Frontdoor [FTDR] Conference call transcript for 2023 q3
2023-11-01 12:41:10
Fiscal: 2023 q3
Operator: Ladies and gentlemen, welcome to Frontdoor's Third Quarter 2023 Earnings Call. Today's call is being recorded and broadcast on the internet. Beginning today's call is Matt Davis, Vice President of Investor Relations and Treasurer, and he will introduce the other speakers on the call. At this time, we'll begin today's call. Please go ahead, Mr. Davis.
Matt Davis: Thank you, operator. Good morning, everyone, and thank you for joining Frontdoor's third quarter 2023 earnings conference call. Joining me today are Frontdoor's Chairman and Chief Executive Officer, Bill Cobb; and Frontdoor's Chief Financial Officer, Jessica Ross. The press release and slide presentation that will be used during today's call can be found on the Investor Relations section of Frontdoor's website, which is located at investors.frontdoorhome.com. There is also additional information about our Frontdoor brands at frontdoor.com and our new mobile app that you can download in the App Store and at Google Play. As stated on Slide 3 of the presentation, I'd like to remind you that this call and webcast may contain forward-looking statements. These statements are subject to various risks and uncertainties, which could cause actual results to differ materially from those discussed here today. These risk factors are explained in detail in the Company's filings with the SEC. Please refer to the risk factors section in our filings for a more detailed discussion of our forward-looking statements and the risks and uncertainties related to such statements. All forward-looking statements are made as of today, November 1, and, except as required by law, the Company undertakes no obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise. We will also reference certain non-GAAP financial measures throughout today's call. We have included definitions of these terms and reconciliations of these non-GAAP financial measures to their most comparable GAAP financial measures in our press release and the appendix to the presentation in order to better assist you in understanding our financial performance. I will now turn the call over to Bill Cobb for opening comments. Bill?
Bill Cobb: Thanks, Matt. And what a quarter. We crushed it. It was just over a year-ago when Frontdoor was experiencing some of the lowest margins ever as a result of an extremely challenging macroeconomic environment. Our team responded to these challenges and took decisive action to improve the business. Fast forward a year and we have had an exceptional turnaround in our financial performance. Third quarter revenue increased 8% to $524 million, and our gross margin has rebounded 760 basis points to 51%. This drove a $48 million increase in adjusted EBITDA to a record high for a quarter of $128 million. Given these results, we are raising our full-year outlook for revenue, adjusted – and adjusted EBITDA and share repurchases for the second time this year. While things continue to fall our way, we have also done a lot of smart things to drive process improvements, which are contributing to better margins. Jessica will describe these in more detail shortly. The key message is we expect the benefit of these process improvement initiatives and cost trends to largely continue into next year. Now, I want to highlight an important point. At our Investor Day in March, we laid out a target of $2 billion in revenue and at least $300 million in adjusted EBITDA for 2025. We have already surpassed our adjusted EBITDA target, and we are working extremely hard to close the gap on our revenue objectives between now and then. I believe Frontdoor is an extremely compelling investment. 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. Now turning to Slide 5, we want to clarify the difference between our two brands. Let me be clear right upfront, the American Home Shield brand will continue to focus on selling home warranties, while the Frontdoor brand will now evolve to selling on demand home services. You can think about American Home Shield as our 12-month home warranty contract and Frontdoor as our pay-as-you-go model. It is our current assessment that the home warranty category is both undifferentiated in a [bit stale], and we strongly believe that we have an opportunity to breathe new life into American Home Shield through a brand relaunch in 2024. We want to celebrate what a home warranty can offer. As our consumer research shows, there are still millions of homeowners who are naturally inclined to buy our products because they want that financial protection and peace of mind for when home systems and appliances inevitably break. Now moving to Slide 6 and our direct-to-consumer channel. Let me be clear, we are keenly aware of the drop in our customer account as part of a larger category trend, but let me assure you that it is our top priority to turn that around. The current macroeconomic environment has resulted in a pullback in consumer demand for home warranties. In the near-term and prior to our rebrand early next year, we will be tactical with our approach. We will continue to utilize our discounting strategy, which is evolving to maximize demand conversion. And in the fourth quarter, we are increasing the actual marketing spend behind our American Home Shield brand to drive brand awareness. In the long-term, our strategy is grounded in relaunching the American Home Shield brand to unlock the full potential of home warranties. I strongly believe that the home warranty space continues to offer massive growth opportunities. I look forward to providing more specific details on how we plan to capture that demand at our next earnings call. But for now, know that we will be supporting the brand relaunch with a new marketing campaign. Our goal is to bring some of that Frontdoor marketing magic to American Home Shield, and from the early creative development that I have seen so far, I think we are well on our way to doing that. Now turning to Slide 7 and our real estate channel. The National Association of Realtors, or NAR, recently released housing market statistics for September, and the market remains severely challenged. Existing home sales declined 22% through the first nine months of the year, and full-year expectations have declined at just under 4 million homes. As you can see from this chart, that is a substantial decline from the 6 million existing homes sold in 2021 as high mortgage rates and home prices have diminished consumer affordability. At the same time, inventory remains tight. NAR also reported properties remained on the market for just 21 days in September, and that all cash sales increased to 29% of transactions, a segment that has generally not been conducive to buying a home warranty. This all adds up to an extremely challenging environment for our real estate channels. Now turning to Slide 8 and the renewal channel. While demand in our DTC and real estate channels remain soft, we continue to be pleasantly surprised by the performance of our renewal channel where our rates remain strong. In the third quarter, our overall retention rate increased 90 basis points to 76.2%. This is especially impressive considering that we are implementing an 11% realized price increase this year. We are building on the impressive work that the renewals team has done, improved onboarding, increased engagement throughout the customer journey, and elevating the service experience through greater deployment of our preferred contractors. In short, we continue to take the right actions to sustainably drive higher retention. Now let's turn to Slide 9 of the web deck where I will go into more detail on the Frontdoor brand monetization strategy. We launched the Frontdoor brand earlier this year as a new growth engine to sell services to a fundamentally different segment of homeowners. As I said at our Investor Day, we intentionally launched the brand quickly as a first mover advantage and to learn our way into a new market. What we have found is that the essence of the brand remains strong, which is comprised of app-based customer interactions and the video chat feature with one of our experts. Just six months since the launch of Frontdoor, we have over 1.3 million downloads and account registrations have grown to 133,000. But I want to be transparent with you. We went to market with a new version of a home service plan, Frontdoor Premium that did not sell the way we thought it would, so we have quickly made the decision to stop selling it. Our offering in the market today is a lower price product, only $25 per year with unlimited video chats for consumers to take advantage of the unique user experience with our experts. So that's today. Our strategy in the future is an on-demand offering. I believe this new focus based on our research and the success of our HVAC upgrade program will be a compelling proposition for a much larger group of homeowners who want an a-la-carte experience. Our value proposition for Frontdoor is based on two key components. The first is on-demand access to our network of experts that will allow homeowners to get repairs, maintenance services, and upgrades. This is paired with a modern app-based interaction that is anchored by our video chat with a live expert. Membership also includes discounts to appliances and systems as well as how to content. We are still working on the exact products and timing for what the Frontdoor brand will offer in 2024, but we are largely coalescing around three main categories: on-demand repairs, maintenance services, and upgrades for home systems and appliances. Starting with repairs. On-demand repairs will address a real pain point for consumers when home appliances and systems inevitably break. We are currently building out the booking flow within the Frontdoor app, so the consumer and contractor will have a simple and seamless a-la-carte experience. Second, we will provide on-demand home maintenance for those who want to ensure their home continues to run well. This could be anything from filter replacements to tuning up your HVAC before the season changes. And finally, we will offer on-demand upgrades for when it makes more sense to replace a home system or appliance rather than fix it. As validated by the great success we continue to see with our HVAC upgrade program, which was about $20 million of revenue in Q3 trending toward a total of $50 million for 2023. Our value proposition here is to partner with our contractors and share our bulk buying power to provide discounted pricing on new appliances and home systems. This is a win for our customers, contractors and for Frontdoor. We will provide more details on the Frontdoor brand on our next earnings call, but I believe that we are on to something big here. We know we have great brand awareness and we now have a clear strategy for monetizing that demand through a suite of paid services we plan on offering next year. In closing, I am thrilled with the turnaround in our financial results, which reinforces my belief in the power of this business and the actions we have been taking. We have demonstrated that we can quickly reestablish our margins through pricing and process improvement initiatives. We continue to take bold and decisive steps that will lay a strong foundation for future growth, and I am very optimistic about where we are heading. I will now turn the call over to Jessica to review our financial results. Jessica?
Jessica Ross: Thanks, Bill, and good morning, everyone. As Bill just mentioned, we are extremely pleased with our strong third quarter financial performance. Our prior pricing actions continue to flow through, inflation is moderating, and we are seeing a greater financial benefit from our comprehensive cost management efforts. Now turning to Slide 10, where third quarter revenue increased 8% versus the prior year period to $524 million. This was driven by a 10% increase in price, which more than offset at 2% decline in volumes. Looking at revenue in more detail on Slide 11. Third quarter revenue from our renewal channel increased 14% as a result of our prior pricing actions flowing through. Real estate revenue decreased 23% and direct-to-consumer revenue decreased 16% as a result of lower volume. Other revenue increased $11 million driven by our growing on-demand home services business, primarily our HVAC upgrade program. Now let's turn to Slide 12. Gross profit for the quarter increased $57 million to $268 million, and our gross margin increased 760 basis points to 51%. This improvement was driven by higher realized price, continued process improvement initiatives, favorable cost development, a transition to higher service fees, and a lower number of service requests per customer, that was partly offset by inflationary cost pressure. On Slide 13, you'll see that our higher gross margin largely flowed through the net income, which increased to $43 million to $71 million and adjusted EBITDA improved $48 million to an all-time high of $128 million. Let's now move to the table on Slide 14 and I'll provide more context for the year-over-year improvement in third quarter adjusted EBITDA. Starting at the top, we have $37 million of favorable revenue conversion, primarily driven by our pricing initiative, partly offset by the decline from lower volume. Contract claims cost decreased to $22 million compared to the third quarter of 2022. Our team has been working hard to advance a host of process improvement initiatives in response to the macroeconomic challenges we experienced throughout last year. I'm very pleased to report that we are seeing increased traction from these initiatives, which led to a greater financial impact on our third quarter results. The improvement in our contract claims costs versus the prior year period was primarily driven by four factors. First, we saw greater financial impact from our collective process improvement initiative, specifically better cost management across our contractor network. Two examples include a new high cost claims review process implemented last year that worked extremely well during our peak summer season and our continued efforts to increase our percent to preferred contractor deployment, specifically in our appliance and plumbing trades that drove meaningful cost improvement. Second, we had favorable claims cost development of $9 million in the third quarter compared to a $2 million favorable adjustment in the third quarter of 2022. As a reminder, last year we had a large favorable development in the fourth quarter that included $18 million related to the prior year third quarter claims cost. Third, we have been transitioning to higher service fees, which benefits our gross margin. And finally, we had a slightly lower number of service requests per customer in the third quarter, primarily in the appliance and plumbing trades. These benefits helped to more than offset ongoing inflationary cost pressures. After removing the positive impact of claims cost development, we saw inflation of about 4% in the third quarter versus the prior year period well below what we have seen over the past year. Now, getting back to the table on Slide 14 and our sales and marketing costs, which increased $10 million over the prior year period due to higher marketing spend for the Frontdoor brands. General and administrative costs increased $4 million, primarily due to increased personnel costs and interest and net investment income increased $4 million as a result of rising interest rates on cash deposits. Before we leave this slide, I would like to take a moment to go into more detail on why we beat our third quarter adjusted EBITDA outlook by approximately $45 million. Bill and I have consistently said that we have taken a more conservative posture in our guidance, given that we are still emerging from an extremely high inflationary environment. That being said, we have been pleasantly surprised by the traction we are seeing from our cost reduction initiative implemented over the past year. We are also seeing unexpected favorability in our renewals, weather and cost inflation compared to our expectations. For example, our third quarter outlook incorporated a much larger impact from hot weather, which did not play out the way we thought it would. Now let me provide more color as to why our actual results were favorable to our outlook, which is mainly from three areas. The largest driver of our beat was $30 million from lower claims costs, which includes $9 million of favorable claims cost development. The remaining portion is a result of the collective impact of our process improvement initiative. Our team has been working very hard cross-functionally to improve these operations over the past year, and I am extremely pleased to see the manifestation of this work that really helped in the third quarter. Second, we have $5 million to $10 million higher-than-expected revenue conversion, primarily through [indiscernible]. Third, our SG&A [indiscernible] across several areas, which was due to timing. Let's now turn to Slide 15 for review of our statement of cash flow. Net cash provided from operating activities was $139 million for the nine months ended September 30. Net cash used for investing activities was $23 million for the first nine months of the year and was primarily comprised of capital expenditures related to investments in technology. Net cash used for financing activities was $88 million through September and was comprised of share repurchases and scheduled debt payments. On Slide 16, you will see that our free cash flow was $116 million for the nine months ended September 30. We ended the third quarter with $320 million in cash. This was comprised of $152 million of restricted net assets and unrestricted cash of $167 million. Keep in mind that this is after returning $75 million year-to-date to our valued investors through share repurchases. Before I get to our outlook, I'd like to take a moment to touch on our capital allocation strategy. We remain focused on growth and we will continue to prioritize investments that expand revenue, both organic and through M&A. Our second objective is to ensure we have a solid financial profile, which includes maintaining appropriate levels of liquidity to run the business and a prudent long-term debt structure. We currently have very modest levels of debt and we have an extremely strong net leverage ratio of 1.3x as of September 30. And finally, our third objective is to return cash to shareholders. Let me be clear, absent any acquisition, we will continue to return substantially all of our excess cash to shareholders. This business is performing very well and we are pleased to be stepping up our full-year share repurchase target to $125 million, which amounts to buying back approximately 5% of our outstanding shares in 2023. Now turning to Slide 18 and our fourth quarter and full-year 2023 outlook. We expect our fourth quarter revenue to be between $350 million and $360 million, which reflects renewal revenue up 12%, real estate revenue down 20%, DTC revenue down 16%, and other revenue up $4 million to $16 million. Fourth quarter adjusted EBITDA is expected to range between $20 million and $30 million. This is in line with the fourth quarter of 2022, which included $25 million in favorable claims cost development. Now, when comparing to the third quarter, it is important to note that our fourth quarter outlook also takes into account a significant impact from seasonality relating to our revenue and cost. Specifically, we expect a lower contribution from our HVAC upgrade program as well as a lower benefit relating to our cost reduction initiative as the fourth quarter typically has a lower number of service requests. Now turning to our full-year outlook where we are increasing our 2023 revenue range to $1.765 billion to $1.775 billion or an approximately 7% increase over 2022. This revenue range anticipates a nearly 15% increase in the renewal channel, a mid-20% decline in the real estate channel and a low double-digit decline in the DTC channel. It also assumes other revenue will increase to approximately $70 million as a result of growing on-demand services. We continue to expect approximately 11% growth from higher price, which will more than offset a 4% decline from lower volume. We also expect our number of home service plans to decline in the mid to upper single digits in 2023. As a result, we continue to target ending the year with approximately 2 million home service plans. This includes about 460,000 first year customers across the DTC and real estate channels. We are increasing our full-year gross profit margin outlook to be between 48% and 49.5%. This also assumes that inflation will be around 4% to 5% on a net cost per service request basis, and the number of customer service requests will decline 10% to approximately $4 million. Our full-year SG&A target is between $580 million and $590 million and includes $40 million of working marketing spend related to the Frontdoor brand. This also includes a further increase in our marketing investment for the American Home Shield brand, which is now slightly higher than 2022. Based on these updated inputs, we are raising our full-year adjusted EBITDA range by $55 million to be between $320 million and $330 million. To put that in perspective, this is about a 50% increase over our 2022 results. Our full-year outlook also includes $60 million of interest income and reflects stock compensation expense of approximately $28 million. And finally, we expect our full-year capital expenditures to be approximately $35 million and the annual effective tax rate to be approximately 25%. For our normal practice, we will provide a more detailed 2024 outlook on our next earnings call. But before I close, I wanted to discuss a few major themes heading into next year. On the revenue front, we are still determining where we want to take price. However, we are targeting a more modest level of realized price in 2024 as we are mostly focused on increasing our customer count and because inflation expectations have moderated. Additionally, we will continue to be smart about how we implement our pricing strategy using our dynamic pricing model to minimize customer churn. Even without more price increases, the momentum from our prior pricing actions will result in a low-to-mid single-digit realized price increase next year. Our customer count will obviously depend on the relaunch of American Home Shield and how successful our on-demand strategy plays out for the Frontdoor brand. So stay tuned for more details here. Turning to gross margins. We have come off some massive swings, down over 600 basis points in 2022 and now projected to be up 600 basis points in 2023. Our gross margins are starting to stabilize, and we are really at an inflection point for this business. With that in mind, we don't expect to see that level of volatility again in 2024. While there are some factors in 2023 that will likely not repeat next year, such as our larger realized price increase and favorable weather trends, we have other levers that are working to protect margin as we head into 2024. These include the benefit of higher service fees, the continued impact of our process improvement initiative and similar levels of cost inflation. I will point out that our gross margins going forward are also subject to our product mix, meaning how much revenue will be derived from the new Frontdoor brands and our on-demand products. Finally, our SG&A levels depend on where our total marketing budget ends versus this year. We are still working through exact numbers, but we expect that it will be more of a mixed shift between brands than a more dramatic increase or decrease in our total spend. I hope that is helpful context, and again, we are currently finalizing our strategic plan and we will share more details with you next quarter. In conclusion, we delivered extremely strong third quarter financial results. We continue to work hard on building a strong foundation for the future, and we remain very excited about where this business is heading as we look forward to 2024. I will now turn it back over to Matt.
Matt Davis: Thanks, Jessica. I would just like to point out that we are experiencing a bit of a delay on our phone call, so please bear with us during the Q&A process as there might be a bit of delay between questions and answers. Operator, let's now open up the line for questions.
Operator: Thank you. [Operator Instructions] Our first question today comes from the line of Mark Hughes from Truist. Please go ahead, Mark. Your line is now open.
Mark Hughes: Yes. Good morning. Thank you.
Bill Cobb: Hi, Mark.
Jessica Ross: Hi, Mark.
Mark Hughes: I think last quarter you talked about shifting a little bit of marketing spend, I think it was $20 million that was going to the direct-to-consumer channel. Did that flow through in the quarter? Or is there a lag perhaps on the likely impact on new business?
Bill Cobb: Yes. Mark, thanks for the question. There is a lag by the time we got that into market, and we've also upped our spend to Q4. So overall, our spend on American Home Shield, which – as we earlier in the year, we thought would be down versus last year, is actually going to be up. So we're trying to fuel some growth as we head into the relaunch early next year. But as I said in the script, we're going to be very tactical right now. We're still going to continue to use discounting. We are trying to put some more marketing spend behind what we call the good/bad campaign. But all roads are going to lead to the relaunch next year with a new marketing campaign and new look. And really, we've got to get back to selling the virtues, if you will of a home warranty, and that's what we plan to do.
Operator: Our next question today comes from the line of Sergio Segura from KeyBanc. Please go ahead. Your line is now open.
Sergio Segura: Thank you. Good morning, Bill and Jessica. Congratulations on the very strong quarter. Two questions. So 2023 was largely driven by price, wondering how we should think about the mix of plan growth versus pricing growth going forward. Sounds like it should be more balanced into the future. And then on gross margins, congratulations on the [beat] despite a historically hot summer, can you talk about work you've guys done to mitigate the impact of weather and I guess should we expect less volatility tied to weather on gross margins going forward? Thank you.
Bill Cobb: So wait there's a delay, right, Matt.
Matt Davis: Yes.
Bill Cobb: Sorry, Sergio. First of all, congratulations to you on your promotion. So great to hear from you. I'll take the first question and then we'll give the second one to Jessica. I'll take the pricing question. The answer is yes. You are correct. It'll be more balanced. When we look back at our pricing strategy, in 2022, we were probably a little late and with the $100 million in cost increases we had last year, we had to price aggressively. Inflation has moderated, as you saw. So that is coming down, it's flowing through. So we will have a more balanced approach. We have not nailed down, as Jessica said, our exact pricing strategy for 2024, as of yet. We're still working on that, but it will not be – clearly at the levels that we have this year. So we'll have more to say on that in the Q4 earnings. So gross margin, I'll turn it over to Jessica.
Jessica Ross: Yes. Hi, Sergio. Thanks for the question. Yes. Just in terms of margins, we talked a lot last quarter about things falling our way and margin really being driven by a lot of that weather favorability that we saw. I think as we're thinking about this quarter, we're really just super excited that this is the business just performing to get better. Bill came in a year-ago and really focused the team on execution. Our teams across the Board have been focused on process improvements, and it's not just been one silver bullet. I mean, it's been every team, every function, and what we really saw this quarter is the manifestation of those in our results. And we talked about various things like the high cost claims review that was implemented last year, but it was really during this peak season that we really saw that come to life, and we saw the benefits of that. And so as we think about going forward, we're seeing these external factors normalize, but we're also seeing kind of the results of the hard work as our business has been doing, really manifesting and coming to life, and we expect that to continue in our margins as we look to Q4 and beyond.
Operator: Thank you. The next question today comes from the line of Brian Fitzgerald from Wells Fargo. Please go ahead. Your line is now open.
Brian Fitzgerald: Thanks, guys. A couple of quick questions. A follow-up on the price increases. Can you talk about the phasing? Is that a steady tailwind as we meet or through 2024, or does it crescendo at some point? And then the second question was just on the debt ratio. I think Jessica, you mentioned 1.3x. Do you have a bogey or a target you'd like to keep that at? Thank you.
Bill Cobb: Which one you want?
Jessica Ross: I can take both. Just on pricing. As you know, it takes about 12 to 18 months for our pricing actions to flow through, and we took some really aggressive pricing actions in 2022. Even with those, we're expecting about mid to single – mid single-digit price increase flowing into 2024 from those actions. So if we're thinking about next year, it is really us being focused on unit growth versus leveraging any additional significant pricing increases. But again, we are finalizing our strategic plan and we'll come back to you with more on that on 2024. From a leverage ratio perspective, we really try to keep that between 1x and 2x. So we're feeling really good about where we're sitting right now, but it's something to continue to keep our eyes on.
Brian Fitzgerald: Thank you. Appreciate it.
Jessica Ross: Thanks, Brian.
Operator: The next question today comes from the line of Ian Zaffino from Oppenheimer. Please go ahead. Your line is now open.
Ian Zaffino: Hi. Great. I'd love to hear a little bit more about AHS and kind of the marketing or the relaunch you plan to do. I know there was – basically, I'm seeing a lot more ads on AHS in particular. So what's going to change as you get into next year and “relaunch the brand?” And then just if I could squeeze in one more on the Frontdoor side, how are you thinking about either breakeven points or losses or profitability of that? And what I mean by that is, is you're adjusting prices, you kind of drop the premium model. You’re now working on that roughly $2 a month plan. What do you actually need there as far as profitability or breakeven, et cetera? Thanks.
Bill Cobb: Thanks, Ian. Let me take both of those and then Jessica may add something on the Frontdoor piece. Let's start with AHS. I think that we've talked about the category softness, and I think that some of the sticker shock from the price increases that all of us had to take around this area have hurt the overall demand plus real estate is just as we said in this, severe decline. And real estate will work itself out. So that will be part of the comeback whenever that occurs. We keep thinking the bottom is here, but it keeps dipping. The other piece is a new message and I said in the script, we want to, if you will, celebrate home warranty. So I don't think we as a brand have done a good job of really getting back to the essence of why a home warranty, the financial protection, the peace of mind that it brings. I don't think we've done a good enough job there. And so our marketing team is working on re-messaging. At the same time, as I said, we're running, we like the good/bad approach. We think it's a fresh new approach. So I think it's going to be a better focus on marketing, a more impactful marketing approach coupled with people rediscovering the category and pricing slowing down, if you will. On the Frontdoor piece. I think what I've been happy about, we talked about the consumer response, et cetera. I'm disappointed. And that's on the premium piece that we tried to come in with a second home service plan. We've got a good home service plan on American Home Shield. We really want to zero in on this larger segment, the 42 million people that we talked about in Investor Day, 42 million households rather. The whole on-demand piece, you heard us reference pay-as-you-go, or a-la-carte. We think that there's really a market for people who don't want to get locked into a contract and want to pay for a repair or upgrade their system on a one-time basis. And that's really what we're going to zero in on. So for now, we're really trying to engage, we're not making money at $25 with unlimited chats, but we think it's a good lead into the brand. It's certainly the unique user experience with our experts. We are really proud of, and we think it's going to enhance the brand long-term. So still working on the specifics of that – as we bring the booking engine into the app and the like. So we've got – we're very, very excited about the strategy, but you know, as Jessica said, we've got to bring the execution level to the same level that we've had across the company. Is there anything you want to add on that?
Jessica Ross: No, I would just add in, I'm glad you asked both questions AHS and Frontdoor. Because as we think about growing this business and long-term profitability, it really is about both brands. We are very pleased and thrilled with how our margins have rebounded so quickly. And we're really excited about, especially like a lot of that has been our core, but as we're thinking about the future and really growing this business, it's going to be about being innovative. It's going to be launching new products and offerings and going after more customers, which is really about Frontdoor. I think the margin profile of that product is going to be very different, I think, from a home on an on-demand services perspective. And so if we're thinking about that longer term profitability mix, it's really, again, like I said earlier, going to depend on what of that is coming from Frontdoor. But we are excited about both. We're excited about where our margins are right now and what that's going to look like going forward.
Ian Zaffino: Okay. Thank you very much.
Bill Cobb: Thank you very much.
Jessica Ross: Okay. Thank you, Ian.
Operator: The next question today comes from the line of [indiscernible] from JPMorgan. Please go ahead. Your line is now open.
Daniel Pfeiffer: Hey. This is Danny Pfeiffer on for Cory Carpenter. I just have two quick ones. On the claims cost inflation, can you maybe unpack that 4% in 3Q and talk about what components are being the stickiest there? And then on the second one, on the success in on-demand services outside of HVAC, are there any other categories or services to call out you're seeing success in or most excited for from a revenue opportunity perspective? Thanks.
Bill Cobb: Why don’t you pick the first, I'll pick the second.
Jessica Ross: Thanks, Bill. So just from a claims cost perspective, yes, we have been forecasting, right, 9% compared to the 4% that we're seeing this quarter. I think a couple of things I just want to – concepts that I just want to put out there is, one, there's a lot of concepts in this business that operate on a delayed views, right? We talk about our pricing actions, claims cost development, and some of that is what you've seen this year just in terms of how we've seen inflation or deflation manifest into our results. We've talked also about in terms of, as you think about Frontdoor cost inflation, really it being comprised of three buckets, the contractor-related costs, parts and equipment and additionally, some of the impact that we're seeing on regulatory changes. I think right now what we're seeing from inflation is it's really comprised or heavily driven by two buckets, the contractor-related costs and the parts and equipment. And that's probably equally balanced between the two of those, which are really trending closer to CPI right now at this 4%.
Bill Cobb: Now, with regard to other services, to your question, Danny. So let me unpack this. So the engine for us right now is upgrades, specifically HVAC upgrades. We have a long way to go on that. That is just touching the service. We are thrilled with our contractor relations team, our contractors have done, the marketing team in terms of reaching out to our customers in terms of getting an HVAC upgrade. And I won't go into right now, we'll talk about this more in Q4. The changes that the EPA is bringing in that it's going to basically force a bunch of consumers to have to upgrade their system, but I won't get into that now. We will talk about that in Q4. But upgrades are the engine. We do think that there is opportunity, real opportunity in appliance and water heater. We're getting the model down on HVAC and then moving to probably those two areas, whether we could get into pool, spa and other things. But the two to think about behind HVAC are appliances and water heaters. Then the repair piece. We've been doing appliance repairs in about 15 markets, and we're working through the model and how that whole piece works. That is showing good traction. We will expand the number of markets we're still working through what that is, but repair will be not only in the shorter term an expansion of markets, but as we get a booking engine into the app where people can call for a repair as they put it an a-la-carte basis, that we think will be an additional good driver. I think there'll be a, let me call it a nice little business on maintenance. We actually have a good business right now doing tune-ups around HVAC. I think we're still working through. We have other maintenance services. I think we've got to sort through how we position those to customers and make those available. But I think that is a part of it, that's a natural part. So I'm excited from an on-demand basis that we can look at these three areas and have real opportunity and all, it's pretty much a greenfield for us.
Daniel Pfeiffer: Thanks.
Operator: The next question today comes from the line of Eric Sheridan from Goldman Sachs. Please go ahead. Your line is now open.
Eric Sheridan: Thanks so much for taking the questions. Maybe two, if I could. First on marketing longer-term, you obviously leaned into marketing intensity in the last 12-plus months and seeing good returns on that. How should we thinking about marketing levels and marketing ROI that you want to sort of think about for the medium to long-term as sort of a cost input to drive the types of growth you want to establish as a baseline for the business? That'd be number one. And then number two, I'm curious just to go a little bit deeper in the idea that you could be in the more individual service request business over the long-term, and how you think about the market opportunity there and what investments would be key to capitalize on that potential shift? Thank you.
Bill Cobb: Okay. Let me take those, and Jessica, if you want to add anything to that. In terms of the marketing investment, we have – as Jessica pointed out earlier, we have two growth engines here. Next year, we will be spending the vast majority of our marketing money on American Home Shield. We're still working through the exact mix. We'll spend less on Frontdoor. But it is important to keep the vitality of the Frontdoor brand. Because to answer your second question in terms of on-demand, the catalyst for that is going to be customers, all non-AHS customers, thinking that Frontdoor is the place to go for repairs, maintenance, and upgrades. So the key is to continue to build the brand and make it synonymous with this a-la-carte offering. That's going to take us a while, but we have to maintain a level of pressure for next year. So that in terms of a return will probably be a negative return next year. But it'll be part of our overall fit within our overall equation in terms of our SG&A expense, et cetera. So that's Frontdoor and that's how we think we can get to the on-demand piece. The other thing is the TAM on that market is much bigger than just the home warranty market, and that's what makes us excited. We have seen with this real estate situation that people are staying in their homes longer. Well, systems are going to continue to break and so we do think that there's a big opportunity for people who don't want to get locked into a contract to use the on-demand piece. Now, as far as AHS investment, that'll be a – in a more traditional sense of the spending we have for the returns we want to generate. So that will be – I won't get into specifics of what we're looking for in terms of CAC or anything else. But that'll be – that's an existing business, that's a business we want to invest in. We did not spend at the levels we probably should have this year, but we're going to correct that next year. And I think with a fresh new message and really driving home the benefits of the home warranty, I'm excited that our DTC one business will start to turn around, we'll see on real estate, and I'm really pleased with how renewals continue to be so resilient.
Eric Sheridan: Thank you.
Operator: [Operator Instructions] The next question is a follow-up question from Mark Hughes from Truist. Please go ahead, Mark. Your line is now open. Please do ensure that you are unmuted locally.
Mark Hughes: Okay. Yes. Here I am. Thank you. Good morning. Is there a particular seasonality to be on-demand? Is that a kind of Q2, Q3 along with the HVAC? Or should we think about that being more steady through the year?
Bill Cobb: I think that's an intriguing question. I don't think we know it. We don't have a great answer for you now. Other than I think generally home services follow a seasonal pattern, which is spring cleaning, spring, I got to get our house in order over the summer stuff breaks, especially in the HVAC area. So I do think the seasonality would be consistent, but I can tell you that we've got a great empirical study on this. But I think my sense is, this maybe a little better as a year-round business, but if it just follows the pattern of our service requests, the seasonality would be the same.
Mark Hughes: And then on the real estate channel, I hear what you're saying about higher interest rates impacting activity there, some indication perhaps at least year-over-year, some of the purchase activity could be steady or even moving up possibly. How much do you need kind of more days on market to put pressure on the sellers? Or if you could just theoretically if the existing home sales flattened out or turned positive, how much of a help would that be?
Bill Cobb: Yes. As the days on market is a big deal. I know only 21 days on market because with that level of inventory that drive demand is high against a limited number of homes. So the seller doesn't feel. It doesn't feel it's necessary to attach a home warranty. I think what – if ideally it's more like four to six months worth of inventory, that probably is more ideal for us. But we're not sitting still, just fields and the real estate team are really starting to turn their attention, trying to engage buyer agents more, not just the seller agents to get that direct-to-consumer piece. We also have a big team lined up against trying to drive increased real estate RE 1 renewals. So there are various ways we can go at this. The overall real estate business while we're working through this macroeconomic effect of the industry continuing to have this severe decline. And again, the real estate business is resilient. It's going to come back. We continue to hold our share within the amount of home warranties that are done through the real estate channel. But having said that, we're working across a lot of different dimensions to try to drive units.
Mark Hughes: Understood. And then Jessica, did you give specific numbers for sizing the weather impact on EBITDA or the preferred contractor utilization?
Bill Cobb: Over to you, Jessica.
Jessica Ross: No.
Bill Cobb: You're the weather person.
Jessica Ross: Yes. No, well, we definitely had less flavor on Q3 compared to prior quarters this year. We talked about last quarter there being about – sorry, last quarter we talked about the decline in the cooling degree days and that being significantly lower, this year was about 3% up compared to last year. So last quarter Q3. So that should give you some flavor into where that's placed. Definitely less of an impact in Q3 than what we saw in the first half of the year.
Mark Hughes: And then the preferred contractor utilization?
Jessica Ross: And that's about 83% this year. And again, 1% change in percent to preferred drives about $5 million in gross profit.
Mark Hughes: Excellent. Thank you.
Jessica Ross: Awesome. Thank you.
Operator: Ladies and gentlemen, thank you again for joining Frontdoor's third quarter 2023 earnings call. Today's call has now concluded.
