2023-08-15 15:39:37 ET
Summary
- Lemonade's stock has declined 22% since reporting second-quarter earnings.
- The company announced a partnership with General Catalyst on a "Synthetic Agent" program.
- We view this structure as negative for Lemonade.
The key takeaway from Q2 earnings
Customer Growth and Retention
Lemonade's ( LMND ) customer count grew 20% year-over-year and 2.7% quarter-over-quarter to 1.9 million in Q2 2023. The dollar retention rate improved to 87% in Q2 2023, higher than the insurance industry average of 84 %. This suggests Lemonade continues to build customer loyalty. Premium per customer increased 24% year-over-year and 2% quarter-over-quarter to $360. This also indicates improving loyalty and retention.
However, with the Metromile acquisition almost one year behind, growth appears to be plateauing. Quarter-over-quarter growth was just 2.7%, annualizing to 10.8%, which is not very strong. Lemonade's penetration with young customers is still low. Even if all 1.9 million customers are under 30, that's only a 3.5 % penetration of that demographic. Since insurance is highly concentrated (top 3 have 80 %+ share), as its customer base growth slows down, Lemonade's "young customer dominance" story seems less compelling to the market now in our opinion.
Premium Growth Challenges
Lemonade grew its in-force premium by 5% this quarter and guided to 2.7% and 0.1% growth in Q3 2023 and Q4 2023. The company also received approval for 30% and 23% rate increases on its home and pet insurance products. However, despite the Metromile acquisition, launching new insurance products like home, auto, and pet, and implementing rate hikes, Lemonade has failed to meaningfully increase premiums through cross-selling or price increases. This suggests challenges in growing the business even with new products and markets.
Synthetic Agents Model
Insurance companies make significant profits over time from customers that stay for years and pay steady premiums. However, acquiring new customers has high upfront costs for advertising and customer acquisition. It takes time to earn back this initial investment from new customers' premium payments.
Traditionally, insurance companies use agents to acquire new customers. Agents spend their own money to find and sign up new customers, and the insurance company pays them a commission on each new policy. This helps reduce the insurer's acquisition costs.
Lemonade came up with an alternative model called "synthetic agents" to get the benefits of agents without actually using them. They partnered with an investment firm, General Catalyst, which pays up to 80% of Lemonade's customer acquisition costs.
In exchange, GC gets a 16% commission on the premiums from those new customers for 2-3 years. After that period, all premiums go to Lemonade.
This benefits Lemonade by:
- Maintaining a direct relationship with customers rather than going through an agent middleman. This improves customer experience and provides more data to Lemonade.
- Getting an upfront cash boost to grow faster without spending its own cash on acquisition costs.
- Capturing all customer premiums after 2-3 years rather than sharing with an agent indefinitely.
In essence, Lemonade believes this synthetic agent structure will facilitate faster growth and greater long-term profits. They get the customer acquisition benefits of agents without the revenue sharing. It's a creative new model to drive scale and reduce costs.
Critique of Synthetic Agent Model
We have several comments about Lemonade's new synthetic agent program:
- It will likely hurt earnings in the near term without helping revenue. While Lemonade saves 80% of acquisition costs upfront, they have to pay back 16% commissions for 2-3 years before getting paid premiums from those customers. Lemonade's premium growth guidance also suggests this program won't drive top-line acceleration.
- This can lessen cash burn, which is currently around $50 million per quarter with only $200 million cash on hand.
- The financing seems very expensive for Lemonade. Even with a high beta of 2, a 5% risk-free rate, and a 5% equity risk premium, Lemonade's cost of equity is about 15% based on the CAPM model. Equity financing would be cheaper than the 16% synthetic agent commissions. The structure gives General Catalyst a priority claim ahead of even debt holders. We believe this signals potential issues with Lemonade's capital market access.
Give Priority to Cross-Selling Instead of Pursuing Growth
With only a 3.5% overall market share, far behind larger peers, we don't think Lemonade should prioritize broad customer growth right now. Lemonade claims a higher renters insurance share among under-35-year-olds. We believe they should leverage this young customer advantage and focus more on cross-selling to increase revenue per customer. This can improve loyalty and profitability over time. It can also make its disruption story more compelling.
Valuation
Lemonade's valuation multiple has contracted and is now more aligned with its peer group. Given the slowing growth outlook per management's quarterly guidance, the current valuation seems justified rather than cheap. We believe upside potential exists only if Lemonade can increase revenue per customer and dollar retention rate (which they guided lower over the next few quarters). With growth prospects diminishing, the current valuation level does not appear attractive relative to peers. Lemonade trades at a fair multiple now, but lacks catalysts to drive a re-rating absent improving retention and customer monetization.
Conclusion
Lemonade faces slowing growth and challenges to meaningfully expand its customer base and premiums, making its disruptive model story less compelling. The synthetic agent model's merits are uncertain due to its substantial financial expenses and indications of restricted access to capital markets.
We believe Lemonade should refocus on maximizing value from its existing core customer base through cross-selling and improved retention. Growth for the sake of growth should not be the priority. With muted prospects in the near term, Lemonade appears fairly valued relative to peers. Strong execution on customer monetization and retention will be needed to drive upside from current levels. In the absence of these catalysts, significant multiple expansion seems unlikely. We retain our Neutral Rating.
For further details see:
Lemonade Q2 Earnings: Analyzing The Synthetic Agents Model