Steel City Capital recently released its Q4 2020 Investor Letter, a copy of which you can download here. In 2020, the fund returned 10% net of fees, while the S&P 500 Index was up 16.3%. You should check out Steel City Capital’s top 5 stock picks for investors to buy right now, which could be the biggest winners of 2021.
In the Q4 2020 Investor Letter, Steel City Capital highlighted a few stocks and Trupanion Inc. (NASDAQ:TRUP) is one of them. Trupanion Inc. (NASDAQ:TRUP) is a pet insurance provider. In the last three months, Trupanion Inc. (NASDAQ:TRUP) stock gained 49% and on January 20th it had a closing price of $117.65. Here is what Steel City Capital said:
“Trupanion (Short): Trupanion is one of the leading pet insurance companies in the United States. In the Partnership’s 3Q’20 letter I wrote, “TRUP remains a frustrating short for the Partnership.” Let’s just say not much changed during 4Q’20: shares rallied ~50% during the quarter. The increase was catalyzed by a number of factors: passive flows, short covering, market-wide outperformance of companies with shaky balance sheets, increased revenue guidance (but not profits!), and a co-investment from Aflac.
Aflac invested $200 million in return for a roughly 9% stake in TRUP and agreed to market pet insurance policies alongside their traditional workplace coverage. A capital infusion wasn’t entirely unexpected as TRUP was facing a capital and liquidity crunch. What was unexpected, in my view, was the market’s reaction. Unlike a run-of the mill equity offering which would have undoubtedly pressured shares, TRUP spiked nearly 30% in the days following the deal, adding roughly $800 million to its pre-announcement value. The excitement of potential growth via new channels and Aflac’s “good housekeeping seal of approval” outweighed both the economics and the operational details (or lack thereof) of the deal.
Right out of the gate, management applied $30 million of the proceeds to pay down the company’s outstanding revolving credit facility, with another $7.5 million earmarked for deal-related expenses. Additionally, buried in the company’s 10-Q filing on the same day was a disclosure relating to the acquisition of an unaffiliated software company and an “asset acquisition” for approximately $48.2 million. (My view is the company “conveniently” left the news about the acquisitions out of their earnings press release and subsequent analyst call in order to create the impression they would have more capital available for pet acquisition than they actually did. More on these asset acquisitions in a moment…) TRUP was left with roughly $145 million to invest in pet acquisition.
Based on management guidance, the company was on pace to exit 2020 with Pet Acquisition Costs (PAC) around $300/pet (+35% y/y, following a +22% y/y increase in 3Q’20). At $300/pet, the $145 million of “free” proceeds from the Aflac investment hold the potential to buy, at most, 483,000 new pets. What’s a pet worth? Using the company’s IRR framework along with some very generous assumptions (no fixed cost allocation and a 5% discount rate), implies each new pet adds ~$400 of value to TRUP. This equates to about $200 million of total value (at 483,000 pets), or about $5.00 per share, which is certainly far below the $800 million / $20 per share added in the days after the announcement (and even further below the $2.0 billion / $50 per share added in total since the announcement).
For “fun” we can also extrapolate this a step further: if a pet is worth $400, then TRUP’s $4.6 billion market capitalization is currently discounting 11.5 million pets vs. the roughly 550,000 at 9/30/2020. TRUP would need to grow its pet count at a ~23% CAGR for the next 15-years in order to reach 11.5 million policies. “TAM!” the bulls say.
Of course, there are some puts and takes in this assessment, but mostly takes. What if PAC is greater than $300/pet? If PAC is greater than $300/pet, then the value added is lower. This is probably highly likely given the recent rate of PAC growth and the hardening competitive dynamic in the industry. What if the new pets are burdened with some sort of fixed cost? If per-pet economics are weaker than I assume, then the value added is lower. This too is probably highly likely as a result of the acquisitions made by the company which by all accounts appear “back office” in nature and will likely cause some degree of fixed cost de-leveraging. And what if the appropriate discount rate is higher than 5.0%? If the discount rate is higher, then the value added is lower. For context, when the company shared its own DCF analysis in its 2019 shareholder letter, which implied an intrinsic value of ~$35/share, management used a 10.8% discount rate.
So, about those acquisitions – what did the company buy? Per the 10-Q, “[t]he acquired technology in both transactions focuses on the pet space and, along with the acquired personnel, is intended to enable the Company to improve its back-end software to help facilitate growth opportunities, additional products and geographies, as well as enhance its mobile platform.”
No less than two weeks after the Aflac investment and acquisition disclosure, Walmart announced it was joining the growing pet care market by offering insurance through Petplan. Walmart probably shopped its offering around the market while looking for a partner, making it more likely than not TRUP knew exactly what was coming down the pike from a competitive perspective. My best guess is the acquisitions (as well as the Aflac investment) were defensive in nature, seeking to shore up the company’s capital position, back-office and customer facing functionality, and provide it with additional liquidity for an increasingly competitive backdrop and rapidly rising PAC costs.
Where do we go from here? Positing an investment thesis on valuation alone isn’t enough, although TRUP’s FY’22 P/E multiple of 1,385x (the street expects losses again in FY’21) and current 13.6x P/B multiple are in the twilight zone. I expect fundaments to roll over (no pun intended) this year, specifically with management’s much-touted IRR beginning to break below the long-held target range of 30-40%. Unless PAC growth ceases, this is but a mathematical certainty. The deterioration will be masked to some extent by the company’s presentation of IRR on a trailing twelvemonth basis which offers the benefit of last year’s lower PAC costs. But on a single quarter basis – the most real time view – the numbers become ominous. At $325/pet (remember, the company will exit 2020 spending ~$300/pet, with 3Q’20 and 4Q’20 having grown +22% and +35% y/y, respectively) IRR falls to 24%. At $350/pet, IRR falls to 20%.”
Steel City Capital has been a long time Trupanion Inc. (NASDAQ:TRUP) bear. In July 2020, we shared Steel City Capital’s bearish EBAY’s thesis in this article.
In Q3 2020, the number of bullish hedge fund positions on Trupanion Inc. (NASDAQ:TRUP) stock decreased by about 20% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t believe in Trupanion’s growth potential. Our calculations showed that Trupanion Inc. (NASDAQ:TRUP) isn’t ranked among the 30 most popular stocks among hedge funds.
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