When this article about home service plan provider frontdoor, inc (FTDR) was published last January, the outlook was neutral even though the company had made significant progress in its gross margins and cash flow.

The primary concerns at the time were that shares were near all-time highs with a forward PE that was high relative to projected EPS growth and in relation to the S&P 500 multiple. The company’s leverage also raised concern given the discretionary nature of the company’s service plans.

The company has reported three quarterly results since then, one of which fully includes the impact of the COVID-19 pandemic. Based on its results, the outlook for frontdoor is now bullish. The company’s strength in generating revenue and cash flow, its improved leverage position, and improved earnings multiple support a favorable view.

Revenue

Revenue is earned by frontdoor in three channels: renewals of existing plans (direct to consumer (DTC) and real estate related), new plans from home sales, and new plans from DTC sales. In 2016, 2017, and 2018 about 66% of revenue was typically from renewals, 20% from new plans related to home sales, and the remainder (about 12%) was from new DTC plans.

As this chart shows, the proportion of revenue from renewals crept up to about 68% in 2019 and Q120 (ended 3/31/20) and then to more than 69% in Q220 (ended 6/30/20). Concurrently, less than 18% of revenue was derived from new home sales in Q220 which is down from more than 20% in the 2016-2018 period and about 19% in 2019 and Q120. This shift to renewal revenue from new home sale plan revenue in Q220 is attributable directly to the significant slowdown in real estate transactions caused by COVID-19 lockdowns in the April through June time frame.

From the Q220 earnings call,

Additionally, our first year real estate sales continue to be impacted by COVID-19. While the decline in second quarter existing home sales was better than anticipated, the real estate space continues to face macro headwinds and tight inventory levels and has constrained transaction volume.”

In terms of the split between real estate and DTC, when including renewals in each category, between 44% and 46% of revenue is from real estate and 54% to 56% is from DTC. The company does not disclose this information on a quarterly basis thus the impact of COVID-19 on the split between real estate and DTC is not yet available.

Looking at overall revenues, in Q220 they rose by 7.5% from the prior year with higher prices and increased volume contributing equally to the increase. Drilling down to the segments, renewal revenue was up by 10%, first year DTC revenue was up 7%, but first year real estate revenue was down by 1%.

The primary drivers of the higher renewal revenue was improved customer retention and ‘improved price realization’ which relates to frontdoor’s dynamic pricing model that sets prices at the ZIP code level rather than state wide.

An increase in the number of plans sold drove the improvement in first year DTC revenue and was a result of the company’s investment in marketing within the segment to compensate for the slowdown in home sale transactions which was the driver of the weaker first year real estate revenue.

While the 7.5% growth in Q220 revenue is solid, it is down 100 bps from the growth in Q120 (8.5% y/y) and 180 bps from Q219 (9.3% y/y). On a trailing twelve month basis Q220 TTM growth of 7.9% is down sequentially from 8.3% in Q120 and 8.9% in Q419.

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Revenue is still growing well, but the growth rate is beginning to lag, which is not surprising in the current environment. Unfortunately, frontdoor guided Q320 (ended 9/30/20) revenue which at the midpoint ($435M) is only 6.9% above the prior year quarter. In addition, they have guided FY20 (ended 12/31/20) full year revenue of between $1.45B and $1.47B which at the midpoint represents an approximate 7% increase from 2019. The guided rates of growth for Q320 and FY20 are 110 and 100 bps below their respective prior year periods.

The company has taken steps to correct their declining revenue growth rate. For example, as was communicated in the Q220 earnings call,

Since May, we’ve seen an improvement in efficiency of our broadcast marketing compared with 2019. Given that improvement, and to offset a decline in our real estate channel, we feel it’s important to ramp up our marketing spend until such time the efficiencies return to more normalized levels.”

This increase in marketing spend, which was about $12M in Q220, is a long term investment in the DTC channel which sees renewal rates at 2.5x the rate of the real estate channel.

CEO Rex Tibbens went on to say,

So as we invest more in marketing last quarter and this quarter, we recognize revenue 1/12 at a time. So the impact that we’ll see from a revenue perspective will be muted this year, but we’ll see it more next year. So you take the marketing expense in the quarter, and you’ll see the revenue line grow as the customer pays every month.”

Gross Margin

Gross margin declined in Q220 to 52.0% from 52.8% in the prior year quarter primarily as a result of the cost of increased service requests which the company believes was caused by shelter at home orders related to the COVID-19 pandemic during the quarter.

Specifically, contract claims costs increased by $13M or 6.5% of the total cost of services for the quarter. In contrast, there was a negligible increase in contract claims costs in Q120 which saw the gross margin improve to 50.0% from 47.2% in Q119.

Despite the weakness in Q220, both Q220 and Q120 gross margins are above the 45.5%-49.7% range achieved from 2016 through 2019. Gross margins may be crimped somewhat while the COVID-19 restrictions continue, but management believes that the increased contract claims may be due to the pulling forward of service requests from future periods.

If this is the case then margins may be boosted in these future periods when COVID related lockdowns ease and service requests abate to below normal rates because the repair has already been done during lockdown.

Adjusted EBITDA

Adjusted EBITDA is a metric which frontdoor uses as one indicator of its operating success. This metric is defined as EBITDA before non-operating expenses such as non-cash stock-based compensation expense, restructuring charges, secondary offering cost, and spin-off charges.

In Q220, the marketing spend initiative discussed above was detrimental to profitability but is being made for the long term. The increase in claims cost from increased service requests also hurt profitability. Taken together, the higher marketing spend and higher claims cost reduced adjusted EBITDA by $13M y/y in Q220 which show up in the company’s cost of service and operating expense lines.

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Specifically, in Q220 adjusted EBITDA declined by 4.8% y/y, resulting in a margin of 24.0% which is 310 bps below the 27.1% margin in Q219. The 80 bps decline in gross margin discussed above, when combined with a 400 bps increase in operating expense margin (32.4% vs. 28.4%), yielded the weak Q220 adjusted EBITDA margin.

The weakness in Q220 adjusted EBITDA margin continues the trend of declining margin which began with the Q419 (ended 12/31/19) results. During that quarter, adjusted EBITDA margin declined 80 bps to 16.0% from 16.8% in the prior year quarter. In Q120 the trend improved but continued with margin down 20 bps to 16.0% from 16.2% in the prior year quarter.

Note that frontdoor’s results are seasonal with adjusted EBITDA margins ranging from 13%-16% in Q1, 20%-27% in Q2 and Q3, and 16%-19% in Q4.

Guidance from the company for Q320 (ended 9/30/20) is for a 10.4% y/y decline in adjusted EBITDA to $90M-$100M. This would yield a margin of 21.8% at the midpoint of revenue guidance of $430M-$440M and would be a 420 bps decline from the prior year quarter at 26.0%.

The Q320 guidance assumes that the revenue and expense trends observed in Q220 continue into the third quarter. CFO Brian Turcotte explained on the Q220 call,

The additional marketing investments and the projected increase in service requests are the primary drivers of our third quarter adjusted EBITDA range being lower than the prior year period.”

Management is still assessing the potential impact of increased COVID related service requests on Q4 results thus the company has decided not to provide full year adjusted EBITDA guidance that corresponds with its full year revenue guidance.

Leverage

When discussing frontdoor’s leverage, the previously published article pointed out,

As a result of this level of debt, the ‘transition to growth’ strategy which frontdoor is pursuing may prove to be risky if cash flow is impaired (by unsuccessful growth plans or a recession) before the absolute debt amount is reduced to a more reasonable level relative to adjusted EBITDA.”

In the three quarters since then, frontdoor has kept its total debt (long term and short term excluding capital leases) at roughly $1B. Concurrently, because its operations have generated solid cash flow, frontdoor’s net debt (total debt less cash) has declined meaningfully to $480M.

While adjusted EBITDA margin suffered in Q220 as discussed, TTM adjusted EBITDA is essentially unchanged from Q319 at $301M. As a consequence, the total debt to TTM adjusted EBITDA ratio has remained flat at 3.41x while the net debt to TTM adjusted EBITDA ratio has improved to 1.59x at Q220 from 1.95x at Q319.

This improvement is a continuation of the trend which saw the net debt to TTM adjusted EBITDA ratio fall from 2.94x at the end of 2018.

Clearly the previous assessment of frontdoor’s leverage as a threat to cash flow (& ultimately to its operations) was unwarranted.

Only if the COVID-19 restrictions continue for an extended period of time would frontdoor face diminishing cash flow resulting from declining revenue and increased expenses. But as Q220 demonstrated, even during the height of lockdowns revenue is still growing and the company is still throwing off cash flow.

Specifically, revenue grew 7.5% in Q220 while adjusted EBITDA was $100M and cash flow from operations was $80M. All three metrics were reduced from the prior year period but their absolute level shows how significant and extended any recession would need to be for frontdoor’s leverage to be a threat to operations.

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Fortunately, frontdoor’s debt does not mature until 2025 and 2026 so the extent of an economic slowdown related to COVID-19 that could jeopardize frontdoor is well beyond any worst case scenario currently contemplated.

Multiples

Frontdoor’s share price has fallen to about $42 from $47 at the time of the prior article, but the current forward PE is slightly elevated from the previous PE because consensus EPS has come down more than share price.

FY20 consensus EPS has declined to just $1.61 from $1.89 at the time of the earlier article. As a result, the forward 2020 PE is 25.9x which is about 1 turn above the previous 25x forward PE. Using FY21 (ended 12/31/21) consensus EPS of $1.79 yields a forward PE of 23.5x. On an absolute PE basis shares are currently slightly more attractive than previously.

Relative to the market, shares have become more attractive. Specifically, the previous gap between frontdoor’s forward PE and the S&P was 5.3x (25x vs. the S&P 500 forward PE of 19.7x as of 1/3/20. Now that premium has flipped to a discount of 2.1x (23.5x vs. the S&P 500 forward PE of 25.6x as of 10/16/20).

The Takeaway

The outlook for frontdoor is now slightly bullish which is improved from the neutral outlook at the last writing. This improvement is due to several factors. First, although revenue growth has slowed, it has continued to be good through the pandemic thus far, and the company has increased its marketing spend to return to the higher growth rates of 2018 and 2019.

Next, once the impact of COVID-19 abates, gross margin and EBITDA margin may be poised for a rebound to above average levels. This is due to 1) the pull forward of service calls which have elevated current costs and 2) the temporary increase in marketing spend to improve revenue growth.

Third, frontdoor’s robust cash flow capacity offsets prior concern about the amount of leverage on the balance sheet. The net debt to adjusted EBITDA ratio has improved by more than 18% (1.59x vs. 1.95x previously) despite the unchanged level of total debt.

Next, as a result of the more than 10% decline in share price, shares are more attractive on a forward PE basis and relative to the general market forward PE.

Finally, the revenue weakness has been primarily in the company’s 1st year real estate channel. The latest existing home sales data offers optimism for this channel which has suffered from tight inventory levels and constrained transaction volume.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com