U.S. Markets open in 7 hrs 18 mins
  • S&P Futures

    +36.75 (+1.13%)
  • Dow Futures

    +286.00 (+1.08%)
  • Nasdaq Futures

    +122.25 (+1.10%)
  • Russell 2000 Futures

    +14.90 (+0.97%)
  • Crude Oil

    +0.08 (+0.21%)
  • Gold

    +3.80 (+0.20%)
  • Silver

    +0.14 (+0.60%)

    +0.0007 (+0.0588%)
  • 10-Yr Bond

    0.0000 (0.00%)
  • Vix

    +6.93 (+20.78%)

    +0.0031 (+0.2395%)

    +0.0680 (+0.0652%)

    +36.75 (+0.28%)
  • CMC Crypto 200

    -9.86 (-3.61%)
  • FTSE 100

    -146.19 (-2.55%)
  • Nikkei 225

    -91.92 (-0.39%)

Lemonade Stock Is In for Turbulence. Buy Only If LMND Slides 30%

Thomas Yeung
·9 mins read

Investors looking to gamble this summer have had no shortage of options, as Lemonade’s (NYSE:LMND) initial public offering (IPO) highlighted in July. LMND stock didn’t disappoint, with shares of the loss-making insurance startup popping 138% on its first day of trading.

The Lemonade (LMND) website is displayed on a smartphone screen.
The Lemonade (LMND) website is displayed on a smartphone screen.

Source: Piotr Swat / Shutterstock.com

A short while later, however, Lemonade’s stock came back to earth a bit — tumbling 30%. These losses might tempt investors to roll the dice again. But don’t be fooled.

Lemonade has a far higher risk profile the management likes to admit. Even though shares were a buy at its IPO price of $29, here’s why investors should now wait for a better entry point.

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

LMND Stock: What Does Lemonade Do?

Before diving into the company’s valuation, let’s take a moment to understand what the Softbank (OTCMKTS:SFTBY)-backed Lemonade does.

At its core, Lemonade is a Property and Casualty (P&C) insurance company. It writes insurance policies for homeowners and renters, much like competitors Allstate (NYSE:ALL), Farmers, Liberty Mutual, State Farm and Travelers (NYSE:TRV). Much like traditional P&C insurers, Lemonade then sells part of its premiums to reinsurance companies to transfer risk (Lemonade transfers 75% of premiums while retaining 25% on its books).

What Makes Lemonade Different?

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. Of the company’s customers, 70% are under 35 according to SEC filings.

And like its fintech peers, Lemonade has seen revenues skyrocket. Net earned premiums have exploded, rising 200% in 2019 alone. Gross loss ratios have also narrowed as the company gained scale, shrinking from an eye-watering 161% in 2017 to 79% in 2019. While not yet at industry standards of 65% – 68%, it’s certainly moving in the right direction.

That’s why 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 riding a wave of excitement over all things new-tech and digital.

But can the excitement last?

Lemonade Understates Three 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. Although most P&C insurance is annually renewable, meaning actuaries can measure risks over a relatively short time horizon, the size of claims are often not known for several years.

Lemonade’s actuarial team will face 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 so severely that even two years on, 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)

And as AIG’s (NYSE:AIG) spectacular collapse showed the following year, even managers themselves can be oblivious to insurance risks even within their company.

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 US, 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.

LMND - Market share of homeowners insurance
LMND - Market share of homeowners insurance

Source: Data courtesy of Allstate 2019 Annual Report

What’s LMND 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 more lines might get added. 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 investors 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 Lemonade’s stock price 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 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 Esurance (acquired by Allstate in 2011 for $1 billion) 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.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing. As of this writing, Thomas Yeung did not hold a position in any of the aforementioned securities.

More From InvestorPlace

The post Lemonade Stock Is In for Turbulence. Buy Only If LMND Slides 30% appeared first on InvestorPlace.