#171: Rebuttal To Some Trupanion Hate $TRUP; Discussing the Toxicity Of Twitter $TWTR

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Summary

I received this email last year about Trupanion and wanted to
address some points made. The entire email is here:


Hi Eric,
  I come in peace as a Chester County native who still
very much prefers Wawa over Sheetz, despite living in Pittsburgh.
You seemed very open to hearing counterpoints, as per your podcast
on TRUP, so I wanted to give you some things to chew on. 
  You made two points (I'll summarize): 1) It is justifiable
to exclude development expenses from IRR and 2) there are "no
accounting shenanigans" going on.    I would love, then,
to hear your thoughts on the following:   Let's first level
set with the IRR methodology: the company allocates fixed
expenses between Subscription and Other based on their
relative revenue contributions. This includes a pro-rata allocation
of G&A expenses.    So let's get into G&A
expenses -- what's in there? Typical back office stuff, finance,
accounting, etc. But also a couple million bucks of rental
income related to subleasing of the company HQ. Per their 2019
10-K: "The change was primarily due to a $3.1 million increase in
compensation expenses, a $0.8 million increase in professional
service fees, and a $1.5 million increase in depreciation expense
mainly due to owning our home office building since August
2018, partially offset by a total of $2.6 million in savings
from additional lease income and less rental expense."  
The rental income has the effect of reducing reported G&A (i.e.
it's netted against expenses). So my first question for you is
as follows: if you firmly believe development expenses that aren't
related to acquiring new pets are justifiably excluded from IRR
calculations, how are you comfortable with several million dollars
of sublease income that's clearly not related to acquiring
subscription pets benefitting IRR?   Next up is their pet-food
VIE. Also from the 10-K: The Company has also entered into a
series of agreements to provide ancillary services to
the variable interest entity at cost. The Company
provided $1.2 million and $1.4 million of these services
for the years ended December 31, 2020 and 2019, respectively,
which were recorded against its operating expenses.   So TRUP
provides back office support to the VIE and reduces its reported
opex to account for the compensation for providing the
services.    So the next question is the same as the
first: Would you bucket this in line with "development expenses" as
being rightly excluded from IRR, or are you OK with the company
getting the tailwind from the expense reduction?   Now here's
where the situation becomes a bit more nefarious. The VIE has
received a total of $9.5 million of funding from TRUP, including
$7.0MM of preferred capital and $2.5MM from a line of credit. Think
for a minute about what's going on here: the company pushed $9.5MM
of cash down to another legal entity, and now reduces its reported
OpEx for services provided to the VIE, with the payments being
made with money TRUP used to finance the VIE. Money coming out of
one pocket and right into the other.    Third question:
Do you think this is an accounting shenanigan?   Lastly,
management knows PAC is getting out of hand and pulled a fast one
in the first quarter to make it look like they've got things under
control. Aren't you the slightest bit curious how they're going to
hold PAC at $280 for the balance of this year in an increasingly
competitive environment?   Management casually slipped in the
following comment during the earnings call: "We expect stock-based
compensation to be around $6-$7 million per quarter for the
remainder of the year." Coupled with the $8.4 million of SBC
already booked in 1Q'21, TRUP is on track to recognize $28
million of SBC expense in 2021. Putting this figure into
perspective, it is 3x higher than last year's $8.9 million
of total recognized SBC expense. Last year SBC
expense was 1.8% of revenue; this year it will be 4.1%.   What
does SBC have to do with PAC and IRR?    Well, for the
purposes of calculating PAC (a key input into the IRR calculation),
management excludes SBC because it's non-cash. By upping
the portion paid in the form of equity, management is artificially
reducing the level of PAC incorporated in their IRR calculation. in
1Q'21, fully-loaded PAC (including SBC) was $328/pet,
representing 22.4% y/y growth. SBC embedded in Sales and Marketing
was $40/pet -- leaps and bounds above historical levels
($20/pet). See the charts at the bottom of the email. Had SBC
been more in-line with historical levels ($20/pet), PAC (for the
purposes of the company's IRR calculation) would have been
~$310...much closer to the full year figure I was expecting.  
This is all a long winded way of saying, if you were to run
the company's IRR calc with PAC of $315 or above, there is
absolutely no way they would be within the boundaries of their
self-imposed 30-40% target range. The only reason they'll print
numbers within range this year is a result of their increased use
of SBC in compensating their employees.     The
table below illustrates Restricted Stock grants (not expense, but
grants) since 1Q'19. The grants in the most recent quarter -- $66
million! -- jump off of the page and explain why SBC will be
elevated in the quarters to come. But don't just take my word for
it. From what I can tell, we both respect Buffett a lot, and here's
what he's got to say on the topic: "I have no objection to the
granting of options. Companies should use whatever form of
compensation best motivates employees -- whether this be cash
bonuses, trips to Hawaii, restricted stock grants or stock options.
But aside from options, every other item of value given to
employees is recorded as an expense."     When it
comes to SBC, RSUs are a functional cash equivalent, so there
is no legitimate justification to exclude the related expense from
any measure of profitability -- GAAP or otherwise.  
      Perhaps using RSUs makes sense for the time
being given the extreme overvaluation of TRUP. Management can
handsomely compensate employees and gloss over the dilutive impact
on the company's financials. But what happens when shares are back
at $30, but territory partners are expecting their compensation to
remain flat in nominal terms? Shareholders will either be 1)
massively diluted or 2) the company would have to lean more heavily
on cash compensation. The latter of the two options is a functional
non-starter at the current juncture given the company's
persistently negative free cash flow (another topic the bulls don't
understand, but I'll let sleeping dogs lie on this one).  
Last question: Do you believe SBC is a true expense? If it is,
should the company be including it in its IRR
calculation?     Management updated guidance, and
frankly, I think the financial outlook is worse than I was
expecting. "Adjusted Operating Income" -- which is ex. SBC,
D&A, and Pet Acquisition -- is forecast at $75MM. PAC -- ex.
SBC -- is forecast at $66MM. That leaves us to $9MM. "Development
expense" will be $4MM (at the mid), SBC is $28MM, D&A will be
$12MM, resulting in a pre-tax net loss of $35MM. This is
larger than the company's cumulative net loss for the past six
years combined!      I know this is a battleground
stock and don't expect everyone to come around. But I also think:
1) there's only one set of correct answers to the questions I've
laid out above, 2) none of the afforementioned points are
"dumb", and 3) management is using sleight of hand to paint a
picture of the company that is out of step with reality.  As
someone who puts a lot of value in associating with the right
people, I certainly don't appreciate the games / shenanigans that
Daryl and team are pulling.      $MM Adjusted
Operating Income 75 - PAC (66) - Development expense (4) - SBC (28)
- D&A (12) Pre-tax Income (35)

 
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Disclosure: Eric Schleien and some SMA clients of Eric Schleien
through GSCM own shares of TRUP. Nothing here is investment
advice. Do your own due diligence.