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It’s been about 100 days since Lemonade went IPO to much fanfare (and was actually the topic of my very first post ). It IPO’ed at $29 per share and rocketed up to a high of $96.51 per share on the back of strong investor demand.

It has since followed a familiar pattern of retracing part of its first day “pop” and today Lemonade trades at approximately $50 per share, almost 50% off its all time high but more than 70% above its IPO price.

The volatility in the stock price seems to indicate that investors are struggling to price both the potential of the company as well as the risks to its growth story.

What is fascinating is that you could make an argument why the company should be worth multiples of its current valuation. You could also make an equally persuasive argument why the company should be worth much less than what its currently worth.

In this sense, an investment in the company seems more like a late stage venture capital investment (but with all of the liquidity of the public markets). It’s relatively rare to get these opportunities, as an increasingly proportion of private companies are staying private for longer and only really tapping public markets much later in their growth cycle.

In this post, I will try to outline the key arguments of the bull case. In part II, I will do the same for the bear case. Readers can then make up their minds on what arguments are more persuasive.

Before we start, a quick recap of what Lemonade actually does:

• • Lemonade (NYSE: LMND) is a new breed of insurance company that promises to challenge the status quo. Its business model is to offer homeowners, renters and pet insurance in the United States in a radically different way.
  • The main departure from industry norms is that it promises to give excess premiums away to charity. It is registered as a ‘Public Benefit Corporation’ which allows the company to do this, rather than be obligated to maximize profits for shareholders.
  • Through its use of technology, it also provides an experience for customers that involves zero paperwork and zero bureaucracy and, as a result, lightening fast speed. This is also very different from incumbent insurance companies that are inhibited by their legacy systems and processes.
  • Additionally, it makes substantial use of reinsurance. For every dollar of insurance it provides, it only keeps 25 cents and offloads the rest to reinsurers. This is also somewhat different to many insurance companies that want to keep most of the premiums (‘float’) to generate investment income. 

So basically think insurance meets technology meets ESG and you are not far off what the business does. Some facts and figures for context:

• • Its current market capitalisation is ~ $2.9 billion.
  • It had 814,160 customers as of Q2 2020, representing 84% YoY growth.
  • Premium per customer was $190 as of Q2 2020, representing 17% YoY growth.
  • In Force premiums were $155 million as of Q2 2020, representing 115% YoY growth. 
  • It expects total in force premiums of between $190 and $195 million for full year 2020.
  • It expects revenue of $86-88 million for full year 2020
  • It expects an adjusted EBITDA loss of approximately $100 million for full year 2020.
  • Its loss ratio was 67% in Q2 2020, down 18% YoY. 

To sum up, it’s a money losing company (even on an adjusted EBITDA basis) but it is undergoing hypergrowth – premiums have more than doubled YoY and customers count is up 84%. Now to the bull case:

Bull Case

1. Digital disruption. As is the case in many industries, digitalisation is becoming much more prevalent and the insurance industry is no different. Customers increasingly demand the convenience, speed and familiarity of a digitally native experience. The insurance industry is still dominated by insurance agents and brokers that provide offerings that are mostly offline experiences. Digitalisation has also been accelerated by COVID-19 (again as in many other industries) with customers unwilling to visit traditional retail offices/branches. Lemonade stands to benefit from this ongoing dislocation.
2. Potential Data Moat. Although Lemonade is at a disadvantage compared to incumbent insurance companies in terms of historical data, it is quickly catching up. Whereas typical insurance providers collect 20-50 data points per customer, Lemonade collects close to 1,700 data points from its customer interactions. This is a massive data advantage which it can use to fuel further improvements to its AI as well as its pricing. 
3. High Customer Satisfaction. The company boasts a Net Promoter Score (NPS) above 70, which is unusual in the insurance industry that normally suffers from very low NPS scores. This helps attract more customers to the company through word of mouth and should, over time, lower its customer acquisition costs. 
4. Low Cost Advantage. Through the use of AI, the company is able to originate, distribute and service many times more volumes of insurance business than its competitors who mostly rely on human ‘horsepower.’ This shows up in the number of policies per employee it is able to administer. For Lemonade, its roughly 2500 policies per employee which is about 5 times more than its nearest competitor (when accounting for the use of agents in competitor firms). This allows the company not only to scale, but to attract customers through lower prices. Since insurance is somewhat of a commodity product, being the lowest cost provider is a massive advantage.
5. New Product Lines. High customer satisfaction, its data advantage and its scalable tech platform, also allows the company to enter new parts of the insurance industry and increase its total addressable market (TAM). It started out with renters insurance (~ $3.8 billion market size), before adding homeowners insurance ($105 billion market size) and pet insurance (~$1.6 billion market size). Over time, it will likely add travel (~$2.5bn), auto (~$308bn) and life insurance (~$723 billion). It also worth noting, the company has the potential to increase the size of some of these markets as well. As consumers gain greater understanding of insurance, put more trust in insurance companies and the ease of use improves, the overall insurance pie is likely to increase. This is perhaps especially the case for renters insurance in the US. It is estimated that only 40% of US renters have renters insurance compared to more than 90% for homeowners insurance. New product lines will also likely increase the premium per customer as the company gains the ability to cross sell.
6. New Geographies – today it operates primarily in the USA, Netherlands and Germany. However, it holds a license to operate in 31 countries across Europe and will likely look to expand to these territories over time. New geographies help to further increase the TAM described in the previous point.
7. Tailwinds in Customer Churn– despite having very high customer satisfaction, the company does suffer from a high churn rate in its customers, however this has been improving over time. As with almost all subscription-type models, Year 2 customers are less likely to churn than Year 1 customers, Year 3 customers less likely to churn than Year 2 customers and so on. The worst years of customer retention are in Year 1, so as its customers age, churn rates will improve, which in turn lowers customer acquisition costs and increases the lifetime value of a customer. Additionally, not all of its churn is ‘negative churn.’ For a cable company, a customer ‘cutting the cord’ is more likely to be negative churn, since they are probably never coming back because they have discovered new ways of consuming entertainment (such as Netflix).  However, with insurance, life circumstances often impact the need for insurance. People move away to college, move back with family, get divorced, buy pets etc – which all influence the demand for renters, home and pet insurance. Customers that leave in one particular period are likely to be back in another with a new need for insurance. Also worth noting, as the company adds new product lines, it will help reduce churn through bundling. Homeowners insurance is also more stable compared to renters insurance and the same is likely to be true of potential new products (e.g. life insurance). 
8. Change in customer behaviour. Since the company donates excess premiums to charity, it changes the dynamic of its interactions with customers. Traditionally, insurance companies and customers have been locked into a ‘zero-sum game’, where one side wins and the other loses. This makes for very adversarial encounters and a high degree of mistrust from both sides. By removing the incentive to cheat on both sides, consumers (theoretically) are less likely to file false claims since this would directly impact the charity causes they care about. The company also (theoretically) does not have a profit incentive to deny claims. Since it is estimated that insurance companies lose billions in false claims each year, even a small change in this dynamic could lead to an advantage over its competitors.
9. Reinsurance helps reduce variability. The fact that Lemonade hands over 75 cents of every dollar in premium to reinsurers may, on the surface, seem undesirable. After all, many insurance companies rely on investment income derived from the premiums they collect (the ‘float’) to offset underwriting losses and achieve profitability. However, through the use of re-insurance Lemonade is able to achieve two very important and desirable results. (1) It needs less capital to grow (2) it reduces the variability of its underwriting result since most of the risk is shouldered by the re-insurer. This is important as it makes the company a more pure play on its technology and customer experience rather than the risks inherent in an insurance business. 
10. ESG. Through its public benefit corporation status,  its strong stance on transparency and ethics, and its refusal to invest its share of the float into coal and other fossil burning companies, it has attracted and will likely continue to attract interest from ESG funds that are themselves growing rapidly. 

In my next post, I will outline the bear case for the company. It primarily rests on the risks to its growth story and the assumptions implied by its valuation. Briefly, it is priced more like a SaaS company rather than an insurance company, when there are strong reasons why it shouldn’t be. More on that in the next post.

Source: https://ipohawk.com/lemonade-a-closer-look-part-i/?utm_source=rss&utm_medium=rss&utm_campaign=lemonade-a-closer-look-part-i