Steel City Capital LP, an investment management firm, published its first quarter 2021 investor letter – a copy of which can be downloaded here. A net return of 7.6% was delivered by the fund for the Q1 of 2021, above the S&P 500 and MSCI All World Index that delivered a 5.8% and 4.8% returns respectively, but below its Russell 2000 benchmark, that had a 12.9% gain for the same period. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.
Steel City Capital, in their Q1 2021 investor letter, mentioned Trupanion, Inc. (NASDAQ: TRUP), and shared their insights on the company. Trupanion, Inc. is a Seattle, Washington-based pet insurance company that currently has a $3.2 billion market capitalization. Since the beginning of the year, TRUP delivered a -32.25% return, while its 12-month gains are up by 187.79%. As of April 30, 2021, the stock closed at $81.10 per share.
Here is what Steel City Capital has to say about Trupanion, Inc. in their Q1 2021 investor letter:
“As I’ve long argued, Trupanion’s (TRUP) Pet Acquisition Costs (PAC) have been growing at an unsustainable rate which will ultimately cause the company’s preferred profitability metric – IRR – to fall beneath their target of 30- 40%. By my calculations, the company is going to be hanging on by the skin of its teeth in 2021, although the “real” figure – excluding various self-help initiatives – will undoubtedly fall below the low end of its target.
Subscription pet revenue was guided to $484 million at the midpoint. Assuming Monthly Average Revenue per Pet of $63.99 (which is in-line with the company’s commentary of ARPP growing 6.0% in 2021) means average pets will total 631,000 for the full year. To average this figure, year-end pets will need to reach 684,350 at 12/31/2021. Quarterly churn is running just shy of 4.0%, meaning that in a run-off scenario, year-end pets would decline to 493,550. In order to offset churn and grow subscription pets to 684,350, TRUP will need to add 191,000 gross pets during the year. Management indicated they expect to spend ~$60 million on pet acquisition in 2021, which equates to ~$315/pet. This is 28% higher than FY’20 PAC spend of $247/pet.
The punchline is that, by year end 2021, IRR will fall to ~30%. And as I’ve consistently pointed out, this is a trailing twelve-month figure, meaning that as the year progresses, leading edge pet acquisition will more likely than not be below the 30% target.
I’ve also long been critical of the accounting sleight of hand used by the company to inflate IRR, specifically including several million dollars of non-operating items (rental income at company HQ and a VIE expense offset) making expenses appear lower than they actually are. In 2020, I estimate these items reduced OpEx by ~$3.5 million.
And in 2021, the company will exclude anywhere from $2-$5 million ($3.5 million at the midpoint) of pre-revenue “development expenses” when calculating IRR. It’s really unclear what the expenses actually are, but my best guess is that it’s some combination of fixed costs associated with its recent acquisition, potential costs associated with setting up its own underwriter in Canada, and expenses associated with its Aflac partnership. The company said, via footnote:
“As we enter the next phase of our growth, we expect to invest in initiatives that are pre-revenue, including adding new products and international expansion. These development expenses are costs related to product exploration and development that are pre-revenue and historically have been insignificant. We view these activities as uses of our adjusted operating income separate from pet acquisition spend.”
The intellectual dishonesty (hypocrisy) is stunning when you think about it. Management has the balls to include non-operating items to boost IRR, but is selectively excluding operating items when they hurt it. They must have a really low opinion of the intelligence of their shareholders. If we were to fully load the IRR calculation with development expenses and exclude the non-operating items, IRR would be ~25.2%.
The company’s revenue guide crushed consensus going into the print ($664 million guidance at the midpoint vs. consensus of $627 million) and the stock has traditionally traded on revenue growth as opposed to profitability, so it was heartening to see the stock sell-off following the strong guide. At least based on the commentary of one analyst on the earnings call, subscription revenue guidance was in line with their expectations, while “Other” was substantially ahead. TRUP’s management has long used the “Other” line of business to turbo-charge revenue growth, without corresponding profits, so perhaps investors are starting to “wake up” to the game. To be more specific, “Other” business revenue is forecast to grow by $65 million this year, while adding only $2.7 million of incremental profits.
Speaking of profits – they are still nowhere to be found, despite the forecast for topline growth of 32%. Isn’t this company supposed to scale? Adjusted operating income is expected to be $73 million, PAC will be $60 million, “development” will be $3.5 million, leaving only $9.5 million of pre-tax profits. And with SBC likely to clock in between $10-$12 million (based on its historical relationships to revenue), then TRUP will, once again, report negative GAAP Net Income in 2021. The company has never reported GAAP Net Income in at least the past 10-years. What’s $3.3 billion of market cap divided by negative net income?
The prospective risk from a portfolio management perspective is management raising revenue guidance throughout the year. I found it curious that the “Other” segment is forecast to grow by 58% this year, a sharp deceleration from last year’s 82% and the 4Q’20 exit rate of 92%. My guess is that management is sandbagging the numbers for a rainy day (unless people are returning their pandemic puppies).”
Our calculations show that Trupanion, Inc. (NASDAQ: TRUP) does not belong in our list of the 30 Most Popular Stocks Among Hedge Funds. As of the end of the fourth quarter of 2020, Trupanion, Inc. was in 18 hedge fund portfolios, compared to 12 funds in the third quarter. TRUP delivered a -27.72% return in the past 3 months.
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Disclosure: None. This article is originally published at Insider Monkey.
