Tech-centric and artificial intelligence (AI) insurance company Lemonade (LMND 1.64%) announced strong second-quarter 2023 results last week, but you'd be forgiven for thinking otherwise if you saw the stock's post-earnings plunge.
In my view, Lemonade's results were exceptional by every measure. And I think long-term investors would do well to buy this dip.
Strong growth and narrowing losses
First, Lemonade's top and bottom lines were solid relative to Wall Street's expectations. Revenue soared 109% year over year to $104.6 million, above the $97.6 million most analysts were modeling. In-force premium (IFP) jumped 50% to $687 million, helped by 21% customer growth to more than 1.9 million and a 24% increase in premium per customer. Lemonade also narrowed its quarterly net loss to $67.2 million, or $0.97 per share, from $1.10 per share a year earlier (also beating estimates for a per-share loss of $1.00).
Lemonade management previously told investors the company has already seen quarterly "peak losses" in Q3 2022. With around $942 million in cash, cash equivalents, and investments on the balance sheet at the halfway point of the year, management reiterated its commitment to pushing the company through to sustained profitability without raising additional capital.
About that 94%...
But here's where Lemonade's results get really interesting. I've seen several analysts upset that Lemonade's gross-loss ratio -- how much the company pays in claims out of premiums collected -- climbed to 94% this quarter, up from 86% in the same year-ago period and 74% two years ago. That seems to be a problem, they reason, as it could indicate a fundamental shortfall with Lemonade's AI-driven underwriting models as it pertains to supporting the company's march toward sustained profitability.
However, Lemonade has made it absolutely clear this isn't a result of subpar underwriting but rather an industrywide phenomenon related to a surprising surge in what meterologists call "severe convective storms," or SCS -- that is, storms that include difficult-to-predict damage catalysts such as hail, straight line winds, tornadoes, and thunderstorms. Indeed, while loss ratios for insurers are typically lowest in Q1 and Q4, and seasonally higher in Q2 and Q3 due to more hurricanes, wildfires, and SCS in the middle of the year, it turns out the first half of 2023 was "one of the worst" for these unexpected weather events, the company said in its second-quarter shareholder letter.
Even so, in their Q2 letter to shareholders Lemonade management noted the company's
reinsurance did what it was supposed to do, shielding our financials from the worst of these [catastrophic events] CATs, and, indeed, our [earnings before interest, taxes, depreciation, and amortization] EBITDA came in ahead of expectations notwithstanding the spike in gross loss ratio and CAT related-claims.
"This was significant," they added, "because CAT-related losses increased by more than 4X year on year, representing 21 points of our gross loss ratio in Q2."
That puts Lemonade's gross-loss ratio ex-CAT at around 73%, a healthy figure that's in line with management's longer-term target for maintaining a gross-loss ratio in the range of 75% across all products. This also extends the last few quarters' trends as the company continues to efficiently scale.
When we drill down further into each individual product line, Lemonade achieved a gross-loss ratio of 47% for renters (below 50% for the first time) even including CAT impact, 77% for pet insurance (falling into the 70s% range for the first time), and 69% excluding CAT for homeowners (in the 60% range for the first time). The big outlier at this point remains Lemonade's car insurance lines -- noting the company only just closed on its acquisition of usage-based auto insurance company Metromile almost exactly a year ago -- where Lemonade has yet to make meaningful headway on its gross-loss ratios so far.
Source: Lemonade investor presentation.
To be clear, the occasional bump in CAT-related losses is a cost of doing business as a nationwide insurer. And I'll be perfectly content as long as Lemonade manages to successfully survive these bumps while keeping its gross-loss ratio ex-CAT below its 75% target.
If that wasn't enough, Lemonade also says it's seeing an acceleration in its rate approvals, which tend to lag inflation-fueled increases in claims costs. Most notably, the state of California (which accounted for more than 25% of Lemonade's total gross written premiums last quarter) recently approved a 30% increase in homeowners rates and a 23% increase for Lemonade pet insurance rates. It will take several quarters, of course, for these rate increases to make a positive impact on Lemonade's loss ratios. But when they do, I suspect the chorus of loss-ratio naysayers will fade.
The "capital light" at the end of the tunnel
Meanwhile, Lemonade enjoys two other significant catalysts that should continue to propel its business, particularly in helping it remain a "capital light" business as it scales.
First is its new "synthetic agent" program announced in late June. For perspective, Lemonade continues to enjoy attractive customer lifetime value-to-customer acquisition cost (LTV/CAC) ratios, but it also requires financing 100% of that CAC up front while taking around 24 months to realize full payback on that spend. As such, Lemonade management purposefully slowed their growth initiatives, recognizing that in today's market with increasing costs of capital, it would be unwise to pursue unprofitable growth simply for the sake of growth.
Enter the new synthetic agent program formed in partnership with General Catalyst (GC), a venture capital firm and early Lemonade investor. Starting on July 1, General Catalyst agreed to finance up to 80% of all Lemonade's CAC in return for a synthetic "commission" of up to 16% of the premium streams they helped finance -- much in the same way legacy insurance companies lean on independent agents to drive growth. Once General Catalyst recoups its investment, any remaining LTV of the customers from that cohort go straight to Lemonade indefinitely. It's a win-win for both Lemonade and GC.
"Thanks to Lemonade's Synthetic Agents, we believe we will be able to accelerate growth without drawing down our capital reserves or selling more equity," said Lemonade co-founder and co-Chief Executive Officer Daniel Schreiber. "That means generating a significantly larger business, sooner, with more cash in the bank, and with a materially higher return on capital."
More specifically, Lemonade expects its synthetic agent program to nearly double the internal rate of return (IRR) on its CAC spend, from around 50% to 90% -- again enabling a capital-light growth model without eating into Lemonade's precious cash reserves.
In the end, we should also keep in mind Lemonade shares have rallied in recent months; shares are up about 15% year to date, but less than a month ago they were up more than 75% on the year. So perhaps some of this pullback was simply traders using the gross-loss ratio concerns as an excuse to take profits. Over the longer term, however, if Lemonade can prove it's able to continue its march toward profitability even as it leans into more rapid growth, the stock should have plenty of room to run higher.
