Description

Overview

Frontdoor (FTDR) is a Memphis, TN-based provider of home serivce plans to residential customers in the U.S.  The stock has come way down this year on what I think is not a fundamental change in the business of the company's market position.  FTDR is a great business trading at a fair price.  On 2022 numbers, the company trades at about 9.5x EBITDA, 10.5x EBIT, and 13x EPS with about 1x leverage.  The company grows at mid-to-high single digits organically and has for a long time, could see margin expansion going ahead, and requires virtually no invested capital.  I think the company will perform well on its own but is an attractive acquisition target for either a financial or strategic player.  The company could carry a lot more leverage than it currently does.

FTDR has been written up on VIC 3 times: on 9/21/18 by akritai at $38.00, on 12/23/19 by idealogue at $46.90, and on 2/8/21 by manatee at $54.51, and I refer you to those writeups and threads for background.  Not too much has changed in the business since - the bull case on dramatically increased margin from dynamic pricing has not come to pass, recent margins have been impacted by Covid and inflation, and revenue guidance has come down over the course of 2021 to its current 8%.  EBITDA is still up 8% CAGR from $238 million in 2018 to guidance of $315 million in 2021 while the company has producied over $600 million FCF.  The company has used the FCF to pay down net debt from $866 million to $475 million and is likely to get more aggressive on share repurchase.  In September, they announced a $400 million repurchase plan.

Business Summary

⦁ Frontdoor sells home service plans to residential customers through its main brand American Home Shield, which was founded in 1971 and is the industry leader. Customers pay ~$50/month as well as ~$100 trade service fee (pay per visit to contractor) in exchange for normal wear and tear warranty service for 21 different home systems and appliances: HVAC, heating, electrical, water heaters, refrigerators, washer/dryer, microwave, etc. Unlike many insurance products, customers are expected to use the service (avg. ~ 2x per year). The purpose of the service is to provide ease of mind and quick and efficient repair of those systems with minimum hassle for the customer. A national network of 17.5k local contractors hired by FTDR either repair or replace the broken system to get it back in working order. Aside from the trade service fee from the customers, parts & labor (30-35% of COGS) are paid by FTDR. Claims on average cost 50% of revenue. 

⦁ The company spun-off from ServiceMaster (SERV) in October 2018. Rex Tibbens, the CEO, has a background at Amazon and Lyft and, in addition to growing the core home service plan business, is trying to build an on-demand model over time, where FTDR is the home services hub and is a marketplace for home services, taking a cut on transactions.

⦁ FTDR has 2.2 million customers and does 4+ million service requests per year. 56% of customers are direct and 44% are from relationships with real estate agencies, and that shift has been moving towards direct over time. In 2020, the company did $1,474 million revenue, 49% gross margins, $270 million Adj EBITDA (18% margins). There is negative tangible invested capital, minimal stock comp, and annual capex is ~$33m. The company has grown revenue ~8% organically over the last 5 years, with most of that in volume growth, along with modest increases in pricing and customer retention.  The business is relatively recession resistant as the repairs done are non-discretionary.

⦁ FTDR is very well positioned in the industry. They are the #1 player with 50% market share, 4x size of #2. The industry has grown high-single digits over time and FTDR has been taking share.  They are the highest price provider with the best reputation and generally, the best coverage.

⦁ The financial model is terrific. In addition to no required net capital, margins are reasonably stable over time. Adj EBITDA margins averaged 16% from 2009-2014 and 21% from 2015-2020. The business is susceptible to short-term fluctuations in claims costs due to weather and labor costs.  Scale benefits are significant (500-1000 bps vs. competitors) and result from the high customer volumes that lead to discounts on parts & labor and leverage of SG&A. FTDR is the only player with a full national presence.

⦁ The business has a somewhat bad reputation as it tends to generate a lot of bad reviews from customers with denied claims (est. ~5% of claims). It is also seen by bears as a predatory business.  I think those claims are generally baseless. FTDR is a well-run company that tries to do well for its customers and provides a decent value proposition.  I think the bear reference to low retention rate (76%) is also a misunderstanding of the underlying dynamics of the two separate customer bases, real estate and direct.  Real estate customers have plans purchased by the seller and only 26% of those plans renew, which drags down the aggregate renewal rate.  The aggregate retention rate has been rock solid between 75-76% the last 6 years and had increased from 72% in 2009.

⦁ The company has two small and growing businesses that they are trying to build up: ProConnect and Streem.  ProConnect is an on-demand repair platform that will do $20 million revenue in 2021 and Streem is an remote video service which aims to cut down on contractor visits and will do about about $9 million revenue in 2021.  The online-booked home repair business is a nut that still has to be cracked by the big national players.  Multiple companies are coming at the problem from different angles: FTDR, ANGI, AMZN.  It’s a very large market and there is possibly room for multiple winners. FTDR has a good asset base with which to start: over 1.5 million self-paying customers and 17.5k contractors who like working with them and getting business at no marketing cost.  If they fail in these efforts, it is not difficult for them to retrench and their position makes them an interesting chip on which an acquirer could build off.

Business Details

Customers

Customers come from two main buckets: real estate and direct-to-consumer (DTC). Of the total customer base, 44% are from real estate and 56% are from DTC.

Real estate

Real estate customers come from relationships with real estate agencies. FTDR has active relationships with 7 of the 10 biggest real estate agencies in the country and this was historically how the company grew. I.e. they pay Realogy a big annual fee to be the preferred provider to its agents. There are rules regarding compensation to specific agents for selling a policy, and the business has evolved to one where FTDR ends up compensating the agent via marketing co-op fees.  Real estate agents generally push home sellers to buy policies as an inducement for home buyers. In addition, the agent doesn’t want angry buyers claiming that the home wasn’t sold as advertised. The one-year plan is generally a small price in the context of the larger transaction and helps smooth it along. Retention rates for real estate customers for the 2nd year are low, 29% in 2018 (up from 21% in 2012), as the plan beneficiary did not purchase the plan. This compares to 75% retention for DTC plans. After the first year, renewal rates are similar for real estate and DTC customers.

Real estate funnel math: in 2018, 5.5 million homes were sold, of which 27% had a home service plan.  FTDR had 32% market share, for ~480k new customers.  After year 1, 29% renewed, for 139k ongoing customers.  FTDR market share has grown in this channel over time as it has strong relationships with the agencies (26% in 2012 > 32% in 2018).

DTC

Direct-to-Consumer (DTC) customers sign up with the company directly. Advertising is a mix of digital (38%), direct mail (24%), social & other (22%), and broadcast TV (16%). There is a 30 day waiting period for repairs after signing up, which helps address the adverse selection problem of people signing up as soon as they have a need for major repairs. Still, DTC customers tend to have higher repair costs in the first year. Less the real estate channel, there are about 3 million households out of 120 million households in the U.S. that have home warranty plans.  FTDR has over 50% share.

Home warranty plans are most popular in the smile states, starting in CA (where AHS was founded), dipping through Texas and up through the Southeast. The plans are not popular in the Northeast and Pacific Northwest for a variety of historical reasons.

Industry

FTDR has over 50% market share in the industry. Old Republic and First American are #2 and #3, with 13% and 10% market share. They are both part of larger title insurance firms and got into the business from that angle. There are a number of smaller regional firms. FTDR is considered the industry mainstay, as AHS founded the category in 1971, and historically has been able to charge a slight price premium as a result. They have a 500-1000 bps EBITDA margin advantage due to their scale.

The home warranty plan spells out in detail what is included in the coverage, but claims are sometimes denied. For instance, the plan covers repair of a garage door opener system, but it will not pay for a new garage door. FTDR, along with the other home warranty players, have terrible online reviews mainly as a result of denied claims. The company’s counter is that people expect the service to do too much for what they charge and that the criticism is misplaced. I tend to agree with FTDR and do not think that the bad reviews signify any major trouble ahead. The company is regulated by different players in different states (e.g. Insurance vs. Agriculture) and appears to have an understanding with regulators that they will self-police. 

Contractors

FTDR works with 17.5k contracting firms who have 62k technicians (avg 3-4 technicians per contractor). These firms all pre-screened by FTDR. 20% of the firms (~3k firms) are “preferred contractors” and do 82% of the work. They are paid much lower rates than retail due to the high guaranteed volumes. The company claims they 50% off market rates on labor to preferred contractors, and contractors I spoke with said 25-50% off. FTDR is ~40% of the total work of those preferred contractor firms.

Contractors are almost entirely mom & pops: Glyn’s Appliance Service, Ross Electrical Contracting, American Door Masters, etc. They like working with FTDR because of the steady volume of work provided. FTDR pays a flat fee. They might pay an appliance repairman $75 per visit, regardless of cost, vs his market rate of $120 per visit. Contractors accept this, despite losing money on some calls, because they are guaranteed volumes, say 1k calls per year. Business tilts towards newer firms, who use FTDR as a way to generate steady volume and build a following. Additional business for them usually comes from word-of-mouth and advertising on their vehicles. Contractors also benefit from the FTDR relationship as they upsell customers on services not provided under the plan and get future referral business. Contractors who I spoke with were almost universal in saying that FTDR was good to work with, especially compared to other home warranty firms. They are run professionally, pay promptly, and have attentive representatives. The contractors usually use FTDR, along with the other home warranty firms, because it is guaranteed business at no cost to them. These companies generally do not pay for work or leads on sites like Home Advisor. They hate the uncertainly of paying for and having to go after leads, especially as many are worthless. Contractors are managed on a 5 star rating system. FTDR claims that the overall average rating improved over time.

Contractors have a heavy incentive to repair rather than replace (e.g. buy a new refrigerator or microwave) as they are rated based on avg. cost to serve per call, and repairing is much cheaper than replacement. Over time, manufacturers are trying to limit the repair market by restricting access to parts in an effort to drive new sales. For instance, Whirlpool used to make spare parts for products up to 15 years and has now restricted that to 5 years.

Having a reliable and steady contractor network is a key component of the value of the FTDR business model and is fairly difficult to replicate.  Poor contractor experiences are the primary driver of customer churn and FTDR manages its contract base tightly.

Summary

FTDR should grow EPS by double-digits for a long-time, augmented by share repurchases or dividends, and the company's multiple is on the low side of where it has traded historically and I think probably should be higher.  I note there is no control shareholder and it has been over 3 years from spin-off.

Catalyst

Share repurchase.