Lemonade Stock: Gaining Momentum In A Tough Market (NYSE:LMND)

Lemonade (NYSE:LMND) is a modern, technologically-driven insurance business offering renters, homeowners, pet, term life, and car insurance. With the backing of renowned private market investors, such as Sequoia Capital Israel, General Catalyst, Softbank, and Thrive Capital, Lemonade entered the public markets with significant fanfare via a traditional IPO in July 2020. However, Lemonade’s success in the private markets has not (so far) translated into the public markets, with shares down 69% from their IPO price and 49% in 2022 alone, resulting in a market cap around $400m below their Series D valuation back in April 2019 of $1.7b.

Lemonade is a classic venture capital investment. They are attempting to disrupt an enormous total addressable market (the US insurance market) using algorithms and automation, boast phenomenal top-line growth rates, and are led by two charismatic, smooth-talking founders with previous entrepreneurial success. However, public market investors have focused less on the above and have become increasingly concerned (and with good reason) about Lemonade’s high cash burn, poor operating margins, and bouts of insider selling throughout the first half of 2021.

In this article, I delve into Lemonade’s latest Q1 2022 results and discuss both aspects of the investment thesis which remain intact and areas of concern. At the current valuation, I remain bullish on Lemonade’s long-term prospects (despite looking incredibly foolish in the short-term) and added to my position last week after their earnings result.

Another quarter of solid top-line growth

As has become the norm with Lemonade, Q1 featured a ‘beat-and-raise’ for their two core top-line metrics: in force premium (IFP) and revenue. Lemonade reported IFP of $419m, which was up an impressive 10% QoQ and 66% YoY, well above their guidance for IFP of $405-410m (61-63% YoY growth).

Lemonade also raised 2022 organic IFP guidance (excludes contribution from the Metromile acquisition) from $530-540m (39-42% growth) to $535-545m (41-43% growth).

When we break out Lemonade’s IFP growth based on the number of products, we see even larger growth in IFP for multi-product customers:

• 1-product customers = 61% YoY growth in IFP.
• 2-product customers = 140% YoY growth in IFP.
• 3-product customers = 390% YoY growth in IFP.

Lemonade also reported Q1 revenue of $44.3m (+8% QoQ; +89% YoY), which beat guidance for revenue of $41-43m. This gave Lemonade the confidence to raise their 2022 organic revenue guidance (excludes contribution from the Metromile acquisition) from $202-205m (57-60% growth) to $205-208m (60-62% growth).

Healthy growth in customers and premium per customer

The two main KPIs driving Lemonade’s impressive top-line growth are: (1) total customer count and (2) premium per customer. Lemonade acquires new customers through a combination of word-of-mouth and paid marketing channels, and increases the average premium per customer when customers sign up for higher cost insurance products (e.g., homeowners insurance vs. renters insurance) or bundle multiple insurance products together (e.g., add pet insurance to their existing renters insurance).

In Q1, Lemonade broke the 1.5m customer barrier, growing their customer base 5% QoQ and 37% YoY. While the rate of customer growth has declined steadily each quarter from 50% YoY growth in Q1 2021, I expect to see this trend reverse as Lemonade completes their acquisition of Metromile (MILE) and rolls out their car insurance product to more US states.

The more important metric to watch for investors is Lemonade’s average premium per customer, as this shows the success (or failure) of their multi-product bundling strategy. In Q1, Lemonade reported an average premium per customer of $279, which was up a healthy 5% QoQ and 22% YoY. This represents Lemonade’s sixth consecutive quarter of 20%+ YoY growth in average premium per customer and I expect this trend to continue (and even accelerate) throughout the back half of 2022 and 2023 as Lemonade launches car insurance across all 50 US states.

Early signs point to material success with car insurance

One of Lemonade’s core growth drivers over the next 12-18 months is the launch of their car insurance product to all 50 US states, bolstered by the soon-to-be-closed acquisition of Metromile. To date, Lemonade has only rolled out their car insurance product in Illinois and Tennessee, but the early signs are very promising, particularly in Illinois where car insurance was available for the entire quarter. Indeed, Lemonade reported the following statistics in Illinois in Q1:

• Bundling rates were 40% higher than the rest of the US market.
• Customers with two Lemonade products outspent single-product customers by a ratio of 3:1, which increased to 7:1 and 9:1 for triple- and quadruple-product customers, respectively.
• Annual dollar retention (ADR) in Illinois was 90%, compared to 82% for the overall business.

These trends could be foreshadowing a material step-change in unit economics and retention for Lemonade’s business over the coming 12-18 months. As Lemonade rolls out their car insurance product across the US to their customer base, they are able to gain additional IFP and revenue (i.e., increase customer lifetime value or LTV) from existing customers with almost no additional marketing spend (i.e., customer acquisition cost or CAC) as the customer has already been acquired.

And this revenue opportunity is material. In their Q1 shareholder letter, Lemonade management estimated that their existing customers spend over $1b annually on car insurance with other insurance providers, which compares favourably to Lemonade’s $418m of IFP. Given Lemonade’s exceptional customer reviews and the fact that they will now be able to offer discounts to customers who bundle car insurance with an existing insurance product, I expect a substantial minority of this existing customer base to switch over to Lemonade in due course.

A (clearer) path to profitability

Lemonade continues to bleed red on their income statement, but the path to profitability is becoming clear with each passing quarter.

In Q1, Lemonade reported an adjusted EBITDA loss of $57m, which was substantially better than their guidance for an adjusted EBITDA loss of $65-70m. Their net loss of $75m was again horrific on an absolute basis, but it’s worth looking into their individual expense lines. The largest increase in expenses went to research and development (+138% YoY) and general and administrative costs (up 100% YoY) in preparation for their upcoming launch of car insurance and acquisition of Metromile.

It was pleasing to see that sales and marketing costs only increased 32% YoY, despite Lemonade growing revenues at 89%, contributing to an improvement in unit economics. As Lemonade completes their acquisition of Metromile and launches car insurance, research and development costs should come down considerably, which will help to reduce their cash burn in 2023. Moreover, the fact that Lemonade continues to grow their research and development spend so aggressively suggests that management is not concerned about needing to raise external capital in 2022 and sees the launch of car insurance as a significant step-change in the company’s long-term trajectory.

If we take a step back and look at Lemonade’s GAAP net losses over time, there is a clear trend emerging where net loss as a percentage of revenue is declining with each successive quarter, despite significant upfront investments to launch their car insurance product:

• Q1 2021: 209% of revenue.
• Q2 2021: 197% of revenue.
• Q3 2021: 184% of revenue.
• Q4 2021: 171% of revenue.
• Q1 2022: 169% of revenue.

I expect to see net income margins improve rapidly throughout 2023 as Lemonade dials back research and development, and sales and marketing costs to prioritise cross-selling to their existing customer base over acquiring new customers and launching new products.

We also gained more clarity this quarter about Lemonade’s unit economics, which is one of the key metrics to judge the future long-term value creation of an unprofitable business. Strong unit economics where customer LTV greatly exceeds CAC is the lifeblood of a growth company and is often overlooked by public market investors who often look myopically at GAAP losses. The below quote from CEO Daniel Schreiber from Lemonade’s Q1 conference call is a long one, but demonstrates Lemonade’s ruthless focus on prioritising investments based on unit economics:

Lemonade does not and never has sold products or maintained campaigns or invested in territories that we don’t believe to be marginally profitable. So even though we are reporting losses at a companywide level, the places that we are investing dollars in terms of promoting products, growing territories, or acquiring customers are all ones where we think the CAC to LTV is incredibly compelling. It’s been hovering at or around a 3 to 1 ratio.

Now, it can be misleading because you look at our losses and it looks like we’d be selling dollars for 90 cents. But that’s just not the case. The reason it is skewed the way it is, is because the costs are borne all upfront since we tend to be predominantly acquiring customers through direct-to-consumer advertising. So we take the CAC hit right at the beginning that is then compounded by the fact that year one loss ratios are the highest. So all of our year one customers have the full brunt of the acquisition plus the worst loss ratios. But we are able to model out their lifetime loss ratios. And we have every confidence and reason to believe and the historical data has proven that our models are doing this pretty well, every reason to believe that they will return something in the order of a 3x return on every dollar that we’re spending.

In short, Lemonade bears the upfront costs of building new products and acquiring new customers via direct-to-consumer (D2C) marketing before generating meaningful revenue from a given customer. Lemonade only makes a significant return on that investment if that customer remains with Lemonade for an extended period of time, which is why ADR is such a crucial metric to watch for investors.

Elevated loss ratios (again)

Similar to last quarter, Lemonade reported elevated loss ratios in Q1, with a net loss ratio of 89% and gross loss ratio of 90%. Both of these figures are well above their stated long-term target of 75% loss ratios.

The reason Lemonade has higher loss ratios today than in 2019 and 2020 is because of the phenomenal growth in newer products launched since 2019 (eg., homeowners, pet, and car insurance), which understandably have significantly higher loss ratios than their oldest and most mature product: renters insurance. Over time, management expect each of these individual product lines to have loss ratios below 75% (renters insurance is currently well below 75%), but this will take another couple of years (at least) for all of these products to reach maturity.

One interesting artefact of Lemonade’s multi-product strategy is that while loss ratios for each of their newer products continue to decline over time (according to management commentary), Lemonade’s overall loss ratios either remain flat or increase as growth in these newer product lines outpaces growth in renters insurance. As an investor, however, I expect greater disclosure from management around individual loss ratios for each of Lemonade’s product lines (excluding car insurance which has not been fully launched). When asked about whether Lemonade would disclose individual product loss ratios on the Q1 conference call, CEO Daniel Schreiber justified their continued lack of disclosure due to competitive reasons, an explanation I am sceptical of.

Another reason for Lemonade’s higher-than-normal loss ratios was the spike in inflation which occurred in Q1 2022. In response to rising inflation, Lemonade has submitted more than 100 applications for rate changes (i.e., to increase premiums), which should help to offset some of the price inflation.

Lemonade COO Shai Wininger and former Co-Founder of Fiverr (FVRR) provided a more optimistic assessment of Lemonade’s loss ratios in the Q1 conference call. He reported that their internal dashboards show that new customers acquired in Q1 should have lifetime loss ratios below their 75% target:

Despite a 90% gross loss ratio for the quarter, these efforts show that the business we generated in Q1 is expected to have a lifetime loss ratio comfortably within our 75% gross loss ratio target.

As Lemonade shifts their core focus from product development and new customer acquisition to increasing multi-product bundling amongst existing customers over the next 12-18 months, we should decreasing loss ratios as their customer cohorts acquired in 2020 and 2021 mature. See the below quote from COO Shai Wininger in the latest conference call:

So we do see steady improvement [in loss ratios] over time when you look at the same cohort as it ages … You’ll see across the book a drop of often times 15 or more percent from year one to year two, and something not altogether different from year two to year three.

A big (positive) beat on share-based compensation

In my last article, I expressed frustration (or more candidly disgust) at the high levels of share-based compensation (SBC) forecasted for 2022. It appears that Lemonade management got the message (although probably not solely from my article!) and reported $14m of SBC in Q1, which was $6m lower than their forecasted SBC of $20m. Moreover, Lemonade reduced their 2022 guidance for SBC from $80m to $60m, reducing dilution for shareholders.

Addressing the elephant in the room: will Lemonade run out of cash?

In short, I believe the answer is no. And it needs to be, given that a capital raising at the current depressed valuation would result in almost fatal dilution for existing shareholders.

As of 31st March 2022, Lemonade had $235m in cash, cash equivalents, and restricted cash on their balance sheet, with an additional $778m in total investments (a combination of bonds, equities, and unfortunately a small amount of cryptocurrency based on media reports). Together, Lemonade holds around $1.01b of cash, cash equivalents, and investments on their balance sheet, which compares to a market cap of $1.33b (as of 20th May 2022).

In Q1, Lemonade reported total net cash outflows of $36m. If we extrapolate this same rate of quarterly cash burn from Q2-Q4, Lemonade would have around $127m of cash and cash equivalents, at which point operating expenses should reduce significantly as the Metromile acquisition will have been completed and Lemonade shifts their focus to prioritising cash burn and EBITDA margins.

Based on Lemonade’s current reinsurance agreements, Lemonade requires a minimum of $1 of cash for every $7 of IFP. If we use their latest reported IFP number ($419m), this corresponds to around $60m of required cash reserves, but this is a bare minimum so I would expect management to set a floor of around $100m of cash and equivalents for one-off extraneous circumstances.

However, this calculation fails to mention two important facts: (1) Lemonade can sell down some of their investments if needed to meet this cash reserve buffer and (2) Lemonade will acquire $164m of cash, cash equivalents, and restricted cash, and $63m of total investments from their acquisition of Metromile, which will help to further boost their cash balance.

Based on the above calculations, I expect Lemonade to get through 2022 without needing to raise additional capital from the public markets.

A concerning lack of insider buying

One of the main red flags put forth by Lemonade bears (who all seem to congregate on Seeking Alpha) is the high amount of insider selling that occurred in early 2021 as Lemonade traded between $120-180 per share and the lack of insider buying throughout 2022 as the share price has traded between $20-30. While I am more forgiving of some insiders (who had likely not had a liquidity event in the previous few years) who wanted to take some chips off the table at a rich (translate: absurd) valuation in early 2021, I am admittedly concerned about the lack of insider buying in 2022.

When asked about this lack of insider buying on the Q1 conference call, CEO Daniel Schreiber responded with the following:

People buy and sell shares for many reasons. And I’ve never found this to be a helpful gauge of anybody’s commitment or faith in Lemonade. In any event, since the question is asked not about the actions of the company for whom I’m authorized to speak, but of individuals who work here for whom I cannot, let me just answer and for myself, I have an incredibly high level of conviction in the long-term prospects of Lemonade and its shares. And indeed, the majority of our family’s wealth is in a single stock: Lemonade. So I expect that to be true for many years to come.

While I somewhat understand his argument, this was definitely a cop-out answer from Daniel Schreiber. In the end, actions speak louder than words and the lack of insider buying is concerning, but I am comforted by the fact that Daniel and Shai together still own almost 10% of shares outstanding, equating to combined ‘skin in the game’ of approximately $130m.

Conclusion

Overall, this quarter was much of the same for Lemonade. Impressive 66% IFP growth, 37% growth in customers, and another quarter of 20%+ growth in average premium per customer due to cross-product bundling. We also gained insight into the early success of the launch of car insurance.

Both losses and SBC (while still large on an absolute basis) appear to be declining as a percentage of revenue and this trend should accelerate in 2023 as Lemonade begins to collect significant revenue from car insurance and is able to dial back their operating expenses after completing the Metromile acquisition and slowing down the pace of new product development.

Lemonade’s valuation remains compelling with only $320m prescribed to their core business (excludes cash, cash equivalents, and total investments). Since their inception in 2015, Lemonade has prioritised product development – culminating in five products – and customer acquisition to reach an impressive base of 1.5m customers. We should begin to see the fruits of this upfront investment shine through in late 2022 and 2023, materialising in improved unit economics and EBITDA margins. It won’t be a smooth ride, but I expect patient shareholders to be rewarded with an investment in Lemonade at the current price.