Frontdoor, Inc. 2018 Q3 Form 10-Q Summary
Business Context and Reporting Period
Frontdoor is a U.S. provider of home service plans under the American Home Shield, HSA, OneGuard and Landmark brands, serving all 50 states and the District of Columbia. The filing covers the three and nine months ended September 30, 2018. The historical financial statements are condensed combined statements reflecting the business while it was owned by ServiceMaster and may not represent results as an independent company.
Frontdoor completed its spin-off from ServiceMaster on October 1, 2018 and began trading on Nasdaq under the symbol FTDR. Approximately 80.2% of Frontdoor's common stock was distributed to ServiceMaster stockholders.
Financial Results and Key Metrics
| Metric | Q3 2018 | Q3 2017 | Change |
|---|---|---|---|
| Revenue | $377 million | $346 million | Up 9% |
| Gross profit | $176 million | $179 million | Down 2% |
| Gross margin | 47% | 52% | Down 5 percentage points |
| Income before taxes | $65 million | $83 million | Down 21% |
| Net income | $49 million | $53 million | Down 7% |
| Net margin | 13% | 15% | Down 2 percentage points |
| Adjusted EBITDA | $86 million | $96 million | Down 10% |
| Pro forma diluted EPS | $0.58 | $0.63 | Down 8% |
| Metric | Nine months 2018 | Nine months 2017 | Change |
|---|---|---|---|
| Revenue | $979 million | $899 million | Up 9% |
| Gross profit | $448 million | $447 million | Approximately flat |
| Gross margin | 46% | 50% | Down 4 percentage points |
| Net income | $108 million | $116 million | Down 7% |
| Adjusted EBITDA | $191 million | $209 million | Down 9% |
| Operating cash flow | $126 million | $136 million | Down $10 million |
- Q3 revenue growth was driven by higher renewal revenue, improved pricing, a shift toward higher-priced real estate plans and increased direct-to-consumer marketing.
- Q3 revenue by channel was $251 million from renewals, $78 million from real estate plans and $47 million from direct-to-consumer plans.
- Customer retention was 76% at September 30, 2018, compared with 75% in the prior-year presentation. Home service plan growth was 7%, compared with 10% reported for the prior-year period.
- Cost of services rendered increased 20% in Q3 and 17% year to date, primarily because of higher contract claims, appliance replacements, repair costs and work orders associated with unusually warm summer temperatures.
- Management identified $5 million of Q3 adverse development related to claims originally estimated in the first half of 2018 and $1 million related to the fourth quarter of 2017.
- The effective tax rate declined to 24% in Q3 and 25% year to date, versus 36% and 37%, respectively, primarily because of the reduction in the U.S. federal corporate tax rate from 35% to 21%.
Cash Flow, Debt and Liquidity
- Cash and cash equivalents were $305 million at September 30, 2018, and marketable securities were $9 million. Combined cash and marketable securities totaled $314 million.
- Operating cash flow was $126 million for the first nine months, compared with $136 million in the prior-year period. Investing cash flow was negative $4 million, including $21 million of capital expenditures. Financing cash flow was negative $98 million.
- On August 16, 2018, Frontdoor incurred a $650 million senior secured term loan and issued $350 million of 6.750% senior notes due 2026. Reported debt, net of issuance costs and discounts, totaled approximately $987 million, including $640 million under the term loan and $344 million of notes.
- The $250 million revolving credit facility had no borrowings or letters of credit outstanding at September 30, 2018, leaving $250 million of available capacity. Frontdoor was in compliance with applicable debt covenants.
- The credit facilities bear variable interest rates. Management estimated that a one-percentage-point change in rates would affect annual interest expense by approximately $7 million on the term loan and $3 million if the revolving facility were fully drawn.
- Effective October 1, 2018, Frontdoor paid ServiceMaster the $144 million intercompany balance and received an $81 million cash contribution. Cash and marketable securities consequently declined from $314 million at September 30 to $251 million on October 1.
- On October 24, 2018, Frontdoor entered into a $350 million interest-rate swap, effective October 31, 2018, under which it pays a fixed rate of 3.0865% and receives one-month LIBOR, subject to a zero-percent floor.
Material Changes and Unusual Items
- Spin-off charges were $8 million in Q3 and $23 million for the first nine months, compared with $6 million in each comparable 2017 period. Management expected approximately $25 million of total spin-off charges for 2018.
- Incremental capital expenditures related to the spin-off were expected to be $15 million to $20 million in 2018, primarily to replicate information technology systems previously shared with ServiceMaster.
- Management estimated spin-off-related ongoing dis-synergies of approximately $4 million in 2018 and projected approximately $7 million for 2019.
- Frontdoor adopted ASC 606 revenue recognition effective January 1, 2018 using the modified retrospective method. The adoption produced a $2 million net increase to opening net parent investment and no significant effect on net income or cash flow for the periods presented.
- Deferred revenue was $176 million at September 30, 2018, compared with $573 million at December 31, 2017, while a $29 million contract asset was recorded at September 30, 2018.
- Regulated subsidiaries had approximately $171 million of net assets subject to third-party distribution restrictions at September 30, with the amount expected to increase to approximately $198 million after the spin-off.
Outlook, Risks and Contingencies
- Management expects the independent-company structure to increase operating costs, particularly in finance, legal, information technology and human resources. Historical allocations from ServiceMaster may not reflect future standalone costs.
- Recurring 2018 capital expenditures were expected to be approximately $10 million, in addition to the $15 million to $20 million of spin-off-related capital expenditures.
- Claims costs remain sensitive to weather, work-order volume, appliance replacement rates, contractor costs and repair inflation. The filing noted higher claims from colder winter conditions and unusually warm summer temperatures.
- Key risks include substantial leverage, variable interest rates, debt covenant restrictions, limited access to capital markets, consumer and housing-market conditions, competition, regulatory and consumer-protection requirements, cybersecurity, third-party contractors and adverse weather.
- Home service plan claims are estimated using historical experience and actuarial projections. Management increased claims accruals by $7 million during the first nine months based on revised estimates; future claim experience could require additional adjustments.
- The company was subject to ordinary-course legal and regulatory matters. Management did not expect them to have a material adverse effect, but unfavorable outcomes could materially affect a particular period.
- The filing states that there were no material changes to the risk factors in the company's Registration Statement. Disclosure controls and procedures were deemed effective as of September 30, 2018.
Investor Verification Items
- Verify post-spin-off standalone revenue, claims trends, retention, margins and Adjusted EBITDA, since the historical statements include ServiceMaster allocations.
- Reconcile the October 1 cash settlement and contribution and assess post-spin-off liquidity after the $144 million payment to ServiceMaster.
- Review the term loan, 2026 notes, revolving facility, leverage covenant and interest-rate swap for refinancing and rate sensitivity.
- Track whether claims-cost adverse development and weather-related costs normalize or remain elevated.
- Confirm total spin-off charges, dis-synergies and technology-related capital expenditures against management's 2018 and 2019 expectations.
- Evaluate restrictions on subsidiary distributions and the amount of capital subject to regulatory requirements.
- Review the effect of ASC 606 contract assets, deferred revenue and deferred customer acquisition costs on future reported revenue and cash conversion.