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The Insuretech Opportunity

Ephesians Chapter 4 verse 2 states, "Be completely humble and gentle; be patient, bearing with one another in love."


Today, there's a lot of division in America, let alone the world. But I like this verse, not only because it embodies peace, but because it challenges me to think about how I truly feel and act throughout each day. I tend to fall short of this statement, to be completely humble and gentle especially. However, while I fall short daily, I remain encouraged to look to improve upon my imperfections and pursue patience, bearing with one another in love. The goal isn't to be perfect, but to recognize my faults and to improve upon them daily.


I think that a lot of the transitions that are upon us today in the business world definitely require investors to be humble and patient. Insuretech is a great example of this. The insurance industry is dominated by large financial institutions that have been operating for decades, while at the same time, it is mirrored in regulation.


This makes it very challenging for any new entrant to simply develop a business model based on technology to "disrupt" the industry. However, the desire to innovate in many ways is hard to disallow versus simply maintaining the status quo. It is a direct result of younger generations looking to achieve was past generations already have. It is why newer companies are formed, rather than a perpetual cycle of the strongest talent going to incumbents. And for these reasons among others, why it is extremely important for investors to consider these newer opportunities, especially as time affords stronger challengers.


Today, I would like to focus on two companies, Lemonade, Inc. (LMND, and Root, Inc. (ROOT). Both are insuretech companies that are taking very similar approaches towards disrupting the insurance industry. Both are relying upon artificial intelligence, AI, technology to create a more seamless consumer experience, which is a major focus for many digital app-based companies. Both companies are experiencing strong growth and if momentum can be sustained over the next decade or further, may offering compelling investment returns from today.


Lemonade is currently focused on home ownership and renter insurance, but has branched into pet insurance, and will be also expanding into term life insurance. Root is predominantly focused on auto insurance, but has accelerated its focus into renter insurance as well.


Incumbents reflect some of the largest insurance companies for these markets in the U.S. But if successful, both Lemonade and Root will have a very large and lucrative addressable market to grow into. However, there is a contradiction thus far in how both companies have grown, and how they are anticipated to continue growing in the short-term from today's market valuation.


Lemonade is currently trading at around $145 per share, or just below 80 times Last Twelve Month, LTM, Revenues, based on an Enterprise Value, EV, standing at $7.7 billion. Lemonade's valuation is about just below 35 times 2022 EV/Revenues. Root is currently trading at around $20 per share, or just below 10 times LTM EV/Revenues. Root's valuation is about 3 times 2022 EV/Revenues.


Neither company is close to being Cash Flow, CF, positive, so the primary metric for valuation is EV/Revenues. I am modeling Lemonade to generate around $230 million in Revenues by 2022, with Root being modeled to generate around $1.2 billion for the same year. The clear contradiction here is the substantial divergence with valuation between the two.


Investors should recognize that most analysts are fixated on each company's respective customers, premium per customer, and In Force Premium metrics. As customers and premiums per customer increase, In Force Premiums grow as a result. The challenge here is that In Force Premiums are not a direct reflection of anticipated Revenues. Both companies Revenues are primarily driven by Net Premiums Earned, which reflects the earned portion of Gross Earned Premiums, less the earned portion that is ceded to third-party reinsurers under reinsurance agreements.


This ratio has declined as each company has continued to scale. The percentage of Net Premiums Earned for Lemonade's Gross Earned Premiums has declined from 84.5% in 2019, to nearly 65% as of the LTM through 2020. For Root, it has declined from 78% in 2019 to 67% as of the LTM through 2020. The trend remains similar for both companies as scale increases, but ceded portions to third-party reinsurers should begin to level out at some point.


Despite the extreme divergence in valuation, it is clear that insurance product mix is the key differentiator. The annualized premium per policy for Roots' auto insurance business stands at over $1,800, while Lemonade's primarily home ownership and rental premium per policy is just over $200 for the most recent quarter respectively. And yet, Lemonade is trading at a steep premium.


This is largely due to the addressable market opportunity for Lemonade as the company grows customers, as well as the anticipated long-term stickiness of rental customers transitioning to higher paying policies for home ownership over time. Lemonade's premium per policy is indicative of a substantial portion for renters. As these renters transition to home buyers there is a five to tenfold potential increase on the horizon, granted it won't happen overnight.


It also includes further diversification into other insurance products, and is all centered around Lemonade's technology platform. The use of AI is something that will continue to impact all facets of sectors and industries. Those who get it right, and have a first-mover advantage are the ones that will likely have the most success. These prospects are at the heart of Lemonade's premium valuation.


Root's focus on auto insurance has a substantial market, but is not being valued in the same way, despite having higher policy premiums per customer. Root has advanced further into rental insurance, and likely, may continue to diversify into other areas such as home ownership. I don't think that Root deserves to be discounted so heavily, and I suspect that based on Lemonade's valuation, that it will rise towards $25 per share sooner than later.


Both companies are net cash-rich with Lemonade holding around $1.1 billion including the most recent capital raise, and Root having $1.2 billion. Lemonade is approaching 1 million customers, advancing at nearly three times that of Root's customers. But the most important part of what needs to be obtained at some point is CF inflection. Both companies are already CF positive for their working capital line items, but reconciliation to net income is far off on being positive. This will necessitate some time and patience to get to a better level with the key focus being on Gross Margin, GM improvement.


As both companies scale, greater efficiencies and cost savings should result from technology platform approaches, but R&D and Sales & Marketing expenses will likely remain high in the short-term.


As stated at the beginning, it will be important to be humble in understanding that these new entrants are motivated and focused to succeed as insuretech disruptors. Like the banking industry, I expect the insurance industry to begin seeing more successful newer technology companies emerge.


At the same time, it will also require patience to continue to monitor how their businesses unfold with respect to key metrics. Today, the market is going to focus intently on customers, premiums per customer, and In Force Premiums as core drivers. As investors, we need to continually read between the lines regarding Net Premiums Earned, GM, and CF prospects. Over time, these core fundamentals will be what justifies long-term gains.


Today I am more cautious on the premium afforded to Lemonade. I see the valuation driven more by the hype surrounding the companies current customer growth performance, and diversified opportunities. For Root, I think that the Stock Price, SP, should appreciate higher from today's level, but at the same time, not head towards Lemonade's premium level.



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