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Trupanion Inc  (NASDAQ:TRUP)
Q1 2019 Earnings Call
May. 02, 2019, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings and welcome to Trupanion First Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. (Operator Instructions) As a reminder this conference is being recorded.

I would now like to turn the conference over to your host, Laura Bainbridge, Head of Investor Relations for Trupanion. Thank you you may begin.

Laura Bainbridge -- Head of Investor Relations

Good afternoon, and welcome to the Trupanion first quarter 2019 financial results conference call. Participating on today's call are Darryl Rawlings, Chief Executive Officer and Tricia Plouf, Chief Financial Officer.

Before we begin I would like to remind everyone that during today's conference call, we will make certain forward-looking statements regarding the future operations, opportunities, and financial performance of Trupanion within the meaning of the Safe Harbor Provision of the Private Securities Litigation Reform Act of 1995. These statements involve a high degree of known and unknown risks and uncertainties that could cause actual results to differ materially from those discussed. A detailed discussion of these and other risks and uncertainties are included in our earnings release, which can be found on our Investor Relations website, as well as the Company's most recent reports on Forms 10-K and 8-K filed with the Securities and Exchange Commission.

Today's presentation contains references to non-GAAP financial measures that management uses to evaluate the Company's performance, including, without limitation, fixed expenses, variable expenses, adjusted operating income, acquisition costs, adjusted EBITDA, and free cash flow. When we use the term adjusted operating income or margin, it is intended to refer to our non-GAAP operating income or margin before new pet acquisition. Unless otherwise noted, margins and expenses will be presented on a non-GAAP basis, which excludes stock-based compensation expense and depreciation expense. These non-GAAP measures are in addition to, and not a substitute for, measures of financial performance prepared in accordance with the US GAAP. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to the most directly comparable GAAP results, which can be found in today's press release, or on Trupanion's investor relations website under the Quarterly Earnings tab.

Lastly, I would like to remind everyone that today's call is also available via webcast on Trupanion's Investor Relations website. A replay will also be available on the site. And with that, I'll hand the call over to Darryl.

Darryl Rawlings -- Chief Executive Officer

Thanks, Laura, and good afternoon. Last week, we published our 2018 Shareholder Letter. I'll review a few of the highlights today, but I would encourage you to read it in its entirety. We intend to hold a more fulsome discussion and answer your questions at our upcoming Annual Shareholder Meeting on June 6th, at our Seattle headquarters. We value shareholder engagement and believe this annual event is the best opportunity to answer your questions, so that you can gain a better understanding of our business, strategy and initiatives, as well as experience our people and culture. We hope you can join us.

With that, I'll recap a few of the highlights for the quarter. Revenue was up 25% and we ended the quarter with over a 548,000 total enrolled pets. In our subscription business, we once again saw solid leads from the veterinary channel. We also benefited from strong ARPU, particularly among newly enrolled pets. Retention and conversion, two ongoing areas of focus, were consistent.

Adjusted operating income grew 56% year-over-year to $9.5 million. As a reminder, our adjusted operating income is a fuel for our growth. Adjusted operating margin expanded 220 basis points over the same time period. The expansion in our adjusted operating margin reduces our payback periods when acquiring new pets. This increased margin and reduced payback period allows us to invest more aggressively while maintaining our targeted internal rates of return.

During the quarter, the pet acquisition team deployed $7.8 million of our adjusted operating income with estimated internal rates of return at the upper end of our targeted 30% to 40% range. Our pet acquisition spend in the quarter reflects investments in additional headcount for both our lead and conversion teams, as well as a small increase in our direct to consumer spend.

I've included a lot more detail around how we think about the internal rates of return on our invested capital in my Annual Shareholder Letter. We also intend to dedicate a significant portion of the Annual Shareholder Meeting to answering questions about our strategy to deploy our adjusted operating income at internal rates of return within our targeted range.

As I noted earlier, we continue to see strong leads out of our core veterinary channel. We hit 9,700 active clinics in 2018, a 14% increase over the prior year. Our territory partners are essential to our efforts to build relationships with the 28,000 estimated veterinary clinics across North America and are a key competitive moat.

We ended 2018 with over 120 territory partners in the field, visiting 20,200 unique veterinary clinics and we continue to recruit for additional open territories. Today, we have 10 open territories, including markets like Pittsburgh, Houston and Cincinnati. Investing in our territory partners, as well as our ongoing education and support, will remain an important area of focus.

Just a few weeks ago, we held our 2019 Annual Territory Partner Conference. This event is a great opportunity each year to celebrate our collective success, share our vision and focus for the year ahead and improve the collaboration of our team. During the conference, we were able to highlight our success of marrying our software with an in-site account representative. As we've discussed previously, we've seen a sustained 40% uplift in clinic penetration rates since deploying this program.

We continue to grow the number of account managers responsible for supporting our partner hospitals and providing more frequent touch points between territory partner visits. We also increased the deployment of our software to over a 3,500 veterinary clinics and paid over $53 million in veterinary invoices directly to veterinarians in 2018, an increase of 33% over the prior year. Approximately, 5% of the invoice is paid with our software were fully automated with an average processing time of just 16.5 seconds.

Claims automation transpired out of our commitment to our software and is a game changer in delivering a best-in-class customer experience. Increasing the number of veterinary clinics that have our software installed, so that we can pay them in seconds, will continue to be a key focus area over the next few years.

Our efforts to eliminate the reimbursement model are expected to not only drive penetration of Trupanion among clinics actively utilizing this software, but are also expected to aid in our aspirations of Nirvana. Nirvana is a very important and difficult goal of offsetting our cancellations by existing members adding pets or referring friends. Delighting our members so much that they add another pet or recommend Trupanion to a friend is an important driver to our road to Nirvana. But so is reducing the number of cancellations among our existing members. With this in mind, improving our first year retention and pricing with increased precision remain two areas of focus.

I talk about this more in our Annual Shareholder Letter, including breaking down our churn by category of rate changes. Looking at average monthly retention this way, we have three primary groups. First, for pets that have been with us for over a year and received a rate change of less than 20% during 2018, our monthly retention was about 99%. This group represented the majority of our pets.

Second, for pets that received a rate change in excess of 20%, our monthly retention averaged 98%. This group represented 12% of our pets in 2018. Third, for pets that have been with us for less than a year and have not yet seen any rate changes, our monthly retention rate was only 97% in 2018. As I note in the letter, our biggest opportunity to improve our blended monthly retention rate is to reduce the number of pets that cancel within the first year.

With more adjusted operating income available to invest in new pet acquisition and a large under penetrated market, we should not expect our blended monthly retention rate to improve over our 10-year historical average of 98.5%, unless we are able to improve our first year retention rates. More upfront education for the pet owners around our product and individual coverage considerations is an important part of our strategy to do so.

Also in our shareholder letter, I highlighted our preference to reduce the number of members that receive a change to their monthly costs that is greater than 20% per year. However, this objective will not supersede our desire to get more pricing categories as accurate as possible first. We aim to deliver our same 70% value proposition across each pricing category, not only do we believe this is the right thing to do, but we also believe it will provide the healthiest and most sustainable results long term.

We also believe our high value proposition, along with transparent and comprehensive coverage drives good alignment with the departments of insurance. We operate in a regulated world by design. Owning our own insurance entity is important to delivering our 70% value proposition. As the only mono-line player in the space, we want and need to take additional time to build deeper relationships with the state regulators.

Communicating our value proposition, product, member experience and our values is essential to this effort. Over the past several years, we have added resources to and placed greater emphasis on strengthening our relationships with state regulators and ensuring that all of our business practices are designed and implemented with applicable regulations in mind.

To summarize, it's a busy time at Trupanion. We're focused on moving the ball forward on our key strategic initiatives while laying the groundwork to grow Trupanion in the category in the years ahead. Ultimately, our success will come down to our team and execution. Executing against our opportunity while maintaining our culture will be the true marker of our success.

I'll now hand the call over to Trish to walk through our quarterly results in more detail.

Tricia Plouf -- Chief Financial Officer

Thanks, Darryl, and good afternoon, everyone. I'll review our first quarter results in detail, as well as provide our second quarter and updated full year outlook. Revenue for the first quarter was $87 million, up 25% year-over-year and led by strong pet enrollment in both our subscription and other business segments.

Total enrolled pets increased 23% year-over-year to over 548,000 pets as of March 31st. Subscription revenue was $74.2 million in the quarter, up 21% year over year. Total enrolled subscription pets increased 15% year-over-year to over 445,000 pets as of March 31st. Pet growth within our subscription business benefited primarily from increased leads in our core veterinary channel.

Monthly average revenue per pet for the quarter was $56.13, an increase of 5% year-over-year, and in line with our historical average of 5% to 6%. In local currency, monthly average revenue per pet increased by 6% from the prior year for our US members, and by 5% for our Canadian members. Average monthly retention was 98.58% compared to 98.63% in the prior-year period. As Darryl noted, improving first year retention continues to be a focus of the organization.

Our other business revenue, which generally is comprised of our revenue that has a B2B component, totaled $12.8 million for the quarter, an increase of 55% year-over-year. Year-over-year growth in our other business segment reflects an increase in the number of enrolled pets. Total enrolled pets in this segment was approximately 103,000 at quarter end compared to 61,000 at the end of the prior year quarter. Based on Q1 performance, we estimate revenue in this segment will be around $55 million for the year.

Subscription gross margin was 19% in the quarter, within our annual target of 18% to 21%. Total gross margin was 18%, which includes our other business segment. Fixed expenses were $5.8 million, or 6.7% of total revenue in the quarter, down 70 basis points from the prior year period, and a 170 basis points from our 5% target at operational scale. Owning our home office building benefited fixed expenses by approximately $1 million in the quarter.

This was partially offset by $500,000 in increased costs to support our continued growth, primarily investments in teams, as well as increased audit and consulting fees. You'll recall that we triggered the requirements for an external audit of SOX compliance in 2018.

Adjusted operating income totaled $9.5 million in the first quarter, a 56% increase from $6.1 million in the prior year period. Net loss for the quarter was $1.3 million. As a percentage of revenue, adjusted operating margin expanded approximately 220 basis points year-over-year to 11%. We are pleased with the expansion in this margin, which reflects the benefits of strong revenue growth and continued scale in fixed expenses.

Turning now to our acquisition costs, in the first quarter, we spent $7.8 million compared to $5.7 million in the prior-year period. Spend during the first quarter related to the acquisition of 34,000 new subscription pets, as well as investments in building out teams, primarily around conversion and increased direct-to-consumer testing.

As we have discussed in the past, we target around 70% of our acquisition spend on core known initiatives and the remaining 30% on longer term strategic or test initiatives that are important to supporting our growth. We were pleased to deploy this incremental acquisition spend while operating within our guardrails of being free cash flow positive and targeting an internal rate of return on a single average pet of 30% to 40%.

Adjusted EBITDA was $1.7 million for the quarter, up from $0.4 million in the prior-year period. Our net loss was $1.3 million, or a $0.04 loss per basic and diluted share, compared to a net loss of $1.5 million, or a $0.05 loss per basic and diluted share, in the prior-year period. Net loss for the quarter includes an increase in depreciation expense of approximately $600,000 compared to the prior-year period related to the ownership of our home office building.

Free cash flow for the quarter was $3.1 million. Operating cash flow in the quarter was $4 million, up from $2.1 million in the prior-year period. At March 31st, we had $88.3 million in cash, cash equivalents and short term investments and $18.1 million of long term debt.

I'll now turn to our outlook for the second quarter and full year of 2019. For the second quarter of 2019, revenue is expected to be in the range of $90.5 million to $91.5 million, representing 24% year-over-year growth at the mid-point. For the full year, we are increasing our revenue guidance range to reflect our Q1 performance. As a result, we now expect revenue for the full year to be in the range of $371 million to $376 million, representing 23% year-over-year growth at the mid-point.

Embedded in our revenue guidance for 2019 is ARPU growth in-line with historical averages of 5% to 6%. At our forecasted revenue levels, we would expect full year adjusted operating income of around $45 million. At our 30% to 40% targeted internal rate of return on a single average pet, we currently estimate we would have allowable acquisition spend in the range of $32 million to $38 million based on the opportunities we see today.

Also, please keep in mind that our revenue projections are subject to conversion rate fluctuations between the US and Canadian currencies. For our second quarter and full year guidance, we used a 75% conversion rate in our projections, which was the approximate rate at the end of March.

Thank you for your time today and I will now turn the call back over to Darryl.

Darryl Rawlings -- Chief Executive Officer

Thanks, Trish. Before, we open the call up for questions I'll remind you that if you've not had a chance, please read our 2018 Shareholder Letter, which can be found on our Investor Relations site. This weekend, we'll be hosting our annual open Q&A session, following the Berkshire Hathaway Annual Shareholder Meeting in Omaha. And finally, we'll be hosting our Annual Shareholder Day at our headquarters in Seattle on June 6th.

With that, we'll open the call up for questions. Operator?

Questions and Answers:

Operator

Thank you. At this time we'll be conducting a question-and-answer session. (Operator Instructions) Our first question comes from Jon Block with Stifel. Please proceed with your question.

Darryl Rawlings -- Chief Executive Officer

John, are you there?

Operator

Mr. Block, you are live. Our next question comes from Kevin Ellich with Craig-Hallum. Please proceed with your question.

Kevin Ellich -- Craig-Hallum -- Analyst

The commentary you gave on the three primary groups and how you guys look at retention, just wanted to see if you could give us, pets that are enrolled for less than a year with monthly retention 97%, what percent does that make up of all your pets?

Darryl Rawlings -- Chief Executive Officer

What we're looking at right now is in our guidance we're looking at about a 15% growth rate year-over-year on our net pets. The total number of new pets generally is a little bit higher than that. So you could be looking at maybe 20% to 25% of the total book in a given year.

Kevin Ellich -- Craig-Hallum -- Analyst

Okay. That's helpful. And then, clearly, we can see that average pet acquisition cost has gone up and LVP to PAC is calculated 3.5 times. So, can you give us a little bit more detail as to what's in your assumptions for the year and how we should be thinking about those metrics going forward?

Darryl Rawlings -- Chief Executive Officer

Yes, sure. So, as a reminder, the reason that we use internal rate of return as a driver for our PAC spend versus LVP is because LVP is a contribution margin and does not include our fixed expenses or an applicable capital charge for the surplus we're required to hold. So we believe the IRR is a much more fulsome and better metric to operate from. And as we've had expansion in our adjusted operating margin, about 220 basis points in the last year and our ARPU is going up 5% to 6%, our payback period is shortening, which is allowing us to increase our pet acquisition spend, while still maintaining an internal rate of return within our target.

And as I mentioned in my opening remarks, in the first quarter, we were at the high end of our range and our range is between 30% and 40% internal rate of return. If you back it in and you look at what Tricia mentioned we're looking at approximately a $45 million adjusted operating margin and as the adjusted operating margin is expected to expand throughout the year, we should be able to spend between $32 million and $38 million acquiring pets, while maintaining an IRR inside of that range. And that's how we kind of think about it. Trish, do you have anything to add?

Tricia Plouf -- Chief Financial Officer

No, the only thing I would add is just, if you're equating this to the LVP to PAC as you mentioned, it will be based on what we've talked about between the 3 and 3.5 is expected to be our run rate for the year, which we think is appropriate based on the opportunities that we have available to us.

Kevin Ellich -- Craig-Hallum -- Analyst

Okay. That's helpful. And then, Darryl, going back to the shareholder letter, looking at the five-year report card, I think AOM, you gave yourself a B, subscription costs of goods or what you paid that invoices is tracking 200 basis points higher than your plan. Can you give us a little bit more color on as to what's going on there, are costs going up or just more claims being filed? And then, how do you plan to get that back on track with your plan?

Darryl Rawlings -- Chief Executive Officer

Yeah. Well, I mean if -- so thanks for reading the shareholder letter and in that letter I kind of do a recap over the last five years. And our long term target is to be paying about $0.70 on the $1 for paying veterinary invoices about $0.10 on the $1 variable expenses and when we hit scale 5% on fixed expenses giving us that 15% adjusted operating margin or that 15% profit on our existing book before we acquire new pets. And we've been tracking closer to $0.72 on $1 versus $0.70 in what we're paying in veterinary invoices. And it's not far off, but the reason that we've been a little bit challenged there is, as we've been deploying more of our software, we see a higher percentages of invoices and we've been playing a little bit of catch up.

And I mean to be fair, our adjusted operating margin is trending nicely and we can afford that. And in the world of a trade off, I'd much rather get our software out quicker, but we've been playing a little bit of catch-up. And I am not disappointed in our results in the last two years. But if you were to ask me five years ago, we're a little bit behind where we expected to be. Long term, if you look over the next five or 10 years, we're looking at having a 15% margin and paying out the highest percentage possible. So, our target may one day become $0.72, $0.73, $0.74, if we can get some movement or improvements on our variable expenses or our fixed expenses beyond where we're at targeting today.

Kevin Ellich -- Craig-Hallum -- Analyst

Got it. And then, one other thing from the shareholder letter, you mentioned that an area of discipline was increasing enrollments and same-store sales ahead of more foundational goals. Just wanted and see how you think about how the companies should balance adding new hospitals, driving higher enrollments and same-store sales at the same time?

Darryl Rawlings -- Chief Executive Officer

Well, what you're looking at was kind of a summary of issues that we talked about year-over-year. And several years ago, we were in my mind -- and this is going back three or four years, we tried to work on same-store sales before going wide, increasing the number of hospitals. This last year is the first year where we've actually done both at the same time. So, I think I said in the opening remarks, a number of active hospitals went up to 9700, I believe that was a 12% or 14% year-over-year improvement.

And at the same time, when we're deploying the software along with an account manager, we have a sustained same store sales penetration rates of about 40%. So, we're starting to learn how to do both of them. If I went back and look over the last 10, 15 years of the Company, we've really grown the business mainly by adding stores and several years ago, we weren't accelerating the stores as much as I want. But I would say in '18, we did a really good job on both and we'll see how how '19 plays out.

Kevin Ellich -- Craig-Hallum -- Analyst

Sounds good. Thank you. I'll hop back in queue.

Darryl Rawlings -- Chief Executive Officer

Thank you.

Operator

Our next question comes from John Block with Stifel. Please proceed with your question.

Jonathan Block -- Stifel -- Analyst

Hi guys. Can you hear me this time around?

Darryl Rawlings -- Chief Executive Officer

We can. Hi, John.

Jonathan Block -- Stifel -- Analyst

Okay. Great. Thanks. I'll take it. So one high level and then one little bit more specific. High level, Darryl, recent consolidation of a couple of players in the market. I just wanted to check in and ask, what does it mean for you if anything and do you think these players adopt a different approach to market post the acquisition, considering they may have deeper pockets at that point in time? And then I've got a follow up.

Darryl Rawlings -- Chief Executive Officer

Well, So John over the last 20 years, we've competed against about 45 or 50 brands. So from a consumer landscape, at any given time, there's been 20 plus brands with maybe about 60 different product variations. So, from a consumer standpoint, I don't think there's really any change in the landscape.

What you have seen is, some people try to enter the space and not be successful and leave the space. In other cases, you see marketing companies get to a certain point of their growth and then, get acquired by typically an underwriter or an insurance entity and we're seeing a little bit more of that. I think if anything it means that as the category continues to grow and last year I think -- or two years ago I think it was reported, it grew at the teens, early indications are that for '18 that it grew in the mid teens. So the category is growing nicely and having some deeper pockets probably means there's going to be continued growth for the entire category.

But for Trupanion, we're really positioned as -- or we try to be positioned as the best product offering to be sold, recommended through a veterinarian, so the highest level of coverage with the best customer experience. Some of the other movements tend to be in either lower priced products or mid-priced products. So I don't think there's really any big changes for us from a competitive landscape, but overall a net positive to the category.

Jonathan Block -- Stifel -- Analyst

Okay. Very helpful. And the more specific one was, at least, from my model looks like you guys spent a little bit more than we expected on sales and marketing, you had a couple fewer adds or gross adds I should say in the quarter. So can you tell me if it was in line with your expectations, was there a bigger percentage of the sales and marketing earmarked for testing within certain markets? And as you know, you've been having the testing going on for some time now. Can you highlight for us what initiatives are working better than others? Thanks guys.

Darryl Rawlings -- Chief Executive Officer

Yeah. So first starting off on our pet acquisition spend, as I mentioned, we're at the high end of our internal rate of return target. So that range is between 30% and 40%. We're at the high end. So if anything we would've liked to have been more aggressive. And the reason that we were able to do that is, we've seen nice margin expansion and the payback period has been shortened, as well as our ARPU increases. So from us from an operational standpoint, we probably -- if we could do the quarter over again, would have liked to have been a little bit more aggressive in our spend than we were.

Now, where we're spending our money? We've spent about 70% -- we try to target about 70% of our PAC spend at any given period of time on things that are kind of core, things we know of, that have predictable high internal rates of return, and then, about 20% of our spend on things that are not yet optimized. We call them growth category, things we're working on, but they are not optimized, and we figure if we stick with it we can get there. And then, about 10% on test.

What you really saw in Q1 was a lot in the growth area. So, we've spent and I mentioned in my opening remarks, more money building out our teams on both the conversion area and the lead conversion or the lead teams. So as we're adding more and more account managers to accompany the rollout of our software, we're seeing increase in same-store sales. That's a way to improve the customer experience and help us long term toward Nirvana, but also to help us with overall lead volume. And then, conversion is an area that has really been a driver of our growth for the last couple of years. I mean we've had good consistent leads from the market and we've been growing by increasing conversion rates. And we believe that there's a lot of opportunity to do that.

So I'd say that most of our uptick in spend on our PAC was in the growth area. We actually didn't spend as much in test as we'd like. I mentioned in my opening remarks, we had a small uptick in our direct-to-consumer, but I'd also say that, some of our direct-to-consumer in certain markets are now kind of moved into growth. We're doing them on a regular basis. They don't quite have 30% internal rates of return, but they're getting reasonable ones. So, we score ourselves in the strong category for our pet acquisition spend for the quarter. And we're optimistic as long as we continue to get margin expansion to be able to deploy more and more capital at those strong returns.

Jonathan Block -- Stifel -- Analyst

Fair enough. Thanks.

Operator

Our next question comes from Mark Argento with Lake Street Capital Markets. Please proceed with your question.

Mark Argento -- Lake Street Capital Markets -- Analyst

Hi. Good afternoon. Just quickly wanted to know if any markets achieved Nirvana in the quarter? And then relative to how you're spending the PAC money, you guys take that approach, do you concentrate in any geographic markets if you are striving to achieve this kind of what we call Nirvana, any thoughts around that would be very helpful? Thanks.

Darryl Rawlings -- Chief Executive Officer

So, as a reminder to people in the call, Nirvana is a lofty ambitious goal to offset our churn, our monthly churn by something that grows as a percentage of book. And those are pets, pet owners either adding pets or telling their friends. And in my shareholder letter, I mentioned we haven't made significant progress in that area over the last couple of years. It hasn't been without effort. So, I'm pleased that we've tried a few things that we won't try again and we're working on new things that hopefully we'll see improvement. And then, last year, in our shareholder meeting, we mentioned that one of our markets, one of our regions reached Nirvana for the first time. I'm pleased to say that that one is held and we don't haven't had any added to that region.

So, the second part of your question was, do we target our PAC spend by geography and the answer is, yes. So, we understand the underlying value of a pet both by breed, geography and then, we're trying to align our PAC spend. And in some areas where you have higher ARPU and higher retention at our targeted margins, we can deploy greater sums of capital. For example, in New York City, where ARPU is a lot higher than it would be in Boise, Idaho, assuming we had the same retention and the same margin, we could spend more to acquire pets in New York than we could in Boise. And we've got strategies to go about that.

Jonathan Block -- Stifel -- Analyst

And just a quick follow up in terms of pricing, and I know one of your competitive advantages is the size and scale of your database and your ability to price. Where do you see yourself in that pricing process? I know it's a constant game of iterating and getting better, but is there still 50% of the way to go, 20% of the way to go, where are you in that process?

Darryl Rawlings -- Chief Executive Officer

Well, I mean when I went over in -- in the shareholder letter I broke out -- and the first question on the call was about the categories of our churn and I put in a chart there that said that 12% of our clients in 2018 saw a rate change of greater than 20%. Now, ideally that would be 0% or 1%. The reason that occurs is, we still have learnings to do, but when it's that 10%, 12%,15% of the book and the retention rate for that group is 98% monthly instead of the better category,which is 99%, it's not dramatically hurting us, it's better for us to get those pricings done, right.

From my point of view, I think, we still lead the category on not only the data, but how we think about it. I think we're forced to do that, because our product coverage is what we think is the greatest. And we don't have limits or caps or controlling mechanism, gotches that show up in the fine print, which are kind of lazy ways to protect your pricing. So we're vulnerable on being able to price geographies accurately as well as breeds in other areas, because we cover congenital hereditary issues and we pay 90% of an actual invoice.

We keep adding to this team. I'm really pleased with the progress over the last couple of years. I think we're doing a really good job. I think we're going to continue to focus more down at neighborhood levels, but I'm really happy with what the team is doing and the progress that we make.

Jonathan Block -- Stifel -- Analyst

Okay. Thank you.

Operator

Our next question comes from Andrew Cooper with Raymond James. Please proceed with your question.

Andrew Cooper -- Raymond James -- Analyst

Hi, guys. Thanks for the question. First one from me, just kind of circling back on the comment from your shareholder letter around the 200 bps of COGS. I just wanted to kind of clarify there, is a portion of that -- has it been around sort of -- what the insurance regulators will call LAE or is it kind of true claims expense? And then, I guess -- I'm sorry, go ahead.

Darryl Rawlings -- Chief Executive Officer

No, I mean it's just us being able to predict the cost and then get the pricing at the same time. The departments of insurance have not slowed us down on this. This is just us. This is our own execution. We need to get our rates approved by departments of insurance, but when we have the data to validate it, we've never had a problem with them saying no. They're aligned with us to make sure that we can offer the, what we think is the category's leading value proposition in a way that is sustainable for both us and transparent to the pet owner.

Andrew Cooper -- Raymond James -- Analyst

I'm sorry. What I meant was more around, I look at the claims expense you report and I think that's been closer to 70 than 72 so just kind of kind of trying to reconcile that and make sure we're thinking about the buckets correctly?

Darryl Rawlings -- Chief Executive Officer

Yes. There's a little bit of a challenge in that. We have -- you're looking at a blended in some of our -- it includes our other revenue and our other revenue sometimes have some targets that are a little bit different. What I'm talking about in the shareholder letter is really targeting the subscription business and we've been 71, 72, 73 over the last five years. And I would rather it be 69, 70, 71 than the latter.

Tricia Plouf -- Chief Financial Officer

Yes. I would say Andrew just to reiterate. Yes, it's specific to the subscription business, which has been running around 72 and that's a combination of pure claims expense as well as claims -- the cost to process a claim, which is referred to as LAE in some filing. And the variance has been on the pure claims expense for the reasons Darryl mentioned. We've been operating very, very tight within our forecast on the actual cost of processing.

Darryl Rawlings -- Chief Executive Officer

I would say though, not only in our pricing by subcategories the team is doing a good job in that, but over the last few quarters, we're seeing that tighten and get closer to our target than not getting -- it's improving, not degrading, but it's a -- what we're trying to do is a really hard thing.

Andrew Cooper -- Raymond James -- Analyst

Okay. That's very helpful. And then kind of diving back into the shareholder letter, I think you mentioned at one place in it, a new test of a different subscription model. Wondering if that -- if you can give any color in terms of, is it a tweak on an insurance product or is it something more related to the food partnership that you've announced or any color on what you're thinking the future could look like in terms of some new launches?

Darryl Rawlings -- Chief Executive Officer

Yes. So what I've been talking about there is really about product innovation inside of our core business, which -- if we can figure out how to make tweaks to our existing products that broadens our coverage, increases conversion rates, increases retention rates, which probably means it's going to have higher ARPU as well, so having higher ARPU with higher conversion rates and equal or better retention rates, that would be a goal.

And we always want to be innovating and pushing and we hoped -- we've been working on some ideas about this over the last couple of years and hope to be testing just in a small geographic area to see if those things can all prove out over the next one to three years. And if they do, then, we'll we'll roll out in a bigger way after that.

Andrew Cooper -- Raymond James -- Analyst

Great. That's helpful. And then, last one from me is a little bit more on the modeling side. I know you talked about the non-subscription pet number, I mean what what to expect on the revenue side for the full year, but is the same kind of trajectory been holding, just that some of those pets that you've rolled off are sticking on the books a little bit longer? I Just want to make sure there's nothing changed there rather relative to what's rolling off versus maybe what's rolling on, growing faster than what we had expected?

Tricia Plouf -- Chief Financial Officer

Yeah. I would say, Andrew, there's nothing significantly different than what we've said in the past in terms of that dynamic. It's just we don't have as much visibility there as we do in our core subscription business, but you'll see that trajectory continue to get to the $55 million that I mentioned.

Darryl Rawlings -- Chief Executive Officer

Really all areas of our other revenue are all doing well. So we're just getting a little bit more visibility into it. It's a little harder for us to predict that area, because it doesn't have the same monthly recurring pattern that the rest of our business does.

Andrew Cooper -- Raymond James -- Analyst

Got it. Thanks. That's all from me.

Operator

Our next question comes from Michael Graham with Canaccord Genuity. Please proceed with your question.

Michael Graham -- Canaccord Genuity -- Analyst

Yeah. Thank you. One is just on the rate renewals that you mentioned, Darryl. What triggers those, is it recategorizing pets, how much of that is just natural escalation in healthcare costs? Just maybe a little more depth on that. And then I also wanted to ask, you mentioned renewing your commitment to regulatory compliance and investing there a little bit. I just wonder, if you could mention some of the vectors that you're focused on making sure that the Company sort of navigates correctly?

Darryl Rawlings -- Chief Executive Officer

Sure. So, the underlying cost of veterinary care is typically going up 5% to 10% for an insured client and that's what we would expect year in, year out. When people are seeing rate changes greater than 20%, it means that either we were wrong or we've taken one category and broken it into two or three, because we have more sets of data. I would say, more often than not, it's us getting more granular, breaking into more categories and it has us being dramatically wrong. But if you look over the last few years, we've got instances of both., but overall, wider swings is us just doing a better job either categorizing or getting more data and more detail.

Your question or I think you're talking about what I mentioned in the shareholder letter about our alignment with the regulatory departments and what we're trying to accomplish. And as a key, when I think about the departments of insurance in a new category, like medical insurance for cats and dogs, there often is a lot of questions. We fall under P&C, and yet we are more like health. So the more that we can involve the departments of insurance and tell them what our values are and what we're trying to do and how we're trying to do it, it's not typical that a company is trying to pay. in our case in minutes or seconds. Often insurance companies are trying to hold on to floats and make investment income. We don't act like other people do. And it's important for us to let people know why and how.

But underlying, we've got the same alignment in that. We want transparency, we want great value proposition, and the more we can communicate them the better. That being said, at different points, the first couple of years we entered the US market, myself and a number of other people were spending a lot of times on planes and in the offices of the departments of insurance, getting to know them, introducing us. And then as the Company continued to grow, we added teams and support. And I'm not sure I always resource them appropriately to be able to be spending as much time on airplanes or in meetings or building those relationships. So we're just trying to hit our 15% adjusted operating margin and get our fixed expenses to 5%. We're also trying to add more resources to strengthen those relationships, so that even new people in departments of insurance or old people understand what we're doing and why we're doing it.

Michael Graham -- Canaccord Genuity -- Analyst

Okay. Thanks. And then -- that's helpful. Just one more quick one on the AOM target that you also sort of reiterated in the letter of 15% exiting next year. It looks like your guidance implies that you get -- that's 420 basis points from where you are today. It looks like you are implying you're going to get about half of that this year and about the other half over the course of next year, so is that the right way to think about it?

Tricia Plouf -- Chief Financial Officer

Yeah. Michael, I would -- I mean we're thinking about it a little bit in buckets too. So in general we're targeting that 70% claims ratio, 10% in variable expense and then we are targeting the 5% in terms of fixed expenses and making headway there to get to our 15% target. And I think we're making good headway. Like you mentioned our guided amount for adjusted operating income implies we get to about 12% this year at the end of the year. Our run rate at the end of the year will be a little better than that. So we can enter next year with good trajectory. A part of it will just depend on how tight we can get around the claims ratio. 1% variance is not unusual there. And then, what margin are our other businesses is running at as well. But overall, you're thinking about it in the right way. Anything to add there, Darryl?

Darryl Rawlings -- Chief Executive Officer

Yes. I mean I'd just say that we're trying to get to the 15% for our subscription business and our other business has a little bit of a different margin profile. The other business typically runs in 8% to 10% bottom line margins target and that's an area where typically we don't have a lot of PAC spend and the bottom line money, we can use to reinvest to grow our subscription business. So we're really focused on the 15% on the subscription business and if the other revenue becomes a bigger percentage of our overall revenue, we will have to account for that.

Michael Graham -- Canaccord Genuity -- Analyst

Okay. Thank you both.

Operator

Our next question comes from Shweta Khajuria with RBC Capital Markets. Please proceed with your question.

Shweta Khajuria -- RBC Capital Market -- Analyst

Great. Thanks. Two for me please. Could you provide -- when you think of the automation, you've talked about 5% of invoices fully automated. Where can that be this year, how do you think about it long term, what has the reception been and what would it take to grow that? And then, second on territory partners, just a little bit more maybe detail on churn, that will be great. Thank you.

Darryl Rawlings -- Chief Executive Officer

So on the claims automation at 5%, so in the shareholder letter that was just published, I mentioned that in 2018 about 5% of our claims that came through our software, we automated and I think at about an average of 16 seconds. We anticipate that's going to grow throughout the year. We're actually going to present something about that in the shareholder letters, so the teams will be up there talking about it, but the drivers to help is volume of data and it's kind of like a machine learning process. The more data that gets in there, it compounds on it. So, I will hold off on giving a lot more insight until the shareholder meeting, but the long term is to get our software in more places which will give us more data.

And then, for territory partners, we've got -- we're now visiting about 22,000 of about a universe of about 25,000 veterinary clinics that we think will eventually have territory partners. And I mentioned that we have about 10 markets opened. They average about 250 clinics each. But when we bring a new person into a new territory, we had about -- 50% of those people will churn inside the first two years. So we'll do our best to add those 10 territories during the year, but you should expect that some that we added over the last year or two will fall off. So it will take us a few more years until we're fully penetrated.

Shweta Khajuria -- RBC Capital Market -- Analyst

Thank you.

Operator

Our next question comes from Tom Champion with Cowen and Company. Please proceed with your question.

Henry Wang -- Cowen and Company -- Analyst

Thanks guys. It's Henry on for Tom. How do you think about the 2% pet insurance penetration rate in North America rising over time. Like on one hand that's a doubling from five years ago, but why is it so much lower than Western Europe? Just curious to hear your thoughts there.

Darryl Rawlings -- Chief Executive Officer

Well, I mean the underlying premise is, why we entered the marketplace in the first -- in North America for the first, is that, we did not believe that there was buy-in for veterinarians and for the penetration rate to equal that in Western Europe or the UK, where one of the four pets have medical insurance, you need buy-in from the vet. So our focus is to build the foundation of veterinarians, asking pet owners at check who their medical insurance is and making it normalized and having them be have the confidence to get behind high quality medical insurance. So we've been working hard at that.

There's different competitors that come in and out of the marketplace. And every one point in market penetration in North America is about $1 billion in revenue. So I think we're making good progress, but I don't look at overall market penetration as the key indicator. What I look at is, what is the market penetration rate of puppies and kittens in either a geo or on a vet hospital level, and in a lot of markets we're seeing 5%, 7%, 10% of puppies and kittens now getting medical insurance. So if you fast for that, for one pet generation, call it, 12 to 14 years, we can have a run rate for the industry in those more established markets that can get to that 5% or 10% penetration rate.

Overall, I don't think it's a consumer issue. I think when messaged appropriately, one out of four pet owners that visit the veterinarian will be happy to buy high quality medical insurance and yet it's still not normal. When you go to the dentist everybody asks at check-in, who your insurance is and that's not normal place in North America and we're working hard to make change that.

Henry Wang -- Cowen and Company -- Analyst

Got it. And another quick one. Last quarter, you called out investment in headcount and just curious how the recruiting efforts are progressing?

Darryl Rawlings -- Chief Executive Officer

Well, some of the areas that we're recruiting heavier is, our internal account managers. These are the people that are supporting our territory partners and the partnered hospitals that have our software. We mentioned about a year or two ago this was really a test and we had three to five people. I think we exited the year at maybe about 20 people. Long term, I think this is going to grow to about 100 and we'll see how much progress we make over the next two years. So that's one area we're really driving.

On the conversion side, I think, there's a lot of things that we can do to help increase the high volume of leads that we have and try to increase conversion rate. So that's an area we're building up. And then just that our scale -- trying to keep up with our variable side is, people helping to pay vet -- paying our veterinary invoices. So, we're trying to automate them, but there's a lot that are not automated, so we need a lot of people for that. And then in our customer care, we want to be able to answer the phone 24/7. We're paying invoices 24/7, so those teams continue to grow in scale.

And then on the fixed expenses, I would say, we continue to invest in IT, Trish mentioned some areas that we --- in her opening remarks in IT, regulatory, legal, we're also investing more in data, so that we can price more accurately. So you can see modest increases in headcount in the areas that are fixed expenses. Our variable expenses, our headcount growth is pretty much in line and the places where we're really having expansion are related to leads and conversions.

Henry Wang -- Cowen and Company -- Analyst

Thanks.

Operator

Final question is from Greg Gibas with Northland Capital. Please proceed with your question.

Greg Gibas -- Northland Capital Markets -- Analyst

Good afternoon. Thanks for taking my questions. First, just looking at the shareholder letter, should we expect an acceleration of TPA hiring in new regions this year and is there a target range that you're willing to share in terms of new territory partner hiring this year?

Darryl Rawlings -- Chief Executive Officer

Well, we've been at -- we've been adding associates which are kind of, in my analogy, the second Coca-Cola truck or third Coca-Cola truck inside of a region. We've been -- that's been ramping pretty steadily over the last two or three years. We just finished our territory partner conference. It was the first time where our second Coca-Cola trucks outnumbered our originals. So, I would expect that that will continue, but what we haven't done as good of a job over the last year and the year before was adding the more regions. And so we want to make sure that we're focused there as well. And we don't have an overall target. I know we want to get into 10 more regions and we'll see how the rest plays out.

Henry Wang -- Cowen and Company -- Analyst

Okay. Got it. And then just lastly, wondering if you could provide just a little bit more color on what drove the growth in the other business segments this quarter and at what point do we see the margins start to expand there?

Darryl Rawlings -- Chief Executive Officer

We would not expect to see margin expand in the other revenue. Our target is kind of the 8% to 10% range and we don't expect that to change over time. Actually, we saw growth in all areas. So, as a reminder, the areas that we focused on, the other revenue is where we're not dealing directly with the consumer. So we have other people paying for people's pets that could be employers, those employers could be general corporate employers or they could be owners of veterinary clinics. We have a contract with the federal government, where we are supplying the broadest, greatest coverage product to veterans who need help dogs. We're looking at areas where we are the Company behind other brands, typically with either low ARPU or medium ARPU pricing and across the board, we're seeing growth in all areas.

Greg Gibas -- Northland Capital Markets -- Analyst

Okay. Thank you.

Operator

That is all the time we have today for questions. And this concludes today's conference. You may disconnect your lines at this time. And we thank you for your participation.

Duration: 57 minutes

Call participants:

Laura Bainbridge -- Head of Investor Relations

Darryl Rawlings -- Chief Executive Officer

Tricia Plouf -- Chief Financial Officer

Kevin Ellich -- Craig-Hallum -- Analyst

Jonathan Block -- Stifel -- Analyst

Mark Argento -- Lake Street Capital Markets -- Analyst

Andrew Cooper -- Raymond James -- Analyst

Michael Graham -- Canaccord Genuity -- Analyst

Shweta Khajuria -- RBC Capital Market -- Analyst

Henry Wang -- Cowen and Company -- Analyst

Greg Gibas -- Northland Capital Markets -- Analyst

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