When Life Gives You Lemons...
Analyzing the most hotly anticipated fintech IPO of 2020 (so far!)
In the wake of all the difficult things happening in the world right now, the news that Lemonade filed their S-1 two weeks ago had been out of my immediate focus.
For those of you who may not be familiar, Lemonade is a fast growing fintech (or more specifically, “insurtech”) company that operates as a property & casualty (“P&C”) carrier. They operate out of New York City (woo!) and have been in business for ~5 years, making them an exception in a world where companies are often staying private for 10+ years before reaching the IPO milestone.
And so while my mind was often elsewhere since the announcement, I was also keenly aware of the fact that this IPO (if it happens) has the potential to be the biggest story in fintech for 2020. So today, I felt it was important to talk about…
why this IPO is important.
My gut instinct when I saw the announcement was that this has to be the the most important and high profile fintech IPO in recent history. And after doing some basic research, I stand by this claim. You could make a strong case for Square (who went public in 2015), but of course we won’t know for sure until Lemonade makes their debut.
It would also be wise to not confuse notoriety with success. If Lemonade’s time in the public markets starts to look more like OnDeck or LendingClub (both IPO class of 2014), it could still be considered “the most important” even if it is a total flop.
And that is because there are so many other fintech companies that could be considering an IPO in the next 2-3 years. You can bet that any fintech company disrupting a traditional category (i.e. Affirm, SoFi, Robinhood, Stripe, and arguably Coinbase) is paying close attention, regardless of their plans to go public, because this IPO has the potential to establish a benchmark for how public markets value fintech firms. And so today, I want to talk through some of the factors that might influence that benchmark.
So let’s start with the Fin - P&C By The Numbers
My first instinct on how to begin thinking about this IPO was to do a comparable analysis. With both limited data and knowledge of the P&C industry, I figured this was the best way to smarten up. So I lined up Lemonade’s S-1 data alongside Travelers and All State on this Google Sheet that you are free to analyze:
The biggest takeaway here has to be the insanely high revenue multiple that Lemonade would trade at, assuming they IPO at $2.5B valuation (slightly above their last reported round). And yes, I realize that number may be hundreds of millions of dollars off from where it lands post-IPO, but for the purposes of this conversation, it doesn’t really matter. Even at a $1B valuation, the company would still be at ~15x revenue. So it is more perhaps important to explain the stark difference in relative value vs. the incumbents (who trade at 1-1.3x) than it is to argue about “what is fair value.”
Okay, fine. So is this where the Tech part comes in?
Well… kind of. But I think this is the most commonly misunderstood piece of the equation and the real reason I wanted to do this analysis. Yes, the tech in FinTech can be just as important, but I don’t think any company that isn’t in the business of selling technology (read: SaaS or maybe hardware) can simply call itself a “technology company,” and to claim otherwise is somewhere in between intellectually lazy and fraudulent.
Lemonade is clearly the type of fintech firm that sells financial services products with the help of technology. One needs to look no further than the first expense line of this table to understand why this is the case:
As a P&C insurance carrier Lemonade will, by design, always spend a large portion of its revenue on claims. In fact, at the moment they are doing it less efficiently than their competitors. So even if technology can become a key reason why they are able to outperform their competition in the long run, it is important to recognize that at maturity, it is highly illogical to expect them to earn a 10-20x revenue multiple in the public markets.
And because Lemonade is a young company with a lot of room for growth, it is important to understand how technology can manifest into greatness:
Digital + Millennials = Organic Growth
Much to the chagrin of Baby Boomers and Gen X (kidding!), Millennials, of which I am a member, are now the largest generational cohort. And while I dare not try to speak for all Millennials, it’s pretty safe to say that these opinionated individuals are what some would refer to as “digitally native.” Worded differently: when we started our first job, we traded in our Gameboy for an iPhone. As a result, we expect digital interfaces and experiences to have a certain level of user friendliness (and ideally joy) associated with them.
As both a target customer and actual customer of Lemonade, I believe that half the battle for many FinTech firms is simply whipping up a potent cocktail of digital marketing and user onboarding that capitalizes on this expectation. And when it comes to Lemonade, they are among the best (which include, most famously, Robinhood). I was genuinely delighted at how fast I was able to purchase renter’s insurance. I was genuinely captivated by the fact that I was guided through the process by AI Maya, their proprietary chat bot. And while this advantage may seem immaterial on the surface, it has major implications for their ability to capture market share.
Lemonade’s growth from 2018-2019 was truly astounding. The company’s S-1 boasted ~3x annual revenue growth and average of 26.5% quarterly customer growth for the last seven quarters including Q1 2020. Can this last forever? Of course not. But three more years of that kind of growth would see the company’s grow 16-20x. Is that ambitious? Certainly. Impossible? Not at all.
And while much of this “technology” is neither hidden nor incredibly complicated (and therefore replicable), I still believe it creates a strong defensive moat around the company. As we separate the ingredients in the aforementioned cocktail, their marketing success now acts as a defense against new entrants. Lemonade (a word more commonly associated with a hot summer day) has become synonymous with “renter’s insurance” in just four years. I assure you those are two very expensive AdWords. That, paired with Lemonade’s great brand, create an unwelcoming environment for any newbies.
And the product itself? It does sound plausible that with enough time (past the projected completion date) and enough money (over the original budget), an incumbent could build “Iced Tea,” its digital answer to Lemonade. But that seems even less likely to me. In general terms, the book explaining why not has already been written (and is great!). As it relates to financial institutions, I can tell you from my own experience that the people tasked with this assignment will feel more like Sisyphus than Steve Jobs. And as it relates to Lemonade, despite the fact that much of their strategy is publicly visible, it is aligned with the product in a way that allows for…Full-Stack Operational Excellence.
Lemonade’s early decision to build its own underwriting engine, and participate in the market as an agent-less carrier allows them to attack and decompose the legacy sales incentives and business operations of their competitors. One needs to look no further than pg. 126 of their S-1 to see it in their own words:
"We leverage technology in everything we do. More than 93% of homeowners insurance policies in the United States are sold via agents, making a platform that finds, onboards, and digitally serves consumers end-to-end very much an outlier. Our digital substrate enables us to integrate marketing and onboarding with underwriting and claims processing, collecting and deploying data throughout, to constantly drive efficient customer acquisition, enhance the experience, and mitigate risk. This approach results in significant, rapid scale without forfeiting the customer experience."
The value that this can generate for Lemonade over the long term is tough to quantify, but our comparable analysis should serve as a baseline for sizing the opportunity.
For sales and marketing, Lemonade’s competitors have a separate line item on the income statement for something called “Amortization of Deferred Acquisition Costs (DAC),” which based on my understanding (I am not an accountant) represents the recognition of commission expenses paid to agents and brokers. Lemonade, however, is fundamentally different in that they do not pay these third parties for sales. While their sales & marketing expense is currently represents 132% of revenue, they disclose that $76M of the of that $89M incurred in 2019 was on advertising, which seems to be working given their hyper growth and should flatten over time as their brand awareness increases.
And for the operations of running the business, Lemonade’s control over the entire customer experience allows them to augment human components that are both inefficient and mundane. My first memory of Lemonade was reading about the world record they set for fastest insurance claim. That announcement landed them great press in the Economist (sorry, paywall) despite having been live for less than six months. At the time, it was likely more PR driven than anything else, but this type of process optimization paired with cutting edge technology (image recognition, machine learning, etc.) can ultimately drive significant cost reductions for both SG&A and insurance losses (more on this later).
So to recap, Lemonade has built a millennial-friendly customer experience that they can continuously optimize with best in class technology and they sell through a completely different sales channel that their competition is entrenched in at 12-15% cost per year. These two factors should, at a minimum, make it very difficult for the competition to respond effectively (or at least quickly) and should allow Lemonade to pass through their saved sales expense to the bottom line as their advertising costs start to normalize.
Of course, their insurance losses are also significantly higher than their competition. They will undoubtedly need to get them under control in order to be a legitimate player in the industry. However, I believe the evolution of their business (both past and future) should explain their current inflated cost and provide some clues for where it can go next, which bring us to our third way in which Lemonade can innovate it’s way past the competition:The Analytics Edge (Hey Sloanies!)
If you are new to insurtech, and you are thinking about how technology can act as a disrupting agent, your first thought might be: “Oh! They can use machine learning to optimize the underwriting process!” At least that was my first thought when I started thinking about this space in 2016. And while I believe that is a good hypothesis, Lemonade’s numbers highlight how the fundamental nuances of insurance make it much harder than it sounds. So let’s talk a little about what might cause their losses to represent 82% of revenue vs. 62% for their competitors.
Oddly enough, despite the fact that they are in the business of underwriting, Lemonade’s S-1 only mentions the term “adverse selection” once. And without too much data or research, my hypothesis here is that this classic insurance dilemma (whereby, those most likely to buy insurance are those most likely to need it) also explains Lemonade’s current cost dilemma. The logic goes something like this: Lemonade’s need for hyper growth and specific target at younger populations (who, let’s face it, are probably riskier) has led them to relax their underwriting standards and trade off more expensive revenue for sheer volume. It is probably not sustainable, but also probably acceptable for some period of time, assuming their growth continues to diversify their applicant pool and continue the downward trend (in terms of %) that they saw from 2018 to 2019.
And if that does come to fruition, Lemonade may finally have the opportunity to highlight its tech prowess on the loss line of the income statement, if they can find a better algorithm to optimize their pricing and underwriting. I’m not convinced it is possible. Insurance has been around for thousands of years. Actuarial science as we know it today has existed for ~300 years. But I also believe that technology is changing the world at an incredibly fast pace. If Netflix was able to improve its collaborative filtering algorithm by 10.06% in one year with an open source competition, it seems plausible that Lemonade has a chance to do something similar.
Alright, that was a lot. Can you just tell me whether or not this company is overpriced?
Sorry, but not really. Since the announcement on June 8th, there hasn’t been any additional updates on price or timing. Their decision to raise $100M allows for a simple estimate that they will sell 5-10% of the company which lands them in the wide valuation range of $1-2B. It is also worth mentioning that their most recent investor is SoftBank (who was has been behind many high profile disasters this year including WeWork, DoorDash, and Oyo), so perhaps investors will be particularly sensitive to price.
However, I did put together a quick pro-forma model to try and understand what kind of future revenue expectations might be baked into a $1.5B valuation, assuming a reasonably industry revenue multiple, albeit one that remains higher than it’s peers because of their technologically enhanced gross margins:
Using the assumptions above, you have to believe that it is nearly a foregone conclusion that Lemonade will reach $1B in revenue. $1B in revenue represents a 16x increase in Lemonade’s top line, which (as mentioned above), represents around 3 more years of growth at its current rate. At that rate, Lemonade will still have less than 0.5% of the entire P&C market.
And that sounds pretty achievable to me, meaning that maybe (just maybe) Lemonade has what it takes to be the disruptor it claims to be.
Okay, sure but that is a lot of assumptions. What if you are wrong?
Impossible!
No, I’m joking. Plenty of other possibilities occurred to me while I was thinking about this. For anyone who thought “if their technology is so great, why don’t they just license it?,” I think that ship has already sailed, but the idea could manifest through the sale to a competitor.
It could be possible the Lemonade is pursuing a dual-track process right now, engaging in both M&A and IPO discussions. If Lemonade thinks that their business is the industry winning hand, it seems unlikely they would settle for a sale. But if they have doubts, I could see a competitor being wooed to purchase their millennial friendly brand and technology. And for a company that is losing money at the rate Lemonade is, I would think they are at least keeping their options open.
And of course, while the junior bankers at Goldman, Morgan Stanley, and Allen & Co. are doing this same analysis, it seems possible that the senior folks are telling a story of why Lemonade will achieve 2-3% market share in the next five years, in which case we might see a stratospheric valuation north of $5B.
We’ll have to wait and see.
But no matter what the outcome, I hope for Lemonade’s sake it isn’t too sour.