Trupanion, Inc. (TRUP) Q3 2018 Earnings Report, Transcript and Summary

Greetings and welcome to the Trupanion Third Quarter 2018 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Laura Bainbridge, Investor Relations. Thank you. You may begin.

Good afternoon and welcome to Trupanion's third quarter 2018 financial results conference call. Participating on today's call are Darryl Rawlings, Chief Executive Officer and Tricia Plouf, Chief Financial Officer. Before we begin, I would like to remind everyone that during today's conference call, we will make certain forward-looking statements regarding the future operations, opportunities and financial performance of Trupanion within the meaning of the safe harbor provision of the Private Securities Litigation Reform Act of 1995. These statements involve a high degree of known and unknown risks and uncertainties that could cause actual results to differ materially from those discussed. A detailed discussion of these and other risks and uncertainties are included in our earnings release, which can be found on the Investor Relations website, as well as the company's most recent reports on Forms 10-K and 8-K filed with the Securities and Exchange Commission. Today's presentation contains references to non-GAAP financial measures that management uses to evaluate the company's performance, including without limitation, fixed expenses, variable expenses, adjusted operating income, acquisition costs, adjusted EBITDA and free cash flow. When we use that term adjusted operating income or margin, it is intended to refer to our non-GAAP operating income or margin before pet acquisition. Unless otherwise noted, margins and expenses will be presented on a non-GAAP basis, which excludes stock-based compensation expense and depreciation expense. These non-GAAP measures are in addition to and not a substitute for measures of financial performance prepared in accordance with the U.S. GAAP. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to the most directly comparable GAAP results, which can be found in today's press release or in Trupanion's Investor Relations website under the Quarterly Earnings tab. Lastly, I would like to remind everyone that today's call is also available via webcast on Trupanion's Investor Relations website. A replay will also be available. With that, I would like to turn the call over to Darryl.

Thanks, Laura. This was a particularly strong quarter. Total revenue grew 24% year-over-year to $78.2 million. We ended the quarter just shy of 500,000 total enrolled pets, a milestone we since crossed and up 23% over Q3 of last year. Performance was strong across both our subscription and other lines of business. Our subscription business continues to benefit from our initiatives to grow same-store sales and increased conversion rates. Adjusted operating income increased 31% over the prior year period to $9.3 million or 12% of total revenue. Driving expansion in this metric remains a key strategic initiative. The primary way we do so is through the scale in our fixed expenses. Trish will elaborate on that in her remarks. But we're beginning to see some of the benefits of owning our own headquarters building. We expect the impact will be even more apparent next quarter. Expansion in our adjusted operating margin increases the funds available for us to invest in new pet acquisition and we intend to do so while operating within our positive free cash flow and targeted internal rates of return guardrails. During the quarter we spent approximately $6 million of our $9.3 million adjusted operating income to acquire approximately 34,000 pets, a continued acceleration in new pets from the second quarter. Importantly, we were able to achieve this accelerated growth, while delivering a calculated internal rate of return above our target of 30% to 40% on an average pet. As a reminder, we review this detailed calculation in our shareholder letters. In addition to driving growth through our core veterinary channel, we continue to test alternative channels, including direct-to-consumer and employee benefits. While results were encouraging, it's still early days in the optimization of these channels as long-term lead sources. As our adjusted operating income continues to compound, we are positioned to deploy greater sums of capital to drive growth, both in the near term through our strategic initiatives and also longer term through new revenue opportunities in adjacent products and new geographies. Now turning to our five key strategic initiatives. We first outlined these initiatives in our 2016 shareholder letter and we intend to provide regular updates on our progress. These are same-store sales, claims automation, Nirvana, which I'll remind you about in a moment, conversion rates and adjusted operating margin. I'll start with same-store sales where we continue to see improvements when we partner with a veterinary clinic and implement our software Trupanion Express. As a reminder, our patented software technology is a key differentiator in the market and is critical to eliminating the cumbersome reimbursement model and in improving the overall customer experience. With our software, our promise is to pay veterinarians directly at the time of checkout within five minutes or less. Based on the ongoing success of the program, we intend to accelerate the deployment to additional hospitals. In October we crossed an important milestone. Trupanion Express is now installed in over 3,000 veterinary hospitals. This is up over 45% from the end of 2017. I want to take a minute to talk about our Territory Partners, who are an important part of our same-store sales initiative and one of the key competitive modes. Territory Partners play a vital role in building relationships with veterinarians and educating them on the benefits of high quality medical insurance. Over 72% of our leads come for veterinarians who are non-paid referrals. Pet acquisition spend within our core veterinary channel continues to be highly effective. Every year approximately 12 million new puppies and kittens visit the veterinarian for the first time. Our target market is the approximate 1 million new pets being entered into practice management software every month. On average these same pets visit the veterinarian 3x during the first year. We believe this access to puppies and kittens is the best way to build the category. Doing so helps us with anti-selection issues that can arise from enrolling older pets through online channels. Puppies and kittens that come through the veterinary channel have a veterinarian ensuring that they are healthy and generally receive a higher level of wellness throughout their lifetime. Year-to-date puppies and kittens represented the majority of our enrollment through the veterinary channel. Long-term, we believe the addressable market is one in four puppies or kittens enrolling with high quality medical insurance. Ensuring those pets stay enrolled over the course of their life is what will help build the penetration of the entire category beyond the estimated 1% to 2% today. One fact that is important for us to reiterate is that our Territory Partners when visiting veterinarians do not sell, solicit, or negotiate Trupanion policies direct to consumers. We have license agents that sell products direct to pet owners through our 24/7 call center or online. It is not required that Territory Partners or veterinarians need to become licensed based on our current business practices. Over the years we've had dialogs with regulators. We believe they understand our business well and that our practices are not only compliant but are also well aligned. We continue to add Territory Partners in new regions, as well as expand our internal account managers. Growth in both areas is an important aspect of our initiative to increase same-store sales as is Trupanion Express. One of the key benefits of our software is that it provides a framework for claims automation. With claims automation, we are reducing the checkout time to seconds. We turned this functionality on in April and today over 10% of invoices submitted through our software are now automated. In addition to helping lower variable expenses, claims automation improves the overall customer experience and helps with Nirvana. Nirvana is where enrollments from our existing members adding pets or referring friends offset the number of members who cancel in a given period. The better our value proposition and the better our customer experience becomes, the more we expect to see our loyalty additions grow. Our goal is to build this category by providing the highest possible value in our product. And the amount we target and spend on paying veterinary invoices is a key part of that value. Today we targeted and spend approximately 70% of subscription revenue paying veterinary invoices. Once we achieve our goal of a 15% adjusted operating margin at operational scale, we intend to return any additional cost savings back to the pet owner by the way of an even better value proposition. Our value proposition is underpinned by our pricing promise, which is to share risk equally and fairly among our subcategories of pets. Through our cost plus pricing model, we seek to understand the underlying costs and trends for a given pet subcategory using factors like breed, geography, age and deductible, and then add a 30% margin. We have a team of 14 actuaries, data scientists and analysts that are constantly utilizing our data to become even more accurate on pricing our sub categories. We believe, we price across more categories than any of our competitors. Today, our pricing categories total millions. Our strategy to have a greater number of categories, price more accurately is key to improving the customer experience and ensuring we have a healthy book of business. It is also helping drive our growth. We continue to believe that responsible loving pet owners are not price sensitive. They are value sensitive. Said in another way, a bulldog owner in New York City is willing to pay more than a cat owner in Boise, Idaho, as long as the value proposition is the same. The problem we're solving is helping pet owner's budget for veterinary care if and when their pet become sick or injured. During periods of economic uncertainty or financial instability, our product can help pet owners budget for responsible care. In our 20-year history, we've consistently grown revenue in excess of 20% during periods of both economic growth and contraction, including the 2008 financial crisis. In fact, we've never had a quarter where revenue did not exceed the preceding period. Our value proposition continues to resonate with pet owners. Blended conversion rates, our four strategic initiatives were once again up in the quarter. Driving more leads and improving conversion rates at the same time is difficult and requires a lot of execution. So I'm especially pleased with the team's efforts on both fronts. Our fifth initiative is expansion of our adjusted operating margin, which I will leave for Trish to expand upon in greater detail. I'd now like to provide some thoughts on the regulatory front. As our business in this industry continues to grow, we expect and welcome increased attention. Ultimately, we believe this attention provides an opportunity for Trupanion to drive even greater awareness of the need for high quality medical insurance. Like any regulated entity, we receive inquiries from state regulators as a part of the normal course of business. No state regulatory agency has ever reached any conclusion that has or is expected to have a material impact on our business. Finally, I wanted to briefly reiterate a couple of things about the test points program we recently discontinued. You can read the release we issued last week for more detail, if you have not already, but here's a summary. This program never incentivize enrollments and was always immaterial to our business performance. And secondly, the decision to phase out the program, which occurred in September, was made because the test program was not having the desired results. And with that, I'll hand the call over to Trish.

Thanks Darryl and good afternoon everyone. We are very pleased with our third quarter results, which reflects solid operational execution and efficient pet acquisition spends. Revenue of $78.2 million was up 24% year-over-year, reflecting slightly stronger than forecasted enrolled pets in both our subscription and other business segments. Total enrolled pets increased 23% over the prior year period to approximately 498,000. Subscription revenue was $67.4 million, up 19% year-over-year. Total enrolled subscription pets increased 16% year-over-year to approximately 417,000 pets as of September 30, up from approximately 359,000 in the year-ago period. Pet growth within our subscription business benefited from increased leads in our core veterinary channel as well as improved conversion rates compared to the prior year period. Monthly average revenue per pet for the quarter was $54.55, an increase of 3% year-over-year. In local currency, ARPU for the quarter increased 4% for our U.S. customers and 3% for our Canadian customers, which is lower than our historical average of 5% to 6%. We have seen a positive change in our mix of new pet enrollments in the past year in areas that are now more accurately priced to our targeted 70% value proposition and results of our pricing optimization work the last few years. For the first nine months of 2018, ARPU increased 5%, which is in line with our historical and long-term expectations of increases of 5% to 6% per year. Average monthly retention for the quarter was 98.61%, consistent with the prior year period. Acceleration and pet adds can act as a headwind to retention, as cancellations are highest in the first 90 days following a pet's enrollment. A continued area of operational focus is on reducing these subscription cancellations within the first 90 days by further improving the sign-up experience, including by educating pet owners more comprehensively around the time of enrollment on Trupanion's value proposition and coverage. Our other business revenue which generally is comprised of our revenue that has a B2B component totaled $10.7 million for the quarter, an increase of 62% year-over-year. Year-over-year growth in our other business segment reflects an increase in the number of pets enrolled in this segment. Similar to prior quarters, year-over-year growth in our other business segment continues to be higher than we had forecasted due to strong performance overall as well as slower than anticipated roll-off of the group of pets we have previously discussed. We now expect the full year revenue growth rate of this segment to be around 60%. Total enrolled pets in this segment was approximately 81,000 at quarter end, up from 45,000 in the year-ago period. Subscription gross margin was 19% in the quarter, in line with our annual target of 18% to 21%. Total gross margin for the quarter, including our other business segment, was 18%. Third quarter fixed expenses represented 6% of total revenue, down from 8% in the prior year period. We continue to make good progress towards our goal of fixed expenses being 5% of revenue at operational scale, which we have defined since our 2014 shareholder letter as when we have between 650,000 and 750,000 total enrolled pets. We saw additional leverage in our fixed expenses this quarter due in part to the purchase of our home office building in August. As anticipated, this purchase helped lower fixed expenses overall. We expect to achieve some additional leverage next quarter since Q3 only reflected a partial benefit due to the purchase closing during the quarter. As a reminder, we estimate owning our own building will lower fixed expenses by $3 million to $5 million per year in lease savings and rental income, providing us additional funds to invest in pet acquisition and other growth initiatives. Adjusted operating income totaled $9.3 million in the third quarter, which was up 31% from the prior year period. Net income was $1.2 million in the quarter, as a percentage of revenue, adjusted operating margin expanded approximately 70 basis points year-over-year to 12% of revenue compared to 11% of revenue in the prior year period. Turning to our pet acquisition spend, in the third quarter, we spent $6 million to acquire 34,000 new subscription pets compared to the prior year period in which we spent $4.7 million to acquire 27,000 new subscription pets. We were able to be more aggressive on our acquisition spend during the quarter, while still operating within our IRR and free cash flow guardrails. Even more encouraging was the fact that we were able to deliver 25% year-over-year growth rates in new subscription pets with PAC only increasing 3% over the same time period. Overall, our pet acquisition spend resulted in an LVP-to-PAC ratio in the quarter of 4.6 to 1, which was in line with the third quarter of 2017 and higher than our internal target heading into the quarter. This was largely the result of stronger than anticipated returns on our pet acquisition spend. Adjusted EBITDA was $3.7 million for the quarter compared to adjusted EBITDA of $2.4 million in the prior year period. Net income was $1.2 million in the quarter compared to $400,000 in the prior year period. Free cash flow for the quarter of negative $46.1 million included operating cash flow of $4.2 million. This compares to free cash flow of $2 million in the third quarter of 2017, which included operating cash flow of $3 million. Excluding the purchase of our home office building during the quarter, free cash flow would have been positive $3.2 million. We continue to expect to be able to fund our growth for the foreseeable future from our internally-generated cash flow. As such, we do not expect to access the capital markets unless an opportunity arises that could accelerate our intrinsic value growth meaningfully beyond our existing opportunity. At September 30, we had $74.1 million in cash, cash equivalents and short-term investments and $8.8 million of long-term debt. I'll now turn to our outlook for the fourth quarter and full year of 2018. For the fourth quarter of 2018, we are forecasting revenue in the range of $82 million to $83 million, representing 24% year-over-year growth at the midpoint. As a result, we now expect full year revenue to be in the range of $303 million to $304 million, representing 25% year-over-year growth at the midpoint. Please keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S. and Canadian currencies. For the fourth quarter guidance, we used a 78% conversion rate in our projections, which was the approximate rate at the end of September. Thank you for your time today, and I will now turn the call back over to Darryl.

Thanks, Trish. Before we open the call up for questions, I want to take a step back and thank the team for their hard work and dedication to our mission of helping pets we all love receive the best veterinary care. In particular, I would like to recognize the pet acquisition team led by Margi Tooth. Over the past 12 months, this team has done a wonderful job, cost effectively deploying greater sums of our adjusted operating income. This is not an easy task. Adjusted operating income has been compounding and increasing at a CAGR of over 200% since 2014 to over $29 million in the last 12 months. As we continue to make annual progress towards our long-stated goal of a 15% adjusted operating margin at operational scale, the challenge will continue to be, how do we deploy greater sums of capital each year within our target internal rates of return between 30% and 40% for a single average pet. We have a long way to go. We operate in a very large and under-penetrated market. We are encouraged by the progress and have plenty of confidence in the team and their leader. And with that, I'll open the call up for questions. Operator?

[Operator Instructions] And our first question is from David Westenberg from CL King.

This one isn't quarter-specific, but kind of something that we get a lot and I guess it is a little bit quarter-specific because your ARPU went up only 2% -- or 2%, a little over that. You historically have done 5%. But we always get an investor that will say, okay, they asked the state regulator for a 10% increase in price. And I think I know the answer to this, but can you just talk a little bit about the discrepancy for the way you maybe talk to a state regulator and how -- and what ARPU does and why ARPU is the better way to look at it?

Yes, Dave. Thanks for noticing that. So ARPU this year is up about 5% year-to-date, which is a little bit lower than we otherwise would have anticipated if we were having the same mix of business. But if you remember going back several years ago, we started talking about our desire to price our subcategories as accurately as we could and we had some sub categories that were overpriced and by -- on the flip side there would be some that were underpriced. What we've done is a better and better job. And as we're accelerating our growth, our mix of new business is coming in and that's having our ARPU coming in a little bit lower. As it relates to what we do with the Department of Insurance is, we ask and look at the trends in our costs and we're looking for rates to be kind of in our cost-plus model. So we understand what the costs are, we see what the trend line is for a given period of time and that we're looking for rates that are 30% higher than that. And some people get confused and if they look at what a base rate change is. Well, the reality is that we have a lot of factors and it could be a combination of a base rate, plus geography, plus breed. And so it's a real mix of business that tells everything. And the two metrics that I think are most important to look at is, as ARPU is changing what's happening to our margin. And as you can see our margin over the last three or four years has been very consistent inside of our range between 18%, 19%, 20%. So that tells us that we've got a good healthy book of business and we are progressing well.

And then another thing on low cost; your pet acquisition cost was also really low. Can you give a tiny bit more --you gave a little bit of granularity there, but can I get a little bit more here? Can you talk about, maybe, is it a higher percentage of territories in Nirvana, do you think you're getting -- you've got the channels right, in terms of your advertising channels correctly? Just any more granularity on that?

Well, we had a really strong quarter on the pet acquisition side and that's been led by same-store sales as well as conversion rates. When we talk about the mix of business we're getting, we're growing faster in some areas versus other areas or subcategories that's because we're pricing more accurately than we have and will continue to get more accurate in the years to come. But the overall challenge for us in building this category is getting more and more veterinarians who see this as being normal, having veterinarians at the time of check-in asking who medical insurance is. And as we continue to grow the business, that's where we're seeing the growth, as well as from our existing clients telling their friends. So we haven't made significant progress on Nirvana. The main increases we've seen so far has really been on same-store sales and conversion rates. And Trish, do you have anything to add?

No, I would probably just highlight where you started your question which is when we went into the quarter with how much we were going to be spending on pet acquisition, what we spent during the quarter was essentially that amount. Where we over performed is, we got quite a few more pets for that spend than we originally forecasted. And that's what drove it from what we thought would be a 4 to 1 to 4.6 to 1. And great execution by the team as Darryl mentioned and being efficient. And this gives us a lot of confidence going into next year as we'll have more and more money to spend, sure [ph] to continue to execute, but feel really good about where we came in this quarter.

Our next question is from Andrew Cooper from Raymond James.

I'll start on a similar path. Just as we think about the big number of Trupanion Express facilities that were added since the last update and kind of trying to square the circle relative to the little bit slower ARPU growth, do you think that the timeline of that being in the 6% to 7% range will get back to and might extend a little bit longer, as you continue growing that number faster or any thoughts around that would be great?

Yes, so this can be a little bit of a complicated subject because if you look over the last 15 years kind of the inflationary cost of insured clients is going to be in and around that 6% rate. So if you're thinking about modeling something out for the next 10 to 15 years, that's the numbers that we use internally. Anytime we are having changes in our subcategories of pricing or adding more of those, we may have a change in our mix of business. And then some cases that may drive ARPU higher which it did a couple of years ago and now we're seeing it come down on the lower end, because we're growing at an accelerated rate. The software Trupanion Express on its own would have us pushing it a little bit higher than the 6%. So if you would have asked us absent of the mix of business and what we were talking about several quarters ago, we would have predicted it to be in the kind of 6% to 8% range this period of time. But because we are seeing a change in the mix of business as we accelerate the growth, we feel good about it and we feel good about it because the underlying margins support this business.

And then kind of stepping away from the quarter specifically and thinking longer term, you've talked a little bit more at the shareholder meeting and recently about international as well as categories like food. So any updates there, especially given some of the personnel movement around food would also be great.

Sure. So at the Annual Shareholder Meeting in June, we talked briefly about us entering the Australian market and doing some testing there. Our goal is to be the world's authority and you can't do that from North America. So we think that Australia is a good place for us to dip our toe and do some testing. As far as food, food is one of the biggest other spends for our clients. Responsible pet owners spend money on veterinary care, as well as food, and we have a lot of intellectual curiosity to understand if there is a connection between high quality food and the health outcomes. So we've made some investments and we have Ian Moffat, who's been in our spaces and with the company for a long time, taking a lead position on that. And we don't know where it's going to take us at this point, except that we're really interested in it and we'll see what happens.

Following up on Australia; I know there's some regulatory hoops to go through and what not. But where are you in the process of being able to start underwriting pets or have you started and how do we think about timing of that as a test and then potentially expanding further?

Well, when we get that to test phase, we will let people know. So the first thing for us do is we're going to be testing in a small number of hospitals and we'll likely be doing that over the next few months.

Our next question is from Jon Block from Stifel.

I'll keep it to two as well. Darryl, you talked about customers not being price sensitive but value sensitive. Maybe you can help us what percent of your base roughly submits a claim within 12 months? In other words, I guess, where I'm going with this is, what percent of your base experience your system, possibly Trupanion Express, claims automation, et cetera? And then I surely got a part B to that same question.

Well, the frequency for us is a lot higher than most people expect. If you think about a child, and I have two kids that are 11 and 13, they get sick and you need to take them to the doctor. Well, pets age 7x faster. And so we have a much higher frequency than people expect. And the frequency is between 12% and 15% are making a claim in a given month. So we do get a lot of exposure. But I think what a lot of people don't intuitively understand is that, if a pet owner has, and I mentioned this in the opening remarks, a bulldog and they live in New York City, they have an expectation of what a good value is, and that's going to be something different than if somebody has a different type of pet living in a different area. So pet owners search out veterinarians that are aligned with their interest and their values and we try to connect with it. And it's surprising, we see it in conversion rates, as well as retention rates that when we are very close to our 70% value proposition is when we're really in the sweet spot for the pet owner.

That's a pretty good segue to sort of my part B and it's still the first question. I think a lot of us do have some level of price sensitivity. So I'm just curious what you see in your data, in other words, sort of the variance in churns if you're increasing ARPU between 1% and 20% versus if you go above that 20% threshold, in other words, is there a big difference between 2% and 15%, but then you see a material difference once you hit 25%. I'm just trying to figure out where that breaking point for consumer maybe, where price sensitivity does override that of value?

Yes. So we talk about that in our pricing promise, which we try to communicate to consumers. And you are dead right. If we are pricing somebody consistently, they are happier with us. And if you think about what we're trying to do to solve a problem is to help people budget. And if we're changing the rate by 40% or 50% year-after-year, that's not helping them budget. Most of our clients as you can tell by our ARPU changes, are seeing rates change around 6% to 7% for the year, if you looked over the last 10 years and what we expect in the future. When we get outside of that range and really about a minus 15% to maybe a plus 15% or 20%, it's pretty much about the same. When we go above 20% and to 30%, we see more clients disappointed in if we have rate changes for a small section of people that is greater than 30%, they're going to be even more disappointed and that will show up in churn. But we also have a pricing promises that says that we're going to charge the same thing for new people as we do for existing. It's a way to make sure that all clients are treated fairly. And if we understand one of our price categories is wrong by 30%, we're not going to slow it down, we're not going to say we're going to spread this out in two years. We rip the band-aid off and get it done, even if that gives us some short-term pain. But our overall goal is to get all of our price categories changing kind of below 15% a year. That would be really good and really accurate and we're moving in that direction.

Tricia for you, I know you don't want to give '19 revenues, but the subscription business has a little bit more visibility and consistency to it. The others moved around. Is there anything when we look to '19 with certain books rolling off and others coming on up, down, sideways, just so you can give us at a very high level for that other business?

What I would say about the other business, you're right, I can't give a lot of detail on 2019 right now. But overall, in the other business segment, what we're seeing and what we continue to expect going into next year is strong performance among all of those lines. And as a reminder, we underwrite our program for the Veteran Affairs program, there's employee benefits within that segment, and then we underwrite to other companies who operate in the space. One began rolling onto our book in 2017 and that's the reason you're seeing some outsized performance from 2017 and 2018 and then also performing well. And then, there is another party that has been rolling off over the past year, but it has been slower. Now that book of business is smaller. So as the other book of business rolls on, it's kind of diminishing that as that roll-off is slow and also that book of business can be lumpy, which is why it's a bit hard to project. But getting to the point, what I would say is, like I mentioned, we're projecting 60% year-over-year growth in that business this year based on those factors and a more normalized growth that we've seen historically is around 10%. So looking into 2019, we currently think it will be somewhere in between there and we'll provide more guidance on the next call.

Our next question is from Paul Penney from Northland Capital.

This is Greg [ph] on for Paul. Thanks for taking the questions. First, could you provide an update on your B2C marketing efforts and select MSAs? And are you seeing any types of tangible benefits there in terms of new customers or conversion rates?

Yes, Greg, the B2C that we've been doing has been primarily TV. It is in markets where we have a higher penetration rate of our software Trupanion Express. We see it not really as an area for lead generation, but increased conversion rate. We think it has been an impact, a partial credit for the performance in the last couple of quarters, but it's relatively small. Most of the drivers that we have are not direct to consumer, but it's really about the same-store sales, but we are testing more and we'll continue to invest.

And then just looking forward, where do you expect to add CPA strength regions?

Yes, so we have about 15 regions that we would like to get territory partners in place and we have some existing markets where we want to add a little bit more density. So over the next year or two, hopefully, we can add probably another total of 15 or 20 people.

Our next question is from Kevin Ellich from Craig-Hallum.

Sorry for the background noise, I'm on road. I guess, Darryl, I might have missed this if you already commented on it, but wondering if you could provide a little bit more color on the lifetime value. It increased 1.9% this quarter [indiscernible] from what we've seen and how do you see the PAC. It came in at 4.6, which is -- I think, Trish said, it's better than what you guys were expecting, but it's still a step-down from last quarter. Can you kind of talk about the quarterly fluctuations we are seeing and I guess what you're expecting on a go-forward basis?

Yes, well, the lifetime value is the combination of the ARPU, the margin we are getting and how long we keep a pet enrolled. And our retention rates have been pretty consistent. The biggest change that we're seeing is the ARPU is a little lower, as I talked about the mix of business. If we grow -- continue to grow at the rate we have in the last couple of quarters, Trish mentioned in her opening remarks, 90-day retention is a little bit like a headwind, if you grow faster. So that will impact our overall lifetime value calculation. So I would expect that lifetime value as our mix of business is changing a little bit, might kind of flatten, but those are the factors that drive it.

I would also just add in terms of the LVP-to-PAC ratio. As I mentioned, we came in better than we forecasted with the 4.6. We still want to continue to be aggressive, as we look to Q4 and going into next year, as long as we're operating within the guardrails of great internal rates of return and also being free cash flow positive. So we still believe for the full year 2018 if we came in closer to four to one, and that is well within our guardrails that we would feel good about that. So we continue to look forward and want to do more testing and be more aggressive.

Yes. Just one other thing to add there is that, our adjusted operating margin as that expands, so that includes our fixed expenses. That's what really helps us with the leverage on our internal rate of return, and I talked about that a lot in my last shareholder letters.

And then, I don't think it's been talked about yet and I don't know, again, if I missed this, I'm sorry. We also have the -- you announced that you're running the Trupanion Express rewards program. Just wanted to see what your thoughts are on that and how it might affect. Actually can we get an update on the rollout of Trupanion Express and I guess utilization by the vet practices? So any update on that would be nice.

Sure. I understand the question. The Points Program, which was a test that we were doing with hospitals that had our software Trupanion Express, we canceled that program because it wasn't getting the results that we wanted to. The total number of hospitals that we have has grown from 2,000 hospitals last year to about 3,000 hospitals today. It is our goal to get our software in as many hospitals as we can. We've got a lot of runway there. There's about 25,000 veterinary hospitals across North America. We're currently visiting about 21,000. We had about 15,000 of them have pets enrolling in the last year, and yet we are only about 3,000 of them have the software today. So we've got a lot of runway there. We continue to do that. We're learning that when we attach an internal account manager, when we download the software, it gives us more opportunities that have higher -- more touch points in between our Territory Partners visit. And we've tested different programs, some that have worked and some that have not to allow us to have more -- as frequent touch points as possible. So that's kind of the key.

Our next question is from Tom Champion from Cowen and Company.

This is Henry [ph] on for Tom. Just a couple of questions here. First, in light of the recent discussion around insurance regulations, how has your thinking changed on the topic of compliance and vet education? And I think most of us might have seen the documentation you've sent to vets, but does a more asserted effort make sense here? And then just trying to understand how a market reaches Nirvana. Is it a function of longevity in the market or maybe the implementation of Trupanion Express and what do you think it'll take to get more markets to Nirvana?

So the first part of the question is talking about educating the market everybody inside of our food chain, which includes regulators, that includes veterinarians, et cetera about what and how we deal with regulations. We have been investing more and more money in this area over the last several years, as the category grows and we grow as a company. We feel very good about our understanding and our position in that area. We've had some more attention and wanted to make sure that veterinarians understood what they can and cannot do, and we like those conversations. Veterinarians really like to be informed and educated and they see us as an authority and we take advantage of any of those opportunities as we can. If I think about it, switching to Nirvana -- we haven't made, I mean, frankly we haven't made as much progress in Nirvana, as I would have liked to be ask me three or four years ago and I talked about this in my last year's shareholder letter. In our shareholder meeting in June, we did mention that we did have one region that hit Nirvana. And if you looked at what was different about that region than others, it was really around Trupanion Express. When we're able to pay hospitals directly and do it really well as well as price as accurately as we can, and increase conversations, have account managers, that's the combination that we think we can -- we need to drive to. We think we have a pretty good roadmap. But to be honest, I think it's going to be several years of us chipping away at it to make this progress. It's a really ambitious goal.

Our next question is from Mike Graham from Canaccord.

I just wanted to go back to the direct to consumer, Darryl. And it seems like it's been in test for a while and I know that that was kind of the plan all along. But just wondering, as we start to think through next year, are you -- is there any possibility that we are sort of moving out of test phase into something heavier when we get into, sort of, your key marketing quarters next year? And I just wanted to get a quick update on Canada. I don't think we've talked about it in a while, just like how that's going and is Canada growing, sort of, faster or slower than the overall business or just anything you can say there that would be of interest?

Yes, we serve around the word test a lot and it's something that we do where we like to try new things. I defined it in the shareholder letter, I believe last year's shareholder letter, and we kind of have three groups. So our goal is to have internal rates of return of between 30% and 40%. If we have an area that we believe can get there, but is not at that mark yet, that's kind of like a growth category. Maybe we'll spend 20% of our PAC spend there, and then maybe 10% of it in test. I would say our direct-to-consumer is in that middle category now. It's not achieving the internal rates of return that we want, over 30%. But it's above zero, we've been doing it for a while. So it's becoming more regular. So you can expect that we'll be doing a little bit more of it, each year. And when we get to the point when we believe it's repeatable and higher volume above 30% is when we'll call it normalized. And then your second question is about Canada, which I'm always proud to talk about as a Canadian, who is also now an American by the way. Canada continues to grow nicely. If our U.S. business can track the same way as our Canadian business which is a solid 7 years in advance, we're going to be a very happy company.

Our next question is from Mark Argento from Lake Street Capital Markets.

Just got a quick question more on the regulatory environment. Obviously, we hear quite a bit of chatter about state regulators and different things going on. Could you just talk a little bit about your interactions with the different regulatory bodies? How often do you interact with them? How familiar are they with your business practices, in particular around the ambassadors or the territory partner model? Because there is, obviously, a lot of noise out there, but maybe you could just opine a little bit on, kind of, the regulatory -- your regulatory practices.

Sure. Thanks for the opportunity to talk about it. We own an insurance entity and we own it so that we can lower our fixed expenses and offer a better value proposition back to the consumers. With that obligation, it means that we live in a regulated world and we need to understand it and we think we do very well. We've been living in this world since 2008. We have been amping up the number of regulatory attorneys, as well as, data and analysts, and people in this space every year and continue to invest more and more. Because as this category grows, we expect we're going to be under the microscope. As regulators are starting to learn about medical insurance for cats and dogs, they have a lot of questions. And sometimes the questions are prompted by their own curiosity and sometimes they are prompted by outside sources, consumers and others. When they have a question they'll reach out to us, they want to understand something and we think that's normal course of business and it's healthy. Every time we do that, we're building better relationships with them and they understand our value proposition. There isn't anything that we've done in the past that we believe from a program or anywhere else that is not a 100% compliant, but sometimes there are questions. I can say that years ago, we weren't as buttoned up as we needed to be on little things. And it's important that we are as buttoned up as we can. An example of that would be, recently Washington State assessed us a $10,000 fine for some relatively small problems. One of them was related to -- we had a pet owner that did not -- that was being overcharged by about $50 a year. And we had about another eight pet owners that did not receive notice -- a 30-day notice, they received about a 21-day notice. And that's not acceptable. When you live in a regulated world, you need to play by the rules and you need to know what the rules are. We're not always perfect. But we do do things for the right reasons and we're well aligned with the department. Trish, do you have anything to add?

No, I think that's a good summary. I would just emphasize like we've said recently we're very focused on this area, we are heavily invested in this area and we don't have any reasons to believe that the regulators view things differently than how we view and material things we do report.

Our next question is from David Westenberg from CL King.

Just so, I wanted to just get a little further in the question about the declining -- or the lower ARPU and the lower pet acquisition costs, you name it. You basically have better pricing across your different sub categories. Can you give -- Dave, you've given this in the past, in terms of, maybe percentage of categories that are not priced correctly. So anything around there to help us kind of figure out what still -- what still needs to be picked, kind of, maybe that's a wrong expression, but just to some something around that?

Yes. I think, I can give you some more color to help you with it. We tend to talk or focus on the negative. So the negatives are, when we have a -- when something is mispriced by 20%, and we need to raise somebody's rates by 20%, obviously, we don't feel good about that, but we need to rip the band aid off and get that done, so we can be fair. Well, if you look at our margins, historically, our blended margins have been very accurate within our range. That means there was another side that was being overpriced -- overcharged by maybe 20%. And what we've been doing is pricing more categories more accurately and some of the ones that were being overpriced, unintentionally or maybe with not enough data are now growing at an accelerated rate, because they get the value proposition that we promised to everyone. So, an example would be, if somebody is being charged $40 a month but instead of us at a 70% target, we're at a 50% target, we need to lower that person's rate to get them to the right price. And just kind of an offset, and we're seeing the accelerated growth in the ones where pricing more accurately.

Thank you. This concludes the question-and-answer session, as well as today's teleconference. Thank you for your participation. You may disconnect your lines at this time.