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[TRUP – Trupanion] A SaaSy Underwriter

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.

Illusion 1: Saxophonist or Woman?Image result for ambiguous images, rabbit duck

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 blithe obliviousness to 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 profits for as long as they remain customers.

With most stuff that you buy – a haircut, an iPhone – there is little confusion about the value of the good to you.  Insurance is a lot squishier because you don’t know at the time of purchase whether or not 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 human life 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 tepidly 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 at least 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 eludes 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 that left to its own development, an organic consensus would emerge among petowners that 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 today and around nearly 85% of members renew their policies every year…and around half of the ones who don’t 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 are responsible for delivering ~54% of TRUP’s new members and from whom pet owners seek trustworthy guidance.  [According this recent Motley Fool interview [1], Trupanion’s CEO claims that when vets recommend Trupanion to their clients, 1 in 4 people enroll.]  The best way for a vet to violate a pet owner’s trust and damage her business is by pitching a solution that results in a distasteful experience…and pet medical insurance fits the bill pretty well.  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 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 in the first place, but pushing a policy that concludes 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 the company has accurately estimated the cost of care, in aggregate, 70c of every premium dollar Trupanion collects goes toward paying vet invoices.

2/ re-directing reimbursement flow (in progress).  Under a traditional pet medical insurance scheme, 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 made by mailing a check, they are increasingly being 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, immediately upon creation, is 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 close or really 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 subterfuged down the line.  Insurance ceases to act as an encumbrance on the vet/pet owner relationship, and actually lubricates the transaction like it’s supposed to: 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 firsthand positive customer experiences.  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 that you commonly hear about, like Healthy Paws and Pet Plan, don’t underwrite the policies they sell and the third party underwriter reinsures part of its assumed risk.  Trupanion’s conceit is that by owning all the 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 then devoted to covering 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). [Note: being the low cost provider does not mean that the company offers cheaper policies than peers; in fact, Trupanion policies are usually more expensive.  It simply means that the company delivers a better value proposition at a lower cost.] 

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 its 17 years since inception, with data from 1.5mn+ claims and over 500,000 invoices paid per year, Trupanion derives 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 price the two pets accordingly.  There are no short cuts to this process.  The time required to amass claims experience and flesh out statistically significant patterns at such a granular level represents 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].  Now, 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 in this context.  Data has to be proprietary, valuable, and part of a self-reinforcing process (data network effects) for it to truly count as a sustainable edge.  There’s a reason why you never hear insurers tout data as a unique advantage…there is no meaningful feedback loop in motion and 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)]

If you’ve spent even 5 minutes researching this stock, you know that the 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 part of the oft-touted bull case for the stock.  Of course, the question that logically follows is 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 convincing 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 if there’s evidence that the method to driving category adoption is sound.  In an embryonic market, which I define as a market with widely divergent opinions to the question “is this even a thing?”, 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 those critical to driving adoption – in this case, the vets – makes sense, b) the company has the temerity and wherewithal to push the ball forward, and c) the product, when discovered and used by the end consumer, actually solves a 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, this could be 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 individual 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, even bad years do not invite catastrophe.  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 drama, 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 (er, “medical insurance for pets”, as the company insists) 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.

 

[VRSK – Verisk] High Quality Cash Flow, Limited Reinvestment Opportunities

Posted By scuttleblurb On In SAMPLE POSTS,[VRSK] Verisk Analytics | No Comments

When evaluating the competitive advantage of a data-based analytics business, three important questions come to mind: 1) Is the data proprietary? 2) Are the insights from the data critical? and 3) Does the data fuel a product feedback loop?

Verisk began its operations in 1971 as Insurance Services Offices (ISO), a non-profit enterprise started by P&C insurers to collect industry data and information that was used by its sponsors to determine premium rates, underwrite risk, develop products, and report to regulators, basically acting as a cost center for the P&C industry.  The entity expanded into analytics with its acquisitions of American Insurance Services in 1997 and the National Insurance Crime Bureau in 1998 (which brought expertise in claims fraud detection and prevention) before converting to a for-profit organization in 1999 and going public in 2009 as Verisk (ISO became wholly-owned subsidiary of Verisk).  The company acquired a bunch of companies from its ISO days to today, bolstering its core insurance risk assessment services and expanding into new industry verticals.

Verisk’s decades-long legacy as the central repository of P&C industry data is the heart and soul of its competitive advantage and has served as the foundation on which all its other offerings have been built over the years.  It is difficult to overstate the critical role that Verisk plays in pricing, claims management, and administrative efficiency across the P&C industry.  For instance, Verisk sets the de facto industry standard on language – “court-tested” and found in 200mn of the 250mn policies issued in the US – used in policy forms sold to insurers via subscription that ensures consumers are getting the same amount of coverage for the same quote across insurers.

The company sits at the center of a network that procures data from a wide variety of sources (claims settlements, remote imagery, auto OEMs), analyzes it, and delivers predictive insights to clients (insurers, advertisers, property managers).  The agreements through which a customer licenses VRSK’s data also allows the company to make use of that customer’s data….so essentially the customer pays Verisk for a solution that costs almost nothing for the company to deliver and Verisk gets to use that customer’s data to enhance its own solutions, which improved solutions reduce churn and attract even more customers (and their data) in a subsidized feedback loop.  This flywheel, built on top of Verisk’s historical advantage as the repository of industry data, has generated world’s largest claims database (VRSK aggregates claims data from 95% of the P&C industry), containing granular information on 1.1bn claims (up from 700mn claims in 2011), with the insurance ecosystem submitting ~200k new claims a day across all P&C coverage lines.  It would be effectively impossible for a competitor to replicate this ever-burgeoning flurry of data.

[Aside: VRSK’s spending on public clouds has dramatically escalated over the last few years, allowing the company to not only realize considerable cost savings (without public clouds, it would have been far more costly for Verisk to secure engagements with European retail banks, who operate under strict privacy laws that require data to reside within the country of origin) and flexibility as its datasets continue to expand in girth and complexity, but to also apply machine learning to those datasets and enable new functionality to its services].

Comprehensive data paired with a decent model generates better insights than limited data paired with a great model.  An insurer that relies solely on in-house claims experience cannot underwrite risks with nearly the same degree of accuracy as one with access to the entire industry’s data.  Consider all the vehicle ratings variables – make & model, location where the car is garaged (down to one of 220k census blocks), mileage, driver’s record, semi-autonomous / safety features in the vehicle – that VRSK accounts for in assessing loss costs on 323 ISO series cars (cars that are part of the ISO ratings series used to match premiums to type of car).  Or the construction costs – from roofing material to drywall to electrical and HVAC contractor rates – monitored across 460 regions across North America and updated monthly using Verisk’s Xactimate software, which insurers use to quantify replacement costs, including labor and material costs, within 21k unit-cost line items in the event of a claim and compare computed insurance-to-value estimates to those submitted by brokers at the beginning of the underwriting process.  A contractor who shows up to a damaged home after a storm can leverage the 100mn price points stored in Verisk’s database, estimate a policy claim, and then share that information with the policyholder, adjuster, and the claims department.  Like Verisk’s policy forms, Xactimate, too, is an industry standard used to estimate nearly 90% of all personal property claims in the US.

Data is further leveraged to improve efficiency and the front-end experience of insureds.  For instance, per one case study, a large auto insurer typically spent 15 minutes walking a policy seeker through its sales funnel (an initial 40-question quote inquiry that transitioned to processing, where 35% of qualified leads had their initial quotes changed, and finally to binding), with lead leakage at each step along the way, ultimately translating into a conversion rate of just ~7%.  With Verisk’s LightSpeed, the insurer spent less than a minute on the sales process and doubled its conversions.  By sifting through a deluge of 300mn transactions per month pulled from odometer readings, vehicle reports, and claims loss history, Verisk only needs a few pieces of information from the customer upfront to arrive at the right price within seconds at the point of quote.

With claims settlements absorbing 2/3 of the $600bn of premiums collected by the US P&C industry every year (not to mention the $6bn-$8bn of fraudulent auto injury claims), and the industry as a whole generating negligible underwriting margins over time, solutions that improve operating efficiency, improve sales outcomes, and accurately estimate the industry’s largest expense item, are obviously critical.  Verisk’s products are tightly integrated into customers’ workflows and consumed as subscriptions (subscriptions represent ~85% of the company’s revenue).

1) Is the transformed data proprietary?  Check

2) Are the insights from the data critical?  Check

3) Does the data fuel a feedback loop that deepens the data moat?  Check.

VRSK has a nice moat in the P&C vertical.  But of course the best companies not only have dominant competitive advantages around their existing business, but also huge advantaged growth opportunities, and it is here, I’m afraid, that prospects look bleaker.  Here are what management sees as its growth opportunities:

Cross-selling:

Selling existing products to new customers and introducing new products to existing ones.  This is the most compelling opportunity from a probability-of-success standpoint and has motivated much of the recurring tuck-in acquisitions made by the company over the years.  Over the last several years, the company has re-oriented how it approaches the customer, moving away from a siloe’d approach to product sales to integrated teams: most of the company’s sales to insurers are bundled products that improve customer stickiness while boosting revenue and sales personnel are compensated on product sales made across both reporting segments (Decision Analytics and Risk Assessment).

New verticals:

Repurposing existing IP and capabilities to breach new industry verticals seems reasonable in theory, but has had only so-so results in practice.  For instance, in 2004 the company acquired its way into healthcare (reporting systems and analytical tools for health insurers) where it could bring its expertise to bear in a big market beleaguered by hundreds of billions of dollars of annual fraudulent claims.  The company also thought that understanding the healthcare market would give it greater insight into workers comp, which constitutes 20% of the P&C market and where rising medical costs constituted a growing portion of claims.  Management pushed further into the space with significant healthcare acquisitions in each of 2010, 2011, and 2012, with seemingly robust growth for several years before healthcare revenue suddenly contracted in 2015.  Then, in a sudden about-face, the company put Verisk Health up for sale in late 2015, blaming a regulatory and industry structure that made it hard to acquire unique data assets.  Another example.  In 2005, Verisk acquired its way into the mortgage sector under the premise that personal property data collected in the P&C business could be leveraged to detect fraud in the mortgage lifecycle only to divest this business in March 2014.

Based on my experience, companies that acquire a bunch of companies only to divest them years later usually leave huge craters in shareholder value.  That is not the case here.  Verisk Health, sold for $820mn to Veritas Capital, realized a 12% pre-tax IRR during the company’s 12-year ownership period while the $155mn sale of Interthinx to First American implied a 15%+ annual return.  While both businesses failed to hit the company’s 20% hurdle rate, they at least met a reasonable cost of capital threshold and if you were feeling charitable, you might even credit management for explicitly considering return requirements at all. The takeaway from these stories would seem to be that the company optimizes returns on capital when it reinvests in its core P&C business….which is why Verisk’s $2.8bn cash/stock acquisition in May 2015 of Wood Mackenzie, a subscription-based provider of data analytics and commercial intelligence for the hydrocarbons industry (with 99% customer retention growing ~10% organically at the time of acquisition) was a head-scratcher to me.  Wood Mac is a mission critical application for anyone involved in the oil and gas industry (E&P companies, investors, banks) who needs to stay on top of the supply curve and understand the productivity of various oil projects around the globe.

According to management, there were some immediate cross-sell gets between WoodMac and Verisk Maplecroft (country risk monitoring), but the latter was a really tiny business.  Apparently, the bigger, medium-term opportunity is introducing WoodMac’s data assets in the energy sector to its P&C insurance customer base, but for the time being this looks more like a standalone data business with an independent growth vector and over the last year, management has acquired several more hydrocarbon data companies to bolt onto WoodMac.  After 2 quarters of growth following the acquisition, WoodMac has experienced y/y declines in each of the last 5 quarters on end market weakness and currency headwinds.  So, on the surface, it looks like the company paid an 18x multiple on peak EBITDA (vs. the 9x that it has historically paid for acquisitions) for a good business, but one with questionable synergies.

And then there’s this third vertical, Financial Services, within the Data Analytics segment that provides competitive benchmarking, analytics, and measurement of multi-channel marketing campaigns for financial institutions around the world, including 28 of the top 30 credit card issuers in North America.  With its consortium-fed depersonalized data sets (which management claims is the most comprehensive in the payments space with a view into millions of merchants, billions of accounts, and trillions of transactions – including PoS and online transactions – tracked daily), the company offers “enhanced marketing” and risk management solutions to clients.

While the acquisitions of Verisk Health, WoodMac, and to a lesser degree Financial Services do indeed bring proprietary datasets into the company’s fold, they more mundanely resolve the problem that all great but maturing business run into, which is what to do with all the cash flow given limited reinvestment opportunities in the core business.  To be clear, these acquired verticals seem like “moaty” businesses in their own right, but synergies with the core P&C vertical are murky or non-existent, so it’s unclear to me why these businesses have much more value inside Verisk than as standalone companies….and they certainly weren’t acquired at distressed, opportunistic prices.  Also, given all the big talk around ROIC metrics and the company’s recurring acquisition activity, it’s a bit irksome that management’s comp is tied to pedestrian measures like total revenue growth (at least it’s organic growth) and EBITDA margins.

Anyhow, I’ve spent too much time on this topic as the core Insurance business still constitutes 70% of revenue and even more of total profits and in any case, if history is any guide, management will dispassionately evaluate these segments against target IRRs.  According to management, from 2002 to 2015, the company has earned a 19% annualized return on its acquisitions (assuming a 10x exit EBITDA multiple) and a 15% return on share repurchases.

International expansion:

The problem with unique data sets is that they’re, well, unique.  P&C insurance is a regional market with asset types, regulatory regimes, and demographics that vary widely by country and so the robust dataset that Verisk has spent decades building in the US has little relevance overseas. As even management will admit, the international opportunity is more aptly characterized as “multi-domestic.”  Furthermore, for the most part, insurance companies overseas have less sophisticated workflows compared to US insurers, and so the product bundles are slimmer and require a more consultative sales approach (i.e. they cost more to sell).

The quality of the business is adequately represented by VRSK’s profitability: 50% EBITDA margins that, depending on acquisition activity, go up a little or down a little each year, but have certainly expanded over time (from 44% in 2011 and 48% in 2012).  The 70% of revenue coming from the P&C industry should basically reflect economic growth (+lsd), share gain, and cross-selling (+lsd) offset by modest contraction from customer consolidation, so call it +5%-6%.  Financial services and energy, the other 30% of revenue, grows at maybe 10%-15%, blending out to something like 8%-10% growth on a consolidated basis, which maybe translates into low double-digit growth after baking in buybacks.

At 27x trailing earnings, valuation seems uninspiring relative to other high quality businesses that trade at similar valuations but have far bigger growth opportunities to boot (MA and V come to mind).  There are weighty long-term risks to consider as well.  For instance, mass Level 5 adoption will not only reduce the number of vehicles on the road and accidents but re-define value capture within the auto ecosystem.  That’s still probably at least a decade out, but on the way, improving advanced driver assistance systems that dramatically reduce accident rates (this reduction will happen quicker than some may think because of the salutary knock-on effects that equipping one vehicle with ADAS has on others.  I think we’re in this moment now where the rate distracted driving has exceeded the rate at which these systems have improved, leading to a recent uptick in vehicle accidents, but the trend will resume is southerly course in due time) may reset accident curves and impugn the relevance of historical datasets, carving horizontal inroads for competitors with more generic big data and machine learning capabilities who can create new, more relevant datasets from sensor data.