Insurance technology company Lemonade (LMND 1.64%) dazzled investors with its first-quarter earnings report in May, demonstrating the improvements in profitability that had eluded it for several years and that investors were waiting for.
That was in addition to incredible top-line growth and progress in most areas. However, net profitability seems like it's still far off, and that's still throwing off Wall Street. This looks like a classic case of risk versus reward. Should you buy Lemonade stock?
Why the growth story looks so compelling
Lemonade sells digital insurance policies, but it's more revolutionary than it sounds. It's a certified B corp, meaning it has a social mission. That's because it allows policyholders to donate any remaining funds after claims are paid to a charity of their choice at the end of a policy year. That's more than a quirk; insurance is, by nature, an industry prone to giving customers the least because parting with funds lowers a company's bottom line and erodes important ratios.
Lemonade's founders were thinking of how to create an insurance company that isn't in a constant fight with customers and that customers wouldn't dread contacting. They came up with the charity idea to make it less likely for customers to abuse their policies or post fraudulent claims.
That attitude of thinking differently and developing a customer-focused insurance company -- which used to be an oxymoron -- infuses everything Lemonade does. The sign-up process is completely digital. Claims can take as little as one second online without human intervention.
Artificial intelligence (AI) plays a big role in Lemonade's operations, and it uses hundreds of millions of data points to train 50 machine learning models that drive its underwriting and policy pricing. For example, management says that AI Jim, its claims bot, handles 98% of initial claims and manages 45% completely at an accuracy level surpassing human capabilities.
Legacy insurance companies have been moving into digital and AI as well, but with decades or even a century of old-style operations, they can't compete with Lemonade's digitized infrastructure. What might be most difficult to achieve is the interconnectedness of Lemonade's various parts, which older companies can't duplicate without completely revamping all their processes. The instantly connected system makes Lemonade more nimble, faster, and responsive.
What the numbers say
Lemonade has demonstrated outstanding growth from the get-go, and that continued in the first quarter of 2023.
In-force premium, Lemonade's top-line metric, increased 56% over last year to $653 million. Customer count was up 23% over last year to more than 1.8 million, and premium per customer increased 26% to $352. That's an important indicator of customer satisfaction and a successful growth strategy that entails wooing younger customers and upselling and cross-selling over time.
This is the pattern of how Lemonade has been operating since Day One, and Lemonade generated investor enthusiasm at first. Growth investors can forgive some losses when sales are soaring. But losses only swelled, and investors were disappointed with the company's deteriorating loss ratio. The loss ratio measures how much an insurance company pays in claims versus collected premiums, so the lower, the better. But instead of a declining ratio, it was, at best, fluctuating up and down.
In the first quarter, Lemonade came through with lower losses and an improved loss ratio. Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) loss was $51 million, or 11% better than last year, and net loss was $66 million, or a 12% improvement over last year.
Gross loss ratio was 87%, better than 94% last year and 89% last quarter. Ex-cat, or without catastrophes, the ratio improved to 72%, close to its target rate of 70%.
Although it's taking time, Lemonade has insisted all along that its AI capabilities perform better than legacy models. It claims the reason it's not yet profitable is that newer customers and newer products have higher loss ratios, and it's pretty much new all around. This makes sense since the whole point is that collecting data points improves the models.
Predicting the future
While no one knows what will happen, there's some predictive power in the generative AI models Lemonade uses to price policies and determine consumer behavior. Its machine learning churns its millions of data points and can produce accurate or close-to-accurate predictions. Right now, the models are predicting that Lemonade will reach its target loss ratio of 70% by 2027.
So what about the stock price? It doesn't look like any AI models out there can accurately predict stock prices yet, so investors have to assess all this themselves.
Despite seriously beating Wall Street's expectations on both the top and bottom lines in the first quarter, Lemonade stock is up about 17% so far this year. That doesn't sound like excessive investor enthusiasm.
At this price, the shares trade at about 3.7 times trailing-12-month sales. That's not extremely cheap, but it looks reasonable, factoring in the growth story and the risks. Risk-tolerant investors can feel comfortable taking a small position right now because there are enough indicators that the model is working to take a chance. Everyone else can wait for more sustained improvements.
