Frontdoor, Inc.
Q3 2018 Earnings Call Transcript

Published: 6 Nov 2018

[Operator:]

Ladies and gentlemen, welcome to Frontdoor’s Third Quarter 2018 Earnings Conference Call. Today’s call is being recorded and broadcast on the internet. Beginning today’s call is Matt Davis, Vice President of Investor Relations and Treasury, and he will introduce the other speakers on the call. At this time, we will begin today’s conference call. Please go ahead, Mr. Davis.

[Matt Davis:]

Thank you, operator. Good afternoon, everyone, and thank you for joining Frontdoor’s third quarter 2018 earnings conference call. Joining me on today’s call are Frontdoor’s Chief Executive Officer, Rex Tibbens; and Frontdoor’s Chief Financial Officer, Brian Turcotte. Before I review the agenda and turn the call over to Rex and Brian, at about 3 pm central time today, Frontdoor issued a press release, reporting our third quarter 2018 financial results. The purpose of today’s call is to provide investors with further details regarding Frontdoor’s financial results as well as provide a general update on the Company’s progress. The press release and a slide presentation that will be utilized during today’s call can be found on the Investor Relations section of Frontdoor’s website, which is located at www.frontdoorhome.com. I’d also encourage all of our listeners to visit our website to find out more about our Company. As stated on slide two of the presentation, I would like to remind you, this call will contain forward-looking statements. Investors should be aware that any forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those discussed here today. These risk factors are explained in detail in the Company’s filings with the Securities and Exchange Commission. Please refer to the Risk Factors section of our registration statement on Form 10 and other filings for a more detailed discussion of forward-looking statements and the risk and uncertainties of such statements. All forward-looking statements are made as of today, and except as required by law, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We will reference certain non-GAAP financial measures throughout today’s call and we have included definitions of these terms in our press release. We have also included reconciliations of these non-GAAP financial measures to the most comparable GAAP financial measures in our press release and the appendix to this presentation, in order to better assist you in understanding our financial performance. References on the call to EBITDA are to adjusted EBITDA, as defined in our press release and the appendix to this presentation. As a reminder, the results for the quarter are presented in a consistent manner with the historical results included in our registration statement on Form-10, which on a carve-out basis derived from ServiceMaster ‘s consolidated financial statements. Our financial statements include all revenues, costs, assets and liabilities directly attributable to us. Additionally, our financial statements for periods prior to the spinoff include allocation of certain costs from ServiceMaster incurred on our behalf. For those following along with the presentation available on our website, I’ll walk through the agenda items shown on slide three. Frontdoor’s CEO, Rex Tibbens will lead off by providing a review of our third quarter 2018 highlights. He will then dive into some of the key drivers for the quarter and our strategy and the business update. Brian Turcotte, Frontdoor’s CFO, will follow and will summarize our third quarter 2018 financial results, provide more details in regard to our financial statements, and then speak to the full-year 2018 outlook. We will then open up the line for questions. I’ll now turn the call over to Frontdoor’s CEO, Rex Tibbens for opening comments. Rex?

[Rex Tibbens:]

Thanks, Matt, and good afternoon, everyone. Let’s start with our third quarter highlights on slide four. After more than a year of hard work by teams across every area of the Company, we completed the spinoff from ServiceMaster on October 1st. I’m truly grateful to all those involved in the spinoff, and I want to thank all the employees and partners who put in the extra effort to execute the spinoff as planned. Now, with the spinoff behind us, I remain even more steadfast in my belief that Frontdoor possesses a great core business, led by its four market-leading brands

[Brian Turcotte:]

Thanks, Rex and good afternoon. Let’s now turn to slide eight and I will review our third quarter 2018 financial results. Third quarter 2018 revenue increased 9% to $377 million, driven primarily by a 7% increase in the number of home service plans, which now totaled 2.1 million and a higher average price per plan compared to the prior year period. As a reminder, the components of total revenue growth have historically been split between about 80% volume and 20% price. And that is basically the same for this quarter with the 9% growth comprised of seven points for volume and about two points for price. I will now provide more detail on the revenue contribution among our three primary customer channels, existing customer renewals; first-year real estate sales; and first-year direct-to-consumer sales. Revenue from customer renewals was up 10% over the third quarter last year, primarily due to improvement in customer retention to 76% this year versus 75% prior year. First year real estate revenue was up 6% versus the prior year period, driven by a mix shift toward higher priced home service plan offerings. First year direct-to-consumer revenue was up 10%, driven by 7% growth in new home service plans over the prior year period. Gross profit declined 2% versus the prior year period to $176 million due to the increase in claims costs, Rex mentioned earlier. Higher claims costs and increase in other operating costs that I will review in moment resulted in net income of $49 million pro forma earnings per share of $0.58 and adjusted EBITDA of $86 million. Turning to slide nine. You will see an adjusted EBITDA bridge in the third quarter of 2017 to the third quarter of 2018 and the factors impacting the results. Starting on the left. The 9% increase in revenue converted to $19 million of adjusted EBITDA which is net of the related claims costs attributed to this revenue growth. Now, let me walk you through the details of the $21 million increase in claims costs versus the prior year period which is broken into four areas. First $7 million relates to the higher underlying cost of repairs across all trades, particularly appliance, HVAC, and plumbing, primarily driven by inflation of both labor and parts. As you would expect, in a tight labor market, contractor firms are paying technicians more to secure their services. We also have experienced a 12% increase in plumbing trade costs from both the mix shift, the higher cost hot water heaters due to increased energy efficiency standards and newly enforced tariffs on products manufactured with imported Chinese steel. Second, $6 million in the adverse development of claims costs from prior periods. As a reminder, cost development is the actuarial process of estimating claims costs and then showing up those estimates to actual costs. Of that $6 million, $5 million was related to claims from the first half of 2018 and $1 million was related to claims from the fourth quarter of 2017. As Rex mentioned, we are enhancing our claims estimation process to increase its accuracy and have more timely insight into unfavorable claims cost trends in the current period. More timely insight into these trends will allow us to take swift action to mitigate. Third, $5 million related to a higher number of work orders received in the third quarter due to significantly warmer temperatures compared with the prior year period, primarily impacting the HVAC price. And finally, $3 million is due to increased appliance replacements. Despite this unfavorable impact in the third quarter, we have begun to see gradual improvement in appliance replacement trends, as previously mentioned. As we continue across the bridge, sales and marketing costs increased $2 million over the prior year period due to incremental investments made to drive the 7% increase in the number of home service plans versus prior year. We also invested an additional $2 million to deliver an improved level of customer service, which resulted in a 50% improvement in average speed to answer calls versus the same period last year. The spinoff of dissynergies of $2 million related primarily to the costs associated with the separation Frontdoor IT Systems from ServiceMaster. And finally, the $3 million of other costs are mainly higher professional fees and bad debt expense in the third quarter. Please turn to slide 10 for review of our cash flow and cash position. Net cash provided from operating activities was $126 million for the nine months ended September 30, 2018, down $10 million from the same period in 2017. This decline was primarily due to a $21 million increase in cash payments related to restructuring and spinoff charges, which was partially offset by a $13 million increase in operating earnings adjusted for non-cash charges. As mentioned during the Frontdoor Investor Day in September, one of the key attributes of this business is its favorable working capital characteristics. For the nine months ended September 30, 2018, the change in working capital was a slight use of cash and roughly the equivalent with the prior year period. Net cash used for investing activities was $4 million for the nine months ended September 30, 2018 compared to net cash provided from investing activities of $5 million for the same period in 2017. The increase was primarily due to $13 million of higher capital expenditures, including the headquarters relocation and separation related costs. Net cash used for financing activities was $98 million for the nine months ended September 30, 2018, compared to $53 million in the prior year period. The increase was primarily due to net cash transfers to ServiceMaster that occurred prior to the spinoff, as well as debt issuance costs. Free cash flow was $104 million for the nine months ended September 30, 2018, compared to $127 million in the prior year period. This decline was due to an increase in property additions related to spinoff, primarily technology assets that we previously shared with ServiceMaster and lower net cash from operating activities. We ended the third quarter with $314 million in cash and marketable securities which does not reflect certain subsequent adjustments made in connection with the spinoff from ServiceMaster. Following those adjustments, effective October 1st, our cash and marketable securities totaled $251 million. This is consistent with a spinoff agreement which provided that Frontdoor would retain $53 million in cash and marketable securities in excess of the required total restricted net assets. Those restricted net assets increased to $198 million on October 1, 2018, due to certain states requiring additional security against claims following the separation from ServiceMaster. As a reminder, our restricted cash balance increases by about 10% of the increase in revenue on a dollar basis. For example, the Frontdoor’s revenue grew $10 million in the period, our restricted cash balance would increase approximately $1 million in that same period. I should note that the 50% figure referenced during the Investor Day related to the proportional rates of restricted cash balance increased compared to the rate of revenue growth in a period. Simply put, if revenue grew 10% off its base, the restricted cash balance would growth half that rate or 5% off its base. Also, I’d like to remind everyone that we successfully completed our $1 billion debt offering on August 16, 2018, which included $650 million term loan facility and $350 million of high-yield notes. We also completed a $350 million interest rate swap on the term loan facility in October. This swap increases the portion of our total debt to revise fixed interest rates to 70%, thus reducing our risk in a rising interest rate environment. Turning to slide 11. I will cover our full-year 2018 outlook. Revenue is anticipated to range between $1.25 billion to $1.26 billion, and reflects our expectations that strong organic revenue growth exhibited through the first nine months of 2018 will continue through the fourth quarter. Gross profit margin for the full-year is anticipated to range between 43% and 44%, reflecting a continuation of higher claims costs through the end of the year. As a result of the higher claims costs and continued investments in sales and marketing to drive sales unit growth and in our call centers to improve customer service, full-year adjusted EBITDA is anticipated to range between $215 million and $225 million. Capital expenditures are anticipated to range between $25 million and $30 million, including $15 million to $20 million related to the spinoff, principally costs to replicate IT systems and approximate $10 million related to recurring capital needs and continued investments in information systems. And finally, the full year effective tax rate for Frontdoor is expected to be approximately 25%. This concludes my prepared remarks this afternoon. Frontdoor has an attractive recurring revenue model, delivering robust organic revenue growth and strong free cash flow. And as Rex mentioned, we are confronting industry-wide cost headwinds by raising home service plan prices across all channels, transitioning to a data-driven organization and improving how we manage our base of contractors and suppliers. With that, I’ll now turn the call back over to Matt to lead us through the question-and-answer session. Matt?

[Matt Davis:]

Thanks, Brian. As a reminder, during the question-and-answer session, we encourage you to ask any questions that you may have, but please note that guidance is limited to the outlook we provided in our press release and webcast presentation. Operator, let’s open up the line for questions.

[Operator:]

[Operator Instructions] Our first question is from Paul Fanelli from G. Research. Please go ahead.

[Paul Fanelli:]

I just wanted to focus on the parts sourcing and replacement. Can you give any further color on sort of when we can see those improvements in parts sourcing and improving replacement rates, when we’ll see those cost start to normalize or how long it will take for this improved sourcing to really filter through the system?

[Rex Tibbens:]

It’s Rex. I think, over -- every quarter we get stronger and stronger. It’s about making sure we have the right supplier network. And then, we will continue to see those -- I think you are referring to the appliance replacement rate continue to gradually move down. I think, it’s over the next couple of quarters that you will continue to see the improvement back kind of to historic levels, if you will.

[Paul Fanelli:]

And then, just one follow-up. You’ve touched -- in the prepared remarks you touched on pushing some of the decision-making down to sort of on more frontline basis. Can you just go maybe into a little bit more detail on what that looks like and how you hope to have that maybe drive some margin improvement?

[Rex Tibbens:]

So, having the right systems and process in place really allows us to make quick decisions via technology that we can then push those -- the decision-making down to the front line. So, if you go online or call us, we will have a lot more robust way of taking care of customers in terms of figuring out the problems ahead of time and then knowing the contract and then knowing what things we need to do from a visibility perspective, be able to identify trends, those type of things. So, if you are a front line associate, you will have the power of the information simply to better help the customer.

[Operator:]

Our next question is from Chris Gamaitoni from Compass Point. Please go ahead.

[Chris Gamaitoni:]

I wanted to focus again on the gross margin. For the fourth quarter, I’m calculating roughly implied 35% level. Is that correct?

[Brian Turcotte:]

Our gross margin?

[Chris Gamaitoni:]

The gross margin percentage. Yes.

[Brian Turcotte:]

That could be right. I’m focusing more on EBITDA margin at this point. But there would be growth by the way. Gross margin pressure in -- I think it’s a little higher than that now that I look at my notes. You’re pretty close for gross margin.

[Chris Gamaitoni:]

And is that being driven completely by your expectation of replacement issues, the plumbing price increases or is there another actuarial adjustment that you expect to incur in fourth quarter?

[Brian Turcotte:]

No, it’s not an actuarial adjustment. It is continued pressure that we see in Q3, the inflationary pressures continuing into Q4. And also October was a very unique month where we had a very hot beginning to the month and had more AC claims than we normally would have. And then it turned cold in the back half of October. So, we had going on for the first time in the year. So, that just the continued inflationary pressures led us to believe that we would have a little more pressure in Q4 than normal. But to be very clear, we’re going to continue invest in our sales and marketing to drive unit growth and in customer service to drive revenue growth going forward, and we do expect to return to our more margin with the initiates, Rex mentioned, going forward.

[Chris Gamaitoni:]

Okay. So, you assume to return on the same in the growth side or is that through improvements on the other lines to drive the EBITDA margin…

[Brian Turcotte:]

That’s growth margin we’re talking about through the improvement. We’re still going spend on the SG&A side, we’re still going to spend to drive growth and revenue growth going forward.

[Chris Gamaitoni:]

And have you have any early feedback about the elasticity of consumer renewals with the price increases that you mentioned?

[Rex Tibbens:]

Yes. Certainly for raising prices, we have not seen any negative impact from that yet. But, again, early days, and we continue to raise prices. Remember that as the customers home service plan comes up month on month, we’re measuring those renewal rates. But, so far they are following in line with our expectations.

[Chris Gamaitoni:]

And it’s the way for the annual renewal for the people that are monthly direct debit, is that how it works?

[Rex Tibbens:]

Right. You sign up for a 12-month home service plan and as that gets closer to month number 12, majority of our customers are never [indiscernible] contracts. So, we remind them that their renewal is coming, and that’s where call on -- of any pricing change.

[Operator:]

Our final question is from Ian Zaffino from Oppenheimer & Co. Please go ahead.

[Ian Zaffino:]

Brian, just a quick question on that, the guidance on the top line. I noted you kind of move that around a little bit. I would have thought, with rising cost you would maybe accelerate the price increases, which will get you an upward adjustment on the revenue guidance. Just kind of curious, looking at the top end of the range, what were their puts and takes there?

[Rex Tibbens:]

It’s Rex. I will actually take that one. So, when we make pricing adjustments, keep in mind that it takes for those to flow through. As I mentioned earlier, as I make, -- rate prices in January, but your contract doesn’t come up renewal till June, you have another 12 months from there until you can see the full revenue impact as we recognize revenue one [ph] at a time.

[Ian Zaffino:]

But, I guess, when I look at the previous guidance for the topline, the top end average has come down. Is that -- you have to 1.27 billion, now you have 1.26 [ph] wanted to know the driver of that was?

[Brian Turcotte:]

Yes. I thought we had forecasted -- that’s how we have forecasted 9% organic revenue growth for the year, Ian. So, I would have to check on that.

[Ian Zaffino:]

Okay. All right. That was the only question. I appreciate that. But final question would be how do we sort of -- what’s the timeline for the on-demand product? As we trying to look for a model -- I know you said we’re not going to give guidance into next year, but how should we be thinking about maybe the ramp in the on-demand product, what will be some of the milestones we as investors or analysts should be looking for?

[Rex Tibbens:]

Sure. So, as I said earlier in the remarks, 2019 is about building out the business, so it’s about getting a robust playbook in place where we understand the unit economics and how the business would work. And then, we would start to scale the business over a couple of cities and really asset test if you will in 2019. 2020, we have a strong playbook in place. We really start to scale across the geographies where it makes sense to have an on demand business, certainly in major metropolitan areas. And then, 2021 is then time that we begin to really optimize the business from there. So, from a financial perspective, we don’t see a material impact in 2019, it’s really in 2020 when we think the industry, the material impact. We were at $1.25 billion business in revenues. So, it’s going to take quite a while before you start to see the revenue impact from that.

[Brian Turcotte:]

Ian, it’s Brian, again. I checked our Investor Day, and we said 8% to 10% organic revenue growth for 2018. We fell right in the middle of that. But you are right, the upper range would have been closer to 1.27 but we are right in the middle of our range.

[Operator:]

This concludes the question-and-answer session. I would like to turn the floor back to Mr. Tibbens for any closing comments.

[Rex Tibbens:]

Thank you. Thank you again for your interest in Frontdoor. We have a great core subscription based business model that is growing fast, generating a high level of free cash flow and has significant upside opportunity. We are taking aggressive actions to strengthen our core processes and systems for the future. We are well-positioned to be a leader in the broader $400 billion U.S. home services market. Thanks again, and we look forward to updating you on our progress in 2019.

[Operator:]

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.