Trupanion: Love The Company But Not The Valuation (NASDAQ:TRUP)

Investment Thesis

Despite the massive TAM (total addressable market) and underpenetrated market, a fresh investment in Trupanion (TRUP) is likely to generate subpar returns as it is richly valued at present. Below I provide a brief introduction to the company and then briefly talk about the opportunity before I dive deep into valuing Trupanion.

A Brief Introduction

Trupanion provides medical insurance for cats and dogs throughout the United States, Canada and Peurto Rico. Below is a description taken from Trupanion’s 2019 Annual report explaining their business.

Our data-driven, vertically-integrated approach enables us to provide pet owners with what we believe is the highest value medical insurance for their pets, priced specifically for each pet’s unique characteristics. Our growing and loyal member base provides us with highly predictable and recurring revenue. We operate our business similar to other subscription-based businesses, with a focus on maximizing the estimated internal rate of return of an average pet.

Source: Quotes taken from Trupanion 2019 Annual Report

Trupanion generates revenue from two segments: subscription business and other business. Below is how Trupanion explains their two business segments.

We generate revenue in our subscription business segment primarily from subscription fees for our medical insurance, which we market to consumers. Fees are paid at the beginning of each subscription period, which automatically renews on a monthly basis. We generate revenue in our other business segment by writing policies on behalf of third parties. We do not undertake the marketing efforts for these policies and have a business-to-business relationship with these third parties. Our other business segment also includes revenue from companies or organizations that choose to offer medical insurance for cats and dogs as a benefit to their employees or members, and contracts include multiple pets.

Source: Quotes taken from Trupanion 2019 Annual Report

The key differentiator for Trupanion is their direct vet pay system. Trupanion is the only brand with software enabling direct payment to veterinarians at the time of checkout. With most other insurances, the pet owners have to pay out of pocket to the vet at checkout and file for reimbursements later.

The Opportunity

Pets are a loyal friend for some, emotional support for some and a family member for some.

In a pet owner survey by Packaged Facts, 95% of dog owners and 94% of cat owners agreed (strongly or somewhat) that they considered their dogs or cats to be a part of the family. This is even more so among millennials. In a survey by Weave of 532 millennials, almost 90% of this cohort would put their animal’s life before theirs, and over 90% of millennials care about their pet’s health equally to their own health. With this high reverence for pets, and the willingness to care for a pet’s wellbeing, the need for pet healthcare is evident.

Source

Pet owners spend a considerable amount of time, effort and money to make sure their pet is happy, healthy and well taken care of. Despite this the pet insurance market is massively underpenetrated. I was shocked to learn that only about 1% of the pets in the USA have pet insurance.

Source: Trupanion August 2020 Investor Presentation

Below is another graph taken from the Trupanion investor presentation which shows the massive potential opportunity in front of Trupanion just in the United States.

Source: Trupanion August 2020 Investor Presentation

At present, with just about 1% penetration, the pet medical insurance is a $1B+ industry in North America. And if you look at the penetration rates in many of the European countries, the TAM (total addressable market) for Trupanion within the United States can be huge if the penetration rate increases. As shown by the graph above, if the penetration rate in the United States reaches 25% instead of the current 1%, the TAM increases to ~$33B.

As you can see below, the pet medical insurance industry has grown at a CAGR of 22% between 2015 and 2019.

Source: Trupanion August 2020 Investor Presentation

According to the market research firm Packaged facts, pet insurance will be a $2B industry by 2022, nearly double of what it was in 2017.

Another research report predicts the global pet insurance market size to reach $11.25B by 2026. The global pet insurance market was $6.08B in 2018. The report predicts a CAGR of 8% from 2019 to 2026.

Trupanion has a lot going for it. The massive TAM, its direct vet pay system, consistent growth through the years and a recurring subscription business. On the surface, Trupanion is the kind of business that I love to own as an investor. This prompted me to take a deeper dive and estimate a fair value for the company.

Traditional DCF Valuation

For the traditional DCF valuation, my assumptions are as below. I have assigned a high revenue growth rate since the market is underpenetrated. On the operating margin side, I start with the current operating margins and assume that the company will be able to converge to the industry average operating margin by year 10. For the tax rate, I start with 0% and assume it will converge to 25% tax rate by year 10. Since the current sales to capital ratio is a lot higher than the industry average of 1, I have assumed that the company will be able to maintain that for the first three years and converge to a sales to capital ratio of 2 by year 10. For terminal value, I went with the industry average sales to capital ratio of 1. For the base year cost of capital, I went with the value that Trupanion has provided in their 2019 Annual report and gradually converging to the industry average of 6.2% by year 10.

Inputting the above values in my DCF model, I get a fair value of $36.84 for Trupanion.

Traditional_DCFSource: Author’s own work

And as with most DCF models, bulk of the value is coming from the terminal year. So based on the assumptions, this value can be whatever you want to be. I do not find a lot of comfort in valuing Trupanion using the traditional DCF model. Hence I decided to value it using per pet economics below.

Valuation using Per Pet Economics

Here I began by valuing the existing pets over its lifetime of around 6 years that the company mentions in its May 2020 Investor Presentation. And then I calculated the value added by new pets based on the pet acquisition cost (NYSE:PAC) mentioned by the company in its May 2020 Investor Presentation. Finally, I subtract the non-pet related corporate expenses like G&A and R&D to arrive at a fair value for Trupanion of $15.36.

DCF_per_pet_calculationSource: Author’s own work

per_pet_economics_valuationSource: Author’s own work

The assumptions I make clearly influences the value. So I decided to vary the key assumptions that have a big impact on my fair value of Trupanion. The three key assumptions that I played with are the PAC, CAGR in net revenue per pet and average life of the pet for Trupanion. Below is what I arrived at using different values for these three key inputs.

what_if_analysisSource: Author’s own work

In the first table, I assumed the lifetime of a pet to be 6 years which is what Trupanion has used in its May 2020 Investor Presentation. With that fixed, I have varied the PAC between $150 and $300, and CAGR in net revenue per pet between 5% and 25%. This gives me Trupanions fair value range of -$12 to $89.

For the other two tables, I have copied the first table and just increased the lifetime of a pet to 7 & 8 years. Assuming the pet lifetime of 7 years, the fair value for Trupanion fluctuates in the range of -$8 to $118. And assuming the pet lifetime of 8 years, the fair value for Trupanion fluctuates between -$3 to $149.

It is abundantly clear that improving the PAC, average lifetime of a pet and CAGR in net revenue per pet can add significant value to Trupanion. And based on the latest August 2020 Investor Presentation, it is obvious that management is working towards that. In the August 2020 Investor Presentation, the PAC has been reduced to $219 from $222 that Trupanion reported in their May 2020 Presentation and the average lifetime of a pet has increased from 71 months to 75 months.The question is what value you believe is achievable and that will determine your fair value for Trupanion. Since the average life of a pet in the USA is 10-12 years, I believe that Trupanion will eventually reach 8 years of average lifetime value of a pet and be able to reduce the PAC to $200. However, I do not think that CAGR in net revenue per pet can increase a lot beyond the current 10.4% that I have assumed based on the 2019 Annual report. This gives me a true fair value of $35 for Trupanion. At the current trading price of ~$60, I believe Trupanion is priced for a perfect future.

Trupanion’s Valuation Per 2019 Annual Report

Trupanion does a great job of explaining its business and per pet economics in its 2019 Annual report. Anyone interested in understanding the business must go through the 2019 Annual report. I will spare the details but I wanted to point out that Trupanion’s own DCF valuation arrives at a fair value per share of $34.21. This indicates that even based on Trupanion’s own DCF model, the company is currently overvalued.

Company_Cash_FlowSource: Trupanion 2019 Annual Report

Source: Trupanion 2019 Annual Report

However, when I take a closer look at the numbers provided in the 2019 Annual Report, it looks to me that Trupanion has not discounted their cash after PAC to the present value nor have they accounted for taxation. Even if I ignore the taxation part and just discount the cash after PAC to the present value, I get a fair value of $15.74.

PV_of_2019_ARSource: Author’s own work based on Trupanion’s 2019 Annual Report

Conclusion

The massive TAM, industry growing at a decent pace and the recurring subscription revenue excites me about Trupanion. However, my deep dive valuation analysis tells me that Trupanion is overpriced at present and now is not the right time to initiate a fresh investment in Trupanion. Unarguably, I love the business and the future prospects of Trupanion, so this will rank high on my watchlist of stocks to buy during the next market downturn.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This article should not be taken as an investment advice. Please do your own due diligence before investing. As with all investments, caveat emptor.

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