ROOT is Rapidly Changing the Auto Insurance Landscape

Be sure to read the disclaimer at the bottom of the post.

Happy early 4th of July to all of my fellow Americans, I hope most of you take some time off tomorrow to enjoy some beer and fireworks while ignoring finance for a day! In the meantime, I have this great post you can sit down with before your vision gets fuzzy:

Root, INC is changing the Auto Insurance Landscape

I think the small/micro cap financial sector is one of the more undervalued industries in the market right now with plenty of great opportunities. As individuals who have read our investor letters already know, this is why we have a position in FFB Bancorp (FFBB) and has most likely contributed to the opportunity in Root.

Our Newest Position

In the past month we (Rogue Funds, LLC) have taken a new position in Root insurance ROOT 0.00%↑. Root IPO’d in 2020 as a car insurance company that uses their app to track how you drive to give you the lowest rates possible. On the surface this seems like a genius idea, since car insurance has become a huge data centric industry and the best companies are dictated by how well they can capitalize on the data they have and how well they can market their business. In this world of data, one would think that having the data on how someone actually drives is the best data you can have.

Data Utilization Determines the Kings of Car Insurance

In recent years the auto insurance business has become much more data centric and less marketing based. Todd Combs (Berkshires CEO of GEICO) has stated that progressive was taking market share from GEICO due to the poor data collection that GEICO has in place and was slamming Buffett with this (his only podcast that I know of discusses this). It took several years until Buffett really registered what Todd was talking about and put him in charge. This change has barely caused a blip in GEICO’s ability to recapture share from Progressive and figure out how to best produce quality data utilization.

In a separate breath, Root initially sucked at their ability to produce a quality loss ratio as their data collection was small and they hadn’t integrated their app driving data in a way that would lead to profitability.

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Four years later and we have hit the point of profitability and the market rapidly recognized it (if you were in ROOT at $10/share congrats on your 5 bagger!). As you can see in the stock chart below, it took a long time to finally get their data going in the right direction and utilized properly.

Created with TradingView

The reason I bring up the GEICO situation is to address the biggest concern most individuals would have with investing in a small cap auto insurer. One might ask “Why can’t the big car insurers just start tracking data in their apps and starting taking away market share from Root?”. Well as the GEICO example showed, even in a organization as well ran as Berkshire, with a manager as adept as Todd Combs, bureaucracy still causes things to move very very slow, especially in an industry as old as car insurance (that’s why GEICO and Progressive were able to capture so much market share from State Farm to begin with).

While the biggest car insurers continue to lag in their ability to really utilize on-the-road data, I believe that driving ability is the single best data point a company can have and Root has a lot of it and it took them 8 years to do so. They now have over 25B miles collected and this will only grow as their customer base grows, slowly building their data collection moat.

From Root Q1 Investor Presentation

Do you think insurance companies would be willing to take drastic steps to change their currently highly profitable models and lose money on tracking customers via an app for 8 years like Root had to do? Of course not and meanwhile Root will keep building up miles and keep decreasing their loss ratio until other insurance companies begin to pay attention.

The only other company I know of that is taking a similar approach to Root is Progressive, using their snapshot program. This still isn’t their main method of providing insurance quotes and I don’t know how good they are at utilizing this data as seen by their loss ratio (seen in the next section).

How do we know Root’s Data is actually good?

Well, the number one indicator is a rapidly lowering and industry leading loss ratio that has allowed them to get to their current profitability inflection and huge increase in the stock price.

Loss Ratio from Root Q1 Presentation

For those of you new to car insurance, the loss ratio is the best indicator of if a company has profitable underwriting and how profitable the underwritings are.

This is the formula:

Gross Loss Ratio = (Claims Paid + Loss Adjustment Expense(LAE)) / Premiums Collected

The lower your loss ratio, the better your underwriting. If you have less than a 100% loss ratio then your underwriting is profitable. So just how good is a 61.2% loss ratio?

Edit: I was unaware that Root calculated their loss ratio without including LAE. Their LAE (which I believe might only be included in Direct Loss & DCC in the table below and not in the Direct loss to EP ratio) is ~9.9% bringing Root’s loss ratio to ~70%.

Private Passenger Auto Insurance from NAIC

The above chart shows the loss ratios, as of 03/18/2024, for the top 25 private auto insurance companies. Since Root is basically a pure play on auto insurance we can see that they have the best industry ratio among the top 25 and by a considerable margin outside of Sentry INS who is right behind them. There could be some slight discrepancies in the loss ratios but it is clear that Root has something the rest of these companies don’t.

This rapidly lowering loss ratio has led to the inverse effect on profitability which is roughly at breakeven at the current moment as of the last quarter and a positive FCF of $64m for the last twelve months.

Better Data = Better Retention

As the data for Root has grown it has started to address its poor retention which (according to management) has improved each year. I tried reaching out to IR to get the retention numbers but they aren’t currently available. I do have the IPO (2020) numbers which IR said the company has improved upon (without much more info). I think it is fair to say that this retention is driven by more appropriate pricing leading to a better user experience.

I have read the poor BBB reviews and poor reddit stories about Root but the app has good ratings and reddit/BBB is usually a hellscape of people complaining about their auto insurers. It seems initially that users were getting in accidents then switching to root as a low cost provider of insurance and that is slowly starting to change. I think at the end of the day, the company’s data/pricing is driving better retention as they get pickier on the drivers they choose and lock them into the best data-driven rates.

IPO Description of Customer Retention

Email with IR Discussing Retention Metrics

They have also streamlined their sign-up process to as few as 3 clicks and a test drive. Streamlining the insurance sign-up process is a trend across the industry and Root does it as well as anyone. Their sign-up process is one of the easiest in the industry and only takes a couple minutes. They utilize one of the best (if not the best) apps for quick onboarding (also shows customer statisfaction in the product).

The next step of their increased retention plan is the cross-selling of products. Like most large scale insurers, Root plans to offer numerous insurance policies such as renters (which they just launched) and homeowners insurance, which they have partnered with another company on. These cross sells tends to increase retention, lowering customer acquisition cost impacts, and leading to a much longer customer relationship. The obvious risk here for renters insurance is that it’s much harder to price properly than their current auto insurance model.

Marketing will Hurt Short to Medium Term Profitability

As I said before, insurance is also reliant on advertising and the ability to market the product, as well as utilizing data. This will most likely keep Roots combined ratio barely above 100% as the company pours money into growing and scaling the business. They still have to do a national rollout as they are only offered in 34 states (serving 75% of the US population) and have licenses for all 50 states. They are growing their premiums at a very fast clip over the past year, with growth of 100%+ while their business gets more and more efficient.

At $331m their premiums are continuing to grow towards the $1B mark and their operating leverage should really begin to show up on the cash flow statement and the income statement. As they get their loss ratio and retention as efficient as possible, I expect their marketing costs to balloon to drive more and more quality customers to the company, which will keep profitability low but growth high.

Management

Management is founder led with a huge internal ownership of 1m shares by the CEO. Their current comp plan is great and aims for lower loss ratio, less direct operating loss, and increased policies written. I think based on the company’s stage in its growth cycle and the size of the incentive bonuses, these are appropriate incentives for now.

Combined Ratio Improvement

At the current rate of improvement in the net combined ratio, we should be breaking profitability in the near future. According to management, they expect Q2 to be a backslide a bit so I would guess that profitability (or break even) will hit in the back half of this year.

Their combined ratio is at 102% (net combined ratio takes into account operating expenses and reinsurance costs, giving a better picture of true profitability vs the loss ratio). Once they break below 100% they will most likely be operating profitably. I would guess that the future combined ratio will sit around 100% as they pour money into marketing and purposefully sit near break even.

Valuation

That makes this valuation a little complicated as we have to try to determine the valuation based on lumpy FCF without much history of FCF and their current EV/sales. Currently FCF sits around $64m but we can probably normalize it near $40m per year since most of it came from one large quarter ($45m). They basically have almost no capex and operate with great operating leverage due to their tech stack and lack of bloat (that most insurers are experiencing). At their current rapid rate of growth and the rapid moat they are building, I think a 30x normalized FCF would probably be appropriate. I know this multiple sounds insane but their growth is simply insane and their operating leverage makes it seem like a more unrealistic number than it actually is. This would be a 1.2 B dollar valuation (since dilution isn’t much of a risk).

They are obviously less than this intrinsic valuation estimations and they trade at roughly 13x EV/Normalize FCF. This is obviously way too small of a number based on their growth.

If we look at their sales they are trading at less than 1x EV/Sales. This seems truly insane given their operating leverage and their rapid growth. I would guess 3x-5x sales is a much more accurate number (3x is roughly the industry norm and they are growing faster than the norm) based on their operating leverage and growth, giving them a valuation of 1.5B-$2.5B.

We can stick with the lower valuation from FCF and this gives you a roughly $1.2B valuation. With little risk of substantial dilution based on their cash position and their historical small amount of dilution this would mean a value of roughly $100/Share. If they keep growing as expected, their current 1x sales valuation would still lead them to hit $100/share this year with no multiple expansion.

There is a substantial chance of huge upside if root experiences a multiple expansion combined with their growth, leaving the opportunity for a major multi-bagger. I think going with a $100/share and giving the company room to surprise us will be the best way to go about this valuation. This valuation will be dynamically changing over the coming years and we’ll adjust our valuation accordingly (since it’s so hard to value high growth, we have to stay more alert than usual to the changes in valuation) as we see how management continues to execute.

Business Neutral Catalysts

If you notice the stock chart at the beginning of the article, you will see that the stock price expanding by 5x in a couple months was astounding. The main reason for this is because of the low float in the stock from a reverse stock split (for those of you who have read my prior stock analysis, this sounds extremely familiar). That situation remains the case today with the float only being 64% of their shares outstanding. Their current short % of float is 17% now after that biblical move in early 2024 as the stock price has slowly creeped down. This is setting up a possible short squeeze scenario that could lead to a rapid re-rating of the stock price.

The company joined the Russell 2000 on June 28th which could increase the liquidity leading to more institutional interest in the stock (again, sound familiar?).

Disclaimer: The author of this idea and his Fund have a position in securities discussed at the time of posting and may trade in and out of this position without informing the reader.

Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment adviser capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC and CSA filings, and consult a qualified investment adviser. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication and are subject to change without notice. The author and funds the author advises may buy or sell shares without any further notice.

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