Trupanion : Q3 2020 Earnings Conference Call Transcript

Trupanion, Inc.

Third Quarter 2020 Results Conference Call

October 29, 2020

Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

C O R P O R A T E P A R T I C I P A N T S

Laura Bainbridge, Investor Relations

Darryl Rawlings, Chief Executive Officer

Tricia Plouf, Chief Financial Officer

Margi Tooth, Chief Revenue Officer

C O N F E R E N C E C A L L P A R T I C I P A N T S

Shweta Khajuria, RBC Capital Markets

Mark Argento, Lake Street Capital.

Jonathan Block, Stifel.

P R E S E N T A T I O N

Operator

Greetings, and welcome to Trupanion Third Quarter 2020 Results Call.

At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require Operator assistance during the conference, please press star, zero on your telephone keypad. As a reminder, this conference call is being recorded.

I would now like to turn the conference over to your host, Laura Bainbridge, Investor Relations. Thank you. You may begin.

Laura Bainbridge

Good afternoon and welcome to Trupanion's Third Quarter 2020 financial results conference call.

Participating on today's call are Darryl Rawlings, Chief Executive Officer, and Tricia Plouf, Chief Financial Officer. Margi Tooth, Trupanion's Chief Revenue Officer, will also be available for the Q&A portion of today's call.

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

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 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, fixed expenses, variable 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 income or margin before new pet acquisitions. 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 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'll hand the call over to Darryl.

Darryl Rawlings

Thanks, Laura. Similar to Q2, Q3 was another strong quarter with high retention rates driving accelerated growth in net subscription pet. Total revenue grew 31% year-over-year and we ended the quarter with over 804,000 total enrolled pets. Within our subscription business, new pets net of cancellations grew 30% year-over-year. Average monthly retention increased to 98.69% on a trailing 12 month basis. We calculate this has extended the average pets' lifetime with Trupanion to 76 months, up from 71 months in the prior year period. As a result, lifetime value of a pet, including fixed expenses, grew 20% year-over=- year to $615.

Adjusted operating income in the quarter was $14.4 million. Last quarter, we highlighted our intention to be more aggressive in our acquisition spend. Expansion in key metrics including retention and lifetime value paves the way for us to do so. In the quarter, we were able to deploy $12.3 million of our adjusted operating income at a calculated internal rate of return of 34% for a single average pet. Hitting the midpoint of our targeted range of 30% to 40% while deploying 40% more capital compared to the prior- year period helped drive our strong quarterly growth. Well done, team. Our ability to grow adjusted operating income while deploying increasing amounts of capital at attractive internal rates of return gives me confidence that we will be able to take advantage of this large and under-penetrated market for the years and decades to come. Since the beginning of April, we've also made good strides in both mobile and social media.

As an example, we've held four webinars that have reached an audience of over 2.5 million. We are excited to continue to build on these skill-sets within the Company. Across the organization, we're seeing the benefits of year-over-year improvements in our service levels. Since the start of the pandemic, the team has pulled together in support of our members to answer the phones and pay veterinary invoices quickly. We've seen two sequential quarters of high retention and strong net pet growth as a result. The

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

team is now tasked with not only maintaining the service levels but also incrementally improving upon them. This will be no easy task given our accelerated growth. We are going to double down on our investments in people and technology to support these efforts. Continuing to delight our members through exceptional member experience is critical to our efforts of Nirvana. In the third quarter, the GAAP to Nirvana was only 0.39. This represents a 21 basis-point improvement over the prior year period.

As a reminder, we define Nirvana as a state where existing members referring friends or adding pets offset the number of cancellations. At Trupanion, we understand the power of the pet. One of the few perks of COVID has been the transition to remote working, which has given many the freedom to bring a new pet into the household. Undoubtedly, where and how people work has changed. We are now more confident than ever that pet medical insurance as a workplace benefit should remain a positive trend for years to come. Today, we are excited to announce a strategic alliance with Aflac, the leading provider of supplemental insurance at the worksite in the United States. Those that know Aflac also know they have very strong roots in Japan with penetration in one in four households.

With as many as 9 out of 10 consumers recognize the Aflac brand, their reputation has helped them earn the trust of over 50 million policyholders worldwide. Our relationship with Aflac began over 18 months ago when their current president and CFO first visited our Seattle headquarters. In the months to follow, we came to realize that both Aflac and Trupanion share similar cultures, values, and business models. To drive alignment, Aflac has committed a $200 million investment at a price of $55 per share with a three- year lockup. Our commitment over the next several years will be to leverage Aflac's leadership position in the United States with a Trupanion product offering to unlock the potential of pet insurance being sold at the worksite. We are also committed to exploring opportunities to bring Trupanion to Japan. Aflac is a world-class organization and we feel humbled and honored to partner with them. We believe this is a good deal for both companies and we look forward to working with the Aflac team over the next several years to unlock the potential of our alliance.

With that, I'll hand the call over to Trish who will discuss our quarterly results in more detail.

Tricia Plouf

Thanks, Darryl, and good afternoon, everyone. We are pleased with our third quarter financial results which once again exceeded our expectations. Our over-performance was led by strong monthly retention and solid growth traditions in our subscription business and continued strong growth in our other business segments. Total revenue for the quarter was $130.1 million, up 31% year-over-year. Subscription revenue was $99.4 million in the quarter, up 20% year-over-year. Total enrolled subscription pets increased 15% year-over-year to approximately 553,000 pets as of September 30th.

Average monthly retention, which is calculated on a trailing 12-month basis, was 98.69% compared to 98.59% in the prior-year period. The increase over the prior year can be attributed to our improved service levels, a focus that we spoke about on our last call and have continued through the year. Monthly average revenue per pet for the quarter was $60.87, an increase of 5% year-over-year. In local currency, U.S. ARPU increased 5% and Canadian ARPU increased 4% over the prior year period. Our other business revenue which is comprised of revenue from our other product offerings that generally have a B2B component totaled $30.7 million for the quarter, an increase of 84% year-over-year.Year-over-year growth in our other business segment reflects an increase in the number of pets enrolled.

Subscription gross margin was 18.8% of revenue in the quarter compared to 19.5% in the prior-year period and within our annual target of 18% to 21%. As a percentage of subscription revenue, our subscription gross margin was comprised of 72% paying veterinary invoices and 9% on variable expenses. Pricing accurately to our 71% value proposition will require annual ARPU increases of 6% to 7% as opposed to the current year trend of 5% increases. We continue to make progress on our pricing

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

initiatives during the quarter and expect to see ARPU trends continue to increase into next year. Total gross margin was 16%, which includes our lower-margin other business segment. Total fixed expenses in the quarter were 5% of revenue, consistent with the prior year period. As a reminder, we achieved our fixed expense target of 5% of revenue in Q3 of last year and have continued to maintain scale year-over- year.

We generated $14.4 million of total adjusted operating income during the quarter and our net loss was $2.6 million. The vast majority of our adjusted operating income was generated from our subscription business during the quarter at $13.7 million. Adjusted operating margin was 14% of subscription revenue in the quarter, which is in line with our expectations but below our targeted 15% margin. With our variable and fixed expenses largely at scale, we would otherwise expect adjusted operating income to increase in line with revenue trends absent small fluctuations in gross margin.

In the third quarter, adjusted operating income grew 15% compared to the prior-year period, our rate slightly lower than subscription revenue reflecting the cost of veterinary invoices outpacing that of our ARPU growth as I previously noted. It's worth reiterating that small fluctuations in gross margin on a quarterly basis are to be expected based on the nature of our business. These fluctuations even out over the course of a year. On an annual basis, gross and adjusted operating income is largely expected to trend in line with revenue growth moving forward. This is consistent with our expectations for the full-year of 2020, which I will cover momentarily.

To further illustrate this, total adjusted operating income for the nine months ended September 30th totaled $40.5 million which is a 27% increase over the prior-year period. During the quarter, we deployed $12.3 million of our adjusted operating income to acquire over 44,000 new subscription pets resulting in a pack of $261 in the quarter, an estimated 34% internal rate of return for a single average pet. For a reminder of how we calculate internal rate of return, please refer to our supplemental financial materials on the investor relations portion of our website.

Adjusted EBITDA was $1.8 million for the quarter as compared to $3.9 million in the prior-year period. Net loss was $2.6 million or a loss of $0.07 per basic and diluted share compared to net income of $0.8 million or $0.02 per basic and diluted share in the prior-year period. Free cash flow in the quarter was $8.5 million compared to $2.9 million in the prior-year period. Operating cash flow in the quarter was $9.8 million compared to $4.7 million in the prior-year period. Trupanion's balance sheet remains strong with over $118 million of cash and investments, and ample availability on the Company's existing line of credit. At September 30th, we had approximately $29.8 million of long-term debt.

As Darryl mentioned, we are pleased to announce our strategic alliance and $200 million investment from Aflac. The proceeds from this investment will strengthen our balance sheet, reduce our reliance on debt if we were to accelerate our growth, enable us to reduce frictional costs, and allow for continued strategic and technology investments.

I'll now turn to our outlook for the full year of 2020. For the full year, we are increasing our revenue guidance range to reflect our over-performanceyear-to-date and visibility into the fourth quarter. We now expect revenue for the full year to be in the range of $498 to $499 million representing 30% year-over- year growth at the midpoint. This implies expected fourth-quarter revenue growth of 32% at the midpoint. Our full-year subscription revenue is now expected to be in the range of $386 to $387 million or 20% growth at the midpoint. This implies expected fourth-quarter subscription revenue growth of 21% at the midpoint. Our other business segment, which continues to perform well but has lower margins, is now expected to be around $112 million for the year.

At these updated revenue levels, we expect total adjusted operating income for the year to be around $57 million with approximately $54 million coming from our subscription business. Within our 30% to 40%

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

internal rate of return guardrails, we estimate allowable pet acquisition spend in the range of $240 to $260 per pet for the full year. At the midpoint, this would equate to total acquisition spend for the year of around $45 million. Also, please keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S. and Canadian currencies. For our guidance, we use a 75% conversion rate which was the approximate rate at the end of September.

Quickly, before we open it up for Q&A, I'll highlight that Margi Tooth, our Chief Revenue Officer, is joining us for today's call and will be a regular Q&A participant moving forward.

With that, Darryl, Margi, and I are now available for questions.

Operator

Thank you. At this time, we'll be conducting a question-and-answer session. If you'd like to ask a question, please press star, one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star, two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, while we poll for questions.

Our first question comes from Shweta Khajuria with RBC Capital Markets. Please proceed with your question.

Shweta Khajuria

Thank you. Two questions, please. First on the subscription debt additions, understood on great retention rates that continued through into the third quarter. Could you talk about what drove gross additions, which marketing channels worked, and anything that you could call out in terms of efficiency of marketing?

Then similar to that question, you had pointed, Darryl, in the last quarter earnings call, it takes about four to five months increased supply of pets and that you'd started hearing from the vet in July that supply was going up, meaning there were more vets. What did you hear through the quarter and did that help? Thank you.

Darryl Rawlings

Thanks, Shweta. I'll start to answer the question then hand it over to Margi.

Across the board, we saw increased leads and increased conversion rates throughout the quarter. We're seeing strong growth across all distribution channels and the effects of our increased retention rate definitely helped our net pet growth.

As far as the increase in new pets entering households, we are seeing that factor. Veterinarians are increasingly busy during Q3 and we're seeing that entering Q4. Margi, got anything to add?

Margi Tooth

Yes. I think in terms of the overall channel, the efficiency that we look at, we still have a strong core channel through the vet space (inaudible) continue. We hear the noise of how busy they are in the animal health space. I think that just reinforces the core channels and the strength we have there.

Darryl Rawlings

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

Operator, are you there?

Operator

Yes. I'm right here. I wasn't sure if she was done with her question or not. Do you have another question for our speakers?

Shweta Khajuria

I think I'm all set. I'll go back into queue to give others a chance.

Darryl Rawlings

Thanks, Shweta.

Operator

Our next question comes from Mark Argento with Lake Street Capital. Please proceed with your question.

Mark Argento

Hi. Good afternoon, everybody, and congrats on a strong quarter, but also the Aflac deal. I just wanted to maybe dive into that a little bit. Obviously big investment, I think they own roughly 10% of the Company. Maybe you could talk a little bit about the strategic plans you have. Are they going to roll out a pet product? Are you guys going to brand it? Maybe just talk to that a little bit.

Darryl Rawlings

Sure. As we mentioned in the opening remarks, we're super excited about partnering with Aflac and their $200 million investment is a strong commitment and a great part of the alliance to make sure we have the right alignment. There's really two areas of focus. One is worksite in the U.S. market and the second is in Japan. Aflac is very strong on the worksite in the U.S. market, and over the next several years, we're going to try to unlock that potential. That's going into both small, medium, and large-sized businesses, and we probably will work with them to come up with a product that is unique and identified for that channel for them. Then we'll work with them as well to figure out how we can enter and access the Japanese market.

Mark Argento

So, will there be a direct-to-consumer play through Aflac or will it all be through their worksite program?

Darryl Rawlings

The focus will be the worksite, but there may be some additional efforts and we'll work that out over the next year or so.

Mark Argento

Great. Then last question for me. State Farm, any updates on the State Farm rollout? Sounds like initially, things have been going well. Do you have any plans, I think it was available on the website, but will the agents be able to directly sell the product anytime soon?

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

Darryl Rawlings

Yes, no big updates from, I think, we mentioned the last quarterly call as well as at the shareholder meeting. Step 1 for State Farm was making sure that people entering the State Farm website naturally could have access. The second stage of that is to allow them to enroll inside of the State Farm website, and then the third stage will be for us to try to work to engage their 20,000 agents.

Mark Argento

Great. I'll hop back in the queue. Congrats again. Thanks.

Darryl Rawlings

Thank you.

Operator

As a reminder, if you'd like to ask a question, please press star, one on your telephone keypad. One moment please while we poll for questions.

Our next question comes from Jonathan Block with Stifel. Please proceed with your question.

Jonathan Block

Hey, guys. Thanks. Good afternoon. Maybe the first one, Darryl, on the pet acquisition costs of around $261 I think in the quarter versus $208 a year ago. It seems like on the incremental pets, call it year-over- year, the pack might have been around 500, and that's with a lot of progress on Nirvana that you called out, and congrats on that. Can you just reconcile the progress that you guys have made on Nirvana which, I think part of the advantage of that is it offers a very low-cost channel for pet acquisitions, versus the de-leverage that we see in the pack of $261 versus $208, and why those are, at least on the surface, supposedly at odds?

Darryl Rawlings

Yes. The way that we think about our business this year, next year, and going into the next decade is we're having increasing amounts of adjusted operating income which we want to be able to deploy the majority of it with great strong internal rates of return. For the quarter, we had a 34% internal rate of return, well in the middle of our 30% to 40% target.

When we think about our allowable pack spend, that is driven by the adjusted operating margin, the actual adjusted operating income or dollars per pet that fall to the bottom line, and then they're multiplied by the retention. As I mentioned before, the increase in our retention rate has taken us from 71 to 76 months and our lifetime value of a pet after fixed expenses has increased about 20%. This means our allowable spend to deploy greater sums of capital increases while maintaining or hitting our internal rates of return target. When I think about the next year, the next decade, we will have going from what used to be $5, $10 million to now close to $50 million of adjusted operating income, and soon to be hundreds of millions of dollars of adjusted operating income. When I can see the team be able to deploy those dollars at 30% to 40% internal rates of return, I'm thrilled. The fact that we've increased our lifetime value, which reduces the payback period time, means that it is more likely that our teams are going to be able to continue to do this at scale. Our individual pet acquisition costs on a per-pet basis as we continue to increase our lifetime value should always be going up quarter after quarter after quarter. So, that

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

allowable spend in our business model should make it easier for us to continue to grow at accelerated growth rates.

Tricia Plouf

I'll just add one thing, Jon, to that, a little bit of color, which is to what Darryl said, there's a couple of things. One is it allows us to invest more in our core channel, strengthen the moat that we have in those channels, not only for the current quarter but for the long term, as well as do new incremental things that may not manifest themselves fully within a particular quarter but will ideally, if they go well, manifest themselves over periods of time, and that gets back to what Darryl said. Those two things and those incremental investments give us a lot more confidence that we can continue to grow month after month, quarter after quarter, and year after year.

Margi Tooth

If I can answer that as well, Jon, it's Margi, just in terms of the way we think about our overall Nirvana approach and what that means from a growth perspective too, we're looking at the initial onboarding phases of a pet and a lifecycle with it too. We don't just look at that first, that let's make sure we enroll our pet; it's also making sure they have a very smooth onboarding process, which in itself helps to drive the overall approach to the growth from Nirvana perspective, so it's all wrapped up in the same thing. But just a point; sometimes, you see an immediate return on that, and sometimes, it will have a later effect further down the line, but we can move with the courage of our convictions as we see that continuing to return and always operating within those guardrails that Darryl outlined at 30% to 40%.

Jonathan Block

Got it. Very helpful. I actually have two or more questions, if that's okay. The first one, just specific to the gross adds, I'm counting gross adds up about 17%, 18% year-over-year. It's a pretty healthy number, but I would love to get your views on what the industry is growing. There were some positive commentary from an industry player earlier today on number of new pets coming to the vet channel where you have a strong hold. Maybe if you can comment on, I guess first, just the math on the 17%, 18% gross adds year over year, and how you think that compares to industry, and then I just got a final follow-up. Thanks, guys.

Darryl Rawlings

Yes. So, we think that the industry is growing revenue, not pets but revenue around 20, 21, 22%. Typically with ARPU, that's about a 17% plus 5% ARPU, 16% maybe for the category. That's what we're seeing. As you did mention, we're seeing for all of our animal health partners strong visits at vet hospitals, etc. So, we expect that to continue moving forward.

Jonathan Block

Okay. Then just a pretty broad-based third question. Trish, for you, can you comment on just DSO seem to be north of 60 versus mid-40s-ish a year ago, if you can give some color there. The AR, I asked about that last go round, but that continues to move higher. Then finally, Darryl, if you can comment on just the price for Aflac. Clearly, we see the value of the strategic investor, but the $55 per share notably below where you guys currently are and where you certainly were about a month ago, so maybe you could just talk to or provide some color on how that valuation was arrived at. Thanks for your time, guys.

Tricia Plouf

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Trupanion, Inc. - Third Quarter 2020 Results Conference Call, October 29, 2020

Sure. Just briefly on the AR and the days outstanding, that increase relates to the increase that you directly see within the other business revenue. Majority of that revenue comes from annual policies, which if the customer is allowed to have monthly payment terms, the insurance accounting puts the remaining balance as accounts receivable, even though it's not due yet. So it's not a backward-looking late payment issue and it is not related to our subscription business in any way. It's just the nature of the other business segment and those 12-month policies which, if you enrolled today, would still have 11 months remaining on them, and you would see that in AR, so when the revenue is growing, the AR is also growing.

Darryl Rawlings

John, as a take to the $200 million cash investment that Aflac has committed to, we did it at a $55 share price with a three-year lockup and we think that's a fair price for both parties considering our 90-day moving average and that three-year lockup.

Jonathan Block

Thanks, guys. Take it offline. Bye.

Operator

There are no further questions. This concludes today's conference. You may disconnect your lines at this time and we thank you for your participation.

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