Frontdoor: Strong Retention, Operational Outperformance Driving Growth (NASDAQ:FTDR)

Investment Thesis

We ascribe Frontdoor (NASDAQ:FTDR) a ‘Strong Buy’ rating on the back of 1) strong brand resonance and market leadership position 2) higher customer retention rate and renewals driving growth providing continued visibility and 3) relative undervaluation driven by continued upwards revisions as a result of strong operational outperformance. Initiate with a Strong Buy and ascribe a target price of $45 (at 24x Fwd P/E).

Company Background

Frontdoor is the largest provider of home service plans with 46% market share in the US (3x the second largest competitor) with 2.1 mn customers through its key brands Frontdoor and American Home Shield. It offers subscription plans in a three-tiered package with average subscription plans of $34 – $74 that focuses on repair or replacement of major components of 20+ home systems and appliances including HVAC, plumbing, electrical systems as well as kitchen appliances such as ovens, cooktops and dishwashers. Home service plans are sold through real estate and DTC channels with real estate plans purchased by home sellers, real estate agents or home builders while DTC subscription are purchased outside of the real estate transaction. Renewals from the existing users form the bulk of the sales demonstrating the brand resonance with strong retention rate and better visibility on the future outlook.

2022 Revenue Split

Historical Financials

The company reported stable growth in revenue during 2018-2022 period primarily driven by pricing initiatives and movement of members to higher tier plans with stable number of home service plans. Average revenue per plan per month increased at ~7% CAGR which has been a primary growth driver for revenue. Customer retention rate remained stable at ~75% which provides continued visibility on the future growth as a result of strong brand resonance amongst its existing users. Gross profit margins declined substantially in 2022 primarily as a result of inflationary headwinds due to higher contractor related expenses as well as higher parts and equipment costs. Adj. EBITDA margins remained around 20% mark on average but declined in 2022 as a result of a shrink in gross margins.

Robust Q3 Beat and Raise

The company reported a beat and raise in Q3 with total revenue of $524 mn, up 8% YoY, above the company’s guide of $500 mn – $515 mn and consensus expectation. The strong beat was driven by an increase in on demand home services which resulted in other revenue increasing by 85% YoY to $24 mn. Home service plan channel remained resilient and largely in line with guidance with renewals growth of 14% (vs guidance of ~15%) while real estate declined 23% (vs guidance of down mid-20s) and DTC channel declined 16% YoY (vs guidance of 15%). Customer retention rate continues to be strong at 76.2% compared to 75.3% YoY and average ~75.1% over the past 5 years.

Gross margins increased by 760 bps YoY to 51% as a result of pricing actions and process improvement initiatives and was further helped by lower than expected claims cost inflation due to lesser service requests. After a steep decline in gross margins during 2022 due to inflationary headwinds, pricing actions and lower claim cost inflation have helped them to post a continued improvement in its gross margins through YTD 2023, in line with its historical levels. Adjusted EBITDA margin improved by about 810 bps to 24.4% primarily driven by robust gross margin expansion as well as higher investment income partially offset by SG&A deleverage of ~80 bps on the back of higher personnel costs and marketing expenses.

Balance sheet remained strong with cash balance of $320 mn compared to $292 mn at the beginning of the year driven by sustained cash generation in YTD period. Total Debt outstanding ended at $597 mn compared to $609 mn in December 2022 with Net leverage ratio of just 0.8x providing sufficient flexibility for cash allocation priorities in the near to medium term.

The company raised its outlook and expects Q4 2023 revenues to be $350 – $360 mn (vs $340 – $345 mn previously), up 5% YoY at midpoint. It also expects Adj. EBITDA of $20 – $30 mn (vs $5 – $15 mn previously), down ~24% YoY at midpoint primarily due to a favorable development of ~$25 mn in Q4 2022 (excluding that Adj. EBITDA is expected to grow three-fold). Full year 2023 revenues is now expected to grow ~6% YoY to $1.77 bn at midpoint, higher than the ~3% growth guidance at the beginning of the year. Gross margin for the year is expected to be ~48.8% at midpoint compared to 46.5% last quarter and 44% at the beginning of the year driven by stronger retention rates despite pricing actions and lower claim costs. Adj. EBITDA for 2023 is also expected to be $325 at midpoint, up 52% YoY which is also over 40% higher than the initial outlook.

Management further increased its share repurchase target to $125 mn from $100 mn previously for 2023 as a result of perceived undervaluation which is a rather rare statement from an otherwise cautious management. It has repurchased about $76 mn YTD 2023 and the sufficient cash balance and flexible balance sheet along with strong cash generation would allow them to sufficiently enhance its shareholder activities.

And while I don’t normally comment on our share price, I want to call out our current valuation, which is at one of the lowest points in the last five years. This is truly an inflection point for Frontdoor. And while some of this is market-driven, we are taking advantage of this opportunity to increase our 2023 share repurchase target to $125 million.

– Bill Cobb, Chairman and CEO, Frontdoor (Source: Q3 Transcript)

Valuation

We compare FTDR with service oriented consumer facing businesses as a result of no direct listed peer within the repairs and furniture maintenance services. The company trades at 14.7x at a significant discount to its peer average of 24.0x as well as the company’s historical long term average of 24.1x. We believe the current discount is on the back of perceived weakness in the overall housing sector and rising unaffordability which could deter real estate segment as well as decline in DTC segment due to inflationary headwinds. However, we believe its strong brand resonance amongst its existing users driving higher retention rates despite pricing increases underlines the quality of service and providing value for money for the consumers.

Management is still contemplating the pricing actions to carry forward to 2024 from the 11% price realized for the current year. We believe the pricing impact will be modest entering in 2024 and expect a mid single digit growth as a result of pricing impact. In addition, we expect real estate segment to continue declining by high teens in 2024 and expect the overall revenue growth to be 5% YoY for 2024. It plans to relaunch American Home Shield brand early next year supported by a new marketing campaign which would be pivotal as the pricing benefit wanes and the company focuses back on growing its home service plans. We expect Adj. EBITDA of about $350 mn for 2024 (vs $325 mn at midpoint in 2023) with a marginal increase in marketing spends and stable gross margins. We Initiate a Strong Buy and ascribe a target price of $45 (at 24x Fwd P/E, in line with its historical average and peers)

Risks to Rating

Risks to rating include

1) Real estate segment recovery could be further prolonged and lead to higher 20%+ decline in the near term as a result of continued housing market challenges

2) Home service plan units could continue to further decline as witnessed in 2022-2023 as a result of inflationary headwinds

3) Gross margins could decline as a result of higher claim cost inflation along with higher than expected inflation in parts and wages

Conclusion

FTDR has been a huge outperformer, up 46% compared to S&P’s rise of 16% in past year. Despite the outperformance, the multiples are trading at 5 year trough levels as a result of continued raising of its forward guidance.

We believe the stable home service plans and strong renewals despite absorbing a double digit pricing growth serves as a testament to its brand resonance and high quality standards for the consumers providing value for money. We ascribe a Strong Buy rating and initiate with a target price of $45 (at 24x Fwd P/E, in line with its historical average)