Where Will Lemonade Stock Be in 1 Year?

Lemonade (LMND 1.67%), which went public in July, is bringing modern technology to the venerable insurance industry. Since its IPO, the stock is up by more than 100%, significantly outperforming the broader market. Needless to say, its shareholders have every reason to be quite pleased at this point. But despite these gains, Lemonade still looks like a great long-term investment. Here's why. 

Lemonade is different

Traditional insurers use agents to sell insurance and pay claims. And after they collect premiums, pay claims, and cover expenses, those companies pocket whatever is left over as profit.

Image source: Lemonade

Lemonade takes a different approach. Its business is built on big data and artificial intelligence, allowing the company to operate more efficiently and without as many employees. For example, consumers interact with chatbots when purchasing insurance and filing claims, and its AI-powered applications help detect fraud and run various parts of the business. This keeps its payroll and other operational expenses low.

The platform is also designed to collect massive amounts of data, which the company uses to more accurately assess the risk associated with each consumer. In theory, this data advantage should help it more effectively underwrite policies and identify fraud.

Finally, Lemonade uses a fixed-fee business model based on reinsurance (insurance for insurance companies). This allows the company to keep a portion of the premiums it collects while offloading most of the responsibility for covering claims to its reinsurance partners. Compared to traditional insurance companies, Lemonade's model should make its business less volatile by creating recurring revenue and highly stable gross margins.

Balancing profitability and trust

Rather than pocketing all excess premiums, Lemonade donates a portion to charity. When individuals purchase insurance, they also make a selection from a pre-approved list of charitable causes. All individuals that select the same cause are grouped into a cohort, and if the loss ratio for a particular cohort is less than 40%, Lemonade donates a portion of excess premiums to the selected charity (up to 40%). For example, the company donated $1.1 million in 2020.

In doing this, Lemonade hopes to create trust and align its values with its customers. But investors shouldn't fret -- there is still plenty of room for the company to become more profitable, even with its charitable giveback. Since its AI- and automation-heavy approach keeps its costs low, it can boost profits by attracting more new customers, and getting existing ones to sign up for more of its services and increase their premiums. 

Lemonade enjoys further profit potential from the difference between what it takes in and what it pays out. Lemonade keeps about 25% of the premiums customers pay. But its reinsurance deals mean that it also only has to pay out 25% of their claims. Even with its pledge to donate extra money to charity, Lemonade can still fatten its bottom line by keeping premiums steady, but paying out less in claims.

While Lemonade doesn't give details on individual cohorts, the loss ratio for the business as a whole was 72% in Q3, indicating that $0.72 was paid out on every $1 in earned premiums. That's not bad -- in fact, it's roughly 10% better than the industry average. But as it shrinks from 72% toward the 40% cutoff -- the point at which Lemonade donates all excess premiums to charity -- the company can keep more customer dollars and become more profitable. 

Moreover, as Lemonade's loss ratio drops, it should inspire confidence in its reinsurance partners. This could help Lemonade negotiate more profitable reinsurance contracts in the future. For example, the company currently receives a 25% ceding commission on each policy, but as its loss ratio drops -- an indication that the company's underwriting abilities are improving -- its reinsurance partners might be willing to bump that up to 30% (or more).

To tie everything together, Lemonade's AI-powered, fixed-fee business model aims to reduce volatility and improve operational efficiency, which should translate into greater and more consistent profitability. At the same time, the company caps its upside with a charitable donation, which aims to reduce the conflict of interest associated with traditional insurance companies. Together, these efforts separate Lemonade from its rivals in a big way.

Disrupting a massive market

Insurance is one of the largest industries in the world. U.S. insurance premiums totaled $1.3 trillion in 2019 -- that's 6% of the gross domestic product. And insurance premiums worldwide totaled $6.3 trillion in 2019.

Simply put, Lemonade has an enormous market opportunity.

And its data-driven strategy appears to be working. It took the tech company just over four years to reach 1 million customers. Incumbents like State Farm and Geico took 22 and 28 years, respectively, to hit that milestone.

In addition to adding new customers, Lemonade's premium per customer is on the rise.

Source: Lemonade SEC Filings.

This isn't happening by accident. Lemonade has made a point of appealing to a younger crowd. For instance, the company does away with long forms, allowing customers to purchase insurance after a two minute talk with chatbot AI Maya. For what it's worth, I've interacted with AI Maya and I found the process quite enjoyable.

The company also spent $57.5 million (78% of revenue) on marketing during the first nine months of 2020. And so far, the pairing of a delightful user experience with aggressive marketing is resonating with young consumers.

Currently, 70% of Lemonade's policyholders are under 35. And as these individuals get older, their insurance needs grow, too. For instance, many renters eventually become homeowners, and premiums on homeowners policies are more than six times higher than rental policy premiums. Ultimately, this should keep Lemonade's premium per customer trending upward. And that should make Lemonade a more profitable business over time.

A final word

Lemonade is a young business. It can take years to truly assess insurance companies, as weather events, natural disasters, and accidents can dramatically impact their bottom lines. Likewise, Lemonade's business model requires reinsurance partners. If the company fails to perform, or causes its partners to lose money, it may lose its reinsurance contracts.

Despite these risks, the insurance industry seems overdue for a modern transformation, and Lemonade's digital-first approach could provide it. Likewise, the company's first-mover status should help it stay ahead of new start-ups in the insurtech space.

So where will Lemonade stock be one year from today? That's a coin toss. The company is not profitable, and its shares trade at a pricey valuation. A year from now, Lemonade could be worth half or twice what it is today. So if you're looking for a guaranteed winner over the next year, this is not the stock for you.

However, investors with longer time horizons should take a close look at this company. A decade from now, you may wish you'd bought a few shares.