Trupanion, Inc. (TRUP) Earnings Call Transcript
August 9, 2022
Earnings Call Speaker Segments
Welcome back to the Bank of America SMID Cap Virtual Conference. We're here in the Trupanion session. We're really pleased to be joined by Drew Wolff, the CFO of Trupanion. Drew has been there about a year and a half at this point. Prior to that, he was the CFO of Starbucks International. And switched also to Seattle-based Trupanion, and where he's been for a little while, and we're really pleased to have him. Drew, thank you for joining us today on the videocast.
Great to be here, and good morning.
Good morning. So we've just gotten through the second quarter earnings reporting and it was sort of -- in terms of how people interpret the quarter, instant quarter, obviously, growth in pets probably exceeded people's expectations. There was a long talk early in Trupanion's success through the pandemic that people's habits were changing, more time at home, adopting more pets. And Trupanion's growth will probably stall once the pandemic ended and you've of course booked your best second quarter in terms of pet growth ever and you head into third quarter now, which during the summer time, people tend to adopt more pets, it's tended to be a very good quarter for Trupanion. We'll see how that unfolds. But your disclosure tends to be very good and you pride yourselves in giving a lot of information to shareholders. In the annual meeting you guys hold, it's an open annual meeting. You invite as many investors to come. And about 40 of your managers presented at the annual meeting that investors get a diverse idea of what's going on at Trupanion. And one of the takeaways -- the takeaway that most people took, which may not be the most important thing, but certainly what they go on down to was that Trupanion had expected to see a 125 basis point deterioration quarter-over-quarter in its loss ratio headed into the 2Q '22 reporting season. The company is very fulsome in their answers and said, a lot of people are going to think this is about inflation. It's not about inflation, it's about frequency of incidents. And we're seeing a lot more people come in from procedures, but that hangs around a lot. It's going to be low-some quarter, it's going to be high-some quarter, and that's when we went into 2Q '22 with. When we came out, the numbers were actually 175 basis points, some people were concerned about that being too high. And there was actually pet medical health inflation seeping into the numbers, which had some people concerned. But Trupanion management says that investors can probably expect that that loss ratio will go down over the next 6 months, returning back to 71% or around there by the end of the year. It's the same thing you said on at June 3 on the -- at the Annual General Meeting, you said it on August 3 again on the conference call. Can you talk about the factors that give you confidence that you can shave 125, 150, I don't know what the exact -- we don't know what the actual number is going to be, but what gives you confidence that that medical loss ratio when we enter 4Q is going to be back to approaching 71%?
We have a predictable business, but it's not a lay-up and coming out of COVID is choppy. And the biggest move in the quarter, the 170 basis points move, 100 basis points of that was frequency. So people getting back to going to that 2019 levels or above. And so that was -- that's what I talked about at the shareholder meeting. The other thing we did was we -- our loss adjustment expense increased 30 basis points. So that's the move I was talking about. Then what we saw in the quarter, right at the end of the quarter, I mean, we're pricing for inflation. We anticipate inflation. What we saw was an acceleration of the rate of inflation. And that was the 40 basis point delta that we ended up talking about in the Q2 results. Looking forward, here are some things that are easier to forecast so we can put a higher cone of certainty around that. But this frequency move, pets don't get sick or injured more and more and more. I mean, there's a long-term trend. What we didn't pick up was the shift coming out of COVID. But now that we've got a hefty frequency trend loaded in, I think we have a pretty good handle on that. So two, that move in our loss adjustment expense that as we staffed up to support the big partners we're launching with, that's in our control. We can drive that down. We've got a super-efficient claims team under Tricia Plouf. They got plans. So that's more clarity of that. And I've got the price changes that I know are coming through, and I have a view of that. And then on top of that, we can file more frequently for just overall trend. I mean, we filed for a lot of different factors, but we could just do a trend filing based on inflation. So we have that lever as well. The part that is harder to predict and what was a surprise at the end of the quarter was severity, the average invoice size. So we're watching closely. It's difficult to predict. I'm not going to make any predictions on that. But we have those other factors plus our growth to push that back down. And we've hit 73%, 4x or 5x in our history. And then that's a great thing about our business model. It's monthly recurring revenue. It's a monthly policy. It's not an annual policy. We can adjust over time. We're not stuck for a long period. And it's high frequency, 15% of our customers are claiming every month, and that's what it's priced for. We want them to claim. We're not trying to put a price -- a low price out there and hope they don't claim. And in this environment, now is not the time to say, we've got a great value proposition, we're as good a Trupanion, we're just a lot cheaper because that means you're underpriced. So that's why we have confidence in just how our business model adjust.
For the audience, I [ must say ] I have a lot of interesting questions that I'm going to be happy to ask, but you can also ask questions. If you're on the Veracast-based conferencing software, you can type in a question, I can ask it and you should feel free to do so. In lieu of audience questions though, I'll happily ask 2 more questions, getting sweat under the hot lights. So -- or I can answer your questions, up to you. So let's turn a sort of a view. Obviously, growth is very good and the company would love to grow as long as spending on growth meets its thresholds of a 30% to 40% internal rate of return on marketing spend. That number has been in the mid-30s for a reasonable period, has been ratcheting down where we're at 31%, 30% is the floor. And obviously, I don't think that you want to spend more on marketing if it's getting below a 30% return, but there's also a lot of marketing opportunities undercome. Chewy is soft launch and will expand in the next couple of quarters. Aflac's big renewal season is in October of this year. In absolute dollars, marketing spend has been going up and the IRR on the return has been coming down, still within the range. How should investors be thinking about the trends in both the absolute dollars of marketing dollars spent in the coming quarters? And whether we are approaching that 30% and we'll stay there or whether we can -- we'll probably move back into the middle of the 30% to 40% range?
One thing important to highlight is that that calculation, and we publish it in our supplemental every quarter, it's making -- I mean, it's using the current margin. And so our margin is below our target and that plays into the IRR. So if our margin was back at our target, that IRR would have been higher. It would have been back towards 35%. So really important to point that out. The point in doing these partnerships is to insure more pets. I remind listeners that 98% of people, pet owners, don't have protection against an unplanned vet expense. And so that goes into the bucket of Chewy, Aflac, State Farm. And we're looking to pay our partners the max we can, right? They're doing the marketing. They're talking to their customers. It's Chewy Insurance powered by Trupanion, Aflac Insurance powered by Trupanion. And we're using the same IRR calc and equation to figure out what we can pay them. And because we think we have one of the highest average lives in the industry, we could pay the most. And so we're excited about that opportunity, but it will be an output. The spend will be an output of what they deliver. And I think that's important. So -- and that's true for our pet acquisition cost in general. We spent $301, $306, $309. It's an output of every quarter we're trying to figure out what we can afford to spend but still stay in those guardrails. So in terms of partnerships, the more successful they are, we'll be happy to pay it. And we -- what we said on the earnings call was that this quarter we expect that to be in kind of the single-digit percentages of our total gross pet. So that's 1% to 9% of the total, which is in a quarter is really good, because like everything in our business, it takes a while to build up. And so that's just another layer we're going to add into cover more pets.
And so Chewy, Aflac coming on, State Farm, a lot of new distribution channels, but of course, there are also new products coming online. And right now, you have, I don't know if you call it soft launch, but you have a Canada-only launch of the Furkin and PHI Direct. The Furkin product being a mid-tier market product that somewhat competes with the broad range of pet health insurance products in the market today. And PHI Direct is a low-tier product but new to the marketplace, which treats all one year long conditions as pre-existing and that sort of lowers your cost if someone is not worried about chronic health issues. Both products are available in, I guess, most of the Canadian markets, not yet in the United States where you're testing those things. Now starting from IRR threshold, you were trying to get a number of customers to join the program. And so far, I don't think that the company has been able to get enough take-up to justify saying that products are ready for prime time or a full launch. How confident should investors be that Trupanion can solve for the -- what's stopping the take-up of these new products from being what you think if they ought to be? And are we certain big at launch in the United States? I mean, you're trying about 12 new things out simultaneously right now. Some of them will be great and some may not work. Where do Furkin and PHI Direct fit in the -- yes, this is part of our future and we know it's going to work?
That remains to be seen. Like you said, we've got a lot of growth levers going. And due to the nature of our business because nothing whips on overnight, you got to kind of lay the groundwork. We pay the long game in everything we do. And so we're kind of looking at this could be growth 2, 3, 4 years from now. We entered Australia in 2018. We spent a lot of time trying to get the model right, and we did it in 12 hospitals. And by the model, we wanted to -- before we step on the gas and investment, we want to make sure that our same-store sales were at a level that could really yield the right flywheel. And we'll take that kind of time. And now we've put our foot on the gas in Australia. We're in 50 hospitals, on our way to 100 and growing. So it's the same thing with PHI and Furkin. Canada is a big market. We are -- they are direct online-only brands. So we don't have the benefit of a vet recommendation, somebody calling into our call center where we have 50% to 60% conversion rate. So we're building new muscles there. But we'll take the time to get it right. I mean, the good thing is it's relatively small amount of money. We have dedicated general managers for each. The path is driving traffic, which we figured out we can do. They're great products. We can drive traffic. Then it's conversion, retention and then you -- then that's the full flywheel. And we're right in that conversion section. So this could take a year, year and a half. And conversion keeps coming up as we learn how to sell these products. So the long-term strategy is to take a part of the market where the Trupanion core brand doesn't participate in, and that is still true. So once again, it's one of the many levers we have that's laying the groundwork for future growth.
So I have a number of questions from the audience. The first one is related, I guess, tangentially to this. The questioner asks if Furkin would cannibalize on Pets Best business? And what's the relation between those 2 products?
If it was a big mature market and we had 50% penetration of pet insurance, maybe, but it's such a huge underpenetrated market. There's -- I don't know, we use the statistics, there's about 20 brands in the market at any one time. There's just lots of business to be had for lots of different groups. So the relative overlap in cannibalization is tiny. And Pets Best isn't worried and we aren't either.
This is a very, very precise CFO question here. The question is, prior period vet claims reserves and subscription business in 2Q was reversed by almost $2 million. Can you give more color on that reversal?
I definitely can. I mean, this over -- we've been talking about our claims process and the use of AI and software and doing everything we can to speed up payment claim. That's why we think that's a big part of our value proposition. It's apples and oranges versus the reimbursement model. You don't walk out with the giant bills, submitted online and hope a check shows up, like you just give the vet your Trupanion number and you pay 10% of the bill and walk out. So we have been accelerating our claims process. And so what you're seeing in the claims reserve is it's a representative of an accelerating process, both for Trupanion and then also in the other business, there was improvement made there as well with our partners. So those 2 things led to a decrease in the overall claims reserve, which leads to more predictability in our business. We're paying the claims almost in the same period that we collect the premium. And you don't have the variance of all these estimates that you have to put into an IBNR and reserve calculation.
Well, this next question is like 10 questions or maybe 5, but let's -- I'll cherry pick. So this questioner asks that Street consensus doesn't have Trupanion profitable on a GAAP EBIT basis until 2027. What scenarios could happen to accelerate that trend?
I guess, the interesting part of our business is the faster we grow, because we expense the full acquisition cost in the period that we acquire the pet, even though we're earning out over time, and in some financial products, that's deferred, like in mortgages. You spend $4,000 to get a mortgage, you deferred over the life of the mortgage. So it does skew the P&L. So the faster we grow, the more negative in EBITDA and cash flow we go. And by the way, there's capital requirements. So slower we grow, the more we drop to the bottom line. For example, in Q2 2020, when nobody knew what was going to happen, we pulled back and had a 52% IRR and had a $5.5 million EBITDA in the quarter and still onboarded 38,000 pets. So that's an example of that dynamic. So the -- when we start to have a positive GAAP EBITDA, it depends on the growth rate. It's as simple as that. And as we get bigger and bigger and bigger, could we get to the size where we can't effectively deploy the type of cash flow coming off the portfolio at a 30% to 40% IRR. It's a pretty high hurdle. It's a very higher. I've embedded other businesses, that wasn't my hurdle rate. And so yes, that could be likely. It also means sort of that we don't have that -- we don't have the growth opportunity at that scale. But I hope that we continue to find those kinds of returns and IRRs and are able to deploy.
So that dovetails on another question I want to ask you. You talked about the $5 million positivity in EBITDA right at the beginning as you pulled back from the pandemic. But if you look at the longer term, I mean, you guys are pretty much running at a breakeven rate for a while. And then in 4Q '20, Aflac gave you $200 million. And when they give you $200 million to sit on, they give you $200 million to spend, and you certainly haven't spent it yet. Some people complained that cash flow went from approximately breakeven to negative, but you also have this huge cash reserve of a major investor telling you to grow the business. Should we expect that Trupanion will fully deploy that $200 million over the next year, 2 years, 3 years? You also have a letter of credit that you entered into in 1Q '22. It seems like you have a lot of cash on your hand. Obviously, the return on investment is going to be a big indicator. But given like the 5 year plan, how much cash should we expect to deploy in excess of cash you're generating internally if the plan is going the way you want?
We are balancing growth with capital -- required capital because we own our own insurance company with return requirements, right? That's the triangle we're always balancing. And the 30% to 40% IRR kind of is calibrated result in kind of breakeven free cash flow or breakeven EBITDA, plus or minus a certain amount. So -- and mostly for most of our life post IPO, we were just self-funding growth. I mean, we did a secondary offering to buy our building and there was a great return on that transaction. But for the most part, that's what we're doing. So you're right, the Aflac investment enabled us to take off the positive cash flow guardrails and invest purely for return, same -- wherever the return could be found. And you're right, Aflac wants a return on their money just like our long-term shareholders. And that's the value of the Trupanion model. I mean, to get a 50-bagger or 100-bagger, you need real returns, not paper returns, you need growth, you need compounding and you need to start small. And that's what Aflac and our long-term shareholders see. So our priority for investment is to acquire pets and that kind of results in a cash flow breakeven. You see, we've allocated certain amount as kind of R&D expense to investigate long-term growth options. That's development expense and we break that out. So that pulls us a little negative. CapEx pulls us negative. And then maybe we'll look at share repurchases. And before that, we would look at M&A and that value. And then at the end of all of that, if we think there's significant undervaluing in our stock relative to our estimate of intrinsic value, we'll do share repurchases. So that's kind of our -- we are investing the Aflac cash. I mean, we -- this is a balance sheet business, it does take cash. We used about $50 million last year. We did an acquisition in Q4 of 2020, the Aquarium Software business. That was about $40 million. So we're using that Aflac cash. And then we entered this time, this really uncertain time with pulling on more liquidity, our first long-term institutional debt facility of $150 million. This is a good time to have it. It's very uncertain. We've got the dry powder and the cash to continue to execute this plan even with the uncertainty on the horizon.
All right. So coming back, obviously, people are concerned about inflation and recession. Trupanion has been around for 20 years, but of course, 10 years where the business looks different than it does today. What confidence do you have that persistency of the policy will be maintained if policy price goes up dramatically because inflation is going up dramatically? And to what extent do you think that if the price of the policy goes up dramatically because of inflation, it acts as a barrier to find new customers who get sticker shock and just don't want to enter into the Trupanion or the pet insurance model broadly speaking? I mean obviously, we don't know, but I mean, you have some data about what happened last time. What can you share with us about your confidence, about the relationship between inflation/recession and persistency and take-up?
Yes, it's an indicator of how uncertain this time. At one minute we're talking about inflation, the next minute we're talking about recession. Our model isn't recession or inflationary proof, but it definitely is resilient. And some of the proof points on the inflation side, we like to say that people aren't price sensitive, they're value sensitive. And if they're getting the value in talking a product that 15% of people are using every month, when they claim, our retention rate goes up. So that's why we want people to claim. So they really -- they get that value. For a long time we've published our retention rate in 3 buckets. People that haven't had a price change yet, people that have had a price change less than 20% and people that had a price change over 20%. And even when they have a price change over that 20%, that's -- you're getting a 20% plus increase. Our retention rate is 98.6%. And that percent, the better we get at pricing, that percent of our cancels has gone down over time and now it's less than 10%, more like 89% of our cancels. So -- and we've never been the cheapest. So it's an example of people see the value in Trupanion, and that's why we're confident on the inflationary side. On the recessionary side, the company has been around 20 years. Last time we went something through this level of significance was the global financial crisis. And if you look at our revenue chart, that goes right through 2008, '09, '10, '11, you don't see a blip. Several -- 3 of our senior management team worked in the pet insurance business in the U.K., which is a much larger, more mature market during that time as well. And what you find is one of the last things you cancel, I mean, you prioritize your mortgage payment, you don't cancel your insurance. You cancel -- you don't take vacation, you probably cancel a whole bunch of video streaming things. But I mean, you don't want to experience an unforeseen vet bill. And so -- and there's -- in this industry, because nobody covers pre-existing conditions, there's a big disincentive to disenroll, because once you disenroll and re-enroll then everything they had before is not covered. And it's -- and we're enrolling people very young. Most of our enrollments are less than 3. You have an incentive to stay there because you have something of value basically. And it's just straight math. We're pretty clear about our margin and people know what they're heading for. And so they continue to pay.
Final question, audience question. Can you talk about capacity constraints at veterinarians? And what that means for your business trends?
Yes. We're coming through and just did an amazing time looking back. And vets have struggled with staffing, but at the same time, their pets are getting treated. And if anything, we're emerging from this time where parts of the country were in curb side, staffing was incredibly difficult. We're getting back to normal. So yes, that traffic can go up and down. Some of the numbers that are reported are negative at traffic, but that's on top of like a 12% to 14% growth last year. So on average, vet traffic is going up 4%. So -- and then our -- we've continued to do a good business through all of this. So our leads and the value proposition of the vet, it really is uncorrelated with overall vet traffic. And if anything, our territory partners are now finally able to really get back out in the field. Software installs have picked up, leads are growing, leads have picked up, and that's our main channel. And we really -- we've had one arm behind our back for the last 2 years. And so that's probably the -- one of the most bullish things we're seeing in the future is that really getting our value proposition, our software and our territory partners back out there to continue to grow pet leads.
Well, we are at the half hour mark. I know you have a lot of conferences or meetings to attend. I appreciate all the audience members who are out there. And if you have any additional questions, you can send them to me and I will be happy to put them through to Trupanion. Thank you to Drew and the whole Trupanion team for participating in our conference, and we will be in touch. Take care.
Thank you.
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