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Trupanion Inc (TRUP 1.79%)
Q2Â 2019 Earnings Call
Jul 30, 2019, 4:30 p.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Greetings, and welcome to the Trupanion Second Quarter 2019 Results Conference Call. (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 Invester Relation
Good afternoon, and welcome to Trupanion's second 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 operation, 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 8K 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 cost, internal rate of return, 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 U.S. 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 will hand the call over to Darryl.
Darryl Rawlings -- Chief Executive Officer
Thanks, Laura, and good afternoon. We had the opportunity to speak at length to many of you during last month's Annual Shareholder Meeting. So for purposes of today's call, I'll keep my remarks brief. Q2 revenue grew 26% year-over-year, and we ended the quarter with over 577,000 total enrolled pets. Adjusted operating income totaled $9.8 million, up 33% over the prior year period. We estimate our internal rate of return at 34% for the quarter, in line with our 30% to 40% target. You'll recall, we focused on these 3 measures when evaluating our performance.
With this in mind, it was a solid quarter, and we're on track to meet our objectives for the year. We discussed the strategies for deploying our adjusted operating income at our targeted internal rates of return at our Annual Shareholder Meeting last month. Growth initiatives, including those around same-store sales and conversion, continue to comprise the bulk of our incremental spend, both in headcount and deployment of our software. We're also investing more on initiatives aimed at Nirvana, including 90-day retention. You'll recall, I highlighted this is as an area of opportunity in my 2018 Annual Shareholder letter.
These are hard, multiyear initiatives, and we expect to measure our success in years as opposed to quarters. Those of you who know us well, those that we maintain a long-term perspective. We are building this company for the decades ahead, and we are making additional investments to deepen our competitive moats. The expansion of our adjusted operating income provides us the flexibility to do so. For those that attended our Annual Shareholder Meeting, I hope you walked away with a greater appreciation of the teams behind these initiatives. I said it before, but it's worth repeating. Execution is hard, and it comes down to people. I'm humbled by the level of talent we've been able to attract and retain here at Trupanion. Before I turn it over to Trish, I'll provide a brief regulatory update starting with last month's settlement with Washington OIC. In short, while we did not agree with some of the state's findings, nothing in the settlement materially changes the way we do business.
Separately, as I acknowledged in my 2018 Annual Shareholder letter, we have made mistakes in the past related to call center licensing that we have since corrected. In the coming weeks, we expect to finalize a settlement with the California Department of Insurance on this.
Conversations are ongoing, but we expect the settlement to reflect the size of our business in the state. We believe we are adequately reserved for any potential fine, meaning we do not expect any meaningful financial impact nor do we expect any resulting changes to our business practices as we have already licensed our contact center team members. Nevertheless, we take these matters seriously. We value our relationships with regulators and are committed to building upon and maintaining the lines of communication with all departments of insurance.
We operate in a rapidly growing industry and expect and welcome dialogue at the state level. Recently, a few states have inquired about the role of Territory Partners, a topic we've discussed at length over the years with state regulators. If on the heels of our dialogue they prefer that Territory Partners within their state operate with a license, we will require that they do so. It is a process in which we are well versed. Since 2015, we have helped hundreds of our contact center representatives achieve the necessary licensing requirements. More fundamentally, we are well aligned with regulators.
Regulators want to ensure our customers receive a high-value proposition, there's transparency and that customers are treated fairly. We want the same things. Trust, transparency, doing what we say, these are the values we live by at Trupanion, an important tenets of our culture. Companies often tilt their culture, and we're no different. Culture has to be experienced to be understood, which is one of the reasons we stressed the importance of attending our Annual Shareholder Meeting.
This once-a-year event is the best opportunity to meet the team, experience the culture and get an in-depth understanding of our key business initiatives. We want to thank those of you who were able to attend this year, especially those who traveled from across the country and around the globe. Your participation is what helps make this event a success. We hope to see you all next year on June 11.
And with that, I'll hand the call over to Trish.
Tricia Plouf -- CFO
Thanks, Darryl. Today, I'll review our second quarter results in detail as well as provide our third quarter and updated full year outlook. Revenue for the second quarter was $92.2 million, up 26% year-over-year and led by strong pet enrollment in both our subscription and other business segments. Total enrolled pets increased 22% year-over-year to over 577,000 pets as of June 30. Subscription revenue was $77.7 million in the quarter, up 22% year-over-year. Total enrolled subscription pets increased 15% year-over-year to over 461,000 pets enrolled as of June 30. Pet growth within our subscription business continued to benefit from increased leads from our core veterinary channel.
Monthly average revenue per pet for the quarter was $57.11, an increase of 6% year-over-year and in line with our historical average of 5% to 6%. In local currency, monthly average revenue per pet increased by 7% from the prior year for our U.S. members and by 5% for our Canadian members. Average monthly retention was 98.57% compared to 98.64% in the prior year period. Keep in mind that retention is a trailing 12-month metric. And in periods of accelerated growth, 90-day retention will act as a headwind. Given this dynamic, we do not expect meaningful improvements relative to our 10-year historical average of 98.5%, though we did see sequential improvement in Q2 over Q1.
Our other business revenue, which generally is comprised of our revenue that has a B2B component, totaled $14.5 million for the quarter, an increase of 52% year-over-year. Year-over-year growth in our other business segment reflects an increase in the number of enrolled pets. Subscription gross margin was just under 18% in the quarter, impacted primarily by increased veterinary invoices expense, which grew 7% year-over-year on a per-pet basis. Generally speaking, we would expect veterinary invoice expense per pet to increase in line with ARPU on an annual basis, about 5% to 6% per year, though it's not unusual to see more variability quarter to quarter.
We continue to expect that our full year subscription growth margin will fall within our annual target of 18% to 21%. Total gross margin was 16%, which includes our other business segment. Fixed expenses were $5.2 million or 5.6% of total revenue in the quarter, down 160 basis points from the prior year period and approximately 60 basis points from our 5% target at operational scale. Scale on our fixed expenses reflects the benefit of owning our home office building. Adjusted operating income totaled $9.8 million in the second quarter, a 33% increase from $7.3 million in the prior year period. Net loss for the quarter was $1.9 million.
As a percentage of revenue, adjusted operating margin expanded approximately 60 basis points year-over-year to 11%. As a reminder, adjusted operating income are the funds available to invest in growth and other long-term initiatives. During the quarter, we deployed $8.2 million of our adjusted operating income compared to $5.4 million in the prior year period. This spend is related to the acquisition of approximately 35,000 new subscription pets as well as investments in building out teams primarily around same-store sales and conversion.
We were encouraged to see small incremental improvements in conversion rates late in the quarter, a trend that has since continued in the third quarter. As our adjusted operating income expands, we intend to deploy greater amounts of capital as long as we can achieve our targeted internal rates of return and remain free cash flow positive. We estimate our internal rate of return at 34% for the quarter, in line with our 30% to 40% target. Internal rate of return is how we measure the return on our pet acquisition spend for a single average pet. Additional details behind this calculation can be found in our quarterly earnings supplement on our Investor Relations website. Adjusted EBITDA was $1.3 million for the quarter compared to $2 million in the prior year period. Our net loss was $1.9 million or a $0.06 loss per basic and diluted share compared to a net loss of $0.4 million or a $0.01 loss per basic and diluted share in the prior year period. In the second quarter, free cash flow was $2 million.
Operating cash flow was $2.9 million, up from negative $0.5 million in the prior year period. At June 30, we had $92.1 million in cash, cash equivalents and short-term investments and $19.1 million of long-term debt. I'll now turn to our outlook for the third quarter and full year 2019. For the third quarter of 2019, revenue is expected to be in the range of $97 million to $98 million, representing 25% year-over-year growth at the midpoint. For the full year, we are increasing our revenue guidance range to reflect our performance in the first half of the year and increased visibility into the second half.
As a result, we now expect revenue for the full year to be in the range of $378 million to $381 million, representing 25% year-over-year growth at the midpoint. Embedded in our revenue guidance for 2019 is ARPU growth in line with historical averages of 5% to 6%. We now estimate other business revenue to be around $60 million for the year. At our forecasted revenue levels, we continue to expect adjusted operating income for the year of around $45 million. We estimate allowable acquisition spend in the range of $32 million to $38 million, within our targeted IRR range of 30% to 40%. Also please keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S. and Canadian currencies. For our third quarter and full year guidance, we used a 76% conversion rate in our projections, which was the approximate rate at the end of June. Thank you for your time today.
I will now turn the call back over to Darryl.
Darryl Rawlings -- Chief Executive Officer
Thanks, Trish. Before we open it up for Q&A, I want to highlight that we've recently updated the date of our at 2020 Annual Shareholder Meeting, which will now be held on June 11, 2020, here at our Seattle headquarters. Shareholder participation is critical to the success of this event, and we've updated the date based on shareholder feedback. We want to make the meeting accessible to all interested shareholders and are providing you with this notice to assist in your planning. Additional details will be forthcoming on our Investor Relations website.
And with that, we'll open it up for questions. Operator?
Questions and Answers:
Operator
(Operator Instructions) Our first question here is from Shweta Khajuria from RBC Capital Markets. Please go ahead. We're going to the next question here from Andrew Cooper from Raymond James. Please go ahead.
Andrew Cooper -- Raymond James
Excuse me. Thanks for the question. I guess first for me, this isn't the first quarter we've seen, to your point, a little bit of movement in the claims expense as a percent of revenue. But just any color you could give on -- where there anything in particular that jumped out or anything that makes you confident that the trend from basically 3Q '18 that has been gradually taking a little bit higher is more just quarter-to-quarter lumpiness than anything else relative to the goal of 70%?
Tricia Plouf -- CFO
Yes. Andrew, this is Tricia. I can give a little bit more color at a -- high-level, particularly within a single quarter. Your characteristic of lumpiness or variability is correct. When it comes to claims as a percentage of revenue, it's really a factor of how is claims per pet increasing based on how ARPU, which is a per-pet number, is increasing. And they don't always in a single quarter increase at the same rate. For example, in Q2, claims increased at 7%, while ARPU increased closer to 5%. For the full year-to-date, they are both increasing at 5%, so they're in line.
That being said, there's a couple -- in addition to just some variability with those dynamics, we're also getting, as we've talked about before, our patented software in more hospitals. We're processing 40% more claims through the hospital -- through that software this year than last year. And so that does provide, when it's celebrating, about a 1% headwind, as we've talked about previously.
And we are OK with that trade-off. But we are trying to update and hold through pricing, which we hope to see in the back half of the year and in the next year where our pricing would be increasing closer to 7%, while claims typically are increasing around 5% to help them make up that delta. So we're closer to the 70% cost of goods ratio rising in the 72% right now. But like I mentioned in my prepared remarks, there's nothing about this single quarter that is overly concerning or an anomaly as opposed to variability. We still feel very comfortable that for the full year, we'll be between the 18% and the 21%.
Andrew Cooper -- Raymond James
Okay. That's helpful. And then just one more kind of financial question and maybe another higher level, if I could. But as we think about the guide, the $5 million increase on the other business or the non-subscription business, but, obviously, tightening kind of a little bit more than that to the higher end, any color you could give on -- is that in the kind of core subscription business or more around tightening your expectations in the non-subscription business?
Tricia Plouf -- CFO
Sure. It's a little bit of both. At a high level, we're halfway through the year. We have more -- you've got actual for the first half and a lot more visibility going into the second half. So when it comes to the tightening of the range for the full year, it's really about visibility. We are raising $5 million related to the other business segment, and that really has to do with the fact that we have less visibility at the beginning of the year in that segment. And all areas of that segment are performing well, so we're flowing through, really, Q2 actuals that came in as well as our visibility that we have currently into the back half of the year. The remaining $1 million that we flow through in the outlook has to do with our core subscription business, which is also performing well. And it's mainly we have a lot more visibility into that business. We wouldn't expect big variations there, but we're flowing through really Q2 at about a 500,000 -- we came in $500,000 above, and we're pulling that through into Q3 and Q4 as well. But overall, all segments are performing well.
Andrew Cooper -- Raymond James
Okay. Great. And I'll just sneak in one more, if I could, and then jump back in the queue. But you mentioned some of the efforts on conversions that started to pay dividends in the later part of the quarter and into 3Q. But is there anything kind of in particular you could give us as though -- what's worked and what hasn't worked? And then how much of what you've done has been more in that testing bucket and not necessarily rolled out at full scale? So maybe you found something that could drive continued upside from where we were, even exiting the second quarter. Any kind of comments or color there would be great.
Darryl Rawlings -- Chief Executive Officer
Sure. It's Darryl. I mean, at a high level, we're looking at our -- the profits we have from our existing book growing over 40% this year from about $32 million to about $45 million, which is giving us the opportunity to be investing in some longer-term visions. I mean, I've been operating this company for over 20 years and I can tell you, having access to these funds to invest in some really hard meaty things is just a privilege to have. And the teams we have working on it are doing a good job. So conversion rates is definitely one of the areas that we're investing in. We're also investing in kind of getting our software in more veterinary hospitals and kind of same-store sales.
We're investing in claims automation and investing in theories around Nirvana, trying to have -- tighten up our churn and increase our referral and added pets. Conversion is something that we are passionate about because we believe we're driving most of the leads in the category. And we would like to get a higher percentage of those people converting with Trupanion. And I use this analogy internally that buying our type of product is kind of like going to the grocery store and buying a can of tuna. It's really hard to know what you get until you open it up.
And we think Trupanion, with the broadest coverage, the highest target payout, what we think are the industry's best customer service is like opening a can of tuna and getting a bit solid piece of albacore. You know that sometimes, you open a can of tuna and it's kind of watery, flaky stuff. And the conversion is really focused around being able to articulate the benefits of our product and being able to do that in multiple locations. And we think the more we educate the consumer, the higher percentage that they will make a better choice. And we're seeing some areas where we're seeing the impact of that. So you're asking the question, is there something we've got in test that we're going to able to run across, and I think you're implying do we think we're going to hit a light switch in Q3 and have a much higher conversion rate, which means more pets, and I would tell you that these are all smaller incremental changes. But the big thing for us is investing in more people to be focused on this area.
Andrew Cooper -- Raymond James
Great. I'll jump back in the queue appreciate it.
Operator
Our next question here is from Shweta Khajuria from RBC Capital Markets. Please go ahead.
Oh sorry about that earlier. Couple of questions, please. So on same-store sales, could you please discuss the trends you've seen in same-store sales growth since you started integrating, deploying software with veterinary clinics? So if you were to isolate the impact, how impactful has automated claims been on same-store sales growth? And then on second on acquisition spend, could you talk about what you're seeing with the 30% of the vet acquisition spend portion of your marketing spend? Last quarter, you called out 20% of that was, but -- what you call growth initiative -- growth channels and the 10% was the test -- spent. So what you're seeing there is -- it is more optimized now and if IRR is getting closer to 30% to 40% target.
Darryl Rawlings -- Chief Executive Officer
Well, thanks for the questions. So the first question was around same-store sales after deploying the software. And you were asking specifically in areas where we had more claims automation. Let me explain how this works. So we, today, have increased our software. We had in 50% more hospitals than we did last year. Every one of those invoices is going through our automation tool, 100% of them go through the automation tool and about 30% to 32% of them are actually being finalized or 100% done with automation. They are not done universally by hospital, so we don't have one hospital that has 100% automation, another one that has 0%. So we don't track the same-store sales by areas we have automation. We do know that same-store sales, and we've mentioned this in the last 2 shareholder meetings, where we have the software. It's up about 40% from before we had the software. So net better customer experience, the automation, we're really excited about it, better for the consumer is better for the veterinarian. But we have not -- we don't have the ability to link directly to that factor.
Your other question was really a breakdown of where we're spending our money. And I mentioned earlier that we have anticipated about $45 million we can invest. We'll be in cash flow positive this year. And we'll try to invest about 70% of it in our core investments. Those typically have an IRR of 35% to maybe 45%. And our goal is to -- that's about 70% of the mix. Year-to-date, most of it has been in the growth factor, which has typically been about 20%. But this year, it has been closer to 25%, 26%, 27% year-to-date, and that's places where we have not yet optimized. And our IRRs there might be between 5% and, call it, 25%. Big bulky areas for us there are building up more account managers to support hospitals that have the software, getting the software installed into most areas, that's still an area of learning, as we're definitely not in a mature stage there. We're also investing a lot more in conversion. And we invest mainly there in people creating content and having that theme. We are seeing progress. As we mentioned earlier, we're excited. And then the last bucket, we're trying to spend about 10% on innovation. These are areas that we have no idea what the internal rates of return are going to be or they may be very long-term projects.
Year-to-date, we've been investing a smaller amount. And in the back half, we hope to invest a little bit more, but those could be partnering with different distribution channels or doing other potential expansions in the future. And that's how we kind of think about our total spend.
Shweta Khajuria -- RBC Capital Markets -- Analyst
Thank you Darryl.
Operator
Our next question is from Mark Argento from Lake Street Capital Markets. Please go ahead.
Mark Argento -- Lake Street Capital Markets
Darryl, Trish, just a followup on the -- I know you just -- you had mentioned California, that your in the process of trying to reach an agreement there after Washington. Now you had mentioned kind of immaterial from a financial perspective and also from a business perspective, but are you moving toward this kind of a blanket? If you're a Territory Partner, you're going to be licensed at this point. Or what -- how do you think about the regulatory environment in regards to your latest settlements?
Darryl Rawlings -- Chief Executive Officer
Well, I'm glad you asked the question, Mark, because California and Washington are not at all related. I know because of the timing of it, people may think it is. But California is related to call center licensing, which is a legacy issue that first showed up around 2013 and '14, where we had an audit where we were previously informed and told by experts, lawyers and departments of insurance that based on our product profile, we did not need to get them licensed. When they listened to the types of calls we were taking, there was a lot of competitive questions and their thought that, that cross the line into solicitation and, therefore, we needed to get them licensed.
We agreed to do that, but we did not get them licensed in a timely manner, and that is why we are getting penalized. And quite frankly, we deserve those penalties. We should have moved quicker. It was not good execution in that time frame. Washington was not related to call center licensing. It was related into 3 different buckets, and so they were not related. The California area is an area that we're letting you guys know because it's a legacy issue. I talked about it in the 2018 shareholder letter, and we expect to get this behind us shortly.
Mark Argento -- Lake Street Capital Markets
That's helpful. And then just, Trish, one quick in terms of the other line item here. I think you talked a $60 million for 2019. That's probably up around -- roughly, what, 50%. I think in the quarter, it was just over 50% year-over-year. What's driving the growth there? And should we anticipate that segment continue to grow at that pace? And what's going on, I guess, that's spurring that level of growth?
Tricia Plouf -- CFO
Sure. I mean, there's 4 different buckets in there as a reminder, and they are all growing nicely, so it's not necessarily one versus another. We've got our partnership with the Veteran Affairs where we ensure their service dogs for veterans. And so that is growing nicely. We've got things related to our employer benefit programs where the employer pays at least a portion of it. That is growing nicely. And then we're underwriting others. And while one partner is rolling off of it, the other one is continuing to add to their book of business. And that one started with us in 2017, so it's still building on and causing year-over-year growth rates to be quite outsized, as well as their business is performing well. And so it's all part of our core strategy. As you have different channels as well as products, so that we're positioned well in overall market. And in general, the overall market is growing nicely as well. So when it comes to our expectations, the growth rates you're seeing right now, in general, we expect to continue and be around 50% for the full year based on our guidance. Absent things coming on or off or building up when it comes to long-term outlook, we would imagine that segment to grow around industry growth, unless we announce something different, which would be more in like the 15% to 20% range currently.
Darryl Rawlings -- Chief Executive Officer
Great very helpful. Thank you.
Operator
Our next question is from Kevin Ellich from Craig-Hallum. Please go ahead.
Kevin Kim Ellich -- Hallum Capital Group LLC -- Analyst
Hey thanks for taking my questions. Just Trish, sorry to keep asking about the guidance here, but just so I understand and make sure I got the numbers right. Maybe I did the math wrong, but -- so excluding the other business, if we look at the subscription revenue, it effectively looks like that revenue guidance was taken down a little bit for the full year. Is that correct? And if so, what's driving that?
Tricia Lynn Plouf -- Chief Financial Officer
It should be that it would be at the midpoint. It was coming up by $1 million for the full year. It shouldn't be coming down. Yes, just there have been higher performance, yes.
Kevin Kim Ellich -- Hallum Capital Group LLC -- Analyst
Okay. I guess I've got mistaken. My bad. And then, Darryl, going back to the other question that Mark asked about California, but you also commented about the licensing of Territory Partners in Washington -- in the state of Washington. What's the plan with other states? Is it going to be a case-by-case example? Or do you plan the kind of if Territory Partners once become licensed, are you going to allow them to do that? And I guess, to that point, what's the incremental cost for you guys? And have you seen any impact on the productivity?
Darryl Rawlings -- Chief Executive Officer
Great question. So Territory Partners, right now, over 25% of them are already licensed. We required them to be licensed any time they are dealing directly with consumers. And we've gone through that process. The cost of it is minimal. It's a couple of hundred dollars a year for Territory Partners, so it's -- it doesn't have a major impact. We have -- as this category continues to grow, regulation may have been changed based on the category's growth. And we think we're at the forefront of having those conversations. If individual states would prefer that the Territory Partner be licensed, then we'll totally be supportive of that and get them licensed. We've had ongoing conversations for years, and they have not historically. That's why we have not historically required all of them to do it. But we'll keep an eye on it. And if any state want us to make that change, we will. And if it becomes a trend, then we would get everybody.
Kevin Kim Ellich -- Hallum Capital Group LLC -- Analyst
Okay. So -- but no impact on productivity from what you're seeing so far.
Darryl Rawlings -- Chief Executive Officer
No, it's not a material impact on productivity. It's -- basically, it takes about a week for a Territory Partner to go through the process, and it's something that were very good at. If the industry ever gets to the point that sales force calling on veterinarians as required to be licensed, that would be a net good thing for us. We're certainly is not there today. Licensing, things specific to our category, the more that happens as more of a moat for the business for us because it's what we specialize in and what we do. So we embrace regulations as long as it's doing what the regulators do, which is to try to make sure that consumers have high visibility on what they're getting, so there's transparency. The people are getting good, equal value proposition, which we believe we're targeting the highest sustainable level in the industry, all with new great customer experience.
Kevin Kim Ellich -- Hallum Capital Group LLC -- Analyst
Got it. Okay. That's helpful. And while we're talking about it, can you talk about how the initiatives to improve same-store sales conversion and retention are going? And what are the long-term targets? And how much do you plan to spend there?
Darryl Rawlings -- Chief Executive Officer
Well, the long-term targets and all of them are better than they are today. I wish I could give you a specific number. Let's take retention, for example. We're already at 98.5% a month, and that includes pet death. We've historically had the broadest coverage at the highest payout ratio. We believe we've got the best customer experience. We're paying hospitals directly. We're 24/7. We think we're priced more effectively, more accurately by most subcategories. We think we're leading the category in that area. There isn't a huge amount of upside. I mean, it's not going to go from 98.5% to 101%. Maybe the highest outside perfection on retention might be 99%, but I'll take every chance that I can get. I also think about areas like conversion. We look at our conversion rate on a blended. We look at how many people get a quote online, how many people get a quote on the telephone, how many people end up enrolling.
And we know that we have a much higher conversion rate on the phone. So we know that when a consumer receives the right accurate information at the right time that we can convert over 40% of people. We're -- we've got a long delta between all of our pets converting at 40%, and if we were to get to that level, we'll be growing at much faster rates. That's not our internal target. But every 1% improvement in our blended conversion rate is helpful. We told people of the shareholder letter -- our Shareholder Meeting that our blended conversion rate has been above 13%. So if we go from 13% to 14% or 14% to 15% or 15% to 18%, those types of percentages, if you -- they can make a real big impact on the business.
Kevin Kim Ellich -- Hallum Capital Group LLC -- Analyst
Great. That's helpful. Thank you.
Operator
(Operator Instructions) The next question here is from Greg Gibas from Northland Capital. Please go ahead.
Gregory Thomas Gibas -- Northland Capital Markets -- Analyst
Good afternoon. Thanks for taking my questions. First, if I could follow up on the pet acquisition spend question. Was wondering if you could break down pet acquisition spend in terms of how much was directed toward leading conversion teams versus the direct-to-consumer side. And can you maybe talk about how this mix is expected to change over time?
Darryl Rawlings -- Chief Executive Officer
Yes. Well, it's interesting. You actually asked the question how we break everything into the lead and conversion. And direct-to-consumer, many people imagine that, that is a lead generator. We actually do not believe or have not seen that to be the case. Our direct-to-consumer approach is really increasing the conversion rates from our already quality leads that we're getting from the veterinarians. Remember, we're not trying to enroll -- or our target audience is not the 180 million cats and dogs today.
Our target audience is the new pets being entered in the household, which are often puppies and kittens, but they also could be a 4- or 5-year-old dog being adopted from the shelter. And we think the time to get somebody enrolled in our product is in the first 3 to 6 months of that pet being in the household. And what we find, when we layer on D2C, is we don't get a higher number of those leads. What we do see is that, sometimes, in a market where we have a higher percentage of our software and more partnering hospitals, that we get a higher conversion rate of those leads that we're already getting.
And right now, our pet acquisition cost is broken about 50% lead and about 50% conversion. If you went back a couple of years, it was about 70% leads, 30% conversion. And the we're investing more and more on the conversion side. If I was to look at my crystal ball in the years ahead, our leads get -- we get scale on our leads and our growth, we're exceeding our subscription business and is growing faster year-over-year has been driven by increased leads. They become more and more efficient. Conversion costs are not an area that we think get more efficient, but an area that we have more deployable cash. We think they can make a big impact.
Gregory Thomas Gibas -- Northland Capital Markets -- Analyst
Great. That's really helpful. And then the second for me was just with respect to your international expansion recently announced, roughly, how long should we expect to take for us really an operations to ramp up? And can you provide some details on why Hollard Insurance decided to partner with you guys in a market where they already have a presence? And I guess, also, where do you expect that current 6% penetration in that market to go eventually?
Darryl Rawlings -- Chief Executive Officer
Well, Australia is early days for us. So we look at the Australian market in a couple of different ways. One is, long term, we have aspirations to be a global player. And we felt going into a market that speaks the same language, that acts very similar to our Canadian market, although penetration rates are higher, is an easier place for us to expand than to try to jump into China. So we went into Australia. We did not want it to be a distraction to our core North American business, so we decided to partner with a local partner that has expertise. And that local partner felt like there was a void in the market on having a product designed to be reviewed and recommended by veterinarians. And that's how we're positioned, and that's why we partnered with the partner that we did. And where we're at today is we're in a handful of hospitals. It's literally like a dozen. And we are just working out the buzz to see how many leads we get, what are the conversion rates, what's the retention rates.
We also want to understand our customer experience, make sure that we've got all of our ducks in the row. And we're going to keep -- we will not expand the number of hospitals until we feel confident that we're really good at understanding those numbers. And then, over time, we'll try to get out from the dozen hospitals. And long term, there's about 3,000 hospitals in Australia that can be our market. And I will -- I'm encouraged to say that our intuition was correct, that veterinarians and consumers are embracing our products, that they like it. It's not a big surprise for us, but we've got a lot of learning ahead and we've got the time to do it. Just for those watching our financials, the pet count does not show up in our total pet count. We have a separate line item for this investment.
Gregory Thomas Gibas -- Northland Capital Markets -- Analyst
Thanks.
Operator
Our next question is from Jon Block from Stifel. Please go ahead.
Thomas M. Stephan -- Stifel, Nicolaus & Company -- Analyst
Hi this is Tom I'm John. Thanks for taking my questions. This is Tom on for Jon. I guess, to start off on marketing spend in your 3 different buckets. Can you maybe share some of the specific initiatives that might be moving up the chains, so from either the test bucket to growth or growth to core?
Darryl Rawlings -- Chief Executive Officer
Yes, I can. I would say, several years ago, we were innovating around TV and radio, and then it went into the growth category and kind of some established market. So we were trying different channels, different times of the day, different messaging. And then in certain markets where we are more penetrated, we are getting internal rates of return based on that conversion rate lift. And in some of those markets, they're now moved into core. Now I would tell you, D2C in general is more in the growth mode, and there's a lot of markets that we do not think we are ready. We do not have enough buy-in from veterinarians. There's not a high enough penetration rate of our software we have not been in the marketplace long enough.
But that's kind of how it runs through. I would tell you another one was signing account managers to be contacting veterinarian hospitals between our Territory Partner visits. That started the office and innovation several years ago. I would say that's firmly in the growth mode today. Internal rates of return are below 30%, but above 5% or 10%. And we are going to keep fine-tuning that and growing that the T-mode. And I would imagine in 3 to 4 years, that will definitely be in core spend and, hopefully, a little sooner.
Thomas M. Stephan -- Stifel, Nicolaus & Company -- Analyst
Great. That's helpful. And then, I guess, quickly is to the -- to churn. The year 1 rate of around 97%, how are the initiatives proceeding to reduce that? And how long does it take for some of them to take effect?
Darryl Rawlings -- Chief Executive Officer
Well, that was something that I highlighted in my shareholder letter last year, which is I broke churn down into the categories, things like pet death and reasons why somebody is canceling, like failed payments or they're unsatisfied. But I also look at different view, and that view was to say how many people churned in the first year before they've had a rate renewal, how many people churn if the rate renewal is within a typical band, which is less than 20%, typically 5% to 6% year-over-year.
And for those people, as we're fine-tuning our pricing by more subcategories and we've been doing this for years and will continue in the years ahead, when we're pricing more accurately by more subcategories, and rates are changing by more than 20%, what is the impact? And what you talked about was in the first year, we have the highest turn of churn, the highest number of pets churning at about 97% month over month. The initiatives that we're trying to work on are more about upfront education. Some people churn in the first year because they thought we were going to cover a wellness exam. Some people churn because their dog got hit by a car an hour before they enrolled and they were hoping that we would cover them.
Other people churn because they were expecting something different, maybe -- for example, maybe a deductible working a different way or some others. So upfront education is the main area. We have seen glimmers of improvement in those areas, areas that we're encouraged by. But as I mentioned earlier, trying to make any improvements in these when we have a blended 98.5% is really hard. I mean, we think we're leading the category. We think we have been for a long time. These are the buckets we're focused on. The initiatives we have, we'll keep at them probably for the next couple of years and see if we can move the needle. And if we're making progress, we'll keep doing it. And if we can't make any progress, we'll deploy funds in other ways.
Operator
Our next question is from David Westenberg from Guggenheim. Please go ahead.
David Wisenberg -- Guggenheim
Hi thanks for taking the question. So just going back to the theme of gross profit. I know that when you're kind of aiming the price, I know you much rather lean on giving the consumer. And I know it also ebbs and flows. But in this particular case, what are maybe some of the factors that got it a little bit higher than that target range, whether it be mix of maybe more in healthy pets, higher claims? And then, subsequently, would there be maybe a sort of a touch-up pricing? I know that revenue was up about 7%. So I mean, maybe, you already did it. I know you increased monthly, but just a little bit more color there.
Darryl Rawlings -- Chief Executive Officer
Well, I don't think it's overly complicated. I mean, our cost of goods have gone up 5%. They average 5% to 6% for the last 15 years. Our ARPU went up 5% year-to-date. If they're staying the same, that would keep us at about a 72%. Our target is 70%. We need -- as Trish mentioned earlier, we need our ARPU to be going up approximately 7% and our cost of goods to be going up 5% for us to make up that variance. And we also have a headwind as we deploy more of our software, which is about another 1 point. And as I mentioned earlier, we have our software 50% more hospitals than we did this time last year, so we have to build that in. And all of it is not instant. We've got this dynamic and we've got to roll it out. The nice thing is our margin that we've been able to improve over the last about 3 or 4 years from what was about $12 million 3 or 4 years ago to $45 million this year means we've got the flexibility to get this right over time, while still being investing in the business. Our targets have not changed.
David Wisenberg -- Guggenheim
Got you. Okay. And then going back to -- on the cost side. Your pet acquisition cost, another quarter of above $200. And I understand that you're exploring the conversion channel and you've kind of now spending more close to 50% of the spending it in conversion. Now that you've kind of out there and exploring channels, is this kind of the normal expense rate you think you could see? Is there any kind of visibility on a go-forward basis in terms of pet acquisition cost?
Tricia Lynn Plouf -- Chief Financial Officer
Yes. Dave, I mean, at a high level, we are using our calculated internal rates of return to inform how much we have available to spend. So to the extent that we can spend within our guardrails of 30% to 40% internal rates of return, if we still we can do so effectively, we will. The biggest thing, and Darryl mentioned this earlier, that is different compared to last year and the year before that is in prior years, the pot of money available was much lower. And so almost all of the spend was going toward things that would enroll pets in that quarter. And now, we -- as we talked about our carving out around 30% of our spend to do things that are building our teams are more long term in nature and thinking more long term and -- about the category and the growth. So it's a little bit apples and oranges, but we are making sure we're within those guardrails, of the 30% to 40%, while we do this and also being cash flow positive. And with those in mind, we feel comfortable and are excited about the opportunities that we have ahead of us.
Darryl Rawlings -- Chief Executive Officer
Yes. I mean, not just for the -- in the -- in my opening remarks, our goal is to drive revenue 20% to 30% year-over-year right at the midpoint. Our goal is to expand our adjusted operating income, and we're doing that about 40% year-over-year, so we're excited about that. And we want our internal rate of return between 30% and 30 -- 30% and 40%, and we're at about a 34% right now, so right at the midpoint. So we feel good about how the year is going and excited about where we're able to deploy those capital.
David Wisenberg -- Guggenheim
Right. That was very helpful. And then just maybe the last one in terms of the switching from emails to text messages. Can you maybe give us a little bit of progress? I know I think you gave some matrix at the Analyst Day about opening -- the opening of a text message being within minutes. Is this kind of the experience that you have? And just maybe a little bit of metrics on how that kind of initiatives are going in.
Darryl Rawlings -- Chief Executive Officer
So in your question is -- one of the initiatives we're working on conversion is how do you get the right content to the person at the right time. And we are historically have been using a lot more emails. We're seeing email rates over the years. Open rates have been declining and the speed at which people do that. I think that's -- we can all understand that as our inboxes get spammed full. But we're finding other ways to communicate, so that's not only things like text, but it's going to be things like instant messaging on our website, other ways that could drive people to the telephones. And we're still in test mode, but were encouraged by the results we've seen so far.
Operator
[Operator Closing Remarks]
Duration: 53 minutes
Call participants:
Laura Bainbridge -- Head of Invester Relation
Darryl Rawlings -- Chief Executive Officer
Tricia Plouf -- CFO
Tricia Lynn Plouf -- Chief Financial Officer
Andrew Cooper -- Raymond James
Shweta Khajuria -- RBC Capital Markets -- Analyst
Mark Argento -- Lake Street Capital Markets
Kevin Kim Ellich -- Hallum Capital Group LLC -- Analyst
Gregory Thomas Gibas -- Northland Capital Markets -- Analyst
Thomas M. Stephan -- Stifel, Nicolaus & Company -- Analyst
David Wisenberg -- Guggenheim
