For those who remember the tortoise vs. hare insuretech thesis, when did it make sense to be a hare?
When your stock was overvalued and thus capital was cheap. You could raise equity as a competitive advantage to allow you to sustain large operating losses while you built out your platform.
Root’s stock has gone from $8 to $80 in a little over a month. That is not a typo. It now trades at over 7X BV!
The stock price is not sustainable by any reasonable metric. There has never been a better time for them to raise capital. I’m surprised they haven’t done it already.
The Logic For More Capital
When I wrote about Root at the time of their IPO, the major concern I expressed was their rate of cash burn and whether they would run out of money.
As losses piled up, the market began to worry about this too. Root has focused on improving its burn rate through downsizing plus reducing growth strain and marketing spend.
But they are not out of the woods yet. While financial results are improving, there is still material risk of a cash crunch.
Thus, they are a perfect candidate for a Hare-like capital raise to remove the risk and stabilize the balance sheet. Given the current valuation, this capital raise would actually be beneficial, rather than dilutive.
Liquidity and Float
Root likes to point to its $679M of cash and $167M of invested assets as “proof” that it has sufficient resources to handle any cash burn from future operating losses.
But this is a very misleading way to look at their resources. We all know what float is. It’s the cash you collect upfront to pay future claims.
In other words, float is an obligation. It’s more like restricted cash than free cash. It is thus not available to fund operating losses.
So how much of Root’s $850M of cash & investments is truly available for corporate uses? Let’s investigate.
Float
There are two main places on the balance sheet we find liabilities related to float – reserves and unearned premium.
Reserves should be self-explanatory. If the reserves are accurate, then that amount will come out of cash & investments when the claims are paid.
Root’s reserves are $284M on the balance sheet. However, that’s a gross number.
The net disclosure is $240M. All of this must be paid out of the $856M of “cash”, so we are now down to $616M.
Unearned premium is another source of float. The cash has already been received, but hasn’t even been earned yet. From a liquidity perspective, this is pure float. It’s cash in, no claims out.
Because it is reported only as unearned premium, and not “unreserved claims”, we have to estimate how much of the $284M of UEP will need to come out of cash & investments in the future.
The simplest adjustment is to multiply UEP by Root’s loss ratio of 83%. This amounts to $235M. So now our liquidity of $616M is further reduced to $381M.
Debt and Other Adjustments
There are other flows on the balance sheet beyond float that need to be trued up to fully assess Root’s net liquidity. Unfortunately, we can only estimate these from the balance sheet, but let’s make a few obvious adjustments.
There are premiums receivable (e.g. people paying monthly, rather than upfront) of $247M, which will add to cash. Subtract from this $54M of reinsurance premium payable and $66M of accounts payable, and we have a net benefit of $127M.
Adding that $127M back to the $381M, means Root has $500M of net liquidity. So all good, right???
Not so fast. We left out one other piece. Root has a $300M debt maturity due in 2027.
It is unclear if they can refinance that. Also, between now and then, they have a debt covenant requiring them to maintain $200M of cash.
So, at best, they have $300M of net liquidity, including the covenant. If we assume they can’t refinance the debt, then it’s just $200M free.
How long will that last them? To answer that, we have to look at the projected cash burn.
Cash Burn
Before getting started, one helpful metric to share is, over the last 3 years, Root’s paid losses have equaled 100% of premium…no not 100% of incurred, but 100% of premium!
It’s hard to stop cash burn when that’s the case. So do we think they can improve this going forward?
It is rather difficult to accurately model the cash burn from public financials, at least to the number of decimal points I would prefer. But we can do a fairly decent approximation.
The simplest place to start is to compare net income to the cash flow statement. One important reminder when looking at cash flow, you can’t stop at cash flow from operations like with a “regular” company.
The float means changes in the investment balances must be captured. My back of the envelope approach is to look at total change in cash, adjusting out any capital raises (which are clearly non-operating).
Using this approach (and skipping a whole lot of steps for brevity), Root’s cash burn last year was $65M better than its net loss.
However, there are reasons to think this may have had some non-recurring benefits, principally due to changes in reinsurance.
Root cut its ceded premium from 55% in ’22 to 27% in ’23. This is very beneficial to cash flow as net premiums rise (from the lower cede), while the increased future claims won’t be paid immediately.
In other words, cutting reinsurance usage temporarily increases your float. Since this cash flow benefit won’t recur in 24, I estimate cash burn will likely be fairly similar to net income.
So what will net income look like in ’24? Let’s try to figure that out.
2024 Earnings
Needless to say, it’s not easy forecasting Root’s EPS. They have had huge volatility in their loss ratio and expenses have been stubbornly high.
Results have been improving of late (which is part of why the stock has taken off). It is hard to know if this is sustainable or an aberration. There are arguments both ways, which I will punt on for the moment.
For now, let’s assume they can maintain the progress they made in Q4. Earned premiums probably grow to something like $600M in ’24.
Their Q4 CR was a 112 (down from 150ish!), so let’s call it a 110 for ’24. That’s a $60M underwriting loss.
Beyond that, there is investment income and interest expense. The latter is greater than the former, so let’s call net loss and cash burn $75M.
But that assumes Q4 was a run rate. What if it’s more like the 150 CR from earlier in the year? Now we’re burning closer to $300M!
That’s obviously a wide range. I’ll use something in the middle and say it’s a 125 CR and cash burn is near $150M. That would leave one to two years of cash runway.
Note, even if they get to a 95 CR, cash generation will only be modestly positive due to the high interest expense and the increase in paids flowing through from the decrease in reinsurance usage.
So, long story short, Root is not out of the woods on cash burn. While their outlook has improved over where it was a year ago, it would still be prudent to raise more capital to put the issue to rest.
The Proposed Capital Raise
My suggestion is Root should raise $300M of equity. This would pre-fund the 27 debt maturity which takes a major risk off the table.
I assume it would have to be at a lower price than today’s. That’s OK. For conservatism (and to make math simple for me), I’m going to assume they raise at $55 (close to 5X today’s BV!).
This would add 5.4M shares and take the total share count to 20M even. Equity would increase to $466M which would make book value $23.30, more than double the starting point of ~$11.50.
That’s right you can increase the share count nearly 40% and still double the book value! That shouldn’t be possible, but that’s what a Hare valuation allows you to do.
Earnings Power
What will raising equity do to earnings? Well, as long as Root is losing money, it will reduce the loss per share.
But let’s be forward looking to a day when they can be profitable. If they can get to a 95 CR in the future, that’s $30M on $600M of EP.
Once they can pay down the debt, the interest expense disappears, so now NII will fall to the bottom line. Let’s call that another $30M.
So, that’s $60M. Given the tax NOL, no tax will be owed, but since we’re doing earnings power, it makes sense to put tax in there. That drops it to $48M net income, which is just over a 10% ROE.
This is $2.40/sh, which means the stock is probably worth something like $30. Thus, raising at $55 is a tremendous opportunity, even if it’s not $80.
Remember, there is no assurance Root can get to a 95 CR. Actual future earnings could be a lot lower.
What happens if they don’t raise the capital? Then, they still have the large interest expense and $30M of underwriting income would lead to about $15M of net income. On the current share count, that’s EPS of ~$1/sh.
So, just like a capital raise could double book value, it can also double earnings.
Time Is of the Essence
Like I said upfront, this raise should have already happened. I don’t know what Root is waiting for. They likely can get a deal done in the $60s, if they move quickly.
There is nothing more value enhancing the company can do than raise money at these valuations. It is a gift. If I were a shareholder and the company did not raise equity here, I would sue the board for negligence!!!
I don’t have a position in the stock (and certainly wouldn’t start one in the $80s), but I hope this piece finds its way to the board quickly. The opportunity may not last long.