“But for its stock valuation and ~$650mn to $750mn in new cash proceeds, Root seems in every way like a business in crisis based on its fundamentals,” Inside P&C’s Research team wrote in November 2020, just after its triumphant $6.7bn debut.
Now, with its market cap down to $480mn, and an enterprise value of -$137mn, it is simply a business in crisis.
Its predicament was dramatized late last week as it let go 20% of its staff, sending its stock into a tailspin following a year of massive depreciation that leaves it 92% lower.
With the negative optics of the move, it is a good moment to revisit that analysis from a period when many observers – including much of the Street – were highly bullish on the firm’s prospects.
A history lesson – the original analysis
The insights which underscored the original analysis still hold today, and explain why the odds on Root pulling up from its downward spiral are long, with paths towards a sale or the wind-up of the business looking more likely.
The insurer’s fundamental problem, as this publication noted in November 2020, is that it “is not a tech-enabled disrupter, but simply another non-standard auto growing too fast with poor segmentation”.
Deliberately or unwittingly, the business built a non-standard auto book without pricing for it, or building the capabilities to service it effectively. Rather than a tech or UX advantage, its rapid growth reflected its willingness to take on non-preferred customers at prices that no other carrier would match.
This explains Root’s sky-high loss ratios and its weak customer retention (a typical feature of the non-standard market). This also contributes to a fundamental issue around the efficiency of its customer acquisition costs (CAC), partially reflecting the challenges of a direct-to-consumer model.
All of this has been exacerbated by the huge valuation placed on the business, which placed pressure on management to grow at all costs.
Commentators widely diagnosed the need to fix the elevated loss ratio, and improve customer retention at the time of the IPO, while Inside P&C stressed the need to improve CAC efficiency.
But, as stated in that note, “it does not seem to be well understood how these goals are mutually exclusive in the near term”.
Rate rises are the clearest path to bringing the loss ratio down to a sustainable level. But above-market rate rises hurt customer retention and also negatively impact CAC by reducing conversion rates.
And, of course, by hurting growth rate rises, tank the share price.
Fixing the profitability of the underwriting is crucial to making the business self-funding over time. But dialling down growth destroys the hype around the business as a disrupter, which makes it harder to raise the fresh capital needed to keep Root on the road.
The obvious medicine for one of the key ailments exacerbates the others.
Existential flaws and macro challenges
Inside P&C called the flaws in the business model “existential” 14 months ago, and they are more acutely so today due to the time that has elapsed - and a more challenging macro backdrop.
That macro backdrop takes two different forms. First, after a period of windfall profits resulting from a reduction in miles driven, the environment has turned against personal auto insurers with a vengeance. This reflects the combination of a rebound in claims frequency and a spike in severity primarily resulting from supply chain disruptions.
Second, the equity market backdrop has become increasingly unfavorable with fears of multiple interest rate rises leading to a growth-to-value rotation that has pushed the Nasdaq into correction territory, and particularly heavily punished tech stocks. Root cited the macro environment around supply chain disruptions and inflation in explaining the 330 layoffs, but competitors are not dropping headcount in the same way. Instead, the move looks like a cash conservation mechanism, a parallel move to the massive reduction in sales and marketing spend the company revealed in its Q3 shareholder letter.
Management looks to be playing for time in the hope that a longer runway, before it is forced to attempt a secondary offering, will give it time to pull up out of its nose dive.
The runway may be somewhat longer than appreciated, extending a couple of years. At Q3, the company had ~$830mn of cash, and this will be bolstered by $126mn from Carvana in Q4 as well as the $300mn Blackrock debt facility, partially offset by its Q4 burn.
All told, though, it likely has more than $1bn of cash, with negative cashflows of ~$280mn in the first nine months of 2021.
With the time that it has bought, the focus is likely to be on a) pivoting to omnichannel distribution; b) pushing rate; and c) deprioritizing short-term growth in an effort to fix the book.
One of the ironies of Root’s recent communications given its prior messaging around disrupting the archaic insurance industry is a tendency to seek to credentialize its initiatives by indicating that these are things done by traditional insurance companies.
(It notes for example in its Q3 letter that it is using a front in Texas, “an arrangement commonly used by insurance carriers that write business in Texas, allowing for greater pricing flexibility that we believe will enable us to more accurately segment risk in Texas and drive better profitability”.)
While the scale of the challenges may have necessitated a drastic approach to cost control, the move will cause real damage to Root from a talent perspective.
Staff morale is already likely to have been a problem at a business that has gone from tech IPO posterchild to fighting for its life in just over a year, with staff equity decimated. Layering this on top will exacerbate the issue, likely impacting retention and engagement. Sources and Reddit posts from staff suggest that Root has still been hiring in recent months, something which sits very uncomfortably with a mass layoff.
Root will also now find bringing new talent on board materially more difficult, something it needs to do if it is to expand into new states.
So what are the paths forward?
It is difficult to predict the end of the period of increased auto severity, but with a couple of years before it has to raise capital, it likely has the time to wait it out.
The bull scenario says that Root’s management team can work hard in that time on business fundamentals, driving down CAC through the use of affinity and independent agency distribution, as it improves its technology and customer segmentation, all alongside a drive to improve the quality of its book by throttling back on growth to secure rate. And that, maybe, combined this is enough to convince public market investors it deserves a future.
As noted above, the number of problems Root has to fix concurrently makes this look a long odds bet. Which you can see just by looking at the share price.
It is possible – if not likely – that the through-the-floor valuation attracts an incumbent carrier looking for a leap-forward in its technology and UX capabilities
The most bearish scenario is an orderly wind-up or bankruptcy, which must be a real possibility for a business that burns capital as quickly and which is not certain to have fresh access to equity.
The third path is that the board finds some kind of Metromile-style solution to the problem that offers at least some value to its shareholders at the cost of extinguishing the dream.
It is possible – if not likely – that the through-the-floor valuation attracts an incumbent carrier looking for a leap-forward in its technology and UX capabilities. Although, of course, Root’s telematics/pricing has failed to prove its worth.
Perhaps Root’s best chance of such a deal is one of the mutuals that do not have to worry about managing shareholder perception around this kind of transaction. Liberty Mutual or Nationwide have the balance sheet size and presence in auto that make such a move conceivable – think USAA-Noblr on steroids.
Even here, though, the extent of the cash burn from Root and also its $300mn debt at a 9% coupon, means the size of the commitment is significantly bigger than with Metromile.
Or, if the share price continues its precipitous fall, Root could become interesting to a name like Enstar – or even a hedge fund – that could buy the business and close it down, leaving the acquirer with the excess cash.
Root remains a business in crisis with a tough road ahead.
Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.
Scan here to download the app