Lemonade-Metromile: Clever deal-making
Lemonade announced earlier this week it had struck an all-paper deal to acquire Metromile for $500mn, as the first of the public Class of 2020 InsurTechs bit the dust following a brutal year of trading.
It is easy enough to throw rocks at the deal, with Metromile a low quality franchise on the road to nowhere and Lemonade wheeling out its trademark rhetorical pyrotechnics.
It was acquiring a trailblazer, a business with mojo (“Metromile mojo” specifically). A firm which has “years of real-world feedback and iteration at scale (sic)”. And one that “those in the know” recognize has “primacy at harnessing telematics and data science to match rate to risk”.
The reality of Metromile's depreciation from a valuation of $1.3bn when it SPAC'd, its rapid cash burn, near-zero-growth and the low chance it would be able to raise fresh capital of course didn't feature in Lemonade's slick talking points.
Nevertheless, there are clever aspects to this deal and given Lemonade's stated strategic priorities I think increases its chances of success – even if building a winning direct-to-consumer auto business still looks like a long-odds bet.
There are three ways in which the deal could work for the market's most lyrical InsurTech.
First, growing any business from zero is hard and personal auto presents very particular challenges owing to regulation and the heavy lift of growing in the direct-to-consumer channel.
Personal auto is a challenging market to penetrate successfully. Buying Metromile mitigates some of the risks.
Gaining access to Lemonade's exposure data and its rate filing work is going to accelerate the acquirer's personal auto roll-out, and it will reduce the likelihood that it miscalibrates its pricing model and gets burned. This reduces some of the risk around the loss ratio.
Despite their emphasis on product and customer segmentation, the overwhelming likelihood remains that the fundamental challenge for the InsurTechs within personal auto is customer acquisition and the creation of a successful distribution strategy.
All of the direct-to-consumer InsurTechs will have to find a successful answer to the "Esurance" problem where they are forced to compete with scaled competitors that spend $1bn on marketing. The undelightfulness of shopping for insurance discourages customer switching and is one of the reasons why traditional agency distribution has held up despite a more rapid pivot towards digital sales elsewhere in the economy.
Organically growing to scale is incredibly hard – and expensive – work. Paper M&A deals therefore make sense, and utilize one of Lemonade’s key assets – its highly rated stock.
Adding ~$100mn of auto premiums in a single move represents a start, but, of course, it's a very small start with Progressive at ~$45bn and Geico at ~$49bn.
Although Lemonade had to pay $2 for every dollar of premium acquired versus a rough benchmark of $1 per dollar in the traditional market, Metromile was a smart target.
This is because Lemonade was able to acquire Metromile without meaningfully diluting its story of technological innovation and industry disruption. Buy a vanilla personal auto insurer, or its book of business, and you taint your story. Buy another InsurTech and you can keep it pristine.
Metromile had a pay-per-mile product that the market did not want, and lacked the marketing and distribution wherewithal to place it on the map and create the required growth engine. When the business rushed through its “me too” SPAC IPO, my colleagues said the company was relying on a Field of Dreams customer acquisition strategy – "Build it and they will come". And, as predicted at that point, this was not enough to scale the business to the $1bn+ premium level where it projected it would break even.
Second, buying a cash rich company for all-paper operates as a kind of "shadow secondary offering", likely pushing back the time when Lemonade has to tap the market again.
Lemonade made it abundantly clear on its third quarter call that it is not anticipating becoming cashflow positive in the near term, with its focus instead squarely on growth and long-term value creation.
The business generated negative cashflow of $171mn in the year-to-date, and with revenue doubling in Q3, this cash burn is only set to accelerate. It is difficult to estimate the way in which the merger will impact the burn, or how Metromile will be managed through to the expected second quarter close of the transaction, but with ~$300mn of cash – it is likely that this provides Lemonade a bigger window to raise equity.
Having floated into a rebounding, tech-friendly stock market, Lemonade stock initially went on a tear, and it carried out a secondary offering in January when the stock was riding high. But since that point it has gone into reverse, and is now trading at around a third of its peak.
Under these circumstances raising fresh capital has scope to be painful. Providing more time to get the story right and increase market confidence is a smart move that reduces down-side risk.
Third, the initial market response to the deal has been negative, but there is scope here for a fresh instance of InsurTech alchemy, as well as some straightforward multiple arbitrage.
Lemonade's shares closed down 11% day one, but there is scope longer term for what I have called InsurTech alchemy to do its work, where assets are moved from one place to another transforming the market perception of their value.
Metromile was a challenged business, but packaged in the right way as an accelerant for Lemonade Car, the same book of business and the associated IP could be a major share price driver for Lemonade and its shareholders.
Moreover, while Metromile net of cash sold out for around 2x premiums in force (PIF), Lemonade trades at around 12x. There is a likelihood that the market over time will choose to recognize that these premiums have more value in the higher growth Lemonade ecosystem than they do with Metromile, and that should drive the stock higher.
However, for all the clever aspects to the deal – and I want to give it its due - it remains that Lemonade is buying a company which had manifold problems, and that was not going to make it on its own.
In buying such a business, there is always a danger that you import fundamental flaws into your own. And there were plenty of those in Metromile that Lemonade will need to identify and shut out of Lemonade Car if it is to stand a chance.