Trupanion, Inc. (NASDAQ:TRUP) Q2 2023 Earnings Call Transcript

Trupanion, Inc. (NASDAQ:TRUP) Q2 2023 Earnings Call Transcript August 3, 2023

Trupanion, Inc. misses on earnings expectations. Reported EPS is $-0.33 EPS, expectations were $0.42.

Operator: Good day. And welcome to the Trupanion Second Quarter 2023 Earnings Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Laura Bainbridge with Investor Relations. Please go ahead.

Laura Bainbridge: Good afternoon, and welcome to Trupanion’s second quarter 2023 financial results conference call. Participating on today’s call are Darryl Rawlings, Chief Executive Officer; Margi Tooth, President; and Wei Li, Interim Chief Financial Officer. Before we begin, I would like to remind everyone that during today’s conference call, we will make certain forward-looking statements regarding the future operations, opportunities and financial performance of Trupanion within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements involve a high degree of known and unknown risks and uncertainties that could cause actual results to differ materially from those discussed.

A detailed discussion of these and other risks and uncertainties are included in our earnings release, which can be found on our Investor Relations website, as well as the company’s most recent reports on Forms 10-K and 8-K filed with the Securities and Exchange Commission. Today’s presentation contains references to non-GAAP financial measures that management uses to evaluate the company’s performance, including without limitation, variable expenses, fixed expenses, adjusted operating income, acquisition costs, internal rate of return, adjusted EBITDA, and free cash flow. When we use the term adjusted operating income or margin, it is intended to refer to our non-GAAP operating income or margin before new pet acquisition and development expense.

Unless otherwise noted, margins and expenses will be presented on a non-GAAP basis, which excludes stock-based compensation expense and depreciation expense. These non-GAAP measures are in addition to and not a substitute for measures of financial performance prepared in accordance with the U.S. GAAP. Investors are encouraged to review these reconciliations of these non-GAAP financial measures to the most directly comparable GAAP results, which can be found in today’s press release or on Trupanion’s Investor Relations website under the Quarterly Earnings tab. Lastly, I would like to remind everyone that today’s conference call is also available via webcast on Trupanion’s Investor Relations website. A replay will also be available on the site.

With that, I’ll hand the call over to Darryl.

Darryl Rawlings: Thanks, Laura. Two months ago, we hosted our annual shareholder meeting. I’ll touch on a few of the highlights today and encourage you to watch our annual meeting highlights video available on our Investor Relations website. Among the highlights shared were three key priorities. First, expansion of our adjusted operating margin, second, deploying capital efficiently, and third, returning to free cash flow positive by Q4 of 2023. In Q2, we saw early signs of progress in each of these areas. I’ll elaborate on these now. Adjusted operating income was $16.8 million in the quarter. After an extended period of margin compression, I’m encouraged to see margins not only stabilize, but sequentially expand. Assuming the rate of veterinary inflation remains consistent with our expectations as it did in Q2, we expect further margin expansion in the second half of the year as our pricing actions continue to take hold.

In the quarter, we deployed $19 million to acquire over 75,000 gross new pets. I’m thrilled with the team’s ability to add 23% more pets year-over-year, while deploying 6% less in acquisition spend, in my opinion, this is a strong result. On a per pet basis, the cost to acquire a pet was 24% lower than the prior year period. Managing acquisition spend in relation to pet lifetime value is a honed skill of the team and one we will continue to refine at extremely granular levels. I’ll elaborate on this point momentarily. The combination of early margin expansion and efficiencies in our pet acquisition spend helped drive a $3.9 million sequential improvement in free cash flow in the quarter. Additional actions taken in the quarter to reduce spend are expected to further advance us towards our goal of achieving free cash flow positive in Q4.

Overall, I’m encouraged by the progress the team has made over the past four months. This progress is evident in our results, which are once again more closely aligned with our expectations. We have more work to do, but the team is focused on executing diligently through a dynamic environment. Long-term, our goal remains to grow adjusted operating income and deploy increasing amounts at high internal rates of return. As we manage through this near-term period of margin compression, we’re throttling back on spend and allocating capital to those markets and geographies in which we are more accurately price to our value proposition. This decentralized approach delivered strong new pet growth in the quarter, while furthering our progress towards our margin expansion and free cash flow goals.

We will maintain our granular approach as the business grows from one too many P&Ls, allocating capital to products, channels and geographies that deliver the highest rates of return. Understanding and managing our spend in relation to how we believe these pets will perform over their lifetime with us will be critical in doing so. As we have discussed frequently, a pet and the corresponding lifetime value can and will vary dramatically based on the individual characteristics of that pet. That’s before introducing varying levels of coverage, products like Furkin and PHI Direct. Our suite of offerings with Chewy and Aflac and new markets like Continental Europe. As our mix of business evolves, our goal is to report on the internal rate of return for our new mix of pets in a more granular way.

Historically, our calculation was based on an average, assumed every new pet behave similarly to our existing book of business. For example, it assumed pets regardless of product, channel and geography had the same ARPU and margin profile and with the equal retention to our existing book. Now for many years as a mostly single line business, this was an appropriate and appropriately conservative way to talk about it. With new products, channels and geographies becoming a more meaningful portion of new business, these assumptions have become less relevant. This is not a new concept for us. Recall, I discuss this in greater detail in this year’s shareholder letter. I further shared an example of Continental Europe, where new pet ARPU is approximately $30 compared to that of our total book at approximately $64.

If we were to use a simple consolidated average as we previously reported, the estimated return on our spend to acquire these European pets would be overstated. This two would be the case with our newer products. If we were to assume equal retention to our existing book. Our newer products with less coverage have retention similar to what we believe the industry average retention is of approximately 30 months compared to Trupanion over 70 months. As you’ve heard me say before, less coverage drives lower retention. With this in mind, moving forward, we intend to provide increasing levels of granularity into the returns of our various products, channels and geographies and underlying assumptions behind those expected returns. Margi will provide some more detail momentarily.

Stepping back, I believe the changes we’ve made over the past several months are proving out and set us up well to deliver improved performance moving forward. We’re starting to see signs of margin expansion. We are investing our capital prudently and we’re making progress towards our goal of free cash flow positive in Q4. We’re seeing good growth and scale in our new initiatives and through our international efforts were meaningfully expanding our addressable market. Most importantly, our decentralized management approach is taking hold with the team delivering stronger and more predictable results. With that, I’ll hand it over to Margi to add additional context around our quarterly performance and execution of our 60-month plan. Margi?

Margi Tooth: Thanks, Darryl. Good afternoon, everyone. I am pleased to share the ongoing progress that has been made since our annual shareholder meeting just eight weeks ago. The team has remained disciplined in capital allocation, leaning into our most efficient channels during the quarter. This strategy enabled the delivery of yet another solid quarter of deliberate and meaningful growth while preserving our balance sheet. We added over 75,000 gross new pets in the quarter. This is particularly strong growth when considering the intentional reduction of pet acquisition investment, which was down 6% year-over-year. In the quarter, we began adjusting and in places reducing our acquisition spend to ensure we are aligning our investment to areas with the strongest lifetime value.

In geographies, where we’re able to provide value to our members consistent with our brand and pricing promise. Our estimated internal rate of return was 25% in the quarter. As a reminder, we use IRR to predict the estimated future cash flows from our newly acquired pets. ARPU retention and adjusted operating margin are key inputs into this calculation. In Q2, on trailing 12-month margin was 10%, which is temporarily reduced given current inflationary pressures. As you will soon hear, we’ve made progress on our pricing actions and are beginning to see early signs of margin expansion, a trend we expect to continue this year and into next. Moving forward, we’ll be contemplating an adjustment to our IRR calculation that we believe will more appropriately and conservatively reflect the new pet ARPU, retention and margin contribution from each line of business and aligned to a more decentralized approach.

Recall, we talked about this more granular approach to capital allocation in our most recent shareholder letter and also at our shareholder meeting. We’ll be providing this updated metric in our Q3 earnings release. Overall, we view the returns on new book of business is strong in the current climate. And moving forward, we will continue to use our multi-angle view when assessing our pet acquisition performance. For the quarter, we continue to benefit from our deepest mode of our centric approach. In today’s inflationary backdrop, the conversation around Trupanion is resonating more clearly than ever before. Veterinary leads are up year-over-year and we continue to see solid levels of conversion. As we continue to increase the penetration of this market, we look forward to the day that our veterinary partners are freed up from financial conversations and instead are able to practice the very best medicine that is studied and trained for.

Ultimately, we look forward to ending economic euthanasia. With this in mind, throughout the quarter, we maintained our focus on retention with the average Trupanion members staying with us an estimated 74 months. Given the increase in rate now flowing through consistently to our members, we are pleased with this level of retention. We believe it’s a reflection of strong execution in today’s environment. Now, let me touch on our pricing efforts. In Q2, the pricing refinement and rate adjustments across North America continued with us securing additional rate in over 30 states. The average rate flowing through our book in Q2 was 16.3%. By the end of this month, we expect to have 20.8% pricing flowing through our book. Keep in mind this rate will be immediately applied to new members and roll through the book as policies renew.

By the end of September, this should increase to 22.9% and by the end of October to 23.9%, a rate we currently expect to hold through year-end. As an example, this means renewing policies in October, we’ll see a 23.9% average rate increase. This increase is relative to what these members are currently paying, which was set last October for these policies. As shared in more detail in our annual shareholder meeting, we are constantly monitoring the overall costs across the industry to ensure operating assumptions remain true. We’re pleased to report that in second quarter growth in cost of care remain consistent with the first quarter and in line with our assumptions. Should this change, we will be poised to take additional actions as needed in the coming months.

As a result of the increased rate flow is over 60 basis points of sequential improvement toward our value proposition target during the quarter. At all times, it’s our goal to return to our target value proposition of 71%. So while we still have some work to do there, I am encouraged by the team’s progress towards this critical target metric. We also saw a 60 basis point sequential improvement in our subscription adjusted operating margin in the quarter. With cost of care currently increasing in line with our 15% year-over-year operating assumptions, we continue to see a path to our 15% adjusted operating margin target towards the end of next year. While Trupanion remains the primary engine behind our performance, we continue to see solid contribution from our newer products and channels collectively.

With these products ramping a market, we’re making solid efficiency gains. In Q2, Chewy expanded the comprehensive and proactive marketing campaign to introduce our insurance product line to their millions of pet parents. Following this activity, we’ve been pleased to see lead growth of this channel accelerate. In addition, we continue to see increasing contribution from our European endeavors. We added approximately 4,000 new pets during the quarter and very shortly we’ll be launching in Poland, adding an additional 8,000 hospitals to our addressable market, which totals over 50,000. Demand in Continental Europe for Trupanion light product, which is known for its broad coverage and vet centric approach remains high. We’re excited to bring a Trupanion product to a handful of countries in Continental Europe by year-end.

Product, channel and international market expansion are key tenants of our 60-month plan. After a period of upfront investment, many of our new initiatives are end market and beginning to contribute more meaningfully to our growth. In the quarter, approximately 13,000 of our gross new pet adds or about 17% came from our new 60-month plan initiatives. Our appetite for sustainable growth in our underpenetrated market has not changed. And yet, we will maintain disciplined in our approach at all times with all products in all markets, balancing our appetite to grow the marketplace with our desire to live within our guardrails. At times, this may mean throttling back or reducing spend and prioritizing the strength of our balance sheet. We believe this is the right thing to do.

In the quarter, we took very deliberate actions to ensure we are operating as efficiently as possible across all areas of our business. The intention of this action was to reduce costs, many of which were centered around some of our long-term test initiatives that derive limited immediate or short-term benefit. While many areas of the organization were able to improve efficiencies, these reductions were predominantly in fixed expenses and pet acquisition and not in areas directly responsible for supporting our members or partners. In further support of our efforts to enhance the effective deployment of our capital, the team has made some very meaningful progress in the development of a long awaited next generation policy administration and claims adjudication platform.

As we approach the final stages of our migration, we should see reduced capital expenditures next year. Subsequent to quarter end, we also launched our new Trupanion website designed to be more interactive and easier for members and prospective members to learn about enroll and engage with Trupanion. In totality, our combined actions across pricing and capital deployment and proven ability to throttle back growth as needed further position us to deliver a solid second half performance related to our key priorities, as well as on a goal to achieve positive free cash flow in the fourth quarter of this year. With that, I’ll hand it over to Wei to talk you through our Q2 results and outlook for the remainder of the year.

Wei Li: Thanks, Margi, and good afternoon, everyone. It’s great to speak with you all on my first earnings call as Interim CFO. Today I will share additional details around our second quarter performance, as well as provide our outlook for the third quarter and full year of 2023. Total revenue for the quarter was $270.6 million, up 23% year-over-year and ahead of our expectations. Within our subscription business, revenue was $173.3 million in the quarter, up 19% year-over-year. Total subscription pets increased 23% year-over-year to over 943,000 pets as of June 30, 2023. Calculated on a trailing 12-month basis, our average monthly retention across all of our North America’s subscription products was 98.61% compared to 98.74% in the prior year period, equating to an average life of 72 months.

Unless otherwise noted, the metrics I’m sharing today are presented on a consolidated basis and it will be influenced by our mix of business, including new products, channels and eventually geographies as Margi discussed. Our European pets are currently underwritten by third-party underwriters and are therefore not included in our per pet metrics today. Monthly average revenue per pet for the quarter was $64.41. This quarter and moving forward, we will also break out to new pet ARPU. Average new pet ARPU for our subscription book of business in North America was $61.49 in the quarter. Breaking down our year-over-year subscription revenue growth of 19% for the quarter, pet growth contributed 19%, pricing increases at a 10%, while mix reduced it by 9%.

Lastly, foreign exchange, reduced revenue growth by 1%. Subscription business cost of paying veterinary invoices were $133.4 million in the quarter, resulting in a loss ratio of 77%, a 60 basis point sequential improvement over the last quarter. As a percentage of subscription revenue, variable expenses were 9.7% in the quarter, down from 9.9% in the prior year period and down from 10.1% in the prior quarter, reflecting some cost efficiencies. Fixed expenses as a percentage of revenue were 5.1% in the quarter, up from 4.3% in the prior year period and 4.7% in the prior quarter. Fixed expenses include costs related to our new subscription products in North America and Europe. Within fixed expenses for the quarter were approximately 700,000 of one-time expenses.

Absent these costs, fixed expenses as a percentage of revenue would have been largely flat quarter-over-quarter. After the cost of paying veterinary invoices, variable expenses and fixed expenses, we calculate our adjusted operating income. Our subscription business delivered adjusted operating income of $14.1 million or 8.2% of subscription revenue. This is up from 7.6% in the prior quarter or approximately 60 basis points of sequential margin expansion. Now I’ll turn to our other business segment, which is comprised of revenue from other products and services that generally have a B2B component and a different margin profile than our subscription business. Our other business revenue was $97.3 million for the quarter, an increase of 32% year-over-year.

Adjusted operating income for the segment was $2.6 million in the quarter. In total, adjusted operating income was $16.8 million in Q2. This was down 19% from the prior-year period, but up 8% sequentially. During the quarter, we deployed $19 million to acquire over 75,000 new subscription pets, excluding the 4,000 European pets. This translated into a pet acquisition cost of $236 per pet in the quarter. We also invested $0.9 million in the quarter in development cost. As a percentage of revenue, development expense was 34 basis points compared to 92 basis points in the prior year period. This step down reflects the shift of some of our new initiatives out of development and into variable, fixed and new pet acquisition expenses within our subscription business.

Adjusted EBITDA was a loss of $3.2 million for the quarter as compared to a loss of $1.7 million in the prior year period. Depreciation and Amortization was $3.3 million during the quarter. Stock-based compensation expense was $6.5 million during the quarter, we continue to expect stock-based compensation to be around $7 million per quarter for the remainder of the year. As a result, net loss was $13.7 million or a loss of $0.33 or a loss of $0.33 per basic and diluted share, the same as the prior year period. In terms of cash flow, operating cash flow was negative $3.4 million in the quarter compared to negative $3.1 million in the prior year period. Capital expenditures totaled $4.7 million in the quarter. As a result, free cash flow was negative $8.1 million, a $3.9 million improvement from the first quarter.

We expect cost actions implemented in the second quarter along with margin expansion to further improve our free cash flow in the second half of the year. We ended the quarter with $236.1 million in cash and short-term investments, we maintained $213.1 million of capital surplus at our insurance subsidiaries, which was $57.3 million more than estimated risk-based capital requirement of $155.8 million. Outside of these insurance entities, we held $25.4 million in cash and short-term investments at the end of the quarter, with an additional $40 million available under our credit facility. I will now turn to our outlook. For the full year of 2023, we’re increasing our guidance at the midpoint for both revenue and adjusted operating income. Revenue is now expected to be in the range of $1.73 billion to $1.89 billion, representing 19% growth at the midpoint.

Subscription revenue is now expected to be in the range of $708 million to $718 million, which would represent 20% year-over-year growth at the midpoint. Total adjusted operating income is now expected to be in the range of $70 million to $80 million. At the midpoint of the range, this continues to imply expansion in adjusted operating margin in the second half of the year as our pricing actions flow more meaningfully through our book of business. For the third quarter of 2023, total revenue is expected to be in the range of $270 million to $275 million. Subscription revenue is expected to be in the range of $180 million to $182 million. Total adjusted operating income is expected to be in the range of $18 million to $21 million. As a reminder, our revenue projections are subject to conversion rate fluctuations predominantly between the U.S. and Canadian currencies.

For the third quarter and full year 2023 guidance, we used a 75% conversion rate in our projections, which was the approximate rate at the end of June. Thank you for your time today. I will now hand the call back over to Darryl.

Darryl Rawlings: Thanks, Wei. Before we open it up for questions, I wanted to remind you of our annual shareholder meeting highlight reel available on our IR website. In addition, we will be in attendance at several upcoming investor events. Margi will be attending the Canaccord Genuity Annual Growth Conference in Boston next week, and next month, we will be in attendance at Lake Street’s BIG7 Conference in New York and the Jefferies Virtual Pet & Wellness Conference. We hope to speak to many of you there. We’ll now open it up for questions.

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Q&A Session

Operator: [Operator Instructions] The first question comes from Maria Ripps from Canaccord. Please go ahead.

Maria Ripps: Great, thanks so much for taking my questions. First, can you maybe update us on your more recent progress in California with rate increases up to you sort of received the approval there. What’s the latest timeline around refiling? And is there anything different that you’re doing in terms of how you approach the filing process this time either in terms of the data that you’re presenting to the regulators, so anything else? And then I have a quick follow-up?

Margi Tooth: Hi, Maria. It’s Margi. Yes. So overall we are pleased with the progress in California during the quarter, we did get our second approval within eight months. So we’ve had two in the last eight months, the stacked rate approval is going to approximately 21%. In terms of the 13% rate that was approved in June that was based on data in November 2022. So specifically to answer your question about a different approach, what we’re doing now, once we have that second approval through and live in market, which will be effective from next week. We’ll then start working with them again on the next filing, which we’re really kind of go into the specifics related to the data that we saw coming through in Q1 and Q2 of 2023. So the last six months effectively, we’ll be able to bake into this new finding and we’ll work with them to dig into the trends we’re seeing specific to California and help to better articulate the need for the rate that we have there in the state.

But overall, I think it’s a big step forward in fixing our loss ratio. We now can increase our addressable market in the State of California, where we have more neighborhoods, which we can reignite growth in and will continue to dig into approach on lifetime pricing in California to speak that additional rate in the near future, but it’s a collaborative relationships and looking forward to that next step.

Maria Ripps: Got it. That’s very helpful. And then you mentioned 16% adjusted OI target towards the end of next year. So assuming inflation sort of remains consistent with your expectations, is this predicated on another round of approvals from a handful of larger states or do you feel like you have enough approvals under your belt?

Margi Tooth: All right. So we have — by the end of this year, we’ll have about 23% will be flowing close to 24%. Essentially what that means is we will have state approvals to hold that rate at the end of the year. So we’re not going to continue to go above that rate and I going in for more approval to expand it. What we are doing though is monitoring that cost of goods and it’s true to say that if that 15% inflation holds. We will continue to see that 24% flow through into next year, which will allow us to catch up on the 15. So if we’re getting a higher rate in 15, you start to see that margin expansion. This month just gone, we had 16.3% rate flowing through our book, which is why you saw that margin expansion, as you mentioned, if that assumption holds true and we don’t see a change in 15.

We believe that we will have sufficient rate and plans in place to get us on track by the end of next year. We will keep monitoring it, if things changed and we will adjust our approach, but we feel confident right now that we have the right plan in place to get that.

Maria Ripps: Got it. That’s very helpful. Thank you so much, Margi.

Margi Tooth: Thank you.

Operator: The next question comes from Shweta Khajuria from Evercore ISI. Please go ahead.

Shweta Khajuria: Thank you for taking my questions. So if the California rate filing, if it does not get approved or if the approval is once again lower than what you are — what you expect to file for. Could you talk about what the alternative is at that point and then or — and/or the impact on the overall book of business. And then I have a follow-up, please?

Margi Tooth: Yes. Hi, Shweta. So we – for the California rate filing right now, what the latest filing the site rate has allowed us to do as I just mentioned is really go a little bit further into California than we have been. So we very deliberately pulled back our, spend. We’re looking at where we have strong margin and in areas where we didn’t have to our margin and we weren’t hitting our target value proposition. We were giving greater that our target value proposition, we really started to pull back that growth. So we’ve been able to dig in further into California and get a little bit about growth in moving in other areas. If we do see an extended delay on the next rate approval, we’ll continue to monitor where we are effective and where we have the strong margin and we will adjust our operating approach in terms of growth strategy depending on where that rate is.