Trupanion, Inc. Q2 FY2022 Earnings Call

Good afternoon and welcome to Trupanion's second quarter 2022 financial results conference call. Participating on today's call are Darryl Rawlings, Chief Executive Officer; Margi Tooth, President; and Drew Wolff, Chief Financial Officer. Similar to prior earnings calls, Tricia Plouf, Chief Operating Officer, will be available for the Q&A portion of today's call. 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 provision 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 is 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 U.S. GAAP. Investors are encouraged to review the 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 call is also available via webcast on Trupanion’s Investor Relations website. A replay will also be available on the site. With that, I will hand the call over to Darryl.

Thanks, Laura. Good afternoon. Q2 revenue was up 30% year-over-year. More importantly, our adjusted operating income, or the profits we earned from our existing pets before we invested in growth, grew approximately 13%, or 16% on a constant currency basis. We invested about $20 million acquiring new pets at an estimated 31% internal rate of return, an additional $2 million in development expenses, and nearly $6 million repurchasing shares of our common stock. With the strength of our balance sheet and available cash, we are well capitalized to invest in areas where we can achieve strong rates of returns. In our large underpenetrated market, investing compounding amounts of adjusted operating income at our high internal rates of return is the key to our value creation. In the quarter, we added over 61,000 new pets. For context, this is up about 10% year-over-year and up about 14% from year-end. Growth was driven by leads and a modest improvement in conversion. In the quarter, we also soft launched Chewy, rolled out the Aflac offerings to brokers serving larger companies, and made progress internationally. We're humbled by the trust these partners have placed in us and are excited to see how these partnerships play out over time. But what I'm most excited about is that after years of shouting from the rooftops that veterinarians should be raising their prices faster, we are finally starting to see it in our data. This is very good news, most notably for veterinarians and their staff, but also for Trupanion. I'll elaborate. Over the course of the past year, we've been monitoring veterinary inflation at an extremely granular level. Earlier in the year, we highlighted a return to pre-pandemic frequency, or the number of veterinary visits per pet for accident and illness. In the past month or so, we've also begun to see an accelerated increase in the size or dollar amount of the average invoices we are receiving. The combination of invoice size, what veterinarians charge, and the frequency of accidents and illness related to veterinary visits makes up our cost of claims. For the last 22 years, this veterinary inflation has increased approximately 5% to 6% per year for Trupanion members. Today, we're seeing the overall cost of care for many veterinary hospitals increase 8% to 12%, or approximately twice that of the historical rate. We expect and hope this will continue to increase in the range of 10% to 15% for at least the next 3 to 4 years, so veterinarians and their staff can be paid appropriately and in line with other medical professionals. Our 20-year track record shows that we're pretty good at pricing in line with our value proposition. More importantly than that is hitting our target for adjusted operating income. Doing both is not easy, and the team will need to remain focused and deliver. It is important to note, our mix of business will continue to influence our reported ARPU, which is a blend of all subscription pets. We are not saying that people should model or expect blended ARPU to grow 10% a year. For example, a higher mix of new cats means a lower blended ARPU. More pets enrolling through the worksite will mean a lower blended ARPU. More pets enrolling from parts of the world with lower veterinary costs will mean lower blended ARPU. Our blended ARPU is simply an output. For that reason, we believe our ability to operate the business effectively can and should be measured by our adjusted operating margin. In the quarter, our adjusted operating margin was approximately 13% compared to our annual target of 15%. As Q2 shows, we don't always time things perfectly, nor would I expect us to. Drew will elaborate on this more momentarily. That said, if I don't see an expansion in our adjusted operating margin in the back half of the year, I would be disappointed. Short term, margin compression is evidence of additional inflation. This environment creates a unique opportunity for Trupanion. With our cost-plus model, the rising cost of veterinary care drives higher ARPU and pet lifetime value over time, increasing our allowable acquisition spend and supporting continued investment in the category. With rising costs also comes a greater need among pet owners to find a solution to help them budget for the unexpected costs of accidents and illness. That is why we exist. I believe and expect that we are, and will continue to be, exponentially better, faster and more accurate than others. In fact, Trupanion's decades of growth has benefited from the cost of veterinary care outpacing the growth of pet owners' bank balances. Now, let's pull back a little and look at the big picture. Parents universally agree that food, shelter, quality health care, and love are the bare necessities for our human children. For the majority of pet owners, particularly our Trupanion members, our four-legged children have the same basic needs. We believe the combination of these bare necessities currently makes up less than 50% of a pet owner's annual pet spend, with veterinary health care being approximately 1/4 of a pet owner's existing share of wallet. If veterinarians were to raise their prices in line with my hopes and expectations, this would not necessitate an increase in monthly pet spend for individual households. Said another way, pet owners could reallocate spend from discretionary items like pet clothing and doggy day care if required. Already, our category is accelerating. Last year, the category added over $650 million in revenue, up from $450 million in the prior year. We believe Trupanion led the category, adding about 30% of its growth. I’ll now turn the call over to Margi, Trupanion’s President, to talk more specifically about the significant opportunity ahead of us.

Thank you, Darryl, and good afternoon, everyone. I want to take a moment to elaborate on Darryl's commentary around why our trusted partnership with veterinarians is critical to the opportunity we have in this large underpenetrated market. There are times when something happens in the world that exacerbates the problem we, Trupanion, are trying to solve. We faced an even greater duty to step in and make a difference. Today's inflationary environment with mounting economic uncertainty and increasing pressure on our veterinary partners is one of those times. We partner with veterinarians to ensure that pet parents are able to provide for their pets' unexpected care. Today, those trusted stewards of veterinary teams are struggling more than ever before, burdened with the rising cost of care, overwhelmed, tired, and stressed; veterinarians have been pushed to the point of burnout. Couple this with a backdrop of rising inflation and the fact that today, the majority of pet owners cannot afford more than $1,400 in unexpected veterinary costs. The threshold for economic use in the U.S. is that low. The rising cost of care will only make it more difficult for the average pet owner to budget for the unexpected, and veterinarians still need to raise their prices. We're starting to see early signs of this increase come through in our data. But it's not enough, and we need to be prepared for this to be much higher. As Darryl noted, in the next 3 to 4 years, veterinarians are going to need to raise their prices in aggregate by 30% to 50%. A few pet owners can currently afford unbudgeted veterinary bills, and even fewer will be able to in the future. With this backdrop, let me walk you through how our value proposition is now more relevant than ever. To start with, we help pet parents budget for the cost of unexpected veterinary bills for the life of their pet. We make it affordable for our members by breaking the cost of care into small monthly payments they can adapt to. Because of our unique pricing at the age of enrollment, we are the only player to offer lifetime coverage. The monthly cost doesn't increase because the pet had a birthday. This is unique in the industry globally. As veterinarians raise their prices, which they will do, our vertical integration and local support through our territory partners, 20-plus years of veterinary data, and unmatched team of actuaries position us ahead of any other player in the industry. Moreover, we are ending the need for reimbursement. Pet owners must understand how paying the vet directly means an end to reimbursement. Our solution has never been more relevant. High-quality insurance should not leave you waiting for a decision, and Trupanion does not. We are paying veterinarians directly more than ever before, enabling them to operate more sustainable businesses. No more time spent on estimates or fees for credit card payments. Year-to-date, total invoice dollars paid directly to veterinary hospitals were up 20% over last year. The majority of these had payments approved in seconds, comparable to, if not quicker than that of a credit card. We want to empower veterinarians to offer and practice the best medicine, removing the emotional toll of heart-wrenching decisions forced by financial constraints. And finally, we will continue to be there 24/7, 365 days a year for both the lucky and the unlucky pets. We remain steadfast in our mission. Through our business model, we are able to reach and educate veterinarians and pet owners alike to offer high-quality medical coverage for the lifetime of a pet and to change the paradigm of pet health forever. Drew?

Thanks, Margi, and good afternoon, everyone. Today, I'll share additional details around our Q2 performance as well as share some thoughts on how we're tracking against our annual goals. Total revenue for the quarter was $219.4 million, up 30% year-over-year, driven by strong pet additions and sustained high levels of retention in our subscription business, along with continued growth within our other business. Within our subscription business segment, revenue was $145.8 million, up 21% over last year. In the quarter, the U.S. to Canadian foreign exchange rate had a larger than typical impact. On a constant currency basis, subscription revenue would have been $147.3 million. Total enrolled subscription pets increased 20% year-over-year to over 770,000 pets. Average monthly retention, which is calculated on a trailing 12-month basis, was 98.74%, equating to an average life of 79 months. This is compared to 98.72% or an average life of 78 months in the prior year period. Monthly average revenue per pet was $64.26, an increase of 0.9% year-over-year. On a constant currency basis, the monthly average revenue per pet increased 1.8% year-over-year and continues to be impacted by the mix of business dynamics that we've previously discussed. Our loss ratio expanded 170 basis points from the prior quarter to 72.8%. While some level of variability is expected, this move is larger than typical and is the result of three factors all occurring in the same quarter. I'll explain. First, frequency was the largest driver of the increase in our loss ratio, as we've discussed at the shareholder meeting. Secondly, elaborating on Darryl's point regarding timing, we had higher claims processing costs as we continued to staff up for business expansion that will yield cost efficiencies in the back half of the year as we bring on new business. And finally, at the end of the quarter, we saw an uptick in the severity of claims. We will continue to monitor data at an extremely granular level and adjust pricing as needed in order to hit our target margins. As a percentage of subscription revenue, variable expenses were 9.9% in the quarter, reflecting continued investments in our member experience, including additional staffing in advance of new product launches. We expect to leverage these pre-revenue investments now that we are actively in the market. Fixed expenses were 4.3% of revenue. After the cost of paying veterinary invoices, variable expenses, and fixed expenses, we calculate our adjusted operating income. Relative to Q1, we took actions to drive operating leverage to partially offset the increase in our loss ratio. Nonetheless, our subscription adjusted operating margin was 12.9% in the quarter, down from 13.8% in the prior year period. We continue to monitor veterinary inflation and are working to push through pricing based on current rates of inflation. With additional cost actions, we expect to drive sequential expansion in subscription adjusted operating margin in both Q3 and Q4 and aim for Q4 to be in the range of 14% to 15%. In dollars, our subscription business delivered adjusted operating income of $18.8 million, an increase of 13% over the prior year period. The aforementioned year-over-year change in foreign currency impacted adjusted operating income by approximately $600,000 in the quarter. 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. Total revenue was $73.6 million. Compared to the prior year quarter, this is an increase of 54% year-over-year, reflecting an increase in pets enrolled within this segment. Adjusted operating income for the segment was approximately $2 million. As a result, our total adjusted operating income was up 13% over the prior year period to $20.8 million. While we do expect some variability quarter-to-quarter, we are running behind the 25% annual growth target outlined in our 60-month plan. I will discuss this more momentarily. During the quarter, we invested 18% more year-over-year or $20.2 million to acquire 61,000 new subscription pets. This resulted in a pet acquisition cost of $309, with an estimated 31% internal rate of return for a single average pet. We also invested $2 million in the quarter on development costs. These are pre-revenue, non-capitalized costs related to new products, channels, and international expansion which we expect will add additional long-term growth levers. As a percent of revenue, development expense was 92 basis points in Q2, a step-up from recent quarters, reflecting activity ahead of the Chewy and Aflac product offering launches as well as some additional international investment. Now that we are in market with these products, we expect to drive development expense back towards 0.5% of revenue by year-end. This resulted in an adjusted EBITDA loss of $1.7 million compared to an adjusted EBITDA gain of $0.2 million in the prior year quarter. Interest expense totaled $1.2 million in the quarter. Total stock-based compensation expense was $8.5 million, in line with our expectations. We also repurchased approximately $5.8 million in our common stock in the quarter. As disciplined allocators of capital, we will seek opportunities to invest where we can find attractive returns. This includes repurchasing our own stock during periods where we believe our market valuation reflects a deep discount to estimated intrinsic value. We will do so in a prudent manner, always balancing our capital needs with our growth projections. As a result, net loss was $13.6 million or a loss of $0.33 per basic and diluted share compared to a net loss of $9.2 million or a loss of $0.23 per basic and diluted share in the prior year period. Turning to our balance sheet, we ended the quarter with over $243 million in cash, cash equivalents, and short-term investments, which is up from approximately $213 million at the end of last year. We held approximately $54 million in debt with $90 million available under our long-term credit facility. With the strength of our balance sheet, we believe we can comfortably fund several years of accelerated growth while also maintaining flexibility to repurchase shares or pursue strategic M&A when we believe the opportunity is compelling. In terms of cash flow, operating cash flow was negative $3.1 million in the quarter compared to negative $2.2 million in the prior year period. Capital expenditures totaled $3.9 million in the quarter, and as a result, free cash flow was a negative $7.1 million. As highlighted in our 60-month plan, it is our goal to deliver 25% year-over-year growth in adjusted operating income. Last year, in the first year of our 60-month plan, adjusted operating income grew 37%. Currently, we expect to grow adjusted operating income in the range of 15% to 20% for this year. With the backdrop of rising costs of care and a growing need for Trupanion in North America, as well as additional distribution channels, products, and international expansion, we believe 25% growth in adjusted operating income remains the right target. This will continue to be our goal for 2023 through 2025. Now, I’ll hand it back over to Darryl.

By the numbers, it was a mixed quarter for execution. As I've said before, execution is tough. But when I look at the thousands of public companies one can invest in during times of uncertainty and inflation, and given current market sentiment, I believe our love affair with our four-legged family members and our large underpenetrated market, high retention, and lifetime value of a pet make us stand out from the crowd. And with that, I'll open it up for questions.

Our first question today is coming from John Barnidge of Piper Sandler.

I wanted to talk about the subscription loss ratio, which came in about 170 basis points above the target of 71%. I know you talked about getting down to the 14% to 15% AOI margin for the fourth quarter. But Drew, you had talked about some scale economies that maybe offset some of that elevation in the loss ratio. So I wanted to circle back to that target. Are you expecting to exit Q4 ‘22 close to 71% again?

Yes, we're expecting to get closer to 71% with additional cost action across fixed, variable, and loss adjustment expense to produce that 14% to 15% adjusted operating margin.

Okay. And then what was curbside versus a quarter ago in vet clinics, please?

Could you repeat that again?

Yes; so curbside only at vet clinics. I know that’s a dynamic that certain vet practices have decided to keep even in a post-pandemic world. Can you maybe talk about vet hospitals or clinics that you’re in that maybe have your software? What percent of those remained curbside only versus a year ago or a quarter ago?

Curbside service is still observed across hospitals in our markets, although it has become more of an exception than the norm compared to last year. Hospitals have adjusted their processes to welcome patients back, allowing them to discuss high-quality medical insurance. Recently, we have not noticed an increase in curbside usage. However, our software and vet portal usage has risen, with a 20% year-over-year increase in utilization rates throughout the quarter. More veterinarians are adopting our software and using it more frequently. As patients return to hospitals, curbside service is becoming less common.

Now, just one thing to add on that, John. Curbside is one thing that affected pet owners. As Margi said, that's largely diminished. The bigger part for us is our territory partners. We’re often not able to walk into the hospitals, and they're now able to walk through the doors, and that's been a big benefit to the company.

And maybe one last question, if I can. Are you seeing any signs in the wake of inflation that insurers are choosing to maybe move from lower deductible, higher monthly ARPU to higher deductible lower monthly ARPU?

I can certainly start that, and others may want to add to it. We've actually been looking at our deductible trend as we always see across the board for everything on a very regular basis. Our deductibles have actually been trending down. We've seen that coming through throughout the quarter, from the back end of Q1 into Q2. So that means both on phone and web, people are taking a lower deductible, which is obviously contrary to the high deductible that you just questioned about there. People are seeing the value. As we’ve said before, people are very value sensitive. This does not differ across markets or different channels; our deductible point is coming down.

The next question is coming from Shweta Khajuria of Evercore ISI.

Okay. Let me try a couple, please. So what is the adjusted operating income growth rate guidance included in terms of the cost? Could you please break it down in terms of your expectations, whether it is investments, loss ratio, etc.? Just a little bit more? And then the second question is, how should we think about the contribution from the lower-priced products in the back half of this year as well as contribution from the Chewy partnership and other incremental growth channels?

Sure. I'll begin with the first question and then pass on the second one. The guidance on adjusted operating margin reflects actions across the board. Our loss adjustment expense will need to decrease. We will achieve additional scale on fixed costs and make adjustments in variable costs, along with implementing pricing changes on the revenue side to help return to our target loss ratio. This is included in the 14% to 15% range.

Okay. Then for the second question, in terms of contribution from lower-class products in the second half, PHI and the products that we have in market right now, we have been disappointed with the overall progress of those products in general. We have changed our overall positioning in terms of having two general managers that are now responsible for driving that growth. We don't anticipate a significant impact from them in the back half of the year. What I will say is that Chewy and Aflac have launched in the market, and we’re very happy with the early stages of that. We are humbled by the fact that we’ve earned the trust of these two brands to be able to partner with Trupanion. We don't anticipate seeing anything more than single-digit growth in the back half of the year with these two products. As a reminder, as the monthly subscription revenue product, we're not going to see the bulk of that impact coming through, as we just start to get those rolled out in early stages. But we do anticipate seeing some impact, albeit minimal, in Q3 and Q4.

The next question is coming from Josh Shanker of Bank of America.

So during the Annual Shareholders Meeting, you threw out a statistic in May about 352 software installs. I don't think you want to go updating that number every month. But maybe we can talk about whether that sort of trend is continuing, whether that was a blip or not? What's happening in terms of face-to-face interactions? How is that trending with the territory partners in the veterinarian clinics?

Yes. So you're right, Josh. We won't go into details about how that number, that 352, has continued to scale. But I can tell you it continues on that same trajectory. We’ve been very happy to have that visits back at the levels that we were seeing back in 2019. We have more people in the field than we ever had before, and they can now walk in the doors of hospitals and rekindle those relationships. This adds to face-to-face interactions, which reinforces the need for high-quality medical insurance and our ability to be there at the time of need. This bolstered local support helps ensure that we are investing effectively and leads to stronger conversion rates. So we're very happy with the fact that we've been able to get back into the hospitals. That trend started at the back end of Q1 and has been maintained through Q2. We continue to see this happening in Q3 as well.

Yes. And I'll just add that with all the general talk of inflation for non-veterinarian services being even more acute in the veterinary space and us seeing that in some of the numbers, it provides real strong talking points for our territory partners, creating urgency and facilitating their presence in veterinary clinics, which has been great for the business. I'm super happy to have them back in the field.

And then if I look at the Investor Relations on customer acquisition cost at 31%, it's getting close to your lower bound of 30%, which suggests maybe the efficacy of customer acquisition spend is weakening? Look, the growth is great in terms of subscription pets. But do we get to that point? Are we at that point maybe where some of the ad spend doesn’t make as much sense some of the marketing spend because you just can’t get that 30% return?

So our IRR is between 30% and 40%, and that doesn't change quarter-over-quarter. When we think about the impact of that, we still see margin compression through the quarter. What we were doing is we saw that coming, and the team for reacting they’re communicating with each other and adjusting their spend profile. So it did put pressure on it and bring it closer to the 30% mark. Overall, though, when we look at our channels and the efficacy, it's strong as ever. The volume is strong, and conversion rates are high, so we don’t have any concerns.

The next question is coming from Katie Saki of Autonomous Research.

Inflation is rising, and your ARPU isn't growing much sequentially. So can you just walk us through why you think you'll get back to a 71% loss ratio?

Yes. This is Tricia. I can address that. At a high level, the ARPU reflected in our consolidated financials is an outcome, specifically of our pricing strategy aimed at achieving that 71% target. As I mentioned during the shareholder meeting, we continuously analyze the data on a granular level, including geography, neighborhood, breed, and age of enrollment, and we frequently adjust our pricing. In many regions and neighborhoods, we've seen price increases ranging from 5% to 10%, with some going even higher. Conversely, in certain areas where we’re operating below our loss ratio target, we've been reducing prices. The ARPU in our financials represents a mix of these changes. Our goal remains to reach a target of 71%. As Drew noted, we are currently adjusting pricing. Given our long experience in this area, we are confident that although the timing of adjustments may vary, we can closely align with our value proposition.

As a follow-up, with inflation running at say, 8% to 12% in the vet channel, can you give us an idea of what Trupanion’s rate increases are looking like today on a nationwide headline rate?

At a macro level, we're seeing in the first half of the year, our ARPU is going up 1.4%, and our claims per pet is going up 1.5%. We've been doing, while there's some timing variation between quarters, a good job at maintaining that gap, although we need to make up about a 1% delta. When filing rate increases, as I said, the vast majority of our book is seeing rate increases between 5% and 10%. It's just offset on a blended basis with regions and breeds where prices were decreased.

Yes, and Katie, I mentioned in my opening remarks, our blended ARPU is an output. It will be what it will be. We hope that workplace and a bunch of other places really can start to make an impact in the back half of the year. Some of these were expecting that lower ARPU, so on a blended basis you may see that it's not tracking what you might otherwise expect with these inflationary comments.

Our next question today is coming from Maria Ripps of Canaccord.

If we are indeed going to see a 10% to 15% increase per year in like-for-like costs of vet care over the next 3 or 5 years, I think you said. That obviously compounds over the years. How do you think about your capacity to increase prices for your members without impacting retention?

We've been doing this for over 20 years, Maria. We know and we've been tracking in our shareholder letter. If we're seeing rate increases in the 10% to 15%, our retention rates and conversion rates remain the same. When we see it over 20% year-over-year, we see it degrade slightly. When I said it's going to be 10% to 15%, that's what I hope the veterinary community will do so that they can pay their employees and veterinarians appropriately compared to other medical professionals. I'm not guaranteeing it will happen, but we certainly hope that they will. We know that members can afford to pay for that care when it's budgeted and broken into monthly payments. We have no concerns with it and are excited to see if it happens.

That's very helpful. And then secondly, on your recently announced partnership with ezyVet, could you maybe provide some additional context on how this offering is different from the core software integration? What other benefits are being addressed by these partnerships so that thousands of additional hospitals are now able to integrate the software?

Maria, this is Margi. The partnership with ezyVet is essentially a full integration within their overall platform within the practice management system. What that does is many folks migrated to ezyVet a couple of years ago that had been working with Trupanion historically. Before this, we didn't have that full integration embedded, and now we do. So we have access to hospitals we've historically worked with. We also have quite a lot of members who are Trupanion members, as well as those that have onboarded with the cloud-based software that ezyVet is. This gives us access to hospitals that have partnered with us for a long time, some of them very large and some new. So when we think about our practice management approach and how our penetration rates are increasing across the North American market, ezyVet really opens up access to a lot of hospitals, enabling us to pay them directly and solve existing problems.

Our next question is coming from Jon Block of Stifel.

Maybe just 2 for me. Just first on the gross adds. I just want to look back the past 6 quarters or so; it looks like the gross adds trend line has somewhat flattened out, 55,000 to 58,000 give or take, for 2021 normalized for a quarter and then 61,000 in the first half of '22. So Darryl, there’s sort of that anecdotal chatter that pet adoptions might be starting to subside from, call it, pandemic highs? I think the majority of your gross adds come from puppies or kittens. Just want to love your thoughts on that. More importantly, that trend line going forward, I think as a growth company, people really have that inflection in '23-'24. So how do we think about that gross add trend line going forward while arguably adhering to your 30% to 40% Investor Relations?

Jon, I think when I look at; we're a monthly recurring revenue business. If I look at our total subscription pets, which is how we get our revenue, over a period of time, in '17, '18 and '19, our growth rates were about 15%. In 2020, it grew to 17%. In '21 and '22, it's going to be between 21% and 22% and total subscription pets. With monthly recurring revenue, sometimes you're accelerating new faster, sometimes retention is faster or slower. But when I look out to '23, '24, '25 for the company, we not only have strong growth driven by veterinary inflation and our territory partners walking through the door. In our 60-month plan, we talked about additional channels that are coming online. A couple launched last quarter and will start to make an impact in Q3 and Q4. I'm really excited about the work we're doing internationally that we expect will start to take hold in '23 and '24 as well. As a company, I monitor the total subscription pets. I monitor the year-over-year increase in adjusted operating income. Our goal is to grow that 25% a year for each year in our 60-month plan which started in '21 and will end in '25. In the first year, we grew greater than 25%. Over 30% actually. As Drew mentioned, we think our adjusted operating income will probably not hit our growth target of 25%, but we believe we will grow 15% to 20%. If we grow 20% to 25%, I’ll be thrilled. I'm happy there. If it's over 25%, I'm ecstatic doing backflips. We’ve got a lot of things in the pipeline, so I’m encouraged about the future.

Can I add as well to that, Jon, just in terms of future trends? When we think about the vet traffic specifically, we’re coming off the back of a tough comp year-over-year with the overall pet count. To Darryl's point, we've seen things moving positively from an overall trend for retention and acquisition. Being back in the hospital, able to offer high-quality products through the vet channel and having our territory partner side, support during this critical time has been paramount. I am very positive about the numbers that we're seeing coming through in the early stages of Q3 and the back end of Q2, meaning that the vet channel traffic, our real growth driver, is looking very strong now.

And then just a second question, maybe a little long. It’s going to end with more of your opinion on something, Darryl: but ARPU is up about 1% year-over-year, so modest, well below the rate of inflation, which I think you said is now 8% to 12% in the veterinary world. Just try to catch up on that on the pricing, I get it. But I think what you’re saying is that the newer pets coming on, maybe puppies or kittens or alternative channels are lower ARPU pets. Let me sort of pause there. Is that correct?

There are two things I want to clarify, Jon. I mentioned there's an 8% to 12% increase among some veterinary hospitals, not all. We're starting to see larger price increases in total invoice dollars, not invoices paid; that’s the first place we look for inflation. Our total invoice dollars are going up 5% to 6%. There was a question earlier regarding deductibles; they’ve actually been going down. But if deductibles were going up, that would change your cost of claims and what we’d be charging. The blended business impacts us, and it is true that we are enrolling more younger pets consistently. However, if we take a city and cut it in half, and one half is at an 80% loss ratio and the other at 60%, we had an average of 70%, what has happened is faster growth at 80% and slower at 60% when we made them both equal at 71%. So you've seen accelerated growth in the lower-priced neighborhoods and a slowdown in the higher price in comparison. Our goal is also to grow, get strong IRRs, refining pricing and changing the blend. In the past, it’s been easier to track financials. Now it’s hard to predict the blend. But good managers monitor adjusted operating margin, year-over-year growth in adjusted operating income, and our ability to deploy at outsized internal returns.

Yes. And Jon, also when we set that up, I mean, it's important that people can replicate our numbers. It's set up so you could take our financials and back into that without having to know new ARPU. It's foundational, so there’s a transparency aspect.

This may have been asked earlier. I might have just missed it. But just want to get your general sense of trends in ARPU and what the impact would be on churn? More specifically thinking about the two buckets; the historic lack of experience price increases, which is about 25% of your book, and then the smaller bucket where there have been in excess of 20% price increases. Curious if you think that change in either of those buckets could have more outsized impact given we’re looking at much higher overall rates of inflation?

It's a good point for those who haven't read the shareholder letter. We're largely seeing three tiers of churn. First, we have the new pets with no rate change, which churns the highest. Second, we have about 70% of our pets seeing less than a 20% increase, which has the highest retention. Finally, some pets are experiencing greater than a 20% increase which is a medium level of churn. Historically, we report all of this. Right now, retention is at an all-time high of 98.74%, and conversion rates are slightly up. Referral and Adapet also are producing record numbers. Customers we attract aren't price-sensitive, but they are value-sensitive. Particularly complex insurance market growth is essential in times of uncertainty and inflation.

I wanted to ask a question on the PAC number in the quarter and trends in PAC. Do you think you could provide a little bit more granularity on what might be driving that? And I think you've provided some detail in the past, giving us a rough split between allocation between lead generation and conversions, with more dollars going to conversions over time. Wondering instead if the relative rate increase in those two categories is essentially equal or if you're seeing the cost of conversion go up at a higher rate than lead generation but maybe just a little bit more insight into the increase in the PAC number this period?

Yes, this is Margi. When we think about PAC generally, if we look at it over the last few quarters, it's been relatively flat. In Q4 of '21 it was 3.06%, Q1 is 3.01%, and Q2 was at 3.09%. When we look at it overall, there's really very little movement between quarters. The real guiding metric for us is the internal rate of returns which has been between 30% and 40%. Our overall split between convert and retention generally has not changed much over the last few quarters. We’re constantly looking at how we ensure we optimize spend for our message and timing. There are many different elements to the journey that guide someone through the funnel. So, in general, it hasn't significantly shifted recently.

Yes, the productivity is key. We’re always monitoring and adjusting as we see trends in our acquisition, looking at our margins and adopting strategies based on those insights. The uptick in severity of claims is significant. It’s not confined to any specific region, but it’s an increase across the board as we've seen in our data.

Ladies and gentlemen, that's all the time we have today for questions. We would like to thank you for your participation and interest in today's Trupanion event. You may disconnect your lines and walk off the webcast and enjoy the rest of your evening.