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Trupanion Inc (TRUP 1.79%)
Q3Â 2020 Earnings Call
Oct 29, 2020, 4:30 p.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Greetings, and welcome to the Trupanion Third Quarter 2020 Results Call. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]
I would now like to turn the conference over to your host, Laura Bainbridge, Investor Relations. Thank you. You may begin.
Laura Bainbridge -- Investor Relations
Good afternoon, and welcome to Trupanion's third quarter 2020 financial results conference call. Participating on today's call are Darryl Rawlings, Chief Executive Officer; and Tricia Plouf, Chief Financial Officer. Margi Tooth, Trupanion's Chief Revenue Officer will also be available for the Q&A portion of today's call. 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, 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 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 will hand the call over to Darryl.
Darryl Rawlings -- Founder and Chief Executive Officer
Thanks, Laura. Similar to Q2, Q3 was another strong quarter with high retention rates, driving accelerated growth in net subscription pets. Total revenue grew 31% year-over-year and we ended the quarter with over 804,000 total enrolled pets. Within our subscription business, new pets net of cancellations grew 30% year-over-year. The average monthly retention increased to 98.69% on a trailing 12-month basis. We calculate this is extended the average pets lifetime with Trupanion to 76 months, up from 71 months in the prior year period. As a result, lifetime value of a pet, including fixed expenses grew 20% year-over-year to $615. Adjusted operating income in the quarter was $14.4 million. Last quarter, we highlighted our intention to be more aggressive in our acquisition spend. Expansion in key metrics, including retention and lifetime value paves the way for us to do so. In the quarter, we were able to deploy $12.3 million of our adjusted operating income at a calculated internal rate of return of 34% for a single average pet, hitting the midpoint of our targeted range of 30% to 40%, while deploying 40% more capital compared to the prior year period, helped drive our strong quarterly growth. Well done team.
Our ability to grow adjusted operating income while deploying increasing amounts of capital at attractive internal rates of return gives me confidence that we will be able to take advantage of this large and under-penetrated market for the years and decades to come. Since the beginning of April, we've also made good strides in both mobile and social media. As an example, we've held four webinars that have reached an audience of over 2.5 million. We are excited to continue to build on these skill sets within the company. Across the organization, we're seeing the benefits of year-over-year improvements in our service levels. Since the start of the pandemic, the team has pulled together in support of our members to answer the phones and pay veterinary invoices quickly. We've seen two sequential quarters of high retention and strong net pet growth as a result. The team is now tasked with not only maintaining the service levels, but also incrementally improving upon them. This will be no easy task given our accelerated growth.
We are going to double down on our investment in people and technology to support these efforts. Continuing to delight our members through exceptional member experience, it's critical to our efforts of nirvana. In the third quarter, the gap to nirvana was only 0.39. This represents a 21 basis point improvement over the prior year period. As a reminder, we define nirvana as a state where existing members referring friends or adding pets offset the number of cancelations. At Trupanion, we understand the power of the pet. One of the few perks of COVID has been the transition to remote working, which has given many the freedom to bring a new pet into the household. Undoubtedly, where and how people work has changed. We are now more confident than ever that pet medical insurance as a workplace benefit should remain a positive trend for years to come.
Today, we are excited to announce a strategic Alliance with Aflac, the leading provider of supplemental insurance at the work site in the United States. Those that know Aflac, also know they have very strong roots in Japan with penetration in one in four households. With as many as 9 out of 10 consumers recognize the Aflac brand, their reputation that has helped them earn the trust of over 50 million policy holders worldwide.
Our relationship with Aflac began over 18 months ago when their current President and CFO first visited our Seattle headquarters. In the months to follow, we came to realize that both Aflac and Trupanion share similar cultures, values and business models. To drive alignment, Aflac has committed a $200 million investment at a price of $55 per share with a three-year lockup.
Our commitment over the next several years will be to leverage Aflac leadership position in the United States with a Trupanion product offering to unlock the potential of pet insurance being sold at the work site. We are also committed to exploring opportunities to bring Trupanion to Japan.
Aflac is a world-class organization, and we feel humbled and honored to partner with them. We believe this is a good deal for both companies, and we look forward to working with the Aflac team over the next several years to unlock the potential of our Alliance.
With that, I'll hand the call over to Trish, who will discuss our quarterly results in more detail.
Tricia Plouf -- Chief Financial Officer
Thanks, Darryl, and good afternoon, everyone. We are pleased with our third quarter financial results, which once again exceeded our expectations. Our overall performance was led by strong monthly retention and solid growth positions in our subscription business and continued strong growth in our other business segment. Total revenue for the quarter was $130.1 million, up 31% year-over-year. Subscription revenue was $99.4 million in the quarter, up 20% year-over-year. Total enrolled subscription pets increased 15% year-over-year to approximately 553,000 pets. As of September 30th. Average monthly retention, which is calculated on a trailing 12-month basis was 98.69% compared to 98.59% in the prior year period. The increase over the prior year can be attributed to our improved service levels of focus that we spoke about on our last call and has continued through the year.
Monthly average revenue per pet for the quarter was $60.87, an increase of 5% year-over-year. In local currency, U.S ARPU increased 5% and Canadian ARPU increased 4% over the prior year period.
Our other business revenue, which is comprised of revenue from our other product offerings that generally have a B2B component, totaled $30.7 million for the quarter, an increase of 84% year-over-year. Year over year growth in our other business segment reflects an increase in the number of pets enrolled. Subscription gross margin was 18.8% of revenue in the quarter compared to 19.5% in the prior year period, and within our annual target of 18% to 21%. As a percentage of subscription revenue, our subscription gross margin was comprised of 72% paying veterinary invoices and 9% on variable expenses. Pricing accurately to our 71% value proposition will require annual ARPU increases of 6% to 7% as opposed to the current year trend of 5% increases. We continue to make progress on our pricing initiatives during the quarter and expect to see ARPU trends continue to increase into next year. Total gross margin was 16%, which includes our lower margin other business segments. Total fixed expenses in the quarter were 5% of revenue consistent with the prior year period. As a reminder, we achieved our fixed expense target of 5% of revenue in Q3 of last year and have continued to maintain scale year-over-year.
We generated $14.4 million of total adjusted operating income during the quarter, and our net loss was $2.6 million. The vast majority of our adjusted operating income was generated from our subscription business during the quarter at $13.7 million. Adjusted operating margin was 14% of subscription revenue in the quarter, which is in line with our expectation, but below our targeted 15% margin. With our variable and fixed expenses, largely at scale, we would otherwise expect adjusted operating income to increase in line with revenue trends, absent small fluctuations in gross margin. In the third quarter, adjusted operating income grew 15% compared to the prior year period. Our rates slightly lower than subscription revenue, reflecting the cost of veterinary invoices outpacing that of our ARPU growth as I previously noted. It's worth reiterating that small fluctuations in gross margin on a quarterly basis are to be expected based on the nature of our business. These fluctuations, even out over the course of a year and on an annual basis, growth and adjusted operating income is largely expected to trend in line with revenue growth moving forward. This is consistent with our expectations for the full year of 2020, which I will cover momentarily.
To further illustrate this, total adjusted operating income for the 9 months ended September 30, totaled $40.5 million, which is a 27% increase over the prior year period. During the quarter, we deployed $12.3 million of our adjusted operating income to acquire over 44,000 new subscription pets resulting in a pack of $261 in the quarter, an estimated 34% internal rate of return for a single average pet. For a reminder of how we calculate internal rate of return, please refer to our supplemental financial materials on the Investor Relations portion of our website. Adjusted EBITDA was $1.8 million for the quarter as compared to $3.9 million in the prior year period. Net loss was $2.6 million or a loss of $0.07 per basic and diluted share compared to net income of $0.8 million or $0.02 per basic and diluted share in the prior year period. Free cash flow in the quarter was $8.5 million compared to $2.9 million in the prior year period. Operating cash flow in the quarter was $9.8 million compared to $4.7 million in the prior year period. Trupanion's balance sheet remains strong with over $118 million of cash in investments and ample availability on the company's existing line of credit. At September 30, we had approximately $29.8 million of long-term debt. As Darryl mentioned, we are pleased to announce our strategic Alliance and $200 million investment from Aflac. The proceeds from this investment will strengthen our balance sheet, reduce our reliance on debt if we were to accelerate our growth, enable us to reduce frictional costs and allow for continued strategic and technology investments.
I'll now turn to our outlook for the full year of 2020. For the full year, we are increasing our revenue guidance range to reflect our overall performance year-to-date and visibility into the fourth quarter. We now expect revenue for the full year to be in the range of $498 million to $499 million, representing 30% year-over-year growth at the midpoint. This implies expected fourth quarter revenue growth of 32% at the midpoint. Our full year subscription revenue is now expected to be in the range of $386 million to $387 million or 20% growth at the midpoint. This implies expected fourth quarter subscription revenue growth of 21% at the midpoint. Our other business segment, which continues to perform well, but has lower margins, is now expected to be around $112 million for the year. At these updated revenue levels, we expect total adjusted operating income for the year to be around $57 million with approximately $54 million coming from our subscription business.
Within our 30% to 40% internal rate of return guardrails, we estimate allowable pet acquisition spend in the range of $240 to $260 per pet for the full year. At the midpoint, this would equate to total acquisition spend for the year of around $45 million. Also, please keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S and Canadian currencies. For our guidance, we used a 75% conversion rate, which was the approximate rate at the end of September. And quickly before we open it up for Q&A, I'll highlight that Margi Tooth, our Chief Revenue Officer is joining us for today's call and will be a regular Q&A participant moving forward.
With that, Darryl, Margi and I are now available for questions.
Questions and Answers:
Operator
Thank you. [Operator Instructions] Our first question comes from Shweta Khajuria with RBC Capital Markets. Please proceed with your question.
Shweta Khajuria -- RBC Capital Markets -- Analyst
Thank you. Two questions, please. First on the subscription vet additions, understood on rate -- retention rates that continued through into the third quarter. Could you talk about what growth additions, which marketing channel worked, and anything that you could call out in terms of efficiency of marketing? And then similar to that question, you had pointed Darryl in the last quarter earnings call, it takes about 4 to 5 months to increase supply effects. And that you've started hearing from the vets in July, that supply was going up, meaning you are -- there were more effect. What did you hear through the quarter, and does that help? Thank you.
Darryl Rawlings -- Founder and Chief Executive Officer
Thanks, Shweta. I'll start the answer to the question then hand it over to Margi. Across the board, we saw increased leads and increased conversion rates throughout the quarter. So we're seeing strong growth across all distribution channels and the effects of our increased retention rates definitely helped our net pet growth. As far as the increase in new pets entering household, we are seeing that factor veterinarians are increasingly busy during Q3 and we're seeing that entering Q4. Margi, you got anything to add?
Margi Tooth -- Chief Revenue Officer
Yes, I think in terms of overall channels, the efficiency that we account [Phonetic], we still have a strong core channel through the base, that's continuing. We hear the noises, how busy they're in the animal health space. I think that just reinforces the core channels and the strength we have there.
Darryl Rawlings -- Founder and Chief Executive Officer
Operator, are you there?
Operator
Yes, I'm right here. I wasn't sure if she was done with her question or not. Do you have another question for our speakers?
Shweta Khajuria -- RBC Capital Markets -- Analyst
I think I'm all set. I'll go back in the queue to give others a chance.
Darryl Rawlings -- Founder and Chief Executive Officer
Thanks, Shweta.
Operator
Our next question comes from Mark Argento with Lake Street Capital. Please proceed with your question.
Mark Argento -- Lake Street Capital -- Analyst
All right. Good afternoon, everybody and congrats on a strong quarter, but also the Aflac deal. Just wanted to maybe dive into that a little bit. It's a big investment, roughly 10% of the company. Maybe you could talk a little bit about the strategic plans you have, that you're going to roll out the pet product. Are you guys going to brand it like, maybe just talk to that a little bit.
Darryl Rawlings -- Founder and Chief Executive Officer
Sure. So we -- as we mentioned in the opening remarks, we are super excited about partnering with Aflac and there's $200 million investment. It's a strong commitment and a great part of the alliance, make sure we have the right alignment. There's really two areas of focus. One is work site in the U.S. market, and the second is in Japan. Aflac is very strong on the work site in the, the U.S market. And over the next several years, we're going to try to unlock that potential. That's going into both small, medium and large site businesses. And we will probably -- we'll work with them to come up with a product that is unique and identified for that channel for them. And then we'll work with them as well to figure out how we can enter and access the Japanese market.
Mark Argento -- Lake Street Capital -- Analyst
So will there be a direct-to-consumer play through Aflac or will it all be through their work site program?
Darryl Rawlings -- Founder and Chief Executive Officer
The focus will be the work site, but there may be some additional efforts and we'll work that out over the next year or so.
Mark Argento -- Lake Street Capital -- Analyst
Great. And then last question from me, State Farm, any updates on the State Farm rollout? It sounds like initially things have been going well. And do you have any plans to I think it was available on the website, but will the agents be able to directly sell the product anytime soon?
Darryl Rawlings -- Founder and Chief Executive Officer
Yes, no big updates from the last -- that we mentioned in the last quarterly call as well as at the shareholder meeting. Step one for State Farm was making sure that people entering the State Farm website naturally could have access. The second stage of that is to allow them to enroll inside of the State Farm website. And then the third phase will be, perhaps to try to work to engage their 20,000 agents.
Mark Argento -- Lake Street Capital -- Analyst
Great. I'll hop back in the queue. Congrats again. Thanks.
Darryl Rawlings -- Founder and Chief Executive Officer
Thank you.
Operator
[Operator Instructions] Our next question comes from Jonathan Block with Stifel. Please proceed with your question.
Jonathan Block -- Stifel Financial Corp -- Analyst
Hey, guys. Thanks. Good afternoon. Maybe the first one, Darryl on the pet acquisition cost of around $261, I think in the quarter versus $208 a year-ago. It seems like on the incremental pets, call it year-over-year, the pack might've been around 500 and that was with a lot of progress in nirvana that you called out and congrats on that. So can you just sort of reconcile the progress that you guys have made on nirvana, which I think part of the advantage of that is it offers a very low cost channel for pet acquisitions versus the deleverage that we see in the pack of $261 versus $208. Why those are at least on the surface supposedly?
Darryl Rawlings -- Founder and Chief Executive Officer
Yes. So the way that we think about our business this year and next year and going into the next decade is we are having increasing amounts of adjusted operating income, which we want to be able to deploy the majority of it with great strong internal rates of return. For the quarter we had a 34% internal rate of return, well in the middle of our 30% to 40% target. When we think about our allowable pack spend, that is driven by the adjusted operating margin, the actual adjusted operating income or dollars per pet that fall to the bottom line and that they're multiplied by the retention. As I mentioned before, the increase in our retention rate has taken us from 71 to 76 months and our lifetime value of a pet after fixed expenses has increased about 20%. This means our allowable spend to deploy greater sums of capital increase as well maintaining or hitting our internal rates of return targets.
When I think about the next year, the next decade we will have growing from what used to be $5 million, $10 million to now close to $50 million of adjusted operating income, and soon to be hundreds of millions of dollars of adjusted operating income. What I can say that the team be able to deploy those dollars at 30% to 40% of internal rates of return. I'm thrilled. The fact that we've increased our lifetime value, which reduces the payback period of time means that it is more likely that our teams are going to be able to continue to do this at scale. Our individual pet acquisition costs on a per pet basis, as we continue to increase our lifetime value should always be going up quarter after quarter after quarter. So that allows us spend in our business model should make it easier for us to continue to grow at accelerated growth rates.
Tricia Plouf -- Chief Financial Officer
Yes, I will just add one thing, John, to that a little bit of color, which is to what Darryl said, there's kind of a couple of things. One is, it allows us to invest more in our core channel, strengthen them both that we have in those channels, not only for the current quarter, but for the long-term as well as do new incremental things that may not manifest themselves fully within a particular quarter. But we'll -- and ideally if they go well, manifest themselves over periods of time, and that gets back to what Darryl said. Those two things and those incremental investments give us a lot more confidence that we can continue to grow month-after-month, quarter-after-quarter and year-after-year.
Margi Tooth -- Chief Revenue Officer
And if I can answer that as well, John, it's Margi. Just in terms of the way we think about our April nirvana approach and what that means from a growth perspective to when looking at the initial onboarding phases of the pet analyze cycle with us too. So we don't just look at that, but make sure we enroll that pet. It's also making sure they have a very smooth onboarding process, which in itself helps to drive the overall approach to the group from nirvana perspective. So it's all wrapped up in the same thing. But just a point, sometimes you see an immediate return on that and sometimes it will down the line, but we can move with the courage of our convictions as we see that continuing to return and always operating within the guardrails that are in the 30% to 40%.
Jonathan Block -- Stifel Financial Corp -- Analyst
Got it. Very helpful. I had two more questions, if that's OK. The first one, just specific to the gross adds, accounting gross adds up about 17%, 18% year-over-year. It's a pretty healthy number, but Darryl, I'd love to get your views on what the industry is growing. There were some positive commentary from an industry player earlier today on number of new pets coming to the vet channel where you have a strong hold. So maybe you can comment on, I guess, first, just the math on the 17%, 18% gross adds year-over-year and how you think that compares to industry? And then I've just got a final follow-up. Thanks guys.
Darryl Rawlings -- Founder and Chief Executive Officer
Yes. So we think that the industry is growing revenue, not pets, but revenue around 20%, 21%, 22%. And typically with ARPU that's about a 17% plus 5% ARPU. 16% maybe for the category. So that's what we're seeing. As you did mention the -- we're seeing for all of our animal health partners strong visits at vet hospitals, etc. So we expect that to continue moving forward.
Jonathan Block -- Stifel Financial Corp -- Analyst
Okay. And then just a pretty broad base third question. Trish for you, can you comment on the DSO, it seem to be north of 60 versus mid 40-ish a year-ago. If you can give some color there. And the AOI, I asked about that last go round, but that continued to move higher. And then finally, Darryl, just if you can comment on just the price for Aflac. I mean, clearly we see the value of the strategic investor, but the $55 per share, notably below where you guys currently are and where you certainly were about a month ago. So maybe you could just talk to, or provide some color on how that valuation was arrived at? Thanks for your time guys.
Tricia Plouf -- Chief Financial Officer
Sure. Just briefly on the AR and the days outstanding, that increase relates to the increase that you directly see within the other business revenue. Majority of that revenue comes from annual policies, which if the customer is allowed to have monthly payment terms, the insurance accounting puts the remaining balance as accounts receivable, even though it's not due yet. So it's not a sort of backward looking late payment issue and it is not related to our subscription business in any way. It's just the nature of the other business segment and those, 12 month policies, which if you enroll today will still have a 11 months remaining on them, then you would see that in AR. So when the revenue is growing, the AR is also growing.
Darryl Rawlings -- Founder and Chief Executive Officer
John, as it take to the $200 million cash investment that Aflac has committed to, we did it at a $55 share price with a three-year lockup. And we think that's a fair price for both parties considering kind of our 90-day moving average in that three-year lockup.
Jonathan Block -- Stifel Financial Corp -- Analyst
Thanks, guys.
Operator
[Operator Closing Remarks]
Duration: 30 minutes
Call participants:
Laura Bainbridge -- Investor Relations
Darryl Rawlings -- Founder and Chief Executive Officer
Tricia Plouf -- Chief Financial Officer
Margi Tooth -- Chief Revenue Officer
Shweta Khajuria -- RBC Capital Markets -- Analyst
Mark Argento -- Lake Street Capital -- Analyst
Jonathan Block -- Stifel Financial Corp -- Analyst
