JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. I'm Justine Underhill. And last week, I sat down with Brad Safalow of PAA Research to discuss the ins and outs of the pet insurance industry. Brad reviewed his short thesis on a particular pet insurer, Trupanion. The stock is already down 20% since Brad's interview following a downgrade by Craig-Hallum from buy to hold. Craig-Hallum's analyst, Kevin Ellich, says he has growing concerns about deteriorating operating metrics at the company. Brad thinks the stock should fall another 80% in the months to come. So with that in mind, please enjoy our interview with Brad.

All right. What trade are you looking at today?

BRADLEY SAFALOW: Today's trade is a short of Trupanion. Trupanion is a pet insurance company. And just from off the go here, it is important to emphasize this is an insurance company. Remarkably, there's a debate in the investment community over how this company should be positioned from a valuation perspective and a narrative around the stock perspective and that the company came public and tried to position itself as a subscription business. Now, they have policyholders, they are an underwriter. They are unequivocally an insurance company.

But the reason why the stock still trades at roughly nine times tangible book value is because they are- in some people's minds, a rapidly growing subscription business, which is an absurd supposition. And you can point to any company you want in terms of excesses in this market, whether it's Tesla or what have you, I think calling an insurance company and it's a subscription business is the height of excess.

JUSTINE UNDERHILL: Interesting. So this is basically insurance on people's dogs and cats and birds and other animals?

BRADLEY SAFALOW: Just dogs and cats and honestly, heavily- the industry is heavily weighted towards dogs. People are very bullish on this company. They're bullish for a few reasons. One, the pet category. There's $70 billion spent on pets a year. It's a growing category, there are a lot of other investments that people are looking at in the pet space. I've talked to people who are long the stock and it's like, well, I really like this category. This company has the opportunity to grow.

Two is that the penetration rate in this total addressable market, and like we're all talking about total addressable market tams all the time and day is low. Now, there's a debate over how low it is. Bulls will argue that it's 1% to 2%. And they will say, hey, I have this analogue that I can look at in countries like the UK, Sweden is an extreme example, where the penetration rate of pet insurance is like 35%, 40%. Here in the US, it's like 1% to 2%.

I think that's fought for a couple reasons. One, the true addressable market, given the cost of pet insurance in the United States is a lot smaller. There's 180 million dogs and pets, of that you have to pare it down, as I said earlier, it's really more of a dog market, no pun intended, that you have about 25 million dogs that are owned by people that make more than $85,000 a year. So based on my math, the penetration rate, given what the average premium is for pet insurance policy at this point is at this point was 8% to 10%.

But the real crux of the issue for Trupanion is that the company has gained a ton of market share based on bringing to market this pet insurance policy that was a 90% payout rate. Historically, the payout rates in any industry might be 50% to 70%, Trupanion said, hey, we're not going to offer wellness policies. But if you have any sort of accident or issue with Fido, you're going to get paid out at 90%.

The problem is an insurance company as an insurance business, it is structurally unprofitable. That won't change if they're- so they have the same underwriting profitability at 100,000 pets as they do at 450,000 pets. So there's this argument that the management team and other investors keep making that, oh, they're going to get to scale, they're going to get to scale, get to scale. There is no escape velocity so to speak for this business in terms of operating margins.

One of the things that's interesting is that this is an insurance company that does not disclose on a regular basis their statutory profitability, which is for an insurance company, basically the measure of underwriting losses versus what you took in in premiums. We've gone through and pulled the stat statements from the regulators and again, over time, what you see is that it's a very low margin business, and one that does not cover all the marketing costs, all the corporate overhead. That is their primary issue.

And when you think about this business, what's really, really problematic for them is that it's a grand exercise in adverse selection. They are acquiring their pets at the vet. Think about that. The owner is at the vet for one- many reasons, but because the pet has had an injury or sick or something is wrong with it from a health perspective. So you're already acquiring pets that in a lot of cases already have health problems.

As a result, if you think about the business, they need to acquire new younger pets with an incredibly high frequency that cover these pets that they have in their system that are ageing and incurring more health problems. So the fact that they are acquiring in the vet channel already creates a negative bias in terms of loss rates in their book, they're already covering at 90% rate. And what's happened now is that based on my own diligence on the regulatory filings, they're having to increase the premiums at in many cases, double digit rates, 10%, 20%, 30%.

So this is, for those maybe not familiar, this is good classic insurance rates spiral, where your rates are going up, because you're trying to cover losses, and you're constantly trying to have to catch up and you're pricing yourself out of the market and then ultimately lose customers. So in any given year, they have about a churn rate of 16% to 18%. But the churn rate for customers that witness price increases is nearly two X, let me just rephrase that, price increase is in excess of 10%, 20%.

JUSTINE UNDERHILL: How long has this company been around?

BRADLEY SAFALOW: That's a good question. The founder of the company really started this business about 15 years ago in earnest. It reached say more of a critical mass in the last five to seven years. They're not the only pet insurance company out there. This space is actually incredibly competitive. You have Nationwide is the largest pet insurer, they have about 750,000 pets. Recently, there's been some M&A activity in the space.

There are obviously some key takeaways from that. And one, the multiples paid on the business is- and it was Pets Best which was acquired by Synchrony- the big credit card company. And then White Mountain Insurance, which is a publicly traded insurance company, acquired a pet insurance platform called Embrace. In both cases, they paid about $500 to $600 per pet, Trupanion currently trades at $2,000 per pet.

If you look at it on a price to revenue basis, price per pet basis, price to book basis, paid about one times tangible book, basically saying that Trupanion's trading 3X the multiple of these companies. These companies were not underwriters themselves, they were just doing the marketing for pet insurance as an agency to acquire pets for the pet insurance underwriters. And then separately, they're actually growing faster than Trupanion. So, the justification for Trupanion to trade at nine times revenue- or excuse me, nine times tangible book value, or the multiple they do on a per pet basis was about 2000 is completely unjustified by private market values.

JUSTINE UNDERHILL: In their latest earnings report, they lost about six cents per share, versus the expected three cents. Could you talk a little bit more about what factored into that as well as other things that you gleaned from the earnings report?

BRADLEY SAFALOW: Sure. When I think about any growth company that's trying to really capture their tam, what are the key metrics that you want to see? You want to see upside to your- whether its revenue, or in this case enrollment forecast, you want to see improving gross margin trends, you want to see stable, if not declining customer acquisition costs. They went over three in all those.

Enrollments were slightly below where the street was. The gross margin was down year over year significantly. And as we talked about before, the loss rates going up is a key factor there. And then lastly, which is a huge dynamic for this business is that their pet acquisition costs were at 40% year over year. And if you think over a longer term, they basically have doubled over 3, 4-year period. They're getting to that point where it's becoming unsustainable for them to continue to grow in this way.

And again, as I mentioned, they've historically focused on the vet channel. They've never had a coherent consumer branding strategy. So if they had to go into the digital channel and acquire consumers on a B2C basis, it would be even more expensive. And there are other companies that have already established their platforms for lead generation in that space.

So, they're really in a rock and a hard place in some respects and that they've exhausted their opportunities to market in the vet channel. Because they've had these territory partners. They have roughly 200 that have been canvassing the 20,000-plus animal hospitals around the country for several years now. On top of which, they have huge turn among their territory partners, which also contributes to their higher pet acquisition costs. So when you think about it, they're spending more than $200 to acquire a pet. Their average premium is $55. So they're still getting a decent return on marketing, but it's declining at a rapid rate.

JUSTINE UNDERHILL: Got you. All right. So then what levels are you looking at for the stock?

BRADLEY SAFALOW: It's interesting, the stock has been a stock in this 30 to 35 range for a long time, at least, for most investors. They're thinking, and there's a huge amount of tension between longs who have this tam oriented pet biased case and then there's the shorts. And so the shortages high. As I said before, after they reported second quarter, it was a disastrous quarter, even on traditional metrics, like revenue EPS and it's badly- and the metrics that matter most in terms of growth, they were horrible. Acquisition costs were up 40%, and all these other things that they're having problems with.

The issue, remarkably, is the stock didn't go anywhere. So I do think ultimately, you're going to see a huge gap down in the stock when what would be the catalyst for that is when I think the growth oriented long investors are really focused on the enrollment numbers. So when those slow a little bit, which we're seeing those pressures now, I think all the issues that I'm talking about as far as the profile of the business and the fact that they'll never be profitable and the loss rates are too high and they're in this rate spiral and the pet acquisition costs, inflation- all those things will come to bare and you will see a dramatic gap in this stock, where I think if it gets rerated, it's going to be sub $10 stock.

At that time, what should an unprofitable insurance business trade at? Is it one times book, two times book? My target of 10 is based on three times book value. So that's what I'm looking for. Now, I'm sure you can ask me then well, what could happen negatively and there have been issues around the cost of borrowing in the stock just cause the stock to squeeze in the past. I think the pressures on the business model are growing more intense. So the likelihood of a squeeze, just given the conviction that people who are short the stock have at this point, you'd have to have a major step function change for several quarters where suddenly the pet acquisition costs are going down, the loss rate dynamics are changing, they were still growing at mid-teens rate, even though more recently they've been losing share. So a lot of those things that I'm focused on would have to reverse for shorts to really change their mind on this business.

JUSTINE UNDERHILL: Great. Brad, thank you so much for breaking this all down for us.

BRADLEY SAFALOW: Thank you.

JUSTINE UNDERHILL: Brad is bearish on true pinion. Specifically, he recommends shorting it at current levels and sees downside risk as low as $5 to $10 over the next 6 to 9 months.

Just remember this is a trade idea and not investment advice. Make sure to do your own research, consider your risk tolerance and invest accordingly. For Real Vision, I'm Justine Underhill.