- Lemonade is a cheap, zero-theta call option. It could potentially deliver >100x returns.
- Auto insurance presents a huge opportunity and will be a preview of things to come. The opportunity isn’t in analyst expectations. European entry is another potential catalyst.
- Technical factors present favorable risk-reward with a price floor, low investor sentiment, and high short interest.
Lemonade (NYSE:LMND) is a very early stage disruptor looking at a massive opportunity. It is a highly scalable company that benefits exponentially both on the revenue and cost front as it scales. It could be a 100+ bagger from today’s levels if successful.
The auto insurance vertical will be a case in point of how Lemonade will operate. It will demonstrate how the company can easily add new insurance verticals quickly. This ability isn’t reflected in earnings expectations.
The company is at the beginning of its international journey starting in Europe where it’s a great fit.
Low consensus expectations, low investor sentiment, all-time-high short interest, and a technical floor will buffer downside risk and provide convexity on upside moves.
I am a buyer of Lemonade stock as I see it as a cheap, zero-theta call option.
Auto Insurance Vertical Shows How Lemonade Will Execute Going Forward
Lemonade announced its entry into auto insurance with its Lemonade Car product In late April of this year. It is only collecting pre-registrations for now but has high hopes for the vertical citing “overwhelming demand” for the product. Lemonade cites a whopping $300 bn market opportunity, which according to the company is more than 70 times larger than each of its current renters and pet insurance markets.
Past Performance Shows Auto Market Share Gains Ahead
Adding new verticals isn’t new for Lemonade. The company started with core renters & homeowners insurance and added life and pet insurance last year. Now, these new categories already make a combined 14% of In Force Premia (IFP) in their second year. This quick ramp-up speaks to the ability of the company to add new verticals and grow its addressable market. The agility and innovation Lemonade demonstrates is a must-have for any disruptor.
Lemonade will be able to gain market share due to its unique competitive advantages. Lemonade leverages technology to increase efficiency and reflects this leanness in its prices. The company uses bots over brokers on its digital platform and utilizes automation and artificial intelligence to minimize variable costs and maximize scalability. Lemonade is often heralded as the fastest and cheapest in its category. I expect the company to carry these advantages born out of technological capabilities onto the auto insurance space to see rapid growth.
A caveat here is that Lemonade’s low prices aren’t only due to the use of technology; poor unit economics are a by-product. Unfortunately, the company is a loss-maker. Lemonade recorded near $170 mn bottom-line losses from revenues of $90 mn. This is not a recent phenomenon but a trend, Lemonade has been widening its losses over time.
I believe that the market will be tolerant of Lemonade’s losses, however. The market tends to tolerate loss-making companies that are disrupting huge markets. We’ve seen this occur in Facebook (FB), Amazon (AMZN), Uber (UBER), Tesla (TSLA), Netflix (NFLX), and many many more where profitability was the cost of market share gains and rapid growth. Investors have been lenient towards Lemonade as well so far, prioritizing the bigger picture. I expect this to continue, given a stable discount factor and risk premia (read the risk section at the end).
I expect Lemonade’s stock price to highly benefit from share gains in the auto market. I expect the street to re-assess Lemonade following these gains and increase Lemonade’s potential addressable market to the entire personal insurance space. I also expect Lemonade to continue to add new verticals to grow its TAM in the future.
Huge Auto Upside Not in Consensus
The auto upside is very large. A quick, back-of-the-envelope calculation yields >$2 bn premium opportunity. My estimate is based on a rough calculation of Lemonade achieving its current market share in its core renters insurance category in the auto market. I calculate the current renter market share by multiplying LTM premia by the Q2 renter's insurance weight (rough calculation because Q2 weight is taken not LTM as a better estimate of future share) and dividing it by the IBIS World’s $4.1 bn market size (consistent with the auto market more than 70 times larger than renters, 4.1*70=287<300). This is a rough approximation but shows the lucrative potential impact of the auto category.
Source: Company filings, IBIS World, author analysis
Bears may say that this is a very long-term thesis but I disagree. Lemonade cites that its current customers are already spending more than $1 bn on car insurance each year. Lemonade will be quick to penetrate that market. Its user-friendly and “hip” product, convenience, speed, and low price should enable quick up-sell of the product.
This product was hardly factored into analyst estimates. Below is the revision chart for Lemonade’s FY23 revenue estimates which is the farthest away year revenue estimates are made for. The chart shows no expectation changes during the time when the Lemonade Car headlines first transpired (April 20) and only consensus changes during earnings announcements, which to me means that the expected changes were related to business results, and not to the new vertical.
I expect results on the auto vertical to push Street analysts to revise their growth expectations of Lemonade higher, yielding generous returns for patient investors.
Lemonade Gets Exponentially Better With Scale
Lemonade is one of those unique names that are exponentially stronger with scale. One of the main reasons why consumers choose Lemonade is its convenience. People who value convenience will also prefer other Lemonade products as they come out, giving Lemonade easy cross/up-selling opportunities. Lemonade’s unique platform enables marginally easier new product sales.
Lemonade’s network effect increases with its size. Consumers who have many products on the same platform are much less likely to leave the platform. Lemonade’s consumers will become more sticky as its verticals expand. Bundling of policies will make consumers less price-sensitive as well as they will value the convenience of a single platform over the low price of many.
Lemonade will be a better underwriter as it grows. It leverages data capabilities to offer the best premiums for its users. As it collects more data, its actuarial models will yield more accurate results. This will in turn reduce Lemonade's risk and selling price.
Lemonade executing will bring exponential growth. This is a very powerful phenomenon and one that potential investors must keep in mind. As Lemonade grows, its further growth becomes easier, gains pricing power, reduces its cost base, and increases efficiency.
European Expansion Can be Another Catalyst
Lemonade’s growth in new geographies could boost its stock price. The company recently launched in Europe and I expect it to see rapid growth in the region. This will likely increase expectations with a larger SOM and boost the stock price.
I expect Europe to be a fast-growth market for Lemonade. Despite the relative lack of venture capital and unicorns as well as innovation of large financial companies in Europe compared to the US, its consumers have been particularly favorable towards startups in the financial space. The region has been home to the likes of Klarna, Monzo, Plum, N26, Revolut, and many more. European receptiveness to digital solutions to financial processes will boost Lemonade’s growth.
Stock is Teed Up For a Large Upside Move
The stock's recent price action has brought it to a technical floor. Technical factors are one of the last things I look at but still matter as many investors pay attention to them. Lemonade’s price is at a double bottom. This presents investors with good risk-reward as it places a price floor as well as providing an easy mental point of exit.
Source: TradingView, author analysis
High short interest would catalyze any upside move. Lemonade's short interest is at an all-time high of 18.5%. As the stock is heavily shorted already, it’ll be less sensitive to negative and more sensitive to positive news. After a long consolidation period, shorts will be easy to cover their positions to lock up gains. Longs buying and shorts covering could lead to a high-convexity short squeeze.
Wall Street is also bearish in the name. Lemonade has a neutral rating across the Street which is rare. Analysts tend to have a strong bias towards Buy recommendations, and a neutral view should be considered as bearish. This limits the risk of downgrades and opens the door for upgrades.
We are at a favorable point in which any positive news arising from earnings beats, favorable details on the auto insurance launch, geographic expansion, or else would result in a large upside but the downside to negative news is buffered by technical factors and lack of marginal sellers / short-sellers.
Lemonade is a Zero-Theta Call Option On the Digitization of Insurance
Lemonade is like a call option in that it is a cheap play on a big upside. The company is at a very young point in its growth cycle. It is a disruptor in one of the largest markets in the world and if successful could go on to 100’s of billions of valuation. It currently stands at a mere $4 bn market cap. Investing in Lemonade should be considered as a highly liquid venture investment with multi-bagger return upside potential.
How the investment is better than an option is that there’s no theta bleed. Theta is the time sensitivity of an option's price. Here, it refers to the out-of-the-money option price decay as maturity nears. Thus an investor in Lemonade doesn’t necessarily need to get the timing right if they get the outcome right (Note: I haven’t included opportunity cost of capital here as real rates are negative. I cover this topic in the next section).
I am a buyer of Lemonade as I believe in the company’s potential. I think that as the company executes, it will be exponentially better and that investors today will be handsomely rewarded over the long term.
No investment is without risk, and Lemonade has lots. It’s a young company carrying a venture investment-like existential risk.
First among these risks is the high valuation. Most early-stage high-growth companies trade at extremely high multiples and Lemonade is no different with a 45x sales multiple. Despite the near-term technical floor and upside catalysts not being in expectations, there is still a lot of growth built into Lemonade’s price. If Lemonade doesn’t deliver, its price will dramatically fall.
The main reason why Lemonade may not deliver is competition. Lemonade’s competitors are insurance behemoths with decades of operations and global footprints. Competitors could cut prices for longer than Lemonade can if they wanted to and with a (relatively) small investment could develop capabilities similar to those of Lemonade and this would make product differentiation an issue. Lemonade faces existential competitive risks.
Notes of importance here: as we’ve seen with disruptors in every sector, legacy vendors are slow to adapt. Also AXA and Allianz, two global insurance giants, are investors in Lemonade. This speaks to Lemonade’s competitive position and moat, as these companies could easily build a competing product with their infinite resources, had they wanted to.
Lemonade Car launch delays could cause underperformance. The extent of the effect will be likely shallow as Lemonade Car isn’t in the analyst consensus nor the management guidance. But this still will be an issue as it is an important growth lever for the company and has occupied a lot of the company’s resources in development. No fruit for this investment would come at an opportunity cost of growth elsewhere.
A prolonged recession could affect Lemonade. Although insurance is one of the last things to cut spending on in a recession it could happen with a prolonged poor employment market. Lemonade is at particular risk as it has a user skew towards first-time insurers with its millennial focus. First-time insurers are more likely to not insure vs. prior insurance purchasers.
A vice versa of the above point to bear in mind is that Lemonade will be the leader in a strengthening economy as it has a discretionary nature. I expect a strengthening job market and that will represent an advantage, but investors with differing views of macroeconomics may want to look elsewhere. A strong economy ahead may not be the case.
Regular readers will be familiar with my macro views on interest rates and the vulnerability of the growth equity complex (read here and here). I believe that it is likely that rates will rise over the coming months. Rising rates will result in a higher discount rate due to a higher risk-free rate. This will disproportionally affect growth stocks because of their long-duration nature. Lemonade is amongst the most at risk as it’s one of the longest duration names in public markets.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMZN, LMND either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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