2023-10-19 14:36:29 ET
Summary
- Lemonade is an early-stage, unprofitable company with a risky insurance business model.
- The stock price has plummeted from its early 2021 highs due to a terrible economy and a lack of progress toward profitability.
- The company is embracing Artificial Intelligence in an attempt to achieve profitability by 2027.
- It is a buy for investors willing to speculate.
Lemonade (LMND) is a company cautious investors should be wary of despite its potential high upside. It is an early-stage, unprofitable company with a risky, unproven insurance business model. This type of stock quickly fell out of favor when inflation rose, and the Federal Reserve started raising interest rates. You can see on the chart below that its stock price plummeted as the economy worsened and its losses increased.
Although its bottom line is trending up in 2023, for the stock to see a significant reversal and trend upward over the long term, investors want to see measurable progress in the underlying fundamentals toward bottom-line profitability. And when it reported its second quarter 2023 earnings on August 2, despite beating Wall Street analysts' top and bottom-line estimates, the company didn't deliver the progress toward profitability investors wanted to see. As a result, since delivering those results in August, the stock dropped 51% from $22.07 to a low of $10.92 on October 4. Even with the price drop, the percentage of float short has risen to 32.91%, signaling a high degree of bearishness in the stock. Seeking Alpha's quant rates the stock at a sell .
However, if you have a contrarian bone in your body, there are reasons to believe it is an excellent time to buy the stock now that the bears have driven much of the speculation out of the name. Shortly after Lemonade came public, speculators gravitated towards the stock, believing the company's digital-first business model would quickly disrupt the insurance market. The worsening economy from 2021 into 2023 disabused speculators of the notion that an insurance industry disruption would be quick. The chart below shows that the company achieved an extreme valuation shortly after its initial public offering in mid-2020 but today sells at a far more reasonable valuation.
Although Lemonade's profitability metrics in its earnings reports have yet to show evidence to skeptical investors that its business model will be successful in the long term if you believe management, the company's AI models predict profitability over the next several years. During the company's Investor Day in 2022, it showed how its Artificial Intelligence and Machine Learning initiatives should bring profitability by at least 2027.
So why aren't we seeing the progress toward profitability in today's numbers? Lemonade management argues that internally, they do see it in the numbers . Chief Executive Officer Daniel Schrieber describes the numbers the company reports in earnings reports as "lagging indicators," but internally, the company is looking at the leading indicators. For instance, the first step in Lemonade's attaining profitability is consistently achieving a Gross Loss Ratio of 75% and below. So, while investors were unimpressed with the 94% Gross Loss ratio reported in the third quarter of 2022, management was looking at the leading indicators generated from its AI models, which predicts that the insurance written in the third quarter of 2022 will produce a Gross Loss Ratio of 60.6% once the premium is "earned in ." If the company's AI models prove correct, the market should reward speculators who invest at today's prices. I encourage investors to watch the company's 2022 Investor Day for a deep-dive explanation of why Lemonade's management believes AI can help it achieve profitability over the next several years.
Let's look at more reasons this stock is a buy for investors willing to speculate.
How it will improve the Gross Loss Ratio
One huge roadblock that Lemonade ran into trying to accomplish its Gross Loss Ratio goals over the last several years was the spike in inflation in 2021 that only started becoming manageable recently.
Rising inflation resulted in higher claims payouts and operating costs for Lemonade, resulting in an increasing Gross Loss Ratio. If an insurance company sets rates today, it assumes a certain amount of dollars of claims payout in the future, factoring in a predicted inflation rate. If inflation increases beyond the prediction, when it comes time to pay those claims in the future, the insurance company will pay them in inflated dollars. In contrast, the premiums paid in by the insured over multiple years were paid in non-inflated dollars, resulting in the company paying more in claims than it accounted for when it first set the premium rates. The insurance company also pays its expenses in inflated dollars, resulting in higher costs than initially accounted for. The combined effect of inflation on insurance claims and expenses raises the Gross Loss Ratio. Management listed this risk on page 115 of its S-1 :
Inflationary factors such as increases in overhead costs may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date [2020], a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of operating expenses as a percentage of revenue, if the selling prices of our products do not increase with these increased costs.
Source: Lemonade S-1
Lemonade's solution to countering inflation was to raise premiums. The problem is that it cannot unilaterally raise premiums; regulators have a big say on the size of the fee an insurance company charges customers. In an inflationary environment, by the time a state insurance regulator approves a rate rise, inflation can make the new rate unprofitable if the company doesn't raise the premium enough. However, the good news for Lemonade is inflation rates are coming down, and at the same time, it is starting to receive approvals to charge higher premium rates. For instance, the second quarter 2023 Shareholder letter reported:
California recently approved a 30% increase in our homeowners rates, and a 23% increase for Lemonade Pet. Across the board we are taking more rate and seeing an acceleration in our rate approvals. We expect this will register on our loss ratio as new rates 'earn in' over the coming quarters.
Source: Second quarter 2023 Shareholder Letter
Management believes it is on the path to a Gross Loss Ratio of 70% by at least 2027 through increasing automation to bring costs down, its AI getting better at predicting risk, more filings for rate changes, achieving more regulatory approvals, and the new premium rates "earning in." If those measures produce steady progress toward its Gross Loss Ratio and bottom-line profitability goals, the market will award the company a much higher valuation.
Provided it can drive the Gross Loss Ratio below 75%, it will still need to continue to reduce operating expenses as a percentage of revenue to achieve profitability. Although Lemonade has driven that percentage down from around 200% in mid-2021 to 76% as of the second quarter, it still has much work to do. In comparison, large insurance companies MetLife ( MET ) and Allstate ( ALL ) have operating expenses as a percentage of revenue of 12.88% and 10.29%, respectively. If you invest in this company, you should track this metric to monitor the company's progress toward profitability.
A few risks to consider
This company's management has made many forecasts in the past that turned out to be false. There are no guarantees things will be different this time, and there is a reason I have labeled this stock as speculative. The use of AI in insurance to the extent that Lemonade uses it is unproven, and whether you invest in the stock or not comes down to how much belief you have that AI can predict the future. If the AI models that Lemonade uses are wrong, the stock price could drop further. For instance, one thing that can throw off the AI models' prediction of the future is natural disasters like hurricanes, wildfires, and "Severe Convective Storms ('SCS')," which are storms with lightning, heavy rain, hail, intense winds, and tornadoes. Lemonade highlighted these storms on page 5 of its second quarter 2023 shareholder letter because unlike hurricanes and wildfires, which have predictable risks, SCSs are far more unpredictable -- bad for rate making in the insurance industry. Unfortunately for the company and its investors, SCSs negatively impacted the Gross Loss Ratio in the second quarter results. Lemonade's Shareholder letter states, "Q2 '23 was marred primarily by a series of SCSs. In fact, the first half of 2023 turned out to be one of the worst H1s ever recorded for SCS-related insured losses, highlighting the intensity of this year's convective weather and related perils (Gallagher)." As a result, the Loss Ratio soared -- terrible for the stock price.
Although management has warned the market that "one time" severe weather or wildfires could obscure its progress toward its Loss Ratio goals, investors ding the stock every time the Loss Ratio goes in the wrong direction. Ever since coming public, the company has promised a Gross Loss Ratio of below 75% would occur soon because of its business model, AI, and data advantages. And because those past prognostications have proved inaccurate, some investors may wonder about the accuracy of management's forecasts. If you decide to invest in this stock, you should prepare for sudden downdrafts in the stock price on news of severe weather events or any other thing that throws the company's AI models off. However, the good news is that the Renters, Home, and Pet insurance segments have made tremendous progress in dropping the Loss Ratio to the desired range, as seen in the chart below.
Lemonade's Second Quarter 2023 Shareholder Letter
One insurance segment missing from the above list is car insurance. Lemonade Car and Metromile are the company's two car insurance brands. Management started Lemonade Car in November 2021 and acquired Metromile , a car insurance company powered by AI, in July 2022. Usually, when Lemonade establishes a new insurance product, it will often start at a high Loss Ratio. It can take some time for the company to gather enough data for its AI to price its premiums correctly to bring the Loss Ratio down. The company likely left car insurance off the above chart until it matures, and starts achieving measurable success. Investors should watch for the company to display car insurance statistics in future company communications
Plans to speed up growth
Another crucial factor in achieving profitability is reaching economies of scale , which, in simple terms, means the business gets to a size where it gains significant cost savings. Although Lemonade grew its top-line in-force premium (IFP) by 50% over the previous year's comparable quarter to $687 million, management is eager to grow faster to reach economies of scale more quickly. However, two things have prevented it from increasing sales faster. First, state regulators place a regulatory requirement on insurance companies to maintain a minimum level of capital to ensure they can fulfill their financial commitment to policyholders. This requirement can limit the speed at which Lemonade can sell new policies, capping IFP's growth rate. Second, how much money an insurance company has to meet short-term financial obligations, also called working capital , can limit its top-line growth rate.
Lemonade has gotten around regulatory limitations to speed up growth through reinsurance. Page 9 of the company's S-1 describes its original agreement with reinsurers, which ceded 75% of its premiums. Lemonade benefits from this arrangement because the reinsurer protects Lemonade's gross margins by paying 75% of all its claims. Management wrote the following in the S-1:
Under U.S. and E.U. regulatory laws, insurance companies are required to set aside "surplus capital" in accordance with various formulae. These requirements tend to be more onerous for younger companies experiencing rapid growth, such that without reinsurance we would need to reserve as much as 50 cents for every dollar of premium sold, known as a 2:1 ratio. Our proportional reinsurance structure shifts most of that surplus capital requirement to the reinsurer, such that the capital surplus requirement for the Company is expected to be approximately 7:1.
Source: Lemonade's S-1
That original agreement has long since expired, and Lemonade replaced it with a second agreement that expired in June of 2023. In the second quarter earnings release, management announced a new deal with a 55% quota share that started on July 1, 2023. The new agreement now covers its car insurance brand, Metromile, which the previous deal did not cover. The fact that Lemonade was able to accomplish this deal was a minor miracle as the reinsurance industry is in a " hard market, " which means reinsurance is scarce.
Next, Lemonade decided to get around its working capital growth limitation through an innovative new program it calls "synthetic agents," which should eliminate the company bearing the upfront costs of customer acquisition and remove working capital limitations. On the company's second quarter 2023 earnings call , Chief Executive Officer Daniel Schreiber describes the problem:
Customer acquisition costs, known by the acronym CAC are borne upfront, and it takes us about 24 months to recoup that initial outlay. To be clear, our expenditure on CAC is money well spent because over their lifetime with us, our customers typically repay their CAC three times over even accounting for the time value of money. But because it takes time to recoup the initial outlay, rapid growth is typically cash flow negative. If we spend $100 million on CAC in year one, for example, and $200 million in year two and $300 million in year three, we could expect that $600 million of CAC investment to yield about $2 billion in gross profit over time, which is a very compelling ROI. But before we saw that return, our bank account would see a dramatic dip in its balance, not a sustainable approach at higher growth rates.
Source: Second Quarter 2023 Earnings Call
Under the "synthetic agents" program , which started on July 1, 2023, General Catalyst will finance up to 80% of all Lemonade's CAC. The terms of this finance agreement will allow Lemonade to grow its top line faster without raising more capital. The upshot of the company's reinsurance renewal, synthetic agent program, and plan to increase rate approvals is that its revenue growth and profitability should pick up meaningfully in 2024.
Can it live to fight another day?
A question that you might have at this point is whether Lemonade has the financial staying power to survive another few years before reaching its projected profitability. After all, the company has burned through $190 million in cash over the last year. So, does it have the balance sheet to survive?
As of June 2023, the company had $941.9 million of cash and short-term investments against $0 of long-term debt on the balance sheet. At the current cash burn rate, it would take approximately five years before Lemonade would deplete its cash without any more capital raises. Assuming the company will improve its free cash flow over the next several years, it has plenty of time to accomplish its profitability goals.
Should you buy it?
Wall Street analysts have an average one-year price target of $19.43, 55.19% above the company's October 13, 2023, closing price.
Lemonade sells at a price-to-book (P/B) ratio of 1.199. In comparison, the P/B ratio for property and casualty insurance industry is 2.39, according to CSIMarket . Additionally, as seen on the chart below, its valuation is below a few of its larger peers. However, some investors may feel Lemonade deserves its lower valuation because it is unprofitable with negative free cash flow ("FCF") compared to its profitable and FCF-positive peers.
Lemonade is potentially a high-reward stock. However, since it has yet to achieve profitability and positive FCF, it would be best to remain cautious despite its high upside potential. If you are risk-averse, put this stock on your avoid list because so many things could go wrong. However, if you are looking for a company with a potentially high upside, can handle its considerable risk, and believe management can achieve profitable growth by 2027, this stock is a buy for the speculative portion of your portfolio. I recommend Lemonade as a speculative buy.
For further details see:
Why Lemonade Is A Smart Long-Term Investment