Few tech companies have been spared in the recent sector-wide sell-off. Most of them are down by at least 20% from their all-time highs, and many are down by more than 50%. As of Tuesday, the tech-heavy Nasdaq Composite index was down 16% from its high, while the S&P 500 was down almost 11%.
Not many stocks, though, have been hit harder than Lemonade (LMND -0.17%). Its share price peaked in January 2021, and since then, it has fallen by 87%. The stock continued to get ravaged after the company delivered an especially disappointing fourth-quarter report on Feb. 23. The difference between that quarter and previous ones is that there were a couple of major concerns for long-term investors. So what is going on at Lemonade?
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A justifiable smackdown
Lemonade has developed an artificial intelligence-based engine that uses big data and machine learning to price insurance policies for more than 1.4 million customers. The company's products have enjoyed fairly rapid adoption, helped by the fact that its AI can both accept applications and process insurance claims in minutes. Also, since the company only keeps, at most, a fixed fee from the premiums it collects, it has no incentive to deny claims. That's a major selling point for Lemonade compared to traditional insurance companies.
However, for its business model to work, the AI needs to be accurate in its risk assessments, and on that score, it has been coming up short. In Q4, Lemonade's gross loss ratio -- the percentage of premiums collected that gets paid out in claims -- was 96%. The company's long-term goal is to keep it under 75%, but Lemonade struggled with this in 2021: Its Q1 loss ratio was 121%, due largely to last winter's Texas freeze, which generated what the company described as "a year's worth of claims in its first few days." High loss ratios caused by unusual situations like that should not worry long-term investors. But last quarter's performance issues should.
The problem with the fourth quarter's high net loss ratio is that it was not caused by a natural disaster, but rather by management's inability to maintain enough reserves on hand to fund large past losses. This is by far the most worrisome aspect of the company's report because it shows that management failed to keep the company financially sound enough to absorb these losses. That's a big red flag on the subject of management's execution ability.
On top of that, the company's profitability continued to worsen. Its Q4 net loss increased 107% year over year to $70 million, and for the full year, its free cash flow burn jumped 60% to $154 million. Lemonade has nearly $1.1 billion in cash and investments to cover these losses, but what's concerning is that the net loss grew faster than revenue in Q4, and the company's free cash flow burn grew at almost twice the pace of its revenue growth in 2021.
The few silver linings
Lemonade's fourth quarter wasn't all bad, however. Its revenue doubled year over year to $41 million, driven largely by an increase in the company's in-force premiums, which grew 78% to $380 million. Its customer count also grew by 43% year over year to 1.4 million.
Another important point to highlight is that the company is seeing increased product adoption. Lemonade's strategy since the beginning has been to add customers early in their adult lives, then expand its relationship with them as they age. This continued to be the case in Q4, with the company's premium per user growing 25% year over year to $266.
Is Lemonade a buy now?
The lowlights of this quarter drastically outweigh the highlights, and the company's earnings report brought its market cap down to $1.4 billion -- only a little more than the amount of cash it has on the balance sheet. In layman's terms, investors now believe that Lemonade is only worth $300 million more than cash it has in its coffers.
I have long been an optimist about Lemonade, and I've long been a shareholder, too, so its current valuation seems like a bargain to me. That being said, buying shares now might not be the best decision. There are simply too many reasons to be concerned about this company's financials, its fundamental stability, and its cash-burn pace.
But if it might not be a smart buy today, selling shares wouldn't be my recommendation either. Based on how investors are valuing Lemonade, it seems likely that the company's valuation should at worst hover at about $1 billion unless it continues to burn cash. Lemonade is clearly in hot water, but the best thing for long-term investors to do right now is nothing.
