What I Like and Dislike about Trupanion (Part 1)

Quick Summary

• Can see valuation upside.
• All the pieces fit. Large under-penetrated TAM means long growth run way. Unique value proposition. The activity/value chain is specifically tailored to that value proposition and hard to duplicate. 
• On the other hand if your entire value chain is tailored to a value prop that's not appreciated by market, that’s a problem!

Trupanion (TRUP) has been a fascinating company to look into. This post will sketch out Trupanion valuation upside, as it's not so obvious. A later article will discuss more qualitative considerations.

Is This Worth Our Time? Sketching Out The Upside

Trupanion will have about $380mm revenue for 2019. The company plans to keep spending on acquisition cost such that it grows 20%-30% a year. This is possible due to an under-penetrated TAM (penetration rate in single digits).

Even if they undershoot that growth CAGR, I can see them reaching $1bn revenue in 5-6 years.

What will margins look like? Trupanion targets 15% margin before acquisition cost, depreciation/amortization (“D&A”), and stock based compensation (“SBC”). This is broken down into 70% claims payout, 10% variable cost, and 5% fixed cost. TRUP is already close to those targets.

We need to figure out what normalized acquisition costs look like once they reach scale and exit growth mode.

How Will Acquisition Costs Look At Scale? 

In other words, how much will Trupanion have to spend on acquisition cost to keep its pets enrollment steady?

The company gives its dollar acquisition spends each quarter. That and other pieces of data allow us to back out the quarterly acquisition and attrition as follows. 

Quarterly additions and attritions are about 8% and 4%, respectively, of pets at beginning of each period. 

To maintain its number of pets, Trupanion would scale down its acquisition spend, such that its pet additions matches its attrition rate. Since attrition are mostly 50-55% of additions, they can scale down their acquisition by that ratio.

Acquisition spend runs about 9% of revenue. Scaling that down means TRUP needs to spends ~5% of revenue to maintain its pet enrollment. 

Upside 

Trupanion appears to be on its way to reaching its target of 15% margin before acquisition cost, D&A, and SBC. We just estimated that they need to spend another 5% on acquisition cost to maintain pet enrollment.

That means about 10% adjusted EBITDA margin. Take out another 3%-4% for D&A and SBC leave us 6-7% EBIT margin.

$1bn revenue at these margins means $60-70mm of GAAP EBIT, or $100mm of adjusted EBITDA. At $36/share, TRUP has under $1.3bn market cap. It has little debt. So it’s trading at <13x 2025 adj EBITDA or 20x 2025 EBIT. I think there’s upside at these valuations, given the long growth runway even when we get to 2025.

Depending on market conditions, an established market leader with steady subscription revenue and long growth runway can easily be at 20x EBITDA. That would be 50% upside but spread over several years. More if you’re willing to look further out in time. 

This is not a ton of upside, but I like this business enough that I'd be interested at a lower price. I will share more of what I like in a later post.

Note: In reality TRUP’s EBIT will be lower at 2025, since it will spend more than 5% of revenue to grow, not just keep subscribers steady. But the market should value the company on future profitability outlooks (which are the 6-7% EBIT / 10% EBITDA margins)

How Small Beats Large

How does a smaller company beat a large company with seemingly unlimited resources?

This is a problem I have been struggling with, and here are some thoughts (basically a synthesis of Porter and Christensen).

The problem has to be looked at from both sides, let's call them SmallCo and BigCo. The SmallCo's strengths alone are not going to be enough, nor the BigCo's weaknesses. It's only when the former's strengths match the latter's weaknesses that you have a David beats Goliath situation.

So let's look at it from both sides, starting with BigCo.

Just because a company has the resources to fight and win on any given single front, does not mean it can do so on all fronts, simultaneously. At some point every empire overextends itself. Where's the weak link?

A large company can have weak points where it lacks a) willingness/motivation, or b) ability to compete.

• Lacking willingness/motivation to compete. Perhaps because
• a) under the radar situation. The market in question is unattractive at the surface, or too small to move the needle for BigCo. 
• b) requires trade-offs. Examples would be if the market takes away resource from BigCo's favored customers, doesn’t match corporate value, or leads to cannibalization of opportunities. In his book "Seeing What's Next", Clay Christensen cited example of a firm that counts on post sale service agreement not being interested in an off-the-shelf /self-service product.
• Lacking ability.
• Perhaps because BigCo's activities and processes are not tailored to the value proposition offered by SmallCo.
• BigCo may have difficulty replicating SmallCo's value chain.

Moving on SmallCo's side. How does SmallCo take advantage of BigCo's weaknesses while avoiding its strengths?  

• Distinct customer segment and value proposition that does not match BigCo's. 
• SmallCo would target over-served customers, under-served customers, non-customers (creating new market)
• Tailored value chain supporting that value proposition. The value chain should show 1) uniqueness, 2) internal fit, 3) independence from BigCo.
• Uniqueness. It has to be different from BigCo's. Otherwise you will just be overwhelmed by brute force.
• Internal Fit (interdependency). The value chain should fit together in a way that’s hard to replicate. Ideally the parts are interdependent on each other. This way your competitive moat compounds and is hard to replicate.
• Independence. Separate value chain. If parts of the value chain overlap, then SmallCo could be forced to play by BigCo's rules.

Basically if your David, make sure you can afford to NOT play by Goliath's rules.

A Short Example with Elastic N.V and Chewy

These are two companies that compete with Amazon in two completely different industries. The differences provide them different strengths and weaknesses relative to Amazon.

Elastic ("ESTC"), which I have written about here, provides search functionalities that Amazon effectively copied. Chewy ("CHWY", as discussed here) is an online pet food/supplies provider. 

Which has a better chance against Amazon?

Amazon's Motivations

I would say Amazon is much more motivated to go after Elastic's search market, which competes with Amazon's AWS segment. This segment of Amazon not only provides more profitability than its e-commerce segment, but it is also growing much faster. A quick look at Amazon's earning releases shows tremendous focus on developing AWS's capabilities. Overall, Elastic's search/indexing market looks strategic to Amazon.

On the other hand, pet e-commerce is seen as a fairly steady, slower growth market. Pets are hardly ever mentioned in Amazon's earning calls. 

Verdict: Amazon is much more motivated to attack Elastic than Chewy.

SmallCo's Value Chain

Chewy has its own distribution facilities, call center, and service reps. These fit together in a way that reinforces Chewy's niche strategy (as discussed here). In terms of pet products, its suppliers does overlap with that of Amazon's, and that could be a problem.

Elastic though, actually deploys its hosted service on AWS! Talk about NOT having an independent value chain! Elastic belated realized Amazon meant harm and started diversifying to Microsoft Azure in addition to Google (GCP), but the damage has been done.

Verdict: Chewy's has a more distinct value chain from Amazon.

We can go further, but this is enough to show that Chewy will have much stronger defense against Amazon's invasion.

Chewy's Competitive Advantages

In my 10/15/2019 post I mentioned that I passed on Chewy and Uber. Over the past few weeks I ended up buying into both.

Here’s a thread I recently tweeted out on Chewy (CHWY). It's a hypothesis of Chewy's "flywheels". I am definitely not wedded to the idea so this is an attempt to crowd-source my thinking process.

1/n. Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft)$CHWY pic.twitter.com/FgzJLcD46L

— mspacey (@mspacey4415) December 12, 2019

For your convenience, here is the expanded thread (lightly edited and reformatted for blog).

Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft):

To fend off Amazon, we have to answer how the value chain is different and how those pieces fit together in a way that competitors: a) can't copy, b) not willing to copy.

I think the answer is Chewy's vertical Focus strategy.

Start with right hand side of diagram:

• Niche focus allows Chewy to optimize supply chain (e.g less product variation means easier arrangement/picking at fulfillment centers .. saves space/time/cost..etc)
• Chewy can invest cost savings into customer service (focus strategy reinforces this. e.g knowledgeable reps)
• Good service drives growth/retention. More Autoship customers enhances predictability -> more efficiency. (See original tweet for screenshot of management comments on this topic)
• Reinvest that saving into service = closes the loop on right side of diagram

Move on to left side of diagram:

• CHWY has built up a lot of fixed costs (fulfillment centers..etc). 
• Customer experience drives growth. 
• Growth + fixed cost = operating leverage & economy of scale. 
• Reinvest cost savings into customer service closes the loop

We are already seeing this reflected in CHWY's financials:  more active customers, higher % of Autoship customers, higher gross margins..etc. 

Again, I think it's all enabled by focus strategy, which won't be matched by Amazon.

Feedbacks and Conclusion

Overall reactions to the thread suggest that people are quiet negative about Chewy (even after the stock's recent run up). This makes me uncomfortable as I don't consider myself a contrarian.

The most notable response is from @CharlieZvible. He argues that CHWY's limited TAM means its margin needs to be more than low/mid single digits to justify valuation. He questions if that can be achieved.

"...The TAM is pretty well defined. $65bn if I remember correctly. Remaining share split mostly between wmt, cost, tgt, Amzn, pets. Didn’t look at Q3 but guessing $ sales added still flattening out. Think you need HSD margins to be good stock-high for consumables"

This is definitely a good point that needs to be considered. I'm inclined to disagree after doing some basic calculations. Here's how I think about it.

• At the time of this writing, CHWY trades at about $29/share. This represents <$12bn enterprise value. 
• CHWY is on track for $5bn of revenue a year and growing ~37% for the year ending 1/31/2020.
• They can easily reach $10bn revenue in a few years. A 5% EBIT margin on that is $500mm. CHWY would be trading at 24x EV/EBIT. 
• I would not be surprised that in 5 years it's more like $15bn revenue. At the same 5% EBIT margin, the current price implies ~16x EV/EBIT.
• Well known consumer stocks usually trade at high multiples so these are not far fetched.  

Going back to the TAM limitation. A $15bn revenue would imply 25% of the $60bn TAM cited. That sounds like a lot. Too much? I'm not sure. The whole point of the "flywheel" discussion above is to assert that Chewy's competitive advantages reinforce themselves overtime, so that the company gets stronger relative to competitors, and thus can grab a disproportionately large market share.

It's also possible that the $60bn TAM is not fixed, but in fact expanding due to secular trends ("humanization of pets"). It also seems logical to me that the convenience of e-commerce should expand TAM by converting previous non-consumers. New product innovations is another factor that can increase market size. Along that line of reasoning, I would note that the above is not counting the pet healthcare business.

So I'll leave off here. I bought Chewy under $26/share, as soon as I saw it pop above MA50 on huge volume. The discussion above was to decided whether I should add, hold, or exit. My decision, at least so far, is to hold.

A Quick Assessment of Square's Valuation

Here are some comments on Square's valuation, which will also serve to point out its valuation drivers.

Square ("SQ") reports two segments (not in its 10K/Qs but in shareholder letters and earnings calls): 1) Seller ecosystem, 2) Cash App ecosystem.

Seller ecosystem has ~30% adjusted EBITDA margin for 2019 (Note this is provided by management and they express it as percentage of Adjusted Revenue, which is a much smaller denominator than GAAP revenue because the adjusted version excludes transaction-based costs.)

Cash App ecosystem’s EBITDA margin was not disclosed, but apparently it is much lower EBITDA margin. In the 3Q19 call, an analyst asked:

“thanks for the EBITDA margin disclosure on seller, how quickly you can scale the Cash App margins? And can that ultimately approach the margins you're seeing on seller? That is Cash App versus seller.”

To which management answered:

“...we're continuing to invest aggressively into both our Cash App ecosystem as well as our seller ecosystem, and we think we're in the early days there in terms of customer acquisition and in terms of the product road map. So we'd expect to continue to see strong and growing contributions from Cash app going forward.

With respect to margins, just quickly, we see attributes in the cash business that are very similar to what we see in the seller business in terms of efficient customer acquisition, in terms of retaining customers over the long term and in terms of positive revenue retention. And because of that, we've been able to increase cash margins each of the last 3 years, and we'd expect to do the same in 2020. So over the long term, we see a very positive trajectory there as well."

So Cash App has lower EBITDA margins. But this segment has also been growing revenue at over 100% yoy, far outpacing Square’s overall growth rate in the 30%-40% range.

Thus we can infer that the growth of Cash App must have been weighing on Square’s overall profitability.

Cash App actually enjoys high gross margins (~75% vs ~40% for the Seller ecosystem), but somehow it ends with lower EBITDA margin. This is consistent with my guess that most of the discretionary/fixed cost investments in recent years have been in Cash App.

The big question is where does Cash App’s margin end up? I believe that, at scale, Cash App's EBITDA margin should equal or exceed those of Seller ecosystem. Those much higher gross margins matter, and eventually the R&D costs will be toned down while SG&A will be spread out through a larger base.

If the above is true, here are some basic numbers we can run:

• Adjusted Revenue will be about $2.2-2.3bn for 2019. Let’s say it grows ~25%-30% CAGR for next 5 years. 
• That’s about $6.9bn-$8.3bn of adjusted revenue for 2024. At 30% EBITDA margin that’s $2bn-$2.5bn of adjusted EBITDA
• SQ’s stock at $69/share, or $29b-$30bn mkt cap/enterprise value
• So this is trading at ~12x-15x 2024 adj EBITDA

This sounds ok. It’s a lot worse if we consider that these are adjusted EBITDA with huge stock based comp add backs. Another way to say this is that valuation is higher than it looks because of share count dilution overtime.

So far it would seem that Square’s stock is fully valued.

But at least we now know what SQ has to do. It has to maintain the growth trajectory in its Seller ecosystem (by defending against competitors like Clover). It has to continue growing Cash App by introducing new products and monetization opportunities, while maintaining a path to higher margins through operating leverage (i.e. stay out of ruinous competitive spending sprees).


Competitor PayPal (and its Venmo)

What really surprised me is the fact that Cash App actually makes more than Venmo. Cash App has run rate revenue of over $600mm, while Venmo only about $400mm.

Venmo is a competitor app owned by PayPal and much more popular than Cash App (At least in my experience, no one in my social circle uses Cash App, but may use Venmo). Venmo had $27bn of Total Payment Volume (TPV) for 3Q19, or an annual run rate of over $100bn. To put this in context, Square’s entire GPV for 2019 (most of it from its more established Seller ecosystem and not Cash App) will be just over $100bn!

So how is it that Cash App makes more money? The answer is here:

Main revenue drivers for both are 1) fees on instant deposits and 2) rev share on interchange from Cash Card / Venmo Card. SQ offered 1) for years and started charging 1% fee in 2016, 2) launched same year so more mature. Venmo started both in summer 2018, so still ramping

— CORE Dental DDS (@CoreDentalDDS) November 30, 2019

Now that should get you excited about Paypal. Imagine what happens to its stock when Venmo monetize like Cash App does!

Venmo currently contributes 16% of Paypal’s TPV, but only 2% of revenue. Not only that, Venmo grows faster than core Paypal so Venmo's share of total TPV will be increasing. Put two and two together, it sounds like Paypal's profitability is about to go through the roof.

So we failed to develop a bull thesis for SQ, but we may have ended up with one for PayPal!