ROOT & LMND 4Q24 earnings review
Root is still an amazing long, perhaps a generational one. But the insurance cycle will likely turn sour soon which is why I am happy it has an evil twin that can be shorted as a hedge.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
Yesterday, Lemonade LMND 0.00%↑ reported their 4Q24 earnings. After an initial 16% sell-off, the stock recovered and it is now back to roughly where it was before earnings. Today, Root ROOT 0.00%↑ reported their earnings. We will have to see what it does tomorrow, but as of this writing it’s up 22%.
The pair trade of these two stocks is one of my highest conviction views. It’s one of the starkest mispricings of two assets that I am aware of and it will likely take a while for it to resolve. Both companies are trying to disrupt the insurance industry through a technology-enabled approach. But while Root is making great progress in making their vision reality, Lemonade always leaves me puzzled whether their nonsensical communication and their weak operating performance is the result of incompetence or malice.
Let’s see where both companies stand based on their recent earnings releases. How have they progressed against their own targets and against my expectations?
TLDR Summary
Root’s earnings confirm the bull case that I have outlined in various articles. They have proven once again that they have developed a policy pricing engine and a policy acquisition platform that enables them to earn an industry leading return on capital. Given they are still small, they have an advantage in terms of redeploying their returns into profitable underwriting. This will create a flywheel that will grow them into a much larger company over the coming years.
Their use of reinsurance is moving towards zero which demonstrates management’s confidence in their technology. Their operating leverage and efficiency is on par with established players that are much larger with beneficial economies of scale.
I am not concerned that stalling written premium signals slower growth ahead. Management has a very disciplined approach and an amazing track record that warrants believing in their ability to use their engine to create shareholder value. At 23x earnings, the stock can afford a few quarters of consolidation in the business.
Lemonade actually reported quite strong results with revenue up 29% YoY and net loss narrowing to $30m with both loss ratio and operating expenses tracking in the right direction. While this has indeed surprised me to the upside, it’s also true that this quarter was aided by CAT losses being very low. If the CAT impact had been in line with the average of the last three years, the loss may have been $20m worse. What has now become an outstanding quarter (measured by Lemonade standards), would then have been a mediocre one.
Why had the stock sold off then initially? I believe for two reasons. Firstly, management walked back their ambitious (or should I call them delusional) car insurance growth targets. Guidance was much more cautious than at the investor day a few months ago. Secondly, it seems to dawn on the market that the company’s current trajectory will likely not be sufficient to carry its $2bn valuation.
The key question for Lemonade is how fast they will get to breakeven and how much equity book value will have been depleted by then. They have $593m left, down 17% from a year ago. I reckon they plan to burn through another $200m at minimum by the time they reach breakeven at the end of next year. Book value per share would then be about $5.
If they reached industry-typical profitability relatively quickly afterwards (big if!), their equity market value may be worth 2x to 3x book, suggesting a price target of $10-15, still fairly in line with the target I presented in my original short report. It would be more than 50% downside based on the current price.
Aside from company-specific considerations, it’s worth acknowledging that the insurance industry as a whole has been in an absolute sweet spot over the last two years with inflation in their revenues and deflation in their costs. CPI and PPI data suggest that this gap is closing which may put pressure on loss ratios going forward. From a pure cyclical perspective, it can’t get much better than 2023/24 for the insurance industry. This is the most relevant risk I see for the Root bull case and it is the reason I feel comfortable hedging with it a short position in Lemonade.