Frontdoor, Inc.
Q4 2018 Earnings Call Transcript

Published: 1 Mar 2019

[Operator:]

Ladies and gentlemen, welcome to Frontdoor's Fourth Quarter and Full Year 2018 Earnings 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'll begin today's call. Please go ahead, Mr. Davis.

[Matt Davis:]

Thank you, operator. Good morning, everyone, and thank you for joining Frontdoor's fourth quarter and full year 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 6

[Rexford Tibbens:]

Thank you, Matt, and good morning, everyone. Let's start with our full year 2018 summary shown on Slide 4. I'm pleased to report that we finished the fourth quarter and full year on a stronger note than our revised outlook provided during the third quarter earnings call in early November, with revenue at the higher end of the guidance range and EBITDA above the range. Full year revenue increased 9% to a record $1.26 billion in 2018. We also reported better than expected adjusted EBITDA of $238 million and adjusted EBITDA margin of 19% for 2018, which Brian will expand on later. Continuing down Slide 4, our business continues to grow at a strong rate. As a leader in the U.S. home service plan industry, we continue to grow the number of home service plans, increasing 6% to 2.1 million plans. Complementing our home service plan growth, we had strong customer retention rate of over 75% in 2018, up 30 basis points year-over-year. We also continue to execute on the key strategic initiatives and process improvements to drive our business results, which I outlined on the third quarter earnings call. I will provide additional detail on these initiatives as well as our 2019 objectives in a moment. On the people front, we added a new member to our strong leadership team. In December, Piras Thiyagarajan joined as our Chief Technology Officer. Piras brings more than 20 years of experience with some of the world's most recognized technology companies and holds 6 U.S. patents for data security, transaction and technology systems. Piras recently served as Vice President of Engineering and Technology for RideCell, a Silicon Valley start-up. He previously served as Director of Engineering for Google and has held senior management roles in Amazon where he led the development and execution of new global customer delivery experiences. As evidenced by our recent hires, our management team has the experience to shape Frontdoor's vision for the future. We're laying the foundation for a much stronger and more dynamic company that is intensely focused on improving the core business and building our future platform. We are laser focused on taking the hassle out of your home and this will be our north star as we continue to build and transform the company. Moving to Slide 5, let's discuss our three primary revenue channels

[Brian Turcotte:]

Thanks, Rex, and good morning. Please turn to Slide 7, and I'll briefly review a few key financial results for the fourth quarter 2018 and then dive deeper into the adjusted EBITDA drivers later in my comments on Slide 9. Revenue increased 9% to $279 million, driven primarily by a 6% increase in the number of home service plans and the higher average price per plan compared to the prior year. Similar to prior quarters, our 9% revenue growth was comprised of 7 points of volume and 2 points of price. With the continued price optimization efforts Rex discussed earlier, we would expect price to represent a higher percentage of the contribution to growth in 2019. I'll now provide more detail on the fourth quarter revenue contribution from our 3 primary customer channels of renewals, first year real estate and first year direct-to-consumer. Revenue derived from customer renewals was up 10% over the prior year, due primarily to growth in the number of home service plans and an improved price realization. First year real estate revenue was up 3% versus prior year, also driven by improved price realization, primarily due to a mix shift to higher-priced home service plan. And first year direct-to-consumer revenue was up 9%, driven primarily by growth in new sales resulting from our ongoing investments in marketing. In regard to gross profit, gross profit dollars increased 3% versus the prior year to $125 million, while our gross profit margin declined from 47% the prior year to 45% of revenue due to the higher claims cost that I'll review in a moment. Net income was $17 million, down from $44 million in the prior year. This decrease was primarily driven by a $15 million increase in interest expense as a result of the debt offering we completed in August 2018. Prior to the spin-off, ServiceMaster's debt and associated interest expense were not allocated to our company, nor were we an obligor of that debt. Additionally, fourth quarter net income was impacted by a $13 million increase in tax expense versus prior year, primarily driven by a onetime $20 million benefit in 2017, related to the enactment of the Tax Cuts and Jobs Act. Turning to Slide 8, I'll briefly review a few key financial results for the full year 2018 and again dive deeper into the adjusted EBITDA drivers later in my comments on Slide 10. Revenue increased 9% to $1.26 billion, driven primarily by a 6% increase in the number of home service plans and a higher average price per plan. Again, looking at our three primary customer channels, revenue derived from customer renewals was up 10% over the prior year, due primarily to growth in the number of home service plans and improved price realization. First year real estate revenue was up 5% versus the prior year, driven by a mix shift towards higher-priced home service plan offerings. And first year direct-to-consumer revenue was up 8% due to the growth in new home service plans, resulting from ongoing investments in marketing. In terms of gross profit, gross profit dollars increased 1% versus the prior year to $572 million, while gross profit margin declined from 49% in the prior year to 45% of revenue due to a $58 million increase in claims cost in 2018. Net income was $125 million, down $35 million from the prior year. This decrease was primarily driven by the higher claims cost I just referenced and a $22 million increase in interest expense as a result of the debt offering we completed in August 2018. Full year 2018 EBITDA of $238 million was significantly better than the top end of the revised outlook range we provided in early November. That outlook incorporated a pragmatic forecast that included the extreme temperature impact and the higher claims incidence rate that we had already realized in October that could have potentially continued throughout November and December. While October exhibited the highest claims incidence rate in our 13-year modeling period, November was relatively in line with normal weather patterns, and extremely mild December temperatures resulted in the lowest claims incidence rate on record for that month. As a result, with a lower-than-expected claims incidences in the fourth quarter, we were able to smooth out our system capacity, operate more efficiently and more effectively deploy service request to our preferred contractors. Additionally, we realized process improvements and cost savings in the quarter as the team began to make progress on the initiatives that Rex described earlier. The combination of better-than-expected weather, lower-than-expected claims costs and process improvement initiatives resulted in our exceeding the top end of our revised adjusted EBITDA range. Now turning to Slide 9, the adjusted EBITDA bridge shows the drivers of change from the fourth quarter of 2017 to the fourth quarter of 2018. And I'll walk you through the details of the bridge. Starting on the left, we had $13 million of favorable revenue conversion versus prior year. We calculate revenue conversion as revenue from new customers, minus the related claims cost associated with new home service plans, plus the additional revenue associated with price increases. Continuing to the right, the $9 million increase in claims cost is primarily related to the underlying cost of repairs, particularly in the appliance trade and heating, ventilation and air-conditioning trade or HVAC for short. Sales and marketing cost increased $3 million due to incremental investments made to drive the 6% increase in the number of home service plans versus prior year. We also invested an additional $2 million in our customer care centers to deliver an improved level of service. The spin-off dis-synergies of $1 million relate primarily to the cost associated with separation of Frontdoor technology systems from ServiceMaster. And the $2 million of other costs are mainly higher professional fees in the quarter versus prior year. Now turning to Slide 10, you'll see a similar adjusted EBITDA bridge showing the drivers of change for full year 2017 to 2018 and I'll walk you through the details of that bridge as well. Again, starting on the left, we had $64 million of favorable revenue conversion versus 2017. Continuing to the right, we had a $58 million increase in claims cost in 2018, which are broken into four key areas

[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 on our press release and webcast presentation. Operator, let's open up the line for questions?

[Operator:]

Certainly. [Operator Instructions] Our first question today is coming from Ian Zaffino from Oppenheimer & Company. Your line is alive.

[Ian Zaffino:]

Hi, great. Thank you. Very good quarter. Rex, thanks for the detail on the on-demand. Can you give us an idea maybe of what the R&D spend you are looking at over the next several years? You mentioned this year would be heavy R&D. Give us an idea of that. And also when we anticipate maybe a breakeven or what point does the product gain some type of critical mass? And then I have a follow-up. Thanks.

[Rexford Tibbens:]

Yeah, sure. So this is the year of R&D, as Brian pointed out. We're going to spend about $10 million this year to really build out the playbook. I think it would be premature at this point to kind of comment on when we may be breakeven because we haven't built the product yet. So I think as we build-out the products, we will get them over the course of this year. In 2020, we'll be then focused on target cities, the scale and then we'll optimize in 2021. So in terms of investment, we're comfortable with the $10 million this year. But then as we build-out those playbooks, we can then comment on kind of where we go from there.

[Ian Zaffino:]

Okay. Thanks. And also Brian, in the guidance, what are the assumptions for the real estate channel versus the DTC channel? And how do you sort of go about maybe mitigating any type of slowdown in the housing sales market? Thanks.

[Brian Turcotte:]

Do you want to take that one, Rex?

[Rexford Tibbens:]

Okay. I'll take that one, too. For real estate, our focus is really renewed focus around our core markets. As we talked about on the call, continue to foster relationships with our leading brokerage firms. So really continue to drive penetration in those relationships and expand our market share. The other thing to point out is, if we do see softness, we have the ability then to pivot our marketing dollars or sales dollars from real estate to direct-to-consumer. So that's really our approach for real estate.

[Ian Zaffino:]

Okay. Thank you very much. Good quarter, again.

[Rexford Tibbens:]

Thank you.

[Operator:]

Thank you. Our next question today is coming from Chris Gamaitoni from Compass Point. Your line is now live. Hello, Chris, perhaps your phone is on mute.

[Chris Gamaitoni:]

Can you hear me now?

[Operator:]

Yes. Please go ahead.

[Chris Gamaitoni:]

I am sorry about that.

[Rexford Tibbens:]

Morning, Chris.

[Chris Gamaitoni:]

Thank you for taking my call. Morning. Previously, you have guided to the long-term gross margin of 50%. I wanted to see if - what are your updated thoughts on that? And does the 100 basis point improvement from dynamic pricing, is that added to that number over the long term?

[Brian Turcotte:]

Hey, Chris, good question. We still believe approximately 50% is - attainable gross margin for us. As you can see from our guidance, it not going to be in '19, but going forward, we still think that's achievable for the business. And your second question was about dynamic pricing?

[Chris Gamaitoni:]

Yes. The dynamic pricing commentary was that it adds 100 basis points. Gross margin...

[Brian Turcotte:]

Yes, that will be on an annualized basis. We're not really building that into our outlook for '19. But going forward, that will certainly be something to help drive the business.

[Chris Gamaitoni:]

Okay. I was wondering this year, 2019 is obviously a year of investment, both on on-demand and across call center customer service. I was wondering, take out the on-demand side, but the core business, how long do you think it takes to get to call it a normal level of SG&A spend that beyond that it would just be normal inflation?

[Brian Turcotte:]

Well, if you look at our spend in '19, SG&A, we're spending more on marketing and sales to drive units, as I mentioned in my prepared remarks. We're going to continue to do that going forward. But I think going forward, we will get more flow-through from our revenue conversion than we are this year. We're making such a heavier investment and we're not getting the incremental margin we would normally get. But I think going forward, we will certainly get back to more normalized levels of revenue conversion.

[Chris Gamaitoni:]

Okay. And the - this is...

[Brian Turcotte:]

In incremental margin, I should say.

[Chris Gamaitoni:]

From a corporate reporting standpoint, why not break out on-demand services into a separate segment just so we can kind of track? We understand it's the growth base and it's going to be in an investment period for a period of time, but just to separate it from the overall business. When at scale theoretically, there's different drivers and will probably be a reportable segment itself?

[Brian Turcotte:]

That's another good point, Chris. That could certainly make sense going forward. But again, as Rex said, '19 is a year of piloting, scaling next year and then optimizing the year after. So at some point, it certainly makes sense to break it out in the core business. Do you agree, Rex?

[Rexford Tibbens:]

I agree. Also, I would say that a lot of the technology, the work that we're doing is foundational for both our core business and on-demand. So even at scale, I don't think the two things kind of run separately. They rely on each other, right? So I believe we'll stay out of the way to separate those. We understand the growth of the core business. We understand the growth of on-demand.

[Chris Gamaitoni:]

And just one more, just from a philosophy standpoint, on your gross margin guidance, do you include some estimation of kind of adverse weather? Or you rely on historical average patterns?

[Brian Turcotte:]

Yes, we've got a 13 year historical model we use that we didn't tweak for most recent years, but we do see changing patterns as we have recently with some more extreme weather, for example, last year, both hot and cold. So yes, we do update the model as we go, but it's really based on 13 years of historical data.

[Chris Gamaitoni:]

Okay. Thank you so much.

[Operator:]

[Operator Instructions] Our next question is coming from Jamie Clement from Buckingham Research Group. Your line is now live.

[Jamie Clement:]

Good morning, everyone. Can you hear me okay?

[Rexford Tibbens:]

We can.

[Jamie Clement:]

Okay, great. Brian, comments going back three months about the month of October and then you had some comments in the prepared remarks. Is it fair to say that for the year-over-year $9 million increase in claim cost, was that overwhelmingly tilted towards the month of October?

[Brian Turcotte:]

Yes, October was, as I mentioned in my remarks, was a really unusual year that we started out with really warm weather that drove AC claims and then cold snaps across a lot of the country in the back half that drove the heating claims. So as unfavorable as October was on an incident basis, December was that favorable. So they canceled out and that's the disparity in our outlook versus our actual results. We thought that November and December could have a similar pattern to October and that's why we took a very pragmatic approach to our forecast that you saw on our EBITDA range we gave and you can see that December pretty much canceled out the unfavorability in October.

[Jamie Clement:]

Okay. And going back three months and I think possibly even six months, I think you all cited parts availability as being somewhat of a challenge. How does the process stand as either diversifying or expanding your part suppliers and that sort of thing?

[Rexford Tibbens:]

Yeah. So from a business process perspective, I would say that we're managing to the inputs at a much greater level than 3 or 6 months ago. We look at all of our parts suppliers as well as parts down to the regional level. There, I think we've made great progress. I'd still, over the course of this year, I think we have even more work to do to continue to make sure we're managing to the inputs, but happy with the progress so far.

[Jamie Clement:]

Okay. Great. I appreciate that. And then final question. In terms of the increase in SG&A from '18 to '19, are you -- can you bucket sort of those costs in percentage terms between, I don't know, maybe sales and marketing in one bucket, customer service in another and then on-demand in the third? Maybe that's not the right way to bucket them, but curious for your thoughts.

[Brian Turcotte:]

Yeah, Jamie, this is Brian again. It's a great question. We didn't prepare -- give those comments in our prepared remarks. But let's think about, let's -- approximately 40% of the increase in SG&A will be related to sales, marketing and service. And the balance will be in the G&A bucket and that would include the synergies, technology spend, which will be a big part of our investment in '19; higher depreciation, et cetera...

[Jamie Clement:]

Yeah, that’s phenomenally helpful. I appreciate that.

[Operator:]

Thank you. Ladies and gentlemen, that concludes the question-and-answer session. I'll now turn the call back over to Rex Tibbens for some closing remarks.

[Rexford Tibbens:]

Thank you, again, for your interest in Frontdoor. We are building a foundation that will improve the customer experience, drive our financial performance and position us to continue to grow our core business and new on-demand services in 2019 and beyond. Thank you again and we look forward to updating you on our progress on our first quarter of 2019 earnings conference call.