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EX-32.2 - EXHIBIT 32.2 - HEALTHEQUITY INCexhibit322-cfo906x1031.htm
EX-32.1 - EXHIBIT 32.1 - HEALTHEQUITY INCexhibit321-ceo906x1031.htm
EX-31.2 - EXHIBIT 31.2 - HEALTHEQUITY INCexhibit312-cfo302x1031.htm
EX-31.1 - EXHIBIT 31.1 - HEALTHEQUITY INCexhibit311-ceo302x1031.htm

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

Form 10-Q

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

For the quarterly period ended October 31, 2017
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 
 
 
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)
 

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 (“Exchange Act”) 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 þ No ¨

Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).  Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
þ
Accelerated filer
¨
Non-accelerated filer
¨ (Do not  check if a smaller reporting company)
Smaller reporting 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 þ

As of November 30, 2017, there were 60,672,608 shares of the registrant's common stock outstanding.

 





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 (unaudited)
(in thousands, except par value)
October 31, 2017


January 31, 2017

Assets



Current assets



Cash and cash equivalents
$
184,367


$
139,954

Marketable securities, at fair value
40,711


40,405

Total cash, cash equivalents and marketable securities
225,078


180,359

Accounts receivable, net of allowance for doubtful accounts as of October 31, 2017 and January 31, 2017 were $100 and $75, respectively
21,458


17,001

Inventories
169


592

Other current assets
6,106


2,867

Total current assets
252,811


200,819

Property and equipment, net
6,789


5,170

Intangible assets, net
85,450


65,020

Goodwill
4,651


4,651

Deferred tax asset
4,656


1,615

Other assets
1,760


1,861

Total assets
$
356,117


$
279,136

Liabilities and stockholders’ equity



Current liabilities



Accounts payable
$
3,295


$
3,221

Accrued compensation
6,503


8,722

Accrued liabilities
9,680


3,760

Total current liabilities
19,478


15,703

Long-term liabilities



Other long-term liabilities
2,226


1,456

Deferred tax liability


37

Total long-term liabilities
2,226


1,493

Total liabilities
21,704


17,196

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 October 31, 2017 and January 31, 2017, respectively



Common stock, $0.0001 par value, 900,000 shares authorized, 60,652 and 59,538 shares issued and outstanding as of October 31, 2017 and January 31, 2017, respectively
6


6

Additional paid-in capital
255,245


232,114

Accumulated other comprehensive loss
(188
)

(165
)
Accumulated earnings
79,350


29,985

Total stockholders’ equity
334,413


261,940

Total liabilities and stockholders’ equity
$
356,117


$
279,136

The accompanying notes are an integral part of the unaudited 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 October 31,
 

Nine months ended October 31,
 
2017


2016


2017


2016

Revenue:







Service revenue
$
22,962


$
18,781


$
68,258


$
56,610

Custodial revenue
22,105


14,967


62,709


43,557

Interchange revenue
11,722


9,610


38,122


31,389

Total revenue
56,789


43,358


169,089


131,556

Cost of revenue:







Service costs
17,251


12,675


47,824


34,471

Custodial costs
2,784


2,461


8,370


7,211

Interchange costs
3,027


2,331


9,625


7,748

Total cost of revenue
23,062


17,467


65,819


49,430

Gross profit
33,727


25,891


103,270


82,126

Operating expenses:







Sales and marketing
5,892


4,391


15,707


12,764

Technology and development
6,866


6,209


19,905


15,827

General and administrative
6,252


5,166


18,354


15,290

Amortization of acquired intangible assets
1,155


1,083


3,320


3,214

Total operating expenses
20,165


16,849


57,286


47,095

Income from operations
13,562


9,042


45,984


35,031

Other expense:







Other expense, net
(395
)

(256
)

(523
)

(934
)
Total other expense
(395
)

(256
)

(523
)

(934
)
Income before income taxes
13,167


8,786


45,461


34,097

Income tax provision
2,685


2,778


4,004


11,783

Net income
$
10,482


$
6,008


$
41,457


$
22,314

Net income per share:







Basic
$
0.17


$
0.10


$
0.69


$
0.38

Diluted
$
0.17


$
0.10


$
0.67


$
0.37

Weighted-average number of shares used in computing net income per share:







Basic
60,562


58,938


60,160


58,338

Diluted
61,868


60,073


61,703


59,693

Comprehensive income:







Net income
$
10,482


$
6,008


$
41,457


$
22,314

Other comprehensive gain (loss):







Unrealized gain (loss) on available-for-sale marketable securities, net of tax
7


(23
)

(23
)

(36
)
Comprehensive income
$
10,489


$
5,985


$
41,434


$
22,278

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

-4-


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

Nine months ended October 31,
 
(in thousands)
2017

 
2016

Cash flows from operating activities:



Net income
$
41,457


$
22,314

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



Depreciation and amortization
11,142


9,543

Amortization of deferred financing costs and other
97


53

Deferred taxes
5,093


(1,880
)
Stock-based compensation
10,468


6,399

Changes in operating assets and liabilities:





Accounts receivable
(4,482
)

244

Inventories
423


(324
)
Other assets
(3,027
)

(3,955
)
Accounts payable
(425
)

(973
)
Accrued compensation
(2,219
)

(3,117
)
Accrued liabilities
2,586


1,666

Other long-term liabilities
770


1,059

Net cash provided by operating activities
61,883


31,029

Cash flows from investing activities:



Purchases of intangible member assets
(15,529
)


Acquisition of a business
(2,882
)


Purchases of marketable securities
(343
)

(275
)
Purchase of property and equipment
(3,382
)

(2,705
)
Purchase of software and capitalized software development costs
(7,654
)

(6,799
)
Net cash used in investing activities
(29,790
)

(9,779
)
Cash flows from financing activities:



Proceeds from exercise of common stock options
12,320


4,546

Tax benefit from exercise of common stock options


15,909

Net cash provided by financing activities
12,320


20,455

Increase in cash and cash equivalents
44,413


41,705

Beginning cash and cash equivalents
139,954


83,641

Ending cash and cash equivalents
$
184,367


$
125,346

Supplemental disclosures of non-cash investing and financing activities:



Purchases of property and equipment included in accounts payable or accrued liabilities at period end
$
238


$
569

Purchases of software and capitalized software development costs included in accounts payable or accrued liabilities at period end
501


185

Purchases of intangible member assets accrued at period end
3,429



The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

-5-


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

Note 1. Summary of business and significant accounting policies


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, Health Reimbursement Arrangements, and Flexible Spending Accounts) for health plans, insurance companies, and third-party administrators.
In February 2006, HealthEquity, Inc. received designation by the U.S. Department of Treasury to act as a passive non-bank custodian, which allows HealthEquity, Inc. to hold custodial assets in trust for individual account holders.  On July 24, 2017, HealthEquity, Inc. received designation by the U.S. Department of Treasury to act as both a passive and non-passive non-bank custodian, which allows HealthEquity, Inc. to hold custodial assets in trust for individual account holders and use discretion to direct investment of such assets held in trust. As a passive and non-passive non-bank custodian according to the Internal Revenue Code ("IRC") 1.408-2(e)(5)(ii)(B), the Company must maintain net worth (assets minus liabilities) greater than 2% of passive custodial funds held in trust at each year-end and 4% of the non-passive custodial funds held in trust at each year-end in order to take on additional custodial assets.
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").
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, such partnership is accounted for using the equity method of accounting. The investment was approximately $206,000 as of October 31, 2017 and is included in other assets on the accompanying condensed consolidated balance sheet.
The Company has a 2% ownership interest in a limited partnership that engages in the development of technology-based financial healthcare products. The Company determined there was no significant influence and therefore the investment was accounted for using the cost method of accounting. The investment was $500,000 as of October 31, 2017 and is included in other assets 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 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 October 31, 2017 and for the three and nine months ended October 31, 2017 and 2016 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 on Form 10-K for the year ended January 31, 2017. The fiscal year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.
Business combinations—Acquisition-related expenses incurred in conjunction with the acquisition of a business as defined by ASC 805-10 are recognized in earnings in the period in which they are incurred and are included in other expense, net on the consolidated statement of operations. During the three and nine months ended October 31, 2017 the Company incurred expense of $398,000 and $481,000, respectively, for acquisition-related activity.
Recent adopted accounting pronouncements—In March 2016, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2016-09, Improvements to Employee Share-Based Payment Accounting. This ASU requires excess tax benefits and tax deficiencies to be recognized in the statement of operations and comprehensive income, which were previously presented as a component of stockholders' equity, on a prospective basis. In addition, any excess tax benefits that were not previously recognized because the related tax deduction had not reduced current taxes payable are to be recorded on a modified retrospective basis through a

-6-


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

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

cumulative-effect adjustment to retained earnings. This ASU also requires cash flows related to excess tax benefits to be classified as an operating activity on the statement of cash flows. Finally, this ASU no longer allows tax benefits to be included in the assumed proceeds when applying the treasury stock method for computing diluted weighted-average common shares outstanding, which results in share-based awards having a more dilutive effect on net income per diluted share.
The Company adopted this ASU during the three months ended April 30, 2017.  As required by the standard, excess tax benefits recognized on stock-based compensation expense are reflected in our condensed consolidated statements of operations and comprehensive income as a component of the provision for income taxes rather than additional paid-in capital on a prospective basis.  For the three and nine months ended October 31, 2017, the Company recorded excess tax benefits in the amount of $2.1 million and $12.6 million, respectively, within our provision for income taxes in the condensed consolidated statements of operations and comprehensive income. In addition, any excess tax benefits that were not previously recognized because the related tax deduction had not reduced current taxes payable are to be recorded on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption, which resulted in an increase of $8.1 million to our retained earnings as of February 1, 2017.
For presentation requirements, the Company elected to prospectively apply the change in the presentation of excess tax benefits wherein excess tax benefits recognized on stock-based compensation expense are classified as operating activities on the condensed consolidated statements of cash flows for the nine months ended October 31, 2017. Prior period classification of cash flows related to excess tax benefits were not adjusted. Further, the Company elected to adopt the forfeiture provisions of this ASU, which requires the Company to account for forfeitures as they occur. The adoption of the forfeiture provisions had no material impact on the condensed consolidated financial statements.
In January 2017, the FASB issued ASU 2017-01, Business Combinations: Clarifying the Definition of a Business, which provides a more robust framework to use in determining when a set of assets and activities is a business. This ASU is effective for fiscal years beginning December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The new guidance is required to be applied on a prospective basis. The Company adopted this ASU during the three months ended July 31, 2017. The adoption had no material impact on the Company's condensed consolidated financial statements.
Recent issued accounting pronouncements—On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This ASU will replace most existing revenue recognition guidance in GAAP when it becomes effective. In July 2015, the FASB voted to defer the effective date to fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption beginning for fiscal years, and interim periods within those fiscal years, beginning after December 31, 2016. The standard permits the use of either the retrospective or cumulative effect transition method. In March 2016, the FASB issued ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which clarifies the guidance in determining revenue recognition as principal versus agent. In April 2016, the FASB issued ASU 2016-10, Identifying Performance Obligations and Licensing, which provides guidance in accounting for immaterial performance obligations and shipping and handling. In May 2016, the FASB issued ASU 2016-12, Narrow-Scope Improvements and Practical Expedients, which provides clarification on assessing the collectability criterion, presentation of sales taxes, measurement date for noncash consideration and completed contracts at transition. Finally, in December 2016, the FASB issued ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers, which makes minor corrections or minor improvements to the Codification that are not expected to have a significant impact. In July 2017, the FASB issued ASU 2017-13, Revenue Recognition (Topic 605), Revenue from contracts with Customers (Topic 606), Leases (Topic 840), and (Leases (Topic 842), which clarifies the transition periods related to public and private business entities. The foregoing amendments are effective for annual reporting periods beginning after December 15, 2017 and for interim reporting periods within such annual periods. The adoption of this guidance is not expected to have a material impact on the Company's revenue. The Company expects to capitalize incremental contract acquisition costs, such as sales commissions included in sales and marketing on the consolidated statement of operations, and amortize these costs over the economic life of the contractual relationship with the member. The Company's current practice is to

-7-


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

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

expense sales commissions when the member is added to the Company's platform. The Company expects the adoption to have a significant impact on its consolidated financial statements. The Company will use the cumulative effect transition method and does not plan to early adopt these pronouncements.
In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Liabilities. The amendments in this ASU revise an entity's accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial liabilities measured at fair value. This ASU also amends certain disclosure requirements associated with the fair value of financial instruments. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted for the presentation of certain fair value changes for financial liabilities measured at fair value. The Company does not plan to early adopt and is currently evaluating the potential effect of this ASU on the consolidated financial statements.
In February 2016, the FASB issued ASU No. 2016-02, Leases (ASC 842), which sets out the principles for the recognition, measurement, presentation and disclosure for both parties to a contract (i.e. lessees and lessors). ASC 842 supersedes the previous leases standard, ASC 840 leases. This ASU is effective for financial statements issued for reporting periods beginning after December 15, 2018 and requires a modified retrospective transition, and provides for certain practical expedients; early adoption is permitted. The Company does not plan to early adopt and is currently evaluating the potential effect of this ASU on the consolidated financial statements.
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. The Company believes the adoption of this ASU will have an immaterial impact on its consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230), which provides guidance on the classification of certain cash receipts and cash payments. This ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company does not plan to early adopt this ASU. The Company believes the adoption of this ASU will have an immaterial impact on its consolidated financial statements.
In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740) - Intra-Entity Transfers of Assets Other Than Inventory, which updates the accounting for the income tax consequences of intra-entity transfers of assets other than inventory. This ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the timing of adoption and 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 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 May 2017, the FASB issued ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting, which provides guidance about changes to the terms or conditions of a share-based payment award. This ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in any interim period. The standard should be applied prospectively to an award modified on or after the adoption date. The Company does not expect the adoption of this ASU to have a significant impact on its condensed consolidated financial statements.


-8-


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

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 October 31,
 
 
Nine months ended October 31,
 

2017

 
2016

 
2017

 
2016

Numerator (basic and diluted):




 



Net income

$
10,482


$
6,008

 
$
41,457


$
22,314

Denominator (basic):




 



Weighted-average common shares outstanding

60,562


58,938

 
60,160


58,338

Denominator (diluted):




 



Weighted-average common shares outstanding

60,562


58,938

 
60,160


58,338

Weighted-average dilutive effect of stock options and restricted stock units

1,306


1,135

 
1,543


1,355

Diluted weighted-average common shares outstanding

61,868


60,073

 
61,703


59,693

Net income per share:




 



Basic

$
0.17


$
0.10

 
$
0.69


$
0.38

Diluted

$
0.17


$
0.10

 
$
0.67


$
0.37

For the three months ended October 31, 2017 and 2016, approximately 834,000 and 702,000 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 nine months ended October 31, 2017 and 2016, approximately 729,000 and 1.9 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.
Note 3. Cash, cash equivalents and marketable securities
Cash, cash equivalents and marketable securities as of October 31, 2017 consisted of the following:
(in thousands)
Cost basis


Gross unrealized gains


Gross unrealized losses


Fair value

Cash and cash equivalents
$
184,367


$


$


$
184,367

Marketable securities:







Mutual funds
41,013


271


(573
)

40,711

Total cash, cash equivalents and marketable securities
$
225,380


$
271


$
(573
)

$
225,078

Cash, cash equivalents and marketable securities as of January 31, 2017 consisted of the following:
(in thousands)
Cost basis


Gross unrealized gains


Gross unrealized losses


Fair value

Cash and cash equivalents
$
139,954


$


$


$
139,954

Marketable securities:







Mutual funds
40,670


207


(472
)

40,405

Total cash, cash equivalents and marketable securities
$
180,624


$
207


$
(472
)

$
180,359


-9-


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

Note 3. Cash, cash equivalents and marketable securities (continued)


The following table summarizes the cost basis and fair value of the marketable securities by contractual maturity as of October 31, 2017:
(in thousands)
Cost basis


Fair value

One year or less
$
25,573


$
25,537

Over one year and less than five years
15,440


15,174

Total
$
41,013


$
40,711

Unrealized losses from marketable securities are primarily attributable to change in interest rates. The Company does not believe any remaining unrealized losses represent other-than-temporary impairments based on the Company's evaluation of available evidence as of October 31, 2017. As of October 31, 2017, marketable securities with an unrealized loss position for more than twelve consecutive months were as follows:

Less than one-year
 

Greater than one-year
 
(in thousands)
Fair value


Unrealized losses


Fair value


Unrealized losses

Mutual funds
$
25,537


$
(366
)

$
15,174


$
(207
)

Note 4. Property and equipment
Property and equipment consisted of the following as of October 31, 2017 and January 31, 2017:
(in thousands)
 
October 31, 2017

 
January 31, 2017

Leasehold improvements
 
$
1,449

 
$
860

Furniture and fixtures
 
4,382

 
3,129

Computer equipment
 
8,947

 
7,194

Property and equipment, gross
 
14,778

 
11,183

Accumulated depreciation
 
(7,989
)
 
(6,013
)
Property and equipment, net
 
$
6,789

 
$
5,170

Depreciation expense for the three months ended October 31, 2017 and 2016 was $697,000 and $523,000, respectively, and $2.0 million and $1.4 million for the nine months ended October 31, 2017 and 2016, respectively.
Note 5. Intangible assets and goodwill
During the three months ended July 31, 2017, the Company acquired the right to act as custodian of a portfolio of HSA Members for $6.4 million. The cost, including transaction costs, was allocated to acquired intangible member assets as of October 31, 2017. 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.

-10-


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

Note 5. Intangible assets and goodwill (continued)

To increase its product offering, during the three months ended July 31, 2017, the Company acquired the assets of BenefitGuard LLC, pursuant to a definitive asset purchase agreement, for a purchase price of $2.9 million cash. BenefitGuard LLC is a 401(k) provider that offers 3(16) plan administrator and 3(21) named fiduciary services for 401(k) employer sponsors. The Company accounted for the acquisition of assets of BenefitGuard LLC as a purchase of a business under ASC 805. The preliminary purchase price allocation resulted in customer relationships, or other intangible assets, of $2.9 million. The Company has determined the other intangible assets to have a useful life of 10 years. The asset will be amortized using the straight-line amortization method, which has been determined appropriate to reflect the pattern over which the economic benefits will be realized. The financial impact of this acquisition, including pro forma financial results, was immaterial to the Company's consolidated statement of operations for the three and nine months ended October 31, 2017.
During the three months ended October 31, 2017, the Company acquired the rights to be the sole administrator of a portfolio of HSA Members for $3.3 million.
During the three months ended October 31, 2017, the Company acquired the right to act as custodian of a portfolio of HSA Members for $9.3 million, of which $6.0 million cash had been paid as of October 31, 2017. The cost, including transaction costs, was allocated to acquired intangible member assets as of October 31, 2017. 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 October 31, 2017 and 2016, the Company capitalized software development costs of $2.1 million and $2.0 million, respectively, and $6.3 million and $5.7 million for the nine months ended October 31, 2017 and 2016, respectively, related to significant enhancements and upgrades to its proprietary system.
The gross carrying amount and associated accumulated amortization of intangible assets were as follows as of October 31, 2017 and January 31, 2017:
(in thousands)

October 31, 2017


January 31, 2017

Amortized intangible assets:




Capitalized software development costs

$
30,212


$
23,925

Software

8,490


7,041

Other intangible assets

2,882



Acquired intangible member assets

83,940


64,962

Intangible assets, gross

125,524


95,928

Accumulated amortization

(40,074
)

(30,908
)
Intangible assets, net

$
85,450


$
65,020

During the three months ended October 31, 2017 and 2016, the Company incurred and expensed a total of $3.0 million and $2.6 million, respectively, and $8.9 million and $6.9 million for the nine months ended October 31, 2017 and 2016, 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 October 31, 2017 and 2016 was $3.3 million and $2.9 million, respectively, and $9.2 million and $8.1 million for the nine months ended October 31, 2017 and 2016, respectively.
There were no changes to the goodwill carrying value during the three and nine months ended October 31, 2017 and 2016.

Note 6. Commitments and contingencies
The Company’s principal commitments and contingencies consist of a processing services agreement with a vendor, and obligations for office space, telephony services, data storage facilities, equipment and certain

-11-


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

Note 6. Commitments and contingencies (continued)


maintenance agreements under long-term, non-cancelable operating leases. These commitments as of January 31, 2017 are disclosed in the Company’s consolidated financial statements included in its Annual Report on Form 10-K for the year ended January 31, 2017, and did not change materially during the three and nine months ended October 31, 2017, except for the following:
On May 31, 2017, the Company entered into an amendment to its lease agreement, dated May 15, 2015, by and between the Company and its landlord to expand its current office space. The term of the lease will commence on January 1, 2018 and will expire on March 31, 2027. The Company will be responsible for payment of taxes and operating expenses for its portion of the building, in addition to an annual base rent in the initial amount of approximately $513,000, with annual increases ranging from 2.5% to 3.1%.
Lease expense for office space for the three months ended October 31, 2017 and 2016 was $1.0 million and $1.1 million, respectively, and $3.1 million and $2.3 million for the nine months ended October 31, 2017 and 2016, respectively. Expense for other lease agreements for the three months ended October 31, 2017 and 2016 was $115,000 and $93,000, respectively, and $341,000 and $237,000 for the nine months ended October 31, 2017 and 2016, respectively.

Note 7. Indebtedness

On September 30, 2015, the Company entered into a new credit facility (the "Credit Agreement"). The Credit Agreement provides for a secured revolving credit facility in the aggregate principal amount of $100.0 million for a term of five years. The proceeds of borrowings under the Credit Agreement may be used for general corporate purposes. No amounts have been drawn under the Credit Agreement as of October 31, 2017.
Borrowings under the Credit Agreement bear 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 to be determined based on the Company's leverage ratio as of the most recent fiscal quarter. The applicable spread for borrowing under the Credit Agreement ranges 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. Additionally, the Company pays a commitment fee ranging from 0.20% to 0.30% on the daily amount of the unused commitments under the Credit Agreement payable in arrears at the end of each fiscal quarter.
The Company's material subsidiaries are required to guarantee the obligations of the Company under the Credit Agreement. The obligations of the Company and the guarantors under the Credit Agreement and the guarantees are secured by substantially all assets of the Company and the guarantors, subject to customary exclusions and exceptions.
The Credit Agreement requires 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 Credit Agreement includes customary representations and warranties, affirmative and negative covenants, and events of default. The restrictive covenants include 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 October 31, 2017.

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 months ended October 31, 2017, the Company recorded an income tax provision of $2.7 million and for the nine months ended October 31, 2017 an income tax provision of $4.0 million. The resulting effective income tax rate was 20.4% and 8.8% for the three and nine months ended October 31, 2017, compared with an effective income tax rate of 31.6% and 34.6% for the three and nine months ended October 31, 2016. For

-12-


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

Note 8. Income taxes (continued)


the three and nine months ended October 31, 2017, the net impact of discrete tax items caused a 16.4 and 27.3 percentage point decrease 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 on the condensed consolidated statements of income, pursuant to the adoption of ASU 2016-09, Improvements to Employee Share-Based Payment Accounting. For the three and nine months ended October 31, 2016, the net impact of discrete tax items caused a 4.6% and 1.2% decrease to the effective tax rate primarily due to the recognition of research and development tax credits. The decrease in the effective income tax rate from the same period last year is primarily due to the excess tax benefit on stock-based compensation expense recognized in the provision for income taxes on the condensed consolidated statements of income during the three and nine months ended October 31, 2017, pursuant to the adoption of ASU 2016-09.
As of October 31, 2017 and January 31, 2017, the Company’s total gross unrecognized tax benefit was $789,000 and $674,000, respectively. As a result of ASU No. 2013-11, certain unrecognized tax benefits have been netted against their related deferred tax assets; therefore, no unrecognized tax benefit has been recorded as of October 31, 2017 and January 31, 2017. If recognized, $670,000 of the total gross unrecognized tax benefits would affect the Company's effective income tax rate as of October 31, 2017.
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 October 31,
 
 
Nine months ended October 31,
 
(in thousands)

2017

 
2016

 
2017

 
2016

Cost of revenue

$
720


$
462


$
1,903


$
1,258

Sales and marketing

561


364


1,403


930

Technology and development

831


487


2,365


1,290

General and administrative

1,553


755


4,797


2,921

Total stock-based compensation expense

$
3,665


$
2,068


$
10,468


$
6,399


-13-


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

Note 9. Stock-based compensation (continued)


Stock options
The Company currently grants stock options under the 2014 Equity Incentive Plan (as amended and restated, the "Incentive Plan"). 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 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.
Stock option activity under the Company's equity incentive plans 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, 2017

4,716


$0.10 - 44.53

$
18.36


7.60

$
131,529

Granted

420


$41.28 - 51.44

$
42.72





Exercised

(1,105
)

$0.10 - 46.40

$
11.23





Forfeited

(145
)

$3.50 - 46.40

$
32.64





Outstanding as of October 31, 2017

3,886


$0.10 - 51.44

$
22.49


7.52

$
107,808

Vested and expected to vest as of October 31, 2017

3,886




$
22.49


7.52

$
107,808

Exercisable as of October 31, 2017

1,168




$
14.42


6.57

$
41,797

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.
The key input assumptions that were utilized in the valuation of the stock options granted during the periods presented:
  

Three months ended October 31,
 
 
Nine months ended October 31,
 
  

2017

 
2016

 
2017

 
2016

Expected dividend yield

%

%
 
%

%
Expected stock price volatility

37.79
%

38.15
%
 
37.79% - 38.01%


38.15% - 38.37%

Risk-free interest rate

1.18
%

1.18% - 1.27%

 
1.18% - 2.07%


1.18% - 1.55%

Expected life of options

4.5 years


4.50 - 6.25 years

 
4.50 - 6.25 years


4.50 - 6.25 years

The determination of the fair value of stock options on the date of grant using an option pricing model is affected by the Company's stock price as well as assumptions regarding a number of complex and subjective variables. Expected volatility is determined using weighted average volatility of publicly traded peer companies. The Company expects that it will begin using its own historical volatility in addition to the volatility of publicly traded peer companies, as its share price history grows over time. 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. The Company uses the "simplified" method to estimate expected term as determined under Staff Accounting Bulletin No. 110 due to the lack of sufficient option exercise history as a public company.

-14-


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

Note 9. Stock-based compensation (continued)


As of October 31, 2017, the weighted-average vesting period of non-vested awards expected to vest is approximately 1.9 years; the amount of compensation expense the Company expects to recognize for stock options vesting in future periods is approximately $20.2 million.
Restricted stock units
The Company grants restricted stock units ("RSUs") to certain team members, officers, and directors under the 2014 Equity Incentive Plan. RSUs vest upon service-based criteria and performance-based criteria. Generally, service-based RSUs vest over a four-year period in equal annual installments commencing upon the first anniversary of the grant date. Performance-based RSUs ("PRSUs") vest upon the achievement of certain financial criteria and cliff vest on January 31, 2020.
RSUs are valued based on the current value of the Company's closing stock price on the date of grant and stock-based compensation expense is recognized over the requisite service period. Stock-based compensation expense for PRSUs is recognized over the requisite service period based on the probable outcome of the achievement of the performance criteria.
A summary of the RSU activity is as follows:
(in thousands, except weight-average grant date fair value)

RSUs and PRSUs


Weighted-average grant date fair value

Outstanding as of January 31, 2017

10


$
26.93

Granted

435


43.78

Vested

(9
)

43.34

Forfeitures

(10
)

45.75

Outstanding as of October 31, 2017

426


$
43.33


Stock-based compensation expense related to RSUs, including PRSUs, for the three and nine months ended October 31, 2017 was $1.4 million and $3.6 million, respectively. Total unrecorded stock-based compensation expense as of October 31, 2017 associated with RSUs was $15.0 million, which is expected to be recognized over a weighted-average period of 3.1 years.
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 highly liquid mutual funds.

The following tables summarize 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:

-15-


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

Note 10. Fair value



October 31, 2017
 
(in thousands)

Level 1


Level 2


Level 3

Marketable securities:







Mutual funds

$
40,711


$


$



January 31, 2017
 
(in thousands)

Level 1


Level 2


Level 3

Marketable securities:







Mutual funds

$
40,405


$


$


The carrying value of financial instruments including cash and cash equivalents and certain non-trade receivables approximate fair values as of October 31, 2017 due to the short-term nature of these instruments. The Company has classified cash and cash equivalents as Level 1 and certain non-trade receivables as Level 2 in the fair value hierarchy.







-16-


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 market opportunity, our future financial and operating results, investment 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, 2017 and in our 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 health savings account, or HSA, a financial account through which consumers spend and save long-term for healthcare on a tax-advantaged basis. We refer to the HSAs for which we serve as custodian as our HSA Members. We are the integrated HSA platform for 87 health plans, and over 34,000 employer clients. Our customers include individuals, employers of all sizes and health plans. We refer to our individual customers as our members, our health plan customers as our Health Plan Partners and our employer clients with more than 1,000 employees as our Employer Partners. Our Health Plan Partners and Employer Partners collectively constitute our Network Partners. Through our Network Partners, we have the potential to reach more than a third of the under-age 65 privately insured population in the United States.
Since our inception in 2002, we have been committed to developing technology solutions that empower healthcare consumers. In 2003, we began offering live 24/7/365 consumer support from health saving and spending experts. In 2005, we integrated HSAs with our first Health Plan Partner, and in 2006, we were authorized to act as an HSA custodian by the U.S. Department of the Treasury. In 2009, we integrated HSAs with multiple health plans of a single large employer, began delivering integrated wellness incentives through an HSA, and partnered with a private health insurance exchange as its preferred HSA partner. In 2011, we integrated HSAs, RAs, and investment accounts on one website, and in 2013, our registered investment advisor subsidiary began delivering HSA-specific investment advice online. In 2015, we launched our HSA Optimizer, which helps HSA Members optimize their accounts based on their individual preferences and goals. In 2016, we launched a new feature which provides HSA account holders advance access to employer contributions.
We generate revenue primarily from three sources: service revenue, custodial revenue and interchange revenue. We generate service revenue by providing monthly account services on our platform, primarily through multi-year contracts with our Network Partners that are typically three to five years in duration. We generate custodial revenue

-17-


from custodial cash assets deposited with our FDIC-insured custodial depository bank partners and with our insurance company partner, and recordkeeping fees we earn in respect of mutual funds in which our members invest. We also generate interchange revenue from interchange fees that we earn on payments that our members make using our physical and virtual payment cards.
Key factors affecting our performance
We believe that our performance and future success are driven by a number of factors, including 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 for the year ended January 31, 2017.
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 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.
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 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. 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. We intend to continue to invest in our technology development to enhance our platform’s capabilities and infrastructure.
Our “DEEP Purple” culture
The new healthcare consumer needs education and advice 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 FDIC-insured custodial depository bank partners and an insurance company partner to hold custodial cash assets on behalf of our members, and we generate a significant portion of our total revenue from interest rates offered 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 FDIC-insured custodial depository bank partners, the terms of which are impacted by the then-prevailing interest rate environment. The diversification of deposits among bank 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 would present us with an opportunity to increase our yield. 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

-18-


bank partners and the interest we offer to our members, thus increasing our profitability. 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. These are primarily 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 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 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 Employment Retirement Income Security Act of 1974 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 of 1996, 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 laundry 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. 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. 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 acquisitions that have created value for shareholders. We believe the nature of our competitive landscape provides a significant acquisition opportunity. Many of our competitors view their HSA businesses as non-core functions. We believe they will look to divest these assets and, in certain cases, be limited from making acquisitions due to depository capital requirements. 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 the periods indicated:


October 31, 2017


October 31, 2016


% Change


January 31, 2017

HSA Members

3,012,968


2,378,353


27
%

2,746,132

Average HSA Members - Year-to-date

2,872,744


2,278,994


26
%

2,339,091

Average HSA Members - Quarter-to-date

2,977,367


2,354,227


26
%

2,519,382

HSA Members with investments

98,257


58,226


69
%

65,906

The number of our HSA Members is critical because our service revenue is driven by the amount we charge per HSA Member.

-19-


The number of our HSA Members increased by approximately 635,000, or 27%, from October 31, 2016 to October 31, 2017, primarily driven by the addition of new Network Partners and further penetration into existing Network Partners, and the acquisition of the rights to be custodian of a portfolio of First Interstate Bank and Bank of the Cascades consisting of approximately 14,000 HSA Members, collectively. The number of our HSA Members increased by approximately 776,000, or 48%, from October 31, 2015 to October 31, 2016 primarily due to the addition of new Network Partners and further penetration into existing Network Partners, and the acquisition of the rights to be custodian of the portfolios of The Bancorp Bank and M&T Bank consisting of 160,000 and 35,000 HSA Members, respectively.
During the three months ended October 31, 2017, the Company acquired the rights to be custodian of a portfolio of Alliant Credit Union, of which no HSA Members have transitioned to our platform as of October 31, 2017, and are not included in total HSA Members as of October 31, 2017.
Custodial assets
The following table sets forth our custodial assets as of the periods indicated:
(in thousands, except percentages)

October 31, 2017


October 31, 2016


% Change


January 31, 2017

Custodial cash

$
4,592,658


$
3,713,290


24
%

$
4,380,487

Custodial investments

987,050


570,553


73
%

658,580

Total custodial assets

$
5,579,708


$
4,283,843


30
%

$
5,039,067

Average daily custodial cash - Year-to-date

$
4,469,641


$
3,596,571


24
%

$
3,661,058

Average daily custodial cash - Quarter-to-date

$
4,550,327


$
3,669,480


24
%

$
3,854,518

Our custodial assets, which are our HSA Members' assets for which we are the custodian, consist of the following components: (1) custodial cash deposits, which are deposits with our FDIC-insured custodial depository bank partners, (2) custodial cash deposits invested in an annuity contract with our insurance company partner and (3) members' investments in mutual funds through our custodial investment partner. Measuring our custodial assets is important because our custodial revenue is determined by the applicable account yields and average daily custodial cash balances.
Our total custodial assets increased by $1.3 billion, or 30%, from October 31, 2016 to October 31, 2017, primarily driven by additional custodial assets from our existing HSA Members and new custodial assets from our new HSA Members, and the acquisition of the rights to be custodian of a portfolio of First Interstate Bank and Bank of the Cascades consisting of approximately $55.0 million of custodial assets. Our total custodial assets increased by $1.6 billion, or 59%, from October 31, 2015 to October 31, 2016. The increase in total custodial assets in these periods was driven by additional custodial assets from our existing HSA Members and new custodial assets from new HSA Members, and the acquisition of the rights to be custodian of the portfolios of The Bancorp Bank and M&T Bank consisting of $390.0 million and $63.0 million custodial assets, respectively.
During the three months ended October 31, 2017, the Company acquired the rights to be custodian of a portfolio of Alliant Credit Union, of which no custodial assets have transitioned to our platform as of October 31, 2017, and are not included in total custodial assets as of October 31, 2017.
Adjusted EBITDA
We define Adjusted EBITDA, which is a non-GAAP financial metric, as adjusted earnings before interest, taxes, depreciation and amortization, stock-based compensation expense, and certain other non-operating items. We believe that Adjusted EBITDA provides useful information to investors and analysts in understanding and evaluating our operating results in the same manner as our management and our board of directors because it reflects operating profitability before consideration of non-operating expenses and non-cash expenses, and serves as a basis for comparison against other companies in our industry.

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The following table presents a reconciliation of net income, the most comparable GAAP financial measure, to Adjusted EBITDA for each of the periods indicated:


Three months ended October 31,
 

Nine months ended October 31,
 
(in thousands)

2017


2016


2017


2016

Net income

$
10,482


$
6,008


$
41,457


$
22,314

Interest income

(185
)

(137
)

(521
)

(385
)
Interest expense

69


69


205


206

Income tax provision

2,685


2,778


4,004


11,783

Depreciation and amortization

2,851


2,335


7,822


6,329

Amortization of acquired intangible assets

1,155


1,083


3,320


3,214

Stock-based compensation expense

3,665


2,068


10,468


6,399

Other (1)

511


323


839


1,113

Adjusted EBITDA

$
21,233


$
14,527


$
67,594


$
50,973

(1)
For the three months ended October 31, 2017 and 2016, Other consisted of non-income-based taxes of $113 and $86, acquisition-related costs of $398 and $10, and other costs of $0 and $237, respectively. For the nine months ended October 31, 2017 and 2016, Other consisted of non-income-based taxes of $303 and $260, acquisition-related costs of $482 and $595, and other costs of $54 and $258, respectively.
The following table sets forth our Adjusted EBITDA:

Three months ended October 31,
 


Nine months ended October 31,
 


(in thousands, except percentages)
2017

2016

$ Change

% Change

2017

2016

$ Change

% Change

Adjusted EBITDA
$
21,233

$
14,527

$
6,706

46
%
$
67,594

$
50,973

$
16,621

33
%
As a percentage of revenue
37
%
34
%
 
 
40
%
39
%
 
 
Our Adjusted EBITDA increased by $6.7 million, or 46%, from $14.5 million for the three months ended October 31, 2016 to $21.2 million for the three months ended October 31, 2017. The increase in Adjusted EBITDA was driven by the overall growth of our business, including a $4.5 million, or 50%, increase in income from operations.
Our Adjusted EBITDA increased by $16.6 million, or 33%, from $51.0 million for the nine months ended October 31, 2016 to $67.6 million for the nine months ended October 31, 2017. The increase in Adjusted EBITDA was driven by the overall growth of our business, including a $11.0 million, or 31%, increase in income from operations.
Our use of Adjusted EBITDA has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP.
Key components of our results of operations
Revenue
We generate revenue from three primary sources: service revenue, custodial revenue and interchange revenue.
Service revenue.    We earn service revenue from the fees we charge our Network Partners, employer clients and individual members for the administration services we provide in connection with the HSAs and RAs we offer. Our fees are generally based on a fixed tiered structure fixed for the duration of our agreement with the relevant Network Partner, which is typically three to five years, and are paid to us on a monthly basis. We recognize revenue on a monthly basis as services are rendered under our written service agreements.
Custodial revenue.    We earn custodial revenue from our custodial assets deposited with our FDIC-insured custodial depository bank partners, our insurance company partner and our custodial investment partner. As a non-bank custodian, we deposit our cash custodial assets with our various bank partners pursuant to contracts that (i) have terms that range from three to five years, (ii) provide for a fixed or variable interest rate payable on the average daily cash balances deposited with the relevant bank partner, and (iii) have minimum and maximum required deposit balances. We earn custodial revenue on our cash custodial assets that is based on the interest rates offered to us by these bank partners. In addition, once a member’s HSA cash balance reaches a certain threshold, the member is able to invest his or her HSA assets in mutual funds through our custodial investment partner. We receive a recordkeeping fee related to such investment custodial assets.
Interchange revenue.    We earn interchange revenue each time one of our members uses one of our payment cards to make a qualified purchase. This revenue is collected each time a member “swipes” our payment card to

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pay a healthcare-related expense. We recognize interchange revenue monthly based on reports received from third parties, namely, the card-issuing bank and the card processor.
Cost of revenue
Cost of revenue includes costs related to servicing member accounts, managing customer and partner relationships and processing reimbursement claims. Expenditures include personnel-related costs, depreciation, amortization, stock-based compensation, common expense allocations (such as office rent, supplies, and other overhead expenses), new member and participant supplies, and other operating costs related to servicing our members. Other components of cost of revenue include interest paid to members on cash custodial assets and interchange costs incurred in connection with processing card transactions for our members.
Service costs.    Service costs include the servicing costs described above. Additionally, for new accounts, we incur on-boarding costs associated with the new accounts, such as new member welcome kits, the cost associated with issuance of new payment cards and costs of marketing materials that we produce for our Network Partners.
Custodial costs.    Custodial costs are comprised of interest we pay to our HSA Members and fees we pay to banking consultants whom we use to help secure agreements with our FDIC-insured custodial depository banking partners. We pay interest to HSA Members on a tiered basis. The interest rates we pay to HSA Members can be changed at any time upon required notice, which is typically 30 days.
Interchange costs.    Interchange costs are comprised of costs we incur in connection with processing payment transactions initiated by our members. Due to the substantiation requirement on RA-linked payment card transactions, which is the requirement that we confirm each purchase involves a "qualified medical expense" as defined under applicable law, payment card costs are higher for RA card transactions. In addition to fixed per card fees, we are assessed additional transaction costs determined by the amount of the transaction.
Gross profit and gross margin
Our gross profit is our total revenue minus our total cost of revenue, and our gross margin is our gross profit expressed as a percentage of our total revenue. Our gross margin has been and will continue to be affected by a number of factors, including the amount we charge our partners and members, interest rates, how many services we deliver per account, and payment processing costs per account. We expect our annual gross margin to remain relatively steady over the near term, although our gross margin could fluctuate from period to period depending on the interplay of these factors.
Operating expenses
Sales and marketing.    Sales and marketing expenses consist primarily of personnel and related expenses for our sales and marketing staff, including sales commissions for our direct sales force, external agent/broker commission expenses, marketing expenses, depreciation, amortization, stock-based compensation, and common expense allocations.
We expect our sales and marketing expenses to increase for the foreseeable future as we continue to increase the size of our sales and marketing organization and expand into new markets. On an annual basis, we expect our sales and marketing expenses to increase slightly as a percentage of our total revenue over the near term. Our sales and marketing expenses may fluctuate as a percentage of our total revenue from period to period due to the seasonality of our total revenue and the timing and extent of our sales and marketing expenses.
Technology and development.    Technology and development expenses include personnel and related expenses for software engineering, information technology, and product development. Technology and development expenses also include outsourced software engineering services, the costs of operating our on-demand technology infrastructure, depreciation, amortization of capitalized software development costs, stock-based compensation, and common expense allocations.
We expect our technology and development expenses to increase for the foreseeable future due to higher amortization costs related to our planned capital expenditures to improve the architecture of our proprietary system. On an annual basis, we expect our technology and development expenses to remain unchanged as a percentage of our total revenue. Our technology and development expenses may fluctuate as a percentage of our total revenue from period to period due to the seasonality of our total revenue and the timing and extent of our technology and development expenses.
General and administrative.    General and administrative expenses include personnel and related expenses, and professional fees incurred by our executive, finance, legal, compliance, and people departments. They also include depreciation, amortization, stock-based compensation and common expense allocations.

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We expect our general and administrative expenses to increase for the foreseeable future due to the additional legal, compliance, accounting, insurance, investor relations and other public company costs that we incur as we continue to grow as a public company, as well as other costs associated with continuing to grow our business. Looking forward, on an annual basis we expect our general and administrative expenses to remain unchanged as a percentage of our total revenue over the near term. Our general and administrative expenses may fluctuate as a percentage of our total revenue from period to period due to the seasonality of our total revenue and the timing and extent of our general and administrative expenses.
Amortization of acquired intangible assets.    Amortization of acquired intangible assets results from our acquisition of HSA portfolios. We acquired these intangible member assets from third-party custodians. We amortize these assets over the assets’ estimated useful life of 15 years. We evaluate these assets for impairment at least each year, or at a triggering event. Our amortization of acquired intangible assets will increase going forward due to the HSA portfolios acquisition which occurred during the three and nine months ended October 31, 2017.
Other expense, net
Other expense primarily consists of interest expense associated with our credit agreement, non-income-based taxes and acquisition-related expenses, offset by interest income on corporate cash and marketable securities.
Income tax provision
We are subject to federal and state income taxes in the United States based on a calendar tax year which differs from our fiscal year-end for financial reporting purposes. We use the asset and liability method to account for income taxes, under which current tax liabilities and assets are recognized for the estimated taxes payable or refundable on the tax returns for the current fiscal year. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, net operating loss carryforwards, and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. As of October 31, 2017, we have recorded a net deferred tax asset. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. Due to the positive evidence of current taxable income coupled with forecasted profitability, no valuation allowance was required as of October 31, 2017.

Comparison of the three and nine months ended October 31, 2017 and 2016
The following table sets forth our revenue for the periods indicated:


Three months ended October 31,
 




Nine months ended October 31,
 




(in thousands, except percentages)

2017

 
2016


$ Change


% Change

2017

 
2016


$ Change


% Change

Service revenue

$
22,962


$
18,781


$
4,181


22
%
$
68,258


$
56,610


$
11,648


21
%
Custodial revenue

22,105


14,967


7,138


48
%
62,709


43,557


19,152


44
%
Interchange revenue

11,722


9,610


2,112


22
%
38,122


31,389


6,733


21
%
Total revenue

$
56,789


$
43,358


$
13,431


31
%
$
169,089


$
131,556


$
37,533


29
%
Service revenue
The $4.2 million increase in service revenue from the three months ended October 31, 2016 to the three months ended October 31, 2017 was primarily due to an increase in the number of our HSA Members.The $11.6 million increase in service revenue from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was also primarily due to an increase in the number of our HSA Members. The number of our HSA Members increased by approximately 635,000, or 27%, from October 31, 2016 to October 31, 2017. The growth in the number of our HSA Members was due to growth from our new and existing Network Partners and acquisition of the First Interstate Bank and Bank of the Cascades HSA portfolio.
Service revenue per HSA Member decreased by approximately 3% and 4% from the three and nine months ended October 31, 2016 to the three and nine months ended October 31, 2017. Our service fee tier structure incentivizes Network Partners to add HSA Members by charging a lower rate for more HSA Members. As Network Partners add more HSA Members, the account fee per HSA Member will continue to decrease.

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Custodial revenue
The $7.1 million increase in custodial revenue from the three months ended October 31, 2016 to the three months ended October 31, 2017 was primarily due to an increase in average daily cash custodial assets of $880.8 million, or 24%, and an increase in the yield on average cash custodial assets from 1.57% for the three months ended October 31, 2016 to 1.85% for the three months ended October 31, 2017 primarily due to our entry into new custodial depository agreements with higher interest rates payable on average cash balances deposited thereunder.
The $19.2 million increase in custodial revenue from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was primarily due to an increase in average daily cash custodial assets of $873.1 million, or 24%, and an increase in the yield on average cash custodial assets from 1.57% for the nine months ended October 31, 2016 to 1.80% for the nine months ended October 31, 2017.
Custodial revenue per HSA Member increased by approximately 17% and 14% from the three and nine months ended October 31, 2016 to the three and nine months ended October 31, 2017, respectively, primarily due to the increase in average daily cash custodial assets balances.
Interchange revenue
The $2.1 million increase in interchange revenue from the three months ended October 31, 2016 to the three months ended October 31, 2017 was due to an overall increase in the number of our HSA Members and payment activity.
The $6.7 million increase in interchange revenue from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was primarily due to an overall increase in the number of our HSA Members and payment activity.
Interchange revenue per HSA Member decreased by approximately 4% from the three and nine months ended October 31, 2016 to the three and nine months ended October 31, 2017, primarily due the a decrease in payment activity per HSA Member.
Total revenue
Total revenue per HSA Member increased by 4% and 2% from the three and nine months ended October 31, 2016 to the three and nine months ended October 31, 2017, respectively, due to the increase in custodial revenue per HSA Member, offset by the decreases in service revenue and interchange per HSA Member.

Cost of revenue
The following table sets forth our cost of revenue for the periods indicated:
(in thousands, except percentages)

Three months ended October 31,
 




Nine months ended October 31,
 





2017

 
2016


$ Change


% Change

2017

 
2016


$ Change


% Change

Service costs

$
17,251


$
12,675


$
4,576


36
%
$
47,824


$
34,471


$
13,353


39
%
Custodial costs

2,784


2,461


323


13
%
8,370


7,211


1,159


16
%
Interchange costs

3,027


2,331


696


30
%
9,625


7,748


1,877


24
%
Total cost of revenue

$
23,062


$
17,467


$
5,595


32
%
$
65,819


$
49,430


$
16,389


33
%
Service costs
The $4.6 million increase in service costs from the three months ended October 31, 2016 to the three months ended October 31, 2017 was due to the higher volume of total accounts being serviced. The $4.6 million increase includes increases of $2.6 million related to the hiring of additional personnel to implement and support our new Network Partners and HSA Members, activation and processing costs of $1.3 million related to account and card activation as well as monthly processing of statements and other communications, stock compensation expense of $258,000, information and technology expenses of $360,000, and other expenses of $127,000. Service costs per HSA Member increased by 8% from the three months ended October 31, 2016 to the three months ended October 31, 2017 due to incremental expenses associated to fraud prevention measures.
The $13.4 million increase in service costs from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was due to the higher volume of total accounts being serviced. The $13.4 million increase includes increases of $7.4 million related to the hiring of additional personnel to implement and support our new Network Partners and HSA Members, activation and processing costs of $3.6 million related to account and card

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activation as well as monthly processing of statements and other communications, information and technology expenses of $772,000, stock compensation expense of $645,000, and other expenses of $1.1 million. Service costs per HSA Member increased by 10% from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 due to incremental expenses associated to fraud prevention measures.
Custodial costs
The $323,000 increase in custodial costs from the three months ended October 31, 2016 to the three months ended October 31, 2017 was due to an increase in average daily cash custodial assets which increased from $3.7 billion for the three months ended October 31, 2016 to $4.6 billion for the three months ended October 31, 2017. Our custodial costs on average cash custodial assets decreased from 0.27% for the three months ended October 31, 2016 to 0.24% for the three months ended October 31, 2017.
The $1.2 million increase in custodial costs from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was due to an increase in average daily cash custodial assets which increased from $3.6 billion for the nine months ended October 31, 2016 to $4.5 billion for the nine months ended October 31, 2017. Our custodial costs on average cash custodial assets decreased from 0.27% for the nine months ended October 31, 2016 to 0.25% for the nine months ended October 31, 2017.
Interchange costs
The $696,000 and $1.9 million increase in interchange costs for the three and nine months ended October 31, 2016 compared to the three and nine months ended October 31, 2017 was due to an overall increase in payment activity, which is attributable to the growth in HSA Members.
As we continue to add HSA Members, our cost of revenue will increase in aggregate dollar amount to support our Network Partners and members. Cost of revenue will continue to be affected by a number of different factors, including our ability to implement new technology in our Member Education Center as well as scaling our Network Partner implementation and account management functions.
Operating expenses
The following table sets forth our operating expenses for the periods indicated:
(in thousands, except percentages)

Three months ended October 31,
 
 
 
 
 
Nine months ended October 31,
 
 
 
 
 

2017

 
2016

 
$ Change

 
% Change

2017

 
2016

 
$ Change

 
% Change

Sales and marketing

$
5,892


$
4,391


$
1,501


34
%
$
15,707


$
12,764


$
2,943


23
%
Technology and development

6,866


6,209


657


11
%
19,905


15,827


4,078


26
%
General and administrative

6,252


5,166


1,086


21
%
18,354


15,290


3,064


20
%
Amortization of acquired intangible assets

1,155


1,083


72


7
%
3,320


3,214


106


3
%
Total operating expenses

$
20,165


$
16,849


$
3,316


20
%
$
57,286


$
47,095


$
10,191


22
%
Sales and marketing
The $1.5 million increase in sales and marketing expense from the three months ended October 31, 2016 to the three months ended October 31, 2017 was due to increased staffing and sales commissions of $808,000, stock compensation expense of $197,000, and increases in other expenses of $495,000.
The $2.9 million increase in sales and marketing expense from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was due to increased staffing and sales commissions of $1.9 million, stock compensation expense of $472,000, and increases in other expenses of $534,000.
We will continue to invest in sales and marketing by hiring additional personnel and promoting our brand through a variety of marketing and public relations activities. As a result, we expect our sales and marketing expense to increase in future periods.
Technology and development
The $657,000 increase in technology and development expense from the three months ended October 31, 2016 to the three months ended October 31, 2017 was due to personnel related expense of $1.1 million, increases in amortization and depreciation of $348,000, and stock compensation of $343,000, which were partially offset by decreases in information and technology expenses, professional fees and other expenses of $1.1 million.

-25-


The $4.1 million increase in technology and development expense from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was due to personnel related expense of $3.5 million, increases in amortization and depreciation of $1.3 million, and stock compensation of $1.1 million, which were partially offset by an increase in capitalized engineering of $600,000 and decreases in information and technology expenses, professional fees and other expenses of $1.1 million.
We will continue to invest in our proprietary technology platform. The timing of development and enhancement projects, including whether they are capitalized or expensed, will significantly affect our technology and development expense both in dollar amount and as a percentage of revenue.
General and administrative
The $1.1 million increase in general and administrative expense from the three months ended October 31, 2016 to the three months ended October 31, 2017 was due to increased personnel related expense of $730,000, stock compensation of $797,000, other expenses of $276,000, which were offset by decreases in professional fees of $718,000.
The $3.1 million increase in general and administrative expense from the nine months ended October 31, 2016 to the nine months ended October 31, 2017 was due to increased personnel related expense of $2.3 million, stock compensation of $1.9 million, other expenses of $625,000, which were offset by decreases in professional fees of $1.8 million.
As we continue to grow, we expect our general and administrative expense to continue to increase in dollar amount as we expand general and administrative headcount to support our continued growth and the regulatory and compliance requirements of a public company.
Amortization of acquired intangible assets
The amortization of acquired intangible assets remained relatively unchanged for the three and nine months ended October 31, 2017 compared to the three and nine months ended October 31, 2016.
Other expense, net
The change in other expense, net from the three and nine months ended October 31, 2016 to the three and nine months ended October 31, 2017, was due to the timing of ongoing acquisition-related activity costs, non-income-based taxes, interest income and interest expense.
Income tax provision
Income tax provision for the three and nine months ended October 31, 2017 was $2.7 million and $4.0 million, compared to $2.8 million and $11.8 million for the three and nine months ended October 31, 2016. The decrease in income tax provision for the three and nine months ended October 31, 2017 compared to the three and nine months ended October 31, 2016 was primarily the result of an increase in federal and state income taxes driven by an increase in income before income taxes netted with excess tax benefits on stock-based compensation expense recognized in the provision for income taxes on the condensed consolidated statements of income during the three and nine months ended October 31, 2017, pursuant to the adoption of ASU 2016-09, Improvements to Employee Share-Based Payment Accounting.
Our effective income tax rate for the three and nine months ended October 31, 2017 was 20.4% and 8.8%, compared to 31.6% and 34.6% for the three and nine months ended October 31, 2016. The 11.2 and 25.8 percentage point decrease for the three and nine months ended October 31, 2017 compared to the three and nine months ended October 31, 2016 was primarily due to the change in treatment of excess tax benefits related to stock-based compensation expense pursuant to ASU 2016-09.
Seasonality
Seasonal concentration of our growth combined with our recurring revenue model creates seasonal variation in our results of operations. A significant number of new and existing Network Partners brings new HSA Members beginning in January concurrent with the start of many employers’ benefit plan years. Before we realize any revenue from these new HSA Members, we incur costs related to implementing and supporting our new Network Partners and new HSA Members. These costs of revenue relate to activating the account and the hiring of additional staff, including seasonal help to support our Member Education Center. These expenses begin to increase during our third fiscal quarter with the majority of expenses incurred in our fourth fiscal quarter. We also experience higher operating expenses in our fourth fiscal quarter due to sales commissions for new accounts activated in January.

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Liquidity and capital resources
Cash and marketable securities overview
As of October 31, 2017, our principal source of liquidity was our current cash and marketable securities balances, collections from our service, custodial and interchange revenue activities, and availability under our credit facility. We rely on cash provided by operating activities to meet our short-term liquidity requirements, which primarily relate to the payment of corporate payroll and other operating costs, and capital expenditures.
As of October 31, 2017 and January 31, 2017, cash, cash equivalents and marketable securities were $225.1 million and $180.4 million, respectively.
Capital resources
We have a “shelf” registration statement on Form S-3 on file with the SEC. This shelf registration statement, which includes a base prospectus, allows us at any time to offer any combination of securities described in the prospectus in one or more offerings. Unless otherwise specified in a prospectus supplement accompanying the base prospectus, we would use the net proceeds from the sale of any securities offered pursuant to the shelf registration statement for general corporate purposes, including, but not limited to, working capital, sales and marketing activities, general and administrative matters and capital expenditures, and if opportunities arise, for the acquisition of, or investment in, assets, technologies, solutions or businesses that complement our business. Pending such uses, we may invest the net proceeds in interest-bearing securities. In addition, we may conduct concurrent or other financings at any time.
We have a secured credit facility of $100.0 million. The credit facility has a term of five years and expires on September 30, 2020. The credit facility contains covenants and events of default customary for facilities of this type. There were no borrowings under the facility as of October 31, 2017. We were in compliance with all covenants as of October 31, 2017.
Use of cash
Capital expenditures for the nine months ended October 31, 2017 and 2016 were $11.0 million and $9.5 million, respectively. We expect our capital expenditures to increase for the remainder of the year ending January 31, 2018 as we are devoting a significant amount of our capital expenditures to improve the architecture and functionality of our proprietary system. Costs to improve the architecture of our proprietary system include outsourced software engineering services, computer hardware, and personnel and related costs for software engineering. In addition, we plan to devote resources to leasehold improvements and furniture and fixtures for new office space adjacent to our headquarters in Draper, Utah, which we began occupying in August 2016.
We believe our existing cash, cash equivalents and marketable securities will be sufficient to meet our operating and capital expenditure requirements for at least the next 12 months. To the extent these current and anticipated future sources of liquidity are insufficient to fund our future business activities and requirements, we may need to raise additional funds through public or private equity or debt financing. In the event that additional financing is required, we may not be able to raise it on favorable terms, if at all.
The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods:


Nine months ended October 31,
 
(in thousands)

2017

 
2016

Net cash provided by operating activities

$
61,883


$
31,029

Net cash used in investing activities

(29,790
)

(9,779
)
Net cash provided by financing activities

12,320


20,455

Increase (decrease) in cash and cash equivalents

44,413


41,705

Beginning cash and cash equivalents

139,954


83,641

Ending cash and cash equivalents

$
184,367


$
125,346


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Cash flows provided by operating activities. Net cash provided by operating activities during the nine months ended October 31, 2017 resulted primarily from our net income of $41.5 million being adjusted for the following non-cash items: depreciation and amortization of $11.1 million, stock-based compensation of $10.5 million, a change in deferred taxes of $5.1 million impacted by the adoption of ASU 2016-09 and utilization of deferred tax benefits and changes in inventories, accrued liabilities, other long-term liabilities and amortization of deferred financing costs and other totaling $3.9 million. These items were offset by a decrease in accrued compensation of $2.2 million resulting from the payment of bonuses and commissions subsequent to year-end, an increase in accounts receivable of $4.5 million, an increase in other assets of $3.0 million, and a decrease in accounts payable of $425,000.
Net cash provided by operating activities during the nine months ended October 31, 2016 resulted primarily from our net income of $22.3 million being adjusted for the following non-cash items: depreciation and amortization of $9.5 million, stock-based compensation of $6.4 million, and changes in accounts receivable, other long-term liabilities, accrued liabilities and amortization of deferred financing costs totaling $3.0 million. These items were offset by a decrease in accrued compensation of $3.1 million resulting from the payment of bonuses and commissions subsequent to year-end, an increase in other assets of $4.0 million, a decrease in accounts payable of $973,000, and a change in deferred taxes and inventories totaling $2.2 million.
Cash flows used in investing activities. Net cash used in investing activities for the nine months ended October 31, 2017 was primarily the result of purchases of intangible member assets of $15.5 million and purchases of other intangible assets of $2.9 million. In addition, we continue to develop our proprietary system and other software necessary to support our continued account growth. Purchases of software and capitalized software development costs for the nine months ended October 31, 2017 were $7.7 million. This compares to purchases of software and capitalized software development costs of $6.8 million for the nine months ended October 31, 2016. Our purchases of property and equipment increased from $2.7 million for the nine months ended October 31, 2016 to $3.4 million for the nine months ended October 31, 2017, the increase was as a result of our new facilities at our company headquarters.
Cash flows provided by financing activities. Cash flow provided by financing activities during the nine months ended October 31, 2017 resulted primarily from the proceeds associated with the exercise of stock options of $12.3 million. ASU 2016-09 was adopted during the nine months ended October 31, 2017. This ASU requires cash flows related to excess tax benefits to no longer be separately classified as a financing activity but should be classified as operating activity.
Cash flow provided by financing activities during the nine months ended October 31, 2016 resulted primarily from the proceeds associated with the exercise of stock options of $4.5 million and the associated tax benefits of $15.9 million.
Contractual obligations
There were no material changes, outside of the ordinary course of business, in our contractual obligations from those disclosed in our Annual Report on Form 10-K for the year ended January 31, 2017.
Off-balance sheet arrangements
During the three months ended October 31, 2017 and 2016, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements.

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Critical accounting policies and significant management estimates
Our management’s discussion and analysis of financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable in the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. Our significant accounting policies are more fully described in Note 1 of the accompanying unaudited condensed consolidated financial statements and in Note 1 to our audited consolidated financial statements contained in our Annual Report on Form 10-K for the year ended January 31, 2017. Other than the adoption of ASU 2016-09 described in Note 1 of the accompanying unaudited condensed consolidated financial statements, there have been no significant or material changes in our critical accounting policies during the nine months ended October 31, 2017, as compared to those disclosed in “Management’s discussion and analysis of financial condition and results of operations – Critical accounting policies and significant management estimates” in our Annual Report on Form 10-K for the year ended January 31, 2017.
Recent accounting pronouncements
See Note 1. Summary of business and significant accounting policies within the interim financial statements included in this Form 10-Q for further discussion.

Item 3. Qualitative and quantitative disclosures about market risk
Concentration of market risk
We derive a substantial portion of our revenue from providing services to tax-advantaged healthcare account holders. A significant downturn in this market or changes in state and/or federal laws impacting the preferential tax treatment of healthcare accounts such as HSAs could have a material adverse effect on our results of operations. During the nine months ended October 31, 2017, and 2016, no one customer accounted for greater than 10% of our total revenue.
Concentration of credit risk
Financial instruments, which potentially subject us to concentrations of credit risk, consist primarily of cash, cash equivalents and marketable securities. We maintain our cash and cash equivalents in bank and other depository accounts, which, at times, may exceed federally insured limits. Our cash, cash equivalents and marketable securities as of October 31, 2017 were $225.1 million, of which $750,000 was covered by federal depository insurance. We have not experienced any material losses in such accounts and believe we are not exposed to any significant credit risk with respect to our cash, cash equivalents, and marketable securities. Our accounts receivable balance as of October 31, 2017 was $21.5 million. We have not experienced any significant write-offs to our accounts receivable and believe that we are not exposed to significant credit risk with respect to our accounts receivable.
Interest rate risk
Custodial assets
As of October 31, 2017, we had custodial cash assets of approximately $4.6 billion. We have entered into depository agreements with financial institutions for our cash custodial assets. The contracted interest rates were negotiated at the time the depository agreements were executed. A significant reduction in prevailing market interest rates may make it difficult for us to continue to place custodial deposits at the current contracted rates.
Cash, cash equivalents and marketable securities
We consider all highly liquid investments purchased with an original maturity of three months or less to be unrestricted cash equivalents. Our unrestricted cash and cash equivalents are held in institutions in the U.S. and include deposits in a money market account that is unrestricted as to withdrawal or use. As of October 31, 2017, we had unrestricted cash and cash equivalents of $184.4 million. Due to the short-term nature of these instruments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.

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As of October 31, 2017, we had marketable securities of $40.7 million. Marketable securities are recorded at their estimated fair value. We do not enter into investments for trading or speculative purposes. Our marketable securities are exposed to market risk due to a fluctuation in interest rates, which may affect the fair market value of our marketable securities. However, because we classify our marketable securities as “available-for-sale,” no gains or losses are recognized in net income due to changes in interest rates unless such securities are sold prior to maturity or declines in fair value are determined to be other-than-temporary.

Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act means controls and other procedures of a company that are designed to ensure the information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures included, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II—Other Information
Item 1. Legal Proceedings
From time-to-time, we may be subject to various legal proceedings and claims that arise in the normal course of our business activities. As of the date of this Quarterly Report on Form 10-Q, we are not a party to any litigation whereby the outcome of such litigation, if determined adversely to us, would individually or in the aggregate be reasonably expected to have a material adverse effect on our results of operations, cash flows, financial position or brand.
Item 1A. Risk factors
The risks described in “Risk factors,” in our Annual Report on Form 10-K for the year ended January 31, 2017 could materially and adversely affect our business, financial condition and results of operations. There have been no material changes in such risks. These risk factors do not identify all risks that we face - our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(a) Unregistered Sale of Equity Securities
None.
(b) Use of Proceeds from Public Offering of Common Stock
On August 5, 2014, we closed our initial public offering of 10,465,000 shares of common stock sold by us. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to a registration statement on Form S-1 (File No. 333-196645), which was declared effective by the SEC on July 30, 2014. JP Morgan & Chase Co. and Wells Fargo acted as the lead underwriters. The public offering price of the shares sold in the offering was $14.00 per share. The total gross proceeds from the offering to us were $146.5 million. After deducting underwriting discounts and commissions of approximately $10.2 million and offering expenses payable by us of approximately $3.7 million, we received approximately $132.6 million. There has been no material change in the planned use of proceeds from our IPO as described in our final prospectus (dated July 30, 2014) filed with the SEC on August 1, 2014 pursuant to Rule 424(b) of the Securities Act. We paid a previously declared cash dividend of $50.0 million on shares of our common stock outstanding on August 4, 2014. In addition, we paid a cash dividend of $347,000 on shares of our outstanding series D-3 redeemable convertible preferred stock accrued through the date of conversion of such shares into common stock, which occurred on August 4, 2014. Other than the foregoing dividends, we made no payments directly or indirectly to (i) any of our officers or directors or their associates, (ii) any persons owning 10% or more of any class of our equity securities, or (iii) any of our affiliates.
On May 11, 2015, we closed our public offering of 972,500 shares of common stock sold by us. The offer and sale of all of the shares in the public offering were registered under the Securities Act pursuant to registration statements on Form S-1 (File Nos. 333-203190 and 333-203888), which became effective on May 5, 2015. Wells Fargo acted as the lead underwriter. The public offering price of the shares sold in the offering was $25.90 per share. Certain selling stockholders sold 3,455,000 shares of common stock in the offering, including 380,000 shares of common stock which were issued upon the exercise of outstanding options. The Company received net proceeds of approximately $23.5 million after deducting underwriting discounts and commissions of approximately $1.0 million and other offering expenses payable by the Company of approximately $688,000. The Company did not receive any proceeds from the sale of shares by the selling stockholders other than $222,000 representing the exercise price of the options that were exercised by certain selling stockholders in connection with the offering. We paid all of the expenses related to the registration and offering of the shares sold by the selling stockholders, other than underwriting discounts and commissions relating to those shares. Other than these expenses, we made no payments directly or indirectly to (i) any of our officers or directors or their associates, (ii) any persons owning 10% or more of any class of our equity securities, or (iii) any of our affiliates. There has been no material change in the planned use of proceeds from our public offering as described in our final prospectus (dated May 5, 2015) filed with the SEC on May 6, 2015 pursuant to Rule 424(b) of the Securities Act.
During the year ended January 31, 2016, the Company used funds received from the offerings to acquire the rights to be the custodian of HSA portfolios acquired from The Bancorp Bank and M&T Bank, for approximately $34.2 million and $6.2 million, respectively.

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During the nine months ended October 31, 2017, the Company used funds received from the offerings to acquire the rights to be custodian of two HSA portfolios for approximately $6.4 million and $9.3 million in cash, respectively, and the assets of BenefitGuard LLC, a 401(k) provider that offers 3(16) plan administrator and 3(21) named fiduciary services for 401(k) employer sponsors, for approximately $2.9 million.
The remainder of the funds received have been invested in registered money market accounts and mutual funds.


Item 6. Exhibits
The exhibits listed in the accompanying Exhibit Index are filed or incorporated by reference as part of this Quarterly Report.


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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
HEALTHEQUITY, INC.
Date: December 7, 2017
By:
 
/s/ Darcy Mott
 
Name:
 
Darcy Mott
 
Title:
 
Executive Vice President and Chief Financial Officer

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Exhibit Index
 
 
 
Incorporate by reference
Exhibit
no.
 
Description
Form
File No.
Exhibit
Filing Date
31.1+
 
 
 
 
 
31.2+
 
 
 
 
 
32.1*#
 
 
 
 
 
32.2*#
 
 
 
 
 
101.INS††
 
XBRL Instance document
 
 
 
 
101.SCH††
 
XBRL Taxonomy schema linkbase document
 
 
 
 
101.CAL††
 
XBRL Taxonomy calculation linkbase document
 
 
 
 
101.DEF††
 
XBRL Taxonomy definition linkbase document
 
 
 
 
101.LAB††
 
XBRL Taxonomy labels linkbase document
 
 
 
 
101.PRE††
 
XBRL Taxonomy presentation linkbase document
 
 
 
 
+
 
Filed herewith
*
 
Furnished herewith
#
 
These certifications are not deemed filed with the Securities and Exchange Commission and are not to be incorporated by reference in any filing the registrant makes under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, irrespective of any general incorporation language in any filings.
††

 
In accordance with Rule 406T of Regulation S-T, the information in these exhibits is furnished and deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Exchange Act of 1934, and otherwise is not subject to liability under these sections.


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