Checking In on Lemonade, Spotify, and Etsy

Tune in to this episode of Industry Focus: Tech for breakdowns with host Dylan Lewis and Motley Fool contributor Jason Hall on Spotify's (SPOT -4.01%) ad business, why Lemonade's (LMND 2.58%) not taking Jason on as a customer was a good thing, and how Etsy (ETSY 0.70%) is keeping e-commerce crafty.

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This video was recorded on Sept. 3, 2021.

Dylan Lewis: It's Friday, September 3rd, and we're talking about stocks we've recently bought. I'm your host Dylan Lewis, and I'm joined by fool.com's Jason Hall. Jason, stepping away from his computer, making it back just in the nick of time, how are you doing?

Jason Hall: I'm fantastic this morning. I'm excited to be on. I think our listeners on the podcasts are going to notice a consistent up into the right improvement of the quality of my participation in the show as my coffee intake increases over the next half hour.

Lewis: If you don't like Jason now, just wait 20 minutes until the caffeine really hits.

Hall: Buddy, that's right.

Lewis: I'm in the same boat, Jason. I love coffee, we're going to be talking about some companies that we love. I think this is a fun show, or you were talking about businesses that we bought recently. We're bringing three stocks to the conversation, and I will say, just put it out there to start, as a shareholder, one of these businesses obviously bought one of them. But I've interacted with all three of these companies as a consumer in the past week and a half, which is absolutely wild. We talked about doing some scuttlebutt research here and there. I'm definitely guilty of that. Particularly with this first one we're going to talk about Jason, Lemonade.

Hall: Yeah. But Lemonade it's funny because this is a company that I started out with -- I guess you could say I was really suspicious of their ability to be good at insurance. Because you hear a lot about they talk about AI, talk about the technology, talk about the social aspect of the way that they're trying to change and disrupt this insurance industry that's been pretty much the same way for like, I don't know, a thousand years as long as people have been paying somebody else to ensure their goods. I was very suspicious of that. I started exploring the platform, something you and I we both have in common is actually trying to become customers of Lemonade and going through that experience and seeing it, learning more about it, hearing more about what their executives have to say about the things that they're doing. I opened a position and now I'm also a customer.

Lewis: I took the opposite approach. I was a customer first before I initiated the position, but I had a similar approach there, Jason, where I said I'm in a position where I'm going to be renting for a little bit. I keep hearing about how dumb simple they make the renting process if you're looking for renters insurance, and that's really where they specialize. Let me kick the tires on this. I'm curious before we even get into the nuts and bolts of your thesis and why you bought the stock. I felt like the experience as a customer lived up to every expectation I had in terms of how simple it would be.

Hall: Yeah. I went through the exact same thing and here's an interesting thing about it. Just a quick backstory. We're in Southern California, we're moving to near Boston. We sold our house, we're staying in it, so we need a renter's insurance for a short period of time, so we get the renters policy through Lemonade. The same time we're going to be homeowners insurance on the other end. One of the things that actually impressed me surprisingly, was that Lemonade did not even offer us. They went through the process and said, "Yeah, we can ensure that property for our homeowners." That actually reassured me about my biggest concern for the business, are these guys actually going to be good at underwriting insurance? The fact that they chose to not underwrite a 30-year-old home with an old original roof and some other little minor issues. You know what? They are really focused on making sure that they grow in a smart way and thinking about how they manage risks. That's been my biggest concern about the business or why I've watched it. But now why I decided to become a shareholder is because I think they're figuring out how to underwrite well.

Lewis: I think that that's a good point. You want discipline with a business like that, and you'll see over time, I think with this company, there's going to be a lot of optionality and a lot of different business segments that they can explore once they have that customer relationship. We're seeing them planning on making some inroads in the car market soon as someone who owns a car and has insurance with somebody else, I'm pretty interested in that. I want to see what that offering looks like. But that's only attractive for expansion purposes if they're able to properly underwrite and maintain all of their standards, not spread themselves too thin because as we know, Jason, when the tide goes out, particularly in a business like insurance, it can be pretty destructive if you're not maintaining good standards.

Hall: Yeah, that's exactly it. I think one of the things that's really interesting about Lemonade, and then you think about SoFi, Social Financial Capital, and some of these other companies that are in the fintech space is over the past decade, we've seen how many other tech companies have come in and moved fast and broken things and done incredibly well. That's great when you're streaming DVDs or you're mailing the DVD to somebody. Now you're shifting your business model and you're breaking your business model like Netflix did. But when you're talking about financial services, and you're talking about having real exposure to various things in the real world that are very expensive to fix when they break, or you're talking about lending out money, and the risks if you have a million loans out, and then there's a big financial crisis and 2% or 3% or 5% of your people stop being able to pay on their loans, there's massive risk and massive exposure that as much as these are tech companies, they're still financial services companies and managing that is really important. I really believe strongly that this is why I bought, is at the end of the day, all the other stuff that I think is exciting and disruptive, I think they're proving on the underwriting side that they get it and their business model that supports all of the other things is going to be sustainable and it's going to lead to that optionality you talked about. They started with pet insurance, starting with renter's insurance and now steadily expanding these other lines.

Lewis: Jason, I'm curious was being denied a policy with them, the aha moment for you to buy the stock or did you have one prior to that?

Hall: It wasn't an "aha!" moment. I had actually already bought one before that because this is another one. I was looking at them for, is it the term life they do? There is something else that they do. I've actually been rejected by them twice for insurance. There was a prior one that they said thanks, but no thanks. That was very much an aha moment. The homeowners just reinforced it for me.

Lewis: I think that's a unique take, and one that I don't know that most people would have arrived at. I want to give you some props there, because we talk about the ease-of-use of the business like this and the whole point of their offering is that they are reducing the friction on the user side, and to be rejected, it would be very easy to I think almost take the personal slight of like men, I wanted to use this company and I can't but to instead --

Hall: I was pissed, don't get me wrong, because I can be honest with you, that first-time there was a day I'm like, "What are these guys doing? I'm insurable." Then I started thinking about it. I'm like, that's not the point. I'm insurable for somebody, but for Lemonade at this phase of their business, they've obviously got some discipline, and that's what it told me. It's that they have some discipline. That's really the key thing. Do we have a minute to talk about their business model?

Lewis: Yeah. Let's get into that.

Hall: We probably should hear earlier. That's OK. You know me, it's always stream-of-consciousness. Their business model is different. What are they doing that is disruptive? There's a couple of things. The first thing that I guess it's disruptive is the speed that they have. You can get a claim or you can get an insurance policy, or get told no in my case, very quickly, within moments to minutes. It's a very fast process. Then once you're insured, if you do have a claim, it's the same thing. If you file a claim, they say that they will pay you within moments to minutes. That's great, but how can you facilitate that for the long term? The way the company says they're doing it is by changing the economic models and realigning incentives, because the way insurance companies are built, you give them money and then they find every reason not to give any of that money back to you, that's the business model. If you're an insurance company, you make money two ways. 

No. 1, you make money investing the float, which is all that money everybody gives before they have to pay claims, so some return on bonds or something, and sometimes stocks like I think. But also there's underwriting profit. In other words, every dollar that they never have to give back that somebody gave them for their policy, that's an underwriting profit. The goal is to profit in both of those ways. What Lemonade is doing, you're saying here's what we're going to do; we're going to take a certain percentage, I think it's around 15%, I don't have it right in front of me, but we're going to take that percentage and that's our take. Then we're going to take everything that's left, and we're going to manage some float, but we're also going to buy reinsurance and we're going to use reinsurers to manage all of that risk. They built that into their platform. It's like automatically their economic incentives are clear on the front side and then they have the money that's left over that's largely used for reinsurers, to reinsure those policies. 

There's no incentive for Lemonade to deny claims. The incentive is for them to retain customers. The next part of it, this is a certified B-corp and every insurance member picks a charity, and whatever money is left over from that pool at the end of the year, they divide it among all of those members' charities and they give it away. As a member, that's incentive for me to not lie about a claim they try to get more money. That's a pretty powerful change in all of the economic incentives across the insurance business.

Lewis: I think for 2021 give back, that's what they call that program was $2.3 million.

Hall: That's not nothing.

Lewis: It's not nothing. I think this company has done a very good job with social engineering and managing incentives.

Hall: Entirely.

Lewis: It's the space that people generally really don't like. Who is speaking glowingly about their insurance company, Jason?

Hall: Nobody. That's the bottom line, what people do is they talk to their parents or friends and they say, who do you use? Somebody says, "I used to use so and so, but whatever happened, and I hate them." Then somebody says, "I've used this company forever and they are OK." That's who they call. Or they go online and do a search and get whatever's cheapest, there's no loyalty. Lemonade's trying to disrupt that. In the same way that SoFi and Robinhood and some of these other companies are trying to establish relationships with people that are just starting on their lifecycle of financial decisions to build that loyalty, to build that trust now.

Lewis: That's a big part of, I think, the thesis that you have to buy this business. It's a $5 billion business just about, and the revenue basis is small for this company right now. I think a big part of the story is going to be bringing customers in and then finding multiple products for them and really building long sticky relationships. They are approaching it with a very customer-centric mindset. In some ways, it reminds me of a Vanguard type business. Jason just maybe dressed up in millennial branding.

Hall: I think so. Plus the fact that there's a direct way as an owner of the business, the profit. Vanguard, the shareholders own the business. There is like the ultimate alignment to wring out costs. That's so powerful. With Lemonade it's just a little tweak on that. Because it's a certified B-corp, and it's publicly traded. Just because you are our customer doesn't mean you own it, but it's easy to own it and understand how all of the stakeholders are set to benefit.

Lewis: Jason, the stock I'm going to be throwing out there as a recent purchase for me is, I think, similar in that it absolutely delights the users that it brings in, that's Spotify. This is a business that probably does not need very much introduction for a lot of people. Perhaps if you're listening to the podcast version of this, you're actually listening on Spotify and you're consuming podcasts using them. In which case, Spotify's grateful because that's a major push for them. It's actually one of the main reasons why I'm interested in this business. For folks that maybe have not followed this company for a while, the standard thesis is they are a leader in music streaming, they're neck and neck with Apple Music, they've got 160 million monthly active users that are paid subscribers, paying $10 for an individual account, five dollars for students. Then they have some family plans there. 

Then they have 200 million ad-supported monthly actives. Right now, the money comes from their premium subscriptions. It's about 90% of their revenue. They pay out 70% of that revenue to music rights holders. Then the rest is theirs to cover costs. Jason, when you think about those dynamics, there's not a lot of control over price or cost because Apple Music's there as a company that runs right alongside them. They have these pre-negotiated agreements with the rights holders which dictate what their margin is and what they are able to cover with costs.

Hall: It's an interest. But I think at the end of the day, if you think about the music industry, just the evolution of being on the customer-facing end of it right the provider of that content, whether you were a radio station or whatever. I think this is a company that's in the right space and they are very dynamic. It starts from their leadership.

Lewis: I will say, I have been looking for a reason to buy the stock. The way that I keep that up before, maybe signals there's something great here. People like it, they love the service, the recommendations are fantastic. It is a sticky experience and product once you're in there. But I had hang-ups over the financial model and I worried that they had. They were going to run into issues with pricing power because they're basically providing access to music, which Apple Music also does, and other competitors also do. For those other competitors as big tech companies, it's an attack on service. It's not the core way. They're making most of their money. I read a piece recently that hammered home where I thought Spotify might be going. Really what was in front of this business to its piece in WIRED, all the ways Spotify tracks you and how to stop it. It is essentially the rundown on what they're able to do with ad targeting and how big advertising could be for this business going forward. That was the light bulb moment for me.

Hall: When publications like WIRED start pointing out all of these things it's like there's something there.

Lewis: People embedded in the tech industry are noticing this. I think if you've been casually watching what they've been doing with acquisitions, you probably see this coming together a little bit. They've made heavy investments in the podcast zone, the ones that really got a lot of media coverage for the acquisitions of Gimlet Media makes a ton of super popular shows. Bill Simmons, the ringer, I think, I would argue that like those IP acquisitions are good and helpful. But they've made other acquisitions, namely megaphone and anchor, that are probably more important. That's because these are acquisitions that are targeted at building up their advertising business and helping podcast publishers monetize their content. What I think is weird about the podcast space, Jason, is for the most part ads are just hard-coded into the content. They're read by hosts. From an advertising perspective, you can only target within a show. We don't have the dynamic ability to target the way we would with Google Search or YouTube or anything like that.

Hall: All the things we've talked about, like SEO and targeted ads, that really are thinking about, like, Facebook. Thinking about an overlay between where the technology should be, historically it hasn't existed in this format.

Lewis: It's basically a billboard. You're showing the same thing to everyone because they happen to be in one space. In this case, listening to the show or listening to music. But you don't know that much more about them. I think Spotify is basically trying to do what YouTube was able to do for video advertising in the audio zone. Right now, it is a small piece of the pie for them. Most recent quarter, $2 billion in premium revenue, $275 million in ad supported revenue. That second figure was up triple digits year-over-year, which is darn impressive. Don't get used to those growth rates. It's going to be lower. They happen to be on week tops. But still, the ad business is growing at twice the rate of the premium revenue. I look at this Jason, as something that has really compelling margin dynamics down the road.

Hall: Yeah, exactly. Those ad revenues are almost all incremental margin. Those premium subscriber revenues are essentially the same margins as the customer right before them.

Lewis: If you've been following them for a while, it would look like this has been a drain on their business. It's actually produced negative margins for them. The reason for that is they've had to build up all this infrastructure.

Hall: The opportunity scale behind it.

Lewis: To support it, it is a business line that enjoys leveraging, picking a FANG stock. That's probably the story. It's like you have to eat the losses upfront to enjoy the scale down the road. I think that that's where we're going with Spotify's business, particularly its ad-supported business. I think over time, as they are increasing inventory, as prices start to increase, advertisers see strong ROI and the money that they're spending there, you're going to see some pretty interesting things happen with the company's finances. In some ways, Jason, it reminds me a little bit of like an AWS-type segment for Spotify, where it's not necessarily what people know it for, but it winds up punching way above its weight class when it comes to financial contributions.

Hall: I think that's true. I want to push back a little bit too, on the, you think about the pricing risk of the Apple Music of the world. I don't think Apple goes into any business looking to lose money. I think maybe Amazon Music to some extent is like a bolt-on. But if you think about what's happening here, I think this is more like a New York Times play, people that are looking to pay a premium for access to certain things. On the music content side, it's a level playing field. I don't think they're going to be in any worse position than anybody else. I think it's like the New York Times or streaming.

Lewis: Yeah. I think over time it's probably going to reach some parity with the ultimate contribution that we see from their premium business. What I think is maybe most compelling to me is that I gave you that breakdown and it's like 160 million paid monthly actives and over 200 million ad-supported MAUs. The ad-supported MAUs might ultimately be more monetizable activity for this business and better at monetizable activity. It's a bigger audience, like there are probably more attractive margins to be had in digital marketing and they control the inputs. They have some upside there with price as they're able to prove effectiveness. It's a huge audience to be able to lay that out over.

Hall: It's always going to be bigger than your paying audience.

Lewis: Yeah. They've been criticized, I think for a while, for taking ultimately a customer acquisition strategy of making it very easy to hop on free and a lot of people's cases, but also having these very discounted plans to get people into the ecosystem. But if you're a paid subscriber, you're still getting ad revenue for Spotify because of their podcast business. Even if you're paying to access music commercial-free, those ads are still coming in. I think there's a lot to like there and I think it's a very defendable position. On top of all that, you get into something that is probably pretty helpful for advertisers and pretty helpful for content creators. I think it probably separates them in the audio space. That's my short thesis on that. But I've been looking for a reason to buy this stock for a while, Jason, and finally got it.

Hall: I think your thesis is strong. We'll talk again in five-years and see.

Lewis: We'll see. That's the beauty of it, we put it down on paper and then we revisit it years later and see how we did. Jason, this third company I mentioned, I interacted with all of them. I got built for Lemonade recently with the renters insurance in the new month underway. I've been listening to Spotify and that's up. We ordered some record holders off of Etsy to decorate one of our walls in our place.

Hall: Nice.

Lewis: That was my interaction with Etsy, and that's probably a pretty stereotypical purchase for this platform.

Hall: I think it is, but it's also interesting that the platform continues to expand to a larger, addressable audience. Because a lot of times people think of Etsy as like it's a place that women go to buy cute things or may go to buy cute things for women. It certainly becomes far more compelling across a broader range of demographics and different products. I think the thing is, the way I think about Etsy is just really simple, it's the premier website for both buyers and sellers and makers of custom and unique items. Amazon has made an attempt to get into it, it's Amazon Handmade business, but as usual had a really good first-move advantage in this space. It's clear that makers continue to love selling on our platform. If you look at the rate of new sellers coming on, I think it's doubled over the past year. It's just a massive number, with over 5 million active sellers, around 91 million active buyers and a number that's also continuing to increase at a very high rate. I bought it because I really think that this is going to continue to dominate in this space as the non-Amazon. It's almost like the anti-Amazon place to buy unique, handmade and also second-hand items.

Lewis: Yeah, I think that there is something there where I almost look at Etsy as like I'm going there for Christmas gifts. It's if someone's birthday is coming up, like that's the website for me. I know what I can get at Amazon and Amazon almost feels like the big-box retailer, Jason, to Etsy's mom-and-pop shop around the corner, which is an odd way to explain it because it's a huge business, but that's the field that it has.

Hall: Entirely, but I think the differences that people buy from Amazon, they think of it as buying from Amazon. Even if it's fulfilled by Amazon and there's another merchant behind the scenes, that's a small business. When you are buying from Etsy, you're buying from a maker. You are buying from the person that's making this thing for you, that's customizing it. That's really powerful. I want to highlight just some relatively recent acquisitions that show, whereas these focused on, where the puck is going to be to use Wayne Gretzky term here, about Reverb, maybe two years ago now. Second hand instruments are a really interesting, compelling business that has largely been left to Guitar Center and some of these other, big-box local companies to do, that's become more and more popular. Depop is pretty recent and this is fashion re-commerce rights of second hand goods. We've seen three companies that have gone public in this space over the past. So far this year, I think three that have gone public, really popular with younger cohorts. I think it's huge growth has a trillion-dollar global industry. It's just absolutely gigantic. It bought the Etsy of Brazil, Elo7, with a couple of million active buyers as 24 million visitors come to the website, two thirds of its gross merchandise sales come from repeat buyers. It's a really sticky business. 

That's all of the things that are happening. Growth rate slowed, gross merchandise sales was about 13% in the second quarter. You got to remember, Dylan, that the second quarter of last year was a bananas quarter. All of the regular lines went well, plus everybody that didn't want one of those crappy hospital masks was buying handmade masks on the platform.

Lewis: Yeah. I mean, I think the story with 2020 and 2021 in tech has been like, don't anchor to any growth rate you see in any quarter. Like you just can't do it. In the same way I mentioned Spotify having triple-digit year-over-year growth for the advertising segment. You can't get you to that number, it's going to be lower. We're seeing lumpiness with a lot of these businesses. This one doesn't seem to make any difference to me. But I also think it might be concerning to see a growth dip. I don't see any actual headwinds there. I think it's just tough comps.

Hall: It's tough comps. Also I mean, there's a little bit of reopening that's happening. People are shifting and trying to do a little more stuff in the real-world versus online, which makes sense after two years of being locked in our basements. But again, I think you look out long term and double-digit rates of growth should be a reasonable expectation for the business. Even if those growth rates aren't 20-30% that we want to see because the company's take rate is growing, the percentage of revenues is taking, it's providing more services and that thing. Its revenues are growing and it's earnings as it gets better, operating leverage are continuing to increase. I think those are the positives. Even at a lower rate of overall growth, its earnings and cash flows could continue to grow at a higher rate.

Lewis: Jason, I know you're not the only Fool that's pretty hot on Etsy that winds up in our premium ecosystem, plenty of cases, I think, for most of the companies we discussed today. I mean, we talked about the "aha!" moment on the consumer side with a lot of these always excited to get that perspective from our listeners and members as well. Folks, if you have anything that's interesting about these companies or maybe a business that you are really interested in and feel you have a really great relationship with, that deserves to be on our watchlist, [email protected]; always hit us up there or tweet us at @MFindustryfocus. Jason, we are at our time, but it's always a pleasure to hop on with you and talk tech socks.

Hall: This was fun. I appreciate you having me on The Fool to do that again.

Lewis: Have an awesome weekend, my friend.

Hall: Go Dogs! 

Lewis: That's going to do it for this episode of Industry Focus. If you're looking for more of our stuff, subscribe on iTunes, Spotify, or wherever you get your podcasts. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the glass today and thank you for listening. Until next time, Fool on.