So far, it has been a “show me” story during the Q2 earnings season. Already ripe with rich year-to-date rebounds, companies have been expected to post virtually perfect results just to hold their share prices. Amid generally frothy markets, however, I continue to believe that attractive opportunities exist in individual stock-picking, and Lemonade (NYSE:LMND) in particular looks appealing post-earnings.
The internet-friend insurance company has dropped more than 20% after reporting Q2 results, largely on higher-than-expected losses in a quarter marked by catastrophic storms. Year to date, the stock has still risen ~25%, but the company is down 30% over the past year.
My recommendation on Lemonade: ignore the short-term noise and focus instead on how the company is driving its long-term bull case. In particular, I’m pleased by Lemonade’s strong increases in in-force premiums and total customers. In addition, a new financing agreement provided by General Catalyst will provide Lemonade with much-needed short-term capital to pursue customer acquisition, which is a major gating factor for Lemonade in a business that thrives with economies of scale.
I am keeping Lemonade in my portfolio and remain bullish on this stock. To me, the key long-term considerations for Lemonade are:
- Enormous growth rates showcase the largesse of its market opportunity. Lemonade is nearly doubling its revenue on a y/y basis. And though the current market is very nonchalant about impressive growth rates, to me, this shows a business that is still very much in its nascency and able to scale to much greater heights.
- Lemonade is the new way to buy insurance. Gone are old-school insurance agencies and insurance agents; nowadays, just like everything else, we buy insurance online. As the new generation of tech-savvy millennials and younger cohorts dominate the consumer base, insurtech vendors like Lemonade will gain market share versus their legacy counterparts.
- Building a full insurance flywheel. When it started out, Lemonade just offered home and renters insurance. Now, the company is also offering bundles with pet insurance and car insurance as well (the latter through its acquisition of Metromile). Perhaps in no other industry is diversification more vital than in insurance, so Lemonade’s ability to continue growing into other insurance streams will be critical to its success.
- Loss ratios are set to improve. Lemonade is already on a positive trajectory for loss ratios, driven by both increased scale as well as efficiency of its AI bot for paying off small, legitimate claims. Progress toward regulatory approval for rate changes will help to accelerate the trajectory of loss ratio improvements as well.
Stay long here and hold out for a rebound.
Loss ratios are offset by rising rates
First things first: let’s address Lemonade’s spike in loss ratios.
In Q2, the company’s reported gross loss ratio rose to 94%, up seven points sequentially and eight points year over year. Net loss ratios spiked six points sequentially and nine points year over year to 99%. Excluding CAT (unseasonable weather catastrophes), gross loss ratio was consistent with Q1.
Lemonade notes that there is seasonality to severe weather events, with hurricanes and wildfires more common than Q2 and Q3. Even with this in mind, CAT-related claims rose 4x y/y, denting the company’s loss ratios.
We do note, however, that when excluding CAT in the home segment, and stacking on top of Lemoande’s renters and pet insurance segments, the company has driven gross loss ratios consistently downward with time: illustrating the need for scale in this business.
It’s also important to note that Lemonade has filed for rate increases with state regulators to counterbalance its higher claims, and California recently approved a 30% increase in homeowner insurance policy rates, plus a 23% increase in pet insurance rates.
With higher premiums kicking in, the company can hopefully offset the impact of higher claims and earn higher premiums and revenue.
Customer/premium trends are strong
From a pure growth perspective, Lemonade also continues to achieve well above expectations. The company added 50k net-new customers in the quarter to land at 1.9 million total customers, roughly at the same pace of customer adds as in Q1 and faster than in Q4.
In force premium, meanwhile, grew 50% y/y to $686.6 million, while annualized dollar retention improved y/y to 87% – a function of the company’s building insurance flywheel with multi-product customers.
Partnership with General Catalyst to fuel growth
We’ve solidified the notion that economies of scale are crucial in this business to improve loss ratios over time, but Lemonade is not an established insurance vendor with billions of cash to pour into growth – it has strived so far to remain a capital-light business model by adopting an effective reinsurance policy.
In Q2, the company struck up a new partnership with General Catalyst to fund 80% of its customer acquisition costs (CAC) upfront, effectively giving Lemonade a short-term capital line to draw in new customers and repay General Catalyst with premiums over time.
Per CEO Daniel Schreiber’s remarks on the Q2 earnings call:
To date, our direct-to-consumer business model has served us extremely well and with no plans to change it, but it does have one downside, 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 […]
Taken together, the impact of our reinsurance program and synthetic agents program is significant. In that elemental state, the capital burdens of insurance, both regulatory capital and working capital would weigh up down, slowing growth, idling cash and delaying profitability. That’s why our Q2 agreement are so material. Our reinsurance partners relieve our regulatory capital burden through our quota share program and General Catalyst relieves our working capital burden through our synthetic agents program.
At least from a capital perspective, therefore, the agreements that came into effect July 1 means that we’re all set to grow and to go the distance, which brings us to the next hurdle we need to clear before picking up our growth rates, most notably rate approvals and loss ratio more broadly.”
With this financing in place, and with rate increases set to benefit premiums in the back half of 2024, the stage is set for Lemonade to grow its premium pool and bring down its loss ratios.
Despite being one of the best-known internet insurance companies, Lemonade is still a tiny player in its legacy industry, which is why investors should focus more on the seeds it’s planting to fuel its long-term growth. With a boosted ability to finance customer acquisition, higher homeowner policy rates in place, and a baseline of strong premium growth, there are many reasons to buy Lemonade on the dip.