Trupanion, Inc. (TRUP) Q2 2019 Earnings Report, Transcript and Summary

Greetings and welcome to the Trupanion Second Quarter 2019 Results Conference Call. At this time, all participants are in a listen-only mode. A brief 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 Trupanion's second 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, internal rate of return, 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 will hand the call over to Darryl.

Thanks, Laura, and good afternoon. We he the opportunity to speak at length to many of you during last month's Annual Shareholder Meeting. So for purposes of today's call, I'll keep my remarks brief. Q2 revenue grew 26% year-over-year and we ended the quarter with over 577,000 total enrolled pets. Adjusted operating income totaled $9.8 million, up 33% over the prior year period. We estimate our internal rate of return at 34% for the quarter in line with our 30% to 40% target. You'll recall we focus on these three measures when evaluating our performance. With this in mind, it was a solid quarter, and we're on track to meet our objectives for the year. We discussed the strategies for deploying our adjusted operating income at our targeted internal rates of return at our Annual Shareholder Meeting last month. Growth initiatives, including those around same-store sales and conversion, continue to comprise the bulk of our incremental spend, both in headcount and deployment of our software. We're also investing more in initiatives aimed at Nirvana including 90-day retention. You'll recall, I highlighted this as an area of opportunity in my 2018 annual shareholder letter. These are hard multiyear initiatives and we expect to measure our success in years as opposed to quarters. Those of you, who know us well, know that we maintain a long-term perspective. We are building this company for the decades ahead and we are making additional investments to deepen our competitive modes. The expansion of our adjusted operating income provides us the flexibility to do so. For those that attended our Annual Shareholder Meeting, I hope you walk away with a greater appreciation of the teams behind these initiatives. I've said it before, but it's worth repeating, execution is hard and it comes down to people. I'm humbled by the level of talent we've been able to attract and retain here at Trupanion. Before I turn it over to Trish, I'll provide a brief regulatory update starting with last month's settlement with Washington OIC. In short, while we did not agree with some of the State's findings, nothing in the settlement materially changes the way we do business. Separately, as I acknowledged in my 2018 Annual Shareholder Letter, we have made mistakes in the past related to call center licensing that we have since corrected. In the coming weeks we expect to finalize a settlement with the California Department of Insurance on this. Conversations are ongoing, but we expect the settlement to reflect the size of our business in the State. We believe we are adequately reserved for any potential fine, meaning we do not expect any meaningful financial impact, nor do we expect any resulting changes to our business practices as we have already licensed our contact center team members. Nevertheless, we take these matters seriously. We value our relationships with regulators and are committed to building upon and maintaining the lines of communication with all Departments of Insurance. We operate in a rapidly growing industry and expect and welcome dialogue at the State level. Recently, a few states have inquired about the role of territory partners, a topic we've discussed at length over the years with State regulators and if on the heels of our dialogue they prefer that territory partners within their State operate with a license we will require that they do so. It is a process in which we are well-versed. Since 2015 we have helped hundreds of our contact center representatives achieve the necessary licensing requirements. More fundamentally, we are well aligned with regulators. Regulators want to ensure customers receive a high value proposition, there is transparency and that customers are treated fairly. We want the same things. Trust, transparency, doing what we say, these are the values we live by at Trupanion and important tenets of our culture. Companies often tote their culture and we're no different. Culture has to be experienced to be understood, which is one of the reasons we stress the importance of attending our Annual Shareholder Meeting. This once a year event is the best opportunity to meet the team, experience the culture, and get an in-depth understanding of our key business initiatives. We want to thank those of you who were able to attend this year, especially those who traveled from across the country around the globe. Your participation is what helps make this event a success. We hope to see you all next year on June 11. And with that, I'll hand the call over to Trish.

Thanks Darryl. Today I'll review our second quarter results in detail, as well as provide our third quarter and updated full-year outlook. Revenue for the second quarter was $92.2 million, up 26% year-over-year and led by strong pet enrollment in both our Subscription and other business segments. Total enrolled pets increased 22% year-over-year to over 577,000 pets as of June 30. Subscription revenue was $77.7 million in the quarter, up 22% year-over-year. Total enrolled Subscription pets increased 15% year-over-year to over 461,000 pets enrolled as of June 30. Pet growth within our Subscription business continued to benefit from increased leads from our core veterinary channel. Monthly average revenue per pet for the quarter was $57.11, an increase of 6% year-over-year and in line with our historical average of 5% to 6%. In local currency, monthly average revenue per pet increased by 7% from the prior year for our U.S. members and by 5% for our Canadian members. Average monthly retention was 98.57% compared to 98.64% in the prior year period. Keep in mind that retention is a trailing 12-month metric and in periods of accelerated growth 90-day retention will act as a headwind. Given this dynamic, we do not expect meaningful improvements relative to our tenure historical average of 98.5% though we did see sequential improvement in Q2 over Q1. Our other business revenue, which generally is comprised of our revenue that has a B2B component, totaled $14.5 million for the quarter, an increase of 52% year-over-year. Year-over-year growth in our Other business segment reflects an increase in the number of enrolled pets. Subscription gross margin was just under 18% in the quarter, impacted primarily by increased veterinary invoice expense which grew 7% year-over-year on a per pet basis. Generally speaking, we would expect veterinary invoice expense per pet to increase in line with ARPU on an annual basis about 5% to 6% per year. Though it is not unusual to see more variability quarter-to-quarter. We continue to expect that our full-year subscription gross margins will fall within our annual target of 18% to 21%. Total gross margin was 16% which includes our other business segment. Fixed expenses were $5.2 million or 5.6% of total revenue in the quarter, down 160 basis from the prior year period and approximately 60 basis points from our 5% target and operational scale. Scale in our fixed expenses reflects the benefit of owning a home or office building. Adjusted operating income totaled $9.8 million in the second quarter, a 33% increase from $7.3 million in the prior year period. Net loss for the quarter was $1.9 million. As a percentage of revenue, adjusted operating margin expanded approximately 60 basis points year-over-year to 11%. As a reminder, adjusted operating income are the funds available to invest in growth and other long-term initiatives. During the quarter we deployed $8.2 million of our adjusted operating income compared to $5.4 million in the prior year period. This spend is related to the acquisition of approximately 35,000 new subscription pets, as well as investments in building our teams primarily around same-store sales and conversion. We were encouraged to see small incremental improvements in conversion rates late in the quarter, a trend that has since continued in the third quarter. As our adjusted operating income expands, we intend to deploy greater amounts of capital as long as we can achieve our targeted internal rates of return and remain free cash flow positive. We estimate our internal rate of return at 34% for the quarter, in line with our 30% to 40% target. Internal rate of return is how we measure the return on our pet acquisition spend for a single average pet. Additional details behind this calculation can be found in our quarterly earnings supplement on our investor relations website. Adjusted EBITDA was $1.3 million for the quarter compared to $2 million in the prior-year period. Our net loss was $1.9 million or $0.06 loss per basic and diluted share compared to a net loss of $0.4 million or a $0.01cent loss per basic and diluted share in the prior year period. In the second quarter, free cash flow was $2 million, operating cash flow was $2.9 million, up from negative $0.05 million in the prior-year period. At June 30, we had $92.1 million in cash, cash equivalents and short-term investments, and $19.1 million of long-term debt. I'll now turn to our outlook for the third quarter and full-year 2019. For the third quarter of 2019 revenue is expected to be in the range of $97 million to $98 million, representing 25% year-over-year growth at the midpoint. For the full year we are increasing our revenue guidance range to reflect our performance in the first half of the year and increased visibility into the second half. As a result, we now expect revenue for the full-year to be in the range of $378 million to $381 million representing 25% 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%. We now estimate Other business revenue to be around $60 million for the year. At our forecasted revenue levels, we continue to expect adjusted operating income for the year of around $45 million. We estimate allowable acquisition spend in the range of $32 million to $38 million within our targeted IRR range of 30% to 40%. Also, please keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S. and Canadian currencies. Four our third quarter and full year guidance, we used a 76% conversion rate in our projections, which was the approximately at the end of June. Thank you, for your time today. I will now turn the call back over to Darryl Rawlings.

Thanks Trish. Before we open it up for Q&A, I want to highlight that we've recently updated the date of our 2020 Annual Shareholder Meeting which will now be held on June 11, 2020 here at our Seattle headquarters. Shareholder participation is critical to the success of this event and we've updated the date based on shareholder feedback. We want to make the meeting as accessible to all interested shareholders and are providing you with this notice to assist in your planning. Additional details will be forthcoming on our investor relations website. And with that, we'll open it up for questions. Operator?

Great, thank you. [Operator Instructions] Our first question here is from Shweta Khajuria from RBC Capital Markets. Please go ahead. I'm sorry, your line is now live. We will go to the next question here from Andrew Cooper from Raymond James. Please go ahead.

Hey, thanks. Excuse me, thanks for question. And I guess first from me, this is in the first quarter we've seen to your point a lit bit of movement in the claims expense as a percent of revenue, but just any color you could give on, was there anything in particular that jumped out or anything that makes you confident that the trend from basically 3Q 2018 that has been graduating a little bit higher is more just quarter to quarter lumpiness than anything else relative to the goal of 70%?

Yes, hi Andrew. This is Tricia. I can give a little bit more color at a high level particularly within a single quarter. Your characteristic of lumpiness or variability is correct. When comes to claims as a percentage of revenue, it's really a factor of how is claims per pet increasing based on how ARPU which is a per pet number is increasing and they don’t always in a single quarter increase at the same rate. For example, in Q2, claims increased at 7% while ARPU increased closer to 5%. For the full year-to-date they are both increasing at 5%, so they are in line. That being said, there is a couple in addition to just some variability with those dynamics we're also getting, as we've talked about before, our patented software in more hospitals. We're processing 40% more claims through that software this year than last year, and so that does provide when it is accelerating about a 1% headwind as we've talked about previously and we are okay with that trade-off. But we are trying to update and pull through pricing which we hope to see in the back half of the year and into next year where our pricing would be increasing closer to 7% while claims typically are increasing around 5% to help them make up that delta. So we're closer to the 70% cost of goods ratio as we are in the 72 right now. But like I mentioned in my prepared remarks, there is nothing about the single quarter that is overly concerning or an anomaly as opposed to variability. We still feel very comfortable that for the full year we'll be between the 18% and the 21%.

Okay, thanks. That's helpful. And then just one more kind of financial question, and then maybe another higher level if I could. But as we think about the guide, the $5 million increase on the other business or the non-subscription business, but obviously tightening kind of a little bit more than that to the higher end, any color you could give on, is that in the kind of core Subscription business or more around tightening your expectations in the non-subscription business?

Sure, it is a little bit of both, at a high level we're halfway through the year. We have more actual for the first half and a lot more visibility going into the second half. So when it comes to the tightening of the range, for the full year it's really about visibility. We are raising $5 million related to the Other business segment and not really have to do with the fact that we have less visibility at the beginning of the year in that segment and all areas of that segment are performing well. So we're flowing through really Q2 actual that came in, as well as our visibility that we have currently into the back half of the year. The remaining $1 million that we closed through in the outlook has to do with our core subscription business which is also performing well and it's mainly real lot more visibility into that business. We wouldn’t expect big variations there, but we're flowing through really Q2 and about $500,000 we came in $500,000 above and we're fully not through into Q3 and Q4 as well. But overall, all segments are performing well.

Okay, great. And then I'll just sneak in one more if I could and then jump back in the queue. But, you mentioned some of the efforts on conversions that started to pay dividends in the later part of the quarter and into 3Q, but is there anything kind of in particular you could give as though what's worked and what hasn’t worked? And then, how much of what you have done has been more in that testing bucket and not necessarily rolled out at full scale, so maybe you found something that could drive continued upside from where we were even exiting the second quarter. Any kind of comments or color there would be great?

Sure, it's Darryl. Oh, I mean at a high level, we're looking at the profits we have from our existing book growing over 40% this year from about $32 million to about $45 million, which is giving us the opportunity to be investing in some longer term visions. I mean, I've been operating this company for over 20 years and I can tell you, having access to these funds to invest in some really hard, meaty things is just a privilege to have and the teams we have working on it are doing a good job. So conversion rates is definitely one of the areas that we're investing in. We're also investing in kind of getting our software in more veterinary hospitals and kind of same-store sales. We're investing in claims automation, and investing in the areas around Nirvana and trying to have tight Naphia churn and increase our [indiscernible]. Conversion is something that we are passionate about, because we believe we're driving most of the leads in the category, and we would like to get a higher percentage of those peoples converting with Trupanion. I don’t know, I use this analogy internally that, buying our type of product is kind of like going to the grocery store and buying a can of tuna. It is really hard to know what you get until you open it up. And we think Trupanion with the broader coverage, the higher target payouts, what we think are the industry's best customer service is like opening a can of tuna and getting a big solid piece of albacore. You know that sometimes you open a can of tuna, and there is kind of watery, flaky stuff. And the conversion is really focused around being able to articulate the benefits of our product and being able to do that in multiple locations. And we think the more we educate the consumer, the higher percentage of them will make a better choice and we're seeing some areas where we're seeing the impact of that. Now, you were asking the question, is there something we've done in tests that we're going to be able to run across, and I think you are implying, do we think we're going to hit a light switch in Q3 and have a much higher conversion rate, which means more pets, and I would tell you that these are all smaller incremental changes, but the big thing for us is investing in more people to be focused on this area.

Great, I'll jump back in the queue. I appreciate it.

Yes.

Your next question here is from Shweta Khajuria from RBC Capital Markets. Please go ahead.

Hi all, sorry about that earlier, couple of questions please. So on same-store sales could you please discuss the trends you've seen in same-store sales growth since you started integrating, deploying software with veterinary clinics, who - if you were to isolate the impact, how impactful has automated claims been on same-store sales growth? And then, second on acquisition spend, could you talk about what you are seeing with this 30% of the pet acquisition spend portion of your marketing spend, last quarter you called out 20% of that was what you call growth initiative, growth channels and the 10% was test expense. So what you're seeing there is, it is more optimized now and if IRR is getting closer to 30% to 40% target? Thank you.

Well, thanks for the question. So the first question was around same-store sales after deployment of software, and you are asking specifically in areas where we had more claims automation. Let me explain how this works. So we today have increased our software. We have in 50% more hospitals that we did last year. Every one of those invoices is going through our automation tool. One hundred percent of them go through the automation tool and about 30% to 32% of them are actually being finalized or 100% done with automation. They are not done universally by hospital, so we don’t have one hospital that has a 100% automation, and another one that has zero. So we don’t track the same-store sales by areas we have automation. We do know that same-store sales and we've mentioned this in the last two shareholder meetings where we have the software it's up about 40% from before we had the software. So net better customer experience the automation, we're really excited about, it's better for the consumer, it's better for the veterinarian, but we have not, we don’t have the ability to link directly to that factor. Your other question was really a breakdown of where we're spending money and I mentioned earlier that we have anticipated about $45 million we can invest, we're being cash flow positive this year, and we'll try to invest about 70% of it in our core investments. Those typically have an IRR of 35% to maybe 45% and our goal is to invest about 70% of the mix. Year-to-date most of it has been in the growth factor which has typically been about 20%, but this year it has been closer to 25%, 26%, 27% year-to-date and that space is where we have not yet optimized and our IRRs there might be between 5% and call it 25%. Big bulky area for us there are building out more account managers to support hospitals that have the software, getting the software installed into most areas, that's still an area of learning and we're definitely not in the mature stage there. We are also investing a lot more in conversion and we invest mainly there in people creating content and having that seen. We are seeing progress as we mentioned earlier we're excited. And then the last bucket, we're trying to spend about 10% on on innovation. These are areas that we have no idea what the internal rates of return are going to be or there may be very long-term project. Year-to-date, we've been investing a smaller amounts in the back half we hope to invest a little bit more. So those could be partnering with different distribution channels or doing other potential expansions in the future and that’s how we kind of think about our total spend.

Thank you, Darryl.

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

Hi Darryl, hi Trish. Just a followup on the -- I know you had mentioned California that you are in the process of trying to reach an agreement there after Washington. I know you had mentioned kind of immaterial from a financial perspective and also from a business perspective, but are you moving towards just kind of a blanket if your territory partner you’re going to be licensed at this point, how do you think about the regulatory environment in regards to later settlements?

Well I'm glad you asked the question Mark, because California and Washington are not at all related. I know because of the timing of it people may think it is, but California is related to call center licensing which is a legacy issue that first showed up around 2013 and 2014. Where we had an audit where we were previously informed and told by experts, lawyers and Department of Insurance that based on our product profile we did not need to get the license. When they listened to the types of calls we are taking, there was a lot of competitive questions and they thought that that the crossed the line into solicitation. And therefore we needed to get them licensed. We agree to do that, but we did not get them licensed in a timely matter and that is why we're getting penalized. And quite frankly we deserve those penalties. We should have moved quicker, it was not good execution in that timeframe. Washington was not related to call center licensing, it was related into three different buckets and so they were not related. The California area is an area that we’re letting you guys know, because it's a legacy issue. I talked about it in the 2018 shareholder letter and we expect to get this behind us shortly.

So for then just Trish one quick in terms of the other line item here I think you talked a $60 million for 2019, that's probably – roughly about 50%. I think in the quarter it was just over 50% year-over-year. What's driving the growth there and should we anticipate that segment continue to grow at that pace and what's going on I guess that’s bringing that level of growth?

Sure, I mean there is four different buckets in there as a reminder and they're all growing nicely. So it’s not necessarily one versus another. With regards our partnership with Veterans Affairs, where we ensure the service dogs for veterans. And so that is growing nicely with regard to things related to our employer benefit programs where the employer pays at least a portion of it that is growing nicely. And then we’re underwriting others and while one partner is rolling off a bit the other one is continuing to add to their book of business. And now that one started with us in 2017, so it is still building on and causing year-over-year growth rates to be quite outsized as well as their business is performing well. And so, it’s all part of our core strategy to have different channels as well as products, so that we’re positioned well in the overall market, and in general, the overall market is growing nicely as well. So, when it comes to our expectation, the growth rates you are seeing right now in general we expect to continue and be around 50% for the full year based on our guidance. Apps are things coming on or off or building up when it comes to long-term outlook, we would imagine that segment to grow around industry growth unless we announce something different which would be more in like the 15% to 20% range currently.

Great, very helpful, thank you.

Our next question is from Kevin Ellich from Craig-Hallum. Please go ahead.

Hey, thanks for taking my questions, just Trish, sorry to keep asking about the guidance here, but just so I understand and make sure I've got the numbers right, maybe I did the math wrong. So excluding the other business if we look at the subscription revenue it effectively looks like that revenue guidance was taken down a little bit for the full-year, is that correct and if so what's driving that?

It should be that it would be the midpoint is coming up by $1 million for the full-year, it shouldn’t be coming down.

Got it, again, maybe I have been wront.

Yes just it’s has been higher performance, yes.

Okay, I guess, I got that mistake in my math. And then Darryl going back to the other question that Mark asked about California, but you also commented about the licensing of territory partners in Washington, in the state of Washington. What's the plan with other states, is it going to be a case-by-case example or do you plan to kind of - if Territory Partners wants to become licensed are you going to allow them to do that? And I guess to that point, what’s the incremental, cost for you guys and have you seen any impact on the productivity?

Great question, so Territory Partners right now over 25% of them are already licensed. We require them to be licensed anytime they were dealing directly with consumers. And we have gone through that process. The cost of it is minimal, it’s a couple of hundred dollars a year for Territory Partners, so it doesn't have a major impact. We have -- as this category continues to grow regulation -- have been changed based on the category’s growth. And we think we’re at the forefront of having those conversations if individual states would prefer that the Territory Partners be licensed. Then we’ll totally be supportive of that and get them licensed. We had ongoing conversations for years and they have not historically that’s why we have not historically required all of them to do it. But we’ll keep an eye on it and if any states want us to make that change we will and if it becomes a trend then we will get everybody.

Okay, so but no impact on productivity from what you've seen so far?

No it's not a material impact on productivity. Its basically, it takes about a week for Territory Partner through the process and it’s something that we’re very good at. If the industry ever gets to the point that our sales force calling on veterinarians is required to be licensed, that would be a net good thing for us, where certainly it’s not there today. Licensing, things specific to our category, the more that happens is more remote for the business for us because this is what we specialize in and what we do. So we embrace regulation as long as it's doing what the regulators do which is to try to make sure that consumers have high visibility and what they're getting. So there is transparency. The people are getting good equal value proposition which we believe we’re targeting the highest sustainable level in the industry all with great customer experience.

Got it, okay that's helpful. And then while we're talking about it, can you talk about how the initiatives to improve same-store sales, conversion and retention are going, and what are the long-term targets, and how much do you plan to spend Darryl?

Well the long-term targets and all of them are better than they are today. I wish I could give you a specific number. Let’s take retention for example we’re already at 98.5% a month and that includes pet health. We’ve historically had the product covered at the highest payout ratio. We believe we've got the best customer experience paying hospitals directly we’re 24/7. We think we we’re priced more effectively, more accurately by more sub categories. We think we’re leading the categories in that area. There isn't a huge amount of upside. I mean it’s not going to go from 98.5% to 101%, maybe the highest outside perfection on retention might be 99%. But I'll take every tense that I can get. I also think about areas like conversion we look at our conversion rate on a blended. We look at it how many people get a quote online, how people get a quote on the telephone, how people end up enrolling. And we know that we have a much higher conversion rate on the phone so we know that when consumer receives the right accurate information at the right time that we can convert over 40% of people. We've got long delta between all of our pets that are converting at 40 and if we were to get to that level we will be growing about faster rate. That’s not our internal target, but every 1% improvement in a blended conversion rate is helpful. We told people the shareholder letter -- shareholder meeting that our blended conversion rate is been about 13%, so if we go some 13% to 14% or 14%to 15% to 15% to 18%, those types of percentages if you -- they can make a real big impact on the business.

Great. That’s helpful. Thank you.

[Operator Instructions] Our next question here is from Greg Gibas from Northland Capital. Please go ahead.

Good afternoon. Thanks for taking my questions. First, if I could followup on the pet acquisition spend question, I was wondering if you could break down pet acquisition spend in terms of how much was directed towards leading conversion teams versus the direct-to-consumer side and can you maybe talk about how this mix is expected to change over time?

Yes, well, and it’s interesting, you actually asked the question how we break everything into lead and conversion and direct-to-consumer, many people imagine that that is a lead generator. We actually do not believe or have not seen that to be the case. Our direct-to-consumer approach is really increasing the conversion rates from our already quality leads that we’re getting from the veterinarians. Remember, we're not trying to enroll. Our target audience is not the 180 million cats and dogs today. Our target audience is the new pets being entered in a household which are often puppies and kittens, but they also could be a four or five-year dog being adopted from the shelter and we think the time to get somebody enrolled in our product is in the first three to six month of that pet being in the household. And what we find when we layer on D to C, is we don't get a higher number of those leads. What we do see it that sometimes in a market where we have a high percentage of our software and more partnering hospitals that we get a higher conversion rate of those lease that we’re already getting and right now our pet acquisition cost is broken about 50% lead and about 50% conversion. If you went back a couple years it was about 70% lead, 30% conversion and we’re investing more and more in the conversion side. If I was to look at my crystal ball in the years ahead, our leads gets -- we get scale in our lead sand our growth where we are exceeding our subscription business and is growing faster year-over-year, it's been driven by increased leads. They become more and more efficient. Conversion costs are not an area that we think get more efficient, but an area that we have more deployable cash. We think they can make a big impact.

Great. That’s really helpful. And then second from me was just with respect to your international expansion recently announced, what we -- how long should we expect to take for Australian operations to ramp up and can you provide some details on why Hollard Insurance decided to partner with you guys in a market where they already have a presence and I guess also where do you expect that current 6% penetration in the market to go eventually?

Well, Australia is early days for us. So we look at the Australian market in a couple of different ways. One is, long-term we have aspirations to be a global player and we felt going into a market that speaks the same language, that acts very similar to our Canadian market, although penetration rates are higher, is an easier play for us to expand than to try to jump into China. So we went into Australia, we did not want it to be a distraction to our core North American business, so we decided to partner with a local partner that had expertise, and that local partner felt like there was a void in the market on having a product designed to be reviewed, and recommended by veterinarians. And that's how we're positioned and that's why we partnered with the partner that we did. And where we’re at today is, we’re in a handful of hospitals, it is literally like a dozen and we are just working out the bugs to see how many leads we get, what are the conversion rates, what’s the retention rate. We also want to understand our customer experience, make sure that we've got all of our ducks in a row. And we’re going to keep -- we will not expand the number of hospitals until we feel confident that we're really good at understanding those numbers and then over time we will try to get out from the dozen hospitals and long-term there’s about 3,000 hospitals in Australia that could be our market. And I will -- I'm encouraged to say that our intuition was correct that veterinarians and consumers are embracing our product, that they like it. It’s not a big surprise for us, but we’ve got a lot of learning ahead and we've got the time to do it. Just for those watching our financials, the pet count does not show up in our total pet count. We have a separate line item for this investment.

Thanks.

The next question is from Jon Block from Stifel. Please go ahead.

Hi. This is Tom on for Jon. Thanks for taking my questions. I guess the start off on marketing spend in your three different buckets, can you maybe share some of the specific initiatives that might be moving up the chain, so from either the test buckets accruals [ph], the growth court?

Yes, I can - would say several years ago we were innovating around TV and radio and then it went into the growth category and kind of some established market. So we were trying different channels, different times of the day, different messaging and then in certain markets where we are more penetrated, we are getting internal rate of return based on that conversion rate left and in some of those market there now moved into core. Now I would tell you D to C in general is more in the growth mode and there's a lot of markets that we do not think we are ready .We do not have enough buying from veterinarians, is not a high enough penetration rate of our software. We have not been in the marketplace long enough but that’s kind of how it runs through. I would tell you another one was signing account managers to be contacting veterinarian hospitals between our territory partner visits. That started off as an innovation several years ago. I would say that firmly in the growth mode today, internal rates of return are below 30%, but above 5% or 10% and we are going to keep fine-tuning that and growing that team out, and I would imagine in three to four years that will be definitely be in core stand and hopefully a lot of us in there.

Great. That’s helpful. And I guess to quickly pivot to churn. The year one rate of around 97%, how are the initiatives proceeding to reduce that use that and how long does it take for some of them to take effect? Thanks.

Well, that was something that I’d highlighted in my shareholder letter last year, which is I broke churn down into the categories, things like pet dogs and reasons why somebody canceling like failed payments or they are unsatisfied but I also looked at different view and that view was to say how many people churn in the first year before they had a rate renewal. How many people churn if their rate renewal is within a typical band, which is less than 20%, typically 5% to 6% year-over-year and for those people as we’re fine-tuning our pricing by more subcategories and we've been doing this for years and we will continue in the years ahead, when we’re pricing more accurately by more subcategories and rates are changing by more than 20%, what is the impact. And what you talked about was, in the first year we have the highest turn of churn, that number – highest number of pets churning at about 97% months-over-month. The initiatives that we’re trying to work on and more about upfront education, some people churn in the first year because they thought we were going to cover a wellness exam, some people churn because their dog got it by a car an hour before they enrolled and they were hoping that we would cover them. Other people churn because they were expecting something different. There may be for example, maybe a deductible works in a different way or some others, so upfront education is the main area. We have seen glimmers of improvements in those areas, areas that we're encouraged by, but as I mentioned earlier trying to make any improvements in these where we have a blended 98.5 is really hard. I mean, we think we’re leading the category. We think we have been for a long time. These are the buckets we're focused on. The initiatives we have will keep Adam [ph] probably for the next couple years and see if we can move the needle and for making progress we will keep doing it and if we can’t make any progress we will deploy funds another way.

Great. Thanks.

The next question is from David Westenberg from Guggenheim. Please go ahead.

Hi. Thanks for taking the question. So, just to go back to the theme of gross profit, I know that when you're kind of aiming to price, I know you'd much rather lean on given the consumer and I know it also ebbs and flows, but in this particular case, what were maybe some of the factors that that got it a little bit higher than target range, whether it would be mix of maybe more and healthy pets, higher claims? And then subsequently, would there be maybe sort of a catch up pricing I know that was up about 7%. So I mean, maybe you actually already did it and I know you increased monthly, but just a little bit more color there.

Well, I don’t think it's overly complicated. I mean, our cost of goods have gone up 5%. They average 5% to 6% for the last 15 years. Our ARPU went up 5% year-to-date. If they are staying the same that would keep us at about a 72, our target is 70. We need as Chris mentioned earlier, we need our ARPU to be going up approximately 7% and our cost of goods to be going up 5% for us to make up that variants. And we also have a headwind as we deploy more of our software which is about another one point. And as I mentioned earlier, we have our software in 50% more hospitals than we did this time last year. So we have to build that in and all of it is not instant. It is dynamic and we've got to roll it out. The nice thing is, is our margin that we've been able to improve over the last about three or four years from what was about $12 million three or four years ago to $45 million this year, means we've got the flexibility to get this right over time while still being investing in the business, but our targets have not changed.

Got you. Okay. And then going back to on the cost side. Your pet acquisition costs another quarter of above 200 and I understand that you are exploring the conversion channel and you've kind of now its maybe more closer to 50% of the spending is in conversion. Now that you're kind of out there and exploring channels is this kind of the normal expense rate you think you could see, you know any kind of visibility on a go-forward basis in terms of pet acquisition cost? Thanks.

Yes, Dave, I mean at a high level we are using our calculated internal rates of return to inform how much we have available to spend. So to the extent that we can spend within our guardrails of 30% to 40%, internal rates of return and if we feel we can do so effectively, we will. The biggest thing and Darryl mentioned this earlier, that is different compared to last year and the year before that is in prior years the pot of money available was much lower, and so almost all of the spend was going toward things that would enroll pets in that quarter and now as we’ve talked about, are carving out around 30% of our spend to do things that are building our teams or more long-term in nature and thinking more long-term and about the category and the growth. So it’s a little bit apples and oranges, but we are making sure we’re within those guardrails, the 30% to 40% while we do this and also being cash flow positive. And with those in mind, we feel comfortable and are excited about the opportunities that we have ahead of us.

In my opening remarks, our goal is to drive revenue 20% to 30% year-over-year right at the midpoint. Our goal is to expand or adjusted operating income and we're doing that about 40% year-over-year, so we’re excited about that. And we want our internal rate of return between 30% and 40% and we’re at about 34% right now, so right at the midpoint. So we feel good about how the year is going and excited about where we’re able to deploy this capital.

All right now, thank you. That was very helpful. And then just maybe the last one in terms of switching from emails to text messages, can you maybe give us a little bit of progress is, I know but I think you gave some metrics at the Analyst Day about the opening of a text message being within minutes. Is this kind of the experience that you have been just maybe a little bit of metrics on how that kind of initiatives are going? And thank you. I’ll take the rest offline.

So, I think your question is, one of the initiatives we’re working on conversion is, how do you get the right content to the person at the right time? And we are - historically have been using a lot more email. We’re seeing email rates over the years, open rates have been declining in the speed in which people do that. I think that's -- we can all understand that as our inboxes get spammed full, but we’re finding other ways to communicate. So that not only things like text, but it’s going to be things like instant messaging on our website, other ways to drive people to the telephones and we’re still in testament of a -- we're encouraged by the results we've seen so far.

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