Frontdoor, Inc. (FTDR) specializes in all areas of home servicing from improvement, to repairing, and maintaining. The company’s goal is to take the hassle out of owning a home through its large network of provided services. Frontdoor has 2 million customers and 15,000 contractors, making it the largest home servicing company by nearly four times. After being spun-off from its parent company, Service Master, the newly independent enterprise quickly dropped 40% in share price. Forced selling, window-dressing portfolios for year-end meetings and small tax-loss harvesting seem to be the main drivers behind the company’s share price decline. Current share prices offer close to 50% return.

The investment thesis is simple: Frontdoor has a high-margin / capital-light core business that is growing faster than industry average in a largely under-penetrated market. Free cash flow conversion rates close to 70% provide the company with capital to either pay down debt, invest in ancillary services, give back to its shareholders in dividends, or a combination of the three. Since 2013, the company has grown revenues at 12% CAGR (66% of which are recurring), sports an average EBITDA margin of 22%, and spends less than 2% in CapEx. Finally, Frontdoor has a strong value-add for both the home-owner and the contractor, creating a self-reinforcing competitive advantage as the company expands customers and services.

Management & Their Alignment

The company is led by CEO Rex Tibbens who has an impressive track record. Tibbens took the role in May of 2018 after serving as the COO of Lyft, the on-demand transportation company. While working at Lyft, Tibbens expanded the service to every state and oversaw the development of the company’s Nashville support center. Before Lyft, Tibbens worked as VP at Amazon in which he led the Development of Prime Now.

Tibbens’ compensation is a mix between his base salary, annual bonus, and annual LTI awards. 22% of his compensation will come from the base salary, 22% from any annual bonus awarded, and 56% of his salary will come from various long-term incentive awards. In other words, Tibbens makes the big bucks by delivering strong operational success over the long-term. Such long-term incentive awards include a 50/50 mix between stock options and shares of company stock. Should Tibbens execute well enough to receive the long term award, he would receive close to 95K stock options and 28,000+ restricted shares. These stock options have an exercise price of $57.07

Value Proposition to Home-Owner

Frontdoor offers four main value propositions to the Homeowner: Budget Protection, Peace of Mind, Convenience, and Guaranteed Completion. For most, purchasing a home is the greatest investment decision they will make. However, buying a home isn’t all roses and dandelions. It’s not a matter of if something goes wrong, but when. Annual claim frequency for American Home Shield’s service plans were 156% higher than other insurances such as Homeowner’s, Auto, and Extended Warranty. Frontdoor customers use their plans (on average) twice per year.

To see the value-add for the homeowner, we need to understand the average cost of not having a service plan. Without Frontdoor (or a similar service), refrigerator replacement costs $1,035, HVAC replacement costs $3,565, and oven replacement costs $755. Keep in mind that 69% of Americans have less than $1,000 in savings, and 34% have no savings at all. Frontdoor’s average annual cost for a service plan is around $400. This means that a Frontdoor home service plan pays for itself after the first use.

Value Proposition to Contractors

In a not-so-distant past life, I spent a semester building a landscaping company while attending Syracuse University. I used websites such as Home Advisor and Craigslist to generate leads which would (hopefully) turn into actual contracted jobs. The main problem with a site like Home Advisor is it’s a two-step process. As a contractor, you have to first win the lead and then negotiate a specific price to win the contract.

FTDR eliminates the two-step process by giving contractors actual paid jobs, not leads. By partnering with Frontdoor, contractors are supplied with higher volumes of steady work, access to infrastructure for replacement systems and parts, and the ability to grow their own network through a wider spectrum of potential clients, leading to up-sell opportunities through specific contractor value-adds. The data show that contractors are happy with the partnership as 95% of contractors in Frontdoor’s network want to expand their relationship over the next two years. This combination of 15,000 contractors and two million homeowners translates into 4 million services provided annually (or one every eight seconds).

An Industry Leader with Room To Grow

Frontdoor, Inc. dominates 46% of the home service plan industry, its next closest competitor holds a mere 11%. Because of their size and market dominance, the company is able to efficiently and quickly scale up via four processes. First, Frontdoor has more customers in any local market. More customers translates into more dispatches from those customers. This enables the company to negotiate annual volume discounts with contractors to lower prices for services. Negotiating lower prices provides incrementally higher gross margins enabling FTDR to reinvest back into their core growth business.

The Home Service market has an addressable market of $400B with the Home Service Plan industry making up $2.4B. Even though Frontdoor owns 46% of the share, the overall industry remains highly under-penetrated. Fewer than 4% of U.S. Households have a home service plan (4.5M). Along with its under-penetration, the company has room to grow revenues in the middle of the country with most of the states in middle America representing less than $10M in annual revenues. The under-penetrated industry along with under-monetized sections of its existing customer base gives Frontdoor a long runway for continued growth above industry average.

Where Do Revenues Come From?

The company generates revenue via selling home service plans on an up-front yearly basis or month-to-month commitment. Home service plans work much like health insurance in that there’s both a “co-pay” and a “premium” that one must pay to use the insurance. In Frontdoor’s product, a customer pays an up-front Trade Service Call Fee (think of this as the health insurance “co-pay”) and then are charged monthly for insurance against Systems, Appliances, or a combination of both. Also like health insurance, Frontdoor offers various contract structures with trade-offs between higher Service Call Fees and lower monthly premiums, and vice-a-versa.

The company offers three Trade Service Call fees: $75, $100, and $125 per service call. For the $75 service call, FTDR offers $39.99 for Systems only, $39.99 for Appliances only, and $49.99 for the Combo. The $100 per service call offers $39.99 for Systems, $29.99 for Appliances, and $39.99 for the Combo. The $100/$39.99 Combo is the most popular choice amongst homeowners. In 2017 the company reported that 66% of its revenue is recurring revenue (1.4M customers), with numbers projected to grow closer to 70% over the next two years.

Multiple Revenue Streams – How SG&A Gets Spent

The company splits its revenues between Direct-To-Consumer and Real Estate (52%/48%). On the DTC side, the company is aggressively spending on enhanced ad campaigns with goals to measure the incremental lifetime value of each marketing dollar spent. Investing heavily in online advertising has paid dividends for FTDR as Mobile eCommerce sales have grown to higher shares of overall eCommerce sales (5% in 2014 to 20%+ in 2018).

On the Real Estate side, Frontdoor deploys a Field Sales organization of over 150+ professionals, 50+ phone based sales agents, and National Real Estate partners. Through partnerships with Coldwell Banker, Better Homes, and Sothebys, Frontdoor’s goal is to make purchasing a home service plan a standard procedure in the home buying process. The Real Estate sales market is under-penetrated with only 1.5M homes sold with home service plans (out of 4M homes sold). Out of the homes that are sold with service plans, 32% are Frontdoor plans, leaving ample runway for expansion. 1st term Real Estate renewal rates for Real Estate transactions are only 29%, not up to the standard for DTC of 75%. The trend is upwards, though, as the company has increased Real Estate retention rates from 21% back in 2012.

Future Growth Strategy

Every service Frontdoor adds to its repertoire increases marginal value at little to no incremental costs on a claim by claim basis. By adding services, the company increases its ability to engage and provide to homeowners, which turns Frontdoor into more of a home maintenance solution.

The company currently offers services for various appliance and systems replacements (such as fridges, dishwashers, ovens, HVAC’s, etc.). Management is testing new services such as Locksmiths, TV mounting, Carpet Cleaning, Utility Line protection, and a Handyman Service. Looking farther into the future, Frontdoor expects to provide services such as painting, Smart Home Installation, Landscaping, Home Inspection, and Moving.

These growth trajectories will be accomplished through a mixture of M&A and internal R&D spending. However, if the company is able to execute on its growth strategy and expand its services it could turn Frontdoor into an incredibly sticky business for both the homeowner and the contractor.

Valuation Proposition

Frontdoor grows revenues around 8% annually with low 20% EBITDA margins. 50% of their capital costs come from their service claims, with total capital expenditures representing less than 2% of revenues. Due to the spin-off the company has close to $1B in total debt with $300M or so in cash, for a net debt of around $700M. With shares trading at $22 we get a market cap of close to $1.9B. Subtracting cash and adding debt gets us an EV of $2.6B.

If we take the 8% revenue growth rate and extrapolate that into the next 5 years we end with 2022 revenues of $1.7B and $391M in EBITDA. Subtracting our CapEx and adding back D&A we come to 2022 FCF of $273M or a 12% FCF Yield on an Enterprise Value of $3.1B. Dividing our EV by total shares (84M) gives us an equity value per share of round $32, current share levels providing 44% discount from fair value. Even if the company fails to grow revenues from the $1.2B level, fair value would still fall into the $19-$20 range.

Let’s take a look at Frontdoor’s largest competitor, Angie’s List, which recently acquired HomeAdvisor. ANGI generated $736M in revenues last year, and after spending close to $800M in SG&A the company reported an EBITDA loss of -$110M and Net Income loss of -$103M. ANGI is trading close to 7x EV/Revenues while FTDR is trading 2x EV/Revenues. Angie’s List was eventually acquired by HomeAdvisor’s parent company InterActiveCorporation (IAC) for around 11x EV/EBITDA. Giving FTDR an 11x EV/EBITDA based off its 2022 EBITDA projection of $427M gives us an equity value per share of close to $37, 60% upside from current share prices.

Risks to Overall Thesis

Major risks to Frontdoor’s ability to generate multiple and revenue expansion would be failure to grow its customer base while failing to fully monetize its existing base in the Midwest. With plenty of market still left to capture, failure to add members means another company takes that market share. Furthermore, the company could lose its high percentage of recurring revenue with its existing customer base, reducing stability and predictability in those revenues. A dramatic increase in claims costs (such as the wildfires we’ve recently seen in California) could compress margins and FCF, albeit over the short-term. Finally, a decrease in new / used home sales could pose a headwind for FTDR’s growth. The company is protected farily well from this by employing marketing strategies for current home-owners, but a slowdown in home sales would reduce the nearer term industry growth rates.

Outside of the risks to business execution, the company’s share price has one major headwind for price appreciation: One large shareholder. Even though FTDR spun-off of ServiceMaster, the parent company retained 19.9% of common stock with plans on exchanging it for debt reduction purposes. Should ServiceMaster de-load a significant amount of stock at once it could send share prices plummeting. Keep in mind this risk is mainly to share price, not business economics.

If I had to put various scenarios into probability buckets, I would stick the business that grows revenues at 8%, sports 20% EBITDA margins with 69% FCF conversion into the “more than likely” bucket. In the bucket of “Not Likely To Happen” I would stick the business that fails to grow revenues, reduces its recurring revenue percentage, and fails to generate FCF. Somewhere in-between sits a company that generates 4% revenue growth with adequate margins and stagnant recurring revenue percentages.

All in all, Frontdoor has a long runway for growth, sustainable competitive advantages, high percentages of recurring revenue, and a capital light business model. The majority of the CEO’s salary is dependent on the success of the business, interests indicate proper alignment. The chances for revenue and multiple expansion seem good, and share prices appear cheap at current levels. I’ve started acquiring shares in my paper trading account around the $20-$23 price range.