HealthEquity: High Marks For Recent Profit Growth

seekingalpha11-20 18:16

HealthEquity's future growth relies heavily on capital reinvestment due to the asset-light nature of the business.High multiples of capital are necessary to ensure each $1 of retained and reinvested ...

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(NASDAQ:HQY) the stock is +34% and has broken out from the five-year base I highlighted in Figure 1 of that report. This included 1) an extended phase of accumulation and 2) long-term ownership, whereby now the float is >98% institutionally owned. Figure 1 TradingView Valuations have since stretched to the upside and the stock is now trading at nearly 3x the average peer (Figure 2) and the risk is a compression of multiples from here. Readers will remember from my last analysis I urged to buy HQY at ~17x NOPAT, in line with where it had traded for the last two years. It is now priced at ~33x NOPAT, so I am acutely aware of the downsides in aggressively buying shares at these prices. I will caveat this by saying I am bullish on HQY and do recommend it a buy for the long-term investor; however, there may be more attractive starting valuation points with a healthy consolidation at this point in the market cycle. This report will discuss how HQY has unlocked value for its owners by increasing the intrinsic worth of the business, and what this will look like moving forward in my view. Net-net, I continue to rate HQY a buy, eyeing $120 as the next price objective. Figure 2 Seeking Alpha Q2 FY'25 Earnings breakdown HQY put up $300mm at the top line in Q2 (+23% YoY) and pulled this down to adj. pre-tax earnings of $128mm (+46% YoY). Consensus called for the business to earn $0.70 per share, but it threw off $0.86/share, continuing the trend of outpacing consensus estimates for the fifth consecutive quarter. Management now expects sales of $180mm at the top end of the range on earnings of $1.22 per share for the year. It is projecting adj. operating earnings of $478mm at the upper end, and is set to purchase ~$300mm of stock, authorized at its Q2 earnings. This is an interesting decision in my opinion. Firstly, it represents about 3.5% of the current market capitalization at the time of publication, creating that 'yield' for participating owners. Second, the runway in which management has to retain and redeploy earnings to grow earnings power looks to be diminishing in a small way. Growth has been exceptional to date, measured in terms of earnings and capital invested. These trends are observed below, and have led to a 3x growth in operating earnings from the lulls of FY'23. That it has deployed such exorbitant sums to this advantage (discussed later) means maintaining this pace of capital reinvestment will be exceedingly difficult. The $300mm of buyback is notable as it is more than what the business reinvested towards its competitive position and growth initiatives over the past 12 months. That said, the buyback increases our ownership without any additional outlay (we won't be selling any shares). I therefore see a slowdown in compounding in market value from here, but nonetheless remain constructive on this business from the perspective of an equity owner. Even more so if the business can increase earnings at a constant rate whilst the rate of capital deployment slows. This would increase profitability ratios (ROIC, ROE, etc.) and command higher valuations. Figure 3 Company filings Figure 4 Company filings The critical KPI for the business is its health saving account (\"HSA\") assets which expanded 22% last quarter, i.e. in Q1 FY'25. This trend continued in Q2 with a 27% sequential growth period in HSA assets and +15% in HSA members. Consequently, accounts were up 900bps YoY to 16mm total accounts (this includes 9mm HSAs) which now covers $29Bn in HSA assets (+$6.6Bn YoY). Consequently, invested assets were up 43% compared to last year, comprising $13Bn. Elsewhere, service revenues contributed $116mm to the top line (+400bps) and custodial revenues were up 50%, closing at $139mm. My view of the quarter is that it is a clear indication of the growth route this company is on, particularly when examining operating earnings and returns on incremental capital employed to produce growth. My numbers call for $1.27Bn at the top line this year, compounding at a 14% growth rate to $1.65Bn in FY'26. As such, this reiterates my constructive view on this business at this point in the cycle. Valuation insights The factors driving business growth (and therefore growth in market valuation) for HQY are abundantly clear. The business has produced roughly 500bps of incremental post-tax margin whilst reducing capital intensity/increasing capital turnover by a factor of 0.5x since 2022. Post-tax margins are now at 27% on turnover of 0.33x, up from 0.22 and 0.26x, respectively. The marginal return on new commitments into the business has driven this. In the 12 months to Q1'25, underneath every new dollar put into the business was $0.53 of operating profit, and then the 12 months to Q2, for every dollar employed into the business, underneath it was $0.39 of incremental operating profit. This has been driven by growth after the margin, and high margins are an empirically more relevant driver of returns on anyway. Figure 5 Company filings Given HQY's competitive advantages relative to the industry (as exhibited in Figure 2) it enjoys 1) higher gross and operating margins, which are 2) creating operating leverage and growing operating earnings, which in turn are 3) being methodically rotated into free cash flow (Figure 5). This is explained in a few ways. In my opinion, the business has high returns because it is a highly differentiated offering that exhibits consumer advantages in a niche market segment of selling preferred services. Capacity in the industry has not yet been reached, and arguably is expanding at a reasonable rate based on revenue growth alone. The median industry growth for 3yrs is ~12% and 5yrs is ~17%, with ~9% estimated going forward (note: refer to data from Figure 2). The lack of capacity/competition for HQY across the broad economy means a more favourable pricing dynamic for the business, and therefore pricing is determined by asset factors rather than operating costs. Capacity is only added in anticipation of demand to ensure product availability - this contrasts with commodity-type industries, where conditions of tight supply drive higher prices. Here aren't we have completely the opposite situation which is another competitive advantage. The fact is that, to date, HQY has had many opportunities to redeploy capital into its existing product lines and grow its existing market share around its core segment. It does produce modest turnover per $1 of capital investment (i.e. high capital intensity), but the fact it is a fairly specialized offering that operates in a niche segment of the broader economy, it is not like anyone can simply reproduce watch the business has done. Not cheaply anyway. Consequently, a business such as HQY's earnings and cash flows' are less sensitive to changes at the margin, but more sensitive to changes in sales volumes (in absolute dollar terms). This is precisely why the projected sales out to FY'26 is tremendously attractive in my eyes. Consensus sees ~18% growth in '25, stretching up to 11% the following 2 years, before tempering into the later periods. If this is the case, then I see further returns of incremental capital in the realms of what we've seen recently, which only increases my view that there is potential for further multiple expansion. To this point, my view is that, either (i) multiple expansion is quite imperative for HQY to attract higher valuations in the market, but (ii) if valuations are currently stretched, compounding ability from here relies heavily on capital reinvestment. This is a tangible- asset-light business, so we need high multiples to ensure every dollar of earnings retained + reinvested will be valued highly by the market. That is, we want more than the current 2.9x multiple of EV/IC to drive the stock price in a similar directory as we've seen in 2024. Thankfully, this may be occurring. Since '22, management has rolled in an additional $424mm directly into operations, including acquisitions (net-net). Investors have rewarded the business with an additional $3.7Bn in market value, corresponding to a ratio of $8.88 gain in market value for every new $1 that has been put to work by management. You can see how this fares with a $1 test below as well (Figure 8). My numbers imply the potential for ~9% expansion EV/IC multiple, getting us >3x based on the present value of its future growth opportunities (Figure 7). Figure 6 Author Figure 7 Author Figure 8 Author Remaining conservative, there are two scenarios I see moving forward that could justify the above:  Management will need to reinvest heavily to compounded market values at similar rates to what we've seen recently, as mentioned earlier. I get to ~50% required reinvestment rate, leading to ~44% marginal return on capital this year, producing a 17% growth in earnings power and intrinsic worth of the business. The flipside is that it could earn reinvest less. But if it weren't to maintain a circa 21% reinvestment rate, then it must earn more on its current asset base moving forward. As such, my valuation range is $109-$120 over the coming 12 to 24 months. This equals 2.9x the net tangible and intangible assets required to operate the business.  Figure 9 Author Figure 10 Author Risks to thesis The key downside risk to the thesis from here is multiple contraction, but I give this a 50% probability given the strength of HQY's core offering and capital-light operating model. The equal risk is that investors continue to value it ~3x EV/IC, but the capital base remains stagnant. If management can't redeploy earnings into the business to grow, or make acquisitions, then it will return capital to shareholders (hence the $300mm buyback just started). This is absolutely superb for the current income account - you want businesses drowning in cash with nowhere to put it in those allocations. But for long-term compounding of capital, there must be a mechanism where profits are earned, then retained, then reinvested over a long period of time. That way, those earnings (and the capital) become valued higher over time, or, it attracts a stable valuation but is constantly growing. This could be a risk for the long-term upside of this business. In short  HQY remains a buy for long-term investors. My caveat is there may be better starting valuations with a healthy consolidation. This does not change my long-term views on the competitive advantages of this company, nor management's capacity to unlock further value.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"1","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2484198901"}