Lemonade is not worth buying even at all-time lows

Growth was the only thing that mattered in the past decade. Every startup that could grow really fast could receive tons of investor capital to continue to grow. Investors didn't care much about the viability of a business model as long as the startup could grow rapidly. Why? Because the startup would go public and early investors would sell their stakes at big premiums.

The party is now over and every company is prioritizing profits over growth because losses are no longer affordable. High-growth companies with flawed business models can no longer hide behind their growth rates. Just take a look at Lemonade ($LMND), one of the most successful startups of the past decade. Its stock is down nearly 95% from the peak of the market bubble in 2021 and this year, despite the market rebound, it continues to drop 📉.

The problem with this cute insurance firm is that it has yet to prove that its business model is sustainable. Its underwriting methods don't seem to work. While it claims it uses AI and machine learning to write policies more accurately than legacy insurance giants, it continues not to make an underwriting profit.

The company has actually made some progress toward profitability, which is certainly not enough considering that it remains deeply unprofitable and continues to burn cash. Here's what you need to know about the once high-profile insurtech.

Modern UI & UX But Legacy Processes

Lemonade was founded just eight years ago to disrupt the centuries-old insurance industry. Insurance is generally perceived negatively because of the inherent conflict of interest in traditional insurance: every dollar insurance companies pay out in claims is a dollar less to their bottom line, which creates a misalignment between insurers and their customers.

Unlike traditional insurers, Lemonade is a for-profit Benefit Corporation 😇, meaning that it wants to make a profit while simultaneously addressing social, economic, and other issues. It partners with over 92 non-profits and has created the Giveback program to give a % of the underwriting profits to nonprofits selected by its community.

With its Giveback program, Lemonade wants to make insurance loveable and transform it from a necessary evil into a social good. Also, the modern, consumer-friendly app that is powered by AI and behavioral economics resonates with millennials and Gen Z customers.  

As a private company, Lemonade raised nearly half a billion dollars in just a few years to expand rapidly across the US and beat legacy insurers. There's no doubt that it has found success as it currently has over 1.8 million customers. However, there are a few issues with the company.

The hyper-growth phase is now behind us because it can no longer spend aggressively on marketing to grow. It's scaling back its marketing initiatives and for 2023 it expects growth in premiums of just 11.5% at the midpoint of the expected range. This is an extremely low growth rate for Lemonade that used to grow in the triple digits almost every year since its inception. It's a bit worrying because it shows that there's little organic growth. Instead, it relies heavily on advertising to get new customers, which is an expensive growth strategy.

Slowing growth aside, the company has serious fundamental issues and inflation is making things worse. The loss ratios are extremely high and prevent the company from making any profit. In insurance, the loss ratio is the % of premiums earned that are paid back as claims. The lower the ratio, the healthier and more profitable the insurance company. In Lemonade's case, the loss ratios are so high, that it shows they don't underwrite efficiently. As you can see below, the loss ratios have been moving in the wrong direction.

The company claims it uses AI and machine learning to underwrite more accurately than traditional insurers but this is not reflected in their loss ratios. In the most recent quarter, the gross loss ratio was 89%, meaning that 89% of all premiums were paid back as claims.

Lemonade also uses reinsurance, which is a common practice among all insurance companies to reduce risk. It transfers (cedes) a % of the premiums earned to reinsurers to limit the overall risk exposure. So after subtracting the amounts ceded to reinsurers, the total loss ratio increases to 97%, which essentially means that the company makes almost no money on the insurance policies it sells.

Inflation is one of the main reasons the loss ratios have increased in the past few years as the value of the insured items has increased. And the company needs to be approved by regulators to increase its premiums, which takes time so we're now seeing very weak loss ratios. But its own underwriting processes don't seem to work well as its loss ratios have always been higher than the healthy ratio of about 60%. If it doesn't manage to reduce its loss ratios to around 60%, it may never become profitable, given the high operating expenses.  

Deeply Unprofitable Operations Coupled With Rapidly Slowing Growth

As we saw above, Lemonade's premiums are expected to grow only between 11 and 12% this year, which is a sharp slowdown from the triple-digit growth rates of the past few years. The slowdown in growth wouldn’t be as big of an issue if the company's financials were already healthy, but they're not.  

Lemonade continues to burn tons of money because the business is barely profitable on the underwriting level. In Q4, it lost $68.1 million, slightly improved from the $68.4 million loss in the year-ago quarter. The main contributor to the operating leverage was the 27% y/y reduction in sales and marketing expenses.  

The drop in marketing expenses has improved the bottom line but this is certainly not enough as the Q4 operating margin was -72%, which is awful. The reduction in marketing will actually negatively impact growth that will slow dramatically this year.

Lemonade's financials are also negatively impacted by the recent acquisition of Metromile, another cash-burning insurtech. In Q4, Metromile contributed $15 million to the losses. Assuming that Metromile's losses will drop to around $40 to $50 million per year through synergies between the two companies, it will still negatively continue to the bottom line and will make it even more difficult for the combined company reach profitability.  

The rapidly slowing growth is a threat to Lemonade's plans to achieve operating leverage and the company is taking more risks to keep its revenue growth rates high. It has recently started to keep more of the premiums instead of ceding them to reinsurers to reduce the risk of catastrophic losses. In Q4, it ceded 58% of premiums compared to 71.5% in the year-ago quarter. This artificially makes revenue grow faster than the premiums, but it comes at a cost. Since the company keeps more of the premiums on its balance sheet, it increases its exposure to catastrophic events.

For 2023, it expects to cede 41% of the premiums to reinsurers, compared to 48% in 2022 which will help revenue to grow around 46% this year, even though premiums are expected to grow only 11%. This may seem great but in case of a natural disaster, reinsurers are not going to help much and Lemonade will have to pay the bulk of claims that will severely impact its already weak financials.  

What Else

Lemonade was the poster child of the growth-obsessed startup ecosystem of the past decade. Growth still matters a lot but now profitability, or a clear path to profitability, also plays an important role in the startup world.

Lemonade's cool app has attracted millions of customers but is Lemonade stock a good buy for this reason? Not at all. Its 'AI' capabilities haven’t provided any competitive advantage so far. Instead, its loss ratios are much worse than any other fundamentally sound insurance company. But even if it uses AI, it doesn't necessarily have any competitive advantage over the legacy insurers. The launch of ChatGPT and other AI platforms will democratize AI and all of Lemonade's competitors will be able to use them to keep their leading market positions.

On top of that, the deeply negative profitability and the rapidly slowing growth are quite worrisome. If growth doesn’t accelerate, and loss ratios don’t improve, this company will never be able to turn its deeply negative operating margins positive and it will continue to destroy shareholder value. But if it manages to reduce losses and becomes financially disciplined, we might see a turnaround.

I've no positions in the stocks mentioned.

The boring Disclosures: Newsletters express the opinion of the authors. Nothing in this email is a buy or sell recommendation. I'm not a financial advisor; make your own decisions.