LMND

Publicly traded companies mentioned herein: Lemonade Inc (LMND)

Highlights

The presenter is short shares of Lemonade Inc (LMND), having a view that the company faces a unit economics issue and that they may be facing a significant capital hole. This company started in renters insurance, a market characterized by low premium value and high churn (transient customers). 

For the larger established carriers, renters insurance is traditionally a low margin business. Carriers only profit in this market by having low loss ratios. The larger carriers don’t break this out, but anecdotally, it is assumed that they underwrite to 50% - 60% loss ratios to go along with expense ratios that are naturally much higher compared to other lines. Most of the larger carriers view renters as a lower priority, lower-margin offering with no need for marketing spend.

This is how Lemonade has amassed a sizable share in such a niche market over the past several years. Lemonade has been underwriting a low 70s (%) loss ratio, or at least 10 points higher than the peer group. 

Lemonade’s EBITDA margin has been worse than -125% annually. While negative EBITDA isn’t all that rare in fintech, Lemonade’s is by far the worst the presenter has ever seen.

The bulls argue that renters is just a beachhead to Lemonade getting into auto and homeowners insurance where premium values are much higher, but he thinks this fails to appreciate that the home and auto markets are very competitive and the incumbents are not about to cede market share lightly.

Home and auto are also much more difficult businesses to underwrite with all the catastrophe risk. Notably, when Progressive (PGR), which is a leader in underwriting auto insurance, moved into home, they stumbled at first.

With Lemonade’s move into home and auto, the company’s loss ratios are already edging higher. In the most recent quarter, the loss ratio climbed from the low 70s to high 70s (%). Lemonade’s growth slowed slightly in 2021, as well. If you look at the company’s so-called marketing efficiency (incremental in-force policies over expenses), this ratio has been declining since mid-2020.

The presenter thinks consensus forward estimates are aggressively bullish. Consensus is above what the company is guiding to in 2022-2023. For the company to hit consensus revenue growth estimates in that timeframe, the company will need to reaccelerate back to where it was in 2020, which he considers unlikely. 

There’s also a significant capital hole for the company as they move into these larger businesses, the presenter argues. Profitability is estimated to happen in 7 years. If one assumes that at scale, Lemonade would be sitting on about $4B in annual net premium. To support that, the company would need $2B in capital. Yet, he expects the company’s existing capital will deplete to nearly zero from losses over the next four years.

Such a capital hole can only be raised from equity, but in the current environment multiples are compressing swiftly especially on stocks that trade on revenue multiples. This could create a vicious downward cycle for a company that will need to raise capital.

Lastly, when you look at the company’s statutory filings, they exclude an abnormal amount of expenses. The presenter is surprised that regulators haven’t called this out yet. As Lemonade gets into auto and home with its higher volatility and greater regulatory scrutiny, he expects regulators to take a closer look at the real health of the company.

Consensus valuation has the stock trading at 5x 2023 revenues for a business that at its best delivers 10% margins, whereas many software companies with similar valuations deliver mid-30s (%) margins. 

The presenter expects the stock to trade down to 2x - 3x revenues or closer to tangible book value. That would equate to a low double-digit per share price or 50%+ downside from current price