(2) Average pet acquisition cost is calculated in part based on net acquisition cost, a non-GAAP financial measure. For more information about net acquisition cost and a reconciliation of sales and marketing expenses to net acquisition cost, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Non-GAAP Financial Measures.”
The following tables set forth our key operating metrics for our subscription business and total enrolled pets for the periods ended December 31, 2018, 2017 and 2016, and for each of the last eight fiscal quarters.
We believe that using net acquisition cost to calculate and present certain of our other key metrics is helpful to our investors and an important tool for financial and operational decision-making and evaluating our operating results over different periods of time. Measuring net acquisition cost by removing stock-based compensation expense and other business segment sales and marketing expense offset by sign-up fee revenue provides for a more comparable metric across periods.
Geographic mix of sales. The relative mix of our business between the United States and Canada impacts the monthly average revenue per pet we receive. Prices for our plan in Canada are generally higher than in the United States (in local currencies), which is consistent with the relative cost of veterinary care in each country. As our mix of business between the United States and Canada changes, our metrics, such as our monthly average revenue per pet, and our exposure to foreign exchange fluctuations will be impacted.
Year ended December 31, 2017 compared to year ended December 31, 2016. Total revenue increased by $54.4 million to $242.7 million for the year ended December 31, 2017, or 29%. Revenue for our subscription business segment increased by $45.0 million to $218.4 million for the year ended December 31, 2017, or 26%. This increase in subscription business revenue was primarily due to a 15% increase in total subscription pets enrolled as of December 31, 2017 compared to December 31, 2016, and increased average revenue per pet of 9% for the same period. Increases in pricing were due to the increased cost of veterinary care and more accurately pricing to our cost-plus margin structure by subcategory. Revenue from our other business segment increased $9.4 million to $24.3 million for the year ended December 31, 2017, or 63%, due to an increase in enrolled pets in this segment.
Year ended December 31, 2018 compared to year ended December 31, 2017. Cost of revenue for our subscription business segment was $216.0 million, or 82% of revenue, for the year ended December 31, 2018, compared to $176.9 million, or 81%, of revenue for the year ended December 31, 2017. This $39.1 million increase in subscription cost of revenue was primarily the result of a 23% increase in veterinary invoice expense. As a percentage of revenue, these costs increased to 72% for the year ended December 31, 2018 from 71% for the year ended December 31, 2017, due to the increases in monthly average revenue per pet lagging slightly behind increases in veterinary invoice expense increases. Cost of revenue for our other business segment increased $13.9 million to $36.6 million for the year ended December 31, 2018, due to an increase in enrolled pets in this segment.
Year ended December 31, 2017 compared to year ended December 31, 2016. Technology and development expenses increased $0.2 million, or 2%, to $9.8 million for the year ended December 31, 2017. This increase was primarily due to a $0.5 million increase in amortization expense related to projects placed in service in late 2016. This was offset by a $0.3 million decrease in infrastructure related costs compared to the same period in the prior year.
Year ended December 31, 2018 compared to year ended December 31, 2017. Sales and marketing expense increased $5.9 million, or 31%, to $25.0 million, while gross subscription new pets increased 20%, to 126,182, and PAC increased 8% for the year ended December 31, 2018. The increase in expense consisted primarily of an additional $3.5 million in compensation expense, due to a 27% increase in headcount, and $2.0 million related to new marketing initiatives.
Year ended December 31, 2018 compared to year ended December 31, 2017. Total other (income) expense, net decreased by $0.6 million primarily due to a $1.0 million gain related to the sale of our equity method investment during prior year, partially offset by higher interest expense in the year ended December 31, 2018, primarily due to higher average debt balances.
Year ended December 31, 2017 compared to year ended December 31, 2016. As a result of the Tax Act, we recorded a decrease of $0.6 million to our net deferred tax liability recorded on our consolidated balance sheet, with a corresponding adjustment to income tax benefit for the year ended December 31, 2017. This tax benefit represents our best estimate of the impact of the Tax Act in accordance with our understanding of the Tax Act and available guidance as of our date of filing.
Our primary sources of liquidity are cash provided by operations and available borrowings on our line of credit. In June 2018, we increased the borrowing capacity on our line of credit from $30.0 million to $50.0 million. In addition, we completed the June 2018 follow-on public offering, raising aggregate net proceeds of $65.7 million, primarily to fund the purchase of our home office building. Our primary requirements for liquidity are paying veterinary invoices, funding operations and capital requirements, investing in new member acquisition, investing in enhancements to our member experience, and servicing debt.
We derive operating cash flows from the sale of our subscription plans, which is used to pay veterinary invoices and other cost of revenue. Additionally, cash is used to support the growth of our business by reinvesting to acquire new pet enrollments and to fund projects that improve our members' experience. Cash provided by operating activities was $12.7 million for the year ended December 31, 2018 compared to cash provided by operating activities of $9.7 million for the year ended December 31, 2017. The increase in cash provided by operating activities of $3.0 million was primarily driven by higher operating income, as well as timing differences between collections from members and payments of veterinary invoices and payments to vendors.
Net cash used in investing activities for the year ended December 31, 2018 was primarily related to the purchase of the corporate headquarters in August 2018. Other major investing activities for each of the periods presented were primarily related to the net purchase of investments to increase our statutory capital. As of December 31, 2018, we had $58.1 million in short-term and long-term investments in our insurance entities, APIC and WICL Segregated Account AX. These investments are held to satisfy statutory requirements and we anticipate that we will need to maintain greater amounts of risk-based capital if our pet enrollments continue to grow.
We have a syndicated loan agreement with Pacific Western Bank (PWB) and Western Alliance Bank (WAB), which we amended in June 2018 to increase the borrowing capacity from $30.0 million to $50.0 million and extend the maturity date to June 2021. The required restricted cash increased to $1.4 million. We refer to this line of credit as our PWB credit facility. The maximum amount available to us under the PWB credit facility, inclusive of any amounts outstanding under the revolving line of credit, is the lesser of $50.0 million or the total amount of cash and securities held by our insurance entities, less amounts outstanding relating to other ancillary services and letters of credit, totaling $0.4 million as of December 31, 2018. Interest on the PWB credit facility accrues at a variable annual rate equal to the greater of 4.5% or 1.25% plus the prime rate (6.75% at December 31, 2018).
Our obligations under the PWB credit facility are secured by substantially all of our assets and a pledge of certain of our subsidiaries’ stock. As of December 31, 2018, we had $13.0 million in aggregate borrowings outstanding under the PWB credit facility.
(1) Consists of our revolving line of credit. Excludes interest of the greater of 4.5% or 1.25% plus the prime rate (6.75% at December 31, 2018).
We determine our deferred tax assets and liabilities based on the differences between the financial reporting and tax basis of assets and liabilities. The deferred tax assets and liabilities are measured using the enacted tax rates that will be in effect when the differences are expected to reverse. A valuation allowance is recorded when it is more likely than not that the deferred tax asset will not be recovered. We apply judgment in the determination of the consolidated financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretation of tax laws and the resolution of any tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements.
To the Stockholders and the Board of Directors of Trupanion, Inc.
We have audited the accompanying consolidated balance sheets of Trupanion, Inc. (the Company) as of December 31, 2018 and 2017, the related consolidated statements of operations, comprehensive loss, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and the financial statement schedule listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.
Receivables are comprised of trade receivables and other miscellaneous receivables. Accounts and other receivables are carried at their estimated collectible amounts.
The Company incurs certain costs, including premium taxes, fees and enrollment-based bonuses, and referral fees that directly relate to the successful acquisition of new or renewal customer contracts. These costs are deferred and are included in prepaid expenses and other assets on the consolidated balance sheet and amortized over the related policy term to the applicable financial statement line item, either sales and marketing expense or other cost of revenue. Deferred acquisition costs as of December 31, 2018 and December 31, 2017 were $1.3 million and $1.0 million, respectively. Amortized deferred acquisition costs classified within sales and marketing amounted to $2.1 million, $1.7 million, and $1.4 million and amortized deferred acquisition costs classified within other cost of revenue amounted to $15.9 million, $13.2 million, and $10.7 million, as of December 31, 2018, 2017, and 2016, respectively.
The Company invests in investment grade fixed income securities of varying maturities. Long-term investments are classified as available-for-sale and reported at fair value with unrealized gains and losses included in accumulated other comprehensive loss. Short-term investments are classified as held-to-maturity and reported at amortized cost. Premiums or discounts on fixed income securities are amortized or accreted over the life of the security and included in interest income. There have been no realized gains and losses on sales of fixed income securities.
The Company's financial instruments, in addition to those presented in Note 7, Fair Value, include cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities. The carrying amounts of accounts receivable, accounts payable, and accrued liabilities approximate fair value because of the short-term nature of these instruments.
Property and equipment primarily consists of building, land and land improvements, office equipment, internally-developed software related to the Company’s website, and internal support systems, capitalized during the application development stage of the project. Property and equipment is recorded at cost and depreciated using the straight-line method over the estimated useful life of the respective asset:
The Company generates revenue primarily from subscription fees and through underwriting policies for unaffiliated general agents. Revenue is recognized pro-rata over the terms of the customer contracts.
Sales and marketing expenses consist of costs to educate veterinarians and consumers about the benefits of Trupanion, to generate leads, and to convert leads to enrolled pets, as well as print, online and promotional advertising costs, and employee compensation and related costs.
Advertising costs are expensed as incurred, with the exception of television advertisements, which are expensed the first time each advertisement is aired. Advertising costs amounted to $6.3 million, $4.9 million and $4.0 million, in the years ended December 31, 2018, 2017 and 2016, respectively.
Compensation expense related to stock-based transactions, including employee and non-employee stock option awards, restricted stock awards, and restricted stock units, is measured and recognized in the financial statements based on fair value. The fair value of restricted stock awards and restricted stock units is the common stock price as of the measurement date. The fair value of stock options is estimated on the measurement date using the Black-Scholes option-pricing model that requires management to apply judgment and make estimates, including:
Expected term for awards granted to employees -The Company has based its expected term for awards issued to employees on the simplified method, as permitted by the SEC Staff Accounting Bulletin No. 110, Share-Based Payment, as the Company has insufficient historical information regarding its stock options to provide a basis for an estimate;
Risk-free interest rate-The risk-free interest rate is based on the yields of U.S. Treasury securities with maturities similar to the expected term of the options; and
The Company’s consolidated financial statements are reported in U.S. dollars. Assets and liabilities denominated in foreign currencies were translated to U.S. dollars, the reporting currency, at the exchange rates in effect on the balance sheet date. Revenue and expenses denominated in foreign currencies were translated to U.S. dollars using a weighted-average rate for the relevant reporting period. Cumulative translation adjustments of $0.7 million, $0.1 million, and $0.4 million were recorded in accumulated other comprehensive loss as of December 31, 2018, 2017, and 2016, respectively.
In June 2018, the Company completed a follow-on public offering (the June 2018 follow-on public offering) whereby the Company sold 2,090,909 shares of common stock at a price to the public of $33.00 per share. The Company received aggregate net proceeds from the June 2018 follow-on public offering of $65.7 million, after deducting underwriting discounts and commissions and offering expenses payable by the Company. The proceeds were primarily used to purchase real estate consisting of properties in use as the Company's home office. In addition, in August 2018, the Company issued 303,030 shares of common stock via a private placement to an accredited investor as a portion of the purchase price of the real estate. See Note 12, Real Estate.
The Company’s real estate acquisition was determined to be an asset acquisition, with the purchase price allocated based on relative fair value of the assets acquired. Additionally, acquisition-related expenses were capitalized as part of the purchase price.
The Company leases a portion of its building to third parties and records related rental income within general and administrative expense in the Consolidated Statements of Operations. The Company recorded rental income of $0.9 million for the year ended December 31, 2018.
The lease-related intangible assets relate to in-place lease agreements associated with the building acquisition in August 2018 and will be amortized over a weighted-average useful life of 5.1 years.
The amortized cost, gross unrealized holding gains and losses, and fair value of long-term and short-term investments by major security type and class of security were as follows as of December 31, 2018 and 2017 (in thousands):
The Company evaluated its securities for other-than-temporary impairment and considers the decline in market value for the securities to be primarily attributable to current economic and market conditions. For debt securities, the Company does not intend to sell, nor is it more likely than not that the Company will be required to sell, the securities prior to maturity or prior to the recovery of the amortized cost basis.
In July 2018, the Company purchased $3.0 million in preferred stock of a privately held corporation with a complementary business line. The Company does not have power over the activities that most significantly impact the economic performance of the variable interest entity and is, therefore, not the primary beneficiary. The Company's investment in preferred stock is accounted for as an available-for-sale debt security. Through January 2020, the Company has agreed to purchase an additional $4.0 million in preferred stock of the variable interest entity, contingent upon the exercise of this option by the variable interest entity. The Company has the option to purchase the variable interest entity on the fifth anniversary of the initial preferred stock purchase. Additionally, the Company has extended a $2.5 million revolving line of credit to the variable interest entity. The Company's investment and amounts loaned under the line of credit are recorded in other long-term assets on the consolidated balance sheet. As of December 31, 2018, outstanding loan balance under the line of credit was $0.6 million. The Company has also entered into a series of agreements to provide ancillary services to the variable interest entity at cost. The Company provided $0.6 million of these services for the year ended December 31, 2018, which were recorded against its operating expenses.
In September 2018, the Company acquired a non-controlling equity interest in a joint venture, whereby it has committed to licensing certain intellectual property and contributing up to $2.2 million AUD upon the achievement of specific operational milestones over a period of at least four years from the agreement execution date. As of December 31, 2018, the Company has contributed $0.3 million AUD.
The Company estimates the fair value of long-term debt based upon rates currently available to the Company for debt with similar terms and remaining maturities. This is a Level 3 measurement. Based upon the terms of the debt, the carrying amount of long-term debt approximated fair value at December 31, 2018 and December 31, 2017.
Certain insurance regulators in the United States have contacted the Company regarding whether employees who had helped prospective members enroll by telephone in prior years were required to have an insurance license to conduct such telephone conversations. To date, the Company has resolved each of these matters in non-material amounts and believes it is compliant with the applicable regulations. The Company is currently engaged with a limited number of state insurance regulators to resolve this same legacy issue and believes it has adequately reserved for these matters.
In the following tables, the cumulative number of veterinary invoices represents the total number received as of December 31, 2018, by year the veterinary invoice relates to, referred to as the year of occurrence. If a pet is injured or becomes ill, multiple trips to the veterinarian may result in several invoices. Each of these veterinary invoices is included in the cumulative number, regardless of whether the veterinary invoice was paid. Information for years 2015 through 2017 is provided as required supplementary information. Amounts in these tables are presented on a constant currency basis to remove the impact of changes in the foreign currency exchange rate on development. The cumulative expenses as of the end of each year are revalued using the currency exchange rate as of December 31, 2018.
As of December 31, 2018, the Company had 475,368 unvested stock options and 451,160 unvested restricted stock awards and restricted stock units. Total stock-based compensation expense of $3.1 million related to unvested stock options and $7.8 million related to unvested restricted stock awards and restricted stock units is expected to be recognized over a weighted-average period of approximately 1.9 years and 2.6 years, respectively.
The grant date fair value of stock option awards are estimated on the date of grant using the Black-Scholes option-pricing model. The Company did not grant any stock options during the year ended December 31, 2018. For the years ended December 31, 2017 and 2016, valuation assumptions are presented in the following table:
The below table summarizes the Company’s restricted stock award and restricted stock unit activity for the years ended December 31, 2018, 2017 and 2016:
In August 2018, the Company purchased real property that houses the company headquarters located at 6100 Fourth Avenue South, Seattle, Washington. The purchase price was $65.2 million, consisting of $55.0 million in cash, 303,030 shares of common stock with an estimated fair value of $9.6 million, and transaction costs totaling $0.6 million. The issued shares are subject to a lock-up period that continues to and includes June 25, 2020. The fair value of the issued shares was estimated as of the closing date for the real estate acquisition using the Black-Scholes option pricing model and the following assumptions:
As of December 31, 2018, the Company had 100,000,000 shares of common stock authorized and 34,025,136 shares of common stock outstanding. Holders of common stock are entitled to one vote on each matter properly submitted to the stockholders of the Company except those related to matters concerning possible outstanding preferred stock. At December 31, 2018, the Company had 10,000,000 shares of undesignated shares of preferred stock authorized for future issuance and did not have any outstanding shares of preferred stock. The holders of common stock are also entitled to receive dividends as and when declared by the board of directors of the Company, whenever funds are legally available. These rights are subordinate to the dividend rights of holders of all classes of stock outstanding at the time. The Company is unable to pay dividends to stockholders as of December 31, 2018 due to restrictions in its credit agreements.
During the year ended December 31, 2018, 330,000 of the Company's outstanding warrants were exercised. Warrants to purchase 480,000 shares of the Company's common stock at $10.00 per share remained outstanding at December 31, 2018, which expire in 2019.
The Company has two segments: subscription business and other business. The subscription business segment includes monthly subscription fees related to the Company’s medical insurance which is marketed directly to consumers, while the other business segment includes all other business that is not directly marketed to consumers.
New York law restricts the ability of the Company's insurance subsidiary in New York to pay dividends to its holding company parent. These restrictions are based in part on the prior year’s statutory income and surplus. In general, dividends up to specified levels are considered ordinary and may be paid without prior approval, and dividends in larger amounts, or extraordinary dividends, are subject to approval by the New York State Department of Financial Services, the subsidiary's primary regulator. An extraordinary dividend or distribution is defined as a dividend or distribution that, in the aggregate in any 12-month period, exceeds the lesser of (i) 10% of surplus as of the preceding December 31 or (ii) the insurer’s adjusted net investment income for such 12-month period, not including realized capital gains. Under regulatory requirements at December 31, 2018, the amount of dividends that may be paid by the Company’s insurance subsidiary in New York to the Company without prior approval by regulatory authorities was $0.7 million. This insurance subsidiary did not pay dividends to the Company during the years ended December 31, 2018, 2017, and 2016.
The Company's insurance subsidiary in Bermuda is regulated by the Bermuda Monetary Authority. Under the Bermuda Companies Act of 1981, as amended, a Bermuda company may not declare or pay a dividend or make a distribution out of contributed surplus if there are reasonable grounds for believing that: (a) the company is, or would be after the payment, unable to pay its liabilities as they become due; or (b) the realizable value of the company’s assets would thereby be less than its liabilities. The Segregated Accounts Company Act of 2000 further requires that dividends out of a segregated account can only be paid to the extent that the cell remains solvent. The value of its assets must remain greater than the aggregate of its liabilities, issued share capital, and share premium accounts. Per our contractual agreements with Wyndham Insurance Company (SAC) Limited, the allowable dividend is equivalent to the positive undistributed profit attributable to the shares. This insurance subsidiary paid the Company a dividend of $2.2 million and $2.7 million during the years ended December 31, 2018 and 2017, respectfully. No dividends were paid during the year ended December 31, 2016.
The statutory net income for 2018, 2017 and 2016 and statutory capital and surplus at December 31, 2018, 2017 and 2016, for the Company’s insurance subsidiary in New York were as follows (in thousands):
As of December 31, 2018, the Company had $6.7 million on deposit with various states in which it writes policies.
Loss before income taxes was as follows for the years ended December 31, 2018, 2017 and 2016 (in thousands):
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) was signed into law making significant changes to the Internal Revenue Code, including, but not limited to, a corporate tax rate decrease to 21% effective January 1, 2018. In accordance with Staff Accounting Bulletin No. 118 ("SAB 118"), the Company recorded a $0.6 million income tax benefit in the prior year as an estimate in relation to remeasurement of its deferred tax liabilities. The Company has now finalized its analysis of the Tax Act's impact and no change to the estimated income tax benefit recorded at December 31, 2017 is required.
A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in thousands):