Waterdrop creatively posts big revenue growth, but at massive cost

The online insurance broker’s new technical services business boomed in the first quarter, but soaring user acquisition costs caused its profit to fall

Key Takeaways:

• Waterdrop’s revenue surged 65% in the first quarter, almost entirely driven by a new technical services income category
• The online insurance broker’s expenses also swelled during the quarter, as it spent heavily to boost traffic on its platform

By Warren Yang

Private fintech companies in China need to stay creative to cope with a constantly changing regulatory environment that often undermines their business, as Beijing takes steps to control risk and protect big state-owned companies. Online insurance broker Waterdrop Inc. (WDH.US) is evidently trying that in response to recent regulatory developments, but investors don’t seem impressed.

At first glance, the company’s financial results for the first quarter, released last week, seem to show its efforts to cultivate a new business are paying off spectacularly after regulators imposed a cap on commission fees insurance brokers can charge for their services. Its net operating revenue for the quarter jumped about 65% year-over-year to 1.24 billion yuan ($180 million). That strong start to the year, if it continues, could help Waterdrop break a three-year streak of annual revenue declines dating back to 2021.

But Waterdrop’s underlying performance looks far less impressive, which may explain why its stock fell 8.5% on the day of the earnings release, and is now down nearly 40% this year. Almost all of its revenue growth came from a new business line called “technical services.” Revenue from this segment skyrocketed to 421 million yuan in the first quarter from just 9.4 million yuan a year earlier. Without this new income source, the company’s revenue would have grown just 10% in the first quarter.

The company laid the groundwork for the new business in 2024, as it began integrating its AI -based software directly into the back-office systems of its insurance carrier customers while trying to figure out how to monetize these services. The monetization part was tricky because the software integration coincided with a fierce regulatory crackdown on commission fees charged by insurance brokers like Waterdrop. To navigate this, instead of including technology service fees in its usual commissions on standard sales, Waterdrop split them out into a separate “technical services income” category.

So, what exactly are these technical services? To provide them, Waterdrop uses its Waterdrop Digital AI platform, which deploys an army of more than 30 purpose-built AI agents. These specialized digital tools handle everything from underwriting inquiries to automated claims processing, managing more than 1 million customer service interactions per month to streamline operations for its insurer partners.

Like the case with anything involving AI these days, Waterdrop’s technology services sound pretty promising, and company management has been hyping them up.

“On the technology front, we are accelerating our shift toward an AI native company,” CEO Shen Peng said on the company’s earnings call. “These technologies will be progressively applied to the insurance scenario, such as intelligent customer service and claims, improving service quality and efficiency.”

But seasoned investors probably see the new services as something different, basically as an old product in new packaging. The key giveaway is that Waterdrop only provides technology services for insurance policies that it facilitates on its platform. That means fees for the services probably would have previously been included in the company’s standard commissions it charges to insurers. But now they are simply being placed in a different category to skirt regulators’ efforts to eradicate the practice of including disguised technology fees in commissions. In its latest financial statement, the company includes technology service fees in an “insurance-related income” category, which also includes brokerage fees as a separate item.

Regulatory arbitrage

All this means that technology services aren’t truly a new business. Instead, the category’s creation essentially represents a form of arbitrage designed to skirt the new cap on commission rates. Regulators have already warned that brokers cannot simply rebrand excess commissions on sales under categories like “consulting fees,” “marketing allowances” or “technical utility costs” to bypass the cap. If Beijing decides that Waterdrop’s technology fees are just commissions in disguise, the regulatory axe could quickly fall, wiping out some or all of this fast-growing new revenue category.

Making matters worse, this newly minted technical services revenue stream’s first-quarter result was actually down by double digits from its peak in last year’s fourth quarter. That shows that this potential new goldmine is quite volatile, unlike steadier subscription-based fees for software-as-a-service (SaaS) platforms.

Since Waterdrop’s revenue growth depends heavily on transaction volumes, it has to spend heavily on buying traffic, especially as insurance demand in China is lukewarm these days amid a prolonged economic slowdown. In the first quarter, the company’s total operating costs and expenses ballooned more than 70%, as its sales and marketing expenses more than tripled. Consequently, despite the massive revenue jump, the company’s net profit actually fell about 9% year-over-year to 98.4 million yuan.

Outside its core insurance business, Waterdrop offers crowdfunding services for patients with large medical bills, and it also helps drug companies identify participants for clinical trials. But revenue from these segments is negligible and isn’t growing fast. In fact, fee income from crowdfunding services declined year-on-year in the first quarter.

Waterdrop shares trade at a price-to-earnings (P/E) ratio of just 5, a modest level for a technology-oriented company and far below 12.6 for private digital insurer ZhongAn (6060.HK). This massive valuation gap shows that investors may perceive ZhongAn as a true technology-enabled underwriter that is probably benefiting from the new brokerage commission caps. By comparison, they are treating Waterdrop like a commoditized broker exposed to significant regulatory risks.

Waterdrop can try to be creative to dodge regulatory limitations. But investors seem to want it to do more to take its business model to the next level by reducing its vulnerability to regulatory risks while also cutting costs. Until the company can do that, investors may remain skeptical of any big top-line improvement the company may post.

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