Description

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

 

Recommendation

 

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.

 

Event

 

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.

 

Company Overview

 

Core Business

 

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

 

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.

 

Growth Business

 

 

FrontDoor has several areas of expansion:

 

Home Services

• 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.

 

On-Demand Services

• 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:

• Data

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.

 

• Smart homes

o   FD is testing installation of smart home services, which FD thinks will add value to plans and result in increases in renewals.

 

Market Dynamics

 

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.

 

Financials

 

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.

 

 

 

Model Overview

 

 

 

Revenue

o   Historic

• 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.

o   Projections

• 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.  

• Pricing

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.

 

COGS

 

o   Historic

• 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

 

• Projections

• 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.

SG&A

 

o   Projections

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.

 

EBITDAM

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).

 

Valuation

 

Related peer valuation

Source: 9/3/18 UBS

 

As of 6/30/18, FD will have debt of $988MM (net of $12MM in discounts / OID), total cash of $275MM and 85MM shares outstanding. Of the $275MM in cash, $225MM needs to be set aside for statutory accounting purposes (for claims amounts) and is not freely usable by the company. The below shows FD’s implied price based on various EBITDA levels and potential multiples, and a projected capital structure.

 

 

A downside case of $35 assumes a 12x 2019 multiple, 4 turns below the average peer group, similar to Home Service’s valuation.

 

On-Demand Service

 

What could the on-demand service be worth?

 

Given FD has not released clear details on the endeavor, a valuation of this service are difficult.

 

What FD has said was any on-demand service would be margin accretive to its current 20% and targeted 22% EBITDA margins. Services would be provided via the company’s preferred contracts (80% of total contractors) that the company has a volume agreement with. The 36,000 preferred contractor base (80% of FD’s 45,000 contractors), are spread out across the U.S., but those in FD’s core states (42% of FD’s revenues is in California, Texas, Arizona and Florida) are more likely to be candidates for the on-demand service as route density is key for the on-demand product success.  Assuming a range of 10-50% of the 36,000 preferred contractors are open to this service, at 3 – 4 jobs per contractor per year on an average price of $3,000/job (both HomeExperts estimates) with a product that has EBITDA margins well above 22%, the value add could be significant to FD’s current $296MM 2019 E EBITDA and this segment would garner a high multiple.

 

Peers

 

HomeAdvisor Angie’s List

 

ANGI Homeservices is a collection of brands that create a global online marketplace for connecting homeowners with service professionals across various industries. The company was formed when HomeAdvisor (part of IAC at the time) and Angie's List combined in May 2017. ANGI Homeservices generates the majority of its revenue through consumer connections, which comprises fees paid by service professionals for consumer matches and membership subscription fees paid by service professionals. HomeAdvisor and Angie’s list offer slightly different models:

 

·        HomeAdvisor - Operates a fee-based model where the service provider pays customer connection fee or matches provided by HomeAdvisor + a subscription fee.

 

·        Angie’s List – Operates an advertising business in which service providers pay a fixed fee for advertising, and consumers pay annual membership fee.

 

When FD launches an on-demand service similar to Angie’s List, the company would only charge customers and obtain their volume discount from their contractors. Contractors are incentivized to work with FD as FD provides a steady stream of jobs.

 

Home Service PLC

 

HomeServe

o   Homeserve is a home assistance policy business covering areas such as plumbing, heating and electrics offered in partnership with utility companies. Homeserve delivers its services via a mix of in-house and outsourced/partnered repair networks.  HomeServe is a hybrid of a consumer and financial services business and acts as an insurance intermediary (AmTrust in the US).

 

o   Segments include:

§  Membership, a subscription‐based home assistance plan covering plumbing, heating, electrical, pest control, and technology services. The company’s origin is in repairing outside water service lines:

http://www.utilitysp.net/coverage/

 

§  HVAC - which includes a wide range of heating, ventilation, and air conditioning services; and

 

§  Smart Home - which develops and distributes home automation technology.

 

§  Home Experts – On-demand, online review and booking platform to find vetted and reviewed local tradespeople for home repairs such as plumbing, heating and electrics. This is an attempt to be the ‘go to’ UK home improvement platform market, similar to a TripAdvisor in leisure.

 

Recent enthusiasm around Home Experts is partly a cause of HomeServe’s ~40% outperformance since May 2018 when management started discussing market potential. Before the recent rally, the stock was trading at 12x 2019 EBITDA.

 

HomeServe acquired Checkatrade in November 2017 and since then has ramped up testing of their HomeExperts model. The HomeExperts product gained traction among investors in May 2018 when the products plan was fully communicated.

 

Management incentive

 

Management is incentivized to sell FD within four years, the sooner the better.

 

 

Bonuses are dependent on

• Adjusted EBITDA

• Revenue

• Customer Count (change in the number of customers from the beginning to the end of the year).

 

CEO

·        Rexford J. Tibbens hired as  CEO effective May 15, 2018.

·        Prior experience

o   COO of Lyft from April 2015-February 2018

 

§  While at Lyft, Tibbens worked to expand the service to every state and launched crucial strategic initiatives, including their Nashville support center and Express Drive, a program that allowed potential employees to rent vehicles so they could provide service in select cities

o   VP  at Amazon.com from August 2012 – March 2015.

 

§   Led the technical and product development of the delivery feature of Prime Now, Amazon’s one-hour delivery service

 

§  Created Global Kindle Services from a concept to 20 global launches and support of 30+ Kindle and Digital products in 24 months. Services included customer support, launch readiness, product management and software development for Kindle customer experience (CX), usability, and customer insights.

 

§  Developed Amazon’s first “in app” live help feature (Mayday) which will bring a customer service associate into the customer’s living room to answer questions, provide help, and even take over the customer’s device—on demand, on device.

 

§  Reduced customer defects (contacts) by 46% year over year, reduced overall costs (supply chain and customer service) by over $40M, while improving customer experience scores by 20%.

 

§  Filed three provisional patents

o   Various roles at Dell from August 1999 – August 2011

o   Tibbens is a graduate from the University of Kentucky, with a bachelor’s degree in finance. He earned his MBA from the Case Western Reserve University.

 

Specific CEO compensation

o   Targeted bonus of 100% base salary.

o   Early 2019 CEO to be eligible for annual equity grants with a total grant date value of 250% of annual salary.

 

o   Corporate housing through the first anniversary of his hire date, the reimbursement of reasonable weekly commuting expenses between Seattle, Washington, and Memphis, Tennessee through the first anniversary of his hire date (company HQ is Memphis, Tennessee).

 

o   Initial stock option award of Parent stock options (SERV)

§  Initial stock option award of

·        Parent stock options with a grant date fair value of $1,625,000 (94,478 options), with an exercise price of $57.07.

·        An initial RSU award of Parent RSUs with a grant date fair value of $625,000 (10,952 RSUs)

·        A sign-on RSU award of Parent RSU with a grant date fair value of $1,000,000 (17,523 RSUs)

 

Other CEO Contract Points

o   Contract for four years starting May 15, 2018, with one year automatic extension and an automatic annual extension until terminated.

o   Effect of a Change in Control.

§  Change in Control of Control prior to the fourth anniversary of the grant date (May 15, 2022) results in an Alternative Award meeting the requirements of the plan, vesting fully.

 

CEO plans for FD

o   Tibbens said that he’s excited to lead American Home Shield on the next steps in its growth journey, including focusing on its distinct investment identity and unique market-leading position.

o   “I’m thrilled to join the team of 1,800 employees and 45,000 home service technicians that provide convenient, reliable and expert service to customers around the country,” said Tibbens. “There’s vast potential for growth in American Home Shield and the home services industry. Building and scaling shareholder value begins with outstanding service and digital improvements at every touch point.”

 

Risks

 

·        Customer reviews

o   Speaking to current FD customers as well as reviewing online reviews shows a sharp divergence of opinion on the service.

 

·        Claims and repair costs

o   There is a risk margins continue to be pressured if claim and repair costs continue to be as high as H1’18.

 

·        Leverage

o   From day 1, FD will have leverage of 3.7x net debt / LTM EBITDA; this excludes $225MM in cash required for statutory purposes.

 

Appendix

Form 10

https://investors.servicemaster.com/sites/servicemaster.investorhq.businesswire.com/files/doc_library/file/frontdoor_Information_Statement.pdf

 

CEO Rexford Tibbens

Linkedin Profile

https://www.linkedin.com/in/rex-tibbens-552b05/

 

Press Releases on Hiring

https://www.businesswire.com/news/home/20180503005826/en/ServiceMaster-Appoints-Rex-Tibbens-President-Chief-Executive

 

https://www.sec.gov/Archives/edgar/data/1428875/000142887518000086/serv-20180503xex99_1.htm

 

CEO May 2018 Contract Filing

https://www.sec.gov/Archives/edgar/data/1428875/000142887518000110/0001428875-18-000110-index.htm

 

Analyst Day Deck

https://www.sec.gov/Archives/edgar/data/1727263/000110465918056293/a17-28824_14ex99d1.htm

 

Angie’s list / IAC HomeAdvisor Proxy

https://www.sec.gov/Archives/edgar/data/1491778/000104746917005453/a2233101zdefm14a.htm#ci42601_the_transactions

 

Reviews

https://www.consumeraffairs.com/insurance/am_home.html

 

https://www.highya.com/american-home-shield-reviews

 

https://www.homewarrantyreviews.com/reviews/american-home-shield-ahs

 

https://www.yelp.com/topic/los-angeles-american-home-shield

 

 

 

Catalyst

Clarity around the on-demand product launch. 

Reduced claims costs.