Frontdoor, Inc. annual report, FY2018

Frontdoor, Inc. — FY2018 Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2018. The filing includes quarterly data, but this is an annual Form 10-K rather than a standalone Q4 filing. Frontdoor became an independent public company on October 1, 2018, following its spin-off from ServiceMaster. Historical pre-spin-off results are combined or allocated from ServiceMaster and may not represent standalone costs.

Business context

Frontdoor provides home service plans covering the repair or replacement of major home systems and appliances. It operates under the American Home Shield, HSA, OneGuard and Landmark brands, serving approximately 2.1 million customers across all 50 states and the District of Columbia through a network of more than 16,000 contractor firms.

Revenue is diversified between renewals, real estate transactions and direct-to-consumer sales.
Existing customer renewals represented 66% of revenue and customer retention was 75%.
Home service plans increased 6% during 2018.
Approximately 66% of revenue was recurring, consistent with the prior two years.

Financial performance and key metrics

Metric	2018	2017	Change
Revenue	$1,258 million	$1,157 million	9%
Gross profit	$572 million	$567 million	1%
Gross margin	45.5%	49.0%	Down 3.5 pts
Net income	$125 million	$160 million	Down 22%
Net margin	9.9%	13.8%	Down 3.9 pts
Adjusted EBITDA	$238 million	$259 million	Down 8%
Adjusted EBITDA margin	18.9%	22.4%	Down 3.5 pts
Cash flow from operations	$189 million	$194 million	Down 3%
Free cash flow	$163 million	$179 million	Down 9%

Revenue growth was driven primarily by higher renewals, overall plan growth, improved price realization, a favorable mix of real estate offerings and increased direct-to-consumer marketing. Earnings and margins declined as contract claims costs, sales and marketing costs, customer service costs, spin-off dis-synergies and interest expense increased.

Liquidity, debt and capital resources

Cash and cash equivalents were $296 million at December 31, 2018; short- and long-term marketable securities totaled $9 million.
Total debt was approximately $984 million, consisting principally of a $639 million term loan and $344 million of 6.750% senior notes due 2026, net of issuance costs and discounts.
The company had a $250 million revolving credit facility with no outstanding letters of credit and $250 million of available capacity.
Debt fair value was approximately $958 million at year-end.
Debt agreements contain restrictions on additional debt, liens, asset sales, dividends, acquisitions and other transactions. Frontdoor reported compliance with applicable covenants at year-end.
A $350 million interest-rate swap fixes the applicable floating rate on part of the term loan at 3.0865%, plus a 2.50% borrowing margin, through August 2025.
Capital expenditures were $27 million, including $15 million related to the spin-off. Management expected 2019 capital expenditures of approximately $30 million to $40 million.

Material changes versus the prior comparable period

Cost of services rendered increased 16% to $686 million, reducing gross margin from 49% to 45%. Contract claims increased because of higher repair costs, colder winter and warmer summer temperatures, adverse prior-year claims development and higher appliance replacements.
Higher replacements increased 2018 claims costs by approximately $15 million; weather-related work orders increased claims costs by approximately $17 million.
Selling and administrative expenses rose 9% to $338 million, reflecting increased sales and marketing, customer service investments, professional fees and approximately $4 million of ongoing spin-off dis-synergies.
Interest expense increased to $23 million from $1 million because of approximately $1 billion of financing completed in connection with the spin-off.
Spin-off charges increased to $24 million from $13 million. Management expected less than $1 million of additional spin-off charges in 2019.
Income tax expense declined to $42 million from $60 million, and the effective tax rate declined to 25.1% from 27.2%, reflecting U.S. Tax Reform and lower pretax income.
ASC 606 revenue recognition was adopted on January 1, 2018 using the modified retrospective method. The adoption had no significant effect on 2018 net income or cash flow but materially changed balance-sheet presentation, including receivables and deferred revenue.
Total assets declined to $1.041 billion from $1.416 billion, principally because ASC 606 reduced reported receivables and deferred revenue. Equity moved from $661 million of net parent investment to a reported deficit of $344 million after the spin-off-related debt and distributions.

Guidance, outlook and management commentary

Management expects to continue investing in customer experience, digital platforms, contractor capacity, data capabilities and dynamic pricing.
A central HVAC maintenance offering was expected to launch nationwide in 2019.
Management planned to pilot on-demand home services in the second half of 2019, with broader scaling targeted for 2020.
Management projected approximately $7 million of normal annualized spin-off dis-synergies in 2019, compared with $4 million incurred in 2018.
Management expected 2019 capital expenditures of approximately $30 million to $40 million.
The company does not intend to pay cash dividends for the foreseeable future and expects to prioritize debt repayment, growth investments, share repurchases and working capital.

Risks, contingencies and unusual items

Results are exposed to seasonality and weather, particularly HVAC service demand, repair frequency and replacement costs.
Major risks include competition, consumer and real estate market weakness, contractor and supplier availability, parts and appliance inflation, tariffs, labor shortages, regulatory compliance, litigation, cybersecurity and data privacy.
The company depends on a relatively limited group of suppliers; five national suppliers each represented more than 5% of supplier spending.
Approximately $187 million of subsidiary net assets were subject to regulatory restrictions on distributions to the parent.
The tax matters agreement could require Frontdoor to indemnify ServiceMaster for material taxes and related amounts if the spin-off fails to qualify as tax-free or if specified actions trigger tax liabilities.
Legal and regulatory matters arise in the ordinary course. Management did not expect current matters to have a material adverse effect, but unfavorable outcomes could materially affect a particular period.
Goodwill and trade names totaled approximately $616 million and had no impairment charges in 2018, 2017 or 2016; future impairment remains a risk.
Because Frontdoor was newly public, the auditor emphasized that pre-spin-off expense allocations may not reflect the costs Frontdoor would have incurred as a standalone company.
The company was not required to provide management’s assessment or auditor attestation of internal control over financial reporting because of the SEC transition period for newly public companies.

Investor verification checklist

Reconcile the reported revenue growth with the decline in gross margin, Adjusted EBITDA and free cash flow.
Assess whether 2018 claims-cost pressure from weather, repairs and replacements was temporary or structural.
Verify standalone corporate costs, including the projected $7 million annualized spin-off dis-synergies and the expected reduction in spin-off charges.
Review debt maturities, variable-rate exposure, covenant requirements and the company’s ability to generate cash for debt service.
Evaluate the effect of ASC 606 on receivables, deferred revenue, customer acquisition costs and comparability with prior periods.
Monitor customer retention, plan growth, real estate channel activity and direct-to-consumer marketing efficiency.
Review the tax matters agreement, indemnification provisions and restrictions on strategic transactions following the spin-off.
Evaluate execution risk and investment requirements for on-demand services, dynamic pricing, data-platform initiatives and acquisitions.