Frontdoor Inc

NASDAQ:FTDR

Earnings Call Transcript 2023-Q2

[Operator]

Ladies and gentlemen, welcome to Frontdoor's Second Quarter 2023 Earnings Call. Today's call is being recorded and broadcast on the internet.

Beginning today's call is Matt Davis, Vice President of Investor Relations and Treasurer, and he will introduce the other speakers on the call. At this time we'll begin today's call. Please go ahead, Mr. Davis.

[Matt Davis]

Thank you, operator. Good morning, everyone, and thank you for joining Frontdoor's Second Quarter 2023 Earnings Conference Call.

Joining me today are Frontdoor's Chairman and Chief Executive Officer, Bill Cobb, and Frontdoor's Chief Financial Officer, Jessica Ross.

The press release and slide presentation that will be used during today's call can be found on the investor relations section of Frontdoor's website, which is located at investors.frontdoorhome.com. There is also additional detail about our Frontdoor brands at frontdoor.com and our new mobile app that you can download in the App Store and at Google Play.

As stated on Slide 3 of the presentation, I'd like to remind you that this call and webcast may contain forward-looking statements. These statements are subject to various risks and uncertainties, which could cause actual results to differ materially from those discussed here today. These risk factors are explained in detail in the company's filings with the SEC. Please refer to the risk factors section in our filings for a more detailed discussion of our forward-looking statements and the risks and uncertainties related to such statements. All forward-looking statements are made as of today, August 2, and, except as required by law, the company undertakes no obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise.

We will also reference certain non-GAAP financial measures throughout today's call. We have included definitions of these terms and reconciliations of these non-GAAP financial measures to their most comparable GAAP financial measures in our press release and the appendix to the presentation in order to better assist you in understanding our financial performance.

I will now turn the call over to Bill Cobb for opening comments. Bill?

[Bill Cobb, Chairman and Chief Executive Officer]

Thank you, Matt Davis, and good morning, everyone.

Let me start by saying we had a great second quarter. I'm especially excited to see that many of the headwinds continue to turn in our favor, and this was especially true for the second quarter as everything seemed to fall our way.

Jessica will cover our financial results in more detail, but let me hit the highlights. In the second quarter, revenue increased 7%; gross profit increased 840 basis points to 52%; adjusted EBITDA jumped 57% to $121 million; we repurchased $50 million of stock through July; and we are raising our full year outlook for revenue, adjusted EBITDA and share repurchases. We have come a long way over the last year and I'm proud of how the team is executing across all functions.

Now turning to Slide 5, while it is encouraging to see our margins start to rebound, we still have work to do on driving revenue across our two growth engines: the Frontdoor and American Home Shield brands. To that point, I want to use this call to provide you with a mid-year update on the strategy we laid out at our Investor Day in March.

First, I want to acknowledge that the home service plan category has recently been in a state of the decline. We now estimate that there are about 5 million to 6 million active home service plans in the United States, but we know there is a lot more opportunity. We continue to target a total addressable market for American Home Shield at 13 million owner-occupied homes.

Based on our third-party research, we believe demand for the category was down somewhere around 10% in 2022, and we believe that the decline has accelerated through the first half of 2023. While it is disappointing for all of us that sell home service plans, we believe our overall category share has actually improved.

The real challenge has been attracting new customers to our home warranty product and value proposition that has not substantially evolved over the years. As a category leader, we are committed to updating our marketing and core consumer value proposition to attract new customers. Once they become a customer, they're highly likely to stay, as shown in our strong second quarter retention rate.

Now turning to the Slide 6 and the renewals channel, where our retention rates continue to perform well. Our overall retention rate increased 190 basis points year-over-year to 76.3%. This is especially strong when you consider our 11% realized price increase in 2023. While a large portion of this improvement is driven by a lower mix of real estate customers, we have also been doing some smart things on the execution front, better personalization of customer communications, enhancing our dynamic pricing model and continuing to improve service quality.

One way we have improved our customer service is from our process improvements to optimize contractor capacity and maximize use of preferred contractors. This not only provides us with a lower cost of service, but it also results in a higher quality customer experience. During the second quarter, our deployment of preferred contractors increased to approximately 84% versus 82% a year ago. As a result of all these efforts, we are seeing clear progress. Customer five-star ratings of contractors are now at a decade high, with one-star ratings at an all-time low.

Now, turning to Slide 7 and our real estate channel. The National Association of Realtors, or NAR, recently came out with housing market statistics for June. Existing home sales declined 23% during the first half of the year. This closely correlates with the decline we are seeing in our real estate channel, which is highly dependent on the overall real estate environment. Further, it was reported that only 14 homes out of 1,000 changed hands in the first half of the year, the lowest rate in a decade.

Inventory remains tight at 3.1 months of supply, which contributed to driving median home prices up to $410,000. Prices are rising because there is more demand than supply, and we are seeing bidding wars come back in certain markets. In fact, some homeowners are reluctant to move because they have a substantially lower mortgage rate than the current market of nearly 7%.

In short, the resurgence of a strong seller's market continues to delay the transition to a more balanced buyer-seller environment. While we believe that the housing market will eventually become more conducive for us to sell a home warranty, it is taking longer than we expected.

Now moving to Slide 8. Last quarter, I discussed some of the challenges facing our DTC channel. This includes the impact of changing consumer behavior due to evolving macroeconomic conditions, higher price sensitivity for home service plans and reduced marketing spend. Let me be clear. Growing our DTC demand is our top focus as we head into the back half of this year. To that end, we have several work streams to re-energize this channel.

First, we are optimizing our discounting strategy. We have been testing into various discounts and I am pleased to report that we are seeing some positive results as our sales are coming in higher than our original plan. Second, we are increasing our marketing investment. Given that the Frontdoor brand has generated such substantial consumer awareness, we are now able to reallocate $20 million to the American Home Shield brand. When including the $10 million increase we made in the first quarter, total DTC marketing spend is up $30 million compared to our original plan. This means that we are now virtually flat on our DTC marketing investment on a year-over-year basis.

Now, longer-term, we know we need to update and enhance the AHS brand to reevaluate our core value proposition so that we can engage more consumers in new and compelling ways. This is exactly what Kathy Collins and her team are working on as we speak, to bring some of that Frontdoor brand marketing magic to American Home Shield. More to come here, which includes conducting extensive consumer and competitive research, evaluating product improvements, and finding ways to better connect our offerings with consumers.

Now let's turn to Slide 9 of the web deck, where I'll dive into more details on the Frontdoor brand strategy. Just a quick reminder that we previewed the Frontdoor brand at our Investor Day on March 2. We launched the brand on April 11. And then, on June 6, we launched Frontdoor Premium.

I want to start by highlighting our on-demand services, which totaled $20 million in the second quarter. This is higher than we first anticipated when we decided to pursue HVAC upgrades at the start of the year. As a reminder, an HVAC upgrade is when we partner with our preferred contractors and leverage our scale to sell new HVAC units to our existing members at a steep discount. We are now targeting approximately $45 million of revenue from our Frontdoor Pro on-demand home services in 2023.

Now I'd like to turn to the Frontdoor marketing campaign, which has been a tremendous success in driving consumer brand awareness. As of today, the app has been downloaded nearly 950,000 times, significantly exceeding our original expectations. Additionally, we have received consistently positive customer feedback, including rave reviews on the video chat with an expert feature and the easy-to-use app. In all my years around marketing, I have never seen awareness of a new brand take off like this and just four months after launching. Said another way, we drove a sizable level of awareness at a much lower price and in a much shorter timeframe than originally planned. As a result, we are now able to reallocate that $20 million of marketing spend to help drive DTC sales within our American Home Shield brand.

As I mentioned at our Investor Day, we want the flexibility to invest across both the Frontdoor and American Home Shield brands. This allows us to optimize where our marketing dollars are being invested, which is exactly what we are doing now. But let me be very candid with you. Despite extremely strong brand awareness, conversion of paid membership services has not been what we anticipated. We are working to address this by developing a robust strategy to monetize that high consumer awareness into paid services, and we look forward to sharing more about where we are going next quarter.

We remain very bullish about the new Frontdoor brand. Our research shows there is significant untapped consumer demand. The number of downloads is a strong validation of the opportunity, and now we just need to do a better job of unlocking the revenue potential.

Before I hand it over to Jessica, let me briefly summarize where we are. We had an exceptionally strong second quarter performance, and we are raising our full year outlook across the board.

On the operational front, we are improving execution. The previous cost headwinds we saw last year have largely turned, and we have had some extremely favorable trends, driving gross margins higher. But to be clear, we still have much work to do. While consumer awareness at Frontdoor has been tremendous, we need to be better at converting app downloads into actual revenue.

On the DTC front, we understand the challenges there as well, and are deep into making significant improvements to get this channel back on track. This is our top focus in the back half of the year.

I will now turn the call over to Jessica to review our financial results. Jessica?

[Jessica Ross, Chief Financial Officer]

Thanks, Bill, and good morning, everyone.

Before I get into the details, I want to highlight a few key points. As you heard from Bill, we had an extremely strong second quarter. The midpoint of our adjusted EBITDA outlook was $85 million, and actual results came in at $121 million. This difference was primarily driven by exceptionally favorable weather as well as higher-than-expected revenue and timing of SG&A. Additionally, we had several other items fall away that resulted in stronger financial performance than anticipated. It is also important to highlight that our full year outlook takes into account the recent hot weather trends and assumes higher customer incidence rates in the back half of the year.

I will now dive into our second quarter financial results on Slide 10 of the web deck. Let's start at the top of our income statement. Our second quarter revenue increased 7% versus the prior-year period to $523 million. This was driven by a 9% increase in price, which more than offset a 2% decline in volume.

On Slide 11, second quarter revenue from our renewal channel increased 15% as a result of our prior pricing actions flowing through. Real estate revenue decreased 25%, and DTC revenue decreased 11% as a result of lower volume. Other revenue increased 32%, driven by growth in our on-demand home services, primarily our HVAC upgrade program that Bill just mentioned.

Now let's turn to Slide 12. Gross profit for the quarter increased 28% to $270 million. Our gross profit margin increased 840 basis points to 52%. This improvement was driven by higher realized price, a lower number of service requests per customer, process improvement initiatives, and a moderation of inflation down to 9% from 25% in the second quarter of 2022.

I want to specifically highlight the impact of weather, which provided a $17 million benefit in the second quarter. This was driven by a 23% decline in cooling degree days versus the prior-year period to the lowest level in 10 years. We also saw a similar decline in our HVAC claims due to cooler-than-normal weather. As a result of this favorable weather as well as process improvement initiatives, the second quarter had the lowest number of service requests per customer in nearly 20 years.

On Slide 13, you'll see that our higher gross margin flowed through net income, which more than doubled to $70 million, and adjusted EBITDA improved $44 million to $121 million.

Let's now move to the table on Slide 14, and I'll provide more context for the year-over-year improvement in second quarter adjusted EBITDA. Starting at the top, we had $42 million of favorable revenue conversion, primarily driven by our pricing initiatives, partly offset by the decline from lower volume. Contract claims costs decreased $18 million compared to the second quarter of 2022. This was comprised of the $17 million benefit from favorable weather, a favorable cost development difference of $11 million and the impact of process improvement initiatives. This favorability was partially offset by ongoing inflationary pressures of approximately 9%, which includes higher parts and equipment costs and increase in contract-related expenses, as well as the impact of mix shift and regulatory changes. Sales and marketing costs increased $16 million in the second quarter, primarily related to the launch of the new Frontdoor brand. General and administrative costs increased $6 million, driven by investments in technology and increased labor costs and professional fees. Interest and net investment income increased $4 million as a result of rising interest rates on cash deposits. And finally, customer service costs decreased $3 million in the second quarter as a result of the lower number of service requests.

Please now turn to Slide 15 for a review of our statement of cash flow. Net cash provided from operating activities was $112 million for the six months ended June 30 as a result of the factors I just mentioned. Net cash used for investing activities was $15 million for the first six months of the year and was primarily comprised of capital expenditures related to investments in technology. Net cash used for financing activities was $44 million through June and was comprised of share repurchases as well as scheduled debt payments. I would also like to mention that we repurchased approximately $16 million of stock in July, bringing the total amount of share repurchases in 2023 to $50 million.

On Slide 16, you will see that our free cash flow was $96 million for the six months ended June 30. We ended the second quarter with $344 million in cash. This was comprised of $158 million of restricted net assets and unrestricted cash of $186 million. As a result of our strong first half performance, we are pleased to increase our full year share repurchase target to approximately $100 million.

Now turning to Slide 17, and our third quarter and full year 2023 outlook. We expect our third quarter revenue to be between $500 million and $515 million. This reflects approximately 15% growth in the renewals channel, partially offset by a mid-20% decline in the real estate channel, and a roughly 15% decline in the DTC channel.

Third quarter adjusted EBITDA is expected to range between $80 million and $90 million, an increase of 7% from the prior-year period as a result of improving gross margins. This incorporates the impact of the recent hot weather in July and expectation that it will continue into August and then largely return to normal for the balance of the year. Our outlook also assumes customer service request patterns increase in the second half of the year.

Now turning to our full year outlook, we are increasing our 2023 revenue range to $1.73 billion to $1.75 billion or a 5% increase over 2022. This anticipates a low double-digit increase in the renewals channel, a mid-20% decline in the real estate channel and a low double-digit revenue decline in the DTC channel. It also assumes other revenue will increase to approximately $60 million as a result of growing on-demand services. We continue to expect approximately 11% growth from higher price, which will more than offset a 6% decline from lower volume. We also expect a number of home service plans to decline in the mid-to-upper single digits in 2023. As a result, we continue to target ending the year with approximately 2 million home service plans, including about 500,000 new first year customers across the DTC and real estate channels.

We increased our full year gross profit margin outlook to be between 45.5% and 47.5%. Let me be clear, gross margin was 49% in the first half of the year due to the exceptional favorability I mentioned earlier. The second half gross margin outlook is below the full year range, but remains consistent with the expectations we laid out at Investor Day. This also takes into account the recent hot weather trends and higher customer incidence rates in the back half of the year. This also assumes that inflation will average approximately 9% on a cost per service request basis, and the number of customer service requests will decline 9% to approximately 4.1 million.

We have seen cost improvements accelerate at the macro level for replacement units over the last several months. For example, the producer price index for HVAC declined to 7% in the second quarter from 25% in the prior-year period. We are seeing similar declines in buying like-for-like products. However, our 2023 inflation rate is expected to be 9% when adding in contractor-related inflation, regulatory changes, and mix shift.

Our full year SG&A target is between $575 million and $590 million. While the midpoint has not changed since last quarter, we are reallocating approximately $20 million from Frontdoor to the American Home Shield brand to drive DTC sales. As a result, our target working marketing spend for the Frontdoor brand is now approximately $40 million. We spent approximately $25 million in the second quarter to launch the brand and expect the remainder to be spent in the third and fourth quarters.

Based on these updated inputs, we are raising our full year adjusted EBITDA range by $40 million to be between $260 million and $280 million. This includes stock compensation expense of approximately $30 million and $15 million of interest income.

And finally, we continue to project our full year capital expenditures to range between $35 million and $45 million, and the annual effective tax rate to be approximately 26%.

In conclusion, we delivered an extremely strong second quarter. We remain confident in our long-term business outlook, and we continue to build a strong foundation by progressing initiatives that invest in our brands, technology infrastructure, and productivity enhancements across the business.

With that, I'll now turn the call back over to Bill for a few final comments before we go to Q&A.

[Bill Cobb, Chairman and Chief Executive Officer]

Thanks, Jessica.

One final thing. I would like to extend a warm welcome to Dr. Bala Ganesh, who just joined our Board, and to Prakash Muppirala, who recently joined as Senior Vice President and Chief Technology Officer. Both of them will raise the bar on Frontdoor's ability to leverage technology and data and improve the customer and contractor experience.

So, operator, let's now open the line for questions.

[Operator]

Thank you. [Operator Instructions] Our first question comes from Brian Fitzgerald from Wells Fargo. Brian, please go ahead.

[Brian Fitzgerald, Wells Fargo]

Hey, can you hear me?

[Bill Cobb, Chairman and Chief Executive Officer]

Hey, Brian.

[Jessica Ross, Chief Financial Officer]

Hi, Brian.

[Operator]

Yes. Please go ahead.

[Brian Fitzgerald, Wells Fargo]

Hey, hi. Congrats on the quarter. I just wanted to dig in on the Frontdoor app. You mentioned strong downloads with trouble converting users to paid plans. I'm just curious if you can share any color on how users are engaging in the app. Any sense for user retention of those free users? And then, lastly, I wanted to double-click on that point around improving conversion to paid plans. What near-term levers do you have available to get users onto those plans?

[Bill Cobb, Chairman and Chief Executive Officer]

Okay. So, let me try to absorb all of that. So, in terms of the app, what we're doing is, obviously, where we introduced the brand, the campaign has been very well received, the amount of downloads, et cetera. What has happened is that we are working hard. We have not been able to convert those app downloads into the revenue that we thought, which has caused us to take a look at a number of initiatives, including we just, this week, did a change to the registration flow that is showing early promise in terms of being able to quickly register and become part of the Frontdoor brand, because it goes from registration and then obviously into the membership plans. Right now, we are working to figure out what's the best way between on-demand services and membership plans to monetize that.

But like I say, the reason I'm so encouraged by this is not only the downloads, not only the [indiscernible] activities of the campaign, but I want to give you a couple of -- a few stats -- kind of the KPIs we're looking at. We do a tracking study that has been pretty consistent since we launched this. And I want to give you the latest numbers.

So, in this research, we only take account or take credit for anyone who responds extremely or wary, and I'll talk about what the components are. So, in terms of likability, and this is where someone says they really like the brand, they're extremely or wary, brand average according to the research house that we're using, across leading brands, it's about 70%, we're at 81%. When it comes to relevance, a brand that's relevant to you, the average for our brand is about 44%, we're at 65%. In terms of differentiating, this is something unique, something disruptive, et cetera, average again, 45%, we're at 60%, plus there's over 80% interest in the concept, et cetera. So, all the consumer variables and in my experience, this is going to translate into a real brand.

The other thing is the user experience. And I don't know how many of you have used the video chat with an expert or whatever. We're getting extremely high marks at the ability of the experts to diagnose problems to, in many cases, aid the homeowner in terms of fixing it.

So, we're a little disappointed in terms of the revenue piece, but it's very early days. We're only four months into this, we only launched the premium product less than two months ago. So, we're working right now to figure out what that magic is, if you will. We had a meeting with our Board last week. They are extremely supportive of this. And a lot of them have said, they've seen this in their careers, where you start out and there's such interest in the brand, it's just figuring out what the revenue model is. So, we remain very bullish on this and more to come on this, as I mentioned, but I think there's a real value there.

[Brian Fitzgerald, Wells Fargo]

Awesome. Super helpful. Thanks.

[Bill Cobb, Chairman and Chief Executive Officer]

Okay.

[Operator]

Thank you. Our next question comes from Cory Carpenter from JPMorgan. Cory, please go ahead.

[Danny Pfeiffer, JPMorgan]

Hey, this is Danny Pfeiffer on for Cory Carpenter. I just have two quick ones. In the DTC channel, is there anything in particular that you're seeing that kind of gives you the confidence to lean in heavier with the shift in the $20 million in marketing spend?

And then secondly, on the 84% preferred contract usage in 2Q, are you able to expand on how much kind of more room you have there to move that higher? Thanks.

[Bill Cobb, Chairman and Chief Executive Officer]

So, first of all, with the DTC, I think we've underinvested in the AHS brand to date. And we still think, and we are a big believer in the core value proposition of a warranty plan is still very appealing to consumers. If you look at what I was talking about with the real estate numbers, with people not moving, repairs and maintenance are not going to go away. So, we still think that we have some tailwinds behind us. It's just a matter of us looking into how do we best appeal to people to get them over the line. This is a discretionary purchase with the price increases we've had to take. I think the entire industry has had to take. There's a little bit of sticker shock. So, I think as this normalizes, we feel very confident in terms of how this can resonate and start to turn our unit count in the right direction.

As far as contractor, is the 84% the limit? Of course, not. We don't think it is -- I don't think it will ever be 100%. With the work that we've done over the past six to nine months with the contractor relations team, which has been terrific, we haven't set a specific goal. We wanted to see how things played out. That's something we'll work on in terms of what the stretch target will be. But I'm certainly -- I'm pleased with the 84%, but I don't think anyone with our contractor relations team is satisfied with that, and they want to continue to drive that higher.

[Jessica Ross, Chief Financial Officer]

Yes, I'd just add on to that. From a continuous improvement perspective, we move from the upper 70% range at the time of the spin to where we are now. And I think, as Bill shared, we've really been targeting that mid-to-80% range and we're there, but we can always improve.

And I just want to kind of double down too that we are very excited about our preferred contractor strategy. Just as a reminder, these contractors are very special designation that we give across our system of contractors to both the best in terms of quality and cost efficiency, and they play a major role in both improving the member experience as well as improving our cost structure. So very excited about the results.

[Danny Pfeiffer, JPMorgan]

Thanks.

[Bill Cobb, Chairman and Chief Executive Officer]

Thanks, Danny.

[Jessica Ross, Chief Financial Officer]

Thanks, Danny.

[Operator]

Thanks you. Our next question comes from Justin Patterson from KeyBanc. Justin, please go ahead.

[Unidentified Analyst]

Great, thank you. This is Sergio on for Justin. Bill, I appreciate the color on increasing the investment in the DTC marketing, and I think you said it's flat now or expected to be flat versus a year ago. I was wondering how this strategy of the DTC brand, in particular, has evolved to increase the ROI on that investment versus a year ago?

And then, Jessica, maybe one for you. Just how you're thinking about the weather impact as we head into 3Q and the guide? We've all seen the headlines of extreme heat starting in July. So just curious on how you're thinking about the weather impact there and potential increase in service requests due to warm weather. Thank you.

[Bill Cobb, Chairman and Chief Executive Officer]

Yes, thanks, Sergio. In terms of the ROI, it's an interesting question, because you could argue that the ROI for the first half of the year was actually better because we had reduced spending. But it didn't translate into units. The thing with DTC units is it's not about the first year, it's not about that ROI return. It's about the LTV, the long-term value, up against the cost of acquisition. And generally, we have seen over time that given our strength in the renewals area that we're able to renew people into the mid-to-high 70%-s. Normally that's about 3x return. We don't see anything that has changed that.

We just have to get more units, and we have to appeal to people in an avenue where, as I said earlier, the industry has been on a decline lately. I don't think it's going to be consistent or persistent. I think as we normalize pricing, as people come out of really inflation moderating, there's a need for this product. The value proposition has not declined. So, that's why we're going to continue. We're going to invest more in the back half of the year and look to this as our number one priority as we go forward.

Now with regard to the weather impact, I'll turn it over to Jessica.

[Jessica Ross, Chief Financial Officer]

Yes, thanks, Bill, and thanks, Sergio. It's good to hear from you. It's been interesting from an outlook perspective. As we're thinking about our full year outlook, it's kind of the tale of two halves, right? So the first half of the year was extremely favorable, as we shared, everything fell our way, and we landed at gross margins at about 49% for the first half. But to your point, as we sit here in August, we're all listening to the news, there's extremely hot weather across the United States, we don't expect that favorability to continue into the back half.

So yes, that has kind of been absolutely baked into our outlook. It reflects hotter weather in July and continuing to August. And then as I shared earlier, I think we're going to get back to normal service request patterns in the back half of the year. I think originally, we were guiding to about 4.2% for the full year with the favorability in the front half. We're looking at about 4.1% for the full year in our outlook.

[Unidentified Analyst]

Great. Thank you, both.

[Jessica Ross, Chief Financial Officer]

Thanks, Sergio.

[Operator]

Thank you. Our next question comes from Mark Hughes from Truist. Mark, please go ahead.

[Mark Hughes, Truist]

Yes, thank you. Good morning. Jessica, am I right in thinking that if somebody has an air conditioning issue, they call you up immediately. There wouldn't be any kind of lag in your ability to see what the claims trends are. Is that fair?

[Jessica Ross, Chief Financial Officer]

Could you...

[Bill Cobb, Chairman and Chief Executive Officer]

I'm not sure I fully understand your question, Mark. So, we...

[Mark Hughes, Truist]

The question was...

[Bill Cobb, Chairman and Chief Executive Officer]

Go ahead.

[Mark Hughes, Truist]

Yes. The question was just around the timing of when you get the claims notifications that with the extreme hot weather, if someone's air conditioner goes, I assume you'll get notified pretty quickly that there's a potential...

[Jessica Ross, Chief Financial Officer]

Are you kind of just talking just in terms of the claims development process? So, you're absolutely right. We know absolutely real time, the number of members with service requests each day by trade. But we don't necessarily know the cost estimate until the claim is -- the whole transaction is finalized and the claim is closed, which can take two to three months. Is that kind of where you're going? And then how we can address that?

[Mark Hughes, Truist]

Yes, just the timing.

[Jessica Ross, Chief Financial Officer]

Yes.

[Bill Cobb, Chairman and Chief Executive Officer]

Mark, what I would say also -- and if this isn't answering the question, we can probe further on this. But one of the things that happens during a time like this is an increase in service requests obviously. So yes, we'd love to have our preferred contractors handle every call. But that's when we have to use other contractors, and that's where our costs are higher. We generally know what the preferred contractors are going to do. And that's what happens is we have to estimate the cost at the end of each quarter. So it's a little bit of a tricky formula as you try to blend the preferreds with the -- because we have to try to respond, especially when it comes to something like HVAC, we have to try to respond to our customers as quickly as we can. So that's another part of the equation that can get a little difficult as we try to forecast the cost.

[Mark Hughes, Truist]

Yes. It sounds like, though, that you've got pretty good line of sight at least in terms of frequency of claims, given the hot weather and that has informed your guidance.

[Bill Cobb, Chairman and Chief Executive Officer]

Yes. And Jessica, why don't you talk about how we true things up?

[Jessica Ross, Chief Financial Officer]

Yes, no, that's just from a -- we have a very detailed process within my team. So, every quarter, we are looking at both -- all of the data that we have in terms of actual service requests. We are looking at historical data on cost, current data on weather and performing an estimate each quarter. And I think as you've probably seen, then we typically have either a favorable or unfavorable adjustment at the quarter. So for example, we had about $4 million favorability from that true-up process that's really related to claims and transactions from Q4. So it's definitely something. Like I said, I've got a very experienced team that is running the numbers on this regularly. And we've got a very detailed process to make sure that we're getting those estimates right at period end.

[Mark Hughes, Truist]

Right. And then the I think your revenue recognition pattern, you tend to recognize more revenue in the summer months, Q2, Q3, to correspond with claims costs, so there's more matching there. Were there any updates to that pattern this quarter that were noteworthy?

[Jessica Ross, Chief Financial Officer]

No, there's been no changes. And just to kind of remind our contracts with our customers are generally 12 months in duration. So regardless of whether the cash is received upfront, which, for example, in the real estate channel, the majority of that is, or monthly over the contract period for DTC and renewals, we on a contract-by-contract basis, recognize one-twelfth of the annual contract price each month. So then, subsequently to your point, Mark, we shift the recognition of total revenue to match the expected seasonality of claims costs, which are higher in Q2 and Q3, which typically results in lower revenue in Q1 and Q4. So, as you're thinking about also kind of the guidance that we've given, definitely take that into account in running the Q4 numbers.

[Mark Hughes, Truist]

But no change in that seasonal pattern to speak of in Q2?

[Jessica Ross, Chief Financial Officer]

No.

[Mark Hughes, Truist]

Okay. Great. Thank you very much.

[Bill Cobb, Chairman and Chief Executive Officer]

Thanks, Mark.

[Jessica Ross, Chief Financial Officer]

Thanks, Mark.

[Operator]

Thank you. Our next question comes from Ian Zaffino from Oppenheimer. Ian, please go ahead.

[Ian Zaffino, Oppenheimer]

Hi, great. Thank you very much. As far as the declines in service plans that you were mentioning, is that primarily in you think the real estate channel, the DTC channel, is it in the renewal channel? Basically, what is driving it or what area might be driving it do you think?

And then also, Jessica, on the inflation, it seems like we're kind of stuck at this 9%, but it does seem like inflation is coming down. So, why still 9% or at least why not release in the back half of the year?

[Bill Cobb, Chairman and Chief Executive Officer]

So let me just make sure I understood, your first one, are you asking about the decline in service requests and where is it coming from by channel? Is that your question? Or did I misinterpret it?

[Ian Zaffino, Oppenheimer]

No, I think your initial opening -- yes, your initial opening comments were something to the tune of you're seeing an industry somewhat in decline.

[Bill Cobb, Chairman and Chief Executive Officer]

Okay.

[Ian Zaffino, Oppenheimer]

And you think it's temporary. But I'm asking you, where is that decline most pronounced? Is it in real estate or just renewing it because of whatever?

[Bill Cobb, Chairman and Chief Executive Officer]

It's more in real estate, but also in direct-to-consumer. So it is in those two areas that we are seeing the softness. As you see from our renewals book, that's our renewals book that's been pretty consistent and improving.

[Jessica Ross, Chief Financial Officer]

Is that helpful?

[Bill Cobb, Chairman and Chief Executive Officer]

Yes. And then you want to take the second one?

[Jessica Ross, Chief Financial Officer]

Yes, just on the inflation, hey, so just as a reminder, our Frontdoor internal inflation is comprised of three main buckets, right: the contract-related costs; parts and equipment; and then the impact of regulatory changes and mix and from regulatory changes of things related to energy and efficiency on HVAC and plumbing. And so, while we're seeing what the rest of the world is seeing in terms of lower inflation, when buying like-for-like products, like we talked about HVAC is at 7%, I think PPI for appliance is at 3%. When you add up those three components collectively, we're still sitting at that 9% rate, so which is what we're targeting for our full year outlook. And again, just getting to our internal process improvements, we're working hard on both the sourcing side, the contractor relations side to bring that down. But right now, we're holding with the initial inflation estimate that we gave at Investor Day.

[Ian Zaffino, Oppenheimer]

Okay. Thank you. And if I could just sneak in one quick -- one more. On the Frontdoor initiative, you've seen revenues now come in. Any sense of where margins might settle out or kind of what you're targeting as far as profitability of that business versus maybe the core AHS business? Thanks.

[Bill Cobb, Chairman and Chief Executive Officer]

Yes, I think it's the right question. It's a little early to tell as we figure out the mix of this conversion to paid plans and the on-demand piece. So, we don't answer on that. I don't think we have it at this point. We're still trying to sort through. It should be a positive impact. Obviously on-demand is a little bit different economics set and in many cases, is a really beneficial, especially like on HVAC upgrades in terms of the dollar amount as opposed to the margin itself. But we're still working through that, but we're conscious of the interest in that.

[Ian Zaffino, Oppenheimer]

Okay. Thank you very much.

[Operator]

Thank you. Our next question comes from Eric Sheridan from Goldman Sachs. Eric, please go ahead.

[Eric Sheridan, Goldman Sachs]

Thanks so much for taking the question. And I think the app download success you guys have had seems to be a direct beneficiary to the marketing shift you highlighted at the Analyst Day a couple of quarters ago. Can we talk a little bit about how the marketing approach of the company might evolve between elements of aiming towards brand building and driving app downloads into evolution into conversion and monetization? And what that might mean in terms of both overall marketing spend and some of the targeting of where you spend those dollars as we look not only this year, but over the medium to long term? Thanks so much.

[Bill Cobb, Chairman and Chief Executive Officer]

Yes. I think we're very pleased, that's why we're reallocating money to American Home Shield with the awareness building campaign. We are going to shift our emphasis over time to the conversion aspect. So, I don't really have a specific in terms of what those amounts are. But beyond what as Jessica said, we'll spend roughly $15 million on Frontdoor. In the back half, some of that will be in a test mode as we work through some of these revenue model pieces. But an overall $40 million, we're not going to comment on '24 just yet because we haven't figured out our plan for that. So, we'll see what the notion is, but the idea is that we're really pleased with the awareness building campaign. We're pleased with the receptivity to the concept. Now, we've got to figure out how we're going to convert that into paid membership sales. Okay?

[Operator]

Thank you. That is now the end of the Q&A session. And ladies and gentlemen, thank you again for joining Frontdoor's second quarter 2023 earnings call. Today's call has now concluded.

[Bill Cobb, Chairman and Chief Executive Officer]

Thank you.

[Jessica Ross, Chief Financial Officer]

Thank you.