We believe that shares of Trupanion, Inc. (“Trupanion” or the “Company”), a provider of pet insurance are grossly overvalued and represent a compelling short opportunity. At current levels, they do not adequately reflect the risk inherent in (1) mischaracterization of business model (2) declining gross margins, (3) unfavorable unit economics to the consumer, (4) a product plagued by several customer complaints, (5) declining KPIs, (6) dependent on big q4 to meet guidance, (7) shareholder overhang, and (8) valuation that detracts from reality.

We estimate that fair value is at least ~45% below where the stock currently trades and significantly lower if our thesis is to be believed.

For the bullish view on Trupanion, please refer to the write-up by bdon99 and referenced below.

http://valueinvestorsclub.com/idea/TRUPANION_INC/136762

Company Overview:

Trupanion is a JOBS Act IPO that went public in July of last year. The Company provides pet insurance and services the U.S., Canadian and Puerto Rico markets.

Trupanion was founded in 1999 by its current CEO Darryl Rawlings under the name VetInsurance operating in Canada. In 2007 the company was rebranded to Trupanion. The company enrolled its first pet in Canada in 2000 and its first pet in the U.S. in 2008. The Company has ~260k pets enrolled as of June 30, 2015.

Trupanion’s core product (a direct-to-consumer policy offered as a monthly subscription service) covers accidents, illnesses, diagnostic testing, surgeries, medications, and hospital stays. Also, pet owners can select extra packages that cover items such as boarding fees, acupuncture, or physical therapy for an additional monthly cost.

The Company has also begun offering a new and what it highlights as a “disruptive” product aimed at hospitals and veterinarians. Trupanion’ Express is software that is loaded directly onto veterinarian management systems and allows for quick and seamless reimbursements. Customers benefit by having insurance pay out to veterinarians directly, and veterinarians benefit by having lower collection costs (no credit card fee) and fast payment for services rendered. Management expects 1,500-2,000 activations by the end of 2016, up from 350 targeted for FY2015.

The Company also claims to differentiate itself by deploying a network of Territory Partners that serve as Trupanion’s “boots on the street” on educating/pitching veterinarians and hospitals on the product. The Company is seeking to build out the number of Territory Partners from 70 currently to 100, especially as this channel is the leading source for pet acquisitions. Management expects this initiative to help increase the number of hospitals actively referring Trupanion, which stands at 6k currently of the 28k total veterinarian hospitals in North America.

Management believes that Trupanion will be fully at scale within 5 years when it has 600-700k pets enrolled. To put this in context, the U.S. pet insurance market is approximately 1M currently.

Short Thesis:

Red Flag 1: Mischaracterization Of Business Model

Trupanion, at its core, is an insurance provider. However, instead of specialty insurance analysts owning coverage, internet analysts cover the stock. How that has come about is unclear to us, but sell-side research abounds with quotes such as the below:

“We continue believe TRUP has very attractive characteristics of a typical high-growth Net company (large & under-penetrated market, marketplace-driven network effects, recurring revenue model, etc.), and benefits from highly visible revenues with a 98.5%+ monthly pet retention rate resulting in 90%+ revenues locked prior to start of a quarter” – RBC, August 4, 2015

“We believe high-growth Internet subscription businesses are the most relevant comparables for Trupanion, given the following similarities: large addressable market, a recurring revenue model, the opportunity for operating leverage, and focus on leveraging data assets” – Barclays, August 12, 2014

The CEO has also been extolling the virtues of his business model by making obscene comparisons.

“Our business model is similar to the cable industry in the 1960’s, the cellular industry in the 1980’s, and more recently, two companies we admire - Netflix and Pandora. Purely, we are a direct-to-consumer monthly subscription service” – CEO, 2014 Annual Report

We view the above as irresponsible at best and misleading at worst. Other than a recurring nature of revenue (which is typical for any subscription business including magazines, newspapers and believe it or not insurance companies given monthly premiums), there is nothing in the financials that provide credence to either the Sell-Side or more importantly the CEO to make such comparisons.

 Red Flag 2: Declining Gross Margins Hinder Scalability Of The Business

Trupanion prides itself in paying out approximately 70% of its premiums in claims. Unfortunately, this has created anceiling on its ability to drive gross margin expansion. Moreover, Trupanion has seen a decline in gross margins over the last few quarters (Note: Q4, 2014 saw a bump up but then the trajectory reversed). Management has attributed some of this to pricing snafu but more so as the Company rolls out Trupanion Express.

“What happens is in the old fashion reimbursement model which is in my mind one of the reasons that the penetration rate has been as low as it has been in North America. Some pet owners just don’t get around sending in their invoices with Trupanion Express we see a 100% of the invoices, 100% of the time, it’s our goal to electronically transfer the money into the veterinary and to bank account within five minutes from the time of the invoice being created.

So the biggest change is not so much change in behavior from the consumer although there is a slight change in behavior, the biggest change is that we’ll just see all the invoices, it’s kind of the inverse effect of what you’ll see with a lot of companies that have store cards, a $50 card to be used at our certain retailer. Some of those people just never get around to using it, what was happening before in the reimbursement model is some people just don’t get around sending in the invoice that’s the biggest impact. “– CEO, Q1 2015 Earnings Call

As the Company continues to ramp up its Trupanion Express roll-out (20% of claims dollars being paid out via Trupanion Express), we expect to see sustained pressure on margins. Management is trying to combat this effect by putting through pricing increases. Though historically having been successful (given lower price points), it is our view, that such price increases are going to be met with resistance and we expect attrition to pick up as a result, thereby further impacting profitability.

Red Flag 3: Unit Economics Are Not Favorable To Consumers

There has been a constant debate whether it makes economic sense to take out pet insurance. Consumer Reports (in August 2011) compared the cost vs. payout of nine pet policies for Roxy, a healthy 10-year-old beagle in Yonkers, N.Y.  Based on their analysis, they found that Roxy’s lifetime veterinarian bills have totaled $7,026 (in current dollars). In every case, the total premiums that would have been paid to those insurance companies were higher than Roxy’s medical bills.

The magazine then gave Roxy a few hypothetical medical problems to boost her veterinarian bills to $12,685, and only five of the nine policies (Trupanion included) would have paid out more than they cost.

That said, Consumer Reports believes it makes more sense to put a couple of hundred dollars into a household emergency fund each year for serious pet health issues  rather than purchasing pet insurance. 

http://www.consumerreports.org/cro/magazine-archive/2011/august/money/pet-costs/pet-insurance-rarely-worth-the-price-in-our-analysis/index.htm

We tend to agree with Consumer Reports assessment and are of the opinion that certain breeds are more prone to major health issues than others, which then makes purchasing pet insurance a viable option.  

Red Flag 4: Product Offering Plagued By Several Customer Complaints

Trupanion operates in a highly competitive market against several insurance providers backed by well capitalized companies (e.g. VPI (Nationwide), Petplan (Allianz), Healthy Paws (Aon), Hartville (Fairfax Financial)).

http://files.dvm360.com/alfresco_images/DVM360/2015/01/23/37ff79d0-f607-4a62-9ecb-452dcf4ee66b/vete_PetInsChart.pdf

One way to engender loyalty and drive brand awareness and subsequent future growth is to ensure that existing customers have a great experience such that they become brand ambassors. However, a Google search for “Trupanion Complaints” pulls up Yelp reviews which are generally very poor.

http://www.yelp.com/biz/trupanion-seattle-4

We will let you decide but some of the complaints include the following:

“I have a 6 year old cat that had rarely vomited for hairballs.  I had mentioned it at a doctor visit before I got this policy but wasn't concerned as it was rare and she never stopped eating.  Shortly after getting this policy, she had an incident where she was vomiting a lot and I was concerned for her health.
I filed a claim for the doctor visit and was denied by Trupanion because they felt it was a pre-existing condition.  Even after an appeal and a letter from the vet stating that it was unrelated, the claim was denied.
I let the matter drop and she was fine for over a year.  She then started having a vomiting episode and this time stopped eating altogether.  Again, the claim was denied...even after over a year of no problems.  
I have summarily cancelled this policy and will never recommend this company to anyone.  It certainly did not help me in any way and I felt that it was a huge waste of time and money.  You are better off putting aside $30 to $50 a month and using that to pay the vet directly.” October 12, 2015

“Trupanion was represented to me as among the best for if I was ever in the need. Their price (I pay $50/mo for $150 deductible) was also among the highest. You get what you paid for right? A lot of people on this page (and some fake ones) were helped out greatly.
Well they still may be very good- who knows. But after about 4 years of this almost double priced insurance, I needed help with my dog's surgery. Trupanion has tricks up their sleeve like any other big business- tricks that enrich them greatly. They considered their deductible "per condition" and not per year or per incident like you're used to with auto insurance.
After considering almost every incision in my dog a separate condition, they got me for the deductible times three!  After the deductible was multiplied so many times, the payout was almost not worth driving to the bank. Bad company...
In their defense they said that a condition like diabetes over years would cost more in per year deductible than per condition- great news or whatever. They were nice enough on the phone, but like many businesses are becoming nowadays, they had nobody who could help at all; no flexibility whatsoever to keep me as a customer.
The appeals process put the onus on me to convince my vet to write letters (for a failing cause). I'm sorry but I'm busy working to make the money to put in their pockets! I don't have time to go jump through hoops, especially on something that literally is their line of business, not mine. They could just go to my vet for the info they needed, because alas they are the ones who know what they need to know, not me.
So it was a double whammy for me today... What else will they do? That's what I'm wondering!
It's a pain that for such an expensive plan, I have to go through the fine print of the contract to find where they want to screw me. Usually paying more means less time catching them at their tricks. What a waste of $600/yr so far... Basically if nothing giant happens, Trupanion uses the multiple deductible trick to neutralize payouts so they can make their money hand over fist.
Not saying another company is better, just watch out and don't trust Trupanion's sales team- Read the fine print very carefully- it's where they make their money!” – August 18, 2015

Red Flag 5: Company KPIs Are Beginning To/Have Been Deteriorate/Deteriorating

Trupanion manages its business on certain KPIs as referenced below.

“Total pets enrolled. Total pets enrolled reflects the number of pets subscribed to either our plan or one of the plans offered in our other business segment at the end of each period presented. We monitor total pets enrolled because it provides an indication of the growth of our consolidated business.

Lifetime value of a pet. Lifetime value of a pet (LVP) is calculated in a reporting period as the average monthly contribution margin per pet over the 12 months prior to the period end date, multiplied by the implied average subscriber life in months. The average monthly contribution margin per pet is calculated by dividing gross profit for our subscription business for the period, excluding sign-up fee revenue, the change in deferred revenue and stock based compensation expense recorded in cost of revenue by the number of subscription pet months in the 12-month period. Implied average subscriber life in months is calculated as the quotient obtained by dividing one by one minus the average monthly retention rate. We monitor LVP to assess how much lifetime contribution margin we might expect from new pets over their implied average subscriber life in months and to evaluate the amount of sales and marketing expenses we may want to incur to attract new pet enrollments

Average pet acquisition cost. Average pet acquisition cost (PAC) is calculated as acquisition cost divided by the total number of new subscription pets enrolled in that period. Acquisition cost, a non-GAAP financial measure, is calculated in a reporting period as sales and marketing expenses, excluding stock-based compensation, offset by sign-up fee revenue. We offset sales and marketing expenses with sign-up fee revenue since it is a one-time charge to new members used to partially offset initial setup costs, which are included in sales and marketing expenses. We monitor average pet acquisition cost to evaluate the efficiency of our sales and marketing programs in acquiring new members and measure effectiveness using the ratio of our lifetime value of a pet to average pet acquisition cost.”

From the above tables it is clear that two important metrics (i.e., LVP and PAC) are moving in polar opposite directions from where they need to be. In other words, the LVP has come down from $602 in Q2, 2014 to $570 in Q2, 2015 representing a decline of ~5%. Additionally, we have seen the PAC ramp up from $114 in Q2, 2014 to $133 in Q2, 2015, representing a growth of ~17% over that period.

As a result, the LVP / PAC ratio has trended down from 5.28x to 4.29x over the same period, and below the Company’s target of 5.1x

We are of the opinion, that the low hanging fruit has been captured, and for incremental pet additions, we will see an uptick in PAC as the Company tries to keep up its pace of growth in Total Pets Enrolled. Additionally, with Gross Margin expected to be under pressure, we fully expect the LVP /PAC to remain under sustained pressure.

Red Flag 6: Achievement Of Guidance Requires A Big Q4

From the table below you can see that the trajectory of revenue growth has started to moderate. We have discussed reasons for these in some detail throughout this document. That said, Management provided guidance for Q3 which sets them up for a massive Q4 in order for them to hit the mid-point of their suggested guidance for the full year. Specifically, Management is calling for revenue to range between $36.5M - $38.5M for Q3 and for full year to be between $145.0M - $150.0M.

We are confident that 1) pricing increases and 2) new pet additions will prove inadequate, and that the Company is likely to miss its full year numbers.

Red Flag 7: Venture Funds Continue To Own a Significant Block Of Shares

Trupanion priced its IPO at $10 well below the suggested range of $13 - $15. The Company has since traded below / and continue to trade below the IPO price. Maveron, Highland and RenaissanceRe hold ~42% of the shares outstanding and have been patient thus far. How long their patience sustains is unclear and should they decide to sell, such action will definitely add additional pressure to the stock price.

Red Flag 8: Valuation That Is Far Removed From Underlying Reality

As indicated in an earlier section of this write-up, Trupanion is covered by Internet analysts rather than by specialty insurance analysts. As a result, the Sell-Side is quick to point to LinkedIn, GrubHub, HomeAway, Netflix, Xoom, Pandora amongst others as comparables. There is no mention of any health insurance companies as part of the comparable universe.

Also, it is interesting to take note of RBC’s valuation approach. They basically give the Company credit for a “hypothetical mature margin” in FY2016, something that Trupanion has indicated, should take about 5 years to accomplish, and have slapped on a 15x EBITDA multiple. Voila you now have a $12.00 price target!

“Our $12 price target is based on EV/Gross Profit valuation multiple, and supported by EV/Revenue as well as applying EV/EBITDA multiple to a “hypothetical” mature margin EBITDA. Specifically, our $12 price target is based on 8.0x our $33 MM estimate of 2016 Gross Profit, and a 15x a hypothetical EBITDA assumption of $22.1MM based on applying a mature margin of 12%.” – RBC, August 4, 2015

Theatrics aside, we believe one of the measures of value is an approach tied to a multiple of tangible book value. Below we lay out the Company’s valuation.

The Company reported Tangible Book Value of $46.9M or $1.49 per share as of Q2, 2015. Based on that, the stock currently trades at 5.0x Tangible Book Value.

In contrast, the median P/Tangible BV multiple for healthcare insurance companies (Aetna, Cigna, WellCare, Health Net, Molina, Centene, Universal American and Triple-S Management) is 3.8x

Given that Trupanion is unprofitable, lacks scale and is not growing tangible book value, we think a discount is warranted to the comparables. Applying a 30% discount (we consider appropriate) gives us a multiple of 2.66x, which when applied to Trupanion’s Tangible Book Value of $46.9M results in a share price of $4.09 or ~45% below current levels. Should results deteriorate faster than expected, additional downside to our target is likely.