Key Highlights
— Market outlook is only OK
— Company is doing great but could face growing pains
— Valuation is high variance
— I’m gonna sit out but have below neutral sentiment
Structure of this article
- Why, why, y tho
- Market outlook
- LMND — Strategic assessment
- LMND — Financial valuation
- Investment strategy
Part I: Why, why, y tho
Before diving into the actual sauce, let’s look at the “whys” behind this article:
Why Insurance / Insurtech
The insurance industry is old, like older than the US old. The first “American” insurance company was founded by Ben Franklin in 1752 — he’s done some other stuff too. The industry is mature and good for analysis because cashflows are predictable, long term ranges are evident from readily available data, and plenty of knowledge exists from reputable sources like the NAIC.
Insurtech is a much more recent phenomenon, and most players have effectively been advertisers for actual insurers who do the actual underwriting. Interestingly, Lemonade is an actual underwriter, which brings us to:
Why Lemonade
I’m a sucker for startups and the sheer amount of marketing $ they had spent to plaster those god-forsaken pink ads all over the city was enough for me to take the bait; I was quoted $6.11/month for renter’s insurance with $10k coverage and a $250 deductible. That’s obviously not enough to cover any kind of real disaster but it did cover personal belongings, and knowing my track record with phones, this was a DEAL.
Fast forward 2 years: I’m on my third phone as expected, and received $750 for each phone that got stolen within 10 seconds of filing a claim. The app is intuitive and 90% of the interaction is with a pretty good-lookin’ chatbot, unless it’s a complicated question which is then forwarded to a just as good-lookin’ human who replies in about 2 days. 9.5/10 product and experience and I was initially highly optimistic about the company.
Why now
Lemonade filed their original S1 on June 8, 2020. They IPO’ed on July 2, and their first earnings is on August 12, hence why I’ve procrastinated to the last day to get this out before the ER.
But actually, y tho
In these trying COVID times, ̶c̶h̶i̶l̶l̶i̶n̶’̶ ̶w̶i̶t̶h̶ ̶t̶h̶e̶ ̶b̶o̶i̶s̶ is no longer an option, so I want to channel my time and energy into alternative avenues of ~vALuE aDd~. I’m passionate about business strategy and investing, but realize that written content about these two topics typically come in two equally sh*tty flavors: dense and bland, or interesting but speculative.
I aim to channel my inner “Cracked.com” to conduct analysis with rigor that is palatable and accessible. This is also good modeling practice and a way to get feedback. I plan to build out a full site with content in various forms related to value investing in industries and companies I care about (actually not insurance, it’s boring af), in developed and emerging geographies.
Part 2: Market outlook
Alright, onto the good good —the wonderful world of insurance, aptly summarized by the fact that Des Moines, Iowa is the capitol of insurance.
Size and growth both reside in homeowner rather than renter insurance. It’s a crowded court as expected, but not as consolidated as one might expect. Margins aren’t great.
Market size and growth
“The points don’t matter”
“Play stupid games, win stupid prizes”
These are two of my favorite quotes. The actual TAM calculated as gross written premium, like the points in Whose Line, don’t matter — OK they do, but less so than trends and relative share. Per the figure below:
- Growth %-wise: growth (which is not great in the first place) is expected to come from homeowner rather than renter insurance
- Size $-wise: play the homeowner game, win an Xbox; play the renter game, win one expired skittle
TBH, Mordor and IBIS are far from fantastic sources, but these line up with NAIC’s numbers so it smells good enough for me. The insight here is:
Homeowner insurance = big and kinda growing
Renter insurance = small and not growing
Competition
The insurance market is highly saturated, but is actually not as consolidated as I had guessed. Regardless, the actual underwriting business is not an easy market to enter, as the big boys are gate-keeping (check out this Statefarm ad that tried to flame Lemonade but backfired) while the swarm of little bois have a firm grasp on their niches (that’s what she said).
In the figure below, the left chart shows (1-loss rate) which I effectively interpret as a gross margin, against relative market share on the X-axis.
Essentially, in the little leagues there’s room to win/lose, which makes sense given that there are geographical niches at play. However once you get in the G-League upwards of $1b GWP and especially beyond $5b, there’s a clear upward trend in GM (decrease in loss rate) with scale implying that bigger is better.
The obnoxious pink arrows are approximately where Lemonade would show up — not great, not terrible, as Comrade Dyatlov would say. Their business model currently has an interesting fixed profit of 25% of premiums, but their $116 million (yes, million, you read that right) of GWP barely gets them on this map. So they still have wiggle room at this stage, and you gotta give credit where credit’s due — they’re killing it right now (only in the renter space, however). But my unsolicited NBA analogy here is:
Of course Zion was doing 360 windmills over 5'2" high school juniors, but can he do that against the Wizards? And then if the Pelicans somehow make the playoffs, can he do that against an actual NBA team?
Margins
Not much to say here: it’s a mature industry, EBIT margins are not thicc:
Margins are NOT looking mighty cute in them jeans
Part 3: LMND — Strategic assessment
The industry story is a solid 6/10; let’s dive into the ‘nade.
Business model
“Harness technology and social impact to be the world’s most loved insurance company”
That’s Lemonade’s mission. In comparison to most corporate missions I’ve seen in my day job, this is pretty fresh and zesty and I like it.
To that end, what they do differently:
- 25% fixed fee profit
- highly tech-enabled experience
- donating whatever is leftover
How they are the same:
- underwrite all claims
- subject to the same regulations
- invest your premium for profit
OK, let’s see how these translate into their strengths and threats.
Competitive advantages
1a. Tech — I’d wager to say their strongest and most defensible competitive advantage is their tech. I’m not a UX or programming expert but their chatbot is extremely intuitive and smooth:
Also by force-fitting a digital framework onto the traditional insurance quote and claim process, they’ve inadvertently (probably purposely) dumbed it down so much and implicitly became the market leader in this new game they’ve created only for themselves. When you open the app the only options you have are file a claim, ask (the bot) a question, and settings. My laundry app is more complicated.
Side rant: This digital disruption was overdue for THE LONGEST FRICKIN TIME because of how adverse to innovation these old guard industries like insurance are. I hate calling my insurance, their websites are all garbage. Material for another article but I am itching to see digital disruption, which is thankfully being expedited by COVID, in other slow industries like Real Estate.
1b. OpEx — as a result of their tech, Lemonade is extremely operationally efficient. Their chatbot handled the vast majority of my questions (as I’m sure for the majority of their customers) and the few that cannot get answered are forwarded to a service rep who emails you back personally in 2 days.
No way a regular insurance company with their army of underage and underpaid call center reps can provide this absurd volume nor this quality of service. Think 1,000 Stormtroopers vs. like 3 Ironmans. In such a margin sensitive space, a lot of their terminal value cashflow, as we’ll see below, rests on their ability to pluck margin.
2a. Marketing and branding —Lemonade is 1. targeting the right people and 2. doing it well. Clearly it’s paying off with their astronomical growth. In contrast, think about how wack the legacy insurance ads are (sorry):
Knockoff Rango
Dude with a voice so deep only elephants can hear
Karen from K-Mart
Chris Paul and James Harden who can’t take enough L’s on the court
There’s just something…off. Even if these ads were homeruns for boomers, the insurance industry should know this: these folks have limited shelf life, and they’re not gonna suddenly change insurance company at age 60 from the one they’ve used since ‘Nam because the ads don’t make sense. Rather, they should be grooming the next generation of insurance buyers and it’s just not working for these old insurance companies.
2b. Founder clout — this cannot be understated in today’s age of celebrity founders and SPACs (another future topic), but Lemonade’s founders Daniel Schreiber (former president of Powermat) and Shai Wininger (co-founder of Fiverr) carry some serious clout.
Competitive Threats
It’s certainly not all pink and rosy lemonade.
- Differentiation — This is an insurance company. It might have a really fancy storefront and cool tech inside, but bread and butter will always be bread and butter. I am strongly against assessing or valuing Lemonade as a tech company (unlike Tesla, for example) because there is simply less room for this business model to transform into a platform tech play, which is what drives these insane valuations nowadays. Being tech-enabled in 2020 is table-stakes. There came a point where we just called it a car instead of a combustion engine vehicle, and a train instead of a steam-powered locomotive. This is just a modern insurance company.
- Margins — Partially as a result of the former, you play by insurance industry rules. Their tech can create competitive margins, but the ceiling here is low. No one is buying $50 butter except maybe 2 Chainz.
Growth Opportunities
Given their strengths and threats, here’s where I’d like to see Lemonade try to expand (if it’s financially ready to do so):
- Increase share— I’d love to see Lemonade leverage *cringe* their marketing prowess to aggressively capture share especially in the older segments who command more premium.
- New product — I really truly love their product. They’re already doing renter, homeowner, and pet. I need to dig more into regulations and potential cost synergies but Auto, Life, maybe even Travel would massively increase the size of the pie.
- New geographies — Currently Lemonade is primarily in the US, and very lightly covers Germany and the Netherlands. Again, where operationally and legally prudent, geo-expansion would be significantly increase the prize.
Part IV: Financial valuation
So, a good company that could face growing pains. What about their fuh-nances? This is probably gonna turn some folks off but I’m super into it and tried my best to swauce it up so I encourage giving it a read and would love to get folks’ feedback, but here’s the gist if you want to skip the sausage-making directly to Oktoberfest:
Looks great now, but not sure how long this’ll last
Yes that’s a quote about the company and not my last relationship.
I’ve broken the valuation into 4 parts:
- Revenue
- Margins
- Reinvestment
- Cost of capital
Revenue
I’m assuming renter share growth rate has already peaked in 2019 and continues to slow (conservative) but homeowner share growth has not peaked since Lemonade expanded here later and because it’s a much larger pie, will peak in 2022 and then decelerate at the same rate as renter growth (moderately aggressive).
In context, as the updated figure below shows, these assumptions basically propel Lemonade to #6 on the totem pole in 5 years at about $7.9b revenue and 5.8% share, which I think is difficult but not highly improbable:
This yields the revenue growth curve below that slows down after 2023, and share growth ultimately lags behind the market CAGR in 2026 which causes LMND to lose share if it continues on its current path and the market expands at the same rate:
In summary: I will assume that LMND’s revenues will reach $9.4 billion in 2030, which is roughly 50x today and translates to 100% — 200% growth through 2023 and scaling down exponentially to stable growth (of 2.0%) in 2028.
Margin
The blursed m-word. Here I took the EBIT margins from a few comparables, and used a mean/median for the base case and a 30th percentile for the conservative case. I also assumed a positive EBIT in Year 3, a straight line improvement til then, and a straight line improvement through steady state in Year 8.
If I had more time, I would pick out more comparables, especially growth stage companies in industries with similar margins to get a better sense of ramp rate. This will also be updated after the earnings call tomorrow. But for now, I am assuming 8.7-11.4% steady state EBIT margins, and positive EBIT after 2023.
Reinvestment
Lemonade’s gotta inject fuel for the crazy growth they’re experiencing. I took a play out of Aswath Damodaran’s playbook to estimate reinvestment.
It’s simple but pretty robust: incremental revenue divided by incremental Unlevered Free Cash Flow. Incremental UFCF is interesting because you’re looking at net changes in CapEx, NWC, capitalized R&D, without depreciation — what remains is the freed up cash, and YoY changes are basically what you put back (or take out) of the business. In other words, a 1.50 reinvestment ratio means for every dollar of earnings you throw back into the business, you are driving $1.50 revenue growth.
Based on the competitive strengths I mentioned above, I’m assuming that LMND would reach a 70th percentile reinvestment rate at $1.42 revenue growth per $1.00 re-invested, and a conservative ratio of 1.02.
Cost of Capital
This one’s a bit wonky for several reasons. The good news is LMND has no debt so it’s just the cost of equity. The CAPM model uses Rf, Rm, and beta as its inputs, and herein lie the issues:
First of all somebody give Jerome Powell and his FOMC a back massage for single-handedly carrying the US stock market on his back. 0% interest rate effectively til at least 2022 will artificially deflate Rf.
Secondly, the insurance industry beta of around 0.8 is deceptively low because it’s such a mature industry. The following comps also have very low betas. On top of that, LMND has been super volatile for the past month since IPO so that’s wack too. And to top it all off, market returns are all wonky too because of the recent COVID dip and this ridiculous V-recovery.
Add to this the debate of whether LMND is a tech company or an insurance company, and you get a whole mumbo jumbo mess for discount rate — one of the most sensitive inputs. I’ve put together the following assumptions to try to account for all these:
Base case through 2022 assumes low interest rate environment, and 50/50 weighting of Tech and insurance betas = 4.9% WACC (super super low for a growth stage company)
Conservative case from 2023 onwards assumes pre-COVID interest and market return environment, 70/30 weighting of Tech and insurance betas to reflect a heavier focus on tech needed for differentiation = 7.3% WACC (still pretty low but I’ll let it pass since it is the insurance industry afterall).
Other Considerations
Here is a summary of inputs, assumptions, and other considerations:
One material item that I plan to add after the earnings call is dilution from options. At the time of writing there are approximately 6m shares issuable from employee and other options.
One other interesting thing to note is that the lockup expires 181 days after S1 filing (June 6, 2020), which is Friday, December 4 (a day before my birthday!). The price action and earnings for the next few months will be critical to a trade come December 7. Many hyped up tech IPOs consistently had price drops upon lockup expiry.
Part V: Investment strategy
*drumroll please* and here we are:
Valuation
Base case estimated value of $71 per share, conservative estimate of a whopping $16. Considering option value dilution, I’d peg both a couple dollars further down. I’d guesstimate and apply a normal curve to this distribution in lieu of a Monte-Carlo for now, so looking at somewhere in the low $40s.
Today on August 11, the stock closed at $62.75 in anticipation of pre-market earnings tomorrow, with a sell-off leading into earnings — not a good sign.
Overall, I wish I could like the company more. I love their product and their brand, but the outlook right now is not the superstar as I had hoped for. If the price came closer to the $20s I’d be inclined to nibble just because of how much I like the product.
This feels like getting hyped from watching all the clips from 2017 on HoH of Zion decimating little boys to seeing him actually try to shoot a basketball from further than 0 feet from the basket
Trading
However, apart from the value investing lens, there always exists a strategy to trade profit from any situation — it’s just a matter of sizing your risk/reward. Given the set up, I’d have gone with selling a front month expiry way OTM naked put or really wide iron condor.
I typically use this simple macro-enabled spreadsheet that filters the live-streamed option chain data from TD-Ameritrade’s thinkorswim platform (my broker). The self-explanatory “crap-free” button filters out a ton of crap on the option chain like large spreads, low volume and open interest, low vega etc. to only show certain strikes and expiries that meet various criteria for various trading strategies. Will fully explain in another article.
But sadly, given this limited selection of non-crap options and their crappy greeks, these are terribly outsized risk (and I have another story for another time about AYX and its 30% overnight drop on outsized risk) for a poor reward. Also, price movement since the IPO has been absolutely bonkers, I’d be very cautious trying to collect premium in this environment. I would not even consider any debit plays given the high IV and crazy movement, it’d be pure speculation (shoutout to the warriors trading NKLA).
I personally would not invest nor trade LMND at the moment.
Investing: growth prospects are unclear, margin leadership is uncertain.
Trading: trading down into earnings, poorly priced options.
I’m not short LMND by any stretch of the imagination — just need more information to make a better decision. If I HAD to make a binary decision I’d choose down in the short term, but let’s see what tomorrow’s earnings brings…
Nice to have’s
I have yet to do an actual sensitivity, but just from eyeballing, the most sensitive inputs are EBIT margin and reinvestment rate. It’d be good to update the model with better clarity from the earnings report tomorrow.
It’d be interesting to hear about plans to stimulate top line growth, as that would significantly open up the game.
I also plan to dig more into demographics to refine the growth model as I believe Lemonade has significantly better penetration with certain segments than others.
Finally I’d like to add some probability distributions to the growth models, so at least I can work some option math in there to see how things shake out.
El fin
So, that’s all the real stuff. Hope you enjoyed it.
Parting thoughts
If we’re friends I’ll show you my gratitude with a drink on me, honestly you deserve it for reading it through to here. I really appreciate anyone who reads this, especially if you can provide some feedback or even suggestions for future topics.
Am I a little disappointed that this didn’t turn out to be a banger? Slightly. But this research journey was enlightening and I definitely learned a ton. I’ve also always wanted to start writing seriously so this was a good foray into the space.
By the way, could this be wrong and LMND moons tomorrow? Absolutely. Valuing a company is one thing and pricing it is another. In fact I could have gotten the valuation way off, or the market pricing could also be way off, or most likely some combination of the two. I wrote this piece more as a discussion point, and welcome disagreement.
Please contact me if you’d like to re-use any of the original research or the files I used, I’d be happy to get in touch.
Disclaimer: the above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. I have no position in LMND at the time of writing.
