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Root Q3 earnings: Is it time to pop the champagne?

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A day. Sometimes all it takes is a day for the narrative to shift. At least on the surface.

A day earlier, the discussion had centered on whether Root – which is down 71% YTD – will need to be rescued in a deal paralleling Lemonade's acquisition earlier in the week of Metromile.

This nail-biting suspense was somewhat lifted with the company hanging on by the skin of its teeth and making the numbers when it reported results after close Wednesday. The forward guidance was mostly unchanged. An absence of materially bad news was viewed as a positive.

In our various short interest notes, we have often highlighted the significant gap between InsurTechs and established insurance companies. We have also noted a trend where the short interest has held steady despite the InsurTech stock market rout this year. So, the stock jumping 24% yesterday was not a surprise as a degree of short squeeze played out.

Have we turned a corner? Should the company be popping champagne?

Taking a step back, it makes sense to ask what has changed over the past few days.

As the CPI data illustrates, the broader loss-cost issues have the personal auto sector firmly in their grip.

This new normal includes supply chain issues, covid-related auto-repair labor shortages, increasing new and used car prices, replacement parts costs etc.

And while companies such as Progressive and  Allstate have more room to maneuver around rates/growth/loss costs, new companies find themselves playing a game of whack-a-mole.

For them, it is either pick the growth of the retrenching established carriers or give up on the promise of growing like gangbusters.

Root finds itself pulling back on marketing spend and taking rate action, leading to depressed retention, slow growth, as it hopes to show bottom line improvement.

This sounds good, but the company is simultaneously tweaking its telematics model to do more with less. Theoretically this sounds appealing given the problems it has had, but given the fast-changing loss cost trends, there seem to be many things going on at the same time.

Meanwhile, the Carvana partnership sounds great on paper – but it seems quite possible that this offers improved optics without changing the game. Based on the call, it sounds like the companies are still in the process of cooking it.

One day does not make a trend, and we continue to ask for verifiable proof of a profitable differentiated product. Below is our take on the pertinent topics surrounding this company.

Firstly, Carvana’s potential benefit may be limited.

The company announced a relationship with auto dealer Carvana to embed its insurance products in car purchases at the point of sale. Root’s partnership with Carvana was announced in August and is currently in the development and testing phase in 12 states, where Carvana cars can be bought with Root’s telematics already installed.

While the relationship with Carvana is still at an early stage, the firm hopes that the partnership will in time boost the insurer's policies-in-force.

Carvana is the country’s second-largest used-retail vehicle dealer and is expected to sell over 400,000 vehicles in 2021, a 65% increase from 2020. However, this relationship has to translate into a high take-up rate and run at a decent combined ratio to add to the bottom line.

Below, we estimated how much premium Root could gain from the relationship. Based on Carvana’s car sales and Root’s average premiums per policy, Root could see $17mn to $100mn in additional premiums in 2022 depending on the take-up rate for the policies.

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Even under an optimistic 96% long term combined ratio, $100mn in premiums would translate to about $0.15 of EPS (vs a $0.53 loss this quarter).

Secondly, new business growth will slow as the company cuts marketing expenses.

Root’s management noted a pullback from marketing expenses last quarter, predicting a decline in 2022 top line growth. This quarter's growth remained strong due partly to what management described as “the halo effect” of past marketing efforts.

Year-over-year growth in policies in force is 18% in Q3 vs. 1.2% in Q2 and 11.7% in Q1. While the firm posted strong growth this quarter, we anticipate a slowdown as the lower marketing expense takes effect.

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The company cut sales and marketing costs from $111.7mn in Q2 to $65.4mn in Q3, which helped the bottom line. This difference translates to 53 expense ratio points or $0.18/share.

It remains to be seen how much pressure growth comes under when the effects of current cuts in sales and marketing play out over 2022.

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Thirdly, little improvement in renewal ratios will make improving underwriting results difficult.

Renewal business is crucial for a company’s success. Simplistically, higher customer retention allows the customer acquisition costs to be spread over a longer period, and the lifetime value of a customer grows.

Considering the increase in new business, renewal ratios have seen modest improvements – but still significantly lag market incumbents.

Given the rate environment, when Root raises rates at renewal, the customers who can find a lower rate elsewhere will leave, theoretically leaving Root with less attractive business. This could lead to further pressure on underwriting results.

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Fourthly, rate increases will continue to dampen growth.

In response to the increasing loss ratio, the firm was able to push through 13 rate increases in the third quarter, a number above industry averages, according to CFO/CRO/COO Daniel Rosenthal). It is also planning on more rate increases during the fourth quarter of the year and the first quarter of 2022. The firm also noted that it began increasing rate as early as the end of the first quarter.

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In summary, once the news has been digested, the broader rough winds prevailing against the personal auto sector remain. An established company with deeper roots might weather this differently.

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