The selected statements of operations, balance sheet, and other data presented below should be read with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this report. The selected statements of operations and balance sheet data are derived from our audited consolidated financial statements included elsewhere in this report and our previously audited financial statements that are not included herein. Our historical results are not necessarily indicative of the results to be expected in any future period.
The following tables set forth our key operating metrics for our subscription business for the periods ended December 31, 2017, 2016 and 2015, and for each of the last eight fiscal quarters.
Total subscription pets enrolled. Total subscription pets enrolled reflects the number of pets in active memberships at the end of each period presented. We monitor total subscription pets enrolled because it provides an indication of the growth of our subscription business.
Monthly average revenue per pet. Monthly average revenue per pet is calculated as amounts billed in a given month for subscriptions divided by the total number of subscription pet months in the period. Total subscription pet months in a period represents the sum of all pets enrolled for each month during the period. We monitor monthly average revenue per pet because it is an indicator of the per pet unit economics of our business.
Lifetime value of a pet. Lifetime value of a pet (LVP) is a business operating metric that we believe reflects the lifetime value we might expect from a new pet enrollment. We calculate LVP based on gross profit from our subscription business segment for the 12 months prior to the period end date excluding stock-based compensation expense related to cost of revenue from our subscription business segment, sign-up fee revenue and the change in deferred revenue between periods, multiplied by the implied average subscriber life in months. Implied average subscriber life in months is calculated as the quotient obtained by dividing one by one minus the average monthly retention rate. We monitor LVP to assess how much lifetime value we might expect from new pets over their implied average subscriber life in months and to evaluate the amount of sales and marketing expenses we may want to incur to attract new pet enrollments.
Average monthly retention. Average monthly retention is measured as the monthly retention rate of enrolled subscription pets for each applicable period averaged over the 12 months prior to the period end date. As such, our average monthly retention rate as of December 31, 2017 is an average of each month’s retention from January 1, 2017 through December 31, 2017. We calculate monthly retention as the number of pets that remain after subtracting all pets that cancel during a month, including pets that enroll and cancel within that month, divided by the total pets enrolled at the beginning of that month. We monitor average monthly retention because it provides a measure of member satisfaction and allows us to calculate the implied average subscriber life in months.
We generate revenue in our subscription business segment primarily from subscription fees for our pet medical insurance. Fees are paid at the beginning of each subscription period, which automatically renews on a monthly basis. In most cases, our members authorize us to directly charge their credit card, debit card or bank account through automatic funds transfer. Subscription revenue is recognized on a pro rata basis over the monthly enrollment term. Membership may be canceled at any time without penalty, and we issue a refund for the unused portion of the canceled membership.
We generate revenue in our other business segment primarily from writing policies on behalf of third parties where we do not undertake the direct consumer marketing. This segment includes the writing of policies that may be materially different from our subscription.
Veterinary invoice expense includes our costs to review veterinary invoices, administer the payments, and provide member services, and other operating expenses directly or indirectly related to this process. We also accrue for veterinary invoices that have been incurred but not yet received. This also includes amounts paid by unaffiliated general agents, and an estimate of amounts incurred and not yet paid for our other business segment.
Other cost of revenue for the subscription business segment includes direct and indirect member service expenses, Territory Partner renewal fees, credit card transaction fees and premium tax expenses. Other cost of revenue for the other business segment includes the commissions we pay to unaffiliated general agents, costs to administer the programs in the other business segment and premium taxes on the sales in this segment.
Technology and development expenses primarily consist of personnel costs and related expenses for our technology staff, which includes information technology development and infrastructure support, third-party services and depreciation of hardware and capitalized software.
Year ended December 31, 2017 compared to year ended December 31, 2016. Cost of revenue for our subscription business segment was $176.9 million, or 81% of revenue, for the year ended December 31, 2017, compared to $141.3 million, or 82%, of revenue for the year ended December 31, 2016. This $35.6 million increase in subscription cost of revenue was primarily the result of a 15% increase in subscription pets enrolled, resulting in a 25% increase in veterinary invoice expense and related internal processing costs. As a percentage of revenue, these costs decreased to 71% for the year ended December 31, 2017 from 72% for the year ended December 31, 2016, due to the increase in monthly average revenue per pet outpacing the cost of veterinary care for certain subcategories as we more accurately priced those subcategories. Cost of revenue for our other business segment increased $9.1 million to $22.7 million for the year ended December 31, 2017, due to an increase in enrolled pets in this segment.
Year ended December 31, 2016 compared to year ended December 31, 2015. Cost of revenue for our subscription business segment was $141.3 million, or 82% of revenue, for the year ended December 31, 2016, compared to $109.4 million, or 82% of revenue, for the year ended December 31, 2015. This $31.9 million increase in subscription cost of revenue was primarily the result of a 19% increase in subscription pets enrolled, resulting in a 31% increase in veterinary invoice expense and related internal processing costs. As a percentage of revenue, these costs were 72% for the years ended December 31, 2016 and 2015. Average revenue per pet increased for the year ended December 31, 2016, however the impact of this on gross margin was offset by an increase in compensation expense by $2.1 million, or 17%, related to increases in headcount to service growth and improve member experience. Cost of revenue for our other business segment increased $1.3 million to $13.6 million for the year ended December 31, 2016, due to an increase in enrolled pets in this segment.
Year ended December 31, 2016 compared to year ended December 31, 2015. Technology and development expenses decreased $1.7 million, or 15%, to $9.5 million for the year ended December 31, 2016. This decrease was partially due to a $2.7 million decrease in professional services and compensation expense and related costs as headcount decreased 36% in this department. This was partially offset by a $1.2 million increase in depreciation expense, driven by several projects being placed into service during 2016.
Year ended December 31, 2017 compared to year ended December 31, 2016. General and administrative expenses increased $1.6 million, or 11%, to $16.8 million for the year ended December 31, 2017. This was primarily due to an increase of $1.0 million related to higher rent and occupancy costs after our move to a new building in the third quarter of 2016. General and administrative expenses decreased from 8% to 7% as a percentage of revenue for the year ended December 31, 2017, as we experienced scale in our support functions.
Year ended December 31, 2016 compared to year ended December 31, 2015. Sales and marketing expenses remained consistent at $15.2 million for the years ended December 31, 2016 and 2015. PAC decreased 7% from December 31, 2015 to $123 for the year ended December 31, 2016. Headcount within the sales and marketing department increased by 30% in the year ended December 31, 2016. This cost was offset by a decrease in the use of third-party vendors. Our core sales and marketing initiatives remained consistent each year.
The following tables contain selected quarterly financial information for the years ended December 31, 2017 and 2016. The unaudited quarterly information has been prepared on a basis consistent with the audited consolidated financial statements and includes all adjustments that we consider necessary for a fair presentation of the information shown. These quarterly operating results for any fiscal quarter are not necessarily indicative of the operating results for any full fiscal year or future period.
Our primary sources of liquidity are cash provided by operations and available borrowings on our line of credit. 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 $9.7 million for the year ended December 31, 2017 compared to cash provided by operating activities of $5.0 million for the year ended December 31, 2016. The increase in cash provided by operating activities of $4.7 million was primarily due to the $4.1 million decrease in operating loss, driven by higher revenue and decreased operating expenses as a percentage of revenue as we increased scale in our technology and general and administrative departments.
Net cash used in investing activities for each of the periods presented was primarily related to the net purchase of investments to increase our statutory capital. As of December 31, 2017, we had $40.8 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. Our regulators may increase the required levels of risk-based capital in the future, and we anticipate that we will need to maintain greater amounts of risk-based capital if our pet enrollment continues to grow.
Cash used in financing activities for the year ended December 31, 2015 was $14.2 million. For the year ended December 31, 2016, cash provided by financing activities increased by $21.9 million primarily due to borrowings under our line of credit of $5.0 million, as compared to payments on our line of credit of $14.9 million, for the years ended December 31, 2016 and 2015, respectively.
In December 2016, we entered into a syndicated loan agreement with Pacific Western Bank (PWB) and Western Alliance Bank (WAB) that increased our previous facility from $20.0 million to $30.0 million. The agreement was amended during the current year to extend the maturity date to December 2019. We refer to the restated and amended loan and security agreement 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 $30.0 million or the total amount of cash and securities held by our insurance subsidiaries (APIC and WICL), less $1.8 million for obligations we have outstanding from PWB and/or WAB for other ancillary services and our letter of credit. 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 (5.75% at December 31, 2017).
Critical accounting policies and estimates are those that we consider the most important to the portrayal of our financial condition and results of operations because they require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Generally, we base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates.
The reserve for our subscription business represents our estimate of the future amount we will pay for veterinary invoices that are dated as of, or prior to, our balance sheet date. The reserve also includes our estimate of related internal processing costs. To determine the accrual, we make assumptions based on our historical experience, including the number of veterinary invoices we expect to receive, the average cost of those veterinary invoices, the length of time between the date of the veterinary invoice and the date we receive it, the member's chosen deductible, and our expected cost to process and administer the payments. As of each balance sheet date, we reevaluate our reserve and may adjust the estimate for new information.
For the year ended December 31, 2017, we paid $7.8 million for veterinary invoices dated on or before December 31, 2016, including related processing costs. Our reserve estimate for these expenses was $8.5 million as of December 31, 2016. As of December 31, 2017, we reevaluated the remaining reserve for those periods prior to December 31, 2016 and recorded an adjustment to our income statement to reduce it by $0.1 million. As of December 31, 2017, our reserve was $11.1 million, consisting of $10.4 million for the amount we expect to pay in the future for veterinary invoices dated between January 1, 2017 and December 31, 2017, inclusive of related processing costs, as well as the adjusted reserve of $0.7 million for periods prior to 2017.
Similarly, for the years ended December 31, 2016 and 2015, we adjusted our reserve for prior periods, increasing it by $0.8 million and less than $0.1 million, respectively. These adjustments were recorded in our income statement for each respective year.
On December 22, 2017, the U.S. government enacted the Tax Act, making broad and complex changes to the Code. As a result, we have made significant judgments and estimates in accordance with our understanding of the Tax Act and available guidance as of our date of filing. We may identify newly relevant information or adjust our interpretation of the requirements as additional guidance on the Tax Act becomes available. If an adjustment is required, it may materially change our income tax benefit or expense in the period in which the adjustment is made.
We have audited the accompanying consolidated balance sheets of Trupanion, Inc. (the Company) as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive loss, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2017, 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, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
Trupanion, Inc. (collectively with its wholly-owned subsidiaries, the Company) provides medical insurance for cats and dogs throughout the United States, Canada and Puerto Rico. The Company believes its data-driven, vertically-integrated approach makes its subscription the highest value for pet owners, with pricing specific to each pet’s unique characteristics. The Company strives to operate the business similar to other subscription-based businesses, with a focus on maximizing the lifetime value of each pet while sustaining a favorable ratio of lifetime value relative to pet acquisition cost, based on the Company's desired return on investment.
The Company considers any cash account that is contractually restricted to withdrawal or use to be restricted cash. The Company is party to a financing agreement requiring a restricted cash balance. As of December 31, 2017, the Company was in compliance with all requirements.
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 for the years ended December 31, 2017, 2016 and 2015 were $1.0 million, $0.7 million and $0.6 million, respectively. Amortized deferred acquisition costs classified within sales and marketing amounted to $1.7 million, $1.4 million and $1.5 million, and amortized deferred acquisition costs classified within other cost of revenue amounted to $13.2 million, $10.7 million and $8.6 million, for the years ended December 31, 2017, 2016 and 2015, respectively.
The Company's financial instruments, in addition to those presented in Note 6, 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.
Indefinite-lived intangible assets are not amortized. The Company reviews these assets for impairment at least annually or if indicators of potential impairment exist.
Reserve for veterinary invoices is an estimate of the future amount the Company will pay for veterinary invoices that are dated as of, or prior to, its balance sheet date. The reserve also includes the Company's estimate of related internal processing costs. To determine the accrual, the Company makes assumptions based on its historical experience, including the number of veterinary invoices it expects to receive, the average cost of those veterinary invoices, the length of time between the date of the veterinary invoice and the date the Company receives it, the member's chosen deductible, and the Company's expected cost to process and administer the payments.
Other income of $1.2 million for the year ended December 31, 2017 included the gain of $1.0 million from the sale of the Company's equity method investment in June 2017. Interest income of $0.2 million, $0.1 million, and $0.1 million was recorded in other income for the years ended December 31, 2017, 2016, and 2015, respectively.
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 $4.9 million, $4.0 million and $5.3 million, in the years ended December 31, 2017, 2016 and 2015, respectively.
Compensation expense related to stock-based transactions, including employee and non-employee stock option awards, and 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 volatility -The Company estimates the expected volatility based on the historical volatility of a representative group of publicly traded companies with similar characteristics to the Company, and its own historical volatility;
(SAC) Limited (WICL), and entered into a revised fronting and reinsurance arrangement with Omega General Insurance
until after 2016, at which time dividends will be allowed subject to the Segregated Accounts Company Act of 2000, which
Financial instruments which potentially subject the Company to concentration of credit risk consist primarily of cash and cash equivalents, and investments. The Company manages its risk by investing cash equivalents and investment securities in money market instruments and securities of the U.S. government, U.S. government agencies and high-credit-quality issuers of debt securities.
In November 2015, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) amending the accounting for income taxes and requiring all deferred tax assets and liabilities be classified as non-current in the consolidated balance sheets. The Company adopted this ASU as of January 1, 2017 and has retrospectively applied the provisions of this standard.
Depreciation expense related to property and equipment, inclusive of assets purchased on capital lease, was $4.2 million, $3.8 million and $2.5 million for the years ended December 31, 2017, 2016 and 2015, respectively.
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 the recovery of the amortized cost basis which may be at maturity.
The Company measures the fair value of restricted cash, foreign deposits, and money market funds based on quoted prices in active markets for identical assets. The fair value of the municipal bond is based on either recent trades in inactive markets or quoted market prices of similar instruments and other significant inputs derived from or corroborated by observable market data.
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, 2017.
The reserve for veterinary invoices is an estimate of the future amount the Company will pay for veterinary invoices that are dated as of, or prior to, its balance sheet date. The reserve also includes the Company's estimate of related internal processing costs. The reserve estimate involves actuarial projections, and is based on management's assessment of facts and circumstances currently known, and assumptions about anticipated patterns, including expected future trends in the number of veterinary invoices the Company will receive and the average cost of those veterinary invoices. The reserve is made for each of the Company's segments, subscription and other business, and are continually refined as the Company receives and pays veterinary invoices. Changes in management's assumptions and estimates may have a relatively large impact to the reserve and associated expense.
In the following tables, cumulative number of veterinary invoices represents the total number received as of December 31, 2017, 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 2014 through 2016 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, 2017.
In the following tables, amounts are by year the veterinary invoice relates to, referred to as the year of occurrence. Amounts in these tables are presented on a constant currency basis to remove the impact of changes in the foreign currency exchange rate. The cumulative amounts paid as of the end of each year are revalued using the currency exchange rate as of December 31, 2017. Information for years 2014 through 2016 is provided as required supplementary information.
The following table summarizes the amounts paid for veterinary invoices, inclusive of related internal processing costs and reported on a constant currency basis, for the other business segment (in thousands):
The Company has a revolving line of credit of up to $30.0 million, secured by any and all interests in the Company's assets that are not otherwise restricted. Interest on the revolving line of credit is payable monthly at the greater of 4.5% or 1.25% plus the prime rate (5.75% at December 31, 2017). The borrowing agreement includes other ancillary services and letters of credit of up to $4.5 million as of December 31, 2017. The facility also requires a deposit of restricted cash of $0.6 million. The agreement was amended during the current year to extend the maturity date to December 2019. The credit agreement requires the Company to comply with various financial and non-financial covenants. As of December 31, 2017, the Company was in compliance with all covenants.
As of December 31, 2017, for all employees, the Company had 991,754 unvested stock options and 256,842 restricted stock awards and restricted stock units that are expected to vest. Total stock-based compensation expense of $5.7 million related to unvested stock options and $0.9 million related to unvested restricted stock awards and restricted stock units is expected to be recognized over a weighted-average period of approximately 2.7 years and 1.3 years, respectively.
The following table presents information regarding stock options granted, exercised and forfeited for the periods presented:
As of December 31, 2017, stock options outstanding and stock options exercisable had a weighted average remaining contractual life of 5.4 years and 4.3 years, respectively.
The weighted-average grant date fair value of stock options granted and the fair value of options vested were as follows for the years ending December 31, 2017, 2016, and 2015:
The below table summarizes the Company’s restricted stock award and restricted stock unit activity for the years ending December 31, 2017, 2016 and 2015:
The Company has two segments: subscription business and other business. The subscription business segment includes monthly subscriptions 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.
The following table presents the Company’s revenue by geographic region of the member (in thousands):
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 $2.7 million during the year ended December 31, 2017. No dividends were paid during the years ended December 31, 2016 and 2015.
As of December 31, 2017, the Company’s insurance subsidiary in New York maintained $37.2 million of statutory capital and surplus which was above the required amount of $22.2 million of statutory capital and surplus to avoid additional regulatory oversight. As of December 31, 2017 and 2016, the Company had $6.6 million on deposit with various states in which it writes policies.
The Company is sometimes party to arrangements with the father and brother of the Company’s Chief Executive Officer, who both serve as independent contractors to develop veterinary relationships. The terms of the independent contractor agreements are consistent with the terms of other similar independent contractors that do business with the Company. Total amounts paid to the related parties were less than $0.5 million for each year ended December 31, 2017, 2016, and 2015.
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. The Company has calculated its best estimate of the impact of the Tax Act for the year ended December 31, 2017, based on its understanding of the Tax Act and guidance available as of the date of filing, and recorded an income tax benefit of $0.6 million.
At December 31, 2017, the Company had federal net operating loss carryforwards of $86.7 million and federal credits of $0.2 million. Use of the carryforwards is limited based on the future income of the Company. The federal net operating loss carryforwards currently would begin to expire in 2026. Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of the Company’s net operating loss carryforwards and credit carryforwards may be limited if the Company experiences an ownership change. As of December 31, 2017, the utilization of approximately $0.5 million of net operating losses are subject to limitation as a result of prior ownership changes; however, subsequent ownership changes may further affect the limitation in future years.
A valuation allowance is required to reduce the deferred tax assets reported if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. After consideration of all the evidence, both positive and negative, the Company has recorded a full valuation allowance against its deferred tax assets as of December 31, 2017 and 2016 because the Company’s management has determined that it is more likely than not that these assets will not be fully realized.
The Company accounts for uncertain tax positions based on a two-step process of evaluating recognition and measurement criteria. The first step assesses whether the tax position is more likely than not to be sustained upon examination by the taxing authority, including resolution of any appeals or litigation, on the basis of the technical merits of the position. If the tax position meets the more-likely-than-not criteria, the portion of the tax benefit greater than 50% likely to be realized upon settlement with the relevant tax authority is recognized in the financial statements. No significant changes in uncertain tax positions are expected in the next twelve months.
The Company has a 401(k) plan for its U.S. employees. The plan allows employees to contribute a percentage of their pretax earnings annually, subject to limitations imposed by the Internal Revenue Service. The plan also allows the Company to make a matching contribution, subject to certain limitations. To date, the Company has made no contributions to the 401(k) plan.
The following table contains quarterly financial data for the years ended December 31, 2017 and 2016 (in thousands, except per share data). The unaudited quarterly information has been prepared on a basis consistent with the audited consolidated financial statements and includes all adjustments that the Company considers necessary for a fair presentation of the information shown. The operating results for any fiscal quarter are not necessarily indicative of the operating results for a full fiscal year or any future period and there can be no assurances that any trend reflected in such results will continue in the future.