Root’s IPO: Innovative, but not quite the right time

Insurtech company Root Inc. (NASDAQ:ROOT) released initial details Monday about its plan to go public. In its S-1 statement with the SEC, Root used a filler price plan of $100 million used to calculate filing fees. Reuters reported in late September that Root is aiming for a valuation of $5 to $6 billion. This is substantially larger than the IPOs filed by Lemonade (NYSE:LMND) and SelectQuote (NYSE:SLQT), two other insurtech companies which filed to go public in the summer.

Both of these companies, as is the case with many tech IPOs, had strong debuts but have seen their share prices fall ever since. Lemonade trades at $52.44 as of the time of writing, down over 35% compared to its post-IPO price in early July.

There are some investors who still think that Lemonade could be a great value down the long term due to its innovative business model. But even if that is the case, it would have been better for investors to wait until the IPO hype wears off and then invest over the long term now instead of investing immediately after the IPO.

Root is in some ways quite different from Lemonade, most notably the fact that Lemonade focuses on rental or home insurance while Root focuses on auto. But they are highly similar in many ways, and so it seems that the same recommendation should apply to both companies.

The Future of Insurance?

The auto insurance market is a $266 billion market with well established names that everyone has heard of, and so may seem like a difficult market to break into. But Root, like many who start a company, like YEAH! Local, argue that very size presents an opportunity for a disruptor like itself.

In its SEC report, Root states that established insurance companies rely on the law of large numbers and cannot personalize insurance costs in the way that it can. Root collects massive amounts of data and then uses a data field called telematics and its insurance platform to account for consumer driving habits in unique ways. As one example, Root notes that drivers who hard brake more often file more claims compared to those who do not. By using little tidbits of information like this, Root can offer a better deal to consumers.

This is especially so for younger customer and millennials, Root’s primary target audience. Root states that “93% of millennials are willing to share their driving data” if it can help control their premiums, and the company primarily engages customer through mobile phones and the Internet. Root’s goal is to secure a captive millennial audience through good auto insurance rates, and then offer additional insurance services. Root is also looking to expand into homeowners and renter insurance, but has less than 6,000 renters policies in force as of June 30, 2020 compared to over 330,000 auto insurance policies.

But there is a problem with this rosy story. As noted above, Lemonade focused on rental and home insurance while Root focuses on auto insurance. This distinction is important because homeowner insurance is much less online compared to auto insurance. Major auto insurers like Geico or Progressive (NYSE:PGR) already have a strong online component, and Root needs to show a consistent ability to stay technologically ahead of competitors who will otherwise crush this upstart.

Root’s Finances and Valuation

While Root is going up against larger competitors who are already online, it has its unique telematics approach and is marketing heavily towards millennials. As a result, the company has grown rapidly. Root reported a revenue of $245.4 million in the first half of 2020, a 135% increase compared to the same period in 2019. This spectacular number is made even better by the fact that Root’s policy growth was just 52% during that same time period, which indicates that existing customers are purchasing more and better policies. As noted above, this is a key aspect of Root’s growth strategy.

The major downside is that Root, like many other tech companies, is not profitable as it reported a net loss of $144.5 million in the first half of 2020. Root’s net losses are rising, though not as quickly as its revenue is growing. And the first half of 2020 was the first time where Root’s revenue exceeded its loss and loss adjustment expenses. Furthermore, Root’s cash lost from operating activities decreased from $127 million to $62 million over the same period.

Root may not be profitable yet, but it is on the right path and is in a large market where it should be expected to grow. Its high growth rate is evidence that it can compete against larger insurance companies.

Do those numbers mean that Root is worth $6 billion? Root’s 2019 revenue was $290 million. If we assume a consistent 135% increase, that means Root’s 2020 revenue can be forecasted to be about $681 million, which means a P/S ratio of 8.8.

This is significantly higher compared to other insurance companies, yet also lower than most tech companies. This includes Lemonade which has a double-digit P/S depending on how it is exactly calculated.

Wait and See

Root’s $6 billion valuation is not unreasonable, given the potential of the insurtech industry as a whole as well as its rapid growth. It does have the potential to change how we think about auto insurance, from looking at trends in the aggregate to instead focusing on the individual. It is growing rapidly and while not profitable yet is trending in the right direction.

But most of these very traits, except for the high ratio, could have been applied to Lemonade as well. And in Lemonade’s case, we saw that after some initial hype, the company has struggled ever since. It could turn around, but Lemonade serves as a warning that jumping into an IPO immediately when the hype is largest is a risky bet.

Investors should strongly consider Root’s potential, but should still probably wait until the lock-up period expires in a few months. Nevertheless, do not take this caution to mean that insurtech should be avoid. This is a field with immense potential and many interesting companies.

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