Investment Thesis

Lemonade (LMND) is a recent IPO, one that garnered quite a bit of attention: it is going public while still small and in its high growth phase. A case in point: management said its growth is bottlenecked by its marketing, for which it is seeing almost linear returns on dollars spent.

The company is also founded on the premise of disrupting the (large) insurance industry. As such, and as plenty other IPOs have also experienced, valuations have run up quite a bit at the time of IPO, and the stock now seems to be going through its trough of disillusionment, which means valuations are getting more reasonable.

The means by which Lemonade is disrupting insurance is technology, in particular AI. It is basically automatizing insurance through its bots. This benefits both Lemonade as well as its customers, who give it very high ratings, both due to pricing and customer experience. Moreover, as it captures more data over time, this further improves its bots, not unlike the competitive advantage Tesla (TSLA) bulls ascribe to Autopilot. Improved bots means the company becomes even more efficient, so this works like a virtuous cycle.

While it is not sure how much further the stock will sink in the near term, any additional downside should be welcome for long-term investors. Given its potential to keep growing at high rates for quite some time, this makes the stock reminiscent of Shopify (SHOP), while the business of disrupting existing large players with a “technology substrate” seems akin to Luckin Coffee (OTCPK:LKNCY) and Tesla.

While it is of course by no means guaranteed to which extent the company will succeed, the technological odds seem in its favor. So for investors who missed on Shopify on its way to $100B or Tesla to even higher valuation, investors who don’t want to deal with a delisted company, Lemonade may present an investment opportunity.

However, near term, Q3 is going to present a quite important point for the stock: Lemonade has guided to a sequential 50% drop in GAAP revenue. While the underlying business is not changing (for example, in-force premiums is forecast to continue to grow), Q3 marked the start of a reinsurance policy change, which is changing the GAAP earnings/accounting.

Since high-growth companies are mostly valued based on P/S, a 50% revenue drop implies that already elevated ~40x forward multiples will become ~80x. While as noted the underlying business isn’t changing, it is obviously highly uncertain how the stock will react to these results.

The Company

Lemonade’s insurance business model is based on two differentiated activities.

The first is its use of AI and bots to handle claims and garner data points to improve its business. Lemonade calls this its “digital substrate,” which sounded a lot like Luckin Coffee’s premise of quick expansion through its use technology.

In any case, for its insurance business this means it replaces brokers and paperwork with its AI bots, which can handle claims instantly with zero paperwork.

Lemonade notes that this approach not only benefits the company, but also the consumer. As evidence for this, Lemonade reports that the median time to buy a policy is ~90 seconds, roughly a third of claims are paid instantly, and that first-time buyers of insurance can save 50%. Lemonade further claims it has a net promoter score above 70, which would be “a level usually reserved for brands like Apple (AAPL) or Tesla.”

The second differentiated aspect of its business model is the use of charities, culminating in the annual Giveback.

Products

Lemonade’s product portfolio is relatively small, starting with renter and home-owners insurance. It has seen a trend of a “steady growing percentage of homeowners who started life with us as renters.”

However, it is working on both additional products and international expansion. To that end, in July it introduced pet insurance, and a bundle of both of its products (with 10% savings).

Obviously, as its product offerings become more comprehensive over time, Lemonade expects retention and customer value to increase.

Most recently, Lemonade expanded to France.

We have built the pet product entirely from scratch we are thinking coverages, user experience, the claims process, pricing and even the policy document itself. Our pet product offers a hassle-free digital experience with lightning fast claim payments, best-in-class customer service and a donation of leftover premium to animal-focused charities our customers choose. The new pet insurance is now available in more than 30 states with prices starting at $10 per month.

I am pleased to share that the reception has been positive and the feedback we are getting from customers translates into a net promoter score of well over 80. But as encouraged as we are by the initial results, it’s important to remember that introducing a new insurance product to the market takes time and that we are still in the early days of this process.

(…) And in April, we launched our second European territory early in the pandemic, with a 100% remote workforce with great vigor and efficiency.

Competitive advantage

Lemonade’s disruptive nature comes from its use of AI, which is trained through the many data points it collects, and which will increase even more as it gains more customers over time. This has already allowed it to halve its gross loss ratio (detailed below) over the last two years.

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This results in a virtuous cycle: the company gets better at customer acquisition, which results in more data points, which further improves its bots’ ability to detect fraud, learn which claims to pay out, and so on.

As mentioned earlier, its bots handle a large portion of claims pretty much instantaneously. This results in better service for customers. But also directly benefits Lemonade since it has a much higher (over 5x) customers to employees ratio than industry standard:

I will say two or three things here. The first one is that while our expense ratio today looks high, because we are spending a lot on customer acquisition, the fundamentals of our business actually lead to a very light marginal cost preferred. The biggest and best and most efficient insurance companies in America have about a ratio of 400 customers to 1 employee, so it’s about a 400 to 1 ratio and even among the top 5 that drops off pretty quickly and you get to like 150 to 1 and Lemonade is over 2000s to 1. So, the digital infrastructure that we just spoke about in terms of helping with loss ratios certainly helps with expense ratio in terms of automation, streamlining if you are paying your claims, a third of them without any human intervention at all and you are on-boarding customers pretty much 100% of them algorithmically and you can understand how that will translate into an ability to price more aggressively. And indeed, the same is true with our renters insurance, right. Entry level buys of renters insurance from Lemonade will typically see something in the order of 50%, 50% savings compared to incumbents. And in the early days, people said, oh, we are selling dollars for $0.90, we are selling at a loss that’s unsustainable, but I think our loss ratio at 67% shows that, that’s not the case that we are able to drive efficiencies and do things at a cost point – at a price point and the cost structure that is unfamiliar to the industry at large.

I recently saw a comment on Seeking Alpha from someone who claimed to follow this industry closely, who opined that Lemonade’s moat was “weak.” However, the data presented above presents quite a different view: Lemonade may be similar to Tesla disrupting the automotive industry with its EVs, where the traditional OEMs likewise were reluctant to invest in those.

So to that end, Lemonade views its data (“digital substrate”) as its competitive advantage, and claims that it captures 100-fold more data than the broker-based incumbents. And as its virtuous cycle unfolds, this advantage may very well continue to grow.

These data service training sets for all of our systems fueling a cycle of continuous improvement, with a return of the flywheel, our marketing campaigns become more effective, our bots get better at understanding our customers’ needs, our fraud detection picks up everything to signals and our claims bot Jim learns which claims to pay and which to escalate with growing precision. All this amounts to a powerful closed loop system allowing us to target price and underwrite risk with growing accuracy, which is the very core of insurance.

The Business

Lemonade insurance

Q2 results can be summarized as follows:

  • In-force premium: $155.1 million, +115%
  • Total customer count: 814,160, +84%
  • Premium per customer: $190, +17%
  • Gross earned premium: $35.3 million, +121%
  • Gross loss ratio: 67% as compared to 72% in the first quarter and down from 82% in the second quarter of 2019

Lemonade insurance

Gross loss ratio is defined as follows:

Loss ratio is used in the insurance industry, representing the ratio of losses to premiums earned. Losses in loss ratios include paid insurance claims and adjustment expenses. The loss ratio formula is insurance claims paid plus adjustment expenses divided by total earned premiums. For example, if a company pays $80 in claims for every $160 in collected premiums, the loss ratio would be 50%.

Gross loss ratio in fact represented a milestone in Q2. Lemonade remarked that since it reached the 60s, it is within its target range of 60-70%, and hence expects this ratio to remain in the 60s. This will hence result in its net loss ratio (and unit economics) to remain stable over time.

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Lemonade noted in particular how fast it was able to achieve this ratio: it was its tenth consecutive quarter of declining loss ratios, halving over the past two years. This is evidence of the “continuous learning” as it gathers more data points.

This rate of improvement in loss ratio is to the best of my knowledge, without precedent in the history of the insurance industry and is all the more unusual for coming at a time of very rapid growth.

Lemonade insurance

Reinsurance change

Going into Q3, there would be quite a big slowdown, even decline, in revenue. This will be solely the result of new (reinsurance) agreements (and no underlying business changes), which result in different accounting mechanics. The change is explained in the Q2 shareholder letter:

The end of Q2 marked the end of our three-year reinsurance agreements, and their replacement with our new and improved reinsurance contracts. While these leave our unit economics and risk profile largely unchanged, they do mark an important shift from an ‘excess of loss’ architecture to one based largely on ‘proportional reinsurance.’ The motivation for this restructuring is the capital efficiency it delivers, with every dollar of surplus now expected to support roughly three times the amount of premium that it did in Q2, rendering Lemonade a capital-light business. As shareholders, we imagine you’ll share our enthusiasm for making every dollar go further.

So the bottom line is that revenue will decline in favor of higher gross margin. Effectively, for Lemonade’s future earnings, the overall change for the (underlying) business is likely neutral at worst. In fact, Lemonade believes that these new contracts result in a “significant improvement” in its business fundamentals.

Lemonade insuranceGrowth and management discussion

Management also provided quite an insightful comment about its ability to grow, concerning the ROI on marketing (in light of the pandemic):

And so when we laid out our thoughts and expectations for the second half of the year, the decisions that we control and as we manage, we decided to take that savings from Q2 if you want to term it as savings, money that was unspent in the early part of the quarter and invest that in the second half. Because we are seeing return, we are finding ways to deploy those dollars and it’s working. The uncertain part is the part we don’t control, which is the historical seasonal trend, which if you look at the past 2 years, maybe even 3 years, it’s been a pretty discrete or visible step change with Q3 higher, Q4 lower and really driven by the moving dynamic of people in the U.S. and that’s just uncertain this year.

In response to another question:

So, a couple of thoughts in terms of the first question and customer ramp, our relationship in our spend and customer acquisition is pretty linear. So when we turn things up, you see it right away, it’s almost a real time in the day or in the week that you change how we invest, what channels we use, how many dollars we are putting forth. And so what we are seeing and what we are spending today, we are getting reaction to that and so that’s factored into how we see the second half playing out in terms of both customer acquisition and premium acquisition.

Worth noting that while we certainly track and report the number of customers and the premium, if you had to pick one, that we think is more important, it’s really the premium. A renter customer is a great customer and we will keep them for as long as we can hopefully for a lifetime and they will gradually drive more value. But if we can acquire a customer as a homeowner, efficiently and effectively, we will do that too. And so the reason we guide to top line in terms of in-force premium and not to customers for that very reason is we and our growth team are really optimizing for premium. And sometimes, the customer count can vary a little bit, but we expect to see obviously growth in both of those. We also expect the premium per customer to continue to grow just the underlying dynamics of the trends we have seen and the continued mix shift toward homeowners.

Q3 Revenue Drop

While Lemonade is a disruptive, high-growth company, revenue is forecast to drop significantly due to the reinsurance change. This will result in a steep, 50% drop in revenue: from ~$30M in Q2 to a ~$15M guidance for Q3.

As noted in the introduction, a 50% drop in revenue will double an already rich valuation P/S multiple of ~30x to ~60x. Even though there is really no real change in the business, just by the numbers, this suggests there might be some (further) downside, as the stock has already declined from its heights of over $80.

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On the other side, reinsurance changes aside, Lemonade has been growing at a triple-digit clip; so for example, a ~40x multiple could become a ~20x multiple in just one year, at least if growth does not slow down.

In any case, for the next four quarters revenue growth will appear to be much less than the actual underlying business growth. So for near-term prospects, these dynamics make it highly uncertain what might happen to the stock price.

Risks

Another Seeking Alpha author with a bearish thesis noted among several observations that IFP was slowing down. I would note, though, unless you’re Moore’s Law, there is simply no way to sustain 100% growth forever. As Lemonade noted, it is seeing strong returns on dollars spent, and it has a real value proposition for customers.

So instead, combined with the moat from its technology as described above, the long-term investment thesis looks highly compelling – so to judge a disruptive IPO company on its first quarterly guidance (and guidance is a forecast, which Lemonade noted was conservative given the COVID-19 uncertainties), instead of its long-term potential, seems an erroneous way of assessing an investment. A Buffett quote about holding a stock for 10 minutes or 10 year springs to mind.

While IFP is likely to continue to trend down for the foreseeable, the previous section showed that there might be other issues (the revenue drop) that may affect the stock even more.

Indeed, the second risk lies in its recent reinsurance policy change. This could go several ways. On the one hand, it has caused the company to reduce its GAAP revenue guidance significantly. On the other hand, Lemonade said the underlying business has not changed at all. So in the short term, these accounting peculiarities might perhaps confuse investors and cause the stock to drop down further, even though the company keeps growing at a fast clip.

But that would just result in an even better investment proposition (for the more informed investor perhaps), the more the stock drops further. Nevertheless, a drop in revenue does change the valuation multiple, which will make the stock appear more expensive compared to the previous scheme, even in the long-term.

So if one is convinced that Lemonade has a differentiated approach to insurance, which provides it with a competitive advantage (for example, its customers to employees ratio) to keep growing, then given its current small size, it has quite a likelihood of becoming worth much more over time.

Summary

To summarize the investment proposition:

  • Differentiated, disruptive insurance model based on bots/AI/technology.
  • Benefits Lemonade through lower cost (customers to employees ratio).
  • Benefits customer through lower pricing and customer experience (net promoter score).
  • Steadily declining gross loss ratio (further) evidence of working business model.
  • Still in high-growth phase.
  • Further growth potential from international expansion, additional insurance products, higher value per customer (e.g. renter graduating to home-owner).
  • Near-term, beware upcoming sequential 50% revenue drop in Q3. This will impact YoY comps for next four quarters.

For example, as Tesla is already valued like it has disrupted the entire automotive industry, investing in Tesla at a $3B valuation would have returned a 100-bagger.

Takeaway

Lemonade’s IPO came at quite a turbulent time: the pandemic, the change in reinsurance agreements, the introduction of pet insurance and European expansion, and the gross loss ratio milestone.

All summed up, Lemonade is (for now) a triple-digit growing, disruptive company with a real competitive advantage over incumbents, as evidenced by multiple metrics.

The stock, however, is going the direction: down. This may present an excellent investment opportunity, as its growth should make the company catch up to its valuation sooner rather than later. It is by no means guaranteed this growth will continue for years, but its competitive advantage seems apparent and it is operating in a large market.

However, in the short term, there likely will be quite some uncertainty as GAAP revenue will drop by 50% sequentially in Q3, which will affect growth rates for the next four quarters. Although gross margin will increase correspondingly, since the underlying business remains the same, growth companies are often valued based on P/S ratio (which will suddenly double), so the stock could see further downside.

Disclosure: I am/we are long LMND. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com