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  • Writer's pictureGreystone Capital

WageWorks (WAGE) – not as cheap as it looks

When searching for new investments to add to Greystone’s portfolio, I try to seek out misunderstood or underfollowed businesses that dominate a niche product or service, possess a widening competitive advantage w/ underappreciated growth, have an aligned, experienced management team, and are able to be purchased at a value prices.

WageWorks (NYSE: WAGE) is none of those things….other than a potential value price. I found it interesting enough to do a short write-up though, and may revisit if the company gets de-listed in a few months.

A mess of corporate governance issues including the company not being up to date with their quarterly and annual filings, as well as having to restate 2016 financials due to management overstating revenues has resulted in the cleaning house of the board and management team, as well as a 50% drop in the share price from $60 to $31 as of December 2018. This is still expensive based on the latest quarterly data available, but shares would likely get hammered following a potential de-listing, which may open up an opportunity if WAGE can right the ship.

Here’s a short timeline of events that led us to this point:

  1. WAGE reports a solid Q3 2017 in November, with revenue growth of 30% and net income growth of 43% YoY

  2. In March 2018, WAGE issues a statement saying they are delaying the 10K filing, causing shares to drop 14%. Trading is halted and shares finish down 22% on the day

  3. April 5th, WAGE provides an update, naming Edgar Montes as new CEO, replacing Joe Jackson. Colm Callan resigns as CFO. Kim Wilford resigns as Senior VP and General Counsel. The financial restatement updates include adjustments for the YTD 2016 and 2017 periods, with the ability to file an extension if needed

  4. On June 27th, Stifel cut WageWorks price target from $80 to $64 (shares dropped 5% to around $48)

  5. Joseph Jackson, Chairman and CEO resigns on September 12th

  6. September 13th and 14th – the company announces an investigation by the board into claims that the audit committee withheld information from KPMG, and Rosen Law Firm announces an investigation into the breach of fiduciary duty by the management team – shares fall another 16%

Business Description

WageWorks is a provider of tax-advantaged programs in the United States. The company specializes in consumer-directed benefits such as health savings accounts, health and dependent-care flexible spending accounts, health reimbursement arrangements, and commuter benefit services, including transit, parking, and wellness programs. With the help of WageWorks, employees use pretax dollars to pay for healthcare, dependent care, and commuter expenses and save money on their payroll tax.

In other words, WAGE provides administrative services by offering consumer-directed benefits programs (CDBs) to employee participants within their client network. For those with an office job, you may be familiar with the yearly ‘open enrollment’ period where select employees are able to participate in tax-advantaged accounts such as Health Savings Accounts, Flex Spending Accounts, Health Reimbursement Agreements and various other wellness programs. This is what WAGE helps their clients set up and maintain, for a fee.

WageWorks receives service fees from administrative services provided, as well as payment processing fees from any of their prepaid debit card products (such with an HSA).

The company has three business segments:

  1. Healthcare – made up of HSAs, FSAs, HRAs and Dependent Care programs – 58% of revenues

  2. Commuter – 16% of revenues

  3. COBRA – 25% of revenues

The healthcare and COBRA segments have shown solid growth over the last few years, contributing to a 37% increase in revenues from Q4 2016 to Q4 2017. As of Q4 2017, WAGE had 6.5 million employee participants from over 100,000 employer clients. I’d attribute this low penetration rate to a few things:

  1. Many of the benefits offered by WAGE through their healthcare segment are only available to employees with high-deductible insurance benefits – this is probably a small chunk of the total pie

  2. These services are commoditized, confusing, and with big companies especially (WAGE has Fortune 100 and Fortune 500 companies as clients), employees are sent a few emails but aren’t properly explained the benefits of these programs

  3. There is a lot of friction during the sign-up process

In my conversations with industry experts, I’ve come to understand that the complexity of the system and proliferation of new entrants has made it difficult for employees to fully understand their benefit programs, treatment options and where to go for care.

Despite the above, WAGE has built a solid business with gross margins in the 65% – 68% range, tons of free cash flow and a source of short-term ‘float’ in the form of customer obligations, or deposits for services (more on how this float distorts the financials below).

Below COGS, SG&A remains the largest operating expense, as new clients are prospected by a direct sales force, and WAGE boasts a large relationship management team for each enterprise client. There’s also the occasional bolt-on acquisition, where WAGE will acquire the portfolio of other third-party administrators, or buy the administrator outright (three acquisitions since 2007). With a huge cash balance and several hundred TPA portfolios in the market, this could provide an interesting way to scale and increase market share.

The market for CDBs and direct bill services is fierce, fragmented and commoditized. However, as long as the payroll tax benefits remain in place for employers based on their employees utilization of CDBs, demand should be steady moving forward.

With 60 million CDH accounts in the market as of 2016 and an 11% estimated compound annual growth rate (CAGR) from 2014 to 2020, 86 percent of brokers and 74 percent of employers rate CDH to be a critical component of their future benefits strategies and an essential tool to combat the rising cost of health benefits. To maximize the impact CDH programs can have, brokers and employers must be supported to ensure that benefit designs and communication strategies are effective and CDH programs deliver on their promise of cost savings, greater control over healthcare spending, and greater employee satisfaction – rather than a mechanism to purely shift costs.

WAGE’s size and scale has enabled them to develop a cost structure unlike many of their peers (excluding private companies for which I don’t have access to data), with higher margins, better returns on capital, and profitability (unlike Asure and Castlight Health). WAGE is also able to dedicate a significant amount of resources to customer support, with one dedicated account rep for each of their clients. I don’t love this kind of business, and was specifically interested given the valuation – or so I thought on first glance – but WAGE is actually expensive based on their business model which depends on customer ‘prefunds’ to operate.

Valuation

Let’s start with what we have for the YE 2016 and 2017, including the restatements

2016 Restatement

  1. Revenue decrease of $6.5 to $9.5 million

  2. Net income decrease of $3.5 – $5.5 million

  3. Adjusted EBITDA decrease of $6.0 – $9.0 million

2017 Restatement

  1. Still ongoing, but not expected to cause revenue to differ materially from the company’s previous guidance

Here’s what WAGE provided for guidance for Q4 2017 and YE 2017:

WAGE 2017 guidance

Assuming that the company can hit the low end of 2017 revenue guidance, we are looking at $479mm in revenues, and can assume 10-12% net margins based on Q3 and nine months ended 2017 results. Taking the low end of net margins based on higher COGS, increased investments in technology and additional sales activity, and we’re probably looking at around $50mm in net income. There was $650mm in net cash on the balance sheet as of Q3 2017, giving WAGE a total EV of $528mm. So it may be fair to assume the 2017 ex-cash P/E comes out to around 10.5x. WAGE also spit off around $75mm in free cash flow including stock based comp., giving investors a price to free cash flow of 7x. If the growth profile of this business is still in place and management can continue to gain share and grow the customer base, this is a very cheap price, even taking into account the issues. We are now completely through the fiscal year 2018 as well, so unless the business has fallen off a cliff over the past few months, I’d assume the cash balance is higher, earnings have been relatively steady or growing, and the business continues to generate free cash flow at a healthy clip.

Let’s see.

Wage issued guidance for 2018 during a recent press release of the YTD 2016 and 2017 restatements, indicating:

  1. Full year revenue growth of 1-4%

  2. Adjusted EBITDA margins of 28-32% (excluding restatement costs)

There’s not much info there, but if we assume a similar margin profile as above (let’s call it 8% with some increased expenses), and take the low end of revenue guidance for 2018, we are again looking at an ex-cash P/E of around 13.6x. This doesn’t take into account any balance sheet changes from Q3 2017. Still not an expensive price, but as you can see we are missing just a ton of crucial information.

Those valuations look interesting, but would not be accurate given the use of cash that WAGE holds on their balance sheet that is required to pay off short-term customer obligations.

At first glance, this net cash position looks like WAGE has 50% of their market cap in cash. In reality, that cash amount represents the prefunding of claims to be paid to employee customers of their health plans, due in the current year. The prefunds account gets replenished each month/year based on the intake of prefunds and the signing up of new customers, but this cash is not to be viewed as excess, and the majority of which is needed in the current year.

WAGE prefunds

The reason why the cash account looks like this on the balance sheet is because WAGE is able to record prefunds as cash and equivalents, while also creating a simultaneous and corresponding liability called customer obligations. A portion of the prefunds are invested in short term securities, which has the characteristics of income from float. However, claims are paid within one year, instead of over long periods of time such as with an insurance business.

WAGE balance sheet

In addition, these prefunds are the company’s largest source of operating cash flow, and due to the timing and subsequent payouts of customer obligations, it becomes very difficult to forecast the cash needs of WAGE as well as their normalized operating cash flow.

WAGE cash flows

All this is to say that this little tweak (which is easy to find if you read the financial…I didn’t uncover anything profound) takes WAGE from a business that looks like it has a huge excess cash balance, limited working capital needs, and possible source of float to one with significant short-term cash needs and a net debt position of around $50mm. Add in the corporate governance issues, and WAGE should be a pass for most investors, with the true valuation (assuming the net debt position) of somewhere around 25x earnings and 15x free cash flow. I would need shares to fall off a cliff from here in order to get involved.

Additional Notes

I’d love to get to the reasons behind the flattish growth levels from 2017 to 2016, with WAGE guiding for 1-4% growth after coming off of a 30%+ YoY quarter in 2017. It would be a major catastrophe if these company-wide issues are affecting customers and employees, including the sales force. In my opinion, investing before the restatement would be a huge mistake (even though investors may miss any positive share price movements if the results turn out to be positive). The lack of growth guidance puzzles me, especially given the strength of the HSA and COBRA segments (HSA segment boasts 90%+ renewal rates).

lot more info is needed, but if WAGE continues to spit off cash and the presence of an activists begins to surface, it could be a compelling situation following a delisting.

Positive Developments

The company recently hired Stuart C. Harvey and George P. Scanlon as Executive Chairman of the board and independent director. Both filed Form 3 as 10% owners, but it’s unclear whether this is direct ownership or through options/restricted stock. Both have extensive financial, payment platform and operating experience and should be solid additions to the company.

What’s Missing?

  1. High levels of insider ownership and alignment

  2. The presence of a strong activist

  3. Insight into how the lawsuits/management changes are affecting employees and customers

  4. Financial data – restatements could be horrible

  5. Near-term positive catalyst

Risk Factors

  1. Potential de-listing – waiting until the company’s March 2019 deadline to file would be the best thing to do in this scenario

  2. Corporate governance – addressed in detail above

  3. Lack of transparency – what do financials look like for 2017 and 2018?

  4. Low insider ownership – insider ownership is most likely needed for this to be a potential investment, especially in the absence of a strong activist

  5. Customers switching to their own platforms and abandoning WAGE products to save

  6. Sales process remains difficult

  7. Commoditized products with low-value prop

  8. Regulation – the government deciding to eliminate any CDBs or flex accounts would have a large impact on WAGE and their product offerings

  9. Receivables growing like a weed – having trouble collecting cash for benefit services?

Disclosure: no position

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