies and evaluate forward-looking projections and trends affecting our business. We discuss certain of these key financial metrics, including revenue, below in the section entitled “Key components of our results of operations.” In addition, we utilize other key metrics as described below.
HSA Members
The following table sets forth our HSA Members as of and for the periods indicated:
(in thousands, except percentages)

July 31, 2019


July 31, 2018


% Change


January 31, 2019

HSA Members

4,163


3,574


16
 %

3,994

Average HSA Members - Year-to-date

4,073


3,488


17
 %

3,608

Average HSA Members - Quarter-to-date

4,119


3,533


17
 %

3,813

New HSA Members - Year-to-date

215


219


(2
)%

679

New HSA Members - Quarter-to-date

126


121


4
 %

341

Active HSA Members

3,300


2,933


13
 %

3,241

HSA Members with investments

187


143


31
 %

163

The number of our HSA Members is a key metric because our revenue is driven by the amount we earn from our HSA Member's accounts, balances and spend. The number of our HSA Members increased by approximately 589,000, or 16%, from July 31, 2018 to July 31, 2019, primarily driven by further penetration into existing Network Partners and the addition of new Network Partners.
HSAs are individually owned portable healthcare accounts. As HSA Members transition between employers or health plans, they may no longer be enrolled in an HDHP that qualifies them to continue to make contributions to their HSA. If these HSA Members deplete their custodial balance, we may consider them no longer an Active HSA Member. We define an Active HSA Member as an HSA Member that (i) is associated with a Health Plan and Administrator Partner or an Employer Partner, in each case as of the end of the applicable period; or (ii) has held a custodial balance at any point during the previous twelve month period. Active HSA Members increased 13% from 2.9 million as of July 31, 2018 to 3.3 million as of July 31, 2019.
During the three months ended July 31, 2019, we acquired the rights to be custodian of a portfolio of HSA members for $6.5 million. None of these HSA Members had transitioned to our platform as of July 31, 2019, and accordingly are not included in our total HSA Members as of July 31, 2019. We expect the HSA Members to convert to our proprietary platform in October 2019.
Custodial assets
The following table sets forth our HSA Member custodial assets as of and for the periods indicated:
(in millions, except percentages)

July 31, 2019


July 31, 2018


% Change


January 31, 2019

Custodial cash