Cimpress is a fine business that has been in search of strategic direction for the last 6-7 years, groping for the right balance between value-added customization and low-cost production.  These two sources of differentiation are often at odds because the scale economies required to claim a cost advantage depend on running lots and lots of volume across significant fixed costs, a process that is best suited for homogeneous products that share a common manufacturing base and process.  You can imagine casting a single widget SKU over and over again.  There are no incremental set-up costs from line changeovers.  The assembly line just keeps humming as long as it can, spewing a stream of identical widgets onto a continuously flowing conveyor belt, the upfront cost of heavy equipment diffused over more and more manufactured units.  At the other extreme, a stylist’s average cost per haircut stays roughly the same, whether he does 20 haircuts a day or 30. Of course, most jobs fall somewhere between these two poles.  Cimpress (originally known as VistaPrint), which makes a variety of customized physical marketing materials – business cards, signage, apparel, gifts – for mostly micro business with fewer than 10 employees, claims that it can capture the benefits of both differentiation and low-cost (“mass customization”):

Source: Cimpress Business cards are a perfect use case for mass customization because from the customer’s perspective, a set of business cards, tatooed with a unique logo and font, is unique; but from Vistapint’s perspective, the core manufacturing process and materials required to produce them is essentially the same across all customers.  And after its founding in 1995, Cimpress spent the first dozen or so years of its existence focused on paper-based products…business cards (where it remains dominant) postcards, brochures, presentation folders, data sheets, and the like, predominantly in North America. Volume brought scale, scale compressed average unit costs, profits from cost advantages funded VistaPrint’s strategy, which was to litter inboxes with cheesy marketing campaigns offering something like business cards or return address labels for free and drawing customers to the website, where they could then be cross-sold other products and bamboozled with exorbitant shipping costs on the check out page (after they’d already spent the time designing their items and were psychologically committed to the purchase). 

Today, Vistaprint prints 6bn business cards a year, one for nearly every person on the planet.  It can produce a pack of business cards in less than 10 seconds and fulfill the order in less than 2 minutes.  No one else comes anywhere close to extracting the scale economies enabled by that kind of volume. Although paper-based marketing, including business cards, is in decline, the company’s Vistaprint segment is still showing high-single/low double digit organic growth as it continues to steal share from the tens of thousands of small manual operations that still account for most of the putative $30bn market opportunity [per management; computed as 60mn small businesses with fewer than 10 employees across North America, Europe, Australia, and New Zealand multiplied by $500 in annual marketing spend], leaving Cimpress, with just $2.4bn of total revenue, plenty of runway ahead.

But sometime in 2011, with revenue growth decelerating, management embarked on an aggressive M&A strategy.  Since fy11 (fiscal year ends June), on top of ~$590mn in capex and capitalized software development, management has spent around $900mn buying 15 companies – ranging from a DIY website building (Webs.com) to a host of European print and design companies catering to graphics professionals (consolidated as the “Upload and Print” operating segment) – tangentially related to the core Vistaprint business by dint of their marketing orientation but otherwise diffuse in terms of product SKUs and addressable markets.  And for this ~$1.5bn investment, Cimpress’ EBITDA (after stock comp) has grown by just $106mn, a 7% pre-tax return compared to management’s 10% hurdle rate for predictable organic investments in developed countries and 25% bogey for riskier investments in emerging markets. Now, one might argue that the cost structure is larded with growth opex that will eventually subside.  But, we’ve also heard this line from management before, as it has fumbled its way from one strategy to the next. 

The first course correction came in fy11, when management recognized that deep discounting, aggressive cross-selling, and cheap checkout tricks were compromising repeat purchase rates, diluting lifetime customer values, and attracting low quality customers looking for an easy deal…basically, a leaky bucket that required constant infusions of customer acquisition spend that management did not think was sustainable. And so, Cimpress made significant investments in packaging, product quality, and user experience on the site.  It dramatically reduced what it charged customers for shipping, which at the time apparently made up a “very material portion of revenues”, and introduced less jarring discounts on more transparent list prices.  These actions were meant to chase away the cheapskates who only cared about price, leaving the company with a more loyal and satisfied core more apt to repeat purchase.  Didn’t really work.  Despite some operational improvements – quality complaints, production throughput times, late deliveries all improved –  organic revenue growth slowed from 22% in fy11 to 20%, then 12%, then 4% over the subsequent 3 years.  Gross margins declined a bit, EBITDA margins declined a lot.  Buyer repeat rates actually declined from 30% to 26%.  Management’s initial expectations for $5 EPS (representing 20% annual growth over 5 years) and $2bn in revenue by fy16, would clearly not come to pass. That brings us to Act II. 

Sometime in fy13, the company embarked on an effort to disaggregate its tech platform into a set of software microservices appropriately named the Mass Customization Platform (MCP) as part of a broader effort to centralize all sorts kinds of functions – product management, order routing, fulfillment, commodities procurement – across its 20+ brands:

“…our vision for MCP is to be a constellation of modular, reusable and independently functioning software components and related services which is analogous to a well-organized set of interchangeable Lego blocks. This platform will sort millions of heterogeneous incoming orders into homogeneous specialized production streams which, thanks to the automated workflow and the regular repetitive production steps we can enable, will embody the principles of mass customization. Yet, the overall platform needs to remain reconfigurable and modular to ensure the relevance to a wide variety of applications….what we are doing is we are frankly trying to break the businesses which we bought, not just Vistaprint, but each of the individual companies we bought, into the component parts of the merchant, the customer-facing business unit with the brand and the fulfiller, and then to reconfigure all the IT systems so that those can…act as a routing layer between those.” – Robert Keane, Chairman and CEO (Cimpress Investor Day, 8/10/2016)

Management’s big idea was to create a matchmaking service that would pair the unique, specialized, and often small-sized manufacturing and fulfillment needs of its sprawling internal businesses (“merchants”) – some selling business cards to micro-businesses in the US, others serving graphic design pros in Europe who in turn serve micro-businesses – to its most cost effective option among a network of in-house and third party production plants and shipping/logistics providers.  As the number of fulfillment partners joining the platform expanded, so too would the number of SKUs the company could offer, which in turn would attract still more fulfillment partners seeking production volumes to run through their specialized plants.  Two-sided engagement would lift volumes flowing through Cimpress’ network, bringing procurement leverage to bear against service providers, equipment vendors, and commodities suppliers.

But just 5 months after promulgating this lofty vision during 2016 Investor Day, management conceded that this centralized model, which was intended to increase speed to market and production flexibility, had instead bogged down the company with complexity and bureaucracy.  It announced plans to retreat back to a more decentralized organizational setup wherein production, fulfillment, and product management would be siloed once again by brand, though non-core corporate functions (finance, legal, major capital allocation), procurement, and the modularized technology platform would remain as shared services across banners.  Now the thinking is that decentralization will unleash “entrepreneurial energy”, ensure accountability for results, and improve customer satisfaction.  And that’s where we are today. Mistakes have been made, that much is clear.  The company’s acquisition of DIY website builder Webs.com, one of it’s largest, seems particularly ill-conceived.  Website building is a high gross margin business that pure-plays struggle to monetize because lofty customer acquisition costs eat up all the profits.  But Cimpress believed it could do away with much of these advertising costs by cross-selling web services into its existing customer base, because in management’s own words “…a website is the same as a brochure, but it’s a digital version of that.” 

But of course, a website is more than just another marketing tool that you toss into the shopping cart as you purchase signs and business cards; it’s increasingly the entire digital storefront and a critical system of record.  The companies that do well in website building either own critical on-ramps like domain registration (Godaddy) or offer kick-ass functionality further up the stack, with sophisticated, friction alleviating technology and/or 3rd-party app integrations (Wix and Shopify).  And there’s a reason why website builders don’t bundle business cards…not only are these offerings not a natural point of integration, but doing well in either area involves entirely different processes. I’m not rehashing Cimpress’ somewhat ignomonious capital allocation and strategy choices with snark (or I at least hope it doesn’t come across that way).  On the contrary, I think it’s admirable that this management team at least attempts to take an earnest look at its shortcomings, fesses up to them, and experiments with new ideas.  I bring this up just to frame the difficulty of growing through a continuous product introductions and simultaneously extracting scale economies. 

At one extreme, the company could have just stuck to business cards and closely related paper-based products, gaining a little more production leverage every year and steadily improving its gross margins…but growth would have inevitably slowed and then reversed as the market for business cards is in decline and Cimpress’ business card revenue growth has decelerated significantly over the last decade. But then, proliferating product categories to boost volume growth makes scale economies harder to come by.  Through the acquisitions that now comprise its Upload and Print segment, Cimpress multiplied its SKU count by 300x, and the number continues to grow at a rapid pace.  The scale benefits attending homogeneous manufacturing and fulfillment processes attenuate as you start offering different substrates and formats, and especially as you expand into banners, apparel, pens, magnets, and other trinkets made of entirely different materials, manufactured through a different process with different equipment in different countries.  I think the company recognized this long ago, hence its emphasis on higher quality products to customers with better lifetime values; but I also think it’s fair to say that management underestimated how difficult it would be to reap the benefits of mass production over so many diverse product categories. Check out their margins over time…

The nosedive in gross margins can be mostly explained by investment in design services and a mix shift towards Upload and Print, which has been growing faster than Vistaprint and is more dependent on outsourced production.   But, this segment also has lower sales and marketing costs per order than Vistaprint and all else equal, the two segments should have comparable EBITDA margins…but those have declined considerably as well over the last decade, even as Cimpress has shown some sales & marketing and G&A leverage over time.  I think this can be at least partly explained by shipping, which runs through gross profit.  The company is loath and perhaps embarrassed(?) to reveal how much money it was making on shipping, but assuming average shipping price charged to the customer of $10 and an average order value (back when management still revealed this figure) of around $35, it was clearly significant. 

I don’t imagine its own shipping costs have changed by nearly as much, and so providing relief to its own customers likely translates to a mostly direct gross profit hit.  Also, losses from the “all other business units” segment, which houses speculative investments, emerging markets, partnerships,  continue to grow, from -$9mn in fy16 to -$36mn LTM.  Finally, digital products and services (Webs.com I assume?) has witnessed significant revenue declines. Except for maybe losses in emerging markets, which are still small and sub-scale, none of the above mentioned causes of margin compression will reverse, so the high-teens EBITDA margins of the mid/late 2000s are likely a thing of the past.  Management does not deny this and, in the face of persistently declining margins, now directs investors to think instead about dollar profits, retention rates, and lifetime customer values, tacitly acknowledging that ever more of the scale benefits are shifting from production leverage to value-add per customer. Cimpress’ last 10-K (year ending June 2017) reveals 17mn customers served by Vistaprint, which means the number of unique customers hasn’t budged since fy14.  However, Vistaprint’s revenue has grown by over 25% over that time, implying that revenue per customer has gone from $65 to around $80.  Management does not break out gross profit or opex by business segment in its financials, but we do have this useful exhibit from the last Investor Day:

The buyer repeat rate, at between 30%-35%, is so low that one wonders whether the lifetime value of customers is really the right metric for management to focus on, but let’s just go with it.  So if revenue per Vistaprint customer is $80, then it looks like gross profit per sub is close to $50.  Assuming a 10% discount rate and that 35% of buyers make repeat purchases [I’m assuming it’s higher than the 31% rate the company disclosed for fy17] implies an LTV per customer of $73.   Before the company went on its acquisition spree and it was just basically Vistaprint, the cost of customer acquisition was around $24, suggesting an LTV:CAC of ~3x.  Once you factor in higher recurring costs of supporting today’s relatively higher quality customers, the ratio is probably closer to 2.5x(?), right at the cusp of acceptability.  To put that in perspective, Trupanion is at ~4.5x, Godaddy is over 5x. [Founder and CEO Robert Keane writes the kind of letters that value investors just eat up, chock full as they are of Buffett-esque straight talk and verbiage.  But I’ve actually found disclosure to be frustratingly inconsistent.  For instance, up until fy14, the company provided metrics on average order values (AOV), order volumes, repeat customers, bookings per repeat customer, and other good stuff.  They stopped regularly disclosing most of this in fy15, defending the move by maintaining that a metric like $AOV doesn’t provide much insight because there are so many businesses besides Vistaprint.  Like, huh?  Vistaprint still represents 65% of revenue, 80% of segment profits, and the majority of organic investments.  And even if that weren’t the case, why stop disclosing the very data required to estimate lifetime value at precisely the time in the company’s history when it is explicitly targeting this metric?]

As mentioned earlier, Cimpress’ acquisitions and organic investments over the last 5-6 years appear to have impaired value, with returns on incremental capital falling short of capital costs, and over time, we see that the company’s returns have deteriorated rather markedly in even the last few years.  And they are way below the the 30%+ returns the company was realizing before its spree.  Meanwhile, over the last 5 years, organic growth has been cut nearly in half, from 20% in fy12 to ~10%/11% LTM.

[“adjusted” because the numerator excludes restructuring charges; acquisition related earn-outs, amortization, and depreciation; and impairments] But that hasn’t stopped valuation multiples from doubling over that period.

But perhaps I am throwing excessive shade.  While I think Cimpress is a worse company than it was 5-10 years ago and its mass customization platform is maybe not quite what was promised, it’s still hard to imagine a competitor rivaling Cimpress’ scale advantages, and I think the company will continue taking enough share to deliver high-single/low double-digit organic revenue growth for the foreseeable future.  Founder and CEO Robert Keane, who owns 10.5% of the company and owns the same number of shares as he did 7 years ago, has significant skin in the game.  The company has retired nearly 30% of its shares over the last 7.5 years in the low-$40s. Using the high-end of management’s estimate of investments required to grow free cash flow by at least inflation, LTM mFCFE per share is around $8/share [1], so the stock trades at ~20x, which doesn’t seem too demanding a valuation given the company’s competitive positioning and growth opportunities.  Cimpress recently reported an outstanding quarter across all reported segments, suggesting budding traction with its decentralization initiative.  But I frankly have no idea if this inflection is sustainable. 

Given the pronounced deceleration in core legacy business cards, where the engine of mass customization was applied beautifully for the first 15 years of the company’s life, diversifying into far flung SKUs may have seemed sensible at the time….they were squeezing less juice from scale economies but could compensate for that by moving upmarket, offering a value-added bundle proposition with a heavier service component.  But in retrospect, shareholders would probably have been better off if management just maximized the hell out of lower organic growth and plowed excess capital – capital that could not be reinvested into core Vistaprint – into share buybacks rather than acquisitions. [1] Estimating relief under the new US tax law is tricky because the company already reallocates income across a sprawl of geographies to minimize its tax payments.  Cimpress derives just 40% of its revenue from the US and over the past year paid just $40mn in cash taxes on $180mn in pre-tax cash profit, so I’m not so sure the new rule will meaningfully benefit the company.

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Looking at TRUP is like staring at one of those ambiguous images that could be both a rabbit and a duck, both a saxophonist and a woman’s face: we know that this is an insurance company, but we’re compelled to analyze it as a data-driven subscription service.

Of course, all responsible insurers are data-driven and the recurring nature of premiums also make them subscription-like, but we don’t typically think of insurers as a subscription service in the same vein as a SaaS enterprise.  We do for TRUP largely because its management team has diligently trained us to focus on SaaSy metrics. Some of this is just reframing vocabulary: “subscription fees” not “premiums”, “members” not “policyholders”, “Territory Partners” not “agents”..  Trupanion’s ignorance of the insurance industry lexicon – scarcely a mention of reserves, underwriting leverage, medical cost trends, book value – is so obtrusive as to almost certainly be by design (what fast-growing enterprise wants to be seen as a boring insurance company?).  

But this is also the first insurer I’ve see that disaggregates retention by member cohort and discloses lifetime value to customer acquisition cost ratios. That’s not a knock on the company.  The first principle to any recurring, subscription-like model, insurance company or not, is onboarding customers for far less money than those customers will generate in lifetime profits. With most of the stuff you buy – a haircut, an iPhone – there is little confusion about the value of the product to you.  Insurance is a lot squishier because you don’t know at the time of purchase whether you’ll need it.  For major categories of insurance – where the covered thing is monetarily significant and its cost readily determinable, as in the case of a car or house, or where it transcends monetary value, as in the case of your family’s health – we easily buy into the collective understanding that in any given year, the premiums from those on whom fortune smiles subsidize those on whom she frowns.  We don’t feel like our rights are being trammeled when law mandates we buy such insurance or that we’re being bamboozled when our insurer earns an underwriting profit from this scheme.  We’re risk averse and understand that peace of mind is worth paying for and that an insurer should be compensated for giving it to us. But dogs and cats? 

While there’s no question that we treat our pets far more humanely than we used to and that pets have graduated from the status of mere property, they still don’t occupy the same sanctified hemisphere as humans and we’re far from consensus on the range of seriously unfortunate health outcomes that we should be willing to prepare for.  If you ask your friends about pet medical insurance, as I did, you’ll likely find that only a few have it, maybe half think it a reasonable purchase and the rest may outright scoff.  Rather than pay $50 for a Trupanion policy with a 10% deductible, why not just put $40 in the cookie car every month as a sort of pet health savings account?  If I’m shelling out $600 this year for a Trupanion policy and eat 10% of the costs, I need to think there’s a 20% chance of at least $6,000 in medical emergencies in the next 12 months for the policy to be “worth it”. [to put that in context, treating hip dysplasia for a Golden Retriever can cost anywhere between $2,000 (if diagnosed early) and $5,000 (if diagnosed late and a hip replacement is required)]. 

Of course, the decision to purchase insurance can be an emotional one that goes beyond sterile expected value calculations, and the more importance you place on your pet’s life and comfort, the less willing you are to roll the dice…but the point is that on the surface, it’s not entirely clear to me pet owners feel they need insurance for their pets.  But can they be made to think they need it? There’s some evidence to believe that they can: the number of pets covered by Trupanion has compounded by 25%/year since 2011 to over ~360k and nearly 85% of members renew their policies every year…and half the lost profits of those who don’t renew are offset by existing members who insure more pets or refer their friends.  The proselytizing efforts begin with the 40,000+ vets staffed at the 28,000 vet hospitals across North America (20,000 of which are independently owned and operated) who deliver ~54% of TRUP’s new members and from whom pet owners seek trustworthy guidance.  [According this recent Motley Fool interview ^[4], Trupanion’s CEO claims that when vets recommend Trupanion to their clients, 1 in 4 people enroll.] 

Sometimes oblique coverage restrictions, annual payout caps and long waiting periods for covered treatments are buried in fine print; other times, the insurance company and the vet charge based off different fee schedules, with the pet owner paying for the entire procedure out-of-pocket based the vet’s fee schedule only to be reimbursed weeks later by the insurance company using a lower “usual and customary” rate [which is based on fees charged by other physicians in the surrounding area for the same procedure].  A vet probably won’t be blamed for not proactively recommending pet medical insurance, but pushing a policy that culminates in an expensive “gotcha” moment is poison.  Trupanion attacks these causes of friction and confusion by:

1/ pricing off the cost of care.  Trupanion carefully estimates the cost of medical care across 1mn+ dimensions – species, breed, zip code, deductible, age – and simply tacks on 30% to arrive at the policy price paid by the pet owner…so, a pet owner is basically paying a 30% premium above expected medical costs to rid herself of cost uncertainty.  Trupanion then pays out 90% of the vet’s invoice, with no limits per claim or illness.  So, it doesn’t matter if one vet charges $2,000 and a rival vet across the street charges $1,000; Trupanion will cover 90% of the eligible treatment cost in both cases.  Assuming Trupanion has accurately estimated the cost of care, in aggregate, 70c of every premium dollar Trupanion collects goes to paying vet invoices;

and

2/ re-directing reimbursement flow (in progress).  With traditional pet insurance, the patient covers the entire vet invoice upfront and then hopes the check that arrives from the insurer in 2 weeks will reimburse her for the “right” amount.  While most of Trupanion’s claims are still paid via check, they are increasingly routed through Trupanion Express, in which Trupanion pays the vet 90% of the bill directly, thereby taking the burden of up-front payment away from the consumer. Express can be integrated into practice management software so that an invoice is immediately shot over to Trupanion, who wires the requested funds into the vet’s bank account in less than 5 minutes. The number of vet hospitals with Express installed has grown from 89 in mid-2014 to 500 in 2015 to ~1,300 today, with over 30% of vet invoice dollars channeled through Express, on its way to 95%+.  No other competitor in the space is even bothering to pursue a similar direct payment scheme.

These two changes largely lift the confusion attending discrepant pricing schedules and alleviate the strain of what in some cases could be an enormous immediate upfront payment for the pet owner, followed by an anxiety-ridden reimbursement interval.  The member knows his out-of-pocket burden from the get-go and will not be financially surprised down the line.  And because a Trupanion member need not wrestle with the financial uncertainty of costly medical care, she spends twice as much on vet services over her pet’s life than an uninsured pet owner…and the vet can simply focus on recommending the best treatment, without also stressing over the owner’s ability to pay.

Even so, considering the history of disappointing experiences with pet medical insurance, it’s no wonder that winning over vets has proven a laborious process.  It can take 3-5 visits for a Territory Rep to even get her first meeting…so, if the TR is making 1 visit every 6 months, we’re talking years.  Trupanion makes close to 100,000 face-to-face vet visits every year, with 200 hospitals per territory visited every 60 days (with touch frequency now increasing with impending account manager build out), and even after hammering away at vet conversion for nearly a decade in the US, the company still has significant work ahead: against a universe of 25,000 addressable hospitals in the US, only 8,100 are actively recommending Trupanion today, a figure that is growing by ~500-600 hospitals/year. Competitors, on the other hand, continue to take a direct-to-consumer approach, carpet bombing their territories with online marketing to create awareness, which in the absence of vet buy-in has not proven very effective. 

Building trust is a time consuming process that requires TRs to persistently contact vets, who must then observe positive customer experiences firsthand.  These relationships cannot be bought, but must be earned over time: a vet hospital will not compromise a pet owner’s continuing business for referral fees and besides, Trupanion does not offer kickbacks of any kind to vets for referring patients. You may be surprised to know that with the exception of VPI Nationwide, the largest player in the space with 40% share (vs. #2 Trupanion with 20%), other competitors like Healthy Paws and Pet Plan don’t underwrite the policies they sell.  Trupanion’s conceit is that by owning all links in the chain – from sales to underwriting to claims processing to customer service – and forgoing reinsurance, it can provide insurance at a ~20% lower cost than peers.  These savings are used to cover a greater proportion of claims costs – 70% of premiums at Trupanion vs. closer to 50% for peers – enabling a “no-fuss” payments experience that induces greater satisfaction from pet owners (who remain Trupanion members for longer) and buy-in from vets (who feel comfortable enough to recommend Trupanion to new clients). 

Of course, sustainably profiting off a cost-plus model and credibly delivering on the promise to immediately cover 90% of whatever invoice requires precise, granular insight into the cost of pet acquisition and medical care.  Over 17 years since inception, with data from 1.5mn+ claims and over 500,000 invoices/year, Trupanion has amassed cost and retention experience across 1mn+ category permutations…so, for instance, the company understands how the claims experience of a 5-year old bulldog in zip code 11201 differs from that of a 3-year old Shih Tzu in 60047 and can price the two pets accordingly.  There are no short cuts to this process.  The time required to build claims experience and flesh out statistically significant patterns at such a granular level is a steep learning curve that even a well-funded competitor cannot easily surmount.  Although VPI Nationwide has been around longer than Trupanion, their dataset is less robust because they don’t price their policies with nearly as many observations (zip code, for instance) as Trupanion, nor do they cover congenital and hereditary conditions. [to be clear, Trupanion doesn’t cover pre-existing conditions either, but unlike other insurers, it doesn’t refuse coverage on all future illnesses arising because of pre-existing conditions]. 

Still, while data may be a competitive advantage in the early stages of penetrating a market niche, I’m not sure this in itself constitutes a real moat.  Data has to be proprietary, valuable, and part of a self-reinforcing process (data network effects) for it to count as a sustainable edge.  There’s a reason why you never hear insurers tout data as a unique advantage…there are diminishing returns to data as the relationship between price and insured risk doesn’t change all that much for granular exposures and eventually becomes common knowledge.

(the Lifetime Value of a Pet (LVP) to Pet Acquisition Cost (PAC) ratio that Trupanion reports every quarter is the blended output of explicit LVP:PAC targets across a slew of subcategories.  So, while the lifetime value of, say, a 2-year old cat in Manhattan with a $1,000 deductible will differ from bulldog puppy in Pittsburgh with no deductible, Trupanion can toggle pricing and acquisition spend to get iteratively closer to a common IRR across subcategories, with no cross-subsidization between them.  Ideally, the table would look something like this…  

Not. quite. there. yet…

…

(Tables 13 & 14 from Trupanion’s 2016 Annual Letter)]

Meager pet insurance adoption rate in North America (< 2% of ~180mn dogs and cats) compared to certain Western European countries (25% in the UK, 50% in Sweden), is an oft-touted part of the bull case.  Of course, one wonders why, when pet insurance has been available in America since at least the mid-80s, the disparity exists in the first place?  I don’t really know.  But one reasonable-sounding explanation I’ve heard is that in Western Europe, pet insurers launched by first winning over vets and those vets then pushed the product to consumers…whereas in the US, insurers started by asking “what price will pet owners pay for this thing called ‘pet insurance’?” and then reverse engineered a product without consulting the vets, yielding something that both consumers and vets hated.

In any case, it doesn’t really matter.  I think we just want to see that the method to driving category adoption is sound.  In an embryonic market, it’s up to pioneering companies to create the category.  Pet medical insurance is so nascent in the US that although Trupanion continues to claim share – there are around 20 brands that make up the pet insurance space, but 2 players, VPI Nationwide and Trupanion, account for 60% of the insured pets – it does so in a market that, against the broader population of insurable pets, barely exists.  Rather than look to foreign countries for cues, it seems better to just make a judgment call on whether a) the value proposition for vets makes sense, b) the company has the will and wherewithal to push the ball forward, and c) the product, when discovered and used by the end consumer, solves a real need (including a need the consumer previously didn’t even know she had). a) and c) are tied at the hip since, as previously discussed, vets will only pitch Trupanion if the pet owner perceives benefit.  While I harbor doubts about the intrinsic value to a pet owner, those personal reservations are trumped by nearly a decade of data strongly supporting the claim that yes, pet insurance is becoming a thing in the US. As born out over many cohorts, the average life of a Trupanion member is around 6 years…

…during which period the company pulls 20c in variable profit from every incremental premium dollar, reinvesting most of that into acquiring new pets…

….at compelling lifetime values translating into huge IRRs, leveraging sales & marketing and fixed expenses along the way.

The IRR math works roughly as follows: on average, Trupanion pays $175 to acquire a pet and recognizes premiums of around $53 for that pet each month over 71 months.  That 53 bucks is whittled away like so:

Monthly premium: $53

Vet invoices: ($37) [70% of the $50 premium]

Variable expenses: ($5)

Contribution profit: $11 [20% of premiums.  The Lifetime Value of a Pet (LVP) is computed off this figure]

After adding back sales & marketing, Trupanion’s trailing 12 month EBITDA margin after stock-comp is ~8%, implying fixed costs of ~12% of premiums [20% contribution margins less 8% EBITDA margins ex. sales and marketing], so 60% of contribution profits are being consumed by fixed operating costs at the moment. 

But at scale, which management pegs at ~700k pets (vs. over 360k today growing low/mid-teens y/y), the company thinks it can do 15% adjusted operating margins excluding the cost of adding new pets.  When we back off 1%-2% for stock comp, it’s maybe more like 13%.  Given the degree to which Trupanion has leveraged its cost structure over the last 6-7 years, I find this claim credible.

And so, at scale…. .

Fixed expenses: ($3)

Capital charge: ($0.6) [8% x (monthly premium divided into a premium:surplus ratio of 6x)]

Profit/pet/month: $7 [13% of premiums]

In other words, the company is generating ~$520 in profits over the average lifetime of a member, around 3x the cost to acquire that member.  The cash flow streams over ~71 months impute a 65% IRR.  Alternatively, at a 15% discount rate, the present value of cash flows over of a subscriber’s life is ~$330, nearly twice the cost of acquisition.  Imputing attractive unit economics, of course, requires a sufficiently wide LVP-PAC spread.  The $175 pet acquisition cost that I am using assumes the current LVP/CAC of 4.5x, where it has roughly been for the last 5-6 years.  This figure would have to decay to below 2.5x before the NPV of pet acquisitions turns negative (i.e. destroys value).

But I see no reason to expect such a draconian deterioration and in fact, it’s possible that as the company further densifies its markets with vet allies, layering on radio and TV spend may even boost conversion from vet recommendations, as has been true thus far in Trupanion’s mature markets where half or more of vet hospitals actively recommend Trupanion.

Given the unit economics and the runway, it’s not hard to see how things can get interesting [though whether they can get interesting enough to buy the stock at today’s valuation is an entirely different question].   Assuming today’s annual PAC spending of ~$15mn/year grows by a few million per year and even assuming LTV/CAC deflates to below 4x, I can get to just over 800k enrolled pets in year-7, around 12% growth per annum.  Absent some “silver bullet for cost effective accelerated organic growth” (company’s words), management seems determined to fund its expansion entirely with internally generated profits. 

Applying a pre-PAC scale margin of 13% to implied revenue gets us to around $70mn in pro-forma EBITDA, which, assuming reinvestment, will be growing by low-teens, providing still more ammo for pet acquisition.  With 800k enrolled pets against a universe of 180mn dogs and cats in North America, Trupanion will still not have even nicked the surface of its potential…so, still be plenty of opportunity to deploy maybe 40%-50% of pre-PAC EBITDA into onboarding pets at 40%+ IRRs.  In theory at least. What you’ve just seen is the rabbit.  But what about the duck? 

After all, this is still an insurance company and balance sheet strength reigns paramount.  But is it and does it?  Trupanion’s underwriting leverage – premiums to surplus ratio, a measure of how much underwriting risk you are assuming relative to the capital you hold – is greater than 6x [Trupanion does not reinsure its risk, so subscriptions = gross premiums = net premiums].  Whether this exceeds the standard of prudence depends on the nature of risk being insured.  Typically, a ratio greater than 3x is considered unusually aggressive for a P&C underwriter and an insurer with significant high-severity natural catastrophe exposure will keep it closer to 1x.  Health insurers, in contrast, will underwrite 7x+ their surplus.  In my experience, growth and conservative underwriting are hardly ever simultaneously executed well together, and if this were a run-of-the-mill P&C underwriter, Trupanion’s thin capital base would probably be reason alone to pass. 

But I think Trupanion is a different animal. The risks covered under pet medical insurance are bite-sized and absent a major, widespread health contagion, uncorrelated.  Agglomerating hundreds of thousands of claims results in a more predictable range of experiences from year-to-year at the population level than most traditional P&C exposures and with far less tail risk too.  Given the highly granular, uncorrelated nature of the insured risks, catastrophe is a remote risk.  The company’s exposures are also short-tailed, meaning that claims-triggering events are readily apparent and the costs from those events accurately estimable and paid soon thereafter: over 90% of the company’s reserves as of 3q17 are related to activities incurred in 2017 and close to 95% of claims paid over the last year was related to business underwritten in the same year.  Only a miniscule amount of claims incurred and paid relate to prior years.  [one negative consequence to premiums heading out the door to pay claims almost as soon as they come in is that Trupanion doesn’t benefit from “float” income as a typical insurer does].

Compare this to the “long-tail” risk of asbestos, where the health consequences from exposure remained latent for many years and claims were still being paid more than decade after policies were originally underwritten…that is, people were getting silently screwed by asbestos during the coverage period; the insurance companies didn’t know it at the time and so didn’t properly reserve for it.  In contrast, the short-tail nature of Trupanion’s risk means that its best guess about claims cost and frequency is rapidly (in)validated and any deviations can be dynamically accommodated through price adjustments.  While Trupanion won’t hike a member’s monthly subscription fee based on her pet’s individual medical condition, it will do so if the average cost of care for all pets within the same sub-category rises, so systematic pricing errors are quickly rectified. Steering the ship is 48-year old founder, CEO, and ~8% owner Darryl Rawlings, who has a good story about how his parents’ experience about not having the money to remedy a life-saving procedure for his childhood dog, prompted him to start Trupanion 10 years later (maybe too good a story?).  In any case, I highly recommend reading his annual letters, which are refreshingly exorcised of hygienic corporate bullshit and lay out Trupanion’s operating strategy with a useful degree of granularity.  Darryl seems authentically enthusiastic about this pet insurance mission and appears to “get” how value is created…it’s hard to imagine a diversified underwriter/bank/savings institution like Nationwide pursuing this opportunity with the same single-minded vigor.  

Today’s post is part of a broader discussion about scale advantages: when they apply and to what degree.  I’m addressing this topic in the context of rolled-up entities because, in my experience, it is here that scale advantages seem far too liberally promoted, even if they do sometimes apply with awesome effect.  This write-up was […]

Executive Roundtable: Street Talk (11/9/17), Phocuswright Conference

Rachael Rothman, Sr. Analyst, Gaming, Lodging, and Leisure at Susquehanna Financial Group

(on hotel demand)

“I think we know from the industry-wide data that there is a definite shift to book direct…I would also just highlight that going back 30 years from hotel school, we always thought of brands as occupancy insurance and now that we’re getting 92 months into the recovery, I think you’re going to see that brand power come back into effect, and you’ve seen some of the hotel owners that have moved away from branded product and that relied on things like Expedia and Priceline actually suffer and underperform.  And so I think it’s being proven out to the owners and to the operators that the brands actually are working and scale is working.  Occupancies are at all time highs in the hotel industry, my stocks are at all time highs, and there are no signs [of] waning demand…there’s not a ton of pricing power but it isn’t a demand issue.”

(on hotels possibly filling the OTA gap on meta spend)

“They are unlikely to step in to fill that gap.  I think historically that has not necessarily been a customer that they wanted.  I view it as someone who’s pretty brand agnostic and price sensitive.  I think what you could see though is some of the bigger brands stepping in with something like Instagram and Facebook and saying ‘hey Rachel, I see that you’re celebrating you’re 10-year wedding anniversary at the Ritz Carlton in Naples…how about next year you go to the Ritz Carlton Dana Point and you book today and we give you 20% off’.  They already know I’m a loyal Ritz Carlton customer, they can see that I’m taking photos and interacting…and they can go direct to the customer with a targeted offer.”

(on alternative accommodations)

“First, there is some thought that it takes away pricing power on compression nights.  So, that would be if you had SXSW in Austin, TX for example, historically maybe you could have raised your room rate by 30%, now you can only raise it by 10%.  But, we also have to consider that Airbnb’s supply is flexible, meaning that people put their capacity on when rates are the highest and I personally am of the belief that Hilton and Marriott and their owners’ balance sheets are built for a recession.  When we go into a recession, the Airbnb owners, many of them have extended themselves into having multiple properties and when they find that they can only rent that home for 30 bucks and it’s either $100 or 5 of their own hard labor hours to clean it, you’re going to see a lot of that capacity come off the market and I think it’s going to be the same balance sheet lesson that a lot of individual homeowners learned in the 2008 recession.”

(on loyalty discounts from hotel chains)

“I think it’s working, I think it’s a big deal…Expedia may be able to offer you a free flight or free whatever, what they can’t offer you is 9am check-in, 4pm check-out, free breakfast, unlimited free cocktails, any sort of amenity that any one of these hotel owners or operators can offer to their customers.”

Lloyd Walmsley, Managing Director, UBS

(on OTAs pulling back on meta)

“Priceline has been the most vocal about pulling back and they had spent a lot of money on trivago over the last 2 years and I think trivago was pushing pretty hard and you have a new management team come in and decide to take the strategy a little more aggressively.  They had been funding a competitor in search channel so I think it makes eminent sense to try to reset that auction.  Priceline has spent some money in TV historically but booking.com’s brand in all of our survey work has still lagged that of peers, so I think it makes sense to be building a brand…I think Google is going to continue to move further and further into the travel vertical and that poses obvious risks if you don’t have a strong brand.”

(on TV spending)

“[TV spending] makes the online spend more efficient.  So, Google obviously has a quality score and the higher your click-through rate is the less you pay for ads.  Kayak, when they were public, gave us enough disclosure as part of the IPO process that we could see when they started ramping their TV spend, in the first two years after they ramped their TV spend, the cost that they had to pay for their digitally acquired clicks was cut in half.  I wouldn’t expect the same magnitude for a brand as big as booking.com but there are secondary benefits to being on TV.”

Eric Sheridan, Managing Director, UBS

(on loyalty discounts from hotel chains)

“Phocuswright put up a lot of their own data saying that loyalty rewards don’t actually drive as much velocity of shopping in travel.  We’ve done consumer intention surveys that say similar things.  The business market seems like it’s much more driven by loyalty rewards than the consumer marketplace…I would expect over time that the OTAs and maybe Airbnb explore loyalty and rewards.”

(on Amazon, Facebook, Google getting into travel)

“Amazon’s tried a couple times at this more in beta mode and never really gotten much further than that…I think that the inventory is so fragmented on a global scale that in order to achieve scale, I think it would take quite a long time to achieve the scale benefits that Expedia and Priceline have on the inventory side.  We’ve always been fairly dismissive of the concept that Google will become an OTA.  Google wants more of their partners’ marketing budgets by delivering more qualified leads and delivering more CPCs from it.  So, from our view, Google’s always wanted to own more top-funnel than the actual bottom part of the funnel.”

Joint Interview with Expedia guys (Phocuswright Europe, 5/22/17), Phocuswright Conference

Cyril Ranque, President, Lodging Partner Services, Expedia Inc., Expedia

(on providing technology for hotels and being a “platform company”)

“The idea is pretty simple.  We’ve proven that we can take the platform from our brand and power other brands very effectively in the OTA space and now the idea is to take the same platform and leverage it for hotel partners and allow them to access all the benefits of that technology…and the thinking is if we are improving the customer experience regardless of where the customer wants to book, be it on Expedia or hotels.com or on brand.com…that translates into more disposable income spent on travel.  It should be good for the industry and if we power all these parts of the ecosystem, we’ll get a share of the revenue…hotels have needs for pricing, they need data to price correctly.  We provide them access with competitive data, market demand, etc. so they can do their pricing, it can be a chain or individual hotel, we can provide data that a small hotel would not have access to to optimize their pricing.

Then, after they’ve done their pricing, they need to attract consumers to their website…we launched a product that allows them to spend their marketing to attract consumers from Expedia and hotels.com directly to their website, which was unthinkable a few years ago…and then the next step is powering their website to make it more effective and increase their conversion.  We’re doing this with Marriott on vacations and Vacations by Marriott has grown tremendously…then after that you get to the guest experience, we’ve invested in a company called Alice in which we have a minority share which optimizes hotel operations.  We also allow hotels to sign up more loyalty members…we did a test with Red Lion.  Then we provide real time feedback to increase the customer satisfaction by treating problems that arise on property before customers write a review later on.”

Booking.com Executive Interview – Phocuswright India 2017 (3/13/17), Phocuswright Conference

Oliver Hua, Managing Director, APAC, Booking.com

“Three years ago we had less than 3,000 hotel partners in India.  Now, today we have over 20,000.  And the number of room nights per partner remains roughly steady…it’s pretty significant but we’re still in early stages of growth.  We’re seeing high double-digit growth for multiple years now and we expect that to continue.

Our strategy in China is two-fold.  We develop our own business, China is a major source market for us.  The majority of APAC destinations – Japan, Korea, Thailand – are quite dependent on Chinese inbound.  We have nearly a thousand people working in our call center in Shanghai.  Then the second prong of our strategy is the partnership we have with Ctrip that evolved from a commercial partnership where they were a distribution partner for us into an equity partnership in which we invested pretty heavily into the company in 2014 and 2015…Ctrip has been leading industry consolidation in China, they’ve been rolling out new product and services…and the fact that they’re gaining share in the market is helping us as well because through them we just get a larger audience for our inventory.  Our relationship with agoda, our sister company, is very similar to how we work with Ctrip in China.  They are two separate brands that operate completely independently of each other.”

(on the long tail of properties)

“In Japan, it’s a well known fact that we have a situation where the market is essentially undersupplied from a traditional hotel accommodation perspective, and then you have a lot of long-tail properties that’s unoccupied because of the shrinking population.  The demographic change and migration to large cities…you have a lot of apartments, short-term rentals that’s available for rent and that’s a market we’re definitely very much committed to.  We actually have plenty of that type of inventory that’s available on our site for instant booking and immediate confirmation.  That’s how we differentiate from other offerings.  When you come to booking.com and you book a long-tail property, the customer experience is exactly the same as booking a traditional global chain hotel.”

a16z Podcast (10/28/17; B2B2C Business Models — Trick or Treat?)

Martin Casado

“One of the biggest mistakes I see is ‘listen, we’re working with system integrators, we’re working with MSPs [managed service providers] because they somehow think that’s going to give them reach to a bunch of customers, basically it never pans out…in mature markets it sometimes pans out, but in pre-chasm markets, I don’t think it ever does.  [Pre-chasm meaning] there’s no market category, there’s no budget, the customer isn’t educated about what you’re doing.  And the reason it doesn’t work out is because…a lot of the enterprise actually purchases from a reseller, not from the vendor directly…and the thing is [resellers] don’t have the salesforce to carry pre-chasm products.  They’re good at distributing things where there’s a known budget, but if you’re doing something fundamentally new, there’s no way that a VAR can pitch, educate the customer, and so forth, so normally you have to create a pull-based market before you can actually engage partners.

In the enterprise, the two ends are the vendor, which creates the technology, and the customer, which consumes the technology.  In a direct sales model, the vendor creates a sales team and the sales team shows up to the customer and manages that customer.  So, let’s say you create a widget in a mature market, so the customer doesn’t have to be educated.  And you’re able to get a general partner to sell it.  One of the big problems is you don’t have a relationship with the customer.  So much of enterprise dynamics come from renewals, expansions, and upsells.  Often hyperlinearity in growth comes from expansions, so you actually have to have a relationship with the customer in order to do that.  And so going that route is fraught with peril for startups.  You are not the one that is actually bringing the product to the end customer…you don’t know what they want, you don’t know what they need, and you won’t have the leverage point to expand that sale […]

The biggest jump in operational complexity a start-up will ever do is when it goes from one product to two products.  So, if you do introduce a second product, if you can align it with the same constituency, the same buyer, that’s the best…a natural response of start-ups of not having product/market fit is building another product, which I think is probably the worst thing you can do.

Over time, R&D pencils out as almost a fixed cost or super sublinear but sales scales linearly with people on the ground, so if you hire more sales people, they’re very expensive but to get more dollars you need more sales people.  So, there’s this dream that you can have somebody else bare that cost for you…the problem is that the channel doesn’t have the salesforce to push what you’re doing…the lifecycle that normally works is the startup tries that, figures out that it doesn’t work, but maintains relationships with these channel providers.  Start-up then builds a direct salesforce and creates awareness in the market and starts to sell it.  Once you’ve started to sell it, you’ve actually created now a market and the market isn’t a product market but a market of services around your product.  So I sell something to the enterprise just to do a proof-of-product, requires some implementation, and often companies will pay for that, and then after you’ve sold it, that requires professional services along with it.  Once you’ve sold enough gear, those markets arise and now you have something you can incent a channel partner with….so now you actually have a market to incent them to invest in training, to get a relationship with the customer, etc.

It’s incumbent on the startup to create the market and once you’ve created the market, you have sufficient leverage to turn on the channel.”

Alex Rampell

“The other challenge with B2B2C is that if your C at the end is coming from the B in the model, then the two business models endanger one another.  There’s a company called Yodlee, it’s been around for around 20 years, it’s a key part of the ecosystem for every fintech company that gets data from banks.  So if you ever go to E-Trade and it says ‘log into your Bank of America account to wire funds’, that’s going through Yodlee.  It turns out they get all of that information in aggregate and they have a different business model which is they sell anonymized aggregated information that they’re collecting from everybody, all the businesses they are working with Yodlee.  If they do that too aggressively, it puts them at odds with their core, main business…you can go from being a symbiote [with your middle B] to a parasite or even an antagonist if you start doing things that are competitive with what they’re doing or hurt their primary business model.”

(when B2B2C works)

“I think Rakuten is a good example of this because if you are a bread merchant and there’s another meat merchant you can work with and you realize the meat merchant sells more meat and the bread merchant sells more bread if there’s one communal shopping mall for them all to work with, they don’t want the consumer to sign up directly, they want the consumer to sign up in that shopping mall.  That’s highly symbiotic…there it’s Rakuten getting the end consumer, but those two intermediate merchants have an incentive for Rakuten to own that consumer because it makes the whole thing work.”