Lemonade Stock Is a Sweet Idea with Sour Finances Sending Up Red Flags

Lemonade (NASDAQ:LMND) stock has caught investors’ attention, and for pretty good reason.

If Amazon’s (NASDAQ:AMZN) taught us anything over the past few decades, it’s the power of disruption, and the value of recognising it early. That’s part of the reason that insurance disruptor Lemonade is so attractive.

LMND stock skyrocketed back in January, and although it’s come down considerably, remains an expensive pick.

The group’s tech-driven approach to insurance appeals to younger generations who want instantaneous results with as little human intervention as possible. In short, Lemonade makes regular old insurers look boring and antiquated.

Lemonade is on to something with this approach. The insurance industry was primed for disruption—now that millennials have grown up and started ‘adulting,’ they’re unlikely to spend hours on the phone trying to understand insurance policies when there’s an app for that. 

But alas, a good product doesn’t necessarily guarantee success. Lemonade’s underlying proposition is sweet, but its financials have a sour kick.

LMND Stock Is Loss-Making

Let’s start with profitability—the group has yet to turn a profit, which isn’t uncommon for a young company and doesn’t necessarily spell disaster at this point.

More concerning is its free cash flow, which is decidedly negative and likely to carry on that way over the next few years.

This is problematic because it means Lemonade isn’t making enough money to support its own operations—which will leave management to find ways to raise cash in order to fund growth. 

For now, Lemonade is using the power of the market to top up its cash reserves. The group sold additional 3 million shares of LMND stock earlier this year, which brought in $639.8 million. But profitability looks to be a ways off, which means Lemonade will either have to take on debt or ask shareholders to open their wallets again.

On the bright side, Lemonade doesn’t have any long-term debt to speak of at present. In the current low-interest-rate environment, a little debt is no bad thing. However, you eventually have to start paying back your loans, so profits need to be on the horizon.

Customers are Thirsty for Lemonade

There are signs of life in Lemonade’s customer growth. The group’s been adding to its suite of products to diversify away from renters and homeowners insurance with new life, pets and car insurance offerings.

So far, management’s been upbeat about the potential to cross-sell to existing clients, which is a key advantage for a few reasons.

Selling to existing customers is cheaper than going out to find new ones, but more importantly, it creates stickier users because having all of your insurance products together in one app is much simpler. Switching to save a few bucks isn’t worth the hassle. 

Up to this point, the case for LMND stock is a simple risk-reward scenario. If you think management’s capable of continuing to grow its customer base through international expansion and a growing suite of products, you probably think profits are coming. If not, the group’s cash flow issues are a huge red flag. 

Lemonade’s Reinsurance Debate

But that’s not really the whole story. Lemonade uses something called reinsurance to shield itself from major losses, and that’s where things start to get murky.

Some argue that this policy, in which Lemonade gives up 70% of its premiums to reinsurers who then shoulder the risk associated, means the company’s margins are always stable. That’s not really the case.

The group’s margins won’t be as volatile as insurers who don’t outsource to reinsurers, but Lemonade’s margins are still at the mercy of the group’s gross loss ratio, just like everyone else in the industry.  

A gross loss ratio reflects the percentage of premiums that gets paid out in claims. Ultimately you want this number to be as far from 100% as possible—anything over that means you’re losing money. The norm in the U.S. is somewhere between 65% and 70%. 

In the second quarter, Lemonade’s was 74%, up from 67% last year. More troubling was the fact that the gross loss ratio between January and June was 98%.

Lemonade didn’t have to shoulder all of those payouts because of its reinsurance setup—but reinsurers are in the business of making money. It’s unlikely they’ll stick around on favorable terms if Lemonade’s loss ratio remains above the industry average. 

The Bottom Line

You really can’t knock Lemonade’s business model. The idea of a streamlined, user-friendly insurance app is appealing for anyone who’s waded into the waters of adulting in the last decade.

The problem is it will take more than a snazzy app and reinsurance to become a convincing long-term investment. While its encouraging to see customer growth accelerating and new services gaining traction, it’s expensive.

Investors are paying about $45 for every $1 of sales. Compare that to Microsoft (NASDAQ:MSFT), where you’ll pay just $14 for $1 worth of sales and a whole lot more peace of mind. 

On the date of publication, Laura Brodbeck did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Laura Hoy has a Finance degree from Duquesne University and has been writing about financial markets for the past 8 years. Her work can be seen in a variety of publications including InvestorPlace, Benzinga, Yahoo Finance and CCN.