The excitement of a stock's initial public offering (IPO) can be undone by the scrutiny that goes along with it. Finding a high-quality company that can turn an exciting concept into a valuable business is a difficult task. But it pays off when you find one that actually makes good on its sky-high potential.
Lemonade (NYSE:LMND) is a perfect example of an IPO that is entirely worth the added volatility. Insurance is an industry that's ripe for disruption, and Lemonade is on its way to doing it with a different kind of business model and a huge technological advantage. With the company coming off its first quarterly report as a public entity, let's take a closer look.
Lemonade is an insurance-tech company that went public earlier this year in just its third year of existence. The digitally native organization operates a mobile app and website aimed at making the insurance process as transparent and easy to follow as possible. Today, it offers renters, homeowners, and pet insurance, with long-term plans to add health insurance and life insurance as well.
Lemonade keeps a flat premium fee of 25% up front. This is big because most insurers keep as much as they can after paying out claims; in Lemonade's model, the remaining 75% of its premiums is available for claims, with excess funds paid to a charity of the user's choice at year's end.
This unique feature adds a layer of trust between Lemonade and its customers. A typical insurer makes more profit by denying claims whenever possible. Lemonade removed that conflict of interest by directing excess profits to charity. This feature might also make users less likely to embellish the amount requested, knowing extra funds go to their favorite cause rather than into the company's bottom line.
An AI edge
Perhaps Lemonade's most exciting edge is how it uses artificial intelligence (AI) to streamline its business. Between its customer-service bot Maya, its claims-processing bot Jim, and various back-end processes, Lemonade handles 32% of its support requests through AI, a sharp increase from 6% at the end of 2017. Normal insurers might ask roughly 20 questions and collect 20 data points. Maya asks , fewer questions yet collects thousands of data points at the same time. It can then readily store all collected data far more easily than a human can.
You can also see the benefit in Lemonade's loss ratio (claims paid out divided by premiums collected -- anything under 1 is profitable). In the first quarter of 2017, Lemonade's loss ratio was a frightening 3.68, versus 0.82 for its big rivals. But it's gradually gotten better, from 1.61 at the end of 2017 to 1.13 in 2018, and 0.79 in 2019. In this year's second quarter, Lemonade's machine-learning capabilities helped power that number all the way down to 0.67.
While legacy insurance providers generally have to make a trade-off between rapid growth and better loss ratios, Lemonade doesn't. The company says its massive AI improvement keeps its customer acquisition costs far below those of its competitors. As a result, it can pass these savings on to customers, with average plans for first-time buyers often coming in at half the cost of competing plans.
A great start
The business model has been extremely well received by consumers thus far. The company's compound annual growth rate (CAGR) from 2017 to 2020 was over 450%. That helped boost Lemonade's revenue to $100 million after just 30 months of operation. For comparison, it took Shopify and ServiceNow -- two popular high-growth cloud companies -- twice as long to get to the same mark. Since 2017, Lemonade has surpassed both Allstate and Liberty Mutual in terms of daily Google searches for renter's insurance.
The beauty of Lemonade's business is that more than 90% of its users are new to insurance. Lemonade is committed to wooing these customers early on to give users every reason to grow with them as their insurance needs also grow. How can the company execute that vision? Lemonade fulfills claims instantly and issues new plans within minutes.Competition takes several days to do both and is far more incentivized to reject a claim.
Furthermore, in 2017, just 1.5% of Lemonade homeowner's insurance holders started off as renters. Today that number is 10%, perhaps thanks to its customer-centric business model. Lemonade often does not have to spend a dime to convert renters to homeowner policies, which carry an average premium 6 times larger than what renters pay . That means margin expansion.
This past quarter Lemonade enjoyed 117% revenue growth and customer growth of 84% to 814,600 users. Management commentary focused on the company temporarily pulling back on advertising and hiring to brace for the impact of the pandemic. In CEO Daniel Schreiber's own words: "none materialized."
Improving efficiency, continued progress toward profitability, and rapid growth all continued on "apparently unperturbed by the contagion." For a young company dealing with a generational pandemic, this is encouraging news. Critics will point to the revenue guide slightly missing, but when advertising and hiring is temporarily halted due to global shutdowns that can be expected.
IPOs often coincide with high levels of risk. Lemonade -- with a hefty forward sales multiple of 27 times -- does as well. Still, its explosive growth and consumer-centric business model are two desirable traits making high risk and an expensive valuation more palatable. The insurance industry is as ripe for disruption as any. Lemonade is poised to dominate.