2023-12-01 12:35:47 ET
Summary
- Lemonade reported solid Q3 earnings, with improvements in gross loss ratio, reduced operating expenses, and beating analyst estimates.
- The company aims to focus on rate accuracy rather than rate adequacy as inflation subsides and management believes in the potential of its AI models.
- Lemonade's customer base is growing, with a rising premium per customer and improving revenue from insurance premiums. However, caution is advised due to its past projections falling short.
I wrote about Lemonade (LMND) less than 2 months ago, rating the stock a speculative buy on October 19, 2023. I rated the stock a speculative buy because it has a high potential upside if its AI models prove that it can consistently bring down the company's gross loss ratio below 75% and help bring Lemonade to overall profitability. The company recently reported solid third-quarter earnings on November 1 that displayed a year-over-year improvement in the gross loss ratio, a continued reduction in operating expenses, and beat analyst consensus estimates on the top and bottom lines. The company also projected fourth-quarter revenue of $107 million to $109 million, above the average analyst's estimate of $106.9 million. The stock was up 47% to $16.17 the day after reporting these impressive results.
Suppose the company can string together a few quarters of a declining gross loss ratio, increased top-line growth, and display continued progress toward profitability; the stock could potentially have a sustained rally. Investors who are bullish on Lemonade found a lot to like in the recent earnings report. Although this stock has considerable risk, it is a great time to consider buying if you have room in the speculative portion of your growth portfolio.
Rate adequacy versus rate accuracy
The company stated the following in its third-quarter 2023 shareholder letter:
Rate adequacy may be the name of the game while inflation is high, but rate accuracy is where the long game is played out. And that, we believe, is where we will shine.
-Source: Lemonade Third Quarter 2023 Shareholder Letter.
Rate adequacy is when regulators and insurance carriers set premiums designed to be, on the one hand, reasonable to the insured customer but at the same time be enough to cover an insurance company's operating expenses and claims obligations while producing a decent profit. Rate accuracy is when an insurance company sets rates to reflect the actual risk of each policyholder, a vastly more complex and sophisticated approach, as it requires the insurer to collect and analyze a ton of data about each policyholder's risk profile.
Lemonade was designed from the bottom up to be a "rate accuracy" insurance company, meaning the company's founders believed that technology had evolved enough to estimate the risk of each policyholder with precision using analytics and artificial intelligence. However, when inflation made its ugly appearance starting in 2021, the company went on the defensive. Instead of being concerned with rate accuracy, it was worried about rate adequacy and getting inflation-adjusted insurance premiums approved.
However, the company's long-term game plan has stayed the same. Management still believes rate accuracy is the way to go and plans to return to the long game as inflation rates cool and its new higher insurance rates earn in . Lemonade management often uses the term "earn-in," referring to the premium the policyholder has paid for the portion of an expired policy. The chart below shows how insurance rates are on the rise as inflation declines.
Lemonade Third Quarter Shareholder Letter
If inflation continues to decline, future Lemonade investor conferences, earnings calls, and shareholder letters will spend more time discussing the company's LTV6 model , which the company states in its third quarter shareholder letter as a " million-parameter AI [Artificial Intelligence] able to predict churn, claims, and cross-sales for every Lemonade prospect. " This AI model can also predict the lifetime loss ratio for each policyholder. In comparison, management has previously shared with investors that traditional insurance companies use far fewer data points. For instance, this Lemonade blog on precision underwriting stated, " A standard homeowners' policy is based on a form with 20–40 fields (name, address, birthday…); so, 20–40 data points are what a traditional insurer collects per customer. " Chief Executive Officer ("CEO") Daniel Schreiber believes those 20 to 40 data points are insufficient to provide enough granularity to accurately assess individual policyholders' risk profiles.
You might wonder why Lemonade's "million-parameter" data advantage has not resulted in a loss ratio as good or better than legacy insurance companies. One reason was that inflation threw a monkey wrench in the company's plans. The second reason is that even a million data points on customers do the company no good until it can correlate that data with real-world claims information. Legacy insurance companies may use only 20 to 40 customer data points but have 50 to 100 years of linking those customer data points to actual claims data. Lemonade investors are betting that it will better predict individual users' risk levels once it has gained enough claims data. The excellent news for Lemonade Bulls is that the company might have already reached the point of having enough claims data to make accurate predictions.
In its third-quarter shareholder letter, the company showed a demonstration of LTV6 predicting the loss ratio of a cohort over several quarters and showing the actual loss ratio of a cohort. A cohort in insurance refers to a group of policyholders with similar characteristics. In the following example, Lemonade does not specify whether it is looking at a cohort based on age, location, type of insurance policy, or some other characteristic. In previous presentations, management has shown the predicted cohort lifetime loss ratio in the pink line. However, investors wanted to know how management knew the lifetime numbers were accurate. So, management decided to show LTV6's predicted first-year cohort loss ratio for the second and third quarters of 2022 and compare it to the actual first-year loss ratio.
Lemonade third quarter 2023 shareholder letter
LTV6's results above showed a prediction of 78% for the second quarter of 2022 and an actual loss ratio of 78%. LTV6's third-quarter prediction was 71%, and the exact loss ratio was 68%, showing that the AI model is reasonably accurate in its predictions. Suppose LTV6's predictions continue to hold up; it augurs well for Lemonade's ability to reduce its loss ratio.
The company reported excellent quarterly results
Lemonade's third quarter 2023 shareholder letter highlighted that its gross loss ratio is also declining in its quarterly reports. Its loss ratio dropped 1100 basis points year-over-year to 83%. If this number continues its trend lower, it's an excellent sign for the company's goal of achieving positive cash flow by the end of 2025 and positive adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) by the end of 2026.
Lemonade Third Quarter 2023 Shareholder Letter
In addition to improving the gross loss ratio in the third quarter, the company continued reducing operating expenses, which dropped 11% over the previous year's comparable quarter, and operating expenses as a percentage of revenue declined from 76% in the second quarter to 72.58% in the recently reported quarter. As mentioned in my last article on Lemonade, major insurance companies like MetLife ( MET ) and Allstate ( ALL ) have operating expenses as a percentage of revenue in the range of 10 to 13%. So, the company still needs to reduce costs drastically. If you choose to invest in this company, continue to monitor the gross loss ratio and Lemonade's ability to reduce operating expenses, as both are necessary to achieve profitability.
Growing the company's customer base and the top line remains a priority as the company moves toward profitability. CEO Schreiber said during the third quarter earnings call:
Towards that end, we anticipate accelerating our pace of growth considerably in 2024. We previously communicated the reasons for our slowdown this year and as inflation subsides and [new premium] rates come online; we can see our path clear to reengaging our clusters in 2024. In our Investor Day [2022], we spoke of 25% compounded annual growth rate as our target growth rate and we anticipate our growth rates in 2024 we will be at or around this target. Continuous and strong growth are key to fully harnessing the benefits of automation and it deemed to combined impact of both automation and growth are key to our profitability.
-Source: Lemonade Third Quarter Earnings Call.
The term "reengaging clusters" refers to the company's plan to refocus its growth efforts on specific customer groups, or "clusters," which its AI and analytics had previously identified as having high potential for acquiring its insurance products.
By the end of the third quarter, the company's customer count was closing in on two million. Less than a week after reporting earnings, Lemonade hit the two million active customer mark on November 8. The company also noted that it took 4.25 years to reach one million customers but reduced the time to add an additional million to 2.75 years. These numbers are awe-inspiring, considering the time it took some prominent legacy insurers to reach their first one million customers.
Company name | Time (Years until one million customers) |
Lemonade | 4.25 |
State Farm | 22 |
Allstate | 19-27 |
GEICO | 28 |
USAA | 47 |
Source: NTT DATA
Another vital metric, premium per customer ("PPC"), rose 6% over the previous year's comparable quarter to $362. Management attributed the rise to rate increases and a mix shift to higher-priced products -- a good omen. From the beginning, the company's strategy was to start customers with low-premium policies like renter insurance and, over time, cross-sell and upsell those customers to higher premium policies. A rising PPC can indirectly signal that the strategy is working. Additionally, a rising PPC can help increase customer lifetime value, a measure of the total profit that Lemonade expects to generate from a customer over their lifetime, a benefit to Lemonade's long-term financial health.
The company's third-quarter Annual Dollar Retention ("ADR") was 85%, down from the 87% ADR reported in the second quarter. The Chief Financial Officer ("CFO") Tim Bixby said about the decline, " There was some modest downward pressure on ADR this quarter from the addition of former Metromile customers in the current quarter metric calculation for the first time. " Still, the number is slightly above the insurance industry average retention ratio of 84% . ADR measures Lemonade's customer retention and ability to generate repeat business. According to the company, the metric includes " the impact of changes in policy value, additional policy purchases and churn. " Customer retention is crucial as it allows the company to avoid the high costs of acquiring new customers.
Gross earned premium , the total revenue earned from insurance premiums during a specific period, increased 27% year-on-year in the third quarter. This number shows Lemonade's ability to generate revenue from its core business of underwriting insurance policies. CFO Bixby said gross earned premium grew " a bit faster than IFP growth, due to the partial quarter impact of Metromile results in Q3 of 2022. " IFP stands for in-force premium, the aggregate annualized premium for customers at the end of the quarter. Third-quarter revenue increased 55% year-on-year to $115 million. Revenue is the company's Gross premiums minus premiums ceded to reinsurers plus its investment income. The CFO attributed the increase in revenue to the " increase in Gross Earned Premium as well as a 169% increase in investment income and a decline in the proportion of premium ceded to reinsurers. " Investment income is the cash earned by Lemonade investing in the float, which are premiums that an insurance company isn't using to cover claims.
Lemonade Third Quarter 2023 Shareholder Letter
Lemonade stated in the third quarter shareholder letter :
Connecting the dots, the picture that emerges is of a business that is adding customers faster, with each customer paying more, resulting in an expanding business and increasing efficiencies. That suggests solid progress along the path to profitability, which brings us to the next section.
-Source: Lemonade Third Quarter 2023 Shareholder Letter
All the above has resulted in improving profitability. Third quarter net loss improved by 33% to $62 million, and adjusted EBITDA loss contracted by 39% to $40 million. Last, Lemonade's free cash flow ("FCF") for the third quarter ramped significantly higher to a loss of $8.5 million.
The company ended the quarter with $558 million in cash and short-term investments against $7.7 million in long-term debt. CEO Schreiber believes that when the company achieves positive FCF, it will still have plenty of money on the balance sheet, and Lemonade can avoid raising capital. On the third quarter earnings call, he said, " We expect to become cash flow positive by end of year 2025 and to reach that point with hundreds of millions of unencumbered dollars in the bank. "
The company remains risky
Although Lemonade appears to be trending toward profitability ever since stating in its second quarter 2022 shareholder letter, " We expect our losses to peak this quarter (Q3) [2022], and to continue to shrink thereafter, charting a clear path to profitability, " investors should remain cautious, as management has made a few projections in the past that have failed to pan out. As a result of some failed promises, Lemonade has attracted its fair share of critics and short sellers over the past three years. The stock currently has 30.87% of the shares sold short, an extremely high percentage.
The company has placed a considerable bet that its method of utilizing the latest AI technology differentiates it from legacy insurance companies. Its AI algorithms have yet to conclusively prove that it produces better results than old tried and true methods from legacy carriers. Learning whether its business model will prove itself may take another year or two. If you decide to invest in this company, you must be comfortable investing in unknowns.
Last, on November 9, 2023, the company filed for a mixed-shelf offering. One of these shelf offerings is a secondary offering for stockholders to sell securities, including its largest shareholder , SoftBank Group Capital ( OTCPK:SFTBY ) ( OTCPK:SFTBF ). The second part of the shelf is a primary offering allowing Lemonade to raise capital through securities sales. Lemonade's primary shelf offering creates the risk that the company can sell so much stock in the future that it can dilute existing shareholders' ownership and create uncertainty. The secondary offering can create selling pressure if significant shareholders sell too many shares at once. It can also damage investors' willingness to hold the stock if they think principal shareholders are bailing.
Should you buy it?
Considering how fast the company is growing its top line, the market should value it more like a high-growth company than an insurance company. Lemonade trades at a current price-to-sales (P/S) ratio of 3.053, far too low for a company that produced a 54.73% year-over-year quarterly revenue growth rate this quarter. It should be trading at least at its three-year median growth rate. Multiplying the median P/S ratio of 8.71 by its trailing 12-month sales per share of $5.88 calculates to $51.21, the price I believe the stock should be trading at today. That stock price would give it a 190% upside from its closing price of $17.67 on November 30, 2023.
The stock has a Guru Focus value of $56.92, 222% above Lemonade's closing stock price of $17.67 on November 30, 2023. The GF value is a proprietary method of deriving the intrinsic value of a stock. Based on the GF value, the market significantly undervalues the company.
If you value Lemonade more like an insurance company, it sells at a price-to-book (P/B) ratio of 1.702, below its three-year median P/B ratio of 1.746. In comparison, the P/B ratio for property and casualty insurance industry is 1.9, according to CSIMarket . The chart below shows legacy insurance companies Allstate and MetLife sell at a much higher P/B ratio than their three-year median. Considering the stock is still unprofitable, it is probably trading around fair value if you think it is just another insurance company. If you want to be very conservative, multiplying Lemonade's three-year median P/B ratio of 1.746 times its book value per share of $10.40 equals a stock price of $18.16, only a 3% upside from the November 30, 2023, closing stock price.
Investing in this stock takes a strong contrarian mindset, as some bearish investors will give legitimate arguments to avoid holding this stock. However, if you have a strong mind and a risk-taking mentality, believe Lemonade is a growth company, and are looking for a potentially high-upside stock, consider adding a few shares to the speculative portion of your portfolio. I rate the stock a Buy for its long-term high potential upside.
For further details see:
Why Lemonade's Progress Toward Profitability And Free Cash Flow Make The Stock A Buy