Cabot’s “stock of the week” for Health Savings Accounts

Who does Cabot think will "become one of the biggest profit takers of Trump's 'Repeal and Replace' health care reform?"

By Travis Johnson, Stock Gumshoe, February 14, 2017

This little spiel caught my eye because Health Savings Accounts (HSA’s) are in the headlines as a possible beneficiary of the next wave of healthcare reform — with plenty of early indications, at the least, that the Republican party’s “repeal and replace” strategy for the Affordable Care Act will rely to some degree on an expanded role for HSAs.

And since everything runs through an investing lens here, that immediately makes one perk up and say, “who benefits?”

Cabot has an idea, and in trying to sell their Cabot Stock of the Week service ($997/year) they hint at the pick as one of their potential doubles for 2017… here’s how they put it:

“A Quick Look at This Stock of the Week and You’ll See Why I Can Make You this Money Doubling Guarantee

“The opportunity that I’m about to describe could be the closest thing to a sure thing that I’ve seen in the past three years.

“In fact, it’s so big that I’d be willing to bet that this company could give us Tesla-like returns (+690%) over the next four years.”

There must be a rule over at Cabot that every opportunity has to be compared to Tesla… we get similar language just about every time they pick a stock (like Tesla, only in medical devices! Similar opportunity to Tesla, but in solar panels!)… but, of course, our mantra here at Stock Gumshoe is that we disregard the promise of absurd gains (that just pollutes your thinking, you know) and try to look at each stock we find with fresh eyes and some rational thought. We don’t always succeed, to be sure, but that’s the goal… and we can usually at least squeeze a little skepticism into an over-sold story to try to balance things out a bit.

So what else do we hear about this “Stock of the Week?” More clues:

“… this company will become one of the biggest profit takers of President Trump’s “repeal and replace” health care reform.

“How can this be? It’s because the company specializes in managing Health Savings Accounts (HSAs) that are expected to flourish under the Trump Administration….

“Americans opened nearly 20 million HSAs as of June of last year—up 25% from the year before.

“… the company’s stock jumped 112% over the past 12 months on a 41% revenue and 47% earnings growth.”

And the argument for why the stock will rise:

“With the President and Republican lawmakers planning to expand HSAs, you’re not only going to see billions of dollars flow into them but also see our top company’s sales, earnings and stock price skyrocket again. Especially when President Trump makes it easier for HSA holders to pass on their contributions to their heirs tax-free.

“This is why I see this company’s stock price doubling again in 2017.”

The focus on HSA’s is, as I see it, a way to try to create “market discipline” for healthcare in a way that doesn’t really exist for most providers and consumers these days — with Health Savings Accounts people are paying their own money for their health care, at least up to the deductible for the high-deductible health insurance plan that you have to have to qualify for an HSA account (deductibles have to be at least $1,300 a year for individuals).

Therefore the impact, at least as regulators hope, is that Americans, who are pretty good, cost-conscious and careful consumers of other products and services, will become better and more cost-conscious consumers of healthcare services because they will be more intimately involved in paying for the mid-tier things like elective surgeries or treatment for sprained ankles or whatever, and therefore will exert cost pressure on providers of those services (preventive care, stuff like immunizations and annual physicals, is often covered by these plans for free or under a separate, lower deductible, since insurers know that getting checkups and immunizations is still a cost-saving thing for them in the long run… and big high-ticket things like major surgery or chronic illness will often quickly exceed even the $5-10,000 family deductible and be covered by insurance).

I don’t know whether or not it’s working, I haven’t researched it at all, but that’s the idea — that consumers will be better at keeping costs down than are the big health insurers… or, perhaps, that consumers will keep costs down by opting out of treatments or ER visits that might feel less necessary to them, because they’ll be paying — maybe they’ll not go to the ER with the flu, because they know they’ll pay $500 for that when under “regular” health insurance they would perhaps have paid $50 or something like that for an ER visit copay, or maybe they’ll skip the trip to urgent care for the “just in case” broken arm that’s probably just a bad bruise, because the X-ray will cost them $350 out of their HSA instead of a $25 copay.

So who profits from this? Well, HSA’s are offered directly to consumers by lots of banks and investment companies, and plans are offered by many employers who have replaced their traditional health insurance with lower-cost high-deductible plans paired to HSAs, so lots of the same companies that offer health insurance and retirement savings accounts also offer HSA accounts to employers and direct to consumers.

The one being teased here is HealthEquity (HQY), one of the few “pure play” HSA companies that has really tried to take market share in this space. HSAs appeal to lots of people, but they especially appeal to people who are quite healthy and can afford to subsidize their own healthcare to some degree, since the HSA accounts give you a way to save more than your IRA limits and the money can keep building as balances roll over if you don’t spend the money in a given year.

That’s a challenge, of course, if you have relatively high health costs for a few years in a row and actually have to spend that money on broken legs or wart removal or chronic illnesses of whatever kind, but the dream is that you’ll remain healthy and that at least some of the account can compound over decades and give you a nice savings for your healthcare spending in retirement (or other spending — once you’re over retirement age, you can take money out just like it’s an IRA if you still don’t need money for healthcare… though healthcare withdrawals are tax-free and any other post-retirement withdrawals will incur the same taxes as your 401(k) or IRA withdrawals).

And it may be that folks who have always been covered by traditional employer-provided health insurance and/or Medicare may not have much of a perspective on the appeal of HSAs — you can’t contribute to an HSA once you’ve signed up for Medicare, since Medicare is not a high-deductible insurance plan (you can still spend your HSA after enrolling in Medicare, you just can’t add to it), so many newsletter readers (who are in or near their Medicare years) may not pay much attention… but employers and younger folks are increasingly using HSAs and high-deductible plans, voluntarily or not, and there does seem to be some consensus that further healthcare reform will focus more on these plans.

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Will that growth continue as expected, and will it be enough to justify the high valuation that HealthEquity shares trade at today? That’s the question for investors who look at the stock right now — it’s trading at about $43, and is expected to probably earn about 40 cents for their last fiscal year, so that means they’re trading at a trailing PE of about 100 (their year ended on January 31, so they probably won’t report until at least mid-March… but they did release some financial metrics for the year, and a forecast for earnings, just last week).

A PE of 100 is, of course, very expensive… but it is a profitable company, and earnings and revenues are growing pretty quickly. One of the great things about companies like HealthEquity, who get a lot of their revenue from asset management, is that their business should be extremely scalable — they should be able to double revenue without having much impact on their cost structure, which means there’s room for profit margins to expand considerably as revenue rises.

Is that happening with HQY? Well, the stock has done quite well since the IPO — it went public with a market cap of about $500 million, and it’s now at about $2.5 billion… and the shares have provided a return of about 150% (though there have also been periods, like late 2015 into early 2016, when the stock dropped sharply… in that case, by more than 50%). In the time since they started trading they’ve consistently been profitable and have built on their cash balance, so it’s a solid company… but though it looks like they’re starting to enjoy some economies of scale (with cost of revenue dropping, in particular), the impact is not consistent or dramatic at this point. Here are their margins over the past ten quarters, as calculated by Morningstar:

It could well be that there’s a “sweet spot” for this still-young company, where the impact of increasing revenues (and higher customer balances) will really begin to compound — that’s what you would look toward if you’re a bull on HQY shares, that the assets will keep rising (they have $5 billion now in custodial assets — money they’re holding in their members’ HSA accounts) and that this number will both compound as they add new customers and see their customers increase their balances, and, perhaps more importantly, as more HSA customers begin to get more aggressive with their HSA accounts.

I expect that’s probably the key for HQY — a very small percentage of HSA customers use their HSA money to invest, since, as you might guess, the expectation is that a lot of them will need large chunks of that money for medical expenses. But as balances grow larger and HSA users get more comfortable, they do seem to increase their risk tolerance and they start thinking about growing those HSA assets for future use, shepherded toward that decision by custodians like HealthEquity who make it easy to invest for somewhat higher returns than you can get in what is effectively a savings account as a core HSA account. That improves over time to a pretty dramatic degree, because once you convince someone to become an investor the odds are good that they will stick with their HSA provider, and their balances will rise and improve margins over time — HQY has a slide in their investor presentation that indicates the monetization they can expect from their customers, with a gross margin of 57% for the company as a whole but gross margin of 68% for a 3-year-old HS account, and 72% for a 6-year-old account. The cost to acquire new customers gets covered pretty quickly, and larger accounts mean larger management fees.

This is how they describe their income potential from various parts of their network (employers, healthcare providers, and consumers — this is from last year’s annual report):

“Our business model provides strong visibility into our future operating performance. As of the beginning of the past several fiscal years, we had approximately 90% visibility into the revenue of the subsequent fiscal year. We earn monthly service revenue (previously referred to as account fee revenue), primarily through multi-year contracts with our Network Partners, employer clients and individual members. We earn custodial revenue (previously referred to as custodial fee revenue), which is primarily interest earned on our cash assets under management, or AUM, deposited with our FDIC-insured custodial depository bank partners and our insurance company partner. In addition, through our registered investment advisor subsidiary, we earn fees from mutual funds in which our members invest on a self-directed basis, and fees for investment advisory services. We also earn interchange revenue (previously referred to as card fee revenue), which is primarily interchange fees charged to merchants on payments made with our cards via payment networks. Monthly service revenue, custodial revenue, and interchange revenue are recurring in nature, providing strong visibility into our future business.”

That indicates to me that rising short-term interest rates would probably have a significant impact on the revenue potential — they should have a rising spread as short-term rates rise, because their customers won’t demand particularly high interest rates on their HSA savings (higher balances would be more likely to go to an investment of some kind, lower balances are thought of as more of a transactional account, with customers assuming that they will withdraw money to cover health costs, not necessarily watching to see whether they earn 0.5% in interest or 1.5% in interest).

So that sounds like an interesting investment — gradually improving margins that might be expected to improve more rapidly now that their customers’ accounts are growing (it takes a few years for a HSA to get up to a couple thousand dollars, on average, and give customers the incentive to think about investing that money instead of just letting it sit to cover healthcare costs… since, if they have a couple years without spending up to their deductible, the balance will be larger than the deductible and therefore not needed for expenses). I like the logic of that, and the compounding of the accounts and the assets under management, and I like the sticky customer relationships (retention rates are in the 97% neighborhood, since it’s a pain in the neck to switch providers for health insurance or HSA account management) and the good inroads they have with hundreds of health plans and thousands of employers.

What I don’t like is the current valuation, but that’s often the case — its’ hard to stomach a PE of 100, particularly for a stock that’s dependent on a regulatory regime that seems likely to shift. It’s quite possible that it will shift in HQY’s favor, driving more customers into HSAs, but that’s not at all certain.

Current analyst expectations are for earnings growth to be in the 25-35% range for a few years, which is pretty impressive — the forecasts are for 50-56 cents in earnings in the current year (ending January 2018) and for something like 65 cents the following year (it depends on which analyst summary you check). That means you’re still paying about 67 times earnings out two years, which is a little hard to stomach… but there is some solace in the fact that, assuming the regulatory regime continues to favor HSAs, they will be compounding the growth in their assets under management pretty rapidly and will have, I would expect, a pretty good opportunity to beat those estimates if HSA enrollments rise more rapidly than expected.

So I find myself interested in this one for the prospects of rising interest rates and rapidly compounding assets under management… but still, man, 100 times trailing earnings and 67 times 2018 earnings… that’s hard to stomach for a company that is but one of the five or so major HSA providers. To jump on board you’d probably have to have a pretty high level of conviction that they are better than their competitors (they certainly say they are, but I haven’t done enough research to have a high degree of certainty), and that they’ll continue to take share from the others (they list the major competitors as Xerox/BK, UnitedHealth/Wells Fargo, Bank of America, and Webster) and will not face worrisome margin pressures because of the competitive nature of the asset management/account custodian business… with competition only likely to grow if the HSA market, as expected, balloons in size. As is often the case with recommendations from the Cabot letters, which are almost all focused on growth, you really have to be ready to pay for growth and think about your investing strategy as “buy high, sell higher” in order for this to feel comfortable to you. I’m not there yet, but perhaps I’ll get there.

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February 14, 2017 2:41 pm

Sounds like a great story and priced that way. As you say 100x PE but also 20x sales which is high. I feel like I’d need to know alot more to buy it at this price.

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February 14, 2017 2:45 pm

Alex Green Oxford club recommended this roughly 2 months ago and has been a good small position for me.
Just wish it had a div.

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February 14, 2017 2:53 pm

Michael Robinson’s Nova X report also pushed this stock about 5 months ago and I bought it and am up 19%. His stocks have done well for me but they usually do sell for very high multiples and therefore are hard to buy.

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February 14, 2017 3:29 pm

My HSA account charges me fees every month and nothing I can do about it. Cash cow.

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February 19, 2017 9:25 am
Reply to  yelpik

That is indeed unfortunate, if you had literally shot yourself in the foot you could have had use for the money in the account. To mix metaphors why haven’t you stop shoveling once you found yourself in a hole?

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March 1, 2017 10:25 pm
Reply to  yelpik

what is an HSA account?