Description

Overview

Trupanion provides medical insurance for dogs and cats. The company issued its first policy 20 years ago in British Columbia, Canada and entered the US market 10 years ago. TRUP quickly rose to become the second largest insurer in the space by radically changing the business model.

·         TRUP has been growing at +30%+ for the past few years, capturing 40% of the market growth, and is projected to keep similar growth rates for the next 5 years.

·         TRUP has a 70%+ ROC and 80%+ reinvestment rate (that is not a typo).

·         TRUP has high recurring revenues (98.6% monthly retention rate[1]) and trading at 30x TTM FCF, but 9x 2020 sustainable FCF, at which point they can still grow at double digits.

Industry

Pet owners are often surprised by the cost of veterinary care and can be financially unprepared if their beloved pets are injured or become ill. The cost of medical treatments for pets have become burdensome[2] over time due to increasingly advanced veterinary care. An example area of improvement has been technological diagnostics (CAT scans, MRIs, etc.), which increase the frequency of medical interventions (prior to this many medical issues were seldom diagnosed since pets cannot communicate their complaints).

Some statistics to sum up the industry[3]:

·         Total pet expenditure reached $69 billion last year in the US alone.

·         Half of US households own a dog and 38% own a cat

·         35% of millennials own a pet, a much higher percentage than last generations. This target demographic is likely to spend disproportionally more on their pet.

·         53% of dogs and 58% of cats sleep in bed with owners forging strong emotional attachments.

The first pet insurance was issued in 1982 by VPI (now a subsidiary of Nationwide), the largest pet insurance in North America. Most pet insurance companies (except TRUP) replicated the legacy insurance model for pets. The legacy insurance model is extremely complicated and dysfunctional, lacks transparency for customers, and always benefited the insurance companies. That is why veterinarians­—the gatekeepers of the pet industry—were always resistant to any form of insurance, and winning them is the key to success. Since 1982, the insurance penetration rate in North America remains under 1%, a drop in the bucket compared to Sweden 40%, UK 25%, Western Europe 5-15%.

Vets run local owner-operated businesses[4] and usually have a great relationship with pet owners. Vets are more idealistic than their medical counterparts; enrolling and graduating veterinary school is equally as difficult as dental or medical school. However, in the US, vets on average only earn 75k a year, 5x less than doctors or dentists. This goes to show that there is an idealistic element to pursuing the veterinarian profession that encompasses genuine concern for animals.

TRUP generates 85% of their growth from vets, as opposed to 37% for the industry; if a vet is going to recommend a product, they are going to recommend TRUP - see the table below for calculation. But why are they recommending TRUP and not even getting paid for it? The short answer is because vets are well incentivized financially and morally, TRUP is a superior product than its precursors in every aspect. Insurance helps lower the financial burden, allowing vets to perform all necessary treatments. TRUP policyholders spend twice as much at the vet compared to a client without insurance. However, financial incentive does not explain the full story, otherwise vets would have recommended other companies as well. TRUP showed to the scene 9 years ago and is the second largest player, eating 40% of the industry growth.

Product

Why would vets and pet owners choose TRUP?

Because TRUP has a superior product.

1.       TRUP pays 90% of the costs of veterinary treatment if your pet becomes sick or injured (that includes cost of medication). Most competitors will cover at most 70% depending on the treatment, some do provide up to 90% but limit what they cover.

2.       TRUP has unlimited lifetime coverage, and no limit on the amount covered for any one claim. Competitors have not been able to match that.

3.       TRUP has a 5-day waiting period for injuries and 30-day for getting sick whereas competitors have 6 months to a year; that is the equivalent of a human decade in a pet’s life.

4.       They offer 24/7 customer care and their customer care is top notch. Their phone sales conversion rate is 40%.

5.       TRUP allows you to pick your own deductible up to $1,000 and more importantly the deductible is for the remaining of the pet’s life per injury/illnesses. Competitors have only a couple of options for deductibles ($500 max) and most renew annually. This is an important distinction because assuming your pet needs an intervention each year, under the competitors plan the pet owner will pay deductible x number of years. Pets generally have a few common injuries/illnesses. Assuming a pet suffers from diabetes[5], under TRUP’s plan you only pay your deductible once and you are covered every time the pet needs diabetes treatment.

6.       TRUP is the lowest cost provider in the market; they spend 70 cents on every dollar of premium in claims whereas competitors spend 50-60 cents.

Yes, it is possible to find lower price insurance, but it will cover less, so in the long run pet owners will pay more. Vets know this and pet owners are smart enough to figure that out. Most insurance renews every year whereas TRUP is on a monthly basis and can be canceled any time. Common techniques employed by other insurance companies, but not TRUP:

1.       Most insurance companies increase their price based on age, number of claims, etc. Age inflation alone can double your premium in 7 years – that is a 10% CAGR. Once you sign up for TRUP (depending on age), your premium will only increase based on your local vet’s prices. This is more controlled, transparent, in line with the customers and hovers around 5%-6%. In 7 years’ time, the difference between 5% and 10% is huge. The initial premiums are all teaser rates that could grow tremendously and cost owners more in the long run, in addition to paying out far less than TRUP.

2.       Insurance companies will reimburse you according to a benefit schedule, not the bill. So if a condition “should” cost $2,000 based on insurance calculation and your bill is higher, they will only cover according to their “price”.

3.       Insurance companies cover only menu-specific treatments which owners, way over their head at this point, are forced to choose. They might exclude medical conditions that were previously covered; these conditions are more likely to recur and would be more costly for the company.

4.       Insurance companies need to approve you for your coverage (financial standing of owner, pet condition, etc.). TRUP does not because it is a monthly-based payment (98.6% retention rate).

Pet Insurance worldwide

As we discussed above, pet insurance is widespread in countries like Sweden, UK, Australia; in fact, Sweden was the first country to underwrite insurance for a dog in 1924. In 1890, Sweden was the first to underwrite animal insurance on livestock and other farm animals; now 40% of pets in Sweden are insured. However, factors such as household income, veterinary cost, etc. are quite different worldwide. The table below summarizes some interesting statistics (all figures in USD):

Conclusions:

·         TRUP has a long runaway for growth; pet insurance in the US is a fraction compared UK, Australia and Sweden.

·         Most pet insurance in mature markets is underwritten by one or two big players. As the US market matures, it will force players out of the market and force them to merge. More importantly, fewer than 2-3 will be able to underwrite profitably and competitively in the long run.

·         Annual premiums in the US are not egregious, they are comparable to Australia and Sweden. However, premium growth expectations would be more moderate than the previous years.

·         TRUP paying 70 cents of claims out of every dollar is not abnormal, only in the US.

o   UK firms pay significantly more in claims than US firms – further proof of a dysfunctional insurance system in the US.

o   The average claim in the UK is almost twice as high as in the US

o   Agria Djurforsakring, one of the largest pet insurer in Sweden, paid approximately 70 cents on each dollar of premium.

·         Management’s projected profit margins are reasonable:

o   Agria generates 10% profit margins[6][7].

o   Hollard, which underwrites most of the Australian market, claimed that they were generating 8% profit margins.

o   Allianz’ PetPlan, insures a third of all pets in UK, reported a loss throughout their operations[8], but were generating 11% profit margins on their mature markets.

·         US households are twice as likely to have a pet.

·         UK and Australia are experiencing similar increase in veterinary cost; most insurers are scrambling to adjust prices.

·         Pet insurers in Australia have annual limits of $8,000 (standard) – $15,000 (premium) and co-pay varies from 75% to 80%. Important to note costly medical intervention exclusions are common such as; cancer treatment, dysplasia, diagnostics, etc.

o   Pet insurers in the UK have similar annual limits, co-pays and exclusions to Australia. We were unable to find much information on Sweden.

Trupanion Express

Legacy insurance works in a similar way as other medical insurances. You pay the vet out of pocket for a treatment, file a claim and wait a few weeks from the insurance company to send you a check. Trupanion pays claims very rapidly, 60% the same day, 80% within 5 days. TRUP rolled out Trupanion Express, a free to use software for vets that allows immediate payment, under 5 minutes before the owner pays a cent. Trupanion Express processes around 22.3% of the claims (from none four years ago) and is growing 13 percentage points faster than TRUP’s top line. It is a matter of time before Express will be rolled out throughout most of TRUP’s network. Express can be easily replicated from a technological point of view, but not from an executional one; competitors will be unwilling to since it highlights their flaws and opaque system.

How are they able to pay 90% of the cost?

Because they do not have frictional costs like other insurers. A typical insurance company will have third party underwriters charging 15% of the premium and 3%-5% for lead generation which totals to 18%-20% extra costs. Furthermore, recent acquisitions in the space put a strain on keeping or expanding margins (cutting corners). TRUP is the lowest cost operator.

Pet Owners

Why do people buy pets?

“People are happier and healthier in the presence of animals. Scientifically-documented benefits… include decreased blood pressure, reduced anxiety and enhanced feelings of well-being” – Human Animal Bond Research Initiative Foundation.

People buy pets for a variety of reasons, but at the core of it is the inherent human need for companionship. Most dog owners can attest to the unconditional love that a dog provides. Emotional connection is the biggest driver behind pet insurance (excluding the effects of income). Pet owners do not want to be in a position where financial condition prevents them from providing a necessary medical intervention for their pet. At the core are two trends: the first being baby boomers who are launching their kids into the wild and replacing them with domesticated animals. In almost all pet spending categories, spending declines as a person reaches 55 years of age – but then pet spending peaks between the ages of 55 and 64. The second trend is millennials (people born between 1985-2010) who are probably the first generation to grow up thinking that pets are more like humans than wild animals, a process called humanization of pets.

Is it affordable?

Affordability is ultimately a function of the value provided. The value here is a healthy pet and a peace of mind. $55 a month may sound steep, but surprisingly money doesn’t seem to be a problem. 65% of TRUP’s customers are from mid to low income. Pets require frequent assistance; 14% of their clients have an invoice every month and more and more owners are discovering that medical insurance is a necessity. Speaking of necessity, here are a few stats on how much pet owners are willing to spend on pets:

·         10% of dogs and cats have designer clothes

·         17.5 million dog owners stay with their dog in pet friendly hotels

·         6.6 million dog owners frequent dog-friendly restaurants

·         1.8 million dogs go to work with their owner

Sales and capital allocation

How do they approach vets?

TRUP’s pet acquisition cost is largely comprised of their salesforce which they call territory partners (around 104 in total). Following the earlier Coca-Cola distribution system, each territory partner is responsible for vet hospitals in a certain area. They meet with each vet every 2 months to build a relationship. Their job is to show the vets TRUP’s product and leave it to the vets to recommend it. TRUP pays their territory partners a fixed fee per pet in the area that cover. This cost is much smaller than having a broker model (which usually takes 15% of the premium – hint: Geico). The partners are trained rigorously; TRUP has an in-housed university and each partner receives constant training. If a territory partner does not do his mandatory rounds upper management can easily spot it in the data.

A timeline of their sales process

It takes time for the vet to trust the product and provide full support. One hospital in Canada took about 3 years to reach 1% penetration rate. After 10 years in the hospital, 5% of new enrolled pets are signing up for TRUP – that’s a 5% going forward penetration rate at 0 cost. TRUP is active[9] in 8,000 hospitals out 28,000 in the US, and the majority of those they entered in the past 4 years. Growth will be horizontal (more hospitals) and vertical (higher penetration in each hospital).

Lifetime value/ Pet acquisition cost (LTV/PAC)

The ratio is a proxy for TRUP’s capital allocation. TRUP’s cost structure 70 cents are spent on claims, 10 cents on filing claims/variable expenses, and lastly they expect 5 cents to go to fixed costs – once they reach scale three years from now. Lifetime value is defined as the gross margin (revenue x 20% - excluding fixed expenses only) multiplied by the average policy lifetime which is currently 72 months or 6 years. Pet acquisition cost is the cost spent on sales and marketing (mostly territory partners) to acquire new pets (that includes replacing the churn rate). Last year, discretionary margin was only 8% of revenues (so $15 million) and LTV/PAC of 5:1, meaning they get $75 million of new business over 6 years; that is a +80% IRR. TRUP will go into cash flow negative territory if they spend a cent more on growth.

When they reach scale (in 3 years by management’s estimates) they will be able to make 15% operating margin, which is double the current margin. In 3 years, revenues will grow to $482 million so potential pet acquisition dollar increases to $482*15% or $72 million, almost 5x current spend rate. I don’t expect the LTV to PAC ratio to remain at 5, that is really high. I do expect it to decrease, but management does not expect it to drop below 3x which translates to +40% IRR. How many companies can achieve that IRR? Not many, that is why I encourage the company to run at 0 profit even if they get a 25% IRR. Why? Because if they paid that to me as dividend I would not know where to allocate it at +25% rates. At the current LTV/PAC an investor would need to return 40% annualized to match management’s current opportunity cost of distributing the cash to shareholders. When the PAC drops to 3x[10], TRUP’s opportunity cost is still 28%.  This starts to look very much like Amazon, spend every cent you make because the IRR is too high to report a profit.

TRUP adjusts its premium depending on vet care cost in the area. They won’t raise the premium due to age, number of claims, annual costs, etc. which is quite the normal in the industry. That incentivizes pet owners to insure their pets as puppies since insurance will be low. But that will mean that the lifetime value of the pet should be higher, and that is exactly what management has seen. Pets generally live more than 72 months so each new puppy owner has a higher lifetime value. That is partially offset by the lower early age premium; but it is still higher than current LTV.

Management

I won’t go into too much detail on management, I think reading the 3 shareholder letters[11] is more than enough to get comfortable with the CEO. Trupanion was founded by Darryl Rawlings, the current CEO, and he owns 7.65% of the company. He has been able to grow TRUP into a fantastic business with a great product into second place from non-existent almost a decade ago. TRUP is eating 40% of the industry growth, growing its top line 27% and has an internal IRR of +80%; the CEO must be doing something right.

Maveron, the VC firm founded by Howard Schultz and Dan Levitan, were instrumental in investing and helping Darryl transition from a start-up to a public company. Dan Levitan is a prominent VC investor and Howard Schultz does not need an introduction. As of 2016, Maveron owns 18.9% of the shares and prominent firm Ruane, Cunniff & Goldfarb also owns 6% of the shares.

Risks

·         Pricing

o   This is the primary risk to any insurance company. In the past, it has been difficult to sustain unexpected losses, but they have mostly been within a controllable range. If TRUP has been able to keep risks within bounds when sub scale, the more they grow the better their pricing will get.

·         Capital allocation

o   Despite having high IRR, as the margins and the top line increases, the potential PAC dollars will increase exponentially. That would make it hard for the CEO to allocate it efficiently. The good news is that the IRR is so high that declines are expected, but the margin of safety is still very high. The CEO has said that he will keep a minimum 40% IRR.

·         Succession

o   Rawlings has trained upper management well and all of them have +3 years working with him. Another example of quality hiring is that claims employees have worked +5 years in a vet hospital. Territory partners go through a rigorous training; Rawlings believes that it takes two years for them to become thoroughly ready.

Valuation

Last quarter the company generated $55 million in revenue. Because this business is highly recurring and growing fast, it is unfair to use TTM. We prefer multiplying the latest quarter by 4x and use that as the yearly revenue, for simplicity purpose, so FY 2017 would be 55 x 4 = 220 million. For FY2020 we grow Q1 2017 revenues at 25% for 3 years and multiply by 4x to get $482 million.

·         Claims and variable are always going to be 70% and 10% of revenues, the company has been pretty spot on the previous years.

·         They expect fixed expenses to normalize at 5% of revenues when they reach scale, roughly 650k-750 pets. If we grow current pets enrolled by 21% for 3 years and price increases of 4% we arrive at the lower end of the scale or 677,572 pets enrolled.

·         We assume a maintenance capex of 1.5% of revenues. TRUP has an annual churn of 16.8% (1-98.6% x 12). Half of that churn is replaced by pet owner referral and/or pet owners buying a new pet after their previous one passes away. The other half is replaced by spending only 1.5% of revenues; the model displays it better.

·         At scale, EBIT margin would be 13.5% and we assume 20x EV/EBIT, which is slightly higher than the current EV/normalized EBIT of 18x.

·         Base case, we double our money in 3 years or a yearly return of 25%. We believe that the downside is quite protected and we lose.

·         There is a lot of speculation around the operating margin being sustainable at 15%; after all it is management guidance.

o   To those of you who think this is too high, not quite. The average industry margin in US is 5% when only the largest player (Nationwide 40% of the market) is of scale[12]. Assuming the rest are reporting losses, the profit margin could be around 10% which is EBIT margin @ 15% x 33% tax rate.

o   Furthermore, TRUP is able to maintain a higher margin because of the frictional cost savings @20% that we discussed above.

o   To those of you who think this is too low, it is debatable. We believe that smaller margins and showing 0 accounting profit will keep new entrants away.

[1] Half cancel policies due to financial reasons and the half because the pet is no longer with his pet owner (in most cases, the pet has passed away.

[2] http://fortune.com/2016/09/08/pet-health-care/

[3] https://vimeo.com/orangetreeps/review/214716969/38f274fe6d

[4] 26,000 out of 28,000 vet clinics/hospitals are single-vet operated

[5] One of the most common illnesses for old pets http://dogtime.com/dog-health/general/20268-top-10-most-serious-pet-diseases-list

[6] https://www.agria.se/globalassets/sv/arsredovisning/annual-report-2016.pdf/

[7] Note that Agria had other lines of insurance

[8] Including countries like Brazil, Australia, Canada, etc.

[9] Active means that there is at least a pet enrolled under Trupanion.

[10] Lower than the management’s projection of 3.2x

[11] http://investors.trupanion.com/resources/Shareholder-Letters/default.aspx

[12] Since TRUP, the second largest player, has not reached scale yet we assume smaller players are not of scale either.

Catalyst

Recognition of a great business.