Trupanion, Inc. (TRUP) Q1 2019 Earnings Report, Transcript and Summary

Greetings and welcome to the Trupanion First Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Laura Bainbridge, Head of Investor Relations for Trupanion. Thank you. You may begin.

Good afternoon and welcome to the Trupanion first quarter 2019 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 our 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 cost, adjusted EBITDA; and free cash flow. When we use the term adjusted operating income or margin, it is intended to refer to our non-GAAP operating income or margin before new pet acquisition. Unless otherwise noted, margins and expenses will be presented on a non-GAAP basis, which exclude 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 on 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 on the site. And with that, I'll hand the call over to Darryl.

Thanks, Laura, and good afternoon. Last week, we published our 2018 shareholder letter. I'll review a few of the highlights today, but I would encourage you to read it in its entirety. We intend to hold a more fulsome discussion and answer your questions at our upcoming Annual Shareholder Meeting on June 6 at our Seattle headquarters. We value shareholder engagement and believe that the annual event is the best opportunity to answer your questions so that you can gain a better understanding of our business, strategy and initiatives, as well as experience our people and culture. We hope you can join us. With that, I'll recap a few of the highlights for the quarter. Revenue was up 25% and we ended the quarter with over 548,000 total enrolled pets. In our subscription business, we once again saw solid leads from the veterinary channel. We also benefited from strong ARPU, particularly among newly enrolled pets. Retention and conversion, two ongoing areas of focus, were consistent. Adjusted operating income grew 56% year-over-year to $9.5 million. As a reminder, our adjusted operating income is the fuel for our growth. Adjusted operating margin expanded 220 basis points over the same time period. The expansion in our adjusted operating margin reduces our payback period when acquiring new pets. This increased margin and reduced payback period allows us to invest more aggressively while maintaining our targeted internal rates of return. During the quarter, the pet acquisition team deployed $7.8 million of our adjusted operating income with estimated internal rates of return at the upper end of our targeted 30% to 40% range. Our pet acquisition spend in the quarter reflects investments in additional headcount for both our lead and conversion teams as well as a small increase in our direct to consumer spend. I've included a lot more detail around how we think about the internal rates of return on our invested capital in my annual shareholder letter. We also intend to dedicate a significant portion of the Annual Shareholder Meeting to answering questions about our strategy to deploy our adjusted operating income at internal rates of return within our targeted range. As I noted earlier, we continue to see strong leads out of our core veterinary channel. We hit 9,700 active clinics in 2018, a 14% increase over the prior year. Our Territory Partners are essential to our efforts to build relationships with 28,000 estimated veterinary clinics across North America and are a key competitive moat. We ended 2018 with over 120 Territory Partners in the field, visiting 20,200 unique veterinary clinics. And we continue to recruit for additional open territories. Today, we have 10 open territories, including markets like Pittsburgh, Houston and Cincinnati. Investing in our Territory Partners as well as our ongoing education and support will remain an important area of focus. Just a few weeks ago, we held our 2019 Annual Territory Partner Conference. This event is a great opportunity each year to celebrate our collective success, share our vision and focus for the year ahead and improve the collaboration of our team. During the conference, we were able to highlight our success of marrying our software with an in-site account representative. As we've discussed previously, we've seen a sustained 40% uplift in clinic penetration rates since deploying this program. We continue to grow the number of account managers responsible for supporting our partner hospitals and providing more frequent touch points between Territory Partner visits. We also increased the deployment of our software to over 3,500 veterinary clinics and paid over $53 million in veterinary invoices directly to veterinarians in the 2018, an increase of 33% over the prior year. Approximately 5% of the invoices paid with our software were fully automated with an average processing time of just 16.5 seconds. Claims automation transpired out of our commitment to our software and is a game-changer in delivering a best-in-class customer experience. Increasing the number of veterinary clinics that have our software installed, so that we can pay them in seconds will continue to be a key focus area over the next few years. Our efforts to eliminate the reimbursement model are expected to not only drive penetration of Trupanion among clinics actively utilizing this software, but are also expected to aid in our aspirations of Nirvana. Nirvana is our very important and difficult goal of offsetting our cancellations by existing members adding pets or referring friends. Delighting our members so much that they add another pet or recommend Trupanion to a friend is an important driver to our road to Nirvana. But so is reducing the number of cancellations among our existing members. With this in mind, improving our first year retention and pricing with increased precision remain two areas of focus. I talk about this more in our annual shareholder letter including breaking down our churn by category of rate changes. Looking at average monthly retention this way, we have three primary groups. First, for pets that have been with us for over a year and received a rate change of less than 20% during 2018, our monthly retention was about 99%. This group represented the majority of our pets. Second, for pets that received a rate change in excess of 20%, our monthly retention averaged 98%. This group represented 12% of our pets in 2018. Third, for pets that have been with us for less than a year and have not yet seen any rate changes, our monthly retention rate was only 97% in 2018. As I noted in the letter, our biggest opportunity to improve our blended monthly retention rate is to reduce the number of pets that cancel within the first year. With more adjusted operating income available to invest in new pet acquisition and a large underpenetrated market, we should not expect our blended monthly retention rate to improve over our 10-year historical average of 98.5%, unless we are able to improve our first year retention rates. More upfront education for the pet owners around our product and individual coverage considerations is an important part of our strategy to do so. Also in our shareholder letter, I highlighted our preference to reduce the number of members that receive a change to their monthly cost that is greater than 20% per year. However, this objective will not supersede our desire to get more pricing categories as accurate as possible first. We aim to deliver our same 70% value proposition across each pricing category. Not only do we believe this is the right thing to do, but we also believe it will provide the healthiest and most sustainable results long-term. We also believe our high-value proposition, along with transparent and comprehensive coverage, drives good alignment with the departments of insurance. We operate in a regulated world by design. Owning our own insurance entity is important to delivering our 70% value proposition. As the only mono-line player in the space, we want and need to take additional time to build deeper relationships with the state regulators. Communicating our value proposition, product, member experience and our values is essential to this effort. Over the past several years, we have added resources too, and placed greater emphasis on strengthening our relationships with state regulators and ensuring that all of our business practices are designed and implemented with applicable regulations in mind. To summarize, it's a busy time at Trupanion. We're focused on moving the ball forward on our key strategic initiatives, while laying the groundwork to grow Trupanion in the category in the years ahead. Ultimately, our success will come down to our team and execution. Executing against our opportunity, while maintaining our culture will be the true marker of our success. I'll now hand the call over to Trish, to walk through our quarterly results in more detail.

Thanks, Darryl, and good afternoon, everyone. I'll review our first quarter results in detail as well as provide our second quarter and updated full year outlook. Revenue for the first quarter was $87 million, up 25% year-over-year and led by strong pet enrollment in both our subscription and other business segments. Total enrolled pets increased 23% year-over-year to over 548,000 pets as of March 31. Subscription revenue was $74.2 million in the quarter, up 21% year-over-year. Total enrolled subscription pets increased 15% year-over-year to over 445,000 pets as of March 31. Pet growth within our subscription business benefited primarily from increased leads in our core veterinary channel. Monthly average revenue per pet for the quarter was $56.13, an increase of 5% year-over-year and in line with our historical average of 5% to 6%. In local currency, monthly average revenue per pet increased by 6% from the prior year for our U.S. members and by 5% for our Canadian members. Average monthly retention was 98.58% compared to 98.63% in the prior year period. As Darryl noted, improving first year retention continues to be a focus of the organization. Our other business revenue, which generally is comprised of our revenue that has a B2B component, totaled $12.8 million for the quarter, an increase of 55% year-over-year. Year-over-year growth in our other business segment reflects an increase in the number of enrolled pets. Total enrolled pets in this segment was approximately a 103,000 at quarter end compared to 61,000 at the end of the prior year quarter. Based on Q1 performance, we estimate revenue in this segment will be around $55 million for the year. Subscription gross margin was 19% in the quarter, within our annual target of 18% to 21%. Total gross margin was 18%, which includes our other business segment. Fixed expenses were $5.8 million or 6.7% of total revenue in the quarter, down 70 basis points from the prior year period and 170 basis points from our 5% target at operational scale. Owning our home office building benefited fixed expenses by approximately $1 million in the quarter. This was partially offset by $500,000 in increased cost to support our continued growth, primarily investments in teams as well as increased audit and consulting fees. You'll recall that we triggered the requirements for an external audit of SOX compliance in 2018. Adjusted operating income totaled $9.5 million in the first quarter, a 56% increase from $6.1 million in the prior year period. Net loss for the quarter was $1.3 million. As a percentage of revenue, adjusted operating margin expanded approximately 220 basis points year-over-year to 11%. We are pleased with the expansion in this margin, which reflects the benefits of strong revenue growth and continued scale in fixed expenses. Turning now to our acquisition costs. In the first quarter, we spent $7.8 million compared to $5.7 million in the prior year period. Spend during the first quarter related to the acquisition of 34,000 new subscription pets as well as investments in building out teams, primarily around conversion, and increased direct-to-consumer testing. As we have discussed in the past, we target around 70% of our acquisition spend on core known initiatives and the remaining 30% on longer-term strategic or test initiatives that are important to supporting our growth. We were pleased to deploy this incremental acquisition spend, while operating within our guardrails of being free cash flow positive and targeting an internal rate of return on a single average pet of 30% to 40%. Adjusted EBITDA was $1.7 million for the quarter, up from $0.4 million in the prior year period. Our net loss was $1.3 million or a $0.04 loss per basic and diluted share compared to a net loss of $1.5 million or a $0.05 loss per basic and diluted share in the prior year period. Net loss for the quarter includes an increase in depreciation expense of approximately $600,000 compared to the prior year period related to the ownership of our home office building. Free cash flow for the quarter was $3.1 million. Operating cash flow in the quarter was $4 million, up from $2.1 million in the prior year period. At March 31, we had $88.3 million in cash, cash equivalents and short-term investments and $18.1 million of long-term debt. I will now turn to our outlook for the second quarter and full year of 2019. For the second quarter of 2019, revenue is expected to be in the range of $90.5 million to $91.5 million, representing 24% year-over-year growth at the midpoint. For the full year, we are increasing our revenue guidance range to reflect our Q1 performance. As a result, we now expect revenue for the full year to be in the range of $371 million to the $376 million, representing 23% year-over-year growth at the midpoint. Embedded in our revenue guidance for 2019 is ARPU growth in line with historical averages of 5% to 6%. At our forecasted revenue levels, we would expect full year adjusted operating income of around $45 million. At our 30% to 40% targeted internal rate of return on a single average pet, we currently estimate we would have allowable acquisition spend in the range of $32 million to $38 million based on the opportunities we see today. Also, please keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S. and Canadian currencies. For our second quarter and full year guidance, we use the 75% conversion rate in our projections, which was the approximate rate at the end of March. Thank you for your time today. And I will now turn the call back over to Daryl.

Thanks, Trish. Before we open the call up for questions, I'll remind you that if you've not had a chance, please read our 2018 Shareholder Letter, which can be found on our Investor Relations site. This weekend, we'll be hosting our annual open Q&A session following the Berkshire Hathaway Annual Shareholder Meeting in Omaha. And finally, we'll be hosting our Annual Shareholder Day at our headquarters in Seattle on June 6. With that, we'll open the call up for questions. Operator?

Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Jon Block with Stifel. Please proceed with your question.

Jon, you there?

Mr. Block, you're live.

Next? Keep on moving.

Our next question comes from Kevin Ellich with Craig-Hallum. Please proceed with your question.

The commentary you gave on the three primary groups and how you guys look at retention, just wanted to see if you could give us for the pets that are enrolled for less than a year, where the monthly retention is 97%, what percent does that make up of all your pets?

Well, what we're looking at right now is, in our guidance we're looking at about a 15% growth rate year-over-year on our net pets. The total number of new pets generally is a little bit higher than that, so you can be looking at maybe 20% to 25% of the total book in a given year.

Okay. That's helpful. And then, clearly, we can see that average pet acquisition costs has gone up and LVP to PAC is calculated 3.5 times. So can you give us a little bit more detail as to kind of what's in your assumptions for the year and how we should be thinking about those metrics going forward?

Yeah, sure, so as a reminder, the reason that we use internal rate of return as a driver for our PAC spend versus LVP is because LVP is a contribution margin and does not include our fixed expenses or an applicable capital charge for the surplus we're required to hold. So we believe the IRR is a much more fulsome and better metric to operate from. And as we've had expansion in our adjusted operating margin, about 220 basis points in the last year and our ARPU is going up 5% to 6%, our payback period is shortening, which is allowing us to increase our pet acquisition spend while still maintaining an internal rate of return within our target. And as I mentioned in my opening remarks, in the first quarter, we were at the high end of our range. And our range is between 30% and 40% internal rate of return. If you back it in and you look at what Trish mentioned, we're looking at approximately a $45 million adjusted operating margin. And as the adjusted operating margin is expected to expand throughout the year, we should be able to spend between $32 million and $38 million acquiring pets, while maintaining an IRR inside of that range. And that's how we kind of think about it. Trish, do you have anything to add?

No, the only thing I would add is just, if you're equating this to the LVP to PAC, as you mentioned, it will be based on what we've talked about between a 3X and a 3.5X is expected to be our run rate for the year, which we think is appropriate based on the opportunities that we have available to us.

Okay. That's helpful. And then, Darryl, going back to the Shareholder Letter, looking at the five-year report card, I think AOM, you gave yourself a B, subscription cost of goods are - what you paid that invoice is tracking 200 basis points higher than your plan. Can you give us a little bit more color on as to what's going on there? Are costs going up or just more claims being filed? And then, how do you plan to get that back on track with your plan?

Yeah, well, I mean if - so, thanks for reading the Shareholder Letter. And in that letter, I kind of do a recap over the last five years. And our long-term target is to be paying above $0.70 on the dollar per paying veterinary invoices, about $0.10 on the dollar variable expenses. And when we hit scale, 5% on a fixed expenses, giving us that 15% adjusted operating margin or that 15% profit on our existing book before we acquire new pets. And we've been tracking closer to $0.72 on the dollar versus $0.70 in what we're paying in veterinary invoices. And that's not far off, but the reason that we've been a little bit challenged there is, as we've been deploying more of our software, we see higher percentages of invoices, and we've been playing a little bit of catch-up. And I mean to be fair, our adjusted operating margin is trending nicely, and we can afford that. And in the world of a trade-off, I'd much rather get our software out quicker. But we've been playing a little bit of catch-up. And I'm not disappointed in our results in the last two years, but if you were to ask me 5 years ago, we're a little bit behind where we expect it to be. Long term, if you look over the next 5 or 10 years, we're looking at having a 15% margin and paying out the highest percentage possible. So our target may one day become $0.72, $0.73, $0.74, if we can get some movement or improvements on our variable expenses or fixed expenses beyond where we're at targeting today.

Got it. And then, one other thing from the shareholder letter, you mentioned that an area of disappointment was increased enrollments and same-store sales ahead of more foundational goals. Just wanted to see how you think about how the company should balance adding new hospitals, driving higher enrollments and same-store sales at the same time.

Well, what you're looking at was kind of a summary of the issues that we talked about year-over-year. And several years ago, we were, in my mind, and this is going back three or four years. We tried to work on same-store sales before going wide, increasing the number of hospitals. This last year is the first year where we've actually done both at the same time. So I think I said in the opening remarks number of active hospitals went up to 9,700. I believe that was a 12% or a 14% year-over-year improvement. And at the same time, when we're deploying the software along with an account manager, we have a sustained same-store sale penetration rates of about 40%. So, we're starting to learn how to do both of them. If I went back and looked over the last 10, 15 years of the company, we've really grown the business mainly by adding stores. And several years ago, we weren't accelerating the stores as much as I want. But I would say in 2018, we did a really good job on both. And we'll see how 2019 plays out.

Sounds good. Thank you. I'll hop back in queue.

Thank you.

Our next question comes from Jon Block with Stifel. Please proceed with your question.

Guys, can you hear me this time around?

We can. Hi, Jon.

Okay, great. Thanks. I'll take it. So, one high level and then one a little bit more specific, high level, Darryl, recent consolidation of a couple of players in the market, I just sort of wanted to check in and ask, what does it mean for you if anything? And do you think these players adopt a different approach to market post the acquisition, considering they may have deeper pockets at that point in time? And then, I've got a follow-up.

Well, so Jon, over the last 20 years, we've competed against about 45 or 50 brands. So from a consumer landscape at any given time, there's been 20-plus brands with maybe about 60 different product variations. So from a consumer standpoint, I don't think there's really any change in the landscape. What you have seen is some people try to enter the space and not be successful and leave the space. In other cases, you see marketing companies get to a certain point of their growth and then get acquired by typically an underwriter, an insurance entity, and we're seeing a little bit more of that. I think if anything, it means that as the category continues to grow and last year, I think - or two years ago, I think it was reported it grew at the teens. Early indications are that for 2018 that it grew in the mid-teens. So the category is growing nicely. And having some deeper pockets probably means there's going to be continued growth for the entire category. But for Trupanion, we're really positioned as - or we try to be positioned as the best product offering to be sold, recommended through veterinarians. So the highest level of coverage with the best customer experience. Some of the other movements tend to be in either lower-priced products or mid-priced products. So I don't think, there's really any big changes for us from a competitive landscape, but overall, a net positive to the category.

Okay. Very helpful. And the more specific one was at least from my model, it looks like you guys spent a little bit more than we expected on sales and marketing, you had a couple of fewer adds or gross adds, I should say, in the quarter. So can you tell me if it was in line with your expectations? Was there a bigger percentage of the sales and marketing earmarked for testing within certain markets? And lastly now, you've been having sort of the testing going on for some time now. Can you highlight for us what initiatives are working better than others? Thanks, guys.

Yeah. So first starting off on our pet acquisition spend, as I mentioned, we're at the high end of our internal rate of return target. So that range is between 30% and 40%. We are at the high end. So if anything, we would like to have been more aggressive. The reason that we were able to do that is we've seen nice margin expansion and the payback period has been shortened as well as ARPU increases. So from us from an operational standpoint, we probably, if we could do the quarter over again, would have liked to have been a little bit more aggressive in our spend than we were. Now where we're spending our money, we spent about 70 - we try to target about 70% of our PAC spend at any given period of time on things that are kind of core, things we know of that have predictable high internal rates of return and then about 20% of our spend on things that are not yet optimized. We call them kind of a growth category, things we're working on, but they're not optimized, and we figure if we stick with it, we can get there. And then about 10% on test. What you really saw in Q1 was a lot in the growth area. So we've spent, and I mentioned in my opening remarks, more money building out our teams on both the conversion area and the lead conversion - or the lead team. So as we're adding more and more account managers to accompany the rollout of our software, we're seeing increase in same-store sales, that's a way to improve the customer experience and help us long-term towards Nirvana, but also to help us with overall lead volume. And then conversion is an area that has really been a driver of our growth the last couple of years. I mean we've had good, consistent leads from the markets, and we've been growing by increasing conversion rates, and we believe that there's a lot of opportunity to do that. So I'd say that most of our uptick in spend on our PAC was in the growth area. We actually didn't spend as much in test as we like. So I mentioned in my opening remarks we had a small uptick in our direct-to-consumer. But I'd also say that some of our direct-to-consumer in certain markets are now kind of moved into growth. We're doing them on a regular basis. They don't quite have 30% in internal rates of return, but they're getting reasonable ones. So we score ourselves in the strong category for our pet acquisition spend for the quarter. And we're optimistic as long as we continue to get margin expansion to be able to deploy more and more capital at those strong returns.

Fair enough. Thanks.

Our next question comes from Mark Argento with Lake Street Capital Markets. Please proceed with your question.

Hi, good afternoon. Just quickly, just wanted to know if any markets achieved Nirvana in the quarter. And then relative to how you're spending the PAC money, do you guys take an approach to concentrate in any geographic markets if you are striving to achieve this kind of what we call Nirvana? Any thoughts around that would be very helpful. Thanks.

So as a reminder to people on the call, Nirvana is our kind of lofty ambition goal to offset our churn, our monthly churn, by something that grows as a percentage of book. And those are pets, pet owners either adding pets or telling their friends. And in my shareholder letter, I mentioned we haven't made significant progress in that area over the last couple of years. It hasn't been without effort. So I'm pleased that we've tried a few things that we won't try again and we're working on new things that hopefully we'll see improvements. And then last year in our shareholder meeting, we mentioned that one of our markets, one of our regions reached Nirvana for the first time. I'm pleased to say that, that one is held, and we haven't had any added to that region. So the second part of your questions was do we target our PAC spend by geography, and the answer is yes. So we understand the underlying value of a pet, both by breed, geography. And then we're trying to align our PAC spend. And in some areas where we have higher ARPU and higher retention than our targeted margins, we can deploy greater sums of capital. For example, in New York City, where ARPU is a lot higher than it would be in Boise, Idaho, assuming we have the same retention and the same margin, we could spend more to acquire pets in New York than we could in Boise. And we've got strategies to go about that.

And just a quick follow-up in terms of pricing, and I know one of your competitive advantages is the size and scale, your database and your ability to price. Where do you see yourself in that pricing process? I know, it's a constant game of iterating and getting better. But is there still 50% of the way to ago, 20% of the way to go? Where are you in that process?

Well, I mean when I went over - in the shareholder letter, I broke out - and the first question on the call was about the categories of our churn, and I put in a chart there that said that 12% of our clients in 2018 saw a rate change of greater than 20%. Now ideally, that would be zero or 1%. The reason that occurs is we still have learnings to do. But when it's that 10%, 12%, 15% of the book and the retention rate for that group is 98% monthly instead of the better category, which is 99%, it's not dramatically hurting us. It's better for us to get those pricings done right. From my point of view, I think, we still lead the category and not only the data, but how we think about it. I think, we're forced to do that, because our product coverage is what we think is the greatest. And we don't have limits or caps or controlling mechanism, [gotchas] [ph] that show up in the fine print, which are kind of lazy ways to protect your pricing. So we were vulnerable on being able to price geographies accurately as well as breeds and other areas, because we cover congenital hereditary issues, and we pay 90% of an actual invoice. We keep adding to this team. I'm really pleased with the progress over the last couple of years. I think, we're doing a really good job. I think, we're going to continue to focus more down at neighborhood levels. But I'm really happy with what the team is doing and the progress that we're making.

Okay. Thank you.

Our next question comes from Andrew Cooper with Raymond James. Please proceed with your question.

Hey, guys. Thanks for the question. First one for me just kind of circling back on the comments from the shareholder letter around the 200 bps of COGS. I just wanted to kind of clarify there. Is a portion of that - has it been around sort of what the insurance regulator will call LAE? Or is it true claims expense? And then, I guess - I'm sorry, go ahead.

No. I mean, it's just us being able to predict the cost and then get the pricing at the same time. The departments of insurance have not slowed us down on this. This is just us. This is our own execution. We need to get our rates approved by departments of insurance. But when we have the data to validate it, we've never had a problem with them saying no. They are aligned with us to make sure that we can offer what we think is the category's leading value proposition in a way that is sustainable for both us and transparent to the pet owner.

I'm sorry, what I meant was more around I look at the claims expense you report and I think that's being closer to 70% than the 72%, so just kind of trying to reconcile that and make sure we're thinking about the buckets correctly.

Yeah. There's a little bit of a challenge in that. We have - you're looking at a blended in some of our - that includes our other revenue, and our other revenue sometimes have some targets that are a little bit different. What I'm talking about in the shareholder letter is really targeting the subscription business. And we've been 71%, 72%, 73% over the last five years, and I would rather it be 69%, 70%, 71% than the latter.

Yeah. I would say, Andrew, just to reiterate, yes, it's specific to the subscription business, which has been running around 72%. And that's the combination of pure claims expense as well as claims - the cost to process a claim, which is referred to as LAE in some filings. And the variance has been on the pure claims expense, for the reasons Darryl mentioned, we've been operating very, very tight within our forecast on the actual cost of processing.

I would say, though, not only in our pricing by subcategories, the team is doing a good job in that. Over the last few quarters, we're seeing that tighten and get closer to our target. It's improving, not degrading. But it's a - what we're trying to do is a really hard thing.

Okay. That's very helpful. And then kind of diving back to the shareholder letter, I think you mentioned at one place in it a new test of a different subscription model. Wondering if that - if you can give any color in terms is it a tweak on an insurance product or is it something more related to the food partnership that you've announced or any color on kind of what you're thinking the future could look like in terms of some new launches.

Yeah. So what I've been talking about there is really about product innovation inside of our core business, which if we can figure out how to make tweaks to our existing products that broadens our coverage, increases conversion rates, increases retention rates, which probably means it's going to have higher ARPU as well, so having higher ARPU with higher conversion rates and equal or better retention rates, that would be a goal. And we always want to be innovating and pushing. And we hope - we've been working on some ideas about this over the last couple of years and hope to be testing just in a small geographic area to see if those things can all prove out over the next one to three years. And if they do, then we'll roll out in a bigger way after that.

Great. That's helpful. And then last one for me is a little bit more on kind of the modeling side. I know you talked about the non-subscription pet number and kind of what to expect on the revenue side for the full year. But has the same kind of trajectory been holding just that some of those pets that you've rolled off are sticking on the books a little bit longer? I just want to make sure there's nothing changed there relative to what's rolling off versus maybe what's rolling on, growing faster than at least we had expected?

Yeah. I would say, Andrew, there's nothing significantly different than what we've said in the past in terms of that dynamic. It's just we don't have as much visibility there as we do in our core subscription business. But you'll see that trajectory continue to get to the $55 million that I mentioned.

Yeah, really all areas of our other revenue are all doing well. So we're just getting a little bit more visibility into it. It's a little harder for us to predict that area, because it doesn't have the same monthly recurring patterns that the rest of the business does.

Got it. Thanks. That's all for me.

Our next question comes from Michael Graham with Canaccord Genuity. Please proceed with your question.

Yeah. Thank you. One is just on the renewals that you mentioned, Darryl. What triggers those? Is it re-categorizing pets? How much of that is just natural escalation in health care costs? Just maybe a little more depth on that. And then I also wanted to ask - you mentioned renewing your commitment to regulatory compliance and investing there a little bit. Just wondering if you could mention some of the vectors that you're focused on making sure that the company sort of navigates correctly.

Sure. So the underlying cost of veterinary care is typically growing up 5% to 10% for an insured client. And that's what we would expect year in, year out. When people are seeing rate changes greater than 20%, it means that either we were wrong or we've taken one category and broken it into two or three, because we have more sets of data. I would say more often than not, it's us getting more granular, breaking into more categories. And there's us being dramatically wrong. But if you look over the last few years, we've got instances of both. But overall, wider swings is us just doing a better job either categorizing or getting more data and more detail. Your question - or I think, you're talking about what I mentioned in the shareholder letter about kind of our alignment with the regulatory departments and what we're trying to accomplish. And as a key, when I think about the departments of insurance in a new category like medical insurance of cats and dogs, there often is a lot of questions. We fall under P&C, and yet we're more like health. So the more that we can involve the departments of insurance and tell them what our values are and what we're trying to and how we're going to do it, it's not typical that a company is trying to pay, in our case, in minutes or seconds. Often insurance companies are trying to hold on to floats to make investment income. We don't act like other people do, and it's important for us to let people know why and how. But underlying, we've got the same alignment in that we want transparency, we want great value proposition. And the more we can communicate them, the better. That being said, different points. The first couple of years we entered the U.S. market, myself and a number of other people were spending a lot of time on planes and in the offices of the departments of insurance, getting to know them, introducing us. And then as the company continued to grow, we added teams and support. And I'm not sure, I always resource them appropriately to be able to spend as much time on the airplanes or in meetings or building those relationships. So we're just - while trying to hit our 15% adjusted operating margin and get our fixed expenses of 5%, we're also trying to add more resources to strengthen those relationships so that even new people in the departments of insurance or old people understand what we're doing and why we're doing it.

Okay. Thanks. And then just - that's helpful. Just one more quick one on the AOM target that you also sort of reiterated in the letter of 15% exiting next year. It looks like your guidance implies that you sort of get - that's 420 basis points from where you are today. It looks like you're sort of implying, you're going to get about half of that this year and about the other half over the course of next year. Is that the right way to think about it?

Yeah. Michael, I would - I mean, we're thinking about it a little bit in buckets, too. So in general, we're targeting that 70% claims ratio, 10% in variable expense. And then we're targeting the 5% in terms of fixed expenses and making headway there to get to our 15% target. And I think, we're making good headway. Like you mentioned, our guided amount for adjusted operating income implies that we get to about 12% this year at the end of the year. Our run rate at the end of the year will be a little better than that. So we can enter next year with good trajectory. A part of it will just depend on how tight we can get around the claims ratio, 1% variance is not unusual there, and then what margin our other business is running at as well. But overall, you're thinking about it in the right way. Anything to add there, Darryl?

No. I mean I would just say that we're trying to get to the 15% for our subscription business, but our other business has a little bit of a different margin profile. The other business typically runs in 8% to 10% bottom line margin target. And that's an area where typically we don't have a lot of PAC spend and the bottom line money we can use to reinvest to grow our subscription business. So, we're really focused on the 15% on the subscription business. And if the other revenue becomes a bigger percentage of our overall revenue, we'll have to account for that.

Okay. Thank you both.

Our next question comes from Shweta Khajuria with RBC Capital Markets. Please proceed with your question.

Great, thanks. Two for me, please. Could you provide - when you think of the automation, you talked about 5% of invoices fully automated, where can that be this year? How do you think about it long term? What has the reception been? And what would it take to grow that? And then, second on Territory Partners, just a little bit more maybe detail on churn. That would be great. Thank you.

So, on the claims automation at 5%, so in the shareholder letter that was just published, I mentioned that in 2018, about 5% of our claims that came through our software, we automated, I think, at about an average of 16 seconds, we anticipate that's going to grow throughout the year. We're actually going to present something about that in the shareholder letter. So the teams will be up there talking about it. But the drivers to help is volume of data, and it's kind of like a machine learning process. The more of the data that gets in there, it kind of compounds on it. So, I will hold off on giving a lot more insight until the Shareholder Meeting. But the long term is to get our software in more places, which will give us more data, and allow that to accelerate faster. And then, for Territory Partners, we're now visiting about 22,000 of about a universe of about 25,000 veterinary clinics that we think will eventually have Territory Partners. And I mentioned that we have about 10 markets opened. They average about 250 clinics each. But when we bring in a new person into a new territory, we have about - 50% of those people will churn inside the first two years. So we'll do our best to add to those 10 territories during the year, but you should expect that some that we added over the last year or 2 will fall off. So it will take us a few more years until we're fully penetrated.

Thank you.

Our next question comes from Tom Champion with Cowen and Company. Please proceed with your question.

Thanks, guys. It's Henry on for Tom. How do you think about the 2% pet insurance penetration rate in North America rising over time? Like on one hand, that's a doubling from five years ago, but why is it so much lower than Western Europe? Just curious to hear your thoughts there.

Well, the underlying premise is why we entered marketplace in the first - in North America for the first is that we did not believe that there was buy-in for veterinarians. And for the penetration rate to equal that in Western Europe or the UK, where one out of four pets have medical insurance, you need buy-in from the vets. So our focus is to build the foundation of veterinarians asking pet owners at check-in, who their medical insurance is and making it normalized and having them be - have the confidence to get behind high-quality medical insurance. So we've been working hard at that. There are different competitors that come in and out of the marketplace. And every one point, the market penetration in North America is about $1 billion in revenue. So I think we're making good progress. But I don't look at overall market penetration as the key indicator. What I look at is what is the market penetration rate of puppies and kittens in either a geo or on a vet hospital level. And in a lot of markets we're seeing 5%, 7%, 10% of puppies and kittens now getting medical insurance. So if you fast forward that for a one-pet generation, call it 12 to 14 years, we can have a run rate for the industry in those more established markets that could get to that 5% or 10% penetration rate. Overall, I don't think it's a consumer issue. I think when messaged appropriately, one out of four pet owners that visit the veterinarian will be happy to buy high-quality medical insurance. And yes, it's still not normal. When you go to the dentist, everybody asks at check-in who your insurance is and that's not normal place in North America. And we're working hard to change that.

Got it. Another quick one, last quarter, you called out investment in headcount and just curious how the recruiting efforts are progressing.

Well, some of the areas that we're recruiting heavier is our internal account managers. These are the people that are supporting our Territory Partners, and the partnered hospitals that have our software. We mentioned about a year or two ago this is really a test. And we had 3 to 5 people. I think we exited the year at about maybe about 20 people. Long term, I think this is going to grow to about 100. And we'll see how much progress we make over the next two years. So that's one area we're really driving. On the conversion side, I think there's a lot of things that we can do to help increase the high volume of leads that we have and try to increase conversion rate. So that's an area we're building up. And then, just at our scale, trying to keep up with our variable side is people helping to pay - paying our veterinary invoices. So, we're trying to automate them, but there's a lot that are not automated, so we need a lot of people for that. And then in our customer care, we want to be able to answer the phone 24/7. We're paying invoices 24/7, so those teams are continuing to grow in scale. And then on the fixed expenses, I would say, we continue to invest in IT. Trish mentioned some areas that we - in her opening remarks in IT, regulatory, legal. We're also investing more in data so that we can price more accurately. So you can see modest increases in headcount in the areas that are fixed expenses, or variable expenses. Headcount rose pretty much in line in the places where we're really having expansion related to leads and conversions.

Thanks.

The final question is from Greg Gibas with Northland Capital. Please proceed with your question.

Good afternoon. Thanks for taking my questions. First, just looking at the Shareholder Letter, should we expect an acceleration of TPA hiring in new regions this year? And is there a target range that you're willing to share in terms of new Territory Partner hiring this year?

Well, we've been adding associates, which are kind of in my analogy the second Coca Cola truck or third Coca Cola truck inside of a region. That's been ramping pretty steadily over the last two or three years. We just finished our Territory Partner conference. It was the first time where our second Coca Cola truck outnumbered our original. So I would expect that that will continue. But what we haven't done as good of a job last year or the year before was adding the more regions. And so we want to make sure that we're focused there as well. And we don't have an overall target. I know we want to get into 10 more regions and we'll see how the rest plays out.

Okay, got it. And then, just lastly, wondering if you can provide just a little bit more color on what drove the growth in the other business segment this quarter. At what point should we see the margin start to expand there?

We would not expect to see margin expand in the other revenue. Our target is kind of the 8% to 10% range, and we don't expect it to change over time. Actually, we saw growth in all areas, so as a reminder, the areas that we focus on. The other revenue is where we're not dealing directly with the consumer. So we have other people paying for people's pets. That can be employers. Those employers could be general corporate employers. They could be owners of veterinary clinics. We have a contract with the federal government, where we are supplying the broadest, greatest coverage product to veterans who need help dogs. We're looking at areas, where we are the company behind other brands, typically with either low ARPU or medium ARPU pricing. And across the board, we're seeing growth in all areas.

Okay. Thank you.

That is all the time we have today for questions. And this concludes today's conference. You may disconnect your lines at this time and we thank you for your participation.