20150930 Q3

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

__________________________________________________________

FORM 10-Q

__________________________________________________________

 

 

 

 

 

(Mark One)

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

 

For the quarterly period ended September 30, 2015

 

OR

 

 

 

 

 

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

 

For the transition period from____________   to  ____________

 

Commission File Number: 001-35232

__________________________________________________________

WAGEWORKS, INC.

(Exact name of Registrant as specified in its charter)

__________________________________________________________

 

 

 

 

 

 

 

Delaware

 

94-3351864

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

 

 

San Mateo, California

 

 

1100 Park Place, 4th Floor

San Mateo, California

(Address of principal executive offices

 

94403

(Zip Code)

 

(650) 577-5200

(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       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       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.

 

 

 

 

 

 

 

 

 

 

Large accelerated filer

 

  

Accelerated filer

 

 

 

 

 

Non-accelerated filer

 

  (Do not check if a smaller reporting company)

  

Smaller reporting company

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes      No  

 

As of October 29, 2015, there were 35,942,492 shares of the registrant’s common stock outstanding. 

 

 

 

 

 


 

 

WAGEWORKS, INC.

FORM 10-Q QUARTERLY REPORT

Table of Contents

 

 

 

 

 

 

 

 

 

Page No.

 

PART I. FINANCIAL INFORMATION

 

Item 1. 

Financial Statements

3

 

Consolidated Balance Sheets as of December 31, 2014 and September 30, 2015

3

 

Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2014 and 2015

4

 

Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2015

5

 

Notes to Consolidated Financial Statements

6

Item 2. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

Item 3. 

Quantitative and Qualitative Disclosures About Market Risk

30

Item 4. 

Controls and Procedures

30

 

PART II. OTHER INFORMATION

 

Item 1. 

Legal Proceedings

31

Item 1A. 

Risk Factors

31

Item 2. 

Unregistered Sales of Equity Securities and Use of Proceeds

43

Item 6. 

Exhibits

43

 

Signatures

44

 

 

 

 

 

2

 


 

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PART I.     FINANCIAL INFORMATION

Item 1. Financial Statements

WAGEWORKS, INC.

Consolidated Balance Sheets

(In thousands, except per share amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2014

 

September 30, 2015

 

Derived from

 

 

 

 

Audited Financial

 

 

 

 

Statements

 

(unaudited)

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

$

413,301 

 

$

477,992 

Restricted cash

 

332 

 

 

332 

Accounts receivable, net

 

54,453 

 

 

62,085 

Deferred tax assets - current

 

11,006 

 

 

5,755 

Prepaid expenses and other current assets

 

14,215 

 

 

15,428 

Total current assets

 

493,307 

 

 

561,592 

Property and equipment, net

 

39,137 

 

 

49,493 

Goodwill

 

157,109 

 

 

157,109 

Acquired intangible assets, net

 

94,776 

 

 

86,422 

Deferred tax assets

 

699 

 

 

75 

Other assets

 

9,687 

 

 

4,305 

Total assets

$

794,715 

 

$

858,996 

Liabilities and Stockholders' Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued expenses

$

54,285 

 

$

61,981 

Customer obligations

 

362,451 

 

 

390,403 

Short-term contingent payment

 

3,180 

 

 

727 

Other current liabilities

 

11,924 

 

 

957 

Total current liabilities

 

431,840 

 

 

454,068 

Long-term debt

 

79,219 

 

 

79,016 

Long-term contingent payment, net of current portion

 

695 

 

 

 —

Other non-current liabilities

 

3,537 

 

 

4,239 

Total liabilities

 

515,291 

 

 

537,323 

Stockholders' Equity:

 

 

 

 

 

Common stock, $0.001 par value. Authorized 1,000,000 shares; issued 35,479 shares at December 31, 2014 and 35,932 shares at September 30, 2015

 

36 

 

 

36 

Additional paid-in capital

 

303,568 

 

 

329,062 

Accumulated deficit

 

(24,180)

 

 

(7,425)

Total stockholders’ equity

 

279,424 

 

 

321,673 

Total liabilities and stockholders’ equity

$

794,715 

 

$

858,996 

 

 

 

 

 

 

 

 

 

 

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

 

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WAGEWORKS, INC.

Consolidated Statements of Income

(In thousands, except per share amounts)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

2014

 

2015

 

2014

 

2015

Revenues:

 

 

 

 

 

 

 

 

 

 

 

Healthcare

$

38,600 

 

$

42,204 

 

$

116,176 

 

$

133,307 

Commuter

 

15,078 

 

 

16,003 

 

 

46,171 

 

 

47,928 

COBRA

 

9,544 

 

 

12,229 

 

 

17,283 

 

 

37,112 

Other

 

4,776 

 

 

12,724 

 

 

9,745 

 

 

32,866 

Total revenue

 

67,998 

 

 

83,160 

 

 

189,375 

 

 

251,213 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues (excluding amortization of internal use software)

 

24,951 

 

 

26,364 

 

 

68,905 

 

 

88,210 

Technology and development 

 

8,242 

 

 

11,560 

 

 

18,739 

 

 

33,928 

Sales and marketing 

 

12,059 

 

 

12,824 

 

 

30,758 

 

 

38,445 

General and administrative 

 

10,470 

 

 

12,875 

 

 

30,941 

 

 

39,559 

Amortization and change in contingent consideration

 

5,688 

 

 

6,935 

 

 

14,657 

 

 

19,946 

Employee termination and other charges

 

 —

 

 

(112)

 

 

 —

 

 

1,968 

Total operating expenses

 

61,410 

 

 

70,446 

 

 

164,000 

 

 

222,056 

Income from operations

 

6,588 

 

 

12,714 

 

 

25,375 

 

 

29,157 

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

 

66 

 

 

 

 

85 

Interest expense

 

(499)

 

 

(339)

 

 

(1,010)

 

 

(1,523)

Other income (expense)

 

713 

 

 

(8)

 

 

737 

 

 

280 

Income before income taxes

 

6,803 

 

 

12,433 

 

 

25,105 

 

 

27,999 

Income tax provision

 

(2,690)

 

 

(4,835)

 

 

(9,961)

 

 

(11,244)

Net income

$

4,113 

 

$

7,598 

 

$

15,144 

 

$

16,755 

Basic net income per share

$

0.12 

 

$

0.21 

 

$

0.43 

 

$

0.47 

Diluted net income per share

$

0.11 

 

$

0.21 

 

$

0.42 

 

$

0.46 

Shares used in basic net income per share calculations

 

35,234 

 

 

35,880 

 

 

35,062 

 

 

35,733 

Shares used in diluted net income per share calculations

 

36,152 

 

 

36,516 

 

 

36,267 

 

 

36,595 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

 

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WAGEWORKS, INC.

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine Months Ended September 30,

 

2014

 

2015

Cash flows from operating activities:

 

 

 

 

 

Net income

$

15,144 

 

$

16,755 

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

 

 

 

 

 

Depreciation

 

2,864 

 

 

4,810 

Amortization and change in contingent consideration

 

14,657 

 

 

19,946 

Stock-based compensation

 

10,012 

 

 

14,674 

Loss on disposal of fixed assets

 

14 

 

 

519 

Provision for doubtful accounts

 

(441)

 

 

220 

Deferred taxes

 

8,267 

 

 

10,577 

Excess tax benefit from the exercise of stock options

 

(7,706)

 

 

(5,260)

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(10,907)

 

 

(7,852)

Prepaid expenses and other current assets

 

(5,256)

 

 

(512)

Other assets

 

(2,608)

 

 

2,225 

Accounts payable and accrued expenses

 

480 

 

 

6,953 

Customer obligations

 

(514)

 

 

27,952 

Other liabilities

 

(1,055)

 

 

(1,172)

Net cash provided by operating activities

 

22,951 

 

 

89,835 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(11,628)

 

 

(24,200)

Cash consideration for business acquisitions, net of cash acquired

 

(44,314)

 

 

(9,445)

Change in restricted cash

 

(1)

 

 

 —

Net cash used in investing activities

 

(55,943)

 

 

(33,645)

Cash flows from financing activities:

 

 

 

 

 

Proceeds from debt

 

49,663 

 

 

 —

Proceeds from exercise of common stock options

 

4,726 

 

 

4,695 

Proceeds from issuance of common stock (Employee Stock Purchase Plan)

 

1,776 

 

 

1,793 

Payment of contingent consideration

 

(4,485)

 

 

(3,247)

Excess tax benefit from the exercise of stock options

 

7,706 

 

 

5,260 

Net cash provided by financing activities

 

59,386 

 

 

8,501 

Net increase in cash and cash equivalents

 

26,394 

 

 

64,691 

Cash and cash equivalents at beginning of period

 

359,958 

 

 

413,301 

Cash and cash equivalents at end of period

$

386,352 

 

$

477,992 

Supplemental cash flow disclosure:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

    Interest

$

866 

 

$

2,079 

    Taxes

 

696 

 

 

822 

Supplemental disclosure of non-cash investing activities:

 

 

 

 

 

    Accrued capital expenditures

 

900 

 

 

371 

 

 

 

 

 

 

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

 

 

 

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(1)     Summary of Business and Significant Accounting Policies

 

Business

 

WageWorks, Inc., or the Company, is a leader in administering Consumer-Directed Benefits, or CDBs, which empower employees to save money on taxes while also providing corporate tax advantages for employers. The Company is solely dedicated to administering CDBs, including pre-tax spending accounts such as health and dependent care Flexible Spending Accounts, or FSAs, Health Savings Accounts, or HSAs, Health Reimbursement Arrangements, or HRAs, as well as commuter benefit services, including transit and parking programs, wellness programs, COBRA and other employee spending account benefits, in the United States.

 

The Company delivers its CDB programs through a highly scalable delivery model that employer clients and their employee participants may access through a standard web browser on any internet-enabled device, including computers, smart phones and other mobile devices such as tablet computers. The Company’s on-demand delivery model eliminates the need for its employer clients to install and maintain hardware and software in order to support CDB programs and enables the Company to rapidly implement product enhancements across the Company’s entire user base.

 

The Company’s CDB programs assist employees and their families in saving money by using pre-tax dollars to pay for certain of their healthcare, dependent care and commuter expenses. Employers financially benefit from the Company’s programs through reduced payroll taxes, even after factoring in the Company’s fees. Under the Company’s FSA, HSA and commuter programs, employee participants contribute funds from their pre-tax income to pay for qualified out-of-pocket healthcare expenses not fully covered by insurance, such as co-pays, deductibles and over-the-counter medical products or for commuting costs. Under the Company’s HRA programs, employer clients provide their employee participants with a specified amount of available reimbursement funds to help their employee participants defray out-of-pocket medical expenses such as deductibles, co-insurance and co-payments. All amounts paid by the employer into HRAs are deductible by the employer as an ordinary business expense and are tax-free to the employee.

 

The Company operates as a single reportable segment on an entity level basis. The Company generates revenue from the administration of healthcare, commuter, COBRA and other employer sponsored tax-advantaged benefit services. The entity level is the aggregation of these four revenue streams.

 

 

Basis of Presentation

 

In the opinion of the Company’s management, the unaudited interim consolidated financial statements and condensed notes have been prepared on the same basis as the audited consolidated financial statements and reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (GAAP). The results of the interim period presented herein are not necessarily indicative of the results of future periods or annual results for the year ending December 31, 2015.

 

These unaudited interim consolidated financial statements and condensed notes should be read in conjunction with the December 31, 2014 audited financial statements and related notes, together with management’s discussion and analysis of financial condition and results of operations, included in the Company’s Annual Report on Form 10-K. The December 31, 2014 consolidated balance sheet included in this interim Quarterly Report on Form 10-Q was derived from audited financial statements.

 

There have been no changes in the Company’s significant accounting policies from those that were disclosed in the Company’s audited consolidated financial statements for the fiscal year ended December 31, 2014 included in the Company’s Annual Report on Form 10-K.

 

 

Principles of Consolidation

 

The unaudited consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. 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 accounts and transactions have been eliminated in consolidation.

 

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates in these consolidated

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financial statements include allowances for doubtful accounts, estimates of future cash flows associated with assets, asset impairments, useful lives for depreciation and amortization, loss contingencies, expired and unredeemed products, deferred tax assets, reserve for income tax uncertainties, the assumptions used for stock-based compensation, the assumptions used for software and web site development cost classification, and the assumptions used to fair value contingent consideration associated with acquisitions and purchase accounting. Actual results could differ from those estimates. In making its estimates, the Company considers the current economic and legislative environment in the estimates and has considered those factors when reviewing the assumptions and estimates.

 

 

Fair Value of Financial Instruments

 

Financial Accounting Standards Board (FASB) ASC 820, Fair Value Measurements and Disclosures, or ASC 820, provides a consistent framework to define, measure, and disclose the fair value of assets and liabilities in financial statements. ASC 820 establishes a three-level hierarchy priority for disclosure of assets and liabilities recorded at fair value. The ordering of priority reflects the degree to which objective prices in external active markets are available to measure fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable.

 

The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible. The Company determines fair value based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market. When considering market participant assumptions in fair value measurements, the following fair value hierarchy distinguishes between observable and unobservable inputs, which are categorized in one of the following levels:

·

Level 1 Inputs: Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the reporting entity at the measurement date.

·

Level 2 Inputs: Other than quoted prices included in Level 1 inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability.

·

Level 3 Inputs: Unobservable inputs for the asset or liability used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at measurement date.

 

The contingent consideration payables related to the acquisitions of Benefit Concepts, Inc. (BCI) and Crosby Benefit Systems, Inc. (CBS), are recorded at fair value on the acquisition date and are adjusted quarterly to fair value. The increases or decreases in the fair value of contingent consideration payable can result from changes in anticipated revenue levels and changes in assumed discount periods and rates. As the fair value measure is based on significant inputs that are not observable in the market, it is categorized as Level 3.

 

Other financial instruments not measured at fair value on the Company’s unaudited consolidated balance sheet at September 30, 2015, but which require disclosure of their fair values include: cash and cash equivalents (including restricted cash), accounts receivable, accounts payable and accrued expenses and debt under the line of credit with certain lenders.  The estimated fair value of such instruments at September 30, 2015 approximates their carrying value as reported on the consolidated balance sheet. The fair value of all of these instruments are categorized as Level 2 of the fair value hierarchy, with the exception of cash and cash equivalents, which is categorized as Level 1 due to its short term nature.

 

The following table provides a reconciliation between the beginning and ending balances of items measured at fair value on a recurring basis that used significant unobservable inputs (Level 3) (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Contingent

 

Contingent

   

Consideration

 

Consideration

 

BCI

 

CBS

Balances at December 31, 2014

 

2,705 

 

 

1,170 

Gains or losses included in earnings:

 

 

 

 

 

Losses on revaluation of contingent consideration

 

92 

 

 

Payment of contingent consideration

 

(2,070)

 

 

(1,177)

Balances at September 30, 2015

$

727 

 

$

 —

 

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The remaining contingent consideration for CBS was paid in the third quarter of 2015, while for BCI the remaining balance will be paid in first quarter of 2016.

 

The Company measures contingent consideration elements each reporting period at fair value and recognizes changes in fair value in earnings each period in the amortization and change in contingent consideration line item on the consolidated statements of income, until the contingency is resolved. Losses on revaluation of contingent consideration result from accretion charges due to the passage of time and fair value adjustments due to changes in forecasted revenue levels. 

 

The Company recorded $0.1 million and an immaterial charge for the three months ended September 30, 2014 and 2015, respectively. The Company recorded $0.2 million and $0.1 million charge for the nine months ended September 30, 2014 and 2015, respectively.

   

Quantitative Information about Level 3 Fair Value Measurements

 

The significant unobservable inputs used in the fair value measurement of the Company’s contingent consideration designated as Level 3 are as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value at

 

Valuation

 

Significant Unobservable

 

 

September 30, 2015

 

Technique

 

Input

 

 

(in thousands)

 

 

 

 

Contingent consideration - BCI

 

$727

 

Discounted cash flow

 

Annualized revenue and probability of achievement

 

 

Sensitivity to Changes in Significant Unobservable Inputs

 

As presented in the table above, the significant unobservable inputs used in the fair value measurement of contingent consideration related to the acquisitions are annualized revenue forecasts developed by the Company’s management and the probability of achievement of those revenue forecasts. Significant increases/decreases in these unobservable inputs in isolation would result in a significantly higher/lower fair value measurement.

 

CONEXIS Acquisition

 

The holdback obligation of $10.0 million related to the CONEXIS acquisition in 2014, classified in the other current liabilities item in the consolidated balance sheet, was settled during the three months ended September 30, 2015 for $9.4 million after working capital adjustments.

 

Recently Issued Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers, or ASU 2014-09, which clarifies existing accounting literature relating to how and when a company recognizes revenue. Under ASU 2014-09, a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods and services. Additionally, the guidance requires improved disclosures to help users of financial statements better understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new standard allows for either a full retrospective or a modified retrospective transition method. In July 2015, the FASB deferred the effective date for annual reporting periods beginning after December 15, 2017 (including interim reporting periods within those periods) in ASU 2015-14. Early adoption is permitted to the original effective date of December 15, 2016 (including interim reporting periods within those periods). The Company is in the process of determining what impact, if any, the adoption of this ASU will have on its consolidated financial statements and related disclosures.

 

In April 2015, the FASB issued Accounting Standards Update 2015-03, Simplifying the Presentation of Debt Issuance Costs, or ASU 2015-03, which changes the presentation of debt issuance costs in financial statements. ASU 2015-03 requires an entity to present such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs will continue to be reported as interest expense. It is effective for annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect this ASU will have a material change to its consolidated financial statements and related disclosures.

 

In April 2015, the FASB issued Accounting Standards Update No. 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement, or ASU 2015-05. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should

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account for the software license element of the arrangement consistent with the acquisition of other software license. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The guidance will not change GAAP for a customer's accounting for service contracts. The Company is currently assessing what impact, if any, of adopting this ASU will have on its consolidated financial statements and related disclosures.

 

In September 2015, the FASB issued Accounting Standards Update No. 2015-16,  Simplifying the Accounting for Measurement-Period Adjustments, or ASU 2015-16. ASU 2015-16 provides guidance that eliminates the requirement to restate prior period financial statements for measurement period adjustments following a business combination. The new guidance requires that the cumulative impact of a measurement period adjustment (including the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. The prior period impact of the adjustment should be either presented separately on the face of the income statement or disclosed in the notes. The Company will adopt the ASU for all future business combination that have measurement period adjustments.

 

 

 

(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 September 30,

 

Nine Months Ended September 30,

 

2014

 

2015

 

2014

 

2015

Numerator (basic and diluted):

 

 

 

 

 

 

 

 

 

 

 

Net income

$

4,113 

 

$

7,598 

 

$

15,144 

 

$

16,755 

Denominator (basic):

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

35,234 

 

 

35,880 

 

 

35,062 

 

 

35,733 

Denominator (diluted):

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

35,234 

 

 

35,880 

 

 

35,062 

 

 

35,733 

Dilutive stock options and other

 

918 

 

 

636 

 

 

1,205 

 

 

862 

Diluted weighted average common shares outstanding

 

36,152 

 

 

36,516 

 

 

36,267 

 

 

36,595 

Net income per share:

 

 

 

 

 

 

 

 

 

 

 

Basic

$

0.12 

 

$

0.21 

 

$

0.43 

 

$

0.47 

Diluted

$

0.11 

 

$

0.21 

 

$

0.42 

 

$

0.46 

 

Diluted net income per share does not include the effect of the following anti-dilutive common equivalent shares (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

2014

 

2015

 

2014

 

2015

Stock options outstanding

1,063 

 

1,419 

 

1,158 

 

944 

 

 

 

 

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(3)     Intangible Assets

 

 

Acquired intangible assets at December 31, 2014 and September 30, 2015 were comprised of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2014

 

September 30, 2015

 

Gross

 

 

 

 

 

 

 

Gross

 

 

 

 

 

 

 

carrying

 

Accumulated

 

 

 

 

carrying

 

Accumulated

 

 

 

 

amount

 

amortization

 

Net

 

amount

 

amortization

 

Net

Amortizable intangible assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Client contracts and broker relationships

$

120,723 

 

$

33,885 

 

$

86,838 

 

$

123,879 

 

 

43,437 

 

$

80,442 

Trade names

 

3,880 

 

 

1,657 

 

 

2,223 

 

 

3,880 

 

 

2,218 

 

 

1,662 

Technology

 

13,846 

 

 

9,390 

 

 

4,456 

 

 

13,846 

 

 

10,658 

 

 

3,188 

Noncompete agreements

 

2,232 

 

 

1,798 

 

 

434 

 

 

2,232 

 

 

1,852 

 

 

380 

Favorable lease

 

1,137 

 

 

312 

 

 

825 

 

 

1,137 

 

 

387 

 

 

750 

Total

$

141,818 

 

$

47,042 

 

$

94,776 

 

$

144,974 

 

$

58,552 

 

$

86,422 

 

 

 

Amortization expense for acquired intangible assets totaled $3.4 million and $3.9 million for the three months ended September 30, 2014 and 2015, respectively. Amortization expense for acquired intangible assets totaled $7.8 million and $11.5 million for the nine months ended September 30, 2014 and 2015, respectively. 

 

The estimated expected amortization expense in future periods is as follows (dollars in thousands):

 

 

 

 

 

 

 

 

 

Remainder of 2015

$

4,183 

2016

 

15,868 

2017

 

15,314 

2018

 

12,144 

2019

 

11,584 

Thereafter

 

27,329 

Total

$

86,422 

 

(4)     Accounts Receivable

 

Accounts receivable at December 31, 2014 and September 30, 2015 were comprised of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

 

September 30,

 

2014

 

2015

Trade receivables

$

35,762 

 

$

38,429 

Unpaid amounts for benefit services

 

19,458 

 

 

24,643 

 

 

55,220 

 

 

63,072 

Less allowance for doubtful accounts

 

(767)

 

 

(987)

Accounts receivable, net

$

54,453 

 

$

62,085 

 

 

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(5)     Property and Equipment

 

Property and equipment at December 31, 2014 and September 30, 2015 were comprised of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

 

September 30,

 

2014

 

2015

Computers and equipment

$

13,670 

 

$

14,478 

Software and software development costs

 

77,104 

 

 

90,343 

Furniture and fixtures

 

3,306 

 

 

3,272 

Leasehold improvements

 

8,285 

 

 

16,011 

 

$

102,365 

 

$

124,104 

Less accumulated depreciation and amortization

 

(63,228)

 

 

(74,611)

Property and equipment, net

$

39,137 

 

$

49,493 

 

In the nine months ended September 30, 2015, the Company capitalized software development costs of $12.4 million. In the three months ended September 30, 2014 and 2015, the Company amortized $2.2 million and $3.0 million of capitalized software development costs, respectively. In the nine months ended September 30, 2014 and 2015, the Company amortized $6.5 million and $8.3 million of capitalized software development costs, respectively. These costs are included in amortization and change in contingent consideration in the accompanying consolidated statements of income. At September 30, 2015, the unamortized software development costs included in property and equipment in the accompanying consolidated balance sheet was $28.1 million.

 

Total depreciation expense, including amortization of capitalized software development costs, in the three months ended September 30, 2014 and 2015 was $3.5 million and $4.7 million, respectively and $9.4 million and $13.1 million in the nine months ended September 30, 2014 and 2015, respectively.

  

 

(6)     Accounts Payable and Accrued Expenses

 

Accounts payable and accrued expenses at December 31, 2014 and September 30, 2015 were comprised of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

 

September 30,

 

2014

 

2015

Accounts payable

$

1,180 

 

$

2,240 

Payable to benefit providers and transit agencies

 

19,500 

 

 

23,370 

Accrued payables

 

11,099 

 

 

14,124 

Accrued compensation and related benefits

 

16,045 

 

 

17,534 

Other accrued expenses

 

3,156 

 

 

1,831 

Deferred revenue

 

3,305 

 

 

2,882 

Accounts payable and accrued expenses

$

54,285 

 

$

61,981 

 

 

 

(7)     Long-term debt

 

On June 5, 2015, the Company entered into an Amended and Restated Credit Agreement with certain lenders, including MUFG Union Bank, N.A., as administrative agent. With a $15.0 million subfacility for the issuance of letters of credit, the amendment provides for a $150.0 million revolving credit facility, an increase from the previous aggregate principal amount of $125.0 million the Company could borrow. The amendment also contains an increase option permitting the Company to arrange with existing lenders and/or new lenders to provide up to an aggregate of $100.0 million in additional commitments. The amendment extended the term of the credit facility from July 21, 2017 to June 5, 2020 and reduced the margin added to LIBOR. The margin added to LIBOR rate is now in a range of 125 to 175 basis points, down from a range of 175 to 225 basis points. The interest rate applicable to the revolving credit facility as of September 30, 2015 is 1.70%. The Company incurred fees of approximately $0.3 million in connection with the Amended and Restated Credit Agreement, which are being amortized over the term of the amendment. As of September 30, 2015, the Company had $79.6 million outstanding under the credit facility.

 

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Amounts borrowed, outstanding letters of credit and amounts available to borrow, were as follows (dollars in thousands):

 

 

 

 

 

 

 

 

 

December 31,

 

September 30,

 

2014

 

2015

Amounts borrowed

$

79,600 

 

$

79,600 

Outstanding letters of credit

 

3,182 

 

 

2,950 

Amounts available to borrow (1) 

 

42,218 

 

 

67,450 

 

(1)

Excluding $100 million increase option

 

As collateral, the Company’s obligations are secured by substantially all of the Company’s assets. All of the Company’s material existing and future subsidiaries are required to guaranty the Company’s obligations under the credit facility. Such guarantees by existing and future material subsidiaries are and will be secured by substantially all of the property of such material subsidiaries.

 

The credit facility contains customary affirmative and negative covenants and also has financial covenants relating to a liquidity ratio, a consolidated leverage ratio and an interest coverage ratio. The Company is obligated to pay customary commitment fees and letter of credit fees for a facility of this size and type. The Company is currently in compliance with all financial and non-financial covenants under the credit facility.

The credit facility contains customary events of default, including, among others, payment defaults, covenant defaults, inaccuracy of representations and warranties, cross-defaults to other material indebtedness, judgment defaults, a change of control default and bankruptcy and insolvency defaults.  Under certain circumstances, a default interest rate will apply on all obligations during the existence of an event of default under the loan agreement at a per annum rate of interest equal to 2.00% above the applicable interest rate. Upon an event of default, the lenders may terminate the commitments, declare the outstanding obligations payable by the Company to be immediately due and payable and exercise other rights and remedies provided for under the credit facility.

 

(8)     Organizational Efficiency Plan

 

During the second quarter of 2015, the Company integrated operations and consolidated certain positions resulting in employee headcount reductions. The Company continually evaluates ways to improve business processes to ensure that operations align with its strategy and vision for the future. In the three months ended September 30, 2015, the Company recorded a $0.1 million credit to employee termination costs. This credit is a result of unused and expired outplacement services which were offered to impacted employees. In the nine months ended September 30, 2015, the Company recognized charges in operating expenses of $2.0 million, primarily for severance costs. The Company has recorded these severance costs within accrued compensation and related benefits in the accompanying consolidated balance sheet. 

 

Changes in the Company’s accrued liabilities for workforce reduction costs in the nine months ended September 30, 2015 were as follows (dollars in thousands):

 

 

 

 

 

September 30,

 

2015

Beginning balance

$

 —

Employee termination and other charges

 

1,968 

Cash paid

 

(1,564)

Ending balance

$

404 

 

 

 

The accrued liability for employee termination costs will substantially be settled by the end of 2015.

 

(9)     Employee Benefit Plans 

 

Employee Stock Option Plan

 

The Company’s stock option program is a long-term retention program that is intended to attract, retain, and provide incentives for talented employees, officers, and directors, and to align stockholder and employee interests. The Company considers its option program critical to its operation and productivity.

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The following table summarizes the weighted-average fair value of stock options granted during the period:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

2014

 

2015

 

2014

 

2015

Stock options granted (in thousands)

 

55 

 

 

413 

 

 

988 

 

 

464 

Weighted average fair value at date of grant

$

18.95 

 

$

18.70 

 

$

19.76 

 

$

19.09 

 

 

 

Stock option activity for the nine months ended September 30, 2015 is as follows (shares in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Remaining

 

Aggregate intrinsic

 

 

 

Weighted average

 

contractual term

 

value (dollars in

 

Shares

 

exercise price

 

(years)

 

thousands)

Outstanding at December 31, 2014

3,206 

 

$

20.90 

 

6.75 

 

$

140,029 

Granted

464 

 

 

49.24 

 

 

 

 

 

Exercised

(354)

 

 

13.25 

 

 

 

 

 

Forfeited

(155)

 

 

38.84 

 

 

 

 

 

Outstanding as of September 30, 2015

3,161 

 

$

25.03 

 

6.51 

 

$

67,636 

Vested and expected to vest at September 30, 2015

3,067 

 

$

24.52 

 

6.44 

 

$

67,066 

Exercisable at September 30, 2015

1,984 

 

$

15.05 

 

5.14 

 

$

60,512 

 

 

 

As of September 30, 2015, there was $19.7 million of total unrecognized compensation cost related to unvested stock options which are expected to vest. The cost is expected to be recognized over a weighted average period of approximately 2.85 years as of September 30, 2015.

 

The weighted average assumptions used in the Black-Scholes option pricing model to value option grants during the three and nine months ended September 30, 2014 and 2015 were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

2014

 

2015

 

2014

 

2015

Expected volatility

45.12% 

 

43.43% 

 

46.97% 

 

43.49% 

Risk-free interest rate

1.89% 

 

1.55% 

 

1.87% 

 

1.55% 

Expected term (in years)

6.25 

 

4.74 

 

6.08 

 

4.74 

Dividend yield

—%

 

—%

 

—%

 

—%

 

Stock-based compensation cost is measured at the grant date based on the fair value of the award. The determination of the fair value of stock-based awards 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 peer publicly traded companies as well as the Company’s own historical volatility. The Company expects that it will increase weighting of its own historical data in future periods, as that 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 of the options. The dividend yield of zero is based on the fact that the Company expects to invest cash in operations and has never paid cash dividends on common stock. The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as evidenced by changes to the terms of its stock-based awards.

 

 

Restricted Stock Units

 

The Company grants restricted stock units to certain employees, officers, and directors under the 2010 Equity Incentive Plan. Restricted stock units vest upon performance-based, market-based or service-based criteria.

 

Performance-based restricted stock units vest based on the satisfaction of specific performance criteria. At each vesting date, the holder of the award is issued shares of the Company’s common stock. Compensation expense from these awards is equal to the fair market value of the Company’s common stock on the date of grant and is recognized over the remaining service period based on the probable outcome of achievement of the financial metrics. Management’s estimate of the number of shares expected to vest is based on the anticipated achievement of the specified performance criteria.

 

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Market-based performance restricted stock units are granted such that they vest upon the achievement of certain per share price targets of the Company’s common stock during a specified performance period. The fair market values of market-based performance restricted stock units are determined using the Monte Carlo simulation method. The Monte Carlo simulation method is subject to variability as several factors utilized must be estimated including the future daily stock price of the Company’s common stock over the specified performance period, the Company’s stock price volatility and risk-free interest rate. The amount of compensation expense is equal to the per share fair value calculated under the Monte Carlo simulation multiplied by the number of market-based performance restricted stock units granted, recognized over the specified performance period.

 

Generally, service-based restricted stock units vest over four years with 25% vesting after one year and the balance vesting monthly over the remaining period. Compensation expense is recognized over the requisite service period.

 

In the first quarter of 2015, the Company granted a total of 140,000 performance-based restricted stock units to certain executive officers. Performance-based restricted stock units are typically granted such that they vest upon the achievement of certain revenue growth rates, and other financial metrics, during a specified performance period for which participants have the ability to receive up to 150% of the target number of shares originally granted.

 

The restricted stock units will be eligible to vest based on the Company’s achievement against an average annual EBITDA margin target equal to or greater than 22% and compound revenue growth target for the specified performance period.

 

The following table describes the levels of revenue growth target for the specified performance period for the restricted stock units to vest:

 

 

 

Achievement of Revenue Growth Objective

Percentage of RSU Vesting

20% and Greater

150% will vest

Between 15% but less than 20%

Between 100% and 150% will vest

Between 10% but less than 15%

Between 50% and 100% will vest

Below 10%

None will vest

 

In the second quarter of 2014, the Company granted a total of 199,000 market-based performance restricted stock units to certain executive officers. The number of shares to be vested is subject to change based on certain market conditions.  In the third quarter of 2014, one of the executives notified the Company he would resign and 33,000 market-based performance restricted stock units were forfeited and canceled.

 

The market-based performance restricted stock units will be eligible to vest based on the Company’s achievement of certain per share price of its common stock as reported on the New York Stock Exchange, or NYSE, for any twenty consecutive trading day period during the specified performance period.

 

The following table describes the price per share targets that must be achieved for the specified performance period for the restricted stock units to vest:

 

 

 

WageWorks Per Share Price on NYSE

Payout Percentage

$100

200%

$90

100%

$75

50%

Below $75

0%

 

Stock-based compensation expense related to restricted stock units was $2.0 million and $3.4 million for the three months ended September 30, 2014 and 2015, respectively. Stock-based compensation expense related to restricted stock units was $5.5 million and $9.0 million for the nine months ended September 30, 2014 and 2015, respectively. As of September 30, 2015, there was $21.8 million of total unrecognized compensation cost related to unvested restricted stock units which are expected to vest. The cost is expected to be recognized over a weighted average period of approximately 1.65 years as of September 30, 2015.

 

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The following table summarizes information about restricted stock units issued to officers, directors, and employees under our 2010 Plan:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted Average

 

 

 

Grant Date

 

Shares

 

Fair Value

 

(in thousands)

 

 

 

Unvested at December 31, 2014

637 

 

$

37.99 

Granted

249 

 

 

57.82 

Vested

(70)

 

 

32.04 

Forfeitures

(43)

 

 

39.99 

Unvested at September 30, 2015

773 

 

$

44.81 

 

Stock-based compensation is classified in the consolidated statements of income in the same expense line items as cash compensation. None of the stock-compensation cost was capitalized as amounts were immaterial. Amounts recorded as expense in the consolidated statements of income are as follows (in thousands):  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

2014

 

2015

 

2014

 

2015

Cost of revenue

$

721 

 

$

977 

 

$

1,547 

 

$

2,676 

Technology and development

 

367 

 

 

391 

 

 

862 

 

 

733 

Sales and marketing

 

665 

 

 

660 

 

 

1,563 

 

 

1,992 

General and administrative

 

1,981 

 

 

3,397 

 

 

6,040 

 

 

9,273 

Total

$

3,734 

 

$

5,425 

 

$

10,012 

 

$

14,674 

 

 

(10)     Income Taxes

 

The income tax provision for the three months ended September 30, 2014 and 2015 was $2.7 million and $4.8 million, respectively, and the income tax provision for the nine months ended September 30, 2014 and 2015 was $10.0 million and $11.2 million, respectively. The Company's effective tax rate was 39.5% and 39.7% for the three and nine months ended September 30, 2014, respectively, compared to 38.9% and 40.2% for the same periods in 2015.  The Company provides for income taxes using an asset and liability approach, under which deferred income taxes are provided based upon enacted tax laws and rates applicable to periods in which the taxes become payable.

 

The Company is subject to income taxes in the U.S. federal and various state jurisdictions. Presently, there are no income tax examinations scheduled in the jurisdictions where the Company operates.

 

As of September 30, 2015, the Company remains in a net deferred tax asset position. The realization of the Company’s deferred tax assets depends primarily on its ability to generate sufficient U.S. taxable income in future periods. The amount of deferred tax assets considered realizable may increase or decrease in subsequent quarters as management reevaluates the underlying basis for the estimates of future domestic taxable income.

  

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(11)    Commitments and Contingencies

 

(a) Operating Leases

 

The Company leases office space and equipment under noncancelable operating leases with various expiration dates through 2023. Future minimum lease payments under noncancelable operating leases are as follows (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

As of

 

September 30, 2015

Remainder of 2015

$

1,630 

2016

 

6,370 

2017

 

6,721 

2018

 

6,840 

2019

 

6,980 

Thereafter

 

18,336 

Total future minimum lease payments

$

46,877 

 

Rent expense for the three months ended September 30, 2014 and 2015 was $1.3 million and $1.9 million, respectively, and $3.2 million and $5.9 million, for the nine months ended September 30, 2014 and 2015, respectively. Future minimum lease payments under capital leases, not included in the table above, as of September 30, 2015 are $0.3 million for both the remainder of 2015 and 2016. We have no future minimum lease payments under capital leases extending beyond 2016.

 

 

(b) Legal Matters

 

The Company is involved from time to time in claims that arise in the normal course of its business. The Company is not presently subject to any material litigation nor, to management’s knowledge, is any litigation threatened against the Company that collectively is expected to have a material adverse effect on the Company’s cash flows, financial condition or results of operations.

 

 

(12)Stockholders’ Equity

Share Repurchase Program

On August 6, 2015, the Company’s Board of Directors authorized a $100 million stock repurchase program which commenced immediately and does not have an expiration dateRepurchases made under this program may be made in the open market as the Company deems appropriate and market conditions allow. As of September 30, 2015, no shares have been repurchased.

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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 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, 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 under Part II, Item 1A below. 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 in administering Consumer-Directed Benefits, or CDBs, which empower employees to save money on taxes while also providing corporate tax advantages for employers. We are solely dedicated to administering CDBs, including pre-tax spending accounts such as health and dependent care Flexible Spending Accounts, or FSAs, Health Savings Accounts, or HSAs, Health Reimbursement Arrangements, or HRAs, as well as commuter benefit services, including transit and parking programs, wellness programs, COBRA and other employee spending account benefits, in the United States.

 

We deliver our CDB programs through a highly scalable delivery model that employer clients and their employee participants may access through a standard web browser on any internet-enabled device, including computers, smart phones and other mobile devices such as tablet computers. Our on-demand delivery model eliminates the need for our employer clients to install and maintain hardware and software in order to support CDB programs and enables us to rapidly implement product enhancements across our entire user base.

 

Our CDB programs assist employees and their families in saving money by using pre-tax dollars to pay for certain of their healthcare, dependent care and commuter expenses. Employers financially benefit from our programs through reduced payroll taxes, even after factoring in our fees. Under our FSA, HSA and commuter programs, employee participants contribute funds from their pre-tax income to pay for qualified out-of-pocket healthcare expenses not fully covered by insurance, such as co-pays, deductibles and over-the-counter medical products or for commuting costs. 

 

These employee contributions result in savings to both employees and employers. As an example, based on our average employee participant’s annual FSA contribution of approximately $1,300 and an assumed personal combined federal and state income tax rate of 35%, an employee participant will reduce his or her taxes by approximately $455 per year by participating in an FSA. Our employer clients also realize payroll tax (i.e., FICA and Medicare) savings on the pre-tax contributions made by their employees. In the above FSA example, an employer client would save approximately $56 per participant per year, even after the payment of our fees.

 

Under our HRA programs, employer clients provide their employee participants with a specified amount of available reimbursement funds to help their employee participants defray out-of-pocket medical expenses such as deductibles, co-insurance and co-payments. All amounts paid by the employer into HRAs are deductible by the employer as an ordinary business expense and are tax-free to the employee.

 

We administer COBRA continuation services to employer clients to meet the employer’s obligation to make available continuation of coverage for participants who are no longer eligible for the employer’s COBRA covered benefits. As part of our COBRA program, we offer a direct billing service where former employee participants pay for coverage they elect to continue and we ensure our employer clients meet the challenging aspects of COBRA compliance and administration.

 

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Benefit plan years customarily run concurrently with the calendar year and have an open enrollment period that typically occurs at benefit plan year-end during the fourth quarter of the calendar year. Most of our healthcare CDB agreements are executed in the last quarter of the calendar year. Because the signing of our contract often coincides with open enrollment, employer clients are able to offer our CDB programs to their employees during open enrollment for the upcoming benefit year. As a result of this timing, we are able to obtain significant visibility into our healthcare-related revenue early on in each plan year because healthcare benefit plans are administered on an annual basis, contractual revenue is based on the number of participants enrolled in our CDB programs on a per month basis and the minimum number of enrolled participants for the plan year is usually established at the close of the open enrollment period. In contrast to healthcare CDB programs, enrollment in commuter programs occurs on a monthly basis. Therefore, there is less visibility and some variability in commuter revenue from month-to-month, particularly during the summer vacation period when employee participants are less likely to participate in commuter programs for those months. There is also less visibility into our COBRA revenue, as our agreements to provide COBRA services are not consistently structured and we receive fees based on a variety of methodologies.

 

Organizational Efficiency Plan 

 

We continually evaluate ways to improve business processes to ensure that operations align with our strategy and vision for the future. During the second quarter of 2015,  we integrated operations and consolidated certain positions resulting in employee headcount reductions. The reductions include administrative, operational and support personnel.

 

Key Components of Our Results of Operations

 

Revenue

We generate revenue from the following sources: healthcare solutions, commuter solutions, COBRA, and other services.

 

Healthcare Revenue

 

We derive our healthcare revenue from the service fees paid by our employer clients for the administration services we provide in connection with their employee participants’ healthcare FSA, dependent care FSA, HRA and HSA tax-advantaged accounts. Our fee is generally fixed for the duration of the written agreement with our employer client, which is typically three years for our enterprise clients and one to three years for our small-and medium-sized business, or SMB, clients. These fees are paid to us on a monthly basis by our employer clients, and the related services are made available to employee participants pursuant to written agreements between us and each employer client. Revenue is recognized monthly as services are rendered under our written service agreements.

 

 

We also earn interchange revenue from debit cards used by employee participants in connection with all of our healthcare programs and through our wholesale card program, which we recognize monthly based on reports received from third parties. We also earn revenue from self-service plan kits called Premium Only Plan kits, or POP revenue.

 

 

Commuter Revenue

 

For our Commuter Order Model, or COM, Commuter Account Model, or CAM and Commuter Express, we derive our commuter revenue from monthly service fees paid by our employer clients, interchange revenue that we receive from debit cards used by employee participants in connection with our commuter solutions and revenue from the sale of transit passes used in our commuter solutions. Our fees from employer clients are normally paid monthly in arrears based on the number of employee participants enrolled for the month. Most agreements have volume tiers that adjust the per participant price based upon the number of participants enrolled during that month. Revenue is recognized monthly as services are rendered under these written service agreements. We earn interchange revenue from the debit cards used by employee participants in connection with our commuter programs, which we recognize monthly based on reports received from third parties. We also receive commissions from transit passes, which we purchase from various transit agencies on behalf of employee participants. Due to our significant volume, we receive commissions on these passes which we recognize as vendor commission revenue. Commission revenue is recognized on a monthly basis as transactions are placed under written purchase agreements having stipulated terms and conditions, which do not require management to make any significant judgments or assumptions regarding any potential uncertainties.

 

Revenue from the TransitChek Basic program is based on a percentage of the face value of the transit and parking passes ordered by employer clients and revenue from the TransitChek Premium program is derived from monthly service fees paid by employer clients based on the number of participants. In both programs, revenues also include interchange revenue that we receive from debit cards used by employee participants in connection with our commuter solutions. We also recognize revenue on our estimate of certain passes that will expire unused over the estimated useful life of the passes, as the amounts paid for these passes are nonrefundable to both the employer client and the employee participant.

 

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COBRA Revenue

 

Our COBRA revenue is derived from the administration services we provide to employer clients for continuation of coverage for participants who are no longer eligible for the employer’s health benefits, such as medical, dental, vision, and for the continued administration of the employee participants’ HRAs and certain healthcare FSAs. Our agreements to provide COBRA services are not consistently structured and we receive fees based on a variety of methodologies. 

 

Other Revenue

 

Other revenue includes enrollment and eligibility services, employee account administration (i.e., tuition and health club reimbursements) and project-related professional fees. We offer a direct billing service where former employee participants pay for coverage they elect to continue and we handle the billing, accounting and customer service for these separated employees, as well as interfacing with the carrier regarding the employee’s eligibility. We also derive other revenue from administrative and development services we provide to a customer to operate their health insurance exchange business which includes enrollment, billing, customer service and payment processing services. Other services revenue is recognized as services are rendered under our written service agreements.

 

 

Costs and Expenses

 

Cost of Revenues (excluding the amortization of internal use software)

 

Cost of revenues includes the costs of providing services to our employer clients’ employee participants.

 

The primary component of cost of revenues is personnel expenses and the expenses related to our claims processing, product support and customer service personnel. Cost of revenues includes outsourced and temporary help costs, check/ACH payment processing services, debit card processing services, shipping and handling costs for cards and passes and employee participant communications costs.

 

Cost of revenues also includes the losses or gains associated with processing our large volume of transactions, which we refer to as “net processing losses or gains.” In the normal course of our business, we make administrative and processing errors that we cannot bill to our employer clients. For example, we may over-reimburse employee participants for claims they submit or incur the cost of replacing commuter passes that are not received by employee participants. Upon identifying such an error, we record the expense as a processing loss. In certain circumstances, we experience recoveries with respect to these amounts which are recorded as processing gains.

 

Cost of revenues does not include amortization of internal use software or change in contingent consideration, which are included in amortization and change in contingent consideration, or the cost of operating on-demand technology infrastructure, which is included in technology and development expenses.

 

 

Technology and Development

 

Technology and development expenses include personnel and related expenses for our technology operations and development personnel as well as outsourced programming services, the costs of operating our on-demand technology infrastructure, depreciation of equipment and software licensing expenses. During the planning and post-implementation phases of development, we expense, as incurred, all internal use software and website development expenses associated with our proprietary scalable delivery model. During the development phase, costs incurred for internal use software are capitalized and subsequently amortized once the software is available for its intended use. See “Amortization and Change in Contingent Consideration” below. Expenses associated with the platform content or the repair or maintenance of the existing platforms are expensed as incurred.

 

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of personnel and related expenses for our sales, client services and marketing staff, including sales commissions for our direct sales force and external agent/broker commission expense, as well as communication, promotional, public relations and other marketing expenses.

 

 

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General and Administrative

 

General and administrative expenses include personnel and related expenses of and professional fees incurred by our executive, finance, legal, human resources and facilities departments.

 

 

Amortization and Change in Contingent Consideration

 

Amortization and change in contingent consideration expense includes amortization of internal use software, amortization of acquired intangible assets and changes in contingent consideration in connection with portfolio purchases and acquisitions.

 

We capitalize internal use software and website development costs incurred during the development phase and we amortize these costs over the technology’s estimated useful life, which is generally four years. These capitalized costs include personnel costs and fees for outsourced programming and consulting services.

 

We also amortize acquired intangible assets consisting primarily of employer client agreements and relationships and broker relationships. Employer client agreements and relationships and broker relationships are amortized on a straight-line basis over an average estimated life.

 

We measure acquired contingent consideration payable each reporting period at fair value and recognize changes in fair value in our consolidated statements of income each period, until the final amount payable is determined. Increases or decreases in the fair value of the contingent consideration payable can result from changes in revenue forecasts, discount rates and risk and probability assumptions. Significant judgment is employed in determining the appropriateness of these assumptions in each period.

 

 

Other Income (Expense)

 

Other income (expense) primarily consists of (i) interest income; (ii) interest expense; and (iii) gain (loss) on settlements and other investments.

 

 

Provision for Income Taxes

 

We are subject to taxation in the United States. Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. As of September 30, 2015, we remain in a net deferred tax asset position. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized.

 

At December 31, 2014, we had federal and state operating loss carryforwards of approximately $38.5 million and $47.0 million, respectively, available to offset future regular and alternative minimum taxable income. The state net operating loss carryforward is on the post-apportionment basis. Our federal net operating loss carryforwards expire in the years 2024 through 2033, if not utilized. The state net operating loss carryforwards expire in the years 2018 through 2033. The federal and state net operating loss carryforwards include excess tax deductions related to stock options in the amount of $21.8 million and $16.2 million, respectively. When utilized, the related excess tax benefit will be booked to additional paid-in capital. We also have tax deductible goodwill related to asset acquisitions.

 

At December 31, 2014, we  had federal and California research and development credit carryforwards of approximately $4.7 million and $2.4 million respectively, available to offset future tax liabilities. The federal research credit carryforwards expire beginning in 2022 through 2034, if not fully utilized. The California tax credit carryforward can be carried forward indefinitely. 

 

Our ability to utilize the net operating losses and tax credit carryforwards are subject to restrictions, including limitations in the event of past or future ownership changes as defined in Section 382 of the Internal Revenue Code (“IRC”) of 1986, as amended, and similar state tax law. In general, an ownership change occurs if the aggregate stock ownership of certain stockholders increases by more than 50 percentage points over such stockholders’ lowest percentage ownership during the testing period (generally three years). We have considered Section 382 of the IRC and concluded that any ownership change would not diminish our utilization of the net operating loss or research and development credits during the carryover periods.

 

We make estimates and judgments about our future taxable income that are based on assumptions that are consistent with our plans and estimates. Should the actual amounts differ from our estimates, our provision for income taxes could be materially affected.

 

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Critical Accounting Policies and Significant Management Estimates

There have been no material changes to our critical accounting policies and estimates during the nine months ended September 30, 2015, as compared to the critical accounting policies and estimates disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2014.

 

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Results of Operations

 

Comparison of the Three and Nine Months Ended September 30, 2014 and 2015 

 

Revenue 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Change from

 

Nine Months Ended September 30,

 

Change from

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2014

 

2015

 

prior year

 

2014

 

2015

 

prior year

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

(in thousands, unaudited)

 

 

 

(in thousands, unaudited)

 

 

Healthcare

 

$

38,600 

 

$

42,204 

 

9% 

 

$

116,176 

 

$

133,307 

 

15% 

Commuter

 

 

15,078 

 

 

16,003 

 

6% 

 

 

46,171 

 

 

47,928 

 

4% 

COBRA

 

 

9,544 

 

 

12,229 

 

28% 

 

 

17,283 

 

 

37,112 

 

115% 

Other

 

 

4,776 

 

 

12,724 

 

166% 

 

 

9,745 

 

 

32,866 

 

237% 

Total revenue

 

$

67,998 

 

$

83,160 

 

22% 

 

$

189,375 

 

$

251,213 

 

33% 

 

 

 

 

Healthcare Revenue

 

The $3.6 million increase in healthcare revenue for the three months ended September 30, 2015 as compared to the prior-year period was primarily driven by a $2.9 million increase in FSA and HRA revenue. FSA and HRA revenue increased by $2.0 million due to the addition of new clients and growth in new employee participation in FSA and HRA programs as well as an increase in interchange fee revenue of $0.9 million, due to increased debit card usage and an increase in the number of debit cards issued. Healthcare revenue was further increased by a $0.7 million increase in HSA revenue, due to the addition of new clients and growth in employee participation in this program.

 

The $17.1 million increase in healthcare revenue for the nine months ended September 30, 2015 as compared to the prior-year period was primarily driven by a $15.1 million increase in FSA and HRA revenue, of which $9.5 million was from contribution of a full three quarters of CONEXIS operations, and $5.6 million due to the addition of new clients and growth in new employee participation in FSA and HRA programs. Healthcare revenue was further increased by a $1.9 million increase in HSA revenue, due to the addition of new clients and growth in employee participation in this program.

 

 

Commuter Revenue

 

The $0.9 million increase in commuter revenue for the three months ended September 30, 2015 as compared to the prior-year period was primarily driven by growth in the number of employee participation in our commuter programs and increases in interchange revenue.

 

The $1.8 million increase in commuter revenue for the nine months ended September 30, 2015 as compared to the prior-year period was primarily driven by growth in the number of employee participation in our commuter programs and increases in interchange revenue offset by non-recurring revenue related to expired vouchers recorded in the first quarter of 2014. 

 

COBRA Revenue

 

The $2.7 million increase in COBRA revenue for the three months ended September 30, 2015 as compared to the prior-year period was driven by a full quarter of CONEXIS operations.

 

The $19.8 million increase in COBRA revenue for the nine months ended September 30, 2015 as compared to the prior-year period was primarily driven by $18.9 million of contribution from a full three quarters of CONEXIS operations, as well as $0.9 million from the addition of new clients and growth in new employee participation in our COBRA programs.

 

 

Other Revenue

 

The $7.9 million increase in other revenue for the three months ended September 30, 2015 as compared to the prior-year period was primarily driven by $7.9 million of contribution from CONEXIS operations, of which $7.5 million was related to development and administrative services we provide to a customer to operate their health insurance exchange business and $0.4 million was due to an increase in administration of direct bill services to employee participants.

 

The $23.1 million increase in other revenue for the nine months ended September 30, 2015 as compared to the prior-year period was primarily driven by $22.5 million of contribution from a full three quarters of CONEXIS operations, of which $20.3 million was

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related to development and administrative services we provide to a customer to operate their health insurance exchange business and $2.2 million was due to an increase in administration of direct bill services to employee participants.

 

 

Cost of Revenues