Investors looking to gamble this summer have had no shortage of options, as Lemonade (NYSE:LMND) stock’s initial public offering (IPO) highlighted this year. The insurance fintech initially popped 138%, but then LMND stock sank 45% in August as investors lost interest.
Investors, however, shouldn’t write off this fintech company so quickly. That’s because fintech has been one of the best “millionaire-maker” industries since the 2008 financial crisis.
Since 2008, fast-moving tech companies have created billions in wealth for investors and founders alike. Rocket Mortgage (NYSE:RKT) founder Dan Gilbert, for instance, became worth over $47 billion when his company listed in August.
So, as the dust settles on Lemonade, a once-hot insur-tech company, it’s time to ask:
Is Lemonade a good long-term investment?
LMND Stock: A Golden Opportunity in Fintech?
Labeling Lemonade “just” a P&C company is much like calling Tesla (NASDAQ:TSLA) a car company or Carvana (NYSE:CVNA) an auto retailer. While technically correct, it misses the point that Matt McCall and my other colleagues have made. These companies are changing the way traditional businesses are run.
So what’s Lemonade’s “traditional business” that it’s disrupting? P&C Insurance. LMND writes insurance policies for homeowners and renters, much like competitors Allstate (NYSE:ALL), Farmers, Liberty Mutual, State Farm and Travelers (NYSE:TRV). And much like traditional P&C insurers, Lemonade then sells part of its premiums to reinsurance companies to manage risk.
But what makes Lemonade stand out?
Lemonade: Upending the P&C Insurance Industry
The company simplifies buying home and renters insurance. Rather than spending time over the phone, customers can purchase insurance through an online bot. The process can take less than 30 seconds. And on the claims side, the company says that users can settle in as little as three seconds.
Lured by a snazzy front-end website (and the promise of skipping phone-based customer service), millennials have flocked to Lemonade. Net earned premiums rose 200% in 2019, while gross loss ratios have narrowed to 79% as the company has gained scale. While loss ratios aren’t yet at industry standards of 65%-68%, it’s certainly moving in the right direction. Analysts expect the company to continue growing fast. Revenues are expected to skyrocket 74% in 2020, and another 50% in 2021.
What’s been the secret sauce to Lemonade’s success?
Before Lemonade, home and renter’s insurance had stubbornly remained a commission-based salesman game. Allstate, State Farm and Liberty Mutual relied on agents to sell contracts. And employing full-time agents made insurance more expensive for consumers. For instance, the average agent earns 7-20% commissions on every contract.
Meanwhile, health and auto insurance had both moved towards an online system. Companies like Geico and Oscar Health, and marketplaces like Healthcare.gov have allowed users to buy insurance online while side-stepping expensive agent commissions.
These changes revolutionized the heath and auto insurance business. Geico is now worth over $50 billion by some estimates. And now it’s Lemonade’s turn to bring the same logic to P&C insurance.
Lemonade Investors Face 3 Key Risks
Lemonade’s upbeat S-1 registration with the SEC seems to have its story in order: a digital upstart looking to gain share in a stodgy P&C market. The opportunity appears immense — the P&C insurance market is worth 2.1% of worldwide GDP.
And targeting millennials have worked for other companies. Online health insurer Oscar, for instance, saw its Series A valuation of $800 million in 2015 balloon to $3.2 billion in just four years.
Yet, not all is well once you peel back the layers of Lemonade’s core business. A combination of three financial and economic realities stand in the way of this hot startup.
Risk No. 1: Pricing and Concentration of Premiums Written
Even though LMND has a fancy front-end website, it’s rear still looks like a P&C shop. And the insurance industry has long grappled with pricing risk. Most P&C insurance is annually renewable, meaning actuaries can measure risks over a relatively short time horizon. The size of claims, however, are often not known for several years.
Lemonade’s actuarial team faces a particularly steep learning curve in pricing personal liability in home insurance contracts. That’s because Lemonade doesn’t have a long operating history, and significant liability claims don’t happen often. In other words, the company won’t know its client risk profiles for years.
If that wasn’t enough, there’s an even more significant issue: insurance concentration. It’s the same reason why P&C insurers who specialize in beachfront Floridian property tend to go broke every time a major hurricane season hits the state. It doesn’t matter how many people you insure if their risks are all the same.
Stocks holders in LMND may unknowingly face a similar problem. Not only does the company have an outsized concentration among younger renters in urban and suburban areas. Over 60% of the company’s gross written premiums come from just three states: California, Texas and New York.
That means a localized significant disaster, such as a Californian earthquake or Texas hurricane, could cause a catastrophic loss for Lemonade. And even if the firm survives, its reinsurance policies will almost certainly rise.
Don’t underestimate these risks. The 2005 hurricane season, which included Dennis, Katrina and Wilma, weakened the P&C market severely. Two years later, only one insurance company was able to write hurricane insurance for Florida’s government. (The company, Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B), walked away with a $224 million check.)
Risk No. 2: Lemonade Relies on Customer Excitement
Lemonade has leaned heavily into its messaging to maintain its breakneck growth. “Instant everything. No brainer prices. Big heart,” the company proudly claims on its website.
The company also operates as a “Certified B Corp” and has publicly stated it would give back excess profits to charity after deducting its fixed 25% fee.
In good times, the growth-by-message strategy can work amazingly. For example, the office-sharing company WeWork, another SoftBank-backed startup, doubled membership between 2016-2017. Young office-workers flocked to the free beer and inclusive membership events.
“When I hear Adam [founder of WeWork] speak and he talks about the We Generation,” one member said in an interview with Wired, “I really feel this, because everything that goes on in the world, it is just about what we can do for each other here.”
Meanwhile, competitor Regus saw just 7% growth.
In bad times, however, the same strategy can quickly collapse. In 2019, a series of missteps by CEO Adam Neumann rocked the WeWork brand. Among allegations of sexism and supporting a toxic frat-boy culture, Neuman also made several questionable stock sales from the company. He also trademarked the word “We,” then sold the rights back to WeWork for about $6 million.
Softbank pulled the plug on WeWork’s IPO, sending its valuation plummeting from $47 billion to $12 billion.
Today, Lemonade walks a similar tightrope. Insurance companies already have a poor reputation among consumers, and a series of non-payment scandals by Lemonade (even if justified) could send the company into freefall. Customers might even question Lemonade’s “Certified B Corp” status. In 2019, the company awarded $4.3 million in stock options to insiders but gave just $600,000 to charity.
Not all growth-by-message companies fail; Tesla has defied critics for years now. But it does elevate the risk that when things fail, they can do so fast.
Risk No. 3: Profitability Issues
Finally, Lemonade has a severe profitability issue. The company lost $108.5 million in 2019 on just $63.8 million of net earned premium. In other words, the company lost almost $2 for every $1 it generated.
The problem comes from the company’s sky-high sales and marketing costs. In 2019, the company spent $89.1 million in marketing to generate just $42.6 million incremental premium.
Its growing scale has helped margins to a degree. “We currently spend $1 in marketing to generate more than $2 of in-force premium,” management wrote in its most recent June 2020 report. But that’s far from enough. A P&C company with a 70% loss ratio mathematically needs to generate $3.33 to cover just its marketing expenses. Just as the tooth fairy doesn’t pay capital expenditure, Santa Claus doesn’t pay worker salaries.
To succeed, Lemonade will have to demonstrate that its online platform can bring in customers more efficiently than traditional players. Its established competitor, Everquote (NASDAQ:EVER), which deals only with the acquisition side of the business, spent 81 cents in advertising for every $1 of revenues. It has yet to turn a profit in its four years as a public company.
Lemonade has other fierce competition ahead. Of the four largest homeowner insurance companies in the U.S., three (State Farm, Liberty Mutual and USAA) are mutual companies. That means they send 100% of their profits back to policyholders. The fourth, Allstate, generates twice as much from car insurance as it does from its homeowners business.
What’s LMND Stock Worth?
By 2022, analysts expect revenue to rise to $346 million, which could increase to $1 billion by 2025 if all goes well. Lemonade already added on pet insurance and could grow even further in different P&C areas. At that point, the company could be worth $4-$6 billion, about what Oscar Health Insurance is worth today. (For reference, Oscar generated $1.3 billion in 2019). That comes to $72 to $110 per LMND share, or a 20%-83% upside.
However, the company will need more capital to grow. The company already diluted existing shareholders with its $300 million IPO. More will be required.
Also, Lemonade’s three risk factors means stock holders in LMND should use a higher discount factor in determining fair value (that’s an analyst’s lazy way of pricing investment risk). A 10% annual discount rate lowers fair value to $46-$70 today. Hence CNBC personality and stock analyst Jim Cramer’s note to “back up the truck” only if the stock price for LMND falls below $50. Of the six analysts with stock price targets on LMND, only one has issued a “buy” rating.
In a sense, Lemonade looks like a typical Softbank investment. Some of the Bank’s holdings have performed marvelously; Arm, which the Bank bought for $31 billion in 2016, is now worth $55 billion by some estimates. Others, like WeWork, have lost the billions. Lemonade will follow a similar all-or-nothing path to profitability. Either the company will become the next Geico (worth $50 billion or more) or it will blow up like so many other P&C insurers before it over mispriced risk.
Whatever the case for investors, know this: LMND stock isn’t for the faint of heart. Investors should jump in at their own risk.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.