Trupanion is a company that I would typically rule out fairly quickly. However, after multiple people have indicated to me that I should take a look, I sat down to read both sides of the story. In this case, there is a strong short argument to counterbalance the “believers.” I would have to call the longs believers at this stage because they are certainly betting on the company changing the pet insurance market in North America.
Value investors almost always miss the “shifts” in business models. You can’t evaluate the past financials of a company that did not exist 5 years ago or compare its business model to one that is quite new. A few examples: $4 coffee away from your home (Starbucks), DVD rental by mail on a monthly subscription model (Netflix), two-sided online auction market (eBay), and the list could go on. Some of these aren’t technological shifts that are easy to miss, but instead merely shifts in how people choose to allocate their money, in a way that was not previously common.
Trupanion *could* represent such a shift. I will lay out some of my thoughts below.
The argument for a shift towards people buying more pet insurance is simple. People did not previously buy pet insurance because the product being sold was a terrible product. Traditional pet insurance, the argument goes, imposed a lot of annual and lifetime limits, exclusions on congenital and hereditary conditions, red tape, and if the insurance company did pay, the reimbursement was too slow (i.e. you paid your vet upfront and waited 3-5 weeks for a check to arrive in the mail).
Trupanion aims to reduce these “pain points” by eliminating annual and lifetime limits, doing away with exclusions on hereditary and congenital conditions and speeding the reimbursement process by paying the veterinarian directly (i.e. no “reimbursement hassles”). Trupanion’s argument is that a better product will close the “insured gap” between Great Britain, which has a 25% penetration rate compared to North America, which barely has a 1% pet insurance penetration rate.
Additional arguments in favor of the shifting nature of the pet insurance market are that more expensive procedures are common and acceptable for a price now whereas 15 years ago, you could not treat a dog’s tumor. Furthermore, the “stature” of the pet has increased such that people are more willing to spend to keep Fido alive.
The bullish line of thought compares Trupanion to some other notable companies:
Like Costco, as Trupanion scales its business “[it] expects to be able to share the value [it] creates with [its] members. A noted bull writes, “That’s the key dynamic in this type of company whether it’s Nebraska Furniture Mart or Amazon.com or Trupanion, because this feedback loop simultaneously deepens the moat and drives volume growth.”
Similarly, by combining the distribution side of the business with the underwriting arm, Trupanion argues that it will have a low-cost advantage in a commodity product (insurance), and thus be able to have the highest payout ratios and still be profitable.
In other words, Trupanion would like you to think it is similar to Costco, Geico and Netflix (more on the Netflix comparison). I have my doubts. First, I do not like when companies try to prematurely position themselves as the future Costco or Geico of the world. This may be a personal preference, but it rubs me the wrong way. [Please excuse any references to John and I becoming the next Buffett and Munger].
I have three main concerns:
An insurance product is typically designed to prevent a potentially ruinous financial outcome in a rare situation where the known risk does occur. Home insurance would qualify because replacing your $500,000 house after a fire would be almost impossible. Pet insurance, on the other hand, does not seem to qualify. The “tail risk” of a costly medical procedure required to keep “Fido” alive has a natural alternative. Put Fido to sleep and get another dog. Ouch, I hope my daughters are not reading this. Although painful to read, this is a reasonable alternative for many families, especially if the health issues crop up in the later years of the pet’s life, which they typically do. Additionally, the math does not seem to add up unless there is a catastrophic injury or disease.
Let’s take Fido.
Average Life: 10 years
Average Annual Trupanion Insurance Premium: $600
Annual Deductible: $100
Total Paid (600×10)+(100×2)= $$6,200 (assuming two incidences during life of pet)
Total insurance costs over the life of Fido are approximately $6,200. In other words, a family has to be willing to save the live of their pet for at least $6,200. I find this hard to believe given the majority (over 60%) of pets in North America are still “adopted” for a very low fee or in some cases free.
On this point, I struggle to see the value proposition for the customer, but am willing to admit that I may be wrong on this point.
Fudging The Facts
Investing involves a significant amount of trust. Although you can do a significant amount of due diligence, investing still involves unknowns. However, when management is fudging something in plain sight, I wonder what else they might be fudging that I have not discovered yet.
Below is a cut and paste for Trupanion’s latest 10Q.
The Company operates in two segments: subscription business and other business. The subscription business segment includes monthly subscriptions related to the Company’s medical plan which are marketed directly to consumers, while the other business segment includes all other business which is not directly marketed to consumers.
Trupanion may be a great company, but it is still an insurance business. It is not a subscription business (this is the Netflix comparison). Insurance businesses need to worry about equity capital, reinsurance, loss ratios, etc. These are details that I believe Trupanion is trying to gloss over by nudging investors to ignore its insurance nature and focus instead on the idea that it is a “recurring revenue subscription business.” In a typical subscription business, the marginal cost of a new subscriber is basically zero, one additional user for software, one additional reader for a publisher, etc. This is a great business model for obvious reasons. Insurance is not such a business because the incremental cost of a new “insured member” could potentially be greater than the revenue of said new member. And even under most models, the incremental cost is probability weighted to be around 70-80% of the revenues from the new member.
Perhaps I am being too semantic on this point, but I believe you can tell a lot about the integrity of a management by how they communicate to investors. And this is a significant red flag for me.
Let’s say I am completely wrong about North Americans willingness to insure Fido under Trupanion’s new model. Let’s do some quick back of the envelope math. NA market currently has about 150m pets, of which around 1% is currently insured. Trupanion has around 20% of this market and appears to be growing the pie as opposed to taking direct share from other companies. Let’s say that the market quintuples, such that approximately 5% of the pets are insured. A 20% market share for Trupanion would be around 1.25m pets. At its current growth rate (mid to high 20%), Trupanion would take about 8 years to hit that number, 2024.
- 1.25m pets insured
- Average annual premium: $600
- Annual Revenues: $750m
- Net Income: $75m (10% net margins is Trupanion’s stated goal)
- Valuation: 20x earnings: $1.25B
- CAGR from $525m equity value today: 16%
Keep in mind that these are all rough estimates. This is not a bad return for an investment. However, we need to remember that Trupanion is currently unprofitable and its competitors, Pet’s Best (IHC Group), Healthy Paws (Aon), and Nationwide are no slouches. As you can see from the chart, growth rates have come down significantly and I would imagine over the next year, those growth rates might even fall below the 20% estimates I use in the calculation above.
Some quick pricing checks and calls to Vets confirms that the pricing is standardized (negating Trupanion’s claims of better data) and that Vet distribution is no longer “dominated” by Trupanion. Trupanion has claimed that it “owns” the Vet distribution model, but after calling 10 vets in a matter of 30 minutes, almost every single vet indicated that they had brochures for at least 3 different insurance companies.
I think it is helpful to keep an open mind regarding new business models and the large potential runway for growth in certain areas, but I am not inclined to agree with the upside case on Trupanion. The reporting red flags combined with the questionable value to the customer give me significant pause. However, I am going to keep my eye on this company to see if they can show a shift in penetration rates of pet insurance in the NA market. I could be completely wrong, but there are no called strikes in investing…..
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at firstname.lastname@example.org.