Laura Bainbridge - MD, ADDO Investor Relations Darryl Rawlings - Founder, CEO, President and Director Tricia Plouf - CFO.

Jonathan Block - Stifel, Nicolaus & Company Michael Graham - Canaccord Genuity Limited James Shaughnessy - RBC Capital Markets Paul Penney - Northland Capital Markets William Kerr - Cowen and Company John Godin - Lake Street Capital Markets.

Greetings, and welcome to the Trupanion Inc. Third Quarter 2017 Financial Results Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Laura Bainbridge, Investor Relations. Thank you. You may begin..

Good afternoon, and welcome to the Trupanion third quarter 2017 financial results conference call.

Before we begin, I would like to remind everyone that during today's conference call, we will make certain forward-looking statements regarding the future operations, opportunities and financial performance of Trupanion within the meaning of the safe harbor provision of the Private Securities Litigation Reform Act of 1995.

These statements involve a high degree of known and unknown risks and uncertainties that could cause actual results to differ materially from those discussed.

A detailed discussion of these and other risks and uncertainties are included in our earnings release, which can be found on the Investor Relations website as well as the company's most recent reports on Form 10-K and 8-K filed with the Securities and Exchange Commission.

Today's presentation contains references to non-GAAP financial measures that management uses to evaluate the company's performance, including, without limitation, fixed expenses, variable expenses, adjusted operating income, acquisition costs, adjusted EBITDA and free cash flow.

When we use the term adjusted operating income or margin, it is intended to refer to our non-GAAP operating income or margin before new pet acquisition. Unless otherwise noted, margins and expenses will be presented on a non-GAAP basis, which excludes stock-based compensation expense and depreciation expense.

These non-GAAP measures are in addition to and not a substitute for measures of financial performance prepared in accordance with the U.S. GAAP.

Investors are encouraged to review the reconciliations of these non-GAAP financial measures to the most directly comparable GAAP results, which can be found in today's press release or on Trupanion's Investor Relations website under the Quarterly Earnings tab.

Lastly, I'd like to remind everyone that today's call is also available via webcast on Trupanion's Investor Relations website. A replay will also be available on the site. With that, I'd like to turn the call over to Darryl, Trupanion's Founder and CEO..

Thanks, Laura. Good afternoon, everyone, and thank you for joining us. Today, I'll review our performance in the third quarter. I'll also provide additional perspective on our plans to invest in foundational initiatives for our long-term growth. Turning to our third quarter highlights, it was truly a standout quarter.

We delivered results ahead of our expectations. Across the organization, we came together to advance some key initiatives. We also deployed additional capital to test pet acquisition initiatives, with encouraging early results. For that, I'm proud of the team and the organization. Shareholders often ask me, what I'm most worried about.

And in recent years, the answer has consistently been execution. I'm confident that we have the right strategy, products and team, but all of those key components don't guarantee consistent high-level execution. In recent months, I'm proud to say that our team has executed at a high level on some fairly challenging initiatives.

We've a lot more work to do, but I'm encouraged by what the team has been able to produce thus far. On the other hand, scaling our business for the long term will take time and cannot be measured in quarters.

While we have plan to deploy a significant portion of our adjusted operating income towards these initiatives, we've recently learned that our initial plans underestimated the level of investment required. You can expect that we will be leveraging our growing adjusted operating income on these initiatives in the coming years.

We do not expect these investments to yield immediate returns, but rather help strengthen our foundation for long-term growth. With that as a backdrop, I'll turn to some financial highlights. Total revenue in the quarter increased 29% year-over-year on a constant currency basis, which is within our long-term annual target of 20% to 30%.

As a percentage of revenue, adjusted operating income expanded by nearly 300 basis points to 11%. Expansion in our adjusted operating margins increases the funds available to invest in pet acquisition and is one of our key strategic initiatives. We continue to target an adjusted operating margin of 15% at operational scale.

Behind the financials, our metrics reflect the solid operational execution I mentioned earlier, where the team did a good job moving the ball forward on a number of initiatives. Lifetime value of a pet grew to $701 in the quarter, reflecting improvements in retention and in optimizing our cost-plus pricing strategy by subcategory.

As lifetime value increases, we are able to increase our allowable tax spend and invest more aggressively in testing of new acquisition initiatives, with a goal of understanding whether they can meet our internal rate of return targets over time.

As planned, we put some of this incremental spend to work in the third quarter, investing in certain direct-to-consumer tests and in same-store sales initiatives. The early results have been encouraging, and we delivered better pet enrollments than we had expected. Based on these early wins, our plan is to continue these efforts.

That said, it's still too early to tell whether these tests will satisfy our internal rate of return requirements longer term, and we also do not know how repeatable these tests will be on a broader scale. In summary, it was a very strong quarter, and the team outperformed in almost all of our key areas.

We're in the business of monthly recurring revenue, which provides good forward visibility. So one should not expect me to use words like standout or great on most calls, but the team really performed this quarter. And for that, I'd like to take the opportunity to thank them publicly.

This work is hard, and building the category around Trupanion will take a long time. I'm proud to work with so many people who love what they do and work hard to advance our mission. That said, we are still in very early days of optimizing and scaling our business.

If we were to highlight one area we fell short, it would be our efforts to accelerate same-store sales. We will remain focused on this initiative, and I expect we'll be increasing our investment in this area. Investments such as this are unlikely to change our near-term growth curve, but we believe they are foundational.

And with that, I'll hand the call over to Trish..

Thanks, Darryl, and good afternoon, everyone. As Darryl said, we are very pleased with our third quarter financial performance. Total revenue of $63.1 million was up 29% year-over-year on a constant currency basis. We had a bit of FX tailwinds in the quarter, and after foreign exchange conversion, total revenue increased 31% year-over-year.

Total enrolled pets increased 21% year-over-year to approximately 404,000 pets as of September 30. Subscription revenue was $56.5 million in the quarter, up 25% year-over-year on a constant currency basis and comprised 90% of total revenue. After foreign-exchange conversion, subscription revenue increased 27% year-over-year.

Once again, subscription revenue benefited from increases in average revenue per pet and new pet additions. Total enrolled subscription pets increased 15% year-over-year to approximately 359,000 pets as of September 30. Monthly average revenue per pet for the quarter was $52.95, an increase of 9% year-over-year.

In local currency, monthly average revenue per pet increased by 9% from the prior year for our U.S. numbers and by 8% for our Canadian numbers. Average monthly retention was 98.61%, consistent with the prior year period.

Retention in the quarter was slightly ahead of our expectations, reflecting strong execution and the benefits from some earlier investments in improving our operational processes.

Our other business revenue, which is generally comprised of our revenue that have the B2B component, totaled $6.6 million for the quarter, an increase of 78% year-over-year. Year-over-year growth in our other business segment reflects an increase in the number of pets enrolled in this segment.

Total enrolled pets in this segment was approximately 45,000 at quarter end. Our other business is not as predictable as our core subscription business. It is strategically valuable, but have different margins and less visibility. We've seen healthy growth in our other business in 2017.

The results of a new relationship enrolling pets have begun to roll on at the beginning of the year. Looking ahead, we expect pets from a different relationship to begin rolling off. As a result, we currently expect pets in this segment to peak in the fourth quarter, but then gradually return to our current level over the next year.

Subscription gross margin was 20% in the quarter, within our annual target of 18% to 21%, and total gross margin was 19%. For the quarter, fixed expenses represented 8% of total revenue, down from 9% in the prior year period, reflecting increased scale in our technology and general and administrative departments.

We're pleased with our continued progress towards our long-term target of 5% of revenue, which we hope to achieve when we have between 650,000 and 750,000 total enrolled pets. Adjusted operating income totaled $7.1 million in the third quarter, a 77% increase from the prior year period. Net income for the quarter was $0.4 million.

As a percentage of revenue, adjusted operating margin expanded approximately 300 basis points year-over-year to 11%, benefiting from solid revenue growth and leverage in our fixed expenses. Turning now to our acquisition costs.

In the third quarter, we spent $4.7 million on pet acquisition for a PAC of $151 as compared to $3.7 million or a PAC of $120 in the prior year period.

This resulted in an LVP-to-PAC ratio of 4.6:1 for the quarter, reflecting our decision to spend more aggressively in testing of new acquisition channels, while still maintaining a strong internal rate of return on our acquisition spend.

As Darryl mentioned, average lifetime value of a pet was $701 in the quarter, a strong improvement from $624 in the prior year period. In the third quarter, we generated net income of $0.4 million or $0.01 per basic and diluted share compared to a net loss of $1.6 million or $0.06 loss per basic and diluted share in the prior year period.

Adjusted EBITDA was $2.4 million in the quarter, up from $0.3 million in the prior year period. Additionally, free cash flow was $2 million, increasing from $0.9 million in the third quarter of 2016. We track free cash flow closely and are pleased that this marked the sixth consecutive quarter of positive free cash flow.

Our third quarter operating cash flow of $3 million, was up from $1.3 million in the prior year period. At September 30, we have $59.3 million in cash, cash equivalents and short-term investments and $7.5 million of long-term debt. I will now turn to our outlook for the full year 2017.

Based on our strong financial performance in Q3 and FX tailwinds, we are increasing our outlook for the full year. Revenue is now expected to be in the range of $241 million to $242 million, representing 28% year-over-year growth at the midpoint.

At this revenue range and assuming a 4:1 LVP to PAC ratio for the fourth quarter, we would expect full year adjusted EBITDA to be in the range of $5 million to $6 million. Also, keep in mind that our revenue projections are subject to conversion rate fluctuations between the U.S. and Canadian currencies.

For our full year guidance, we used an 80% conversion rate in our projections, which was the approximate rate at the end of September. With that, I would like to thank you for your time today. And we will now open up the call for questions..

[Operator Instructions]. Our first question is coming from the line of Jon Block with Stifel..

Maybe first question, Darryl, if you can just talk to where you are with the pricing by subcategory. I know that sort of a big initiative of yours this year. You're making steady progress. I think you mentioned, maybe getting it down to 10%-ish exiting the year.

Maybe you can just talk to how that's been trending over the past few months or quarters?.

Well, I think the increase in our lifetime value up to $701 is an indication that we're making - continue to make good progress. And I still think that 10% is a good target by the end of the year..

Okay. And then anymore like that you can give - any more color that you can give on some of your testing. I know it's early. I know you're filing it.

You're not getting too excited, but just any mediums that are working better than you would expected as you go out into the marketplace? And maybe if you can talk about your success when you may be leverage or couple it with your Trupanion Express?.

Well, so I think they are 2 kind of key areas. Our same-store sales initiatives, we are pleased with the progress we're making on an individual store level. But we really need to drive higher velocity in that, a little bit behind what we thought.

The kind of direct-to-consumer spending which we're layering on markets or testing in markets where we have greater number of active hospitals recommending us. We continue to learn on that. We've done a couple of rounds of testing. And I think our messaging is getting better and the team is getting more sophisticated.

We actually enrolled more pets this quarter in Q3 than we had anticipated. So we're encouraged by those results. It's too early for us to know what the retention rates are going to be like and lifetime value of those pets. So we don't want to go out and celebrate yet. But we feel like we continue to get a little bit better.

But we are still convinced that it only works in places where we have a very strong relationship with veterinarians on a market-by-market basis..

Okay. And last one from me, and then I'll hop offline. With those conversion rates, you guys are sort of leader or the leader in the category and out there with your Territory Partners.

I know you're stimulating demand for the industry and obviously, you don't want to have sort of that leaky bucket, and you talked in the past, Darryl, about certain initiatives are improving the conversion rates.

How do you think you guys are sort of exiting '17 versus where you were at the beginning of the year?.

Thanks, Jon. We made decent progress on conversions during the year. Conversion rates are one of our key initiatives that we talk about at our annual shareholder meeting. We had some really good results in Q3. One of the reasons we had better results than we were anticipating on conversion rates, I think there is still a great deal of opportunity.

But they will ebb and flow over the next several years. Conversion rates are take a lot of execution. It takes a lot of people to things move. But I've been pleased with the progress this year so far..

Our next question is coming from the line of Michael Graham with Canaccord..

So I guess, the first question, Darryl, is you made the comment in your prepared remarks about the investment that you need to make is a lot larger than what you had previously thought.

Can you just possibly put a little more depth around that and remind us sort of what the guardrails are around how you think about maximum investment levels?.

Yes, so the guardrails are dictated by wanting to be cash flow positive and the amount of our adjusted operating margin. So last call, I think I brought up that. Last year we had about $15 million of adjusted operating margin and spent roughly $15 million acquiring pets.

This year we're tracking to $22 million to $23 million of adjusted operating margin. So we've got more room to be a little bit more aggressive. We think next year, maybe that $30 million and maybe $40 million or $50 million the consecutive years after that. So we have more money to play with. We want to be cash flow positive.

The other guardrails are internal rate of return. And for any significant investments that we're making, we are targeting internal rates of return of greater than 30% and hopefully, closer to 40%.

When we're doing some different testing or some long-term initiatives, maybe they're a little bit lower, but on a blended basis, we want to be over 30%, internal rate of return closer to 40%. So those are probably the guardrails that we're using.

When I talk about how much more we've learned, it's really driven around increasing the velocity of hospitals in our same-store sales initiatives. And order of magnitude may be we'll invest an additional $2 million or $3 million next year than we otherwise would have anticipated. So definitely inside of our guardrails, but long term and foundational..

Okay. That's helpful. And it kind of leads to the second question. You touched on this a little bit, but when you think about net pet additions, you sort of have some different categories that can fuel that same-store sales, new hospitals, maybe direct-to-consumer and maybe higher retention or lower churn.

And I'm just wondering it sounds like you think the biggest opportunity there is in the same-store sales area, but I just wonder if you can sort of help us understand where you see the biggest opportunities within those categories?.

Well, the biggest opportunity, this is the overall market. I mean, we're still in a very low underpenetrated market. And I'll be saying this for the next 5 years. If you look at the number of pets that have some form of medical insurance, we're over 1%, but we're still under 2%. We want to try to grow the category growth.

When we think about how to do that, it's all around veterinarian first and making it normal and key. We have historically been growing the company by adding stores. Over the next few years, we feel it will become important for us to work on the same-store sales.

We don't necessarily need to do that in the next year or 2 to be able to grow consistently in a 20% to 30% revenue targets. But it is an area that we want to get better at. Direct-to-consumer testing is really about building out our brand and helping impact our conversion rates less than increasing the number of leads.

We have the opportunity to add more geographies by bringing more Territory Partners in the market. So we've got a number of levers. The fact that we have an increased adjusted operating margin or more free cash flow that is compounding will make our life easier. But as you mentioned, we have probably 4 or 5 growth levers that we can pull on.

And over the next 2 to 3 years, 4 years, we'll probably be going back and forth between them and trying to get better.

Retention and trying to get to what I talk about is Nirvana, where we have the number of pets turning off being offset by our existing clients telling their friends or adding pets is going to be one of the key initiatives for us for the next 3 to 5 years when we grow our base of pets because at 98.5% monthly retention rate, you're losing a lot more pets when you have a million pets than you do when you have a 100,000.

So that becomes a bigger hurdle rate. So we need to focus on that..

Okay. And then last quick one is, in the past few quarters, you've given us this metric of the percentage of pets that you think are sort of underpriced or suboptimally priced, which has been marching lower.

Do you care to update that metric?.

Yes. Jon Block at Stifel asked a similar question. Last year, as a reminder, about 20% of the pets are - say 12 to 24 months, about 20% of the pets were kind of suboptimized. At the end of last year, we got that down to about 17%, and we're trying to track to about 10% target this year. And I feel like we're making good progress.

The evidence of that progress is higher lifetime value of a pet that comes in as an output, but we remain focused. And I think the team is working hard, and we're doing a good job at it..

The next question is coming from the line of James Shaughnessy with RBC Capital Markets..

Just wanted to get maybe a quick update on the growth - the hiring of the inside sales team that you had mentioned in the past.

And then maybe sort of a high level question, where are you - I guess, where are you today and how are you thinking about this - the right level investment over time?.

So as a reminder, part of our same-store sales initiative is to kind of partner with the Territory Partners who are in the field. That's our outside sales that typically visit a veterinary hospital about once every 60 days. We're trying to augment our support those Territory Partners by having more frequent touchpoints from inside salespeople.

That team right now is still relatively small, but less than 20. Long term, I think that team will become about 100. We still got a lot of learning. We're trying to learn about the skill sets, about the reporting, what the compensation models are. We like the results that we're seeing from it, but it's still early days.

We're one of the - in my opening remarks, I want to increase the velocity of hospitals into that. That's another skill set we need to learn. So I think we'll be spending more and having more investment in that area. But long term, maybe we're 15%, 20% on the way down the field on that.

But as far as all the props and things we need to learn, we're probably 2 to 3 years away of being good at it..

[Operator Instructions]. Our next question is coming from the line of Paul Penney with Northland Capital..

Kind of touch on you just mentioned.

In terms of hiring efforts of late, could you give us just more color in terms of what's happened in Seattle? And in terms of persons you've hired and also in the field, in terms of TPAs, in terms of where you've added or maybe where you see opportunities going forward?.

Well, hiring around Seattle has been relatively consistent. If I was to look over the last 5 or 6 quarters, nothing dramatically has changed. We're really hiring out of animal health. The vast majority of people that we have inside of a building had at onetime work from a vet hospital.

We're not just hiring people from the Seattle area, we're hiring people from throughout North America. We now have about a 100 people that are remote workers that came and maybe work here for 6 months or a year or 2.

We kind of have a variable expense on the number of customers service and claims type people for every 1,000 new pets we have enrolled, how many people we need to add to the field. It's pretty consistent.

As we have more allowable spend to try to grow - drive growth, I think you'll see the sales and marketing team, including the inside sales, kind of expand at a faster rate over the next 2 to 3 years compared to the rest of the organization. And your last question was really about the sales force.

We've been adding a little bit more kind of a second Coca-Cola trucks in some existing markets. Haven't been doing it as good of a job in the last 6 to 12 months in bringing on new markets. I think for the balance of this year and next year, that need to be a bigger focus. I think there's some good opportunity there.

But we've had some nice success in adding people in to some more mature existing markets and getting some good results..

That's helpful. And one last one. In terms of sales and marketing, 20% growth year-over-year in terms of the absolute expense, but with scale that's actually down on a percent of revenue basis.

Is there a percent of revenue target there that you look at or that you not look at it that way?.

My target is to get our adjusted operating profit, which is our compounding internal cash flow from existing people to 15%. And if I can cost effectively deploy 14% of the 15% with strong internal rates of returns, a hurdle rate of 35% to 40%, I'd like to spend off 14% of that if I can. It's yet to be seen.

It will be able to do that at scale when we have $30 million, $40 million, $50 million, $60 million a year to spend. The market is large enough. But we'll have to wait and see if we're good enough in executing in those areas..

The next question is coming from the line of Thomas Champion with Cowen & Company..

This is Bill on for Tom.

Can you just comment on the relationship with Pets Best and perspective for any additional partnerships in 2018?.

We brought Pets Best a couple of quarters ago. They are part of our other revenue. But as a partner to us, we don't really want to highlight or isolate any significant parts of their business. We don't think it's an appropriate thing to do. But in the other revenue, we have typically kind of B2B relationship.

Those relationships in our mind are different than direct-to-consumer because they can bring on a group of pets or leave a group of pets based on a contract renewing. Pets Best rolled on last year. We thought it was significant enough that we needed to bring visibility into the market. But they have been a good partner for us so far.

But there's a bunch of different groups we have in other revenue. And as Trish mentioned in her opening remarks, we have another partner, a group of partners that we expect to starting to roll off.

So although we've had nearly good growth in our other business in this calendar year-to-date, we think it's going to plateau in Q4 and then kind of get back to our Q3 levels by the end of 2018..

The next question is coming from the line of Mark Argento with Lake Street Capital Markets..

This is John on for Mark. Just quickly I wanted to ask about kind of the software integration within the practices.

Just maybe a high level update of how that initiative is going?.

So as a reminder, our goal is to eliminate a slow cumbersome reimbursement model, where a pet owner fills out a bunch of paperwork and puts it in the mailbox and wait for 2 to 3 weeks to see if they are going to get paid.

We think the problem we're solving for pet owners is making it easier for them to budget for if and when their pet become sick or injured. And part of solving that problem is being able to pay hospitals directly at the time of invoice.

Part of that solution is being able to integrate with practice management software in a way that makes the process very quickly. Our goal is to pay these invoices in under 5 minutes from the time those created. We like the results that we're getting.

But we want to speed up the velocity of the - number of places that we're rolling it out now that we're better at it. And we're still in relatively early days to learn how to speed up the velocity, now that we like the results we get on a per hospital basis. We have reached the end of a question-and-answer session.

And this does conclude today's teleconference. We thank you for your participation, and you may disconnect your lines at this time..