Description

Quick Summary:

·         Description - Frontdoor is the leader in the home warranty industry, with a business 4x the size of nearest peers in a space with serious economies of scale

·         Revenue acceleration - Frontdoor is seeing revenue accelerate above 10% (from 7-8%) from growth in the real estate market, increased marketing investment in their direct to consumer channel, and rapid growth of their new ProConnect offering

·         Margin opportunity - Frontdoor has taken a margin hit due to COVID, but I believe this should reverse when COVID ends (and to the extent it does not, a small price increase can make up the remainder) and it should be able to return to 2019 margins by 2022. Sell side expectations assume FTDR will be well below 2019 margins through 2024

·         Returns – If margins return to near 2019 levels by 2022, at a flat EBITDA multiple FTDR should see a 38% one year return. Over the longer term, if margins continue to expand as they have historically, at a flat EBITDA multiple the stock could reach $120 over a three year period, roughly a 30% IRR

Description:

There have been a couple of good writeups on VIC on FTDR with explanations of what the company does, so we will keep this part brief. Frontdoor sells home warranty plans. These cover various appliance and systems in your home. You pay them (for example) $35 a month and then if your refrigerator breaks, you pay (for example) $100 for them to come out and repair or replace your fridge. The pricing is a bit variable and depends on your region and plan options.

The contractor who comes out to repair or replace your appliance is not on FTDR’s staff. Instead, Frontdoor goes out and contracts with third-party businesses, offering volume in exchange for discounts. There are 17,000 contractors in Frontdoor’s network. Dispatch of contractors is done to favor those with lower prices (to reduce FTDR’s COGS) as well as the contractors reviews (to ensure customer satisfaction/retention).

Frontdoor sells these plans two ways. First, they go direct to consumer (DTC) via advertising. A potential customer sees a TV/online ad and goes online and signs up. Also, they sell via the real estate channel. Typically, this is something done by the seller of a home. Their real estate agent tells them to spend, say $500 on a year-long warranty to provide the buyer assurance that if something key in the home breaks, it will be covered. This provides the buyer assurance that if the air conditioner (for example) breaks a month after purchase it can easily get fixed.

These channels have very different renewal rates. DTC is renewed at 75% in the first year. Real estate on the other hand is 27%, which is low but this is often because the buyer of the policy is the seller of the house, not the user of the policy. Those who have had the policy at least one year renew at rates in the low to mid 80s. Given Americans move roughly every 10 years, this means the theoretical maximum renewal rate is 90%, implying only 5-9% of customers in the cohort that have had the policy longer than a year churn voluntarily. This low “voluntary churn” demonstrates that customers are generally quite satisfied with the product experience.

Competitive landscape:

One of Frontdoor’s key advantages is its dominant market position. According to the chart above from their 2018 investor day, it is ~4x the size of their next largest competitor.

This provides a major advantage for FTDR as there are significant returns to scale in this industry. Not only can FTDR better cover their fixed cost base, but more importantly they can get significantly lower rates from contractors. The contractors are often small businesses and very local, and if FTDR can supply 4x the jobs in a given area, that means they will be able to negotiate a significantly lower rate than peers.

It’s a bit tricky to see this in the numbers as there are no pure play public competitors. However, we can look at California state filings to benchmark margins. These reports are performed every 3-5 years and show gross margins for FTDR’s major competitors. As shown below, FTDR’s competitors have gross margins ranging from 36% to 44%. In contrast, FTDR had a 49.6% gross margin in 2019 and 50.0% in their 2015 California report. These findings of a significant gross margin advantage for FTDR have been confirmed in calls with industry experts.

This structural margin advantage means that each customer FTDR acquires is significantly more profitable than competitors. This in turn means that FTDR can outcompete competitors in DTC, as it can simply outbid and outspend competitors on marketing given a much more favorable LTV. This creates a virtuous cycle, making it possible for FTDR to gain more and more share of the market over time.

COVID impact:

COVID has had a few impacts on FTDR’s business. First off, it caused some temporary disruptions in their real estate channel sales when the housing market froze in 2Q20. The market has rebounded quickly, and existing home sales were up in 4Q20 portending a strong next couple quarters in this channel.

In addition, the company has seen a significant rise in claims as customers stay at home and use their homes’ appliances and systems more frequently. In 4Q20 alone they guide this impact to be a $12M-$14M hit.

I believe it is unlikely this hit remains permanent, as COVID will one day end. Still, it’s worth thinking about how much price would have to increase to offset this hit. Based on the math below, we see it would only require a 3.5% price hike. However, FTDR normally takes 1-2% price a year to offset cost inflation, so really that would mean a 5% price increase in one year to offset COVID costs if they ran forever.

Realistically, COVID will end but some fraction of people will stay working at home more/forever and so they will have to take some fraction of that 3.5% increase to offset permanent work from home increase costs.  Still, whatever price they will have to take will likely be reasonable and unlikely to cause sticker shock.

Also, it’s worth highlighting competitor statements about price increases because their price increases will make it easier for Frontdoor. ORI and FAF both commented on their most recent earnings calls, and they are the 2^nd and 4^th largest players in the market. The 3^rd largest player (2-10 Home Warranty) isn’t public, and the 5^th largest player (FNF) hasn’t said anything about warranty on any earnings call in the past year.

Competitor statements:

“Our home warranty business delivered strong growth, improved retention rates and effective expense management throughout the quarter. The business continues to experience an increase in claim frequency, particularly in the appliance and plumbing trades, which we believe are attributable to the pandemic. Due in part to this trend, we are in the process of making policy changes and adjusting our pricing to offset cost pressure in the business. We expect the home warranty business to continue to generate strong margin performance this year.” – FAF 3Q20 call

“And it's our home warranty business that has seen an increase in loss ratio. So what's behind that are a couple of things. One is the cost of work orders has increased much faster than we expected and much faster than normal. And then secondly, the number of claims that we've seen has increased. And we think that part of that is actually COVID related in that people are home and discovering issues with whether it be appliances or systems in their homes and are making more claims. So you couple those things, and we've seen an increase in our home warranty business. So the good news about home warranty, as you well know, is that it's extremely short-tail. And we can react extremely fast as we always do on that business with pricing. And it's a fairly straightforward business. And when we see those kind of things, we immediately take pricing action.” – ORI 3Q20 call

One last COVID impact some have speculated about is retention and whether a recession would cause households to cut back on FTDR’s service to save cash. Surprisingly, during past recessions the company has seen retention improve, and experts have attributed this to risk aversion. While it is unclear how much of a tailwind this has provided FTDR in 2020 to date, FAF mentions they have seen improved retention in the call excerpt above.

Revenue acceleration + ProConnect opportunity:

Frontdoor has historically grown organically 8% per year since 2014. However, on their most recent (3Q20) call they guided to an acceleration in growth in 2021 to double digits. While they left their 2021 guidance fairly vague and said to expect more details on the 4Q20 call, it’s worth thinking about how they will get there.

First off is the real estate side. As alluded to above, the housing market is currently booming. Frontdoor’s sales are tied to existing home sales which in December were up 22% on a SAAR basis. In addition, FTDR has easy comps in the first half of 2021 as they lap the downturn caused by the onset of COVID (May 2020 sales were the trough, down 27% YoY). While the company has called out some headwinds due to a lower attach of policies on homes sold, it’s easy to come to an outcome where this segment is up mid-teens for the company in 2021.

Next is DTC. In 2020 FTDR accelerated their DTC marketing significantly mid-year to offset real estate declines and take advantage of lower ad rates, and in the third quarter saw a big spike in customers. While the company does not disclose this number exactly, my attempts to back into their number of customers added showed they added >30% more customers via DTC in 3Q20 vs 3Q19. Some of this advertising surge tapered off during the election due to increasing ad rates, but IR hinted that it might make sense to continue with elevated marketing investments to some extent in 2021.

Finally, the company should see a tailwind from their new adjacency called ProConnect (previously called Candu). This product allows non-FTDR customers access to Frontdoor’s contractor network, charging them a fixed fee for repairs of a broken appliance. ProConnect has been in limited testing in a few cities to date, however the company for the first time laid out expectations  for growth in coming years, indicating they have found “product market fit”. Below are Rex’s expectations for the roll-out.

“At this point, we anticipate ProConnect will complete approximately 80,000 service requests in 2021, 200,000 service requests in 2022 and 400,000 service requests in 2023. While we expect our average revenue per job to vary as we add additional services, this translates into an estimated annual earned revenue of $20 million, $60 million and $120 million, respectively, over the next 3 years.” – FTDR 3Q20 call

Given a normal year is 8% growth, it’s not hard to see how the above three growth drivers can get the company into double digits, and I am modeling a 10.7% top line CAGR through 2024. Additionally, if retention improves the way it has in prior recessions, we should see a further acceleration, however I have not put this in my numbers.

Margin expectations vs street:

Due to the issues with claims outlined above, COVID has caused a degradation in FTDR’s margins. In addition, prior to COVID the company had guided to 2020 being somewhat of an investment year, with a 200bps headwind due to spend to upgrade technology and to launch what became ProConnect. These two effects combined to produce a serious headwind on margins, and 2020 street expectations are for 18.1% EBITDA margins vs 22.2% in 2019.

The street’s numbers going forward assume FTDR has little ability to return to prior margins, let alone exceed them. Going forward the street assumes 18.8% in 2021, 19.7% in 2022 and 19.6% in 2023. Yet in our conversations with the company, Frontdoor has reiterated a desire to return to low 20s EBITDA margin.

I believe the path to get there is not extremely challenging. First off, the company targets a 50% gross margin, and getting to this level will allow it to pick up 130bps of margin expansion. This could be achieved by a combination of pricing increases and reduction in claims as COVID eases as discussed.

Second, I believe the company should be able to get a significant amount of leverage out of their 2020 investments. 2020 investments in Proconnect and another technology Streem of $15-$20M of opex were accompanied by very little revenue or cost benefit in 2020, but Proconnect revenue should ramp in 2020 and Streem should provide cost savings, meaning this 100-125bps margin headwind should reverse as well.

Additionally, the company mentioned in 2020 they had headwinds from investments in general corporate overhead, technology and customer service. While the dollar amount of these investments wasn’t given specifically, I believe there should be leverage on these largely one-time costs.

The above items show a clear path back to the low 20s, but there’s more to this story. As this business has grown, it has been able to improve margins meaningfully over time. In 2010, the business had 14.2% EBITDA margins as part of SERV. In 2019, as a business with ~2x the 2010 revenue, margins were 800bps higher. This margin increase was despite the standalone company costs related to the spin, which seem to have caused a ~300bps headwind in G&A alone.

Over time, I believe the company should be able to not just re-achieve 22.1% EBITDA margins, but as it grows it should be able to move those margins more into the mid 20’s over a 3-5 year timeframe. 

Returns:

At a flat EBITDA multiple of 17.4x (current 2021 street multiple if you exclude restricted cash from the Enterprise Value), if this company can return to just under 2019 EBITDA margins by 2022 the stock should return 38% over the next year. Even if the multiple declines a turn and a half to where it was in 2019, the stock should return 26%. I would argue we are unlikely to see multiple compression though as long as growth accelerates in line with guidance.

Longer-term, returns depend on margin assumptions. If the company can achieve mid 20s EBITDA margins in 2024 by continuing their trend of margin expansion since 2010, at a flat multiple there is a path to a $120 stock price, or a ~30% three-year IRR.

Risks/issues:

·         Pay package – Long term CEO package incents revenue growth and market cap. Having revenue growth goals instead of profitability goals may incent them to do low margin expansion. Having a market cap-based goal also skews their incentives around capital return, for example making repurchases not in management’s financial interest

·         CFO – The CFO is the former SERV IR lead. Multiple buyside and sellside contacts I have spoken with have a negative impression of him, and I cannot disagree with any of this. My hope is CEO Rex Tibbens will replace him with a more adept leader. Rex has been making a number of executive changes since the spin (SVP Ops, CTO, CMO, HR), and hopefully will fix this issue

·         Margins – The company has hinted they may reinvest some of the money I am modeling as margin tailwind in further accelerating growth, causing the company to miss my longer term margin targets. However, it seems likely to me that in the current market, accelerating growth will be met with multiple expansion, and returns may even exceed what I’ve modeled.

Catalyst

Results demonstrating margin expansion