Lemonade – Sweet Or Sour, Time Will Tell

The public offering of Lemonade (LMND) has been a truly astonishing success with shares up 140% on their opening day, having risen from $29 to $70, a mind-blowing move higher of course for a period of just a day. The reason for that is somewhat understandable, yet at the same time hard to justify as investors believe that this might really become a disruptive force in a traditional industry. Investors therefore attached high hopes and valuation to the business, while the current financial performance does not justify such valuation, nowhere close.

Hence, the company seems like a potential short as the gap between reality and current performance is very large, yet if this becomes a game changer (with mission, business model and conviction having the potential to create a disruptive force), this very overpriced stock might become far more ”overpriced”.

Disrupting Insurance

The reason for the spectacular returns is that investors apparently have belief in the disruptive business model of the company in a traditional insurance industry. The company claims to have rebuilt insurance from the ground up by leveraging technology, data, artificial intelligence and behavioral economics, to be executed upon in a vertically integrated manner.

The company claims to be able to get coverage and payments on claims in minutes or even seconds, driven by the integrated model of marketing, underwriting, claims, processing, finance and regulation. The company furthermore aims to develop a more predictable business as traditional insurers have seen huge fluctuations in earnings due to weather or other events. This should be done by simply taking a cut on premiums, with excess premium either placed with reinsurers or given back to customers.

It is refreshing to see how the company thinks about insurance, as the industry is among the largest markets in the world, with the market for property, casualty and life insurance being $5 trillion per year already. This market covers some of the most important assets in our lives and often is even mandatory, creating high recurring revenue streams for those providing underwriting of revenues.

Further interesting is, of course, the statement in the S1 that ”insurance allows people to trade the risk of a disastrous loss in the future for the certainty of an affordable loss now” being the fabric of contemporary society. The company furthermore resonates well with millennials given this almost societal mission, usage of technology and targeting of this customer group. This furthermore creates advantageous economics in the future as these consumers scale up in terms of assets which they want to insure and their worth, creating additional premiums for very little marginal costs.

The IPO

Lemonade aimed to sell 11 million shares in a range of between $23 and $26 per share. Strong demand resulted in the final pricing being set at $29 per share, far above the preliminary range. The pricing furthermore meant that gross proceeds in connection to the offering have seen a boost to $319 million.

With 55 million shares outstanding, the equity value stood at $1.60 billion at the offer price. As the company held $240 million in net cash ahead of the offering and including the offering proceeds, net cash has risen to more than half a billion, valuing operating assets at less than $1.1 billion. This of course all changed as shares rose to $69 on their opening day, boosting the valuation to $3.8 billion, or $3.3 billion after adjusting for net cash, a very high valuation for a small business with large losses.

Only launched in 2016, gross written premiums rose to $9 million in 2017, $47 million in 2018, to $116 million in 2019. First-quarter premiums for this year came in at $38 million already; annualised, they are already running in excess of $150 million.

While the gross written premiums show very impressive growth, the results on the profit and loss account are less impressive. Revenues tripled from $22 to $67 million between 2018 and 2019 as operating losses essentially doubled from $53 million to $108 million. Similar trends were observed in the first quarter, with revenues increasing to $26 million on which a loss of $36 million was reported, as losses are only increasing in absolute terms and only modestly improving on a relative basis.

Some Further Thoughts

This is a very tricky situation. On the one hand, it is notably the mindset of the company which is very disruptive in a traditional industry and might easily resonate with millennials. Of course, based on the current revenue base and the growth trajectory, the company could never justify such a situation, if this was a ”traditional” business. On the other hand, if the company could only grasp a small profitable market share of the global market through its innovative business model, shares arguably look cheap.

The biggest risk includes, of course, a high valuation, somewhat limited experience and an innovative approach to underwriting which could backfire, in combination with reliance on behavioral finance and expected economic rationale behavior by customers.

In my view, the company, investment story, and range of outcome leave far too many scenarios with a great range of outcomes, which makes this company hard to value. On the one hand, current performance could never justify the current valuation (looking at traditional peers). On the other hand, buying early into a true innovator which can transform an industry at a valuation of a few billions seems like a good idea.

There are enough traits/characteristics which could lead to Lemonade becoming a truly disruptive force, but probably more reasons why it does not become such as success. Hence, the only potential position in my eyes is a speculative long position, as right here, right now, I do not feel the rush to do so with near-term expectations sky-high as evident by the first move.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.