Unravelling the Mysteries of Root Inc., the Insurance Industry Disruptor

The first mystery is the behaviour of the share price. In 2020 the shares were floated at $27 so where did a 2020 peak price of over $520 come from? On 15 August 2022, Root had an 18:1 reverse share split. Each 18 shares in the company became one.

Even after that, the price dropped to around $3.50 in early 2023 to value the whole business at less than $50m. I had a look at the 2022 annual report and specifically at the balance sheet. Total stockholders’ equity fell from $536m to $277m. The P&L (profit and loss statement) showed a loss of $298m for 2022 and a combined loss for the three years, 2020 to 2022, of $1,188m. This company must have seemed to be on a fast route to oblivion.

But companies don’t just sit there when things get difficult. As somebody once said, ‘When things get tough, the tough get going’. Alex Timm and company sprang into action, battling to save their dream. I quoted this in my first alert on Root but it is worth requoting.

Just over 2 years ago, we underwent a crisis as we saw used car prices soar and observed the worst inflationary environment in recorded history. It was clear that we needed to pivot our business. This entailed making a number of decisions that, while difficult in the near term, were ultimately the necessary and correct decisions to ensure we evolved our company and positioned ourselves to be able to fully disrupt the auto insurance industry. To do this, we crafted a 3-step plan. One, drive toward healthy margins on our business by hitting our target loss ratios; two, materially lower our fixed expenses; and three, efficiently grow to scale in order to drive profitability.

Fast forward 2 years and we believe the transformation is remarkable. For the full year 2023, we restarted our growth engines, increasing gross written premiums by 31pc and policies enforced by 55pc. We generated a Direct contribution of $151m. That’s nearly a 20x expansion from just 2 years ago. We recorded a gross accident period loss ratio of 66pc and a gross combined ratio of approximately 116pc, both major improvements while also validating our efforts to enhance our tech and data capabilities.

Alex Timm, CEO, Root In c., Q4 2023, 21 February 2024

I looked at the balance sheet at the end of Q4 2023 and stockholders’ equity was still falling from $277m for Q4 2022 to $165m. They need to turn that number around to inspire confidence. However, the rate of decline seems to be slowing. The quarterly sequence from Q4 2022, is $277m, $244m, $214m, $177m and $165m.

The company also said in its Q4 2023 Letter to Shareholders that its financial resources were strong.

We ended the year with $507m in unencumbered capital, reflecting an annual unencumbered cash
consumption of $52m in 2023, compared to $179m in 2022, net of proceeds from the issuance of debt.
We are energized and committed to future growth as we start 2024 from a position of strength.

Alex Timm, CEO, Root In c., Q4 2023, 21 February 2024

Insurance companies are a minefield of complexity. I could not find any of those unencumbered figures on the balance sheet but what I found was net cash of $679m in 2023 v $762m in 2022. Again it would be nice to see those numbers climbing not falling but what that means is that net cash is not a million miles away from the market value (MV) of the business and way ahead of what MV fell to in early 2023 when, presumably, it was widely supposed that the business would soon be worthless.

Net cash is not free cash because money will be needed to settle claims but it is important to have it.

Once it became clear, during 2023, that the company was going to survive and most likely prosper that sub-$50m market value was revealed as ludicrously low. The shares have rocketed some 17-fold since then but are still way below the value at the 2020 IPO.

Decades ago I read an article in a highbrow magazine called Encounter entitled ‘The Rubbish Theory of Value’. The author was referring to the value of Georgian property in Islington which fell to rubbish levels (almost negative) after the war before setting off on their long ascent to where they are now.

Many assets go through a rubbish stage (Shakespeare’s First Folios in the 17th century, anything Victorian when I was a child, the Treasures of Ancient Italy and Ancient Rome for centuries until the English ‘looters’ arrived and made the locals realise that this old stuff was worth more intact than as building material).

It seems to me that Root Inc, like Amazon in 2001, has had a rubbish theory of value moment and is set for better things, maybe much better things. Remember that the company has innovative technology and is setting out to disrupt a gigantic market.

Root Inc. is playing a sophisticated numbers game.

Our technology advantage demonstrates our ability to effectively match price to risk as evidenced by our superior loss ratios. Our underwriting results improved significantly throughout 2023, with our performance in Q4 2023 marking one of the strongest since our company’s founding. Our gross accident period loss ratio of 66pc was produced on record quarterly gross written premium of $279m. This resulted in a reduction of our Operating Loss to $12m in the quarter versus $48m in the same quarter last year. This is strong evidence that our technology advantage continues to evolve and translate into improved unit economics. Further, these results demonstrate our continued, disciplined approach to underwriting by focusing on profitable growth. At the core of Root’s strategy is our automated data science platform, which leverages proprietary machine learning across all elements of the insurance value chain, including customer onboarding, underwriting, pricing, telematics, and claims. We plan to continue our expansion of these core assets to enhance our connected car capabilities, shorten the algorithm feedback loop, and further automate pricing and claims. Our technology platform allows us to see changes in claims costs and quickly respond. With this capability, we were able to identify a rapidly changing inflationary environment and adjust our prices to position us for profitable
growth. With this backdrop, Root is looking to expand our geographic reach to even more customers.

Alex Timm, CEO, Root In c., Q4 2023, 21 February 2024

What are insurance companies all about?

They write insurance for cars, buildings, lives etc. generating a huge inflow of cash (gross premiums) from which they pay claims and their costs. Because at any given moment they are sitting on a lot of cash against future claims they can invest that money to generate investment income. When interest rates and returns are high it is often worthwhile for insurance companies to run their underwriting business (premiums less claims) at a loss while making a profit from investment income.

All these things are going on at Root but they also have much in common with software companies deferring profitability while spending heavily on sales and marketing.

We continue to be laser focused on reaching profitability with our existing capital. 2023 results show meaningful progress on this front. We continued our diligent growth trajectory at attractive target unit economics while leveraging our fixed expense base. In the fourth quarter 2023, net loss improved 59pc year-over-year to $24m and adjusted EBITDA improved 99pc year-over-year to a loss of $0.3m. This meaningful progress is driven by loss ratio improvement and fixed expense management that sets the foundation for scalable growth. Last quarter, we communicated an evolution in our reinsurance strategy, which continues to benefit net results through increased retention and lower reinsurance costs. Consistent with prior guidance, in Q4 2023, our gross earned premium cession rate was 18pc*, and the gap between gross and net loss and LAE* ratios was reduced to single digits. As we have achieved our target loss ratio and established a scalable expense base, reaching profitability now largely depends on the level of our discretionary marketing investments. As Root grows, our marketing spend may elevate near-term losses as we do not defer the majority of customer acquisition cost over the life of our customers. Acquisition expenses in our Direct channel will vary, and will be deployed at attractive expected returns over the customer lifecycle.

It’s important to note that we believe we could achieve profitability in the near term if we determined reducing our marketing investments was the best approach to drive shareholder value. However, this would require us to forgo significant amounts of accretive business, reduce our share of market, and ultimately come at the expense of building long-term shareholder value.

Alex Timm, CEO, Root In c., Q4 2023, 21 February 2024

*Loss ratio is used in the insurance industry, representing the ratio of losses to premiums earned. Losses in loss ratios include paid insurance claims and adjustment expenses. The loss ratio formula is insurance claims paid plus adjustment expenses divided by total earned premiums. For example, if a company pays $80 in claims for every $160 in collected premiums, the loss ratio would be 50pc.

*The gross earned premium cession rate is the amount of gross premium ceded to reinsurers

*Loss Adjusted Expense (LAE) refers to the costs an insurance company incurs when investigating, managing, and settling insurance claims. This expenditure is vital to the functioning of insurance companies and directly impacts their financial performance and profitability.

*Gross premium is all the premiums received for policies written

*Earned premium is the premiums received after the expiry of the period for which they were written

*Combined ratio is incurred losses + expenses divided by earned premiums times 100.

The combined ratio is the metric that gives information about the outflows from an insurance company (expenses, incurred claims and related losses) on its earned premium. It gives investors, analysts, and consumers a comprehensive view of how much an insurer pays out in claims and the operational efficiencies of the insurance company.

There is an inverse relationship between the combined ratio and the company’s profitability.  A combined ratio that is below 100pc shows that the company is making a profit.

When the company’s combined ratio is higher than 100pc, it shows that it’s paying out more than it’s receiving.

Hence, the goal of insurance companies is to maintain a low combined ratio.

So, having gone through all that, what is happening to the combined ratio at Root Inc. In the latest quarter, the gross combined ratio improved 22 points to 110pc; the net combined ratio improved by 68 points to 112pc. The net combined ratio seems to be net of reinsurance premiums ceded. The key point is that they are moving in the right direction.

I am digging into the complexities of the Root balance sheet and P&L because I suspect the shares could be massive winners. The chart shows a V-shaped reversal which is a powerful pattern. The recent breakout could hardly be more explosive with the shares climbing from $10 to nearly $60 in three months before the latest reaction.

Root Poised for Virtuous Circle of Growth

The company has the opportunity to enter a virtuous circle of growth.

We have significantly bolstered our pricing and underwriting technology while optimising our expense structure, putting us in an increasingly strong position throughout 2023. Importantly, we believe we have now achieved scale in the business. This provides us the ability to make decisions for the long-term success of Root. Specifically, we believe we are positioned to identify opportunities to profitably gain market share, or if we determine that growth may not achieve our target returns, quickly shift our focus to drive near-term profitability. We are still in the early chapters of disrupting the auto insurance industry. Our conviction remains unwavering that over the long-term, our ongoing investments in data science and technology will continue to provide better experiences and prices for our customers. We believe this will ultimately unlock long-term shareholder value.

Alex Timm, CEO, Root In c., Q4 2023, 21 February 2024

Strategy – Accumulate a Position in Root

Root has a partnership with Carvana to sell insurance alongside the latter’s used car and the pair have similar charts at least in the past three years.

Like Root Inc. Carvana is super positive about 2024 and beyond.

Accordingly, in FY 2024, we expect these gains to lead to both growth in retail units and Adjusted EBITDA compared to FY 2023.
Carvana currently sits in its strongest position ever, for five reasons:

1. Our business is purpose-built to provide the best possible customer experiences. These experiences are what separate us. Over the last year, we have improved the efficiency of our business, and we have also made our customer experiences simpler, faster, and as a result, better.
   We are separating by more.
2. The financial power of our business model becomes clearer every quarter. Our unit economics are
   differentiated today and improving further. Our vertical integration is leading to the highest GPUs in the industry. While we do not have perfect visibility into our competitors’ fixed versus variable costs, we believe our variable costs are now at least similar to our largest competitors despite us being more deeply vertically integrated and therefore having more value-added functions than the competition. Our fixed costs per retail unit sold are much higher than we expect them to be in the future. Across every line item of our income statement, we still see significant opportunities for improvement from here.
3. Our automotive infrastructure is unmatched. We have reconditioning capacity to produce 1.3m cars a year. We have 56 ADESA locations with the capacity to recondition approximately 2m additional units of annual volume once fully built out. We have the second-largest wholesale used vehicle auction business in the US. The sum of these locations comprises ~6,500 acres with over 500,000 parking spots around the country. We have a logistics network with 33 logistics hubs that is custom-built using proprietary tools to get cars directly to and from customers as quickly as possible. We pick up and deliver cars in 316 markets and can get to the door of over 80pc of the US population. Growing into this infrastructure over time will reduce work per sale as we get closer on average to our customers. We believe these dynamics lead to positive feedback for customer experiences, unit economics, and scale.
4. Competitively, we have never had more separation. Competitive separation is about (a) developing difficult-to-replicate capabilities that are valued by customers and that drive positive economics and (b) stacking them in a way that compounds their value. We have done exactly that. Building Carvana has required the development of an entirely new supply chain in automotive retail, an entirely new set of transaction capabilities, and an entirely new finance capability that is optimised for an e-commerce use case. The technology and operations that bind these capabilities together then require wrapping all of it in a cohesive plan that leads to offering customers love. In this way, the whole is greater and more differentiated than 3 the sum of its parts. We are executing at the highest level in our history and adding to our stack.
5. We compete in a trillion-dollar market and we currently have approximately 1pc market share.
   The potential is clear. The five points above bode well for an extremely bright future. Our job is to realize the enormous potential we have. We have to take these advantages and the hard-earned lessons we have gained along the way to achieve our goals of becoming the largest and most profitable automotive retailer and of buying and selling millions of cars. That has always been and remains our plan.

Share Recommendations

Root Inc. ROOT. Buy @ $50

Carvana. CVNA. Buy @ $82