Description

• Frontdoor sells home warranties (aka ‘service plans’) under the American Home Shield, HAS, OneGuard, and Landmark brands

• The company was spun out of ServiceMaster in September 2018

• Home warranties are a recurring revenue/capital light business and FTDR is priced for a low double-digit total return without accounting for improvement initiatives
• FTDR was an undermanaged asset and there are several no-brainer improvements that management can execute to create material upside to the base case double digit expected return
  • Initiatives to lower reserve requirements- an area ignored by prior management
  • Until this year, prices hadn’t been increased in several years despite cost inflation (FTDR will get half the benefit in ’19 and half in ’20)
  • Launched ‘dynamic pricing’ in October to prevent the chronic mispricing that’s resulted from using state-wide pricing
  • Initiatives to reduce customer service costs could boost EBITDA by ~20%
  • Reducing cycle time, improving retention rates, clarifying contract terms, improving the CRM software, reducing payment friction, and integrating the real estate portal with brokers’ software have also been mentioned
• There’s also material optionality in FTDR’s recently launched website that offers pre-priced repair services

Understanding Home Warranties

FTDR customers purchase a defined warranty on a number of appliances/home systems. Customers can pay on a monthly basis or up front for the year. Depending on the systems the customer selects to cover and the price paid up front, there is a per-use servicing fee that runs about $75-$125.

In the event of a service request, FTDR calls on its national network of 16,000 independent service providers (SPs), like HVAC repairmen and plumbers, to service customers. About 20% of FTDR’s SPs are part of the preferred network- SPs that have a history of quality service and elect to offer their services at a 50% discount to FTDR. In exchange, the preferred SPs don’t have to pay for marketing costs, which can be 10-20% of an SPs budget. They also get a guaranteed level of repair volume and the introduction to the homeowner allows them to sell their other services. FTDR accounts for about 40% of the business of an average preferred SP.

There is an existing write up on FTDR post-spin and the comments following the company’s stock price blow up last year are telling:

(small shout out- literally small- to hkup881 calling the move to $21/share ‘bordering on crazy’)

“It's just another fear-based marketing machine targeted at low income people.”

And

“you're looking at this completely wrong because this is an insurance company with rapidly wasting assets”

 In fact, FTDR does not target low income people. The demographics of FTDR customers are similar to US averages in terms of home value and age but DTC customers skew higher than average on household income. 36% of FTDR’s new direct to consumer customers make over $100k/ year.

FTDR isn’t really an insurance company either. Like title insurers, FTDR has certain similarities to insurance companies but also has significant differences that justify a different perspective.

One difference is that FTDR doesn’t face catastrophic risk (home insurance covers that). Another difference is that the average FTDR customer makes 2 to 3 ‘claims’ per year.

The home warranty value prop to the customer is: 1) cost certainty and protection and 2) the convenience of one point of contact. By gaining scale, FTDR can offer greater route density and predictability to service providers as well as cheaply source replacement parts.

FTDR sells warranties in two channels- real estate and direct-to-consumer. The real estate channel consists of 150 internal sales reps that recruit realtors to attach plans to their transactions. About 1.5mm of the 5.3mm homes sold in 2018 included a home warranty, of which ~1/3 were from FTDR. Customers who purchase a warranty when they buy/sell a home are likely most interested in the cost certainty part of the value prop. The warranty is often paid for by the seller too. This results in a low first year retention rate of 28% for the real estate customer acquisition channel.

The direct-to-consumer channel has a higher first year retention rate of ~75% and is a more valuable contract for the company.

There are a few ways to look at market penetration but any way you slice it, the opportunity is wide open. About 5 million US households have a home warranty compared to a potential market of 75 million owner-occupied households.

Undemanding Valuation

The way I’m approaching the valuation is by estimating a total return from the core business and assuming that the company’s investments and improvement initiatives will provide additional upside (you can judge that in the next couple of sections).

FTDR’s core business has grown its top line at a ~10.5% CAGR over the last 5 years. Ex-acquisitions, the company has grown customer count at a 6-7% rate and taken 1-2% price for an ~8% organic growth rate. The business model is tangible-capital light, but according to management, statutory reserves requirements will amount to about half of the dollar revenue growth. To grow the top line at 8%, FTDR needs to keep on its balance sheet about 1/3 of the FCF that it generates.

For just the core business, I estimate the company is trading for a normalized ~4.5% forward FCF yield.

Subtracting 1/3 of FCF for reserve requirements gets you to an 11% total return (3% distributable FCF yield plus 8% growth). I think a total return calculation is appropriate given the growth runway is multiples of FTDR’s current size, but if a 5-year DCF with terminal year multiple compression gets you to a fair value around the current price.

 Additional Upside from Basic Blocking and Tackling

Reserve Requirement Improvements:

As noted above, management guided to reserve requirements of half the dollar increase in revenue. Reserve requirements were not a concern to the previous management as the company was able to rely on the larger parent company to easily pass requirements. Now that FTDR is standalone, management is undertaking several initiatives to lower its requirements. It’s unclear exactly how much they can improve reserves, but it could potentially add another 100bp of annual return over the long-term.

Price Increases:

FTDR hadn’t raised prices in the real estate channel in 2-3 years, and in over a year in other channels. Inflation and cost pressure from SPs depressed gross margins. Management introduced mid-single digit price increases this year that has resulted in lower volume growth and greater price growth relative to FTDR’s history. Roughly half of the price increase will roll through the financials in 2019 with the rest coming in 2020.

Dynamic Pricing Initiative:

Pricing in the industry is done on a state by state basis, with some competitors even pricing on a national level. Shockingly, FTDR charges the same amount for a $3 million dollar house with high end appliances as it does for a similarly sized $200,000 house with low end appliances. Compounding the stupidity is the fact that labor rates, FTDR’s primary input cost, vary dramatically within states. This results in FTDR undercharging the higher income customers and overcharging the lower income customers.

The company just launched its ‘dynamic pricing’ in late October and we should see some results in 2020. Previously, FTDR’s pricing was spreadsheet driven. An engineer would have to spend days manually changing the pricing to put through increases. The new dynamic pricing will price warranties on a zip code plus 4 (neighborhood specific) basis. This will allow the company to introduce all sorts of data into the pricing algorithm and bring the company into the 21st century. The first phase of the dynamic pricing rollout will apply to renewals. The second phase will be launched into the DTC market in 2020, followed by a final stage where it’s used in the real estate channel too.

Customer Service Cost Reduction:

FTDR spends 8% of its revenue on customer service, primarily on call centers. 60% of contacts are phone based and the move to a self-service model could materially impact FTDR’s margins. The business is likely intrinsically customer service heavy, but it’s also clear that previous management didn’t invest much into rationalizing this cost. FTDR’s internal systems are from the 1990s. The company has been rolling out a workflow-based software called Customer Service Central to assist in onboarding customer service reps during peak season, and management believes that over time, they can cut that 8% customer service cost at least in half. While I suspect that this industry will always be phone-centric, a 4% increase in margin would be a ~20% increase in EBITDA.

Loads of other stuff:

There is a lot of other low hanging fruit for the new management team to execute on. Reducing cycle times, improving retention rates, improving CRM systems, reducing payment friction, updating the real estate agent portal to connect it to proprietary systems, and making contract terms clearer are some of the things that have been mentioned.

Venturecapital Investors Club

FTDR just launched its new ‘on-demand’ product (CanduHome.com), a website that offers pre-priced flat-fee repairs. Customers enter some basic information about the appliance and their problem, select a flat fee or diagnosis only fee, and schedule a visit in a 2hr preferred service window.

When the flat fee is selected, the diagnosis portion is paid up front with the rest of the fee paid after the item is repaired. No matter the cost of the repair, the customer only pays the flat fee. Candu also guarantees the repair for 6 months. If an appliance can’t be repaired, Candu only charges the customer the upfront fee (~$80). The customer is given the opportunity to purchase a new appliance through the Appliance Upgrade Program, which includes free delivery, installation, and removal of the old appliance.

The biggest value prop for Candu customers is the pricing transparency followed by the scheduling transparency. Customers will also have the advantage of being able to get service from a bigger company that has more leverage over the SP and can manage them with a bigger stick.

Competitor ANGI Homeservices Inc. (HomeAdvisor and Angie’s List) has a lead-gen model where customers describe their job and are shown paid ads from local SPs. ANGI acquired Handy and is focusing on its own on-demand service. The primary governor of ANGI’s on-demand growth has been the SP network. In fact, the SP network is also the limiting factor in their lead gen business. FTDR has a big leg up because it already has 16,000 SPs (45,000 technicians) in its network along with the experience of managing them for the warranty business. How much supply is available in their existing SP network is unclear to me, but management has indicated that the existing SPs want to do more business with FTDR, and the on-demand model should be more attractive than the ANGI lead gen model.

You could write a book on the ins and outs of this venture, but it’s worth mentioning that there are a couple of 800lb gorillas- ANGI which is strong in the demand half of the marketplace, and FTDR, which is strong in the supply half. The businesses probably belong together. I suspect that FTDR would also be a great fit with other real estate-related companies as traditional brokers and iBuyers struggle with margins.

Risks and Concerns

Housing downturn:

FTDR will be negatively impacted, but perhaps less than expected. New plans sold through the real estate channel account for about 15% of FTDR’s revenue in a given year. This would be most affected by a decline in home sales.

FTDR grew its revenue 4% in ’08 and 2% in ’09 because the company switched its investments from the real estate channel into the DTC channel. The DTC business was smaller back then, but presumably they could use a similar playbook today. Management is already placing greater emphasis on DTC anyway.

Negative reviews:

If you look at FTDR’s social media presence/online reviews, it’s clear that there are a lot of pissed off customers. I’m guessing that this is due to a combination of factors.

First, FTDR was historically undermanaged and the company probably hasn’t provided great service.

Second, there’s a higher proportion of customer dissatisfaction from the real estate channel due to the warranty being improperly represented by real estate agents. Clearer contract terms and better training of brokers can help with this.

Finally, I suspect that the home warranty business is likely to attract more negative reviews than other industries because the company is responsible for repairing essential systems that life sucks without. If a landscaping company takes an extra week to complete its job, it’s not going to result in the same proportion of negative reviews as an HVAC or refrigerator repair that takes an extra week. American Home Shield (FTDR) has a dismal 1.1 rating on highya.com, but competitor Old Republic Home Protection has a 1.2- not much better. HomeAdvisor (ANGI) only has a 1.3, and since they don’t do anything except connect people to local SPs, it indicates that dealing with SPs probably generates a disproportionate amount of negative reviews.

Capital allocation:

Management doesn’t have a capital allocation track record. They could let the cash build or engage in value destructive M&A. We also don’t know yet how much they plan to spend on customer acquisition for Candu, which could end up being worthless. Management has said that Candu won’t radically change the company’s margin profile.

Earnings variability:

Shortly after the company was spun out, FTDR’s margins cratered on higher than expected inflation in SP costs and particularly poor weather. Investors just have to be comfortable with lumpiness in results. It’s important to use normalized margins when evaluating the company.

Catalyst

Time and/or the success of Candu