Earnings Call Transcript - LMND Q3 2023

Operator, Operator

Hello, everyone, and welcome to the Lemonade Q3 2023 Earnings Call. My name is Charlie and I'll be coordinating the call today. You will have the opportunity to ask questions at the end of the presentation. I will now hand over to our host Yael Wissner-Levy, the VP of Communications at Lemonade to begin. Yael, please go ahead.

Yael Wissner-Levy, VP Communications

Good morning, and welcome to Lemonade's third quarter 2023 earnings call. My name is Yael Wissner-Levy and I am the VP Communications at Lemonade. Joining me today to discuss our results are Daniel Schreiber, Co-CEO and Co-Founder; Shai Wininger, Co-CEO and Co-Founder; and Tim Bixby, our Chief Financial Officer. A letter to shareholders covering the company's third quarter 2023 financial results is available on our Investor Relations website. Before we begin, I would like to remind you that management's remarks on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of our Form 10-K filed with the SEC on March 3, 2023, our Form 10-Q filed with the SEC on August 4, 2023 and our other filings with the SEC. Any forward-looking statements made on this call represent our views only as of today, and we undertake no obligation to update them. We will be referring to certain non-GAAP financial measures on today's call, such as adjusted EBITDA and adjusted gross profit, which we believe may be important to investors to assess their operating performance. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our letter to shareholders. Our letter to shareholders also includes information about our key performance indicators, including customers' in-force premium, premium per customer, annual dollar retention, gross earned premium, gross loss ratio and net loss ratio, as well as definitions of each metric, their usefulness to investors, and how we use each to monitor and manage our business. With that I will turn the call over to Daniel for some opening remarks.

Daniel Schreiber, Co-CEO and Co-Founder

Good morning, and thank you for joining us to discuss Lemonade's Q3 results and our updated outlook for the full year. We are very pleased with this quarter's results, including topline, bottom line and operational metrics. Starting at the top, we saw continued growth with in-force premium growing 18% year-on-year, boosted by strong marketing efficiencies and rising prices. At the same time, we also saw our gross loss ratio improve by 11 percentage points, both quarter-on-quarter and year-on-year to 83%. This continues the trend we had seen in recent quarters, which was unfortunately interrupted in Q2. Our operating expenses similarly declined by 11% compared to the third quarter of last year. As a result of all this, our gross profit increased 170% year-on-year and our adjusted EBITDA loss contracted by 39%. We are pleased with the results this quarter. This month, we expect to pass the 2 million customer mark. The comparison of our business today to when we hit the 1 million customer mark is informative. Today, with double the number of customers, we have 3.5 times as much gross earned premium, as our premium per customer jumped by 17% over the intervening years. At the same time, net loss as a percentage of gross earned premium has roughly halved. Taken together, these improvements highlight the strong progression of the business in recent years and this positions us well for profitability. This month we also marked the anniversary of our first Investor Day. In our shareholder letter, you'll find significant updates to the projections and models we shared a year ago, and I encourage you to review it. One notable highlight is that we expect to become cash flow positive by the end of 2025, and we aim to reach that point with hundreds of millions of unencumbered dollars in the bank. We anticipate becoming adjusted EBITDA positive by year-end 2026. To that end, we expect to accelerate our pace of growth considerably in 2024. We previously communicated the reasons for our slowdown this year, and as inflation subsides and rates come online, we clearly see our path to re-engaging our clusters in 2024. In our Investor Day, we discussed a 25% compounded annual growth rate as our target growth rate, and we anticipate our growth rates in 2024 will be at or around this target. Continuous and strong growth is essential to fully harness the benefits of automation, and the combined impact of automation and growth will be key to our profitability.

Shai Wininger, Co-CEO and Co-Founder

Thank you, Daniel. Before I get into some of the exciting work we've been doing with generative AI, I want to acknowledge the challenges faced by our Israel-based team members in light of the recent attacks. I want to express our collective appreciation and support for their extraordinary resilience and strength during this period. I want to assure our investors that throughout this unprecedented heartbreak and upheaval in Israel, Lemonade has continued to operate without interruption. It helps that the overwhelming majority of our team is based outside of Israel, in the U.S. and Europe. Thanks to the resilience of our distributed team and the automation we already have in our operations, our productivity remained high and our business continued to operate smoothly. Speaking of automation, I'd like to provide more insight into the advances we've made in implementing generative AI across our business processes. It's been an exciting few months working on multiple initiatives with our dedicated generative AI teams, and the preliminary impact is already reflected in our shrinking expense ratio. For instance, we've recently introduced large language models into our customer support process, where our generative AI-powered automation now handles customer emails from start to finish. This initiative is just a few weeks old and has already managed over 7% of our incoming customer service emails. This is in addition to the requests handled by AI Maya in our mobile and web apps, where AI Maya now handles one-third of all customer interactions. This is just the beginning. There are many more initiatives in progress, and we believe the percentage of processes handled by generative AI, such as answering customer tickets, will increase substantially. We are focusing our efforts on automating manual, intensive work such as underwriting property inspections by leveraging the latest generative AI image analysis technology. For example, we recently introduced a self-inspection feature that guides customers through a house tour and automatically analyzes captured images to reduce both risk and cost. With the new generative AI vision capabilities, we can determine construction quality, materials, finishes, and levels of repair. We can even read labels on water heaters and other equipment to assess their age and risk levels. These are just some examples, and we are working on dozens more, with new capabilities being introduced regularly. The rapid incorporation of these new technologies is made possible by the fact that our system was built entirely by Lemonade, with zero reliance on third-party providers. Over the past few years, we have built a modular and adaptable platform that can seamlessly integrate with new technologies like generative AI. As Daniel mentioned, our shareholder letter this quarter warrants a close read. One statistic from the letter that's worth highlighting is that in just two years, our gross earned premium more than doubled, while our operating expenses only grew by 19%. This speaks volumes about our growing efficiency and bodes well for the coming years. As we expand the scope and depth of our automation efforts, we expect to accelerate our top-line growth while simultaneously improving our bottom line. AI and automation play key roles in enabling this dynamic, charting our path to profitability and beyond. And with that, I'll turn things over to Tim.

Tim Bixby, CFO

Great. Thanks, Shai. I'll review highlights of our Q3 results and provide our expectations for the fourth quarter and the full year, and then we'll take some questions. It was a strong quarter across the board with excellent loss ratio improvement coupled with rigorous cost control, resulting in strong results that exceeded our expectations. In-Force Premium (IFP) grew 18% in Q3 compared to the prior year to $719 million. As a reminder, the third quarter is the first quarter where our year-on-year comparisons include the impact of Metromile in both the current and prior year results, as the acquisition closed in July of 2022. Customer count increased by 12% to just shy of 2 million compared to the prior year, and premium per customer increased 6% versus the prior year to $362, driven by rate increases and a shift to higher-priced products. Annual Dollar Retention (ADR) was 85%. We measure ADR on an annual cohort basis and include the impact of changes in policy value, additional policy purchases, and churn. There was some modest downward pressure on ADR this quarter from the addition of former Metromile customers in the current quarter's metric calculation for the first time. Gross earned premium in Q3 increased 27% compared to the prior year to $173 million, a bit faster than IFP growth due to the partial quarter impact of Metromile results in Q3 of 2022. Revenue in Q3 increased 55% from the prior year to $115 million, driven by the growth in gross earned premium, a 169% increase in investment income, and a decline in the proportion of premium ceded to reinsurers. Our gross loss ratio was 83% for Q3, compared to 94% in both Q3 2022 and in Q2 2023. The impact of catastrophes in aggregate in Q3 was roughly a 10 percentage point impact within the gross loss ratio. This is roughly equal to the average quarterly catastrophe impact over the last couple of years; absent the total catastrophe impact, the underlying gross loss ratio ex-Catastrophe was in line with the prior quarter and nearly 15 percentage points better than the prior year. Prior period development was roughly a 3.8% favorable impact in the quarter primarily due to pet reserve adjustments. Operating expenses, excluding loss and loss adjustment expense, decreased by 11% to $98 million in Q3 compared to the prior year. A bit of detail on the unique entries in the quarter included one-off expenses related to the Metromile acquisition. We had a notable non-recurring expense in the quarter related to a successful sublet of excess office space in San Francisco, a lease acquired in conjunction with the Metromile acquisition. This sublease of the space is a positive outcome in a challenging West Coast real estate market. The current prevailing rents are well below the market peak of 2019, resulting in approximately $3.7 million written down in relation to this transaction. We have also reserved $3 million for other potential liabilities related to Metromile operations pre-acquisition based on facts known now that were not apparent at the time of the acquisition. These expenses impact our net operating loss and earnings per share and have been excluded from our adjusted EBITDA calculation. Given the unique nature of these activities related to the Metromile acquisition, the San Francisco office lease was our only material excess real estate obligation. We're comfortable with our other existing lease obligations relative to our space needs across all our physical locations. Other insurance expense grew 25% in Q3 versus the prior year, slightly ahead of the growth of earned premium, primarily in support of our aggressive investments in our rate filing capacity. Total sales and marketing expense declined by $11 million or 32%, primarily due to reduced customer acquisition spending. Total growth spend in the quarter was $12.6 million, down from $23 million in the prior year quarter. Growth spend was about 15% more efficient in Q3 versus a year ago, due in part to lower absolute spend but also to better results in certain marketing channels. In July, we began to draw down on our loan facility, and our synthetic agents program financed about 50% of our Q3 growth spend. While the impact of the new financing mechanism is visible on the cash flow statement and in the balance sheet, we need to mention that 100% of our growth spend flows through the P&L as always. Technology development expense increased just 2%, close to flat compared to the prior year. G&A expense decreased 9% compared to the prior year. Personnel expense and headcount remained quite stable despite growth in customers and premium; total headcount is actually down about 5% compared to the prior year at 1,304. Our net loss was $62 million in Q3, or a loss of $0.88 per share, compared to the $91 million loss reported in the third quarter of 2022 or a loss of $1.37 per share. Adjusted EBITDA loss was $40 million in Q3, down from $66 million of adjusted EBITDA loss in Q3 2022. Our total cash, cash equivalents, and investments ended the quarter at approximately $945 million, reflecting primarily a use of cash for operations of $103 million since year-end 2022. It's worth noting that the total cash and equivalents and investments balance was essentially unchanged compared to the prior quarter. With these goals and metrics in mind, I'll outline our specific financial expectations for the fourth quarter and the full year. For the fourth quarter, we expect in-force premium by December 31 to be between $726 million and $729 million, gross earned premium between $174 million and $176 million, revenue between $107 million and $109 million, and adjusted EBITDA loss between $44 million and $42 million. Stock-based compensation is expected to be approximately $16 million, CapEx about $3 million, and a weighted average share count of approximately 70 million shares. For the full year, this would result in in-force premium again at $726 million to $729 million, gross earned premium between $665 million and $667 million, revenue between $421 million and $423 million, and an adjusted EBITDA loss between $188 million and $186 million. Stock-based compensation is expected to be approximately $62 million, capital expenditures about $10 million, and again, the weighted average share count for the full year will be approximately 70 million shares. All in all, a really strong quarter. It's worth summarizing the key points: cash flow positive is expected by year-end 2025, adjusted EBITDA positive by year-end 2026, continued progress on loss ratio, rate filings and approvals with more to come, and impressive efficiency with nearly flat headcount. We can look back to almost two years ago when we first spoke about our expected peak loss quarter happening in Q3 2022. Now, a year later, our adjusted EBITDA loss has shrunk by nearly 40%. Taken together, our results give us confidence that we are on the path to creating a sizable, defensible, and profitable business, and we hope you see them similarly. With that, I'd like to hand things back over to Shai to answer some questions from our retail investors.

Shai Wininger, Co-CEO and Co-Founder

Thanks, Tim. We'll now turn to our shareholders' questions submitted through the platform. I've also seen recurrent questions on Twitter, specifically from Neil, and I'll try to address as many of those questions as possible in our comments this morning and during the following answers. We received the most common question about when we expect to reach meaningful profitability. Our letter and comments earlier in the call clearly addressed that. So, I'll take the time to get to additional questions. Matthew asked about the Lemonade stock, specifically what steps are being taken to raise its value and maintain the stock? Matthew, we get this question quite often, and we understand why. The share price is not at a level we would like to see. As previously mentioned, we're not focused on the short-term performance of the stock, but rather on the long-term, and we encourage our investors to do the same. We have high conviction in the long-term prospects for Lemonade and the value we can create for shareholders. Quarter after quarter, we are delivering meaningful and significant underlying improvements to our business. As we move closer to profitability, we are optimistic that the true value of Lemonade will be reflected more fully in our stock price over time. Our next couple of questions were about Lemonade car. Darren asked what is hindering the process of Lemonade car, and others have asked for a similar update. As with any of our products, we are focused on growing profitably, expanding our book of business with healthy sales that are contingent upon getting our loss ratio to where we want it to be. As we increase rates to keep up with rising inflation, I'm happy to report that California approved a 51% rate increase for our car product. This is significant since approximately 50% of our car premium comes from California. These new rates should earn in and we expect them to yield a healthy loss ratio, allowing us to grow car faster in the coming years. Paper Bag also inquired about cost-cutting measures, noting that other insurance companies are taking actions to cut operating expenses. I appreciate the question and want to clarify that we apply great scrutiny to every initiative we're working on and to the resources at our disposal. This approach has enabled us to iterate steadily rather than make sudden and drastic changes. Over the last two years, gross earned premium grew six times faster than operating expenses. This quarter exemplifies our ability to grow while cutting costs; with IFP growing 18% year-on-year, gross loss ratio improving by 11 percentage points to 83%, and operating expenses declining by 11%. You can see that in our headcount as well. We'll end 2023 with roughly the same number of full-time employees as at the start, even as our business has grown considerably. Now, I will turn the call back to the operator to take some questions from our friends in the field.

Operator, Operator

Our first question comes from Matt Smith of Halter Ferguson. Matt, your line is open. Please go ahead.

Matt Smith, Analyst

Hi. Thanks, and congrats guys on a great quarter. Please know about our support and prayers to the team in Israel. I know it's been a very chaotic time. I wanted to touch on your LTV to CAT ratio; you mentioned pretty significant improvement, getting to greater than four in recent quarters. It looks like this is related in part to the more efficient marketing spend that Tim touched on. Can you give some additional color on what things AI is picking up to drive that LTV component of that equation higher?

Daniel Schreiber, Co-CEO and Co-Founder

Yes, I believe you highlighted the two key drivers. One is, indeed, when you spend somewhat less over time, you tend to invest in the more productive channels with higher ROIs. It's worth reminding that our pace of spending and growth throughout this year has been in the mid to upper teens by design, and we can control our growth pace by the amount of growth spend we allocate. With the addition of our synthetic agents program and our improving loss ratios, we are now at a point where we can lean in more and increase our growth spend over time. We provided some indications in the letter that heading into 2024, all these elements are aligning so we can increase spending while maintaining a strong ROI.

Shai Wininger, Co-CEO and Co-Founder

Matt, thank you for your comments of support. I also want to add that we should not extrapolate that doubling or tripling our spending would yield the same LTV to CAC ratio; it's essential to recognize the efficiency of our systems that allow us to make targeted marketing investments. The fewer dollars we spend, the greater the LTV to CAC ratio. However, we don't want to bank entirely on the current scenario. Additionally, at a macro level, the insurance industry has faced significant challenges, and we're seeing some of the largest players either exit markets entirely or drastically reduce their spending. This has created unique opportunities for us as we continue to adapt and respond to these dynamics.

Matt Smith, Analyst

Yes, that makes sense. Thanks and congrats again.

Operator, Operator

Our next question comes from Tommy McJoynt of KBW. Tommy, your line is open. Please go ahead.

Tommy McJoynt, Analyst

Hi, good morning guys. Thanks for taking my questions. Can you help bridge what changed in terms of the timing of the cash flow and EBITDA turning profitable bit sooner than you expected? Just what were the inputs exactly that drove that change?

Daniel Schreiber, Co-CEO and Co-Founder

Yes. I can comment on short-term cash flow. Our cash flow in the quarter was interesting with essentially zero change quarter-to-quarter, largely due to timing impacts from our new reinsurance structure. However, a notable cash flow benefit was present this current quarter. In terms of our longer-term view, two fundamental changes from the Investor Day a year ago are important: First, we've gained more clarity on how the loss ratio is likely to evolve due to time, rate approvals, and earnings. We now have almost five more quarters of data, which is a key driver. Second, the impact of automation and leverage is becoming evident in our operating expense lines. We've seen premium grow at a healthy pace while operating expenses grow at a much slower rate. These factors help solidify our long-term models with greater granularity and confidence and provide a expected cushion in the trough years roughly double what we anticipated a year ago. Overall, we're seeing good developments.

Tommy McJoynt, Analyst

Thanks. And then comparing the large rate increase approved in auto in California, can you talk about the trajectory of how you see that book of business diversifying over time? Obviously, there's a lot of concentration in California now, and you're continuing to roll out in new states, but you got a significant premium bump in California. Can you discuss how you see the diversification on a geographic basis playing out?

Shai Wininger, Co-CEO and Co-Founder

Yes, I would consider it an opportunistic approach. The California rate approval significantly changes our ability to grow generally in car. Our loss ratio has been improving even before that rate increase. I believe that we can be strategic about our growth not only among states but also across regions. We aim to build out our entire portfolio, not solely focusing on car insurance. Our other products, such as renters and home insurance, are also performing nicely regarding marketing efficiency, growth, and loss ratio. Therefore, though car will see an increased opportunity now in California, we remain committed to expanding all product lines sustainably.

Tommy McJoynt, Analyst

Thanks. And just my last question, from a modeling perspective, do you have an expectation for your annual catastrophe load in percentage terms or dollars, considering how much you are growing?

Tim Bixby, CFO

Yes, so we do not guide to that intentionally, but we model it. Looking at the last eight or nine quarters, you'll see an average catastrophe load of roughly between 9.5% and 10.5%. There was obviously a spike in Q2, which skews that number, but it remains consistent over the years. If you're looking at a yearly basis, that's a reasonable number to consider. Just be aware that quarter-to-quarter will have fluctuations. Q2 and Q3 of this year were notable examples; if you were just looking at weather patterns historically, you might have swapped the two quarters. The average over a year remains steady.

Tommy McJoynt, Analyst

Makes sense. Thanks, Tim.

Operator, Operator

Thank you. Our next question comes from Jason Helstein of Oppenheimer. Jason, your line is open. Please proceed.

Jason Helstein, Analyst

Hi, guys. Before my last question, I want to express our support for everyone in Israel dealing with the current situation. I have two questions, both tied to catastrophe impact. Tim, can you clarify the catastrophe impact this quarter? Just want to be sure we heard it correctly. Also, if the fourth quarter also turns out light, how would you think about reinvesting any excess back into growth or other areas?

Tim Bixby, CFO

Yes, great question. The total catastrophe impact this quarter was roughly 10 points. It was a bit skewed, slightly more towards major storms, not named storms, at about a 60-40 split. This is in line with historical averages over the last few years. Comparatively, Q3 saw a better performance from both a hurricane and home product perspective. If the upcoming quarters yield lighter results, we would consider the ability to redeploy that upside or incremental margin into growth. It's challenging to predict the impact in any given quarter since timing of catastrophes can vary significantly.

Shai Wininger, Co-CEO and Co-Founder

Hi Jason. I want to add that, while we appreciate the kind words of support, it's essential to recognize that catastrophe events are unpredictable. We encourage everyone to focus on the long-term trend rather than on short-term fluctuations. We always prepare for the possibility that the next quarter may differ significantly. Our reinsurance provides us a cushion against the worst shocks in terms of EBITDA impact. If we have several good quarters, it does give us room to consider how to reinvest wisely, but we also remain prudent in our planning.

Jason Helstein, Analyst

Thank you.

Operator, Operator

Our next question comes from Andrew Anderson of Jefferies. Andrew, your line is open. Please go ahead.

Andrew Anderson, Analyst

Hi, good morning. I think you mentioned the ex-CAT gross loss ratio earlier, which was 73% in the quarter. This is consistent with first and second quarter results. I'm curious why we haven't been seeing a little more sequential improvement. Could this be impacted by seasonality or the lagging timing of earned rates?

Tim Bixby, CFO

Yes, the ex-CAT gross loss ratio does experience some fluctuations. We don't expect improvement every single quarter. We have seen some ups and downs in Q3. The net impact this quarter was better due to the combination of previous loss ratio improvements, which influence the overall numbers. Segment by segment, we're making steady progress. We have seen adjustments in car and continues improvement in claims performance through rate changes and efficiency. As we implement new rates, these will push the figures up even more, supporting overall growth in performance moving forward.

Andrew Anderson, Analyst

Got it. And could you clarify, did you have the catastrophe losses reported previously on a net basis too, as well as the 3.8 points of favorable prior period development? Was that on a net basis?

Tim Bixby, CFO

Yes, gross and net impacts tend to be very close but not identical; it's been consistent for some time. The prior period development that was favorable was primarily driven by CAT reserve benefits this quarter. The overall prior period development figure for the quarter was approximately 3.8% favorable. The impact from the prior year development is smaller and typically varies based on prior periods and factors in question. Happy to discuss more if needed.

Andrew Anderson, Analyst

Great, thank you.

Operator, Operator

Thank you. At this stage, we have no further questions. Therefore, this concludes today's call. Thank you all for joining. You may now disconnect your lines.