Greetings and welcome to the Trupanion First Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Laura Bainbridge, Investor Relations. Thank you. You may begin.

Good afternoon and welcome to Trupanion’s first quarter and full year 2023 financial results conference call. Participating on today’s call are Darryl Rawlings, Chief Executive Officer; Margi Tooth, President; and Drew Wolff, 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 variable expenses, fixed expenses, adjusted operating income, acquisition costs, 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 and development expenses. Unless otherwise noted, margins and expenses will be presented on a non-GAAP basis, which excludes stock-based compensation expense and depreciation expense. These non-GAAP measures are in addition to and not a substitute for measures of financial performance prepared in accordance with the U.S. GAAP. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to the most directly comparable GAAP results, which can be found in today’s press release or on Trupanion’s Investor Relations website under the Quarterly Earnings tab. Lastly, I would like to remind everyone that today’s conference call is also available via webcast on Trupanion’s Investor Relations website. A replay will also be available on the site.

Thanks, Laura. Two years ago, we kicked off our 60-month plan. We are now 28 months in and on track to achieve many of the goals we've set. Since that time, we've grown revenue to above 30% annually, increased our adjusted operating income by nearly 50%. The number of active hospitals in North America now approximates 16,000. We're paying nearly half of veterinary invoices through our software, and retention rates remain strong. We're seeing consistent levels of conversion and strong growth in pet owners referring friends and adding pets. We've also added new brands and new channels and have laid the foundation to double our addressable market, extending our runway for growth by decades. I provided more detail around these highlights in my annual shareholder letter published in March. The core of our business model is to earn the trust of veterinarians and pet owners. We do this by providing a solution to the rising cost of veterinary care, making it easier for pet owners to budget for their pets' care over their lifetime. Over the long term, the underlying need and demand for high-quality insurance will continue to grow. Last year, the cost of veterinary care increased at an unprecedented rate, with veterinarians raising prices multiple times throughout the year. As expected, we saw veterinarians take additional price early this year, and it is our belief that the long-term sustainability of the veterinary industry will require veterinarians to pass on higher fees in the form of inflation for the years to come. Keep in mind that the cost of veterinary care for Trupanion is a combination of the number of veterinary invoices received and the increase in our average invoice size. As one can imagine, these on-going rapid rate increases will prove more challenging to uninsured pets compared to…

Thanks, Darryl, and good afternoon, everyone. Today, I will share additional details around our first-quarter performance as well as provide our outlook for the second quarter and full year of 2023. Total revenue for the quarter was $256.3 million, up 24% year-over-year and ahead of our expectations. Revenue performance was driven primarily by strong pet additions and sustained high levels of monthly retention in our subscription business and continued growth in our other business. Within our subscription business, revenue was $165.2 million in the quarter, up 18% year-over-year. On a constant currency basis, subscription revenue would have been up 20% year-over-year or $167.2 million. Total subscription pets increased 23% year-over-year to over 906,000 pets as of March 31st. Calculated on a trailing 12-month basis, our average monthly retention across all our North American subscription products was 98.65%, compared to 98.75% in the prior year period, equating to an average life of 74 months. Monthly average revenue per pet for the quarter was $63.58, which was largely flat year-over-year on a constant currency basis. On that same basis, cost of veterinary invoices per pet increased 9.5% over the same time period. This increase per pet is attributable to both an increase in the number of veterinary invoices received as well as a higher average invoice size. Using insights from Q1 data, we also increased the size of our reserve for veterinary invoices by 1.2 million for prior periods, primarily Q4. As a percentage of subscription revenue, variable expenses were 10.1%, up 10 basis points from the prior year period. This slight year-over-year increase reflects investments in maintaining our member experience and initiatives shifting out of development. Fixed expenses as a percentage of subscription revenue were 4.7%, down from 4.9% in the prior year period as the team continued to drive efficiencies…

Thank you, Drew. Good afternoon, everyone. Following the recap of the quarter, I will provide more context for our Q1 results and our plans to deliver against our key financial targets. It was another quarter of strong pet growth for Trupanion. We acquired over 74,000 new subscription pets, including 4,000 new pets from Europe. While the Trupanion product remains the primary engine behind our reportable performance, we are excited that our new initiatives, including international markets, are starting to positively impact our growth. Excluding European activity, on a per-pet basis, we enrolled 18% more subscription pets, at an average cost of $247, which is $54 less than the prior year period. I am encouraged by the overall efficiency of our spend, which was especially impressive given the margin headwinds faced throughout the quarter. Growth within our core, Trupanion product remained robust, led once again by the vet channel. We also continue to see strong growth from our members referring their friends and adding pets to their family. Member retention for the quarter remained at healthy levels and on a training 12-month basis, the average Trupanion pets stayed with us for 75 months. With necessary pricing continuing to roll through our book, we are doubling down on our approach to communicate our value proposition and deliver on our pricing promise. I remain encouraged by our ability so far to sustain high levels of retention within our Trupanion product, but do expect to see some pressure throughout the year as pricing rolls through our total book. That said, our expected ARPU increases should more than offset any revenue impact from this pressure. After several quarters of the foundation of work, we are finally seeing price take effect. As a reminder, in January, we had 11.2% pricing approved, and flowing through the business.…

Thanks, Margi. At Trupanion, we value trust and transparency. These values form the basis of our interactions with all stakeholders, including pet owners, veterinarians and their staff, state regulators, team members, and you, our shareholders. We value the trust you have placed in us and recognize the importance of delivering on our promises. With this in mind, we invite you to join us for our two upcoming investor-focused events. This weekend, Margi and I will be hosting our annual Q&A following Berkshire Hathaway's annual shareholder meeting in Omaha. This is a great forum to connect with long-term like-minded investors. On June 7th, we will host our annual shareholders meeting at our headquarters in Seattle. This once a year event is your opportunity to hear directly from the team members leading the execution of our 60-month plan in an open Q&A forum. We hope to see you there. More details, including registration, are included on our investor-relations website. With that, we'll open it up for questions.

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from John Barnidge with Piper Sandler. Please proceed with your question.

Good afternoon. Thank you for the opportunity. Can you talk about the decline and retention experience in the quarter? Is there any signs that insurers are shifting to lower price products in the face of price and increases not just in Trupanion but industry wide?

Yes, sure. Hi John, it's Margi. In terms of retention overall, we saw some really short. We saw a strong performance. We've now flown through at the end of Q1, 14.4% close of 15% worth of rates. We saw a very minor adjustment in our call book of business. We saw a 74-month average retention for the quarter-paying subscription book. We still feel very encouraged by that. We now got additional rate flying through an April and we haven't seen other signs about lowering, so I think overall given the rate and we've talked about anticipating a slight adjustment to retention based on this increase in ARPU. We're not seeing that any degradation to degree to offset the poll increase that we have there.

I don't think we really haven't even visibility on the category as a whole but I can't say that the category is always taking large rate increases.

Thank you and the follow-up. You talked about the other partner migrants [Ph] who knew underwriter. Do you have any update on timing of that or the capital in that other business? Thank you.

Sure, this is true. And to reiterate, this is something we've been working on for many years transition paths past. I think calls go back to 2019. We're really happy with how that came out. What we agreed is that they would transition or they would add a new underwriter. They can continue to underwrite business with us. We have more line of sight to that and that's why we're raising revenue. So we continue to think there are lots of business with us and that's kind of updated in our outlook. It does free up significant amount of capital for us and we walk in the book that they have with us for three years and the new business that stays with us at a higher margin. So overall, really positive and reflecting our guidance is enough data on how that transition will look.

Thanks for the answers.

Our next question comes from Maria Ripps with Canaccord. Please proceed with your question.

Great, thanks so much for taking my questions. I wanted to go back to the reasons you sort of outline in your shareholder letter. In terms of why your loss ratio has been impacted in the near term, including high-than-expected frequency, the on-going mix shift in the business and sort of more claims being processed through a software. While changes in frequency coming out of COVID kind of seem to be one-time in nature, could you maybe talk about whether you're making any adjustments in terms of pricing strategy and framework sort of to enable you to manage this factors going forward?

Yes, sure. Hi, Maria. So just through taking that piece by piece to provide more context. In terms of frequency, you're right, kind of COVID was the one-time impact on our business we hadn't seen before. Really person gets there getting more or less during a period of time. We noticed with our frequency is the impact of software, really influences the arrival patterns of invoices. But in terms of where we are right now and kind of the mix shift, when we take price, we take price in a period and it takes 12 months that to roll through. And at the moment, as I walked through in the early remarks, by the end of Q1, we're at 14.4% that was rolling through in terms of ARPU. We will be at the end of this year at 23% that's staggered through the year, which is an average of 18%. So when that, what happens with the mix of business that we see? If you have an average increase of 18%, there are a couple of things that happen with that. The first thing you have a buy-down. So typically what that is, someone will get there increased and they will call us and they will contact us. And they'll ask, can I hold what I'm paying in a monthly basis, which means I may adjust my deductible? So the team will work for it up with them. We use about 2% of that 18%. And then beyond that, you have a mix shift, which is about 10%. So that make shift relate to products, specific distribution, strategy, geography. So if you think about international business, that's also going to start to play into that as well. So as we manage I'm moving forward, we're doing is we're making sure that we are pricing appropriately by geography, by category to ensure we can hit that 71. And what that means is you're going to see a more frequent number of findings with the regulators, to ensure we can say on top of that and monitor that curve at pricing increase that we see coming through. We have an operating assumption right now that we will see a 15% of that inflation year-over-year for the coming years. And with that operating assumption, we are required to make sure we are on top of that data, reviewing that data. We're looking at it in different ways and we've looked at it previously, which will allow us to get ahead of those changes. And make sure that we are having constant adjustments that say at the 71% level in terms of all lost ratio. Did that answer some of your questions there? If something that I can touch on more.

That's very helpful. Thank you very much. And then secondly, given your lower or guidance, when do you expect your sort of margin by the end of this year? And any thoughts on when you think you may return to 15% margin for your core subscription business?

So our working assumption is 15% that inflation year-over-year in 2023, 2024, 2025. If the rate of inflation is flat at that level, it takes us 12 to 18 months to reprise. So with that assumption, we're looking 12 to 18 months to get back to our original to our target.

Got it. That's very helpful. Thank you both.

Our next question comes from Josh Shanker with Bank of America. Please proceed with your question.

Yes, thank you. If we go back in time about a year ago to June of the investor day, that definitely you first acknowledge that you saw inflation above expectations in the numbers. It would have come a bit in the 2Q numbers. And certainly around the country, there was a lot of inflation. It would have been really present in the back half of the year. The rate actions you were taking really didn't have any impact in the back half of the year. They're really starting to come through now. Why are we seeing the spike in the loss ratio now? In retrospect, it looks like things are really well managed in the back half of the year. Give there was a lot of inflation and not a lot of rate. Now you're getting the rate through and the loss ratio is going up why is it having in 1Q and we didn’t see it in the back half of 2022?

Right, yes. So when we think, so said the back half of 22, what happened in 22, just to take a little bit of a step back, because you're right, when we first acknowledged there was some inflationary pressures in the business and started to recognize that in the data, that was the midpoint of 22. The inflation really kicked off at the back end of Q1. So what we saw in 22 was a series of inflationary periods that we had never seen before. So typically on average, you'll see a 6% inflation. We saw inflation come through in March. We saw it three months later and again and again. So those four stages of high inflation started to put pressure through the book. And you're right, we reacted quickly. The team increased the number of filings we were putting through. We got the rate approval and to the point, we get one month at a time. So it takes a good period to really start to impact. We started to see that rate at a volume in Q1, so coming into this year. In Q1 also, as we were pricing our strategy in 2022, we were anticipating a 12% increase in vet inflation. Now that went up another 300 basis points to 15. And we were still playing catch up from 2022. So our rates, as we file it, you need to look forward somewhere between 12 to 18 months before that impacts the business. So you've got the compounding impact of 2022 and 2023. So what you see now is the catch up, which we're doing. We're now looking at our rates for 2024 today because we know it's going to take us time to catch up on that. And the biggest shift in Q1 was acknowledging the fact that we saw we were seeing it from a 12% assumed in primary inflation to 15%. And then the reserves adjusted because we saw the higher rate. We saw our actuarial team could see the inflation coming through and our software and arrival pattern of that claim meant that our reserve rate reflected that, which is where that loss ratio really came in because we were expecting 12% and we got 15%. I think now looking forward, confident that the changes we've seen in both the rates we're taking, the rates that are taking action, how they're affecting our books and the on-going increases we see that April is looking strong. We're not seeing anything that is surprising to us in April right now with the data analysis we're doing. And we fully expect to maintain that same rhythm with the filings, making sure we're staying on top of those so we can bring it back to margin expansion through the back end of this year and into 2024.

Earlier, you said that your working assumption, which may prove to be better than it turns out, is that inflation of this 12%, 15% inflation will continue in 23, 24, 25 and you'll price for it. At that level of inflation, the lifetime value of the PETS is lower than it was going into this period of time. You continue to grow at a very, very strong rate. Is there in your assumption of a lifetime value that it improves at some time and you're willing to acquire PETS at lower than the 30% IRR because you'll eventually get the pricing right? I guess it's 541 or 547. Is that the working assumption you're working with when you decide, yes, let's go ahead and acquire the new balance?

It's a great point. The way that we've tried to be transparent about our lifetime value is taking a look at the previous 12 months rolling adjusted operating income, which is based on the margin and multiplying it by the ARPU and the number of months to create the lifetime value. The margins that we're receiving today that we expect that we'll see in the next six months and the previous six months are much lower than we would anticipate over the entire life of a PET. So we are staying very focused on getting strong internal rates of return, but historically our margins have been very consistent. That inflation has been and that methodology has been very prudent in the past. It is important that we say in the future, what do we think is the best estimate for a lifetime value of a PETS? And our previous calculation would underestimate it or methodology to estimate it would.

All right. Thank you for the answers.

[Operator Instructions] Our next question comes from Katie Sakys with Autonomous Research. Please proceed with your question.

Hi, thank you. Good afternoon. My first question has to do with ARPU. You talked about having about 15 points of rate flowing through in the first quarter, but average revenue per PET really hasn't moved all that much. So I'm wondering why that is and if there's something that's offsetting that metric.

Yes, sure. Hi, Katie. So I'll kick this off and hand over to Drew to add further context as well. But just at the highest level, so if we look at this year, and you're right, we've got, by the end of this year, for example, we'll have close to 23% flowing through the book. So that would hit at the end of December. You've got a full year for 2023. That means an average increase of 18%. 2% would be offset by people that are changing their deductible to take it a little bit higher to get their monthly cost either the same or a little bit lower. So that takes it to 16%. Then you have that 10% mix. The mix is the bigger chunk, so it takes that 16% down to 6%. And what's included in mix is not only new geographies, so penetrating new geographies that we have not been in before. We're also seeing new distribution products. So the products that we've been working on as part of our 16-month plan and coming into the market, they themselves have a very different ARPU profile. So when you put them all together, you see that downwards ARPU. Ultimately, that's where the ARPU ends up. So the 18% transfers up to 6% by the end of the year. So we think about how that kind of manifests itself. That's why we're trying to work hard to ensure we get our prices through on a consistent basis, on a rolling basis. But there is absolutely a difference between the filed and the realized. Drew, do you want to talk a little bit about more at the end of the year?

Sure. I mean, just for that rate flow view, for that positive mix, just pointed into the financial view, which we've talked about in the past, translating this to what you'll see for the full year, consistent with what we said in February. And really, the rates we've been talking about are consistent back to November. And we've just updated our mixed assumptions. You'd see an average of about 3.5% for the full year, constant currency. And obviously, that builds through the year. So starting from where we are today, you can kind of figure out what that would be for Q4, but it builds throughout the year.

Right. Okay. Thank you. And then my second question is regarding your operating margin outlook. What's driving management's view that that starts to improve in the second half of the year? It kind of seems to imply that there's going to be a sub-73% invoice expense ratio, but I was wondering if there's any other color you can provide there.

Well, the main thing for us, Katie, is that we entered the year assuming a 12% year-over-year increase in our cost of goods. If you go back to Q2 of 2022, on our earnings call, I said we expected and hoped that the veterinarians would increase their rates 10% to 15% for the next three to four years. In 22, we saw a 12% increase, and we thought that that was the prudent and appropriate assumption going into 15. What gives us greater confidence today than we even had 45 days ago is as we analyze our data, we are seeing a consistency in our data with our new analysis, as well as looking at additional third-party sources like the AVMA. So if the assumption holds true that it's 15%, we know the rate that's flowing through our book, we'll start to get margin extension.

Thank you.

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

Thanks, guys. Good afternoon. Darryl, the first one is just sort of strategic. The 16-month plan has a lot of interesting initiatives. You've got international, you've got new plans and food and other channels. But the core business has a lot going on, right? I mean, there's inflation. You're trying to move off pets best. You've got a lot of management turnover. And it just seems from the outside that it's really a business that's in flux. So is this the right time to pursue all these initiatives? Or do you take a step back, you arguably get the house in order, and then pursue everything else in 12, 18, 24 months' time?

Jon, I think to put in context, this rapid change in inflation, I've been in the business for 23 years. If you go back to 40 or 50 years, veterinary and inflation has never had such a rapid change. So that is a single challenge that is primarily focused on a pricing team. But we are now also making sure that the information we're getting from additional data sources include the field help us along with that. That's a core consistent challenge that we have been dealing with for 20 years, how to price more accurately by breed, by neighborhood, the core competency. What's changed right now is just the rate of inflation. And as we've said, if that remains consistent at 15% for the next three years, which would be great for the veterinary industry, that will be much easier for us to price to. It's just a rapid change. It takes us 12 to 18 months in the United States to get pricing right through the book. If you look at our cost of goods, the change of inflation in the last 18 months, it's gone from 6% consistent to 15%. So I think anybody can understand that with our business model, that that's going to be a challenge.

If I can add to that as well, I think kind of as we think about the 16-month plan in general, our 16-month plan is designed to set us up for the long-term. And this is a business for the long-term. We have a hugely underpenetrated market both here in the United States, in Canada and across globally. We believe that we can take our products globally where no other brand or no other product has been able to take it to help more vets to support more veterinarians. And for us doing this today, we have decentralized our business to allow us to do these things without interruption to the core business. So to Darryl's point, while we're seeing this as a once in a 20-year move, we remain incredibly confident about the plan for the long term to be able to add this addressable market and double the addressable market that we have globally and be able to have a lot of leverage across the international space. And just kind of on that, to touch on that a little bit, we weren't able to talk a lot about it earlier in the opening remarks, but we're making really good progress internationally. We've added around 4,000 new pets, so incredibly good growth in those markets. And in Q1, we're able to add Belgium. This in itself, again, it's kind of really taking those baby steps that help us to build for the longer term.

Okay. Thank you. That was great color. And maybe the next question I might try to slip into, so the first, maybe I'll ask Drew a question on his last call. But the balance sheet, I think I heard $40 million to draw with the debt. The free cash flow, I believe, was negative $12 million alone this quarter. So is there an estimate for cash burn for the rest of this year? And how should we think about the balance sheet? Is there a potential raise as we exit 23 into 24? And the part B of this disjointed question is, last quarter, I asked a question on California and regs there. And you mentioned working with pets best. But I guess I'm confused because as of recently, pets best has not been able to underwrite in California until they get a new underwriter. So it just seems unusual to me that there was a cohesive handoff if they can't underwrite in the biggest state. So were there actually stipulations from a regulatory standpoint that you had to stop underwriting that as of the end of March of 23? Thanks for your time, guys.

Sure. The draw in the quarter was $35 million. That was our long-agreed draw plan with our lenders because this delay draw facility is only open for a certain amount of time. As I said in the remarks, we've got $253 million in cash and investments on the balance sheet. That's up from $230 million at year end. We have been pretty clear about the strategic nature of this Pets Best agreement and how much capital that frees up. In fact, in Darryl's 22 shareholder letter, he starts to put some quantum behind that. He also wrote it out in 21. So embedded in our outlook is operating within our current funding, which we have a strong history of doing for most of our lifespan. On California, we talked about this in the November call that there is this Prop 103 stipulation that applies to every insurance company, not just Trupanion, and it was holding up our pricing increases that we needed. We agreed with them and Pets Best that Pets Best would find a new underwriter in California. We've been talking to Pets Best about this well before this, so this actually worked out nicely. I can't speak to operationally why they weren't able to make that transition, but that was agreed back in the fall.

Okay. I'll follow up with you guys offline. I appreciate the time.

We have reached the end of our question-and-answer session. This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time.