Frontdoor Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
November 1, 2023

There are 10 speakers on the call.

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.

Operator

Davis.

Speaker 1

Thank you, operator. Good morning, everyone, and thank you for joining Frontera's Q3 2023 earnings conference call. Joining me today are Frontera'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.

Speaker 1

There is also additional information about our Frontdoor brand atfrontdoor.com and in 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 sections in our filings for a more detailed discussion of our forward looking statements and the risks and uncertainties related to such statements.

Speaker 1

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?

Speaker 2

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.

Speaker 2

3rd quarter revenue increased 8% to $524,000,000 And our gross margin has rebounded 760 basis points to 51%. This drove a $48,000,000 increase to a record high for a quarter of $128,000,000 Given these results, We are raising our full year outlook for revenue, adjusted EBITDA and share repurchases for the 2nd 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.

Speaker 2

Now I want to highlight an important point. At our Investor Day in March, we laid out a target of $2,000,000,000 in revenue and at least $300,000,000 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 BruntDoor 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 5 years.

Speaker 2

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 $125,000,000 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.

Speaker 2

It is our current assessment that the home warranty category It's both undifferentiated and 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 Search 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.

Speaker 2

Let me be clear, we are keenly aware of the drop in our customer count 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 Q4, we are increasing the actual marketing spend behind our American Home Shield brand to drive brand awareness.

Speaker 2

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 And 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 front door 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.

Speaker 2

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 1st 9 months of the year and full year expectations have declined to just under 4,000,000 homes. As you can see from this chart, that is a substantial decline from the 6,000,000 existing homes sold in 2021 As high mortgage rates and home prices have diminished consumer affordability. At the same time, inventory remains tight.

Speaker 2

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 in the renewal channel. While 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 3rd quarter, our overall retention rate 90 basis points to 76.2%.

Speaker 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 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.

Speaker 2

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 6 months since the launch of Frontdoor, we have over 1,300,000 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.

Speaker 2

Our offering in the market today is a lower priced 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 2 key components.

Speaker 2

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 where what the Frontdoor brand will offer in 2024, but we are largely coalescing around 3 main categories, On demand repairs, maintenance services and upgrades for home systems and appliances. Starting with the repairs.

Speaker 2

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. 2nd, 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 Tuning up your HVAC before the season changes. And finally, we will offer on demand upgrades for when it makes more sense To replace our home system or appliance rather than fix it.

Speaker 2

As validated by the great success we continue to see with our HVAC upgrade program, Which was about $20,000,000 of revenue in Q3 trending toward a total of $50,000,000 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 This is a win for our customers, contractors and for Fronthor. We'll provide more details on the Fronthor 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.

Speaker 2

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?

Speaker 3

Thanks, Bill, and good morning, everyone. As Bill just mentioned, we are extremely pleased with our strong Q3 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 3rd quarter revenue increased 8% versus the prior year period to $524,000,000 This was driven by a 10% increase in price, which more than offset a 2% decline in volumes. Looking at revenue in more detail on Slide 11.

Speaker 3

3rd 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 $11,000,000 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 $57,000,000 to $268,000,000 and our gross margin increased 7 60 basis points to 51%.

Speaker 3

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 flows through to net income, which increased $43,000,000 to 71,000,000 And adjusted EBITDA improved $48,000,000 to an all time high of $128,000,000 Let's now move to the table on Slide 14 and I'll provide more context for the year over year improvement in Q3 adjusted EBITDA. Starting at the top, we had $37,000,000 of favorable revenue conversion, primarily driven by our pricing initiatives, partly offset by the decline from lower volume. Contract name cost decreased $22,000,000 compared to the Q3 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.

Speaker 3

I am very pleased to report that we are seeing increased traction from these initiatives, which led to a greater financial impact on our Q3 results. The improvement in our contract same cost versus the prior year period was primarily driven by 4 factors. First, we saw a 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 of preferred contractor deployment, specifically in our appliance and plumbing trades that drove meaningful cost improvement. 2nd, we had favorable claims cost development of $9,000,000 in the 3rd quarter compared to a $2,000,000 favorable adjustment in the Q3 of 2022.

Speaker 3

As a reminder, Last year, we had a large favorable development in the 4th quarter that included $18,000,000 related to the prior year Q3 claims cost. 3rd, 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 Q3, 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 Q3 versus the prior year period, well below what we have seen over the past year.

Speaker 3

Now getting back to the table on Slide 14 and our sales and marketing costs, which increased $10,000,000 over the prior year period due to higher marketing spend for the Frontdoor brands. General and administrative costs increased $4,000,000 primarily due to increased personnel costs. And interest and net investment income increased $4,000,000 as a result of rising interest rates Before we leave this slide, I would like to take a moment to go into more detail on why we beat Our Q3 adjusted EBITDA outlook by approximately $45,000,000 Bill and I have consistently said that we have taken a more conservative 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 initiatives implemented over the past year. We are also seeing unexpected favorability in our renewals, weather and cost inflation compared to our expectations.

Speaker 3

For example, our Q3 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 3 areas. The largest driver of our beat was $30,000,000 from lower claims costs, which includes $9,000,000 of favorable claims cost development. The remaining portion is a result of the The impact of our process improvement initiative. Our team has been working very hard cross functionally to improve its operations over the past year, and I am extremely pleased to see the manifestation of this work that really falls into the Q3.

Speaker 3

2nd, we have about $5,000,000 to $10,000,000 from higher than expected revenue conversion, primarily through revenue renewal. 3rd, our SG and A team is around $5,000,000 favorable across several areas, which was due to timing. Let's now turn to Slide 15 for a review of our statement of cash flow. Net cash provided from operating was $139,000,000 for the 9 months ended September 30. Net cash used for investing activities was $23,000,000 Net cash used for financing activities was $88,000,000 through September and was comprised of share repurchases and scheduled debt payments.

Speaker 3

On Slide 16, you will see that our free cash flow was $116,000,000 for the 9 months ended September 30. We ended the Q3 with $320,000,000 in cash. This was comprised of $152,000,000 of restricted net assets And unrestricted cash of $167,000,000 Keep in mind that this is after returning $75,000,000 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 and A.

Speaker 3

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 1.3 times 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 $125,000,000 which amounts to buying back approximately 5% of our outstanding shares in 2023.

Speaker 3

Now turning to Slide 18 and our Q4 and full year 2023 outlook. We expect our 4th quarter revenue to be between $350,000,000 $360,000,000 which reflects renewal revenue up 12%, real estate revenue down 20%, DTC revenue down 16% and other revenue up $4,000,000 to $16,000,000 4th quarter adjusted EBITDA is expected to range between $20,000,000 $30,000,000 This is in line with the Q4 of 2022, which included $25,000,000 in favorable claims cost development. Now when comparing to the 3rd quarter, it is important to note that our 4th quarter outlook also takes into account a significant impact from seasonality relating to our revenue and costs. 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 Q4 typically has a lower number of service requests. Now turning to our full year outlook, where we are increasing our 2023 revenue range to $1,765,000,000 to $1,775,000,000 Or an approximately 7% increase over 2022.

Speaker 3

This revenue range anticipates a nearly 15% increase in the renewal channel, A mid-twenty percent decline in the real estate channel and a low double digit decline in the B2C channel. It also assumes other revenue will increase to approximately $70,000,000 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 volumes. 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 2,000,000 home service plans.

Speaker 3

This includes about 460,000 1st year customers across the B2C and Real Estate channels. We are increasing our full year gross profit margin outlook to be between 48% 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 4,000,000. Our full year SG and A target is between $580,000,000 $590,000,000 and includes $40,000,000 of working marketing spend 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 $55,000,000 to be between $320,000,000 $330,000,000 To put that in perspective, this is about a 50% increase over our 2022 results.

Speaker 3

Our full year outlook also includes $16,000,000 of interest income and reflects stock compensation expense of approximately $28,000,000 And finally, we expect our full year capital expenditures to be approximately $35,000,000 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.

Speaker 3

Even without more price increases, the momentum from our Prior pricing actions will result in a lowtomidsingledigitrealizedpriceincrease 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 margin. 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.

Speaker 3

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 initiatives 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 brand and our on demand products.

Speaker 3

Finally, Our SG and 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 mix 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'll share more details with you next quarter. In conclusion, we delivered extremely strong Q3 financial results.

Speaker 3

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 over back over to Matt.

Speaker 1

Thanks, Jessica. I would just like to point out that we're experiencing a bit of a delay on our phone call. So please bear with us during the Q and A Operator, let's now open up the line for questions.

Operator

Thank you. Our first question today comes from the line of Mark Hughes from Troost. Please go ahead, Mark. Your line is now open.

Speaker 4

Yes, good morning. Thank you. I think last quarter you had

Speaker 2

talked about

Speaker 4

shifting a little bit of marketing spend, I think it was $20,000,000 that was going to the direct Consumer channel. Did that flow through in the quarter or is there a lag perhaps on the likely impact on new business?

Speaker 2

Yes, Mark, thanks for the question. There is a lag by the time we got into market and we have also upped our And 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 these discounting.

Speaker 2

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 Segre from KeyBanc. Please go ahead. Your line is now open.

Speaker 5

Thank you. Good morning, Bill and Jessica. Congratulations on the very strong quarter. Two questions. So 2023 was largely driven by price.

Speaker 5

Wondering how we should think about the mix of planned growth versus Pricing growth going forward, it 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 guys done to mitigate the impact of weather? And I guess, should we expect less volatility tied to weather on gross margin going forward? Thank you.

Speaker 2

Wait, there's a delay, right, Mats? Yes. 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.

Speaker 2

I'll take the pricing question. The answer is yes. You are correct. It will be more balanced. When we look back at Our pricing strategy in 2022, we're probably a little late and with the $100,000,000 in cost increases we had last year.

Speaker 2

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 So we'll have more to say on that in the Q4 earnings.

Speaker 2

So gross margin, I'll turn it over

Speaker 3

to Jessica. 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.

Speaker 3

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.

Speaker 3

And what we really saw this quarter is the manifestations of in our results. And we talked about various things like the high cost claims review that was implemented last Sure. 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 Certain 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.

Speaker 6

Thanks guys. A couple of quick questions, Follow-up on the price increases. Can you talk about the phasing? Is that a steady tailwind as we Meter through 24, does it crescendo at some point? And then the second question was just on the Debt ratio, I think you Jessica you mentioned 1.3 times.

Speaker 6

Do you have a bogey or a target you'd like to Keep that at. Thank you.

Speaker 2

Which one do you want?

Speaker 3

So I can take both. Just on pricing, And as you know, it takes about 12 months 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 single digit price increase flowing into 2024 from those So as 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 debt leverage ratio We really try to keep that between, 1 and 2 times.

Speaker 3

So we're feeling really good about where we're sitting right now, but it's

Operator

The next question today comes from the line of Ian Zaffino from Oppenheimer. Please go ahead. Your line is now open.

Speaker 7

Hi, great. I'd love to hear a little bit more about AHS and kind of the marketing or the relaunch 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 front door side, How are you thinking about either breakeven points or losses or profitability of that? And what I mean by that is, you're adjusting prices, you kind of dropped the premium model, you're now working on that roughly $2 a month plan.

Speaker 7

What do you actually need there as far as profitability, breakeven, etcetera? Thanks.

Speaker 2

Thanks, Egan. Let me take both of those and then Jessica may add something on the front door 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've said, we've seen a severe decline.

Speaker 2

And real estate will work itself 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.

Speaker 2

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 front door piece, I think what I've been happy about, we talked about the consumer response etcetera. I'm disappointed, and that's on me that the premium piece that we tried to come in with a second home service plan.

Speaker 2

We've got a good home service plan on American Home Shield. We really want to 0 in on this larger segment, The 42,000,000 people that we talked about at Investor Day, 42,000,000 households rather. The whole on demand piece, You heard us reference pay as you go or a la carte. We think that there is really a market for people who don't want to get locked into a contract. They want to pay for a repair or Upgrade their system on a one time basis.

Speaker 2

And that's really what we're going to 0 in on. So for now, we're really trying to engage without Making money at $25 with unlimited chats, but we think it's a good lead in to 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 this as we bring the booking app in the booking engine into the app and the like.

Speaker 2

So we've got we're very excited about the strategy, but 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 the front?

Speaker 4

No, I

Speaker 3

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 An on demand services perspective, and so as we're thinking about that longer term profitability mix, it's really again, Like I said earlier, it's going to depend on what of that is coming from Frontdoor.

Speaker 3

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.

Speaker 7

Thank you very much.

Speaker 3

Thank you, Anne.

Operator

The next question today comes from the line of Cor from JPMorgan. Please go ahead. Your line is now open.

Speaker 8

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 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

Speaker 2

Thanks,

Speaker 3

Jill. 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 I think a couple of things I just want to or 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 fees, 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 Seeing inflation or deflation manifest into our results. We've talked also about in terms of as you think about front door Cost inflation, really it's being comprised of 3 buckets, the contractor related cars, parts and equipment And additionally, some of the impact that we're seeing on regulatory changes.

Speaker 3

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 2 of those, which are really trending closer to CPI Right now, at this 4%.

Speaker 2

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 surface. We are thrilled at what 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 Great.

Speaker 2

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 Yes, 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. The upgrades are the engine. We do think that there is opportunity, real opportunity in appliance and water heater.

Speaker 2

We're getting the model down in HVAC and then moving to probably those two areas, whether we could get into pool, spa and other things, but the 2 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.

Speaker 2

But repair will be not only in the shorter term and expansion of markets, but as we We'll get a booking engine into the app where people can call for a repair, as they put it in 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.

Speaker 2

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 in all.

Speaker 2

It's pretty much a greenfield for us.

Speaker 7

Thanks.

Operator

The next question today comes from the line of Eric Sheridan from Goldman Sachs. Please go ahead. Your line is now open.

Speaker 9

Thanks so much for taking the questions. Maybe 2 if I could. First on marketing longer term, you've obviously Leaned into marketing intensity in the last 12 plus months and seen good returns on that. How should we be 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 1. And then number 2, I'm curious to just 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.

Speaker 9

Thank you.

Speaker 2

Okay. Let me take those and Jessica, if you want to add In terms of the marketing investment, we have as Jessica pointed out earlier, we have 2 growth engines here. Next year, we will be spending the vast majority of our marketing money on American Home Shield. We will 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, non AHS customers Thinking that Frontdoor is the place to go for repairs, maintenance and upgrades.

Speaker 2

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 will be part of our overall fit within Our overall equation in terms of our SG and A expense, etcetera. So that's front door 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.

Speaker 2

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 is 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 will be in a more traditional sense of the spending we have for the returns we want to generate.

Speaker 2

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 will be that's an existing business, it's a business we want to invest 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 on the home warranty. I'm excited that our DTC1 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.

Speaker 9

Thank you.

Operator

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.

Speaker 4

Okay. Yes, here I am. Thank you. Good morning. Is there a particular seasonality to the On Demand?

Speaker 4

Is that a kind of Q2, Q3 along with the HVAC or should we think about that being more steady through the year?

Speaker 2

I think that's an intriguing question. I don't think we know 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 my 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 may be 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.

Speaker 4

And then on the real estate channel, I hear what you're saying about higher interest rates impacting activity there. There's 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?

Speaker 2

Yes. 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 with it's more like 4 to 6 months worth of inventory Probably is more ideal for us, but we're not sitting still.

Speaker 2

Dust Fields and the real estate teams are really starting to turn their attention To try and engage buyer agents more and 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 RE1 renewals. So there are various ways we can go at this, the whole of the overall real estate business While we're working through this macroeconomic effect of the industry continuing to have this severe decline. So and again, the real estate business is resilient. It's going to come back.

Speaker 2

We continue to hold our share within the amount of Home warranties that are done through the real estate channel. So, but having said that, we're working across a lot of different dimensions to try to drive units.

Speaker 4

Understood. And then Jessica, did you give specific numbers for sizing the weather impact on EBITDA For the preferred contractor utilization.

Speaker 2

How are you Jessica? No. You're the weather person.

Speaker 3

Yes. No, we definitely Favor beyond 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 It's definitely less of an impact in Q3 than what we saw in the first half of the year.

Speaker 4

And then the preferred contractor utilization?

Speaker 3

So that's about 83% this year and again a 1% change in percent to preferred drives about $5,000,000 in gross profit.

Speaker 4

Excellent. Thank you.

Speaker 3

Awesome. Thank you.

Operator

Ladies and gentlemen, thank you again for joining Frontdoor's 3rd Quarter 2023 Earnings Call. Today's call is now concluded.

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