Description

Investment case in brief

Trupanion (TRUP) is a ~$260 mm market cap company (including dilutive shares) that is innovating and almost singlehandedly expanding the nascent market for pet insurance in North America. The company presents an attractive opportunity for patient, growth-minded investors as well as those who are interested in owning a company that possesses structural competitive advantages that may allow it to dominate a growing market (with tons of white space).

Because the company has chosen to pursue long term growth over nearer term profitability, real free cash flow will likely be put off until the end of the decade but at that point I foresee the opportunity for $1.20 of FCF per share as well as $65 mm of ‘discretionary margin’ (ebit before marketing spend) and the company will still have a significant runway for growth and margin expansion. Using a discounted cash flow valuation, I arrive at a price target of $15 and believe the company will provide out-sized returns over an extended investment horizon.

Bringing things closer to the present time, I expect TRUP to break even from a cash flow standpoint in mid-2016 and can go on to generate >$20 mm of 2017 discretionary margin, which places today’s valuation at ~13x 2017 discretionary margin and just over 1x 2017 sales – not traditional bargain levels but reasonable in the context of a pre-scale, fast-growing subscription based company.

Hopefully more than just a few loyal pet owners will read on to better understand what I think is a very interesting company...

­­­Investment case in greater detail

I’ll be bold and compare TRUP to some other great companies like Geico and Costco (as TRUP’s CEO likes to do). The Geico comparison works because TRUP is the operator who has by-far the lowest cost structure (up to 20 percentage points) and is then able to pass those savings on to consumers in order to grow market share. Similarly, TRUP functions like Costco (as well as other quality subscription models) because the company’s policy is to maintain a high cost-of-goods sold (or loss ratio in this case) in order to ensure customers know they’re getting the best deal. More detail on this and other competitive advantages later.

As for the stock, TRUP is making a play to become a dominant player in the N.A. pet insurance market. This will occur when the company reaches “scale” at 650,000 – 750,000 pets insured (compared to ~246,000 pets in the most recent quarter). This will be no small feat (the entire N.A. pet insurance market is not much more than 1 mm pets currently) and one that I don’t think will be accomplished until at least 2019 (like I said, this stock is best suited for patient growth investors). However, at that point, the company will have utilized its competitive advantages to take a highly defensible market position in a predictable, recurring revenue business and will be able to (as cited earlier) generate ~$1.20 of free cash flow and ~$65 mm of ‘discretionary margin’ in 2020. The use of discretionary margin, rather than ebitda, is fair because TRUP is currently generating very high pre-tax IRRs (70+%) on its marketing spend and so it’s useful to view the company without penalizing it for this “growth capex type” expense.

Moreover, these figures are based on TRUP writing business to a loss ratio that’s up to 20 ppts higher than the competition. Upon attaining scale (or potentially sooner), TRUP could begin to capture more of that margin for its own bottom line and would have a significant margin improvement opportunity in addition to significant top-line growth – I haven’t yet mentioned that that N.A. pet insurance penetration is a paltry 1% compared to 5% in France, 25% in the U.K., and 40% in Sweden. While TRUP’s pricing is very beneficial to the consumer and it has chosen to scale up in a big way (i.e., delaying meaningful profitability), if North Americans do start to utilize pet insurance as much as Europeans, there could be a 25x market growth opportunity here.

As mentioned, using the FCF numbers above, I arrive at a DCF price target of ~$15 (based on 10% wacc), or ~$10 (based on a 12% wacc). Given the company’s growth potential, the current valuation of 1x 2017 sales and 13x 2017 discretionary margin leaves room for significant upside over the next two years.

Read on for a more thorough overview of the investment merits but I also encourage you to read the CEO’s letter in the 2014 annual report – you will see that he is clearly approaching the company from the perspective of creating shareholder value over the long term. And there’s even a quote from Warren Buffet in there in case you’re not already excited.

The Pet Insurance Market

As alluded to above, the pet insurance market in North America has never really taken off. Out of the 120 mm cats and dogs who visit a veterinarian each year, just over 1 mm have pet insurance, and so penetration is <1%. A 2013 Munich Re report and the general prevailing sentiment is that this is largely because of the failure to win over veterinarians as endorsers of the product. Understandably, vets are loathe to see their industry corrupted with the ways of the human health industry – negotiated rates with 3^rd party payors, long payment periods, limitations on treatment, heavy paperwork, and bureaucracy nightmares. Currently, vets are paid directly by the customer (usually at the time of the visit but sometimes arranging a payment plan for more expensive procedures as some treatments can cost many thousands of dollars). However, there are also considerable drawbacks given the lack of insurance coverage – too often pet-owners can’t afford the proper, more expensive treatment for their animal and may even be forced to do an “economic euthanasia” of the pet. Clearly, this is a losing outcome for the pet-owner, but also for the veterinarian who must forgo the profitability of more expensive and appropriate treatments. This is the reason why a well-designed pet insurance product should work. TRUP has that product and is leading the way for the entire industry. While the overall pet insurance market has grown at ~13% per year over the last five years, TRUP itself represents ~40% of the entire category’s recent growth.

The Competitors and Loss Ratios

There are ~20 providers in the North American pet insurance market, but most are sub-scale. TRUP currently has ~16% share but is rapidly taking share as it captures 40% of incremental volumes, as discussed. Dominating the peer group is Veterinary Pet Insurance or “VPI” which is owned by Nationwide and has a market share of ~61% according to its website. Hartville Group and PetHealth are the next notable competitors, holding ~10% share. Lying behind these two companies is Fairfax Financial, who has a strong record of capital allocation (and therefore their interest in the pet insurance industry can be viewed as evidence of the market’s potential). Fairfax acquired Hartville in 2013 and Pethealth in 2014. Based on pre-acquisition financials from Hartville and Pethealth, the companies targeted a low-50’s loss ratio which is consistent with overall pet insurance industry loss ratio data (which, by the way, is well superior to the larger P&C industry). TRUP, however, is targeting a 70% loss ratio – 20 ppts above the peers in order to provide a superior value proposition to consumers and vets.

Why TRUP is solving the problem in terms of product design

TRUP has the simplest pet insurance product on the market with just one coverage option unlike the other pet insurance companies, who have various plan options and exclusions that more closely resemble traditional human insurance. TRUP covers 90% of the entire veterinarian bill, with no limit at all. The deductible can be adjusted to make the monthly premium more affordable. TRUP’s policy is designed to pay for pet accidents / illnesses, not wellness visits where the customer-pay model has been working just fine. Because of the no-limit, 90% coverage (the most generous in the industry), TRUP is not necessarily the most affordable insurance on a monthly premium basis. However, because the company commits to return 70% of all premiums in the form of losses (well above the low 50% rate of the industry), the bang-for-your-buck from signing up with TRUP is far superior to competing brands. And while the policy is very attractive for pet-owners, it may be becoming clear that the real beneficiaries of TRUP policies are the veterinarians. This is absolutely crucial – without vet buy-in, the industry won’t gain steam. With vet buy-in, the industry may have decades of growth ahead of it. By endorsing TRUP, vets can benefit from customers using the simplest possible policy, without any limitations on the level or cost of care. No longer will pet-owners opt out of expensive treatments and veterinarians can continue to pursue the latest technological advances in animal treatment while making more profit and performing more procedures. The paperwork involved is minimal and even becoming non-existent as TRUP is rolling out “Trupanion Express” whereby Trupanion software ties in to veterinarian software and provides immediate payment at the end of a visit. 

Review of Competitive Advantages

I’ve already discussed some of TRUP’s competitive advantages including its vet-friendly product design but let me elaborate further:

TRUP is the low-cost provider (which is essential in a mostly commoditized business like insurance) and therefore provides a superior value proposition for customers. TRUP is able to afford this because, unlike competitors, it is a completely vertically integrated model with a robust technology platform which eliminates a full 20 ppts of “frictional” costs that competitors face. TRUP does everything in-house including its underwriting, risk management, claims processing, and call centers. Competitors mostly use external underwriters (often switching every few years) and may function only in an agency capacity, taking an upfront commission on the initial policy and perhaps participating in ongoing profits via a reinsurance arrangement with the primary underwriter. This can quickly diminish the take-home dollars (to provide one example, a competing pet insurance company may capture just $61.25 of each $100 of premiums (a $22.50 agent commission plus 50% share in the remaining premium via a reinsurance agreement). TRUP also makes very effective use of its website – 85% of sales leads are funneled through the website. Of the leads, web quotes convert 8% outright and sales calls (with TRUP’s excellent customer representatives) yield 40% conversion.

In addition to running a low cost operation, TRUP has low acquisition costs relative to customer life-time value, as they are targeting a 5:1 acquisition cost to customer lifetime value ratio (this corresponds to the 70+% IRR I mentioned earlier – basically, TRUP has been spending $119 to gain a new customer who then earns TRUP $93 of contribution margin for the next 6.3 years). Additionally, in the most recent quarter, 22% of acquired customers were referrals from existing members – a very low cost way to acquire new customers. Here again is the potential for unseen upside in TRUP stock – at a certain level of market share (both in terms of customers but more importantly in terms of veterinarians), TRUP may benefit from a network effect as more and more new customers come from lower cost referrals.

TRUP’s unique go-to-market strategy which targets veterinarians is a differentiator relative to competitors and is not easily duplicated. In order to sell its product, TRUP has prioritized developing relationships with veterinarians. The company currently employs ~74 “territory partners” who are specially trained salespeople that meet with veterinarians and explain the merits of Trupanion’s product (this is not necessarily an easy sell as vets may be predisposed to sneer at insurance; however, as discussed earlier, the TRUP policy and technology is very favorable to vets). These territory partners were responsible for 150,000 face-to-face visits with veterinary offices over the last two years, covering 16,000 of the 28,000 veterinary hospitals in N.A. – no easy task. Of those, TRUP ended 2014 with 6,000 “active” hospitals (defined as those with TRUP enrollments in the last 90 days) leaving significant runway for more adoption.

As of the middle of last year, ~80% of TRUP’s business came from ~50% of the recommending veterinary hospitals, as each new hospital tends to be relatively deliberate in their pace of adoption. However, once hospitals are able to witness Trupanion’s value proposition, they become much more likely to recommend Trupanion in the future. This is another indication that the company has a long growth runway ahead as its product design wins over more and more hospitals. Further, the continued roll-out of Trupanion Express (the instantaneous payment software) will create stronger and “stickier” relationships with recommending veterinarians.

In addition to the low-cost and unique distribution model, TRUP has an important company culture that is not easily replicable, effectively bringing a tech-like, start-up vibe to the insurance industry (along with a highly pet-friendly office). TRUP prides itself on its award winning claims and customer service (>100,000 claims are paid and >160,000 customer interactions occur per quarter). The company also has embraced technology and data. TRUP uses 14 years-worth of proprietary data to create ~1.2 mm pricing categories (i.e., a 2-year old Shih Tzu in zip 10014 receives one price quote while a 5-year old Boston Terrier in zip 59101 gets another). Only the American Kennel Club, VPI, and Hartville have been in the business longer than TRUP but only TRUP has used the same (internal) underwriter during that entire time.

Risks

There are a number of risks:

Market share / expansion: As discussed, by providing such a great value proposition in the form of its high loss ratio, TRUP requires significant scale (650,000 – 750,000 pets) in order to become profitable – this is the amount of pets required in order to allow G&A and technology expense to scale down to ~5% of revenue. Given that the entire market is not much more than 1 mm pets currently (but growing double digits), this is an ambitious goal which will require penetration of pet insurance to expand – however, it’s also important to note that if TRUP maintains ~35% incremental market share, the entire category need only grow to ~1.7% penetration in order TRUP to hit scale. As a further mitigant to this risk, I believe at some point TRUP could choose to lower its loss ratio below 70%, although this would be a departure from the messaging of its value proposition.

Pricing: like all insurance companies, TRUP could always be mispricing the business. As a mitigant, the company does have the ability to raise prices annually in order to match underlying inflation in veterinarian care. Nevertheless, if the company has misjudged incidence and / or severity of claims, its profitability will suffer. Trupanion’s impressive pricing precision (recall >1 mm categories based on 14 years of data) should further help mitigate this risk. Another interesting mitigant is that if animal health costs do continue to rise, the overall relevance of a pet insurance product may increase, and penetration will increase.

Competition: Nationwide and Fairfax are no lightweights and could take action to mitigate (over time) TRUP’s competitive advantages.

Regulatory / Capitalization: TRUP is thinly capitalized, holding not much more statutory capital than what is required by the regulators. This is likely already constraining growth slightly; however, the larger risk is if, for some reason, the regulatory environment changes or if TRUP suffers higher-than-anticipated losses, the company may need to raise new capital. Furthermore, the thin capital and the lack of an A.M. Best Rating may put the company at a disadvantage relative to competitors, though there is no indication of this as of yet.

Technicals: TRUP is a microcap stock, with only ~50% free float and significant VC backing which could all create volatility and selling pressure. However, so far the insiders appear to remain bullish. 

Underlying Assumptions

Here’s my base case underlying assumptions, which are roughly in line with the company’s vision. I have a detailed model and so I’m happy to provide more detail but the below provides a nice way to pencil into how I view the company’s potential:

·         “Scale,” which is defined as >650,000 pets, is achieved in 2019;

·         At scale, the company maintains its 70% loss ratio;

·         Other variable costs total ~10% (call center, claims handling, credit card processing, premium taxes, etc.);

·         G&A and technology expenses scale down to ~6% of revenue;

·         The “discretionary margin” (defined above) is therefore ~13% of revenue (would be ~15% excl. stock comp.)

·         The above results in discretionary cash flow of ~$65 mm in 2020. Again, I think this is an interesting metric in which to view the company as much of the further investment in sales and marketing would resemble “growth capex”

·         Nevertheless, assuming the company needs to continue to invest another 4-5% of revenue into sales and marketing, TRUP will achieve an adjusted ebitda margin of ~11% at scale (and could always go higher if the company decides to capture more of the value proposition for itself)

·         I haven’t yet mentioned the revenue assumption. For this, I slightly temper the company’s current growth rate and assume 30% growth in 2015 gradually ratchets down to 25% growth in 2019 at which time revenue will be just shy of $400 mm – so I am still assuming significant growth for an extended period of time but for all the reasons in the preceding write-up, I believe this company may have what it takes to dominate and grow the industry.

Would love to hear any thoughts or learn if anyone else has followed the company. I’ll follow up with any additional info in the comments section.

Catalyst

·         Continuation of rapid growth

·         I believe that TRUP could also be an attractive acquisition candidate for a larger insurance co.

·         More coverage / discovery / trading liquidity