Frode Jensen - General Counsel Jon Kessler - President & CEO Ashley Dreier - Chief Information and Technology Officer Darcy Mott - EVP & CFO.

Lisa Gill - JPMorgan Peter Costa - Wells Fargo Securities Greg Peters - Raymond James Sandy Draper - SunTrust Robinson Humphrey Steven Wardell - Leerink Partners Randy Reece - Avondale Partners Mark Marcon - Robert W. Baird.

Welcome to the HealthEquity Second Quarter 2016 Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Frode Jensen, General Counsel. Please go ahead..

Thanks very much. Good afternoon and welcome. My name is Frode Jensen and I'm General Counsel of HealthEquity. Please be advised that today's discussion includes forward-looking statements including predictions, expectations, estimates or other information that might be considered forward-looking.

Throughout today's discussion, we will present some important factors related to our business which could affect those forward-looking statements. These forward-looking statements are also subject to risks and uncertainties that may cause actual results to differ materially from statements made today.

As a result, we would caution you against placing undue reliance on these forward-looking statements.

We encourage you to review the risk factors detailed in our annual report on Form 10-K which we filed with the SEC on March 31, 2015 and any subsequent periodic or current reports for a discussion of these factors and other risks that may affect our future results or the market price of our stock.

Finally, we're not obligating ourselves to revise our results or publicly release any updates to these forward-looking statements in light of new information or future events. With that I will turn the call over to Jon..

Thank you, Frode. Let me begin where I usually and by thanking some remarkable people at HealthEquity for working hard over the summer and spring to deliver a fantastic quarter along with our partners and our members, so thank you. And thanks, everyone, for joining the call today.

Halfway through FY ‘16, HealthEquity is on track to deliver another solid year of growth and increased profit margin. In the second quarter, we saw excellent progress in four key metrics that drive the business; revenue, adjusted EBITDA, HSA members, and assets under management or AUM.

Revenue of $30.5 million grew 46% compared to the second quarter FY ‘15. Adjusted EBITDA of 11.1 million continued to grow faster than our revenue with an increase of 62% in the second quarter compared to the year ago period, and we demonstrated the operating leverage in the business with 350 basis point increase in our EBITDA margins to 36%.

HSA membership reached 1.5 million, up 45% year-over-year and AUM reached $2.6 billion, up an even larger 47% year-over-year. Let me make two observations on the market and HealthEquity's position therein. First, the HSA market continues to grow at a rapid rate.

According to Devenir's midyear 2015 report, the number of HSAs market-wide has grown 23% year-over-year from 2014, and market-wide AUM has grown 25%.

We believe that this is happening because the purchasers of health benefits, employers, and consumers are looking at the numbers and concluding lower premium HSA-compatible health plans coupled with lifetime triple tax-free savings through an HSA are simply a better value proposition than traditional kinds of health benefits.

Second, HealthEquity continues to gain market share. In roughly the same period as cited in the Devenir report, the number of HealthEquity members has grown 45%, nearly twice as fast as the market growth reported by Devenir.

Our 47% organic growth in assets under management is also nearly twice the industry's 25% growth, and that is remarkable considering that HealthEquity's account base is much newer than many of its competitors. In addition, HealthEquity organically grew its AUM the fastest out of the top 10 HSA providers according to Devenir.

Why does HealthEquity continue to materially outperform? Our proprietary technology platform that powers remarkable people and a broad ecosystem of relationships.

To speak a bit more about the sophistication, flexibility, and scalability of our technology, I would like to welcome to the call Ashley Dreier, HealthEquity's Chief Information and Technology Officer. Like many of our executives, Ashley has spent her career at the intersection of healthcare and finance.

She joined HealthEquity 2 1/2 years ago after achieving positions of rising responsibility in the product and technology organizations at GE Financial, Krames StayWell, and Wolters Kluwer. Ashley's contributions to the tech industry were recognized by the Women Tech Council in 2013, and she was named a CIO of the Year by Utah Business in 2014.

Ashley?.

Thank you, Jon. For a dozen years, HealthEquity's engineers have been building and refining the company's technology.

The goal has always been not so much to administer employer benefits or manage financial accounts of scale, but we do these things well, but to in fact power consumers to make highly individualized healthcare savings and spending decisions. Meeting that goal starts with data and lots of it.

As of July 31, HealthEquity's production database included 4 terabytes of transactional information on our members. It is a diverse set of data that includes relevant financial transactions and health benefits to insurance claims and investment preferences. Year-over-year, the size of our transactional database grew 60%.

Where does it come from? Jon, as mentioned before, the over 1,300 data pipes that HealthEquity has built with our ecosystem, including most major insurers, PBMs, benefit managers, and the growing number of consumer-focused medical application providers. These data connections are both real-time and [indiscernible].

There is no single data standard or set of business rules, and so the proprietary capability we have built to take in data are in nonstandard formats and frequencies without major investments by those on the other end of the data pipe, what we call the HealthEquity correlation system, is very important to our growth.

All of this yields a rich set of data from which to generate highly personalized insight. To illustrate, let me use the example of Sally, one of our HSA members who began her relationship with HealthEquity highly skeptical of her employer's claim that she could spend less and save more on healthcare, especially with a growing family.

Because of integration with Sally's Blue Cross Blue Shield plan and medical information providers, Sally can dig into the details of a bill from her kids' pediatrician.

A data pipe to Endion, a company Sally's employer pays to analyze claims for potential savings, reveals that the pediatrician charges $96 more per visit than a comparable practice closer to her home.

A data pipe to the PBM used by Sally's health plan reveals that under Sally's specific health plan design, the address [ph] Sally uses costs $35 less at a different pharmacy than the one she uses. Sally changed pharmacies and stuck with her pediatrician, but only after asking about price and getting a lower rate.

At year's end, Sally called HealthEquity expert to see how she might spend HSA dollars contributed by her employer and was delighted to learn that there was no use-or-lose requirement.

Because of a link to the retirement plan used by Sally's employer, her HealthEquity advisor knew she had maxed out her 401(k), but explained how she could grow savings even more by contributing to her HSA for the long term. We believe that we have only just begun to tap the value of the HealthEquity platform for our members.

Current capacity is three times the size of today's database and our data pipes now number in the thousands. An important component of the platform is the ability to add new pipe or change the direction or applicability of the given data source quickly and inexpensively. As Dr.

Neeleman discussed on last quarter's call, we're just beginning to use analytics to optimize consumer engagement, personalizing both what and how we present to consumers. And we have built the platform with scalability in mind on a standard code set that allows for new capabilities or capacity more or less on demand.

I would like now to turn the call over to Darcy Mott, our Executive Vice President and CFO, who will review the details of our second quarter results.

Darcy?.

Thanks, Ashley. Today, I'll discuss our results on both a GAAP and a non-GAAP basis. Our non-GAAP operating metrics include adjusted EBITDA and pro forma non-GAAP earnings per diluted share.

We define adjusted EBITDA as adjusted earnings before interest, taxes, depreciation, and amortization, non-cash stock-based compensation expense, and other certain non-operating items.

Pro forma non-GAAP earnings per diluted share is calculated by adding back to net income all stock-based compensation expense net of tax and then dividing the result by diluted weighted average shares outstanding.

I would like to spend my time on the call today reviewing the second quarter financial results and discussing our outlook for the remainder of the fiscal year. As Jon mentioned earlier, revenue for the second quarter of FY ‘16 was $30.5 million, an increase of 46% compared to the second quarter of FY ‘15.

As we've mentioned previously, we report our revenue in three categories, account fees, custodial fees and card fees. Revenue growth continued to show strength in all three categories. Account fee revenue was 48% of total revenue at $14.6 million, representing an increase of 38% compared to Q2 of 2015.

Custodial fee revenue represented 30% of total revenue at $9 million and represented an increase of 52% compared to the year ago period. And card fee revenue represented 22% of total revenue in the quarter at $6.8 million, an increase of 60% compared to last year. Our investment AUM as a percentage of total AUM continued to increase.

At the end of the second quarter of FY ‘16, investment AUM represented 14% of our total AUM and compared favorably to 13% at the end of the same quarter last year. Gross profit for the quarter was $18.6 million compared to $11.8 million last year, an increase of 58%.

Gross margin for the quarter increased from 56% a year ago to 61% in the second quarter of FY ‘16. Income from operations of $7.5 million during the quarter increased 48% year-over-year and generated an operating margin of 25% compared to 24% in the second quarter of FY ‘15.

We generated net income of $4.4 million for the second quarter compared to $3 million in the year ago period. Our non-GAAP adjusted EBITDA for the quarter was $11.1 million compared to $6.9 million in the same period last year. Our GAAP EPS for the quarter was $0.08 per diluted share compared to $0.06 a year ago.

On a pro forma non-GAAP basis, earnings per diluted share was $0.09 for the second quarter of FY ‘16 compared to $0.07 in the prior year. Turning to the balance sheet, as of July 31, 2015, we had $149 million in cash, cash equivalents and marketable securities and no debt.

Now turning to guidance, we’re raising our revenue outlook for FY ‘16 from our previous range of $119 million to $123 million to a range of $120 million to $124 million. We’re maintaining our adjusted EBITDA range of $36 million to $38 million and our pro forma non-GAAP earnings per diluted share range of $0.28 to $0.30 per share.

Our pro forma non-GAAP earnings per diluted share is based on an estimated 60 million diluted weighted average shares outstanding and is calculated by adding back to net income all non-cash stock compensation expense net of tax. We expect total stock compensation net of tax for FY ‘16 to be between $3.5 million and $4 million.

The business outlook for the year ended January 31, 2016 assumes a projected effective income tax rate of approximately 37%. I want to note that while we recorded outstanding gross profit margins in Q2 and are raising our revenue guidance, we’re maintaining our adjusted EBITDA and pro forma non-GAAP EPS outlook for 2016.

With our FY ‘16 pro forma non-GAAP earnings per diluted share guidance between $0.28 and $0.30 per share and accounting for the Q1 and Q2 results, that leaves $0.09 to $0.11 for the second half of FY ‘16 in our guidance range.

As we have discussed in the past, a significant number of new partners and HSA members join our platform during the second half of our fiscal year and particularly in January, concurrent with the start of many benefit plan years.

We experience seasonality in our cost of services in our third and fourth fiscal quarters as we gear up to onboard these new customers. We also accrue sales commissions as new accounts are opened.

In FY ‘15, for example, we recorded approximately $3.5 million in additional account fee costs and $1.5 million in additional sales and marketing costs, in the second half of the year as compared to the first half of the year.

A comparable phenomenon will occur this year with their magnitude influenced by the results of the selling season currently underway. We’re taking two other steps that will have an influence on second-half expenses.

To clear the deck for onboarding season within our service delivery teams, we’re pulling approximately $1 million of card replacement activities forward into Q3 that would otherwise occur in Q4.

To get an early start on a great FY ‘17, we’re accelerating approximately $1 million of technology and development expenses into each of the third and fourth quarters that were previously slated for later on. Now let me turn the call back over to Jon for some closing remarks..

Thank you Darcy. Dr. Neeleman and I are really pleased with the team's performance here today. And a big part of being remarkable as our team is or being purple as we call it, is setting our sights high and always working to improve.

In that spirit at this point in the year, I would like to recognize the work of Ashley's engineers and technologists, who work tirelessly to make what we do for our members better and as Darcy indicated they will be doing more of that work in the remainder of the fiscal year.

As we reach the open enrollment season which is kind of the climax of our year, we really believe that the best is yet to come and look forward to sharing the results with you. Thank you. With that, let's open the call for questions..

[Operator Instructions]. We will take our first question from Lisa Gill with JPMorgan..

I was wondering Jon if we could start with where you are gaining the market share from? You talk about taking market share in the quarter.

Is it penetration within your existing accounts or are you actually taking market share from others?.

I think the short answer is both. Certainly, we’re seeing, we have seen over the last several quarters that we continue to penetrate our employers as well as our health plans, and it would be very difficult for me to gauge whether we're doing that faster than our competitors are doing, but clearly we're doing something right.

And then, as we commented last quarter, we’re taking market share and I think the best evidence of that is the rollover activity which we certainly saw last quarter and saw some of it again this quarter.

That rollover activity is coming from, I think largely from what I might call more conventional legacy banking providers with frankly more limited functionality and limited ability to support the idea of the HSA not as a standalone account or debits and credits and whatnot but really as kind of an integrated component of the consumers’ healthcare experience, particularly in the world of these higher deductible plans.

So I guess that is a long way of saying, both..

Since we have the opportunity to have Ashley on the call today, Ashley, without giving away too many secrets here, can you talk about some of the things that you are working on, on the technology development side where these incremental dollars are going and you talked about analytics to get consumers more engaged.

Can you maybe just give us some example of that and how that translates to your model when you can get the person more engaged?.

Well, I can't really describe a lot of details in the pipeline in this form. I can share the principles that guide that pipeline which have really been the same since before the IPO. We have based our pipeline on the imports of integration and the awareness of the healthcare system in vast and consumers interact with many players.

The value that we bring is our ability to curate these sources and yield a robust set of information to empower consumers to make highly individualized healthcare savings and spending decisions. On the analytics side, Dr. Neeleman mentioned in the earnings call last quarter we’re really just starting to tap into this area.

We believe there's a lot of opportunity to optimize consumer engagement through analytics, and you can see with the vast set of data that we have, there is a lot that we can do to personalize both what and how we present to our consumers to really empower them to make informed healthcare decisions..

And is there a way, either Ashley or Jon, to talk to us how that translates from a business model perspective? Is it those that are more engaged are putting more into their HSA, they utilize it more? How do we think about it from a business perspective?.

It is a great question and I think in short, our experience is that an engaged consumer, and in this case, I think the word engaged is one of those words that gets thrown around a lot, but I think from our perspective, it means a consumer that is paying attention to the money as it goes out the door and the opportunities to save more.

What are the behaviors that consumer engages in that benefit our business? Well first, they tend to spend less, and so those are balances that remain with us, and sometimes that is by not terribly fancy things like actually looking at the bills that are available to view on our system and evaluating whether they actually owe the money and sometimes with our help of course, identifying where maybe errors have been made or where clarification is needed before they pay the doctor.

So, the first thing is they spend less, and then the second thing is that they do tend to save more.

That is to say that these are -- more engaged members are far more likely to see the account as a long-term savings vehicle, far more likely to become investors, and as we have talked about many times, the thing that really drives our profitability as a business is the balances and the accounts filling up, and so engage members are there.

And then lastly, they are stickier members. Obviously, we have had great account retention throughout the base, but the stickiest of the stickiest are people who are really engaged and know what they get from HealthEquity and want to keep getting it.

So those are really three ways in which, ultimately, our ecosystem connectivity really benefits the user. Obviously, it differentiates us among our channel partners when they are determining who they want to work with and that is really important, but I think ultimately from the consumer's perspective, those are the three benefits..

We will take our next question from Peter Costa with Wells Fargo Securities. Please go ahead..

Ashley described some nice vignettes about how you can save money for your members.

Can you talk about your ability to perhaps sometime charge for connecting people through those pipes, and any progress that you have made on the thought process or the ability to charge for that? It clearly helps you with your better account growth but can it drive revenue as well from another source?.

I think Pete, the answer to that question is, we will have to see. At this point, our focus has been -- is and has been on building out the ecosystem and building the pipes that our network partners want us to have and that prove valuable.

Out of that, we’re getting some insight as to the types of services that -- beyond others wanting them to use them, that consumers themselves are saying I like this, this seems really valuable and I think that is where we might focus energies in terms of any further monetization strategies.

So without going into details here, I can certainly see a world where we would want to collaborate even more closely with some of these partners to drive more consumers to the services that are really clicking.

I think the advantage that we have is we have some visibility into not what might hypothetically work based on some calculation of how people might save money.

There is a lot of ways I might save money that I don't do for one reason or another, but rather what is actually working, and so that is where our energy's likely to be as we look for new modernization opportunities by collaborating even more closely with some of these folks..

Looking at your quarter's performance, gross margin was up nicely even sequentially better than last year, it was down sequentially. So you see nice improvement in gross margin, but your G&A was also up a little bit and so that masks some of the improvement that you would have otherwise seen on the bottom line.

With some of the rise in G&A, was that share-based comp or was that some of the tech spending that you talked about increasing for 3Q and 4Q? Did you start that already this quarter? Can you talk about that a little bit more and can you give us exactly the amount again just to make sure I have it on the increased tech spending beyond plan in Q3 and Q4?.

I'll answer the last one first. We said we would spend an extra $1 million in both Q3 and Q4 above current levels is what we’re adding in the technology and development--.

In each quarter?.

In each quarter, correct. On the G&A front, as many of you may be aware, as of July 31 we crossed over to become a large accelerated filer which means we have to be SOX compliant by January 31, 2016, so we have already started and we incurred some of those costs.

There is a lot of compliance work that goes into that to get prepared for that and so some of those costs were started in Q2, Pete and that will continue through the rest of the year..

And then last question, housekeeping, what was the yield on cash AUM in the quarter?.

1.56%, same as the first quarter..

We will take our next question from Greg Peters with Raymond James..

I thought we would step back if you could, Jon and Steve. We've had a little time to digest the Anthem/Cigna announcement and the Aetna/Humana announcement and I'm just curious from your perspective if you see those transactions as being an agent of change for what you are trying to do in the marketplace as you look out going forward..

We haven't hidden Steve away, he's probably listening in from one of our most valuable partners where he is out visiting with them today. So I will take this one. First of all, it is a good question.

I think the first part of the answer is that we see health plan consolidation as, to some extent, validating the premise of the business which is that you are seeing dollars shift from, to some extent, from pure centralized managed care to the consumer.

So consumerization and retailization are one of the reasons that have been cited for this kind of consolidation to be happening and so we certainly see it as evidence that the trends that we see are trends that others are putting lots of dollars at stake on, as well.

Second comment is I think that a practical effect of this consolidation is likely to be that there will be several years where innovative companies of all stripes will have opportunities to move forward because some of our larger brethren generally will be focused on getting these transactions through the regulatory environment and on understanding what the integration environment looks like.

So I think from that perspective, I would generally say whether it is HealthEquity or any number of other companies, there is an increased period of time for us to really prove what we do and I think it is helpful that that coincides with some of the regulatory changes that I know you are aware of that have the potential to drive our business even faster than it is moving forward today.

And then the last comment I would make is I think change is always an age of change.

And that sounds like one of those truisms but it is meant to be slightly more profound than that, in that when people change it does give and we’re already seeing this, it gives employers and individuals a reason to lift their head up from whatever they are doing and evaluate their direction.

So I suspect as folks do that, as we said in the prepared remarks, I think folks who do the math and really step back and think about this really see the kind of thing that we’re doing and then there are others, but certainly what we’re doing as something that is really a win/win/win for everybody involved.

And so to the extent that change causes everyone to step out of their established patterns a little bit, I think it is a good thing.

I don't know whether at a more mundane level, where the net/net will be, on the one hand having more consolidated buyers of some types of healthcare services, but on the other hand having lots of new entrants from the hospital and the ACO as well, that will pan out and I suspect anyone who says they know probably has an ax to grind.

But at a meta level I think change is good when you are an agent of change and certainly we’re..

My second question, I guess, comes in two parts.

Just as we think about your enterprise partners, as you go into the busy enrollment season, has there been any change in the number of RFPs that you have seen on a year-over-year basis or just the structure of the RFPs? And then the second part of this would be compared with the first quarter can you update us on the number of large employers and the number of health plans if there has been any change?.

I will do the second part first. We do that update once a year after the sales cycle is over and we will do it this year in the same fashion after the end of the sale cycle. I'm not going to do quarterly updates on that.

But on the first part of your question, yes, we have seen an increase in RFP activity this year over last and certainly we’re winning our share.

The thing that I want to say to temper that just a little bit is that as you know, whether it is a new employer or a new health plan, there is a period of time around which the adoption at the outset is fairly modest and then for those who really get into this it grows over time.

So more activity, while certainly to date has translated into more accounts, obviously we’re up about 24% year-over-year in terms of new accounts open year to date and that is great. I think that that trend will continue over the course of the year.

What we're not saying is we're getting 50% more RFPs, we're going to get 50% more accounts; it doesn't really work that way..

What about the structure of the RFPs? Are they pretty much cookie-cutter, the same thing you were seeing last year or are these enterprise or prospective enterprise partners changing what they are looking for in the marketplace?.

One of the happy effects of a public offering is you get a certain amount of free publicity. Or to put it differently, you have more people reading the stuff you were putting out in the first place. And so I think one thing that we're seeing is a greater emphasis on integration.

Do you as an HAS provider or what have you, are you going to cost all the people I hire or is everyone going to play in their own little sandbox? Obviously that plays to our strengths.

I think the second factor we’re seeing and this is in part a result of consolidation on the managed care side, is questions about, you talked to my health plan that I have now and their ecosystem friends; what about the next health plan and their ecosystem friends? And both of those things play to our strengths.

I say on the flip side of that in part because you have employers who are new to this and just dipping their toe in the water; that is where you see the true cookie-cutter, here is someone else's RFP, I just put my name on it and sent it to you.

Those are the ones where your view tends to be, I hope I can win it but I will probably have another bite at this apple before this company gets terribly serious about this..

We will take our next question from Sandy Draper with SunTrust Robinson Humphrey..

A lot of the bigger picture ones have been asked, but maybe it's a slightly different spin on that last question, Jon.

When you are looking at going to market and you are selling to an employer who has not had an HAS before, versus someone who maybe has an HAS and is looking for making a switch, how different are those sales? And what are people who are new to the market looking for? Are they just looking to understand HSAs and what is this thing called an HAS? And how does that compare to someone who is looking to actually maybe switch from an existing HAS provider?.

Would be too banal to just say yes? Yes is the answer to your question, they are to some extent looking to dip their toe in the water and understand.

What is interesting is that sometimes what you see is that the folks who are new are -- the reason that they are here has something to do with a broader -- the light has just come on that is, whoa this may be our future, this may be what we’re doing for everyone.

So at the same time they're trying to get their toe in the water, they are also thinking, hey, I might have to jump all the way in at some point, I just do not know when that is.

The result of that is that I think you get questions, whether it is in the RFP context or finalist meetings, that are all over the place and really what we try and do, Sandy, is the benefit that we have is really more specialized experienced than anyone else in the business and a solid reputation for delivering from a service perspective.

And a lot of the job in that setting is to recognize and then have your customer, your would-be customer, recognize that things are going to change, they are going to learn something new, but as a partner we’re going to be there with them.

HealthEquity is not going to come in and out of the HAS business, HealthEquity is not doing the HAS business as a sideline, HealthEquity has been developing this technology and service model for a long time and certainly we put ourselves out there as a public company.

So I think that is somewhat helpful in assuring that kind of customer that I can't say we've reached the stature that IBM once held in terms of you're never going to go wrong hiring HealthEquity from a perception perspective, but we’re getting there. And I think that does help us in the marketplace, particularly with some of the new groups.

That having been said, I always try and have a little salt with the sugar and the salt is when someone is new into this, sometimes they do not really know the questions to ask and they are more susceptible to effective salesmanship and I say that with great respect.

There is a lot less capital required to be an effective sales executive than there is to build the best product in the marketplace and it is a little bit more random.

So there are cases that we do not win and very often we don't win because the next guy has done a better job executing than we have in the sale cycle itself and that is something we need to work on, too..

And then my second question is probably directed towards Ashley and it is a question I know I've asked you, Jon and Steve, but I'd love to hear Ashley's perspective.

When you look at build versus buy in terms of new functionality, new opportunity, new product, Ashley from a technology perspective what are some of the key things that you look at and the swing factors that make you say, hey, this is something we should or absolutely will build here, versus, hey, this is something we can buy and plug in? We would love to the technology perspective to that question.

Thanks..

We definitely are always looking at these decisions.

I think one of the key factors is going to be looking at the offering and where we consider it a parity type offering, that would make sense to be more of a buy decision especially where it is something that is not our core competency, but is someone else's core competency, but those differentiators -- that is where we're really going to focus our innovative efforts and our built efforts..

We will take our next question from Steven Wardell with Leerink Partners..

I’m wondering, are you talking to customers and prospects? Are you hearing back from the field, from the sales force in the field, can you tell us about what you are hearing, how the selling season is going, what is changing in the minds of prospects and clients, what they're thinking about for the coming year and how they are thinking about the coming year -- what is changing for them? Are they bringing up the Cadillac tax with you? Are they talking about expanding use of HSAs?.

First, as you have written, I think we’re hearing greater interest on the part of our partners and would-be partners this year in the exploding universe of consumer applications out there, in what we used to call wellness, but somehow that seems trite now, what we used to call telemedicine, somehow that seems trite now since it has become such a robust field.

I think it helps that in every one of these fields there are multiple providers that are doing this great job and it legitimizes the whole field.

So there is a lot of interest in, for lack of a better term, attacking the demand side of the health expenditure equation and what we can do by having all of us talk to each other better to really leverage the incentives that these HSA-style plans create for individuals to spend less and save more. So that's, I think, theme number one.

And I think that goes along with the concept of integration that I talked about earlier. I think theme number two, you asked about the Cadillac tax.

It is interesting, while certainly it's something we hear about in a funny way and I think we saw this with the ACA generally, HR departments tend to be reactive and while they want to plan ahead and a reasonable person can look at this and say the sooner you steer the ship around the easier it is going to be to do, I think that to some extent all the political back and forth that we all read about every day and will watch on television results in a little bit of inaction.

And so, I think the growth that we’re seeing this year which, already in the first two quarters has been a substantial boost from last year, is really being driven by the basic economics more so than Cadillac tax preparation, although certainly that is something that is in the back of people's minds.

So that's my sense of what we’re hearing and as I commented earlier we have seen a little more, more than a little more, activity this year from an RFP perspective and obviously we’re winning our share of that. And as I've said before, the best result, the best indication of future results is what you have seen to date.

And the nice thing about having a diverse set of distribution channels is we can look at the first couple of quarters and draw conclusions to some extent about how effective things are going in the marketplace.

And I think on that basis we're certainly feeling good about outpacing what we did last year from a sales perspective measure in terms of AUM or accounts or what have you. But we will see..

Can you break out your sales by partner versus direct? About what percent is from partner, like a health plan and what percent is direct? And where you expect the growth to come evenly from those or more from one than the other?.

We tend to be about 50/50. The way we think about it is everything is partnered, but some are enterprise employer partners and then some are through our health plan partners in both the small group and individual market and -- however, they are not even over the course of the year.

In the middle quarters of the year, much more of our growth is coming from the health plan side and that is simply because the larger employers tend to have a January 1 plan year beginning and beginnings and that's where you see a lot of our December/January growth.

So in terms of -- these quarters are an excellent measure of the health of our health plan channel because that is where the accounts come from, both in the small group market, but also in the individual market..

We will take our next question from Randy Reece with Avondale Partners. Please go ahead..

I was first of all impressed with the expense leverage you got in the quarter. I was wondering how you ended up with sales and marketing expenses that were down sequentially and if there is anything that I should read about that because the year-over-year comparison is quite low compared with the revenue growth..

You do not see that every day. I will offer a general comment and then ask Darcy to chime in on some of the specifics. This is something we talk about often.

In our company, we would be happy to deploy every dollar we can in sales and marketing to the point where the incremental dollar has an acceptable return on investors' capital and we think about technology expenditure the same way, but we’re very, very thoughtful about that, at least we think we’re.

And the result of that thinking is we tend to deploy dollars generally where we have relationships built, those partnership relationships we've talked about and we don't tend to put people out on islands because they don't tend to feed themselves and we don't like to subsidize, for lack of a better term, unprofitable sales adventures.

It does bad things for the sales culture from our perspective and generally just doesn't produce good outcomes. So that is our philosophy on it and we will spend whatever we can, but we will be very thoughtful about the incremental return rather than just the average return.

That having been said, Darcy, any specific comments on the quarter?.

Generally, as you have seen historically, Randy, our first and second quarters become fairly predictable. We don't make a lot of changes.

There might be some timing of some of the marketing-type expenses that we did in the first quarter, some of the conferences or things that we participate in get expensed in the first quarter, but nothing materially significant to even point at.

But we do have a very efficient sales organization as you have seen and particularly in our first and second quarters you are going to see that predictability coming forward..

It goes without saying, though I will say it anyway, this is an area of seasonality that has always been embedded in our expectations regarding full year. That is, because a significant component of sales marketing expense is commission and those commissions largely hit in Q4.

As accounts are opened you'll obviously see an increase in that spending over the course of the rest of the year..

And with the increase in technology and development expenses, I want to make sure I understand the implications for future spending levels.

It sounds like you are stepping up sequentially by about $1 million versus the second quarter expense level, but I'm wondering how much we should expect R&D expense, that technology and development line, to grow in FY ‘17 now that you have jacked it up in the second half of FY ‘16..

Why don't we have Darcy talk about the second half of FY ‘16 so we're clear on what we said here, and I will talk a little about what you should I just think about going forward..

You are correct, we were accelerating some of the spend by about $1 million into the third and to the fourth quarter above the levels that we have spent in our second quarter in an effort to be responsive to things that we're seeing in the marketplace that we think that we can go out and fuel it for FY ‘17 and then I will let Jon comment about impact on FY ‘17..

It is kind of the same ROIC discussion as with sales expense, except here and it is important that you understand that, when we spend more money it's typically because either the result is going to be -- ultimately going to be growth in the top line or growth in the margin; that is why we do it. It is not just to put fresh coats of paint on things.

And so I guess the way I would look at this is we feel like the pipeline of potential expenditures in this area and I’m sure almost anyone at HealthEquity would attest to this, is fairly full. We've tried to apply some rigor to it and we've tried to get that Rigor better over the course of the years.

But we felt like we had a full pipeline here and the other thing we have the benefit of is, again, because we have such a wide view of the sales environment with different kinds of distribution, we can look, we use the net promoter system for this, we can look at what our biggest advocates really think we can do better.

And even though we’re still hitting our stride from a sales perspective this year, there are some things we can see that we can do better and we feel like we have the capacity to push some of that forward, so why not do it? And that is really what we’re doing.

As far as what that means go forward, we’re going to make decisions period over period based on where the return is.

I don't think I would look at it either like oh, it's run-rate expense or like it is a bump, a one-time bump, but rather that what we’re communicating is, really our technology organization and our product development team have expanded their capacity to get things done efficiently and effectively.

There are profitable things to do in terms of using shareholders' money and so we’re going to do them. There is no reason to wait and if that is true in Q1 of FY ‘17 or Q2 of FY ‘17, we will do it again..

We will take our next question from Mark Marcon with Robert W. Baird..

With regards to your net promoter score, how is that trending?.

Certainly I know there are a lot of people at HealthEquity who appreciate the question. For those who are not familiar with this net promoter system, one can become an evangelist about just about anything and I always think that whatever the way you measure something is less important than the fact that you measure it and measure it consistently.

So we have adopted net promoter as a framework, a general framework and the key, the way net promoter works is for anyone who's, all of us have heard these surveys, the gist of which end up being how likely are you based on a particular experience to recommend the organization on a 1 to 10 scale? The key observation, statistically speaking, that net promoter people make is that the folks who are giving you the middle scores, 5, 6, 7 and 8, they are not promoters, they are just okay with it.

It is the 9s and 10s that you really want and those are the people who you have to listen to, because they are committed to your success. And they are the ones who know where you can do better. And so that is a way to introduce the topic.

Then, Mark, the best companies in the world at this organizations like USAA that are the gold standard, have net promoter scores at the consumer level in the 70s and low 80s. So do we, and it bounces around a little bit, depending on which product and whatnot, but generally that is where we want to be too and it's generally where we’re.

On the B2B side, scores tend to be a little lower as they should, B2B relationships are little more complicated. But again, the best companies in the world are in the 50s and 60s and so are we. It is not about improving the score. It is about using the data from the survey to maintain the score and so forth, from our perspective.

So what is less important to us than, did I gain a point this quarter, is, what did my promoters, what did my fans, what did the people who really believe and are invested in our success tell us we can do better? And I will give you a real live example of that.

One area where we will be spending money on over the course of the remainder of this year is and then perhaps into next, it is mundane, but it is improving how people access our mobile application. There are, among our population as it turns out and particularly among our population of fans.

We have an overrepresentation of people who use fingerprints and some of the other more sophisticated ways that allow you to access mobile commerce and particularly mobile banking without having to reenter your passwords every time and that is the kind of stuff that they're telling us, hey, we're using the mobile app enough that this is stuff we would like you to do too.

That is not something we would have thought was really critical to our customer base, based solely on the aggregate numbers, but when you listen to your fans and they tell you it is important, then it is important.

And I can name a dozen more of them, some mundane, some truly business-changing in terms of things that our customers would like to buy from us that we don't sell yet that I'm probably not going to share right here. But you get the idea. What's import about net promoter is how we use it.

Our scores are outstanding, but patting ourselves on the back for that is not -- doesn't really change anything, what changes something is using the data to help guide your investments..

And it sounds like that the scores on the whole aren't really changing that much. They have always been quite good. But you are clearly utilizing the information in a way to improve the service..

Yes, I think that is right. You'd love to have 100% of people give you 9s and 10s so you always work towards that. But the way to do it is not by trying to figure out what the person who gave you a 1 thought.

It's by improving on what you do well and that is the statistical observation, really behind a lot of these systems, is that the tendency, certainly of folks like us. I mean let's face it, we like to make people happy just like everyone does, maybe even a little more so and that is how Utah is.

It is easy when someone tells you're not doing something well to focus on that, less than here's a person who believes in the organization that has invested in you, they are telling you do something well, well they already like you, let's move on.

But the real message of the data that underlies this from the marketing profession is, focus on what the people who know you best, know you can do better and then that is what we’re doing..

And with regards to the competitive environment that is out there, you are clearly gaining share, growing much faster than the overall market, but you mentioned earlier on the call, you don't always win on the RFPs.

When you don't win, what would be the primary reason why somebody wouldn't select you?.

I think generally when we don't win RFP, there are and you never want to engage in, I would have wanted if they really looked at it more seriously.

But I think when we don't win, as I said before and I’m sure there is someone listening to this call who this will pain, it is often because somebody outsold us and by that I mean that we had a better solution for that partner's problem, but for whatever reason we weren't as effective at presenting and I'm using that in a broad sense.

If I look at our competitors and I have a genuine both affection and respect for a number of our competitors, maybe not everyone but respect for all of them, affection is maybe a little bit for some. But I think we have the best solution in the marketplace and I think that the market more or less acknowledges that.

Can we do a better job of presenting that more effectively in every case? Yes we can, that is to my view, the biggest issue. When I look beyond that there are things that we see as long-term trends that are really interesting to us and on opportunities, so when you lose something you learn something.

For example, certainly an area that we have responded is people who, while it is still a small percentage of members that see investing as a significant part of the HAS. I think as the partners get more sophisticated they see that coming and so they pay more attention to things like OERs on mutual funds.

And we have some of the best in the business and we have more options than anyone in the business in terms of ways that our health plan and employer partners can offer really low-cost investment options for people who are planning to build a balance here.

And I think what we do stands up to anything in our industry or frankly, the broader retirement industry and that is something that probably two years ago wasn't part of the sales process. Today, maybe two years ago we wouldn't have been as prepared to answer those questions. Today we nail those.

I'm sure there is something that today we’re less prepared for that we will nail next year. I guess that a long way, Mark, of saying I think for the most part when we’re not winning, I see it primarily as an execution issue rather than a structural issue. That having been said, as you know, there is business, there are areas we do not play in.

Just as we tend to win with our health plan partners' small group accounts, we’re, as we said before in this forum, we're not going to die on the hill of a small group that is using one of the health plans that is not a HealthEquity network partner and using someone else who has their own [indiscernible] solution.

That's just not a good use of our sales resources. So perhaps I would be talking about more structural issues if we were deploying our sales resources less efficiently. I don't really know, but that is another way to look at it..

And then with regards to your account gross margins, your account fees are going down as you discussed during the last quarter for the volume reasons, but your gross margin ended up going up materially.

How did you pull that off? Is that partly the efficiency that you are gaining from your IT platform or how should we think about it?.

I’m going to go with yes, as well as we have a really hard-working group of folks on our operations team that are, I think as a group up and down, really committed to continuing to look for better ways to do things and if you look at unit costs per on the account cost side of things which is where most of those operations' costs are those have come down quite a bit.

I don't want to pat myself too hard on the back here. In fact, as Bill will tell you, Bill will be the first to tell you, I have very little to do with it, but we certainly had some tailwinds in the quarter that helped us out as we have had in the past in Q1 and Q2.

But I think the short answer is that you build a platform to scale and although we do have material incremental costs, the platform is scaling and you're seeing that in markets.

Now, I do want to stress, just so we're all on the same page, we have held our value notwithstanding the fact that we have had a really good first half, we're not running around raising our guidance in terms of profitability and that is because the second half, we always see seasonal factors and then Darcy has identified some items here that go beyond, either in terms of timing or totals, the specific seasonal factors.

But the seasonal factors are real. If I look at HealthEquity today, we’re ramping up right now for busy season. Busy season will be upon us within a few weeks. Don't kid yourself in terms of the third and fourth quarter having lower gross margins than the first and second as they have in prior years.

While we don't give quarterly guidance, our annual guidance certainly speaks to the fact that they will..

Just to be clear on the IT, the incremental IT spend, it is basically to address additional opportunities as opposed to. You had the same task that you were trying to get done, but it just became more expensive for whatever reason..

Correct.

This is part of the reason we're telling you about this now, in fact, a big part is it should indicate to you, given that certainly we didn't have these expenses in Q2, that this is a result of affirmative decisions we've made from a planning perspective as opposed to, oops, something is costing us more, we didn't know it was going to cost us more, in retrospect we want to tell you about it.

And that is, I think the way you would want us to act so that is what we’re doing..

I would just add to Jon's comment on the profitability year-over-year. We have had some net margin performance improvement year-over-year by about 5 bps and when you get over $2 billion that makes a meaningful difference there.

And as Jon said, the first half of the year we've had a significant improvement in just the efficiency of our service delivery organization, notwithstanding the fact that we probably had about a 5% year-over-year decrease in admin or account fee revenue per custodial account.

And we've talked about this on prior calls and I will reiterate it, that there is a trade-off that happens between account fees and custodial fees that we’re very cognizant of and we'll be very mindful of as we look at those two components of revenue, but we certainly believe as our marching orders are to build health savings that building health savings is what is going to grow that custodial line more than anything else..

Couldn't have said it better myself..

And our final question will come from Greg Peters with Raymond James..

I just wanted to follow up and just see if you had a view on some of these other emerging technology-driven benefit intermediaries. We're hearing noise about this company, Zenefits, there has been a bunch of capital that has been infused in that organization.

I'm just curious if you have a perspective on those types of platforms and how they might intersect, obviously with HealthEquity?.

I guess my short answer is I don't really have a view that I think would be truly informed and appropriate to share here. We’re going to work with anyone who is helping our partners and members do things right.

If the Zenefits guys, whether it is Zenefits on one end or the folks trying to do track the question by monitoring your cell phone on the other end if I sort of think of the two ends, one a very benefits and administration oriented and the other consumer, about solving in a rather unorthodox way a consumer problem, we don't discriminate.

We’re equal opportunity integrators. And we're going to work with people who will help our members and partners do what they need to do which is to navigate this transition to first dollar consumer responsibility and long-term health savings and we will work with anyone who is able to get that job done. I do not have any particular comment.

There are plenty of other people that have commented on the Zenefits business model, I'm not sure I can add to that..

Darcy, one last cleanup, I know you said 156 basis point average yield that didn't change from the first quarter.

Is there anything in the environment that is leading you to have a changed perspective on that for the balance of the year or next year?.

No, not at this time..

We have no further questions in the queue..

Thank you, everybody. Have a great evening and I hope everyone had a great summer. We're all heading back to work here..

Ladies and gentlemen, this concludes today's conference. We appreciate your participation..