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Frontdoor Inc
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Ladies and gentlemen, welcome to frontdoor's Second Quarter 2019 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.
Thank you, operator. Good afternoon, everyone, and thank you for joining frontdoor's Second Quarter 2019 Earnings Conference Call. Joining me on today's call are frontdoor's Chief Executive Officer, Rex Tibbens; and frontdoor's Chief Financial Officer, Brian Turcotte.
Before I review the agenda and turn the call over to Rex and Brian, after the market closed today, frontdoor issued a press release reporting our second quarter 2019 financial results. The purpose of today's call is to provide investors with further details regarding frontdoor's financial results as well as provide a general update on the Company's progress.
The press release and a slide presentation that will be utilized during today's call can be found on the Investor Relations section of frontdoor's website, which is located at www.frontdoorhome.com. I would also encourage all of our listeners to visit our website to find out more about our Company.
As stated on Slide 2 of the presentation, I'd like to remind you that this call will contain forward-looking statements. Investors should be aware that any forward-looking statements are subject to various risks and uncertainties that 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 Securities and Exchange Commission. Please refer to the Risk Factors section of our filings for a more detailed discussion of forward-looking statements and the risks and uncertainties related to such statements.
All forward-looking statements are made as of today, August 7, and, except as required by law, the Company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.
We will reference certain non-GAAP financial measures throughout today's call, and we have included definitions of these terms in our press release and presentation available on our website. We've also included reconciliations of these non-GAAP financial measures to the 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.
Our financial statements include all revenues, costs, assets and liabilities directly attributable to us. Additionally, our financial statements for periods prior to the spin-off, which occurred on October 1, 2018, include allocations of certain costs from ServiceMaster incurred on our behalf. For those following along with the presentation available on our website, I'll walk through the agenda items shown on Slide 3.
Rex will lead off by summarizing our second quarter performance. He will then provide a business update and discuss our strategic objectives for 2019. Brian will follow. He will speak to our second quarter of 2019 financial results, provide more details in regard to our financial statements and then update our full year 2019 outlook. We will then open up the line for questions.
I'll now turn the call over to Rex for opening comments. Rex?
Thanks, Matt, and good afternoon, everyone. Let's start with our quarterly summary shown on Slide 4. In the second quarter, revenue increased 9% versus the prior year period to $388 million. Gross profit margin rose 800 basis points to a second quarter record of 53% on greater than anticipated contribution from our business process initiatives, and seasonally mild weather.
These factors also help drive a 44% increase in adjusted EBITDA versus the prior year period to $105 million. Brian will provide further details on our financial performance and outlook shortly.
Further down on Slide 4, we continue to grow the number of home service plans by 4% to 2.1 million plans. Similar to last quarter, our customer retention rate remains stable at 75% although we do see some potential headwinds which we'll discuss later.
We're also starting to realize the benefits of the investments we've made in technology and process improvements. We remain bullish about our core business and continue to see a lot of potential and growth in the future.
Recently, we announced the opening of our new technology campus in Denver, Colorado. The new campus will bring additional capacity to our technology and engineering groups based in Memphis and Phoenix. We feel Denver has the right attributes of talent and culture that will allow us to establish a seamless team environment that emulates our House Rules.
Also, we expanded our service planning coverage to include optional electronics and smart devices. Our customers can now protect an unlimited number of eligible devices in their homes. The feedback from our customers has been strong and we intend to scale this coverage over the next several months.
Finally, our House Rules were fully implemented earlier this year. They are quickly being ingrained in our cultural fabric and hiring practices.
Let's now move to Slide 5, where I'll provide a business update for each of our three customer acquisition channels. In our first year direct-to-consumer channel, we made operational improvements by increasing our call center staffing to support new sales and better align compensation.
We believe this will drive new unit conversion from inbound sales calls in future quarters. We also continue to invest in marketing to drive top line growth. We not only increased our total dollars spent in this channel, but also work to improve the efficiency of our marketing dollars. In the first year, real estate channel macro headwinds have resulted in a slight year-over-year decline in the number of home service plans.
The existing home sales figures from the National Association of Realtors show a decline of 3% in the second quarter. While slowing home sales remains a concern, we believe that the real estate environment could improve heading into the back half of the year as mortgage rates have been meaningfully declined.
In response to slowing existing home sales, we have been laser focused on growing our base of real estate brokers. I am pleased to report that we have recently launched a strategic national home service plan program with home services of America, the nation's largest residential real estate company based on transaction size.
The frontdoor real estate team continues to expand our partnerships with most of the major brokerage firms. We now work with nine of the top 10 real estate brokers in the U.S. These partnerships and improving macro environment will help us improve real estate units going into the back half of the year.
Additionally, we are making operational changes in the real estate channel to improve the efficiency and effectiveness of our sales team in the field. We are in the process of implementing new technology to better enable our sales team and ensure they have the data to focus on the most productive real estate brokers to drive new units.
Turning to renewals our largest channel. As I mentioned earlier, we recently expanded our product offering to add electronics coverage. This includes everything from personal computers to smart home technologies. Is a great partnership that also increases the value proposition for our customers.
Finally, renewal rates are the new focus of our tiger teams. These rates are under pressure from a mix of poor processes, suboptimal customer experiences last year and reduced plan usage. We see a direct correlation between usage of our home service plan products and customer renewals.
Our tiger teams are digging into the root causes here, which could include cycle time service or mild weather to reverse this trend. Additionally, while the customer attrition related to pricing is in line with what we modeled, any price increase has a small impact on our renewal rates.
Given the nature of our 12-month customer contracts, it takes time for the full impact of any changes to be felt in our customer renewal rates. At this point, we anticipate our blended retention rate could round down 1% to 74% by the end of the year with similar trends in each of our channels.
However, we are optimistic that our tiger team efforts could partly offset the current year impact and increased renewal rates over the course of 2020.
Now please turn to Slide 6, where I'll give an update on our 2019 strategic objectives. Let me start by saying that we are making great progress delivering on the promises that we laid out to stabilize the core business and grow into the broader $400 billion U.S. home services market.
Also want to take a moment to acknowledge the great work that our cross functional teams have done in such a short period of time. We continue to build a culture of ownership and I could not be more proud of how quickly we stepped up the speed at which we implemented our changes.
Our first strategic objective is enhancing the customer experience. We are passionate about delivering a product that delights our customers. While it's still early, we are consistently working to enhance the overall customer life cycle experience, which includes improving customer service and outreach at our call centers, adding new products such as HVAC tune-ups and electronics coverage, improving payment processes, reducing cycle time, re-evaluating coverages and limitations in our core plan and improving contractor service and management.
We're in the process of making additional investments to address each of these areas as we continue to improve our overall customer experience.
Our second strategic objective is pricing. As I mentioned on previous earnings calls, our overall average price increase was in the mid-single digit range this year with attrition rates consistent with where we modeled them. By the end of the second quarter around 50% of our customers have realized a price increase.
In regards to dynamic pricing, we're on track for a broad roll out by the end of 2019 and we still anticipate a 100 basis point gross margin increase in 2020. Dynamic pricing will allow us to attract customers who may have been previously out priced by historic statewide pricing.
Our goal here is to better manage our profitability at the customer level. We will do this by better matching pricing to our costs, the ZIP Code plus 4-digit level.
Let me take a moment to talk about our expectations for margins. I'm thrilled that our business process improvements have allowed us to get closer to our financial targets earlier than expected.
Our goal has been to deliver approximately 50% gross margin and adjusted EBITDA margin in the low 20% range. Our intention is to reinvest all margin in excess of these targets back into the business. We would target those investments to improve the overall customer experience and product coverage. Additionally, we'll use excess margin to further develop our technology capabilities and grow our on-demand product offering.
Now turning to our third objective, improving our business processes and cost containment objectives. Again, we have made great strides in this area. Some of our largest wins from our tiger teams include increasing our preferred contractor capacity and utilization, improving collection of service fees and reducing the number of contractors dispatched to complete a service request.
For example, last quarter we told you about the changes made to our dispatch algorithm to increase the percentage of preferred contractors utilized. As a second step, we changed our algorithms to redeploy preferred contractors the same day, if a previous service request was canceled.
These efforts have resulted in preferred capacity rising to the low 80% range during peak season. This increased utilization, reduces our costs as our preferred contractors charge us about half the labor rates charged for the retail work.
We also continue to roll out our new call center technology solution, Customer Service Central. We are seeing meaningful improvements to the customer experience as well as cost-containment with the workflow nature of our new solution.
Finally, we are working to reduce expenses through better procurement leverage. The team is always looking to move our purchasing spin among different OEMs and distributors in order to leverage volume discounts for better service and incremental cost savings.
Now moving to our fourth objective, which is people we have fully rolled out our House Rules that I have discussed last quarter. It's great to see our team fully engaged in building a fast moving culture that enables employees to take ownership of their areas.
We believe that our investment in people will provide a compounding effect that will continue to pay dividends over time. Technology is our fifth strategic objective for 2019. As I've mentioned previously, we are making significant improvements to our infrastructure and customer service platform.
Our technology initiatives are currently on track and I’m pleased with our velocity in this area. The Denver Technology campus paired with our great technology teams will serve as an integral driver of our technology transformation, because we move our infrastructure to the cloud and establish more micro services, we'll be able to open-up new opportunities to improve our business processes and innovate at an even faster pace.
Our sixth strategic objective on-demand is still on course to launch our initial product next year. We have pilots currently underway to provide more detail on what our offerings will be by the end of the year. Our initial focus continues to be on what we do best, repair and maintenance within our core skilled trades.
As we continue to develop our on-demand playbook is becoming increasingly clear that we can leverage our existing platform and operations. In turn, the process of building the on-demand playbook has helped to improve several aspects of our core home service plan business. These synergies will allow us to leverage our investments across both businesses and raise the bar for all the frontdoor.
To conclude, I'm extremely pleased with how far we’ve come on this journey in such a short period of time. We've made tremendous progress on our business process improvements and cost reduction initiatives. Our North Star continues to be taking the hassle out of the home. We are building a strong foundation that will support future growth and profitability. It'll benefit all of our stakeholders.
I'll now turn the call over to Brian, who will cover our second quarter 2019 financial results in more detail and discuss our updated full year 2019 outlook. Brian?
Thanks, Rex. Good afternoon and please turn to Slide 7 and I'll briefly review a few key financial results from the quarter. As Rex mentioned, revenue increased 9% to $388 million driven primarily by an increase in the number of home service plans and a higher average price per plan. Of the 9% revenue growth realized five points came from volume and four points from price this quarter.
As mentioned on the previous earnings call, we expected our year-over-year revenue growth composition to shift more toward price this year than in the past due to the higher than normal price increases. We implemented in late 2018 and early 2019.
Looking at our three primary customer acquisition channels, revenue derived from customer renewals was up 12% over the prior year, due primarily to growth in the number of home service plans and improved price realization. First year real estate revenue was up 1% versus the prior year, mostly driven by improved price realization that was partly offset by a decline in new sales. And first year direct-to-consumer revenues was up 8% due to the growth in new home service plans driven primarily by increased investments in marketing.
Gross profit dollars increased 29% to $205 million in the second quarter. Gross profit margin increased 800 basis points versus the prior year to 53%. The increase was driven by our business process improvement and cost containment initiatives as well as seasonally mild weather that have a favorable impact on claims incidents.
Net income was $60 million or 34% higher than last year. This increase was driven by a $23 million favorable impact from higher revenue conversion. $24 million of lower claims cost and $7 million of lower spin-off charges. This favorability more than offset a $17 million increase in selling and administrative expense, a $15 million increase in interest expense and a $5 million increase in income tax expense. Second quarter adjusted EBITDA of $105 million was up $32 million or 44% versus the prior year period, driven primarily by the aforementioned increase in gross profit.
Let me now walk you through the adjusted EBITDA bridge on Slide 8, which shows the drivers of change from second quarter 2018 to second quarter 2019. So starting on the left, we had $23 million of favorable revenue conversion versus prior year. As a reminder, we calculate revenue conversion as the estimated gross margin impact from volume growth plus the impact of price increases. This quarter price represented $13 million of the change and volume was $10 million.
Continuing to the right, claims costs were $24 million lower in the prior year period. The break-down of lower costs include first $13 million benefit from our process improvement and cost containment initiatives, which we previously discussed. Second, we had $10 million benefit related to the favorable impact of mild weather on claims incidents. During the second quarter of 2019, cooling degree days in the U.S. were about 40% lower as compared to the historical average and 28% lower than the second quarter of 2018.
As background, a cooling degree day is a reference for energy use based on the maximum and minimum temperature. The more cooling degree days, the more demand is placed on air conditioners and other cooling systems. We saw similar temperature trends in the geographic areas where we have our highest customer concentration, including the Southern U.S., where we experienced a 14% decline in cooling degree days.
In addition, cooling degree days in the Western U.S., were down about 43% compared to the second quarter of 2018. While we're still refining the algorithm that correlates heating and air conditioning claims by geography to the mean outdoor temperature variances, we are certain that the seasonally mild weather did play a meaningful role in lowering our claims incidents in the second quarter of 2019.
And third, we had $12 million net favorable impact of adjustments related to contract claims cost development, which comprises a $5 million adjustment in the second quarter of 2019, primarily related to favorable development of prior quarter claims and a net $7 million adjustment in the second quarter of 2018 related to adverse development of claims. The aforementioned benefits were slightly offset by $3 million in tariff related costs and $8 million in other inflation this quarter.
Now turning back to the bridge, sales and marketing costs increased $7 million, due to planned incremental investments made to drive home service plan unit growth primarily in the direct-to-consumer channel.
Next, the spin-off dis-synergies of $1 million relate primarily to the costs associated with the separation of frontdoor technology systems from ServiceMaster. And finally, the $7 million of other costs include higher insurance related costs of $3 million, annual incentive compensation of $2 million and general and administrative expense of $2 million. The higher G&A expense primarily consists of professional fees and an increase in bad debt expense, offset in part by an increase in interest and net investment income versus the prior year period.
Please now turn to Slide 9 for a review of our cash flow and cash position. Net cash provided from operating activities was $140 million for the first six months of 2019, compared to $122 million for the same period in 2018. This increase was primarily driven by our favorable earnings and improved working capital over the prior year period.
Net cash used for investing activities was $12 million for the first six months of 2019, compared to $16 million for the same period in 2018, primarily due to lower capital expenditures. Capital expenditures or CapEx for short, decreased $10 million compared to $17 million in the prior year period, which included spin-related technology costs.
Please note that despite the relatively low amount of CapEx through the first half of the year, we continue to target full year CapEx of between $30 million and $40 million. Net cash used for financing activities was $4 million for the first six months in 2019, compared to $74 million for the same period in 2018. Current year activity was driven by debt payments while the significantly higher activity in 2018 which driven by net transfers to our then parent, ServiceMaster that ceased after the spin-off in October.
Free cash flow, which we calculate as net cash provided from operating activities minus property additions or CapEx was $130 million for the second quarter 2019, compared to $105 million in the prior year period. This 24% increase was due primarily to higher adjusted EBITDA, positive working capital contributions and lower CapEx, partially offset by higher cash payments for interest expense.
I should note that adjusted EBITDA conversion to free cash flow for the first half of 2019 was 87%. We projected full year 2019 adjusted EBITDA conversion to free cash flow will be in the 50% to 60% range due to interest expense, cash taxes and CapEx. They're more heavily weighted towards the back half of the year.
We ended the second quarter of 2019 with $425 million in cash and marketable securities and $120 million increase from December 31, 2018. Of that total, $203 million were considered to be restricted net assets to remain in compliance with the regulatory requirements of certain states, which is $16 million increase from year-end.
As a result of our adjusted EBITDA growth and increasing cash balances, our net debt-to-adjusted EBITDA leverage ratio improved to 2.8 times at the end of the second quarter. We are now lowering our net leverage ratio target to 2 to 2.5 times. I should also note that we would consider flexing our leverage ratio up a bit if the right acquisition opportunities arose.
Turning to Slide 10, I'll cover our updated full year 2019 outlook. We continue to believe that full year revenue range between $1.36 billion and $1.38 billion, despite the impact of lower growth in the real estate channel. We now expect full year gross margin to be approximately 49%. This reflects our process of improvement and cost reduction efforts as well as the favorable impact of milder weather in the first half of the year.
Full year adjusted EBITDA is now anticipated to range between $290 million and $300 million. And I’d like to take a moment to provide some additional color on this outlook. Our adjusted EBITDA growth in the back half of 2019 is lower than the first half, largely due to weather and timing of our selling and administrative expenses. For example, we had about $18 million of mild weather impact on claims costs in the first half of the year and we're assuming normal seasonal weather patterns for the remainder of 2019.
Additionally, we expect a meaningful increase in our selling and administrative expenses in the second half of the year versus the first half. This ramp up is due to timing of our investments in technology, sales and marketing, customer service, staffing levels, and other corporate costs.
At this point, we are estimating our full year 2019 selling and administrative expenses to be approximately $400 million, as we continue to invest in the business to build a stronger foundation for the future. I should also note that third quarter 2019 adjusted EBITDA is anticipated to range between $95 million and $100 million.
Moving down the table, I previously covered the CapEx range. In the full year, annual effective tax rate is expected to remain at approximately 25%. In summary, we continue to invest for growth in a great business that generates strong cash flow. Our long-term targets remain the same. We expect revenue growth in the upper single-digits with gross margins of approximately 50% and adjusted EBITDA margins in the low 20% range.
With that, I'll turn the call back over to Matt to open the question-and-answer session. Matt?
Thanks, Brian. As a reminder, during the question-and-answer session, we encourage you to ask any questions that you may have. But please note that guidance is limited to the outlook we've provided in our press release and webcast presentation. Operator, let's open the line for questions.
Thank you. At this time, we will be conducting the question-and-answer session. [Operator Instructions] Our first question comes from Ralph Schackart with William Blair. Please state your question.
Good afternoon. Two questions if I could. Rex, on my call, you talked about reinvesting any potential cash flow upside once you achieved your margin objectives. Just curious if the on-demand product, which I think contemplates $10 million investment, would sort of garner potentially that reinvestment. And then maybe just a little bit broader, what sort of projects would you have or initiatives that you think would warrant incremental investment? Then I have a follow-up. Thanks.
Sure. So from a gross margin perspective, I think there's opportunity to – continue to invest in the business as well as in the EBITDA margin. Specifically for on-demand, we're pretty comfortable with the investment we laid out earlier in the year. So about $10 million of OpEx spend, I think we'll still kind of come in that range. But in terms of other things to spend money on, certainly we have a long way to go. We are on a journey from a customer service perspective, we just implemented our customer service central platform, still more work to do around helping customers.
Then from a technology perspective, as we continue to evolve a company that I think there's also opportunities to spend there as well. And then lastly, we're always looking for ways to improve our products. So whether that's adding additional services or strengthening the services that we already provided today, those are areas that we're looking at.
Great. And then on the call, you have to talk about blended retention rates, maybe being down around a point or so and then increasing renewals in 2020. Just curious what the levers you could pull or what you're sort of contemplating to remind your consumers or people purchasing this – the value that holds for them? Thank you.
Yes, great question. The one thing to think, I think we're going to – we potentially might round down to 74 or so, I wouldn't view it as 100 basis point drop. The thing that we're working on with the Tiger teams enhancing our onboarding process. So we really ramped up welcome calls. Obviously, if customers don't fully appreciate the product that they have and they don’t use it. And in our business usage equals retention. We're really – I've spent a lot of time reducing the payment friction. So well over two-thirds of our customers are on auto pay, just ensuring that there's no credit card hiccups on that front, and other frictions from a renewal perspective we've worked on.
And then from a broader perspective, adding more services and products, we talked about rekey [ph] this year but – or last year. HVAC tune-up is another area that we have been focused on from a products perspective. And then lastly, really enriching our core service experience so CSC, the platform will really began to be the kind of underpinnings, if you will or the foundation to help us move to self service. And we think self service provides a better overall customer experience and it also should be less costly to handle customer's claims.
Great. Thank you, Rex.
Sure.
Our next question comes from Justin Patterson with Raymond James. Please state your question.
Great. Thank you very much. Two if I can. First, just a big picture one on sales and customer acquisition. Many of your digital competitors are encountering headwinds from both Google Search engine, marketing costs being inflated as well as SEO headwinds. As you execute on the digital transition and start acquiring more customers through digital channels, how do you think about the appropriate marketing mix? And then I've got one follow up to that.
So we kind of view the world in kind of three buckets. Renewals, which is our largest channel, if you will and then real estate and the direct-to-consumer. From a true direct-to-consumer, I believe that's where your question is focused. We're working on a couple of different things, when it comes to that area. One, we move some work in-house, so trying to build a little more ad-tech or experience in that area. So that we have more control over our spend, trying to get closer to the efficient frontier. And then we've made a lot of changes in terms of compensation structures and how we're rolling out incremental salespeople from an inbound sales perspective.
But from an SEO – Google SEO perspective, overall, we're actually not seeing the level of headwinds that we did last year. It seems to be the same headwinds. So we haven't yet experienced anything abnormal, if you will.
Got it. Thanks Rex. And then Brian, I wanted to elaborate on your comment on M&A, could you just remind us what your M&A philosophy is and how you would think through returns associated with any investment you'd pursue? Thanks.
Sure. Great question, I'll ask Rex to chime in as well. But we talk about our available cash and capital allocation. First and foremost, we’re reinvesting in the business to grow it. And then second, in the pecking order would be, bolt-on opportunistic M&A, whether it's home service plan related or a technology platform or something that could help us get to where we want to go even faster with on-demand or any of our other services in the future.
So in return wise that's kind of a mixed bag. It's on a technology side. I would measure it different than I would on a home service plan side as far as a short-term expected returns because they're just – it would be different levers to pull. Rex, you want to chime in?
Sure. On the technology play, its more bill versus buy, what helps us from a speed to market perspective or if there's a technology portfolio that would allow us to build a different mode around our business from a patent perspective.
Great. Thank you.
Thank you. Our next question comes from Ian Zaffino with Oppenheimer and Company. Please state your question.
Hey guys, this is Mark on for Ian. Thanks for taking our questions. So just a quick one, number one for, Brian, on the M&A front, you said you would be comfortable flexing your leverage beyond where you are or your target is, can you just give a little bit more details on where I guess like you would be comfortable with getting up to and then how quickly would you like to get it back down? Thanks.
Yes. Thanks Mark. Good question. Well, you know how we generate cash. So anything we would do, we quickly build up cash again on the balance sheet to offset anything we do. Again, we're talking in bolt-on range here, so haven't really defined how high we would go because we're just not thinking and drastically changing the ratio at this point. But we started at 3.9, I think back in the good old days when we were spun out and we brought it down to 2.8.
So in a way we build cash and grow EBITDA, that'll be a lot lower soon by next year or so. I don’t know, Rex, we haven't really talked about a ceiling on how high we go but it wouldn't be dramatically different.
I think that's fair. To Brian’s point, I mean, less than a year we brought down a full turn, so I don't think we're looking to do something so dramatic that it puts us in parallel so to speak.
Okay, great. Thanks guys. And then just another one on – thanks for going through the on-demand and what you guys are doing in there. But is there any sort of updates on industry those with partnerships with utility companies or partnerships with third-parties that you I guess like, are working on or could progress quickly by 2020? Thanks.
Are you talking about specifically for on-demand or for our core business as well?
Sorry. I guess a little bit of both, but more on the just core business. Thanks.
Sure. So core business, we're really excited about our strategic partnership with home services of America that leading from a transaction volume, leading real estate brokerage firms. So that's in its very early stages. So we think that will definitely bear fruit. And then we're looking at a lot of – we've piloted with some of the kind of the high buyer type of firms, can’t give names there just yet. But yes, we're exploring a lot of different partnerships in broad areas.
We don't have a specific utility play that comes to our core business, but we have been working with utilities as it comes to how we can leverage our business to help them. So more to come but we have a very aggressive BD arm and we're focusing those areas.
Okay, great. Thanks Rex.
Our next question comes from Mike Ng with Goldman Sachs. Please state your question.
Thank you very much for the question. I just have two if I could. The first is…
Hi Mike.
Hi, I was just wondering if you'd be able to provide an updated view on tariffs for 2019 and 2020, following the increase of tariffs from 10% to 25%. And whether or not there's any additional impact from a list for tariffs, if they were implemented on September 1? Thanks.
Sure. This is Brian. I'll start on that. As you know, we estimated about $10 million unfavorable impact in 2019 from the tariffs on the Chinese steel. And that's holding pretty true to form. And subsequently, I think they announced an increase from 10% to 25% and our prices are locked in for 2019. So no impact on that for the balance of the year, although, we'll begin negotiating soon with our OEMs and parts distributors on prices for 2020.
Whatever the increase is going to be, we don't think it's linear because we have leverage to negotiate with our providers on our products, whether it be appliances or systems or parts. So that's to be determined like or we've got to start the negotiation soon for 2020. The recent announcement, I believe was more consumer products and didn't impact our industry.
Great. Thank you. And my second question is, just on weather – I understand that weather will always be an exogenous factor that could impact claims costs. But could you talk a little bit about some of the changes you're making in the core business to better withstand those outside servicing claim requests and any initial view on what you're assuming in terms of the weather impact for the third quarter given July was a fairly extreme? Thank you.
Yes. This is Rex. When it comes to weather, obviously we're looking for the perfect crystal ball. We have definitely improved our ability to forecast, we're working with a couple different services and trying to inform our own models. We are – when it comes to weather, the biggest thing that we do is our name is preferred contractor capacity. So the algorithm changes that we've made last quarter as well as the capacity algorithm changes we've made over the course of last quarter and this quarter has really allowed us to dispatch more preferred capacity.
So as we look at these models and we see that there's a potential for a warmer or colder weather, but we then do is reach out to our contractor network to see if they could take on incremental capacity ahead of the storm, so to speak. Luckily, this year, weather has been much more favorable than last year, we have baked in to our guidance, where we think weather is going to come out for the back half of this year. But we think this is going to be a “more normal years than that last year”.
Great. Thank you very much.
Hey Michael, this is Brian. And by the way, you did a great piece on weather and that was very well done. I didn't want to see – you asked about July. And July was not a typical for us as May and June were. It was not that extreme. We haven't seen our third-party data yet on the degree cooling days. But to your question, it was not abnormal for us and we weren't surprised by the weather.
Great. Thank you very much for the follow-up, Brian.
Our next question comes from Cory Carpenter with J.P. Morgan. Please state your question.
Thanks for taking the questions. Two for me as well, maybe first on dynamic pricing, I know you've mentioned, you're on track to finish the roll out by the end of the year. Could you just update us on where you are on that today and any flow through you're starting to see on gross margins? And then as a quick follow-up on on-demand, any more color you can provide on the pilots that you're currently running would be helpful. Thanks.
Sure. So in terms of dynamic pricing, we'll finish the majority of the tech work by the end of the year. So no, I would say material gross margin impact from that. Today, although we do use our models to inform our overall pricing, so, I think that as we finished it up towards mid-to-late Q4, that's when we'll see the impact in over 2020.
And then from an on-demand perspective, we have a lot of people on the phone who aren't analysts, we generally have a lot of people on our phone calls who aren't analysts. So, we're being a little bit discrete in terms of how we're talking about the models. But I can tell you that the things we're piloting is around where I think we have a lot of leverage and that's a repair and then maintenance services. So we have, kind of pilots running in different markets around those things.
They're small pilots that are more aimed at kind of learning what customers appreciate, how we're working with our contractor community who've been very responsive to these pilots, which is a great, great sign for us. But I can't give you specific details on cities or the exact things that we're piloting, just because there's a lot of outside interest in kind of what we're doing.
Q -
Thank you.
Our next question comes from Chris Gamaitoni with Compass Point. Please state your question.
Good afternoon everyone.
Good afternoon
I wanted to follow-up on your direct-to-consumer goals. You mentioned your expansion into marketing spend, just high level, what is that intended for? Are you pushing further into, less penetrated states? Is it more focused on where you have density today? Any color would be great.
Yes. So, we're focused on both where we have, yeah, I look at it more in terms of where we first, where we have capacity. So, states where we have a good or a great supply position, so lots of preferred contractors. And then secondly, we grow, where we see opportunity. So, we've made some headway, from a real estate perspective in the northeast. But so that's also because we built supply there that gives us an opportunity from a direct-to-consumer perspective.
So, it's kind of really a two-pronged strategy of where we have supply and good penetration if you will. And then secondly, as we are adding supply for real estate then we are leveraging direct consumer to try to sell through in those areas as well.
Alright. And then I wanted to follow-up on the favorable adjustment in contrast claim cost. I get the year-over-year comp, but it seemed like there was a net positive benefit. Just kind of what drove the realization on the cost versus previous expectations?
Yes. This is a bit of an SAT question. It's good. It's a bit complicated, but yes, a year ago in Q2 of 2018, we had 12 million originally of unfavorable development from prior periods. Subsequent to that we had some unfavorable development for Q2, which you net those two numbers that happen to be five.
So we net it to 7 million unfavorable, development in Q2 of 2018. This year fast forward to Q2 in 2019 we had 5 million of favorable development of prior period claims. So you add those together and that's the 12 million of favorable that I called out in the script. Does that help?
Yes, that helps with the math. I was wondering what drove the extra $5 million of favorable.
It’s just, we accrued at a certain level and perhaps process improvement for whatever reason when we closed out those claims, they cost less than we had anticipated. So there was a favorable adjustment. We over accrued.
All right, perfect. Thank you so much.
Our next question comes from Robert Coolbrith with Wells Fargo Securities. Please state your question.
Good afternoon. Thanks for taking my questions. Following up on Justin's question earlier, the year-over-year increase in marketing was a bit more pronounced in 2Q versus the first quarter. Just warning if there's anything you could tell us about how return on ad spend is tracking in the DTC channels as we're proceeding through the year. And then second wanted to ask about the new electronics plan that you're rolling out, anything you’d tell us initially about uptake or cross sell opportunity and then also since this is being offered with a partner, anything you could tell us in broad terms about, how revenue is going to be recognized there, were margin profile relative to the core of your business. Thank you.
Yes. So, I many of you asked, to repeat a few though, but from an electronics perspective, definitely we are recognizing revenue as our take, if you will of that plan. So it's, kind of all margin dollars, if you will. The plan or the program is fairly new, so we're just ramping it.
So, I wouldn't say it's material at this point, but we do think it will be material in the back half of this year and into 2020. In terms of marketing spend, as we ramped up, we had to ramp up our sales force a little higher pace. So, that's, that kind of caused a delay, if you will, for pushing more marketing dollars into the back half of this year.
We don't publish our LTV to CAC ratios, but I will say they haven't really changed, so we're not seeing more marketing spend for less ROI, if you will. So, that's kind of what's driving that.
Great. Thank you.
Our next question comes from Youssef Squali with SunTrust Robinson Humphrey. Please state your question.
Hi, this is a Sagar on for Youssef. I think you mentioned marketing is one of the areas where you'd be investing excess margins, the revenue guidance for the second half. Does it seem to reflect the faster growth we'd expect? I was hoping you could, speak more to that.
Well, a great thing about our business, is it's subscription based. So as we sell more units so to speak, we recognize revenue a twelfth at a time. So as you sell more in the back half of the year, you're spending more from a marketing perspective. But from a revenue recognition perspective, you're not seeing the dollars flow through until every month passes. Right? So if we sold something in August, you are only going to recognize, a quarter of that revenue versus full 12 months.
Makes sense, thank you.
Our next question comes from Kevin McVeigh with Credit Suisse. Please state your question.
Great. Thanks. Hey Rex, you alluded to just better leverage of the preferred contractor capacity. Any sense of where that was in the quarter? And, what we can expect kind of moving forward on that.
Yes. So, overall for the year we typically are or see kind of around 80%, we're in a summer season. It's not uncommon for that to dip on very, very heavy days. So far for our heavy days we're kind of maintaining near that 80%. So it's a pretty significant change for us.
So, I think overall we'll be kind of in the low-to-mid 80’s as we continue moving forward. So it's been a great win for us, not just from a changing the algorithm perspective but also from a capacity perspective to be able to debit and credit if you will, cancel calls and making sure there were, for every cancelled call there was a preferred contractor. We're giving them another call, has been paying dividends for us so far.
Oh really, really nice. And then just obviously really nice EBITDA beat. If you think about the $27 million relative to expectations and yet a nice bridge in there, was it kind of the contract claims that came up big, the revenue conversion? Just any thoughts, if we were to try to think about, again, the beat relative to kind of where the guide was?
There’s certainly process improvements and cost containment initiatives accelerate faster than we expected. Obviously those algorithm improvements, you can model them, but you don't get to see them until they are really out in the wild. And you're handling the actual claims and dispatches.
May, June weather was very mild. So, after kind of a warmer than normal April, that certainly helped us. And then, the assumed inflation and tariffs, would all set prior year out of period, but we saw about a $5 million, favorable development in Q2 of 2019. Any other thoughts, Brian?
Nope. That captures it.
Awesome. Thank you.
Thank you.
Thank you.
Our next question comes from Jamie Clement with Buckingham Research Group. Please state your question.
Good afternoon gentlemen. Thanks for taking my question. Hey Rex this may be a silly question, but your comments about renewal rates, if you go through a stretch where Mother Nature is favorable and you're not getting as many claims and use of claims, use for your service tends to correlate with renewals. Is it sort of natural to see a down tick in renewals if Mother Nature has been cooperative?
It is now we have to work on the, empirical evidence to prove that. But certainly if you look at our first year real estate renewables are much lower than direct-to-consumer because of direct-to-consumer customers have an intent to purchase, right? So, if you don't, use our service there is a higher probability that you won't renew. So while, good weather is certainly good for the quarter, we are ensuring that we're following up with customers to ensure that they understand, the value proposition of what they bought.
And Brian, if I could just follow up on a prior question or two, I think, there's some stories that July was one of the hottest on record in this country. You guys didn't see crazy claims activity again. Is that what you're saying? It wasn't nuts was it?
Yes, I think, it was hot, but it's hot in the places I think it’s typically hot in the summertime, Texas and across the Gulf or what have you. But no, we didn't see unusual activity that we had seen in May and June when it was so mild. It seemed to be right on, right on our FP&A teams forecast.
Okay, great. Thanks very much. And in terms of like pace off of SG&A ramp, I think Brian you said approximately $400 million this year. I think that implies, let me just take a quick look here. I don't know. It looks like it's probably the implication in terms of like your year-over increase as a percentage of revenue looks pretty balanced between Q3 and Q4. Am I right about that or is one going to be kind of more of an increase than the other?
Of the quarters?
Yes. Like in terms of like, if I think about kind of ramping to, if we get to $400 million for the year, is there more of a spike in Q4 as to Q3 or is it pretty even?
I think it's funny. I look at it on a half basis. Just thinking through this, we typically spend less in marketing in Q4 than Q3. Yes, I would think that I'm spit balling here when I speak, I'll follow up with the guys. But Q4 typically is less than Q3.
Okay. Great. Thank you all for your time. I appreciate it.
Sure.
Take care.
Ladies and gentlemen, that concludes the question-and-answer session. We will now turn the call back over to Rex Tibbens for some closing remarks.
Thank you. It's exciting to see the great progress we're making in our business. We continue to deliver on our promises and I'm pleased with the velocity of change across the organization. Even with the progress shown in the first half of the year, we are not done. We still have to improve the customer experience in our technology platform.
We're also working hard piloting new features and remain on track to launch our on-demand business next year. These actions will position us to continue to grow our core business and expand in new services in 2020 and beyond.
Thank you again and we look forward to updating you on our progress on our third quarter 2019 earnings conference call.
Thank you. This concludes today's conference. All parties may disconnect.