|Shares Out. (in M):||85||P/E||23.5||18.7|
|Market Cap (in $M):||3,211||P/FCF||19||17|
|Net Debt (in $M):||938||EBIT||233||275|
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Company: FrontDoor (formerly known as AHS, American Home Shield)
Ticker: FTDR (FTDR-W or FTDRV when issued, FTDR to being trading October 1, 2018)
Current Price: $38
Trade Date: 9/21/18
Downside Price: $35
Upside Price: $47
Upside / Downside Ratio: 3:1
Situation: Spinoff / Hidden Asset
Buy FrontDoor (FD) at the current price of $38. A target price of $47, represents an upside of 24% over the next year and an upside / downside ratio of 3:1 based on a target peer industry multiple of 16x 2019 EBITDA. Downside is $35, or 12x 2019 EBITDA, 4 turns below the industry average and where peer HomeService traded prior to their on-demand service launch in May 2018. Today FD trades at 13.4x 2019 EBITDA.
There are two key drivers to FD’s outperformance that will become apparent over the next year:
1) Temporarily depressed margins
a. Recent EBITDA margins were depressed due to one-time cost issues, setting up well for H2’18 and 2019 performance.
2) Unrealized growth potential
a. The current price does fully incorporate FD’s plans for an on-demand service, similar service to Angie’s List and HomeService’s HomeExperts product. A near term catalyst will be FD’s management outlining plans for this in 2019. HomeService, a U.K. peer with a checkered past of accounting issues, soared 40% when it launched HomExperts in May 2018, causing the stock to re-rated from 12x to 16x 2019 EBITDA.
On the distribution date of 9/14/18, 1 share of FD common stock for every 2 shares of ServiceMaster common stock will be distributed to current ServiceMaster shareholders in a tax-free spin. The spin will compose at least 80.1% of outstanding shares with ServiceMaster keeping 19.9% FD shares to monetize at a later date.
FD’s core services include providing home service plans that cover the repair or replacement of major components of up to 21 home systems and appliances, including electrical, plumbing, central HVAC systems, water heaters, refrigerators, dishwashers and ovens/cooktops under the American Home Shield, HSA, OneGuard and Landmark brands.
The company is a market leader that serves 2MM customers with a market share that is 4x larger than its nearest warranty competitors. FD has 75% customer retention rates with a national network of 15,000 pre-vetted contractors (45,000 technicians in total) across a technology process platform that connects contractors with customers. FD’s target customer are people with incomes between $50,000 to $150,000 a year.
FrontDoor provides these services through various warranty programs. FD’s plans are 1) systems plans and 2) appliances plans. Appropriately named, the systems plan addresses: garbage disposals, plumbing, hot/cold water dispensers, doorbells, electrical, water heaters, air conditioning, heating, ceiling fans and such. The appliances plan covers refrigerators, ice makers, food processors, microwaves, trash compactors, ovens, garage door openers, washers and dryers.
Consumers pick a plan and pay a monthly annual fee that covers broken items. When an item is broken, a customer can request a contractor to fix the product. The customer pays a Trade Service Fee and the product is repaired or replaced. A pricing example is below:
Sales Channel Overview
FD serves customers across 50 states and takes service calls 24 hours a day, seven days a week. Revenue is a mix of existing contract renewals (66% for H1’18), while 22% was from sales in the Real Estate Channel and 12% in the Direct to Consumer (DTC) channel. Front Door sells plans through two channels:
Real Estate (RE) Channel
o FD built this channel 45 years ago and is the market leader with 32% of market share (transactions related to a home resale in 2017), up from 26% in 2012. The company has long relationships with 7 of the 10 largest real estate brokerages.
o FD markets plans to RE brokers and agents. Plans are often included in home sales as an added benefit to provide peace of mind to buyers by protecting them from unanticipated repair costs for their first year. As many home buyers are “gifted” their FD policy, renewal rates are a low 28%.
o Customers acquired through the real estate channel represented 48% of FD’s customer base in 2017, down from 56% in 2007 as FD has focused on growing its direct-to-consumer (‘‘DTC’’) channel.
o Revenues within this channel have grown at a five percent CAGR from 2007 through 2017.
o In 2017, 1.5MM homes were sold with a home service plan out of 5.5MM homes sold.
Direct-to-Consumer Channel (DTC)
o FD has invested in its DTC channel to broaden reach beyond home resale transactions. FD promotes this channel through search engine marketing, social media, direct mail and TV/radio.
o The DTC channel has higher retention rates and customer lifetime value than the RE channel. Though buyers are viewed as having “adverse selection,” i.e. customers already have broken items, this channel has a 75% renewal rate (after the first contract year) and is profitable in year 2 (compared to RE’s profitability in year 1 and 28% renewal rate).
o Customers acquired through the DTC channel represented 52% of FD’s customer base in 2017, up from 44% in 2007.
o FD has been aggressively promoting this channel as there is low home service plan penetration rate of 4% of occupied U.S. households with only 3MM homes out of the 115MM U.S. households (excluding home re-sales) having a home service plan.
o Since 2012, FD has maintained over 50% market share of home service plans purchased or renewed outside of a home resale transaction.
o Overall revenues within this channel have grown at a 9% CAGR from 2007 through 2017.
Both channels offer areas for FD to improve; pricing is a clear historic issue the company is now addressing. In the past, pricing was calculated on a state to state basis. For example, a home in an upscale area with high end appliances would price the same as a similar sized home in a less affluent area. FD is now exploring zip+4 pricing, pricing for plans based on zip codes. Advertising is another; FD used to market their DTC market solely by mail-in ads, and now targets customers via digital ads, social media, etc.
Core Business Geographic Expansion
Despite having a nationwide contractor network, the company is strongest in its home base of California as well as the “smile states” with significant growth areas in the north east.
Contractors have a preference for working with FD over comparables like Angie’s List as they are provided a steady stream of jobs. In addition to repair replacement work, contractors can also purchase spare parts through FD’s network where they use their purchasing power to drive discounts.
FrontDoor has several areas of expansion:
Repair only makes up 25% of the entire home services industry. This leaves out improvement areas such as remodeling, flooring, painting and maintenance areas such as HVAC check-ups (currently in pilot phase to launch in 2019) and gutter cleaning.
With FD’s network of 15,000 contractors, the company is exploring ways to roll out on-demand services. For example, if a consumer would like to purchase an area outside its warranty service, it can request a contractor through the FD system for home services projects or others. Given FD’s large contractor base and volumetric discounts, the cost per project is accretive to FD from day one.
Property Management Services
Much of what FD provides can be done in multi-family homes as well as apartment complexes.
Other areas include:
o FD is currently reviewing how to monetize its large data library and to provide predictive appliance breakdown services to the OEMs.
o FD has plans to become the source of home information and enable anticipation of repair needs before the customer is aware of them. There is also potential for additional revenue opportunities, targeting real estate companies, manufacturers and other companies within the U.S. home services market as customers.
o FD is testing installation of smart home services, which FD thinks will add value to plans and result in increases in renewals.
Frontdoor operates in the $400Bn U.S. home services market, of which the U.S. home service plan segment is $2.3Bn. The home service plan segment has grown at a CAGR of 7% from 2013 to 2017, below FD’s revenue growth of 12% during the same period.
FD’s market share is just under 50% in the home warranty industry. FD has 2MM homes participating in its services. If FD is viewed as a company that connects contractors with customers to provide services, the TAM goes from 5MM homes to well over 100MM.
12/31/2016 results, adjusted to include Landmark / One Guard acquisitions.
While the company has posted impressive growth over the past few years, recent EBITDA margin is depressed as the company has increased spending to expand its DTC channel endeavor.
FD has grown at 7% volume and 2% of price. Given that under 5% of homes have a service plan, near term volume growth should continue and may even accelerate from higher DTC channel marketing spend.
The base case is driven by:
Average customer counts
o The model conservatively assumes a 7.5% increase in customer count in H2’18 followed by a 7% increase in 2019/2020. This is below the 8.8% average 2015-H1’18.
o The model assumes a 2% price increase, slightly below the 2.5% avg from 2015-H1’18. The 2% figure is conservative based on:
Pricing changes going forward – FD is pushing a dynamic pricing model going forward where the price of service will adjust based on the location of the house (they refer to this as zip + 4 pricing). This gives greater transparency as a house in Silicon Valley and one in Sacramento with the same size differ in price elasticitiy.
The biggest variable in COGS is the change in claims cost as shown below:
FD’s H1’18 contract claims were abnormally high at $28MM, the highest annual cost was $33MM in 2015. The cost in H1’18 was driven by:
More expensive repair parts needed
Higher appliance replacement versus repair rate
Normal claims costs inflation
Higher claims incidence due to hot weather
Unusually cold temperatures drove high incidence rates related to heating systems in Q1’18.
An increase in contract claims cost driven by a higher number of central HVAC work orders driven by higher summer temperatures in Q2’18.
claims development from prior periods related to higher appliance replacement versus repair rates
Incremental costs - incremental COGS due to incremental revenue was set at the company’s average on a quarterly basis for the past three quarters. This is the additional costs to service additional warranty clients when repairs / replacements are needed.
Contract claims – The $21MM in contract claims for Q2’18 was the highest quarterly dollar amount the company recorded since Q4’15, though lower on a percentage of revenue (Q2’18 was 6.1%, Q4’15 was 10.2%). As a caution, a continuation of this cost was assumed to follow a similar dynamic in late 2015/early 2016. Q3’18 was assumed to be 5.2% of revenue, the same figure as Q1’16 and Q4’8 was assumed to be 1.4% of revenue (as was Q2’16). This would normalize to an average of 0.6% for 2019 and 2020, below the 0.3% average from 2013-2017.
A SG&A build was used with an incremental $3MM a quarter for additional SG&A costs, predominantly focused on marketing outreach. Other one-time costs were not included.
o 2018 – Given the assumptions above, margins are assumed to be 20% in 2018, meeting management’s guidance and rising to 21.5% in 2019 and 23.1% in 2020 (in line with management’s target low 20%s goal).
Free Cash Flow
Given the asset light nature of the business, FD has a higher free cash flow conversion ratio.
One of FD’s strengths is its high free cash conversion. Historically the company has been able to convert 14% of sales into free cash flow. This number is expected to be suppressed in the near term as capex is expected to be $20-$30MM for 2018 with a long term target of $20MM. FD is investing in technology, now as an independent company FD needs to replicate the systems its used as part of SERV as well as additional technology and application development projects to strengthen the core business and facilitate the company’s movement into the broader home services category (i.e. the on-demand offering).
Related peer valuation