Frontdoor Inc (FTDR) 2019 Q1 法說會逐字稿

Ladies and gentlemen, welcome to Frontdoor's First 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 Treasury, 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 morning, everyone, and thank you for joining Frontdoor's First 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, at about 6:00 a.m. Central Time today, Frontdoor issued a press release reporting our first 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, May 8, 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'll reference certain non-GAAP financial measures throughout today's call, and we have included definitions of these terms in our press release and the appendix of the 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 of such 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 spinoff, 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.

Frontdoor's CEO, Rex Tibbens, will lead off by providing a review of our first quarter 2019 summary. He will then provide a business update and discuss our strategic priorities for 2019. Brian Turcotte, Frontdoor's CFO, will follow and will summarize our first quarter 2019 financial results, provide more details in regards to our financial statements and then speak to the full year 2019 outlook. We will then open up the line for questions.

I'll now turn the call over to Frontdoor's CEO, Rex Tibbens, for opening comments. Rex?

Thanks, Matt, and good morning, everyone. Let's start with our first quarter 2019 summary shown on Slide 4. I'm pleased to report that 2019 is off to a favorable start with first quarter revenue up 10% versus the prior year period to $271 million, while the gross profit margin increased 150 basis points to 47%.

We also recorded better-than-expected adjusted EBITDA of $43 million, up 34% over the same period last year. Brian will expand on our results shortly, but the better-than-expected performance is largely due to lower-than-expected claims volume driven primarily by mild temperatures in our key markets as well as earlier-than-anticipated progress from our business process initiatives.

Further down Slide 4, we continue to grow the number of home service plans by 5% over the first quarter of 2018 to 2.1 million plans. Our customer retention rate remained stable at 75% on a trailing 12-month basis despite implementing higher-than-normal price increases late last year.

As mentioned, we continued to make improvements in our core business that are driving sustained business results. I'm pleased with the velocity of progress that our entire teams are making as we are seeing the positive momentum from these operational improvements materializing at the bottom line.

On the people front, we filled the remaining open member of our management team in March as we welcomed Jen Alessandra as our Chief People Officer. Jen brings significant depth and breadth of experience as a people leader from both public and private companies. Jen most recently served as Senior Vice President and Chief People Officer for SolarWinds, a global IT management software company. Before this, Jen held multiple HR leadership roles at Raytheon and KB Home.

With the last piece of the executive leadership team in place, we're now all laser-focused on advancing our strategic objectives. As always, our north star will be helping our customers take the hassle out of owning a home.

Finally, we completed the secondary equity offering in March, which resulted in the disposition of ServiceMaster's remaining ownership in Frontdoor.

Moving to Slide 5. Let's review our 3 revenue channels: direct-to-consumer, or DTC; real estate; and renewals. First year DTC sales continued to grow through our marketing efforts, specifically in digital and social media. I should note that the timing of our marketing spend is expected to ramp up a bit more going into the back half of 2019 versus prior year. Additionally, we are benefiting from optimizing our customer acquisition costs by moving some third-party services in-house and revamping the incentive performance metrics for sales associates in our call centers to drive additional unit sales growth.

In real estate, we are seeing more macro headwinds from a decline in existing home sales. The National Association of Realtors released existing housing figures that were down 7% in the first quarter versus the prior year. We are addressing the slowdown through deeper unit growth penetration of our existing broker relationships as well as adding new brokerage partnerships. Expanding our relationships helps us get into new real estate offices and in front of new brokers to further explain the value proposition of a home service plan and more specifically Frontdoor.

We're encouraged by some leading indicators in real estate, such as lower interest rates and rising wages that will, hopefully, result in improving existing home sales in the back half of this year. As always, we will continue to monitor macro market conditions and shift some spend to DTC customer acquisition if the real estate market softness continues.

Renewals, our largest channel, rose 13% in the first quarter versus the first quarter of last year, as we targeted retaining more of our existing customers. One way we do this is by adding new products. For example, we are expanding our HVAC tune-up pilot to meet the growing demand for the service, allowing us to have another touch point with our customers. The milder weather this past quarter allowed us to better leverage this program to provide value to our customers while creating a new avenue for keeping our contractors busy in a slower environment. We are currently using our tiger team approach to look for additional opportunities to drive customer retention.

Now please turn to Slide 6, where I'll give an update on each of our 2019 strategic objectives that I laid out on our fourth quarter earnings call in February. First, improving the customer experience. As I mentioned earlier, we are constantly focused on enhancing the customer experience. We're doing this through a multipronged effort to improve communication, technology and service delivery. We're also making it more convenient for our customers and contractors to interact with Frontdoor when a service order is placed.

We are continuing to roll out our new workflow-based software called Customer Service Central, or CSC, in our customer care centers. CSC provides a more seamless service experience that allows our customer service agents to more quickly address customer needs, leading to a faster time to resolution while also providing a lower cost of service delivery.

Heading into our peak claims and call volume season during the summer months, we're adding hundreds of new customer service agents. CSC allows them to get onboarded more quickly through a more module-based approach to training. As mentioned, our tiger teams are also working on a number of projects to improve our customer experience in order to increase retention rates, improving the way we obtain customer contact details. We can then use the data to increase customer outreach and reduce claim resolution cycle times. Our cycle time or the time it takes for a customer's service work order to be fully completed is being completely reevaluated, as it touches several different elements of our business that are due to be updated. As we work to redesign our processes, we plan to automate certain aspects of the customer service experience and contractor dispatch, allowing our systems to reduce wait time for our customers and have the most delightful customer experience possible.

Further, the customer retention tiger teams, who were formed, will make progress on enhancing the customer onboarding experience, reducing payment friction by expanding conversion of evergreen contracts and auto payment and adding more services to the home service plan. This is a multi-quarter endeavor, and we're all excited about improving the overall customer experience.

Our second strategic objective is related to pricing. As mentioned on our last earnings call, we raised prices for all products across all channels, including first year DTC and renewals in November of last year and first year real estate in February of this year. The overall average price increase was in the mid-single digit range. We have seen some favorable impact from the price increases, with attrition rates consistent where we modeled them.

As previously mentioned, we expect to realize about half the price increase benefits in 2019 with full benefit coming in 2020, as it takes a full 12 months to roll through our entire book of business.

Now turning to dynamic pricing. We're on track to have dynamic pricing fully rolled out over the course of 2019. This objective is expected to increase our overall gross margin by 100 basis points in 2020. As a reminder, dynamic pricing will allow us to model our cost and price sensitivity down to the ZIP Code plus 4-digit level in contrast to historic industry practice of pricing at the state-only level.

Our third objective is to improve our business processes and contain cost. An early win from our tiger teams is improving our contractor selection algorithm to ensure better utilization of our preferred contractor network. This allows us to capitalize on labor rates that are nearly half of contractors outside of our network.

We are starting to see the benefit from this effort as we increased our service work orders to preferred contractors. As we continue to make strides in optimizing contractor costs, we're also working to reduce expense by centralizing more of our procurement and sourcing. Given our growth, we expect to get better procurement leverage than we have in the past. To that end, I've moved the procurement function under Brian and into the finance organization. I believe that Brian will bring a fresh perspective and help leverage our total spend to drive cost savings.

Now moving to our fourth objective, which is people. As I mentioned earlier, we filled our executive leadership team with Jen, our Chief People Officer. Jen is very passionate about developing people and building a culture where our employees are empowered to do great things for customers every day.

We recently introduced our house rules in the first quarter, which are a set of principles to guide us as we work together every day. The 4 house rules are: obsess over customers' problems; be an owner, not a renter; be transparent, build trust; and do great things every day.

Great culture has enabled employees and companies to be more successful than ever, especially in a fast-paced environment like ours. It is thrilling for me to see these house rules be a rallying point for our associates. We will continue to examine our house rules on an annual basis to ensure our principle is aligned to our vision and our mission as a company.

Lastly, relating to Frontdoor's culture, our largest brand, American Home Shield, has been named to Forbes 2019 list of America's best mid-sized employers. The recognition was based on independent anonymous survey of 50,000 U.S. employees, who worked full or part-time for companies that employed at least 1,000 people. This recognition is especially meaningful to me because the award is based on feedback from our associates. This is a tremendous honor, and we are looking forward to building on this company culture momentum in the year ahead.

Technology advancement is our fifth strategic objective for 2019. As we've outlined in the past, technology is an area that historically lacked adequate investment, and we're now focused on advancing our systems and platforms under Piras' leadership as our Chief Technology Officer.

Some of our key technology systems were developed in the early 1990s, and over the course of 2019, we will continue to move to a cloud-based infrastructure, which will further enhance our ability to grow and scale efficiently.

I'm pleased with the velocity in which the team is making improvements and moving forward, but we are still in early innings. We continue to make significant progress in this area and plan to open another technology campus later in the year in a location to be announced.

Our sixth strategic objective, on-demand, is still on course to launch a pilot and complete the playbook later in 2019. We will utilize the playbook to expand and scale in key cities in 2020 and then optimize in 2021.

As we mentioned before, 2019 will be a year of discovery as we build out our strategy for the convenient delivery of home services and information through a digitally driven marketplace. One of our core tenets in this space is to design a pilot that allows us to move fast and be nimble in order to react to the customer and contractor responses to this new offering. This approach will allow for quick pivoting, enable the team to more rapidly redesign improvements as needed.

Also, we are looking to leverage the core business as we grow into on-demand. We have a robust set of data, customers and contractors that we can utilize and don't need to start from scratch to get where we want to go.

To wrap up, I feel that we are making excellent progress on improving our core business, and this work is just starting to bear fruit. We are continuing to build a strong foundation that strengthens our core business and allows us to build a future on-demand business. We think this foundational work will enable us to grow into new revenue channels and drive value for our shareholders.

I'll now turn the call over to Brian, who'll cover our first quarter 2019 financial results in more detail and discuss our updated full year 2019 outlook. Brian?

Thanks, Rex. Good morning. Please turn to Slide 7, and I'll briefly review a few key financial results from first quarter 2019 and then dive deeper into the adjusted EBITDA drivers later in my comments on Slide 8.

Revenue increased 10% to $271 million driven primarily by a 5% increase in the number of home service plans and a higher average price per plan. As mentioned on the previous earnings call, we expected our year-over-year revenue growth composition to shift slightly more to price due to the higher than assort price increases we began implementing in the fourth quarter of 2018 and continuing during the first quarter of this year. Of the 10% growth realized, 6 points came from volume and 4 points from price.

Looking at our 3 primary customer channels, revenue derived from customer renewals was up 13% 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 driven by continued mixed shift towards higher-priced home service plan offerings and improved price realization. And first year direct-to-consumer revenue was up 8% due to the growth in new home service plans resulting from ongoing investments in marketing as well as improved price realization.

In terms of gross profit, gross profit dollars increased 13% to $128 million. Gross margin increased 150 basis points from 45% in the first quarter of 2018 to just over 47% this year. The increase was driven by a lower number of claims due to milder temperatures, especially in Texas, and early progress from cost containment and business process improvement initiatives.

Net income was $13 million or 3% lower than last year, as the $15 million favorable impact from higher revenue conversion and $6 million of lower spinoff charges were offset by a $15 million increase in interest expense and a $7 million increase in selling and administrative expense, which includes our planned investments in sales and marketing and technology.

First quarter 2019 adjusted EBITDA of $43 million was $11 million or 34% higher than prior year driven by the aforementioned increase in gross profit, which more than offset the increase in selling and administrative expense in the quarter.

The adjusted EBITDA bridge on Slide 8 shows the drivers of change from first quarter 2018 to first quarter 2019, and I'll walk you through the details. Starting on the left, and as previously mentioned, we had $15 million of favorable revenue conversion versus prior year. As a reminder, we calculate revenue conversion as revenue from new home service plans minus the estimated related claims cost of those plans plus the impact of additional revenue from our price increases.

Continuing to the right, claims costs were $3 million lower primarily due to the aforementioned mild temperatures as well as the cost-reduction initiatives partially offset by an increase in the underlying cost of repairs.

Sales and marketing costs increased $2 million due to planned incremental investments made to drive the 5% increase in the number of home service plans versus prior year while delivering on our cost per sale targets. The spinoff dissynergies of $2 million relate primarily to the costs associated with the separation of Frontdoor technology systems from ServiceMaster. And the $4 million of other costs are mainly related to technology-related investments in the business and higher professional fees, incentive compensation and bad debt expense versus prior year.

Please turn to Slide 9 for a review of our cash flow and cash position. Net cash provided from operating activities was $52 million for the quarter compared to $49 million for the same period in 2018. This increase was driven primarily by the favorable impact of working capital, which was slightly higher than the prior year period. Net cash used for investing activities was $5 million for the first quarters of both 2019 and 2018 primarily due to net activity in our available-for-sale securities, offset by other investing activities.

Net cash used in financing activities was $2 million for the first quarter 2019 compared to $37 million for the same period in 2018. Current year activity was driven by debt payments while the prior year activity was driven by net transfers to our then parent or ServiceMaster that has since ceased.

Free cash flow, which we calculate as net cash provided from operating activities minus property additions, was $47 million for the first quarter 2019 compared to $44 million in the prior year period. This increase was due primarily to higher adjusted EBITDA and positive working capital contributions partially offset by higher cash payments for interest and taxes. I should note that the adjusted EBITDA conversion to free cash flow was very strong, 109% for the first quarter 2019, which is typically the case in the first quarter of every year due to seasonality. We project that full year EBITDA conversion to free cash flow will be approximately 50%, still strong, but lower than previous years due to higher interest expense, cash taxes and capital expenditures.

We ended the first quarter of 2019 with $348 million in cash and marketable securities, a $42 million increase from December 31, 2018. Of that total, $197 million were considered to be restricted net assets to remain in compliance with the regulatory requirements of certain states, which is a $10 million increase from year-end. The increase in restricted cash is somewhat outside of our typical rule of thumb calculation that we've given in the past due primarily to timing of available equity settlements from state-level entities to the corresponding parent entity.

Turning to Slide 10. I'll cover our second quarter and updated full year 2019 outlook. Full year revenue is now expected to be between $1.36 billion and $1.38 billion, and this reflects our continued expectations that the high single-digit organic revenue growth exhibited in the first quarter will continue throughout 2019. We now expect full year gross margin to be approximately 46% driven by our increased projection for revenue, the impact of our process-improvement efforts and some first quarter weather favorability flowing through.

For those of you wondering why gross margin wouldn't be projected higher, please note that there was significant offset relating to ongoing claims cost inflation, including approximately $10 million in projected tariff-related costs. I should note, this excludes the potential impact of additional tariffs proposed by the administration this past weekend.

Full year adjusted EBITDA is now anticipated to range between $250 million and $260 million. I should mention that even with the increase in the adjusted EBITDA outlook, we continue to plan significantly higher SG&A expense in 2019 as we invest in technology, sales and marketing, customer service and on-demand to drive top and bottom line growth and build a stronger foundation for the future.

Moving down the table. Capital expenditures are expected to remain in the $30 million to $40 million range, and the full year annual effective tax rate is now expected to be approximately 25%. While not part of our normal annual outlook updating process, we thought it may be helpful to provide color for the current quarter as well. To that end, please note that second quarter 2019 adjusted EBITDA is anticipated to range between $75 million and $80 million, an increase versus $73 million in the prior year period driven by continued strong revenue growth and process improvements.

With that, I'll now turn the call back over to Matt to open the question-and-answer session. Matt?

Thanks, Brian. (Operator Instructions) But please note that guidance is limited to the outlook we've provided in our press release and webcast presentation. Operator, let's open up the line for questions.

(Operator Instructions) Our first question comes from the line of Jamie Clement with Buckingham Research.

Rex, if I could start with you, there was some speculation kind of towards the end of last year and even in the beginning of this year that when your industry was faced with higher claims cost last year that perhaps some of our competitors were, how should I put this, less willing to maybe honor their side of the bargain than you all were, dragging their heels, that kind of thing. When you look at the direct-to-consumer channel, do you have a way of knowing whether some of your new customers came from other home warranty plans or this was their first foray into the industry? Any sense on market share gains, that kind of thing?

Yes. We don't have the ability to see if they're moving from one company to another. But given we're 4x larger than our closest competitor, I'm not sure why you wouldn't just come to us first.

Yes. Okay. Fair. Fair. Brian, just moving to you, and then I'll get back in the queue. It looked to me, and maybe I'm looking at this the wrong way, that when I look at your EBITDA bridge for the quarter, your revenue conversion to EBITDA, was it a very high, very strong rate this quarter? Am I correct on that? And what really drives that?

Well, remember, there's 2 things. There is organic volume growth in that and also we had price to revenue conversion. And based on the higher price increases that Rex has alluded to, mid-single digit this year, that's driving the conversion as well.

Our next question comes from the line of Youssef Squali with SunTrust.

This is Sagar on for Youssef. I just have a quick question. Wanted to know more about the progress of the on-demand product and just kind of understanding how big the data is. And any insight to a level of demand you guys have seen in the business model and just more on the timing of when we may see it kind of expand and go more to a broader audience?

Yes. So 2019 is really the R&D year, right? So just to be clear, we don't have anything in-market today where we have the team assembled and we have a variety of things we want to kind of test and learn around. So 2019 is about deciding what is the offer we want to bring to market. 2019 -- I'm sorry, 2020 is really picking the key cities to then kind of launch into and then 2021 would be a year we really scale and optimize. So this is really about discovering and learning this year. Given that of the $400 billion market, half being in home improvement, a little over a quarter being in repair and the balance being in maintenance, we think we will start where we have the most leverage, and that's around repair and maintenance. So as we get closer toward the end of the year and we kind of know what the offer looks like, we'll be happy to provide additional details and what we think the opportunity looks like.

Our next question comes from the line of Ralph Schackart with William Blair.

Rex, on the call today, you talked quite a bit about the tiger team contributions and initiatives within the organization. Maybe if we just take a step back, can you frame some of the biggest near-term impacts that team has made to date? And then maybe a little bit more longer term, where do you think the biggest levers or contributions the team can make? And then a follow-up to that. I know you've been brought on board to roll out some broader technology initiatives and changes and you talked about the customer service experience today getting some traction. But maybe sort of frame the technology opportunities and how you think it will impact the business.

Yes. Sure. So tiger teams are assembled, cross-functional teams that come together. Brian and myself and majority of our leadership team meet weekly around kind of these tiger team initiatives. And so for -- the first one is really about cost containment. We talked a little bit last time about some of the bigger wins were around things like improving our dispatch algorithm to make sure that the algorithm is, for lack of a better term, a little more greedy when it comes to our preferred contractor network. Our preferred contractors are roughly half the cost from a labor perspective of our network of contractors. So as we saw better weather this quarter, that algorithm improvement really helped us as well. Looking forward to stress testing a little bit more as we move into the summer months. Some of the other initiatives they've worked on is really around cost containment in terms of how we're onboarding our contractors, how we have our system setup to collect fees from customers, how we do payments. So it's a variety of things. It's 6 to 8 different work streams going at any time. Since that time, our next kind of mountain to climb that we're starting this quarter is around retention. So it easily takes about 4 to 6 weeks to really get down into the analytics of where are the biggest opportunities. We think that's around -- I mentioned earlier, around our auto pay and some of the evergreen issues that we've worked on. We're looking at how we add more services to our first year real estate product and then really just enriching the core service experience around self-service and continuing to go down the journey of customer experience. So still somewhat early days for those teams, but that's kind of how the tiger teams are set up.

In terms of your question around technology, I think it's still somewhat early earnings in terms of the amount of work ahead of us, but really pleased with the velocity of change that's occurred within the team. So we're moving a lot of our core systems and infrastructure to the cloud, really moving more to micro services environment, which allows us to then, as you think about on-demand, be able to develop other micro services or systems around our core products. So a lot of moving parts, but that's, hopefully, a quick snapshot of what we're doing.

Our next question comes from the line of Chris Gamaitoni with Compass Point.

Can you give us an update on what percentage of your portfolio has received -- or already reflects the price increase?

Well, as we mentioned on the call, I think it was -- Rex had covered it -- that we began rolling out the price increases in the fourth quarter of last year, continued in Q1, but it takes time to flow through as customers renew as well. So I don't know -- what do you think, Rex? How much?

Generally, if you make a pricing increase in, say, January, about half of that will flow through. I think roughly, we're expecting maybe half or a little more than half flow through for this year. So I think we're a quarter of a way though that progress.

Okay. On the gross margin improvement, is there any way to dissect percentage points or however you want to the improvement that came from just beneficial weather versus underlying process improvement?

Yes. That's a great question, Chris. Ballparking it, I would say, of the favorability, 2/3 driven by weather, the lower incident rates due to the mild temperatures, especially through the South in Texas, and the other third process improvement. Does that help?

Absolutely. That's super helpful. And then I guess 2 more. On the on-demand services, do you have an estimated range of how much you spent for that investment this quarter in the SG&A line? And maybe what your thought is of that investment spend throughout the year, given it's an R&D year?

Well, as we've told you on the fourth quarter call, we were going to spend about $5 million on OpEx, about $5 million CapEx. As far as OpEx, in Q1, I don't know, less than $1 million.

All right. And one final one. As it relates to customer engagement, improving retention rate's usability, is there any thoughts of launching like a native iOS or Android app in the future?

Potentially. Certainly, I'm a big believer that people are going to download an app once there's a burning need to use it. And I don't think we've created that yet, right? So as we think about on-demand, certainly, that's something that we're thinking about. As we think about the pilots, what we're testing, I don't think we're going to start with a native app. We'll just bootstrap it.

Our next question comes from the line of Robert Coolbrith with Wells Fargo.

A couple, if we could. Another question on the gross margin improvement, the weather and process improvement benefit versus the underlying cost inflation trends. Wondering if you might be able to tease that out a bit. Then specifically, on process improvements, you highlighted you have a contractor selection optimization. Wondering if there's anything you can tell us about the runway for further improvement there. It sounds like there may be a little bit of tension upcoming over cycle times. Any progress on the repair versus replacement trends? And then secondly, on on-demand, just wondering if there's anything early on that you're doing or could tell us about planned go-to-market with the Frontdoor brand, anything you're doing in advance of the launch to help familiarize the existing member base with the new brand, any early learnings, if there are any.

Yes. I'm happy to -- it's Brian. I'm happy to take the first part of that question. There's 2 questions. As far as process improvement, based on the tiger team success that Rex mentioned, we did realize some of the process improvement quicker than we thought, and that's what we talked about. It's about that 1/3 in the claims cost benefit in Q1. And the rest of the benefit for the remainder of the year is baked into our new forecast. Does that help?

Yes.

And then from an on-demand perspective, as I mentioned earlier, it's still, I think, somewhat early days. We're beginning to test and pilot kind of what -- a series of things that we want to test out. So they're not large-scale pilots, if you will, so no real need to focus on branding or kind of our go-to-market approach just yet. That will come later in the kind of Q4, Q1 time frame.

Our next question comes from the line of Justin Patterson with Raymond James.

Rex, you talked about marketing spend ramping over the course of the year to drive growth. Philosophically, could you talk about the factors that would cause you to lean into or pull back on that spend? And then for Brian, you've got a strong balance sheet and healthy free cash flow generation. In terms of capital allocation, are there any technologies or components of that on-demand product that you think you need to buy versus build?

Yes. So I think that -- sorry. Can you repeat your first question? I was focused on the last one.

So the first question was more about just marketing spend. Philosophically, what type of factors do you look at in terms of leaning into or pulling back on that?

Yes. So we've modeled the year as kind of increase in terms of the marketing spend. Traditionally, Q1 is more of a quiet period for us. So we're -- it's kind of modeled it to be ramped up kind of Q2 through Q4. And so that's just how we modeled the business. In terms of the other piece, Brian, do you want to take that?

About the capital allocation?

Yes.

Yes. Happy to. You're right, we've got a strong balance sheet. We're generating cash at a very high rate, as I mentioned. We think we're going to convert EBITDA to free cash flow about 50% this year, which, based on our guidance, is $125 million to $130 million. So what do we do with that? Reinvesting in the business is key to us. And Rex can weigh in as well, but if we do see a technology that we can acquire to accelerate the on-demand process, we would certainly consider it. But also, paying down debt is certainly an option. We've hedged about -- not about, we've hedged $350 million of our $650 million term loan B. So that means we've got $300 million we can pay down at our discretion. So that's something we're certainly considering.

I would also add that we're always kind of -- we're always looking at kind of build versus buy. So that's something that Brian and I are always focused on.

Our next question comes from the line of Ian Zaffino with Oppenheimer.

Question would be -- Rex, thanks for running us through all the initiatives. Is there an initiative or maybe just some color on maybe an initiative for partnerships with utilities and how we should kind of think about that in the environment surrounding partnerships with utilities?

Yes. Certainly, utilities are something that we do have some small partnerships with. That's something that Brett Worthington, who runs our real estate sales and business development, is focused on. So we're -- I'm definitely interested and open to utilities. One thing we haven't explored is around utility line protection. That's something that definitely we're thinking about.

Okay. And then question for Brian. On the tariff side, this has to [go] through. What's the sensitivity to your business, your guidance? And then would you anticipate any, like, supply chain disruptions because of that? Just any kind of color on that would be helpful.

Yes. In terms -- I guess you're referring to the tweet over the weekend from the administration.

Exactly.

Our guidance for 2019 are pretty much locked in as far as manufacturing for water heaters, appliances, HVAC or they're in production scheduling with existing raw materials, existing prices that we've negotiated. So we'll see how this plays out, but it would be more of a 2020 issue for us than a 2019 issue for the most part, but we're digging into it pretty deeply right now.

Our next question comes from the line of Kevin McVeigh with Crédit Suisse.

In terms of the dynamic pricing, it sounds like you're going to fully ramp in the back half of the year. Any sense of where it was in kind of the first quarter and how we should expect that kind of progression over the course of the year?

Yes. So every quarter, it's going to get kind of -- continue to build on itself certainly from a first year direct-to-consumer as well as renewals, which I've already said. We're continuing to ramp it up. It's somewhat of a manual process today, but we're focused on our higher expense areas first. But because it's a manual process, we can't roll it out across the U.S. So every quarter, as we build the technology and we get all the systems and pieces in place, then you'll see it kind of come on more and more. But I don't expect it to be fully finished until the end of the quarter. There's a lot of -- sorry, end of the year. There's a lot of things we've got to continue to build for the team.

Got it. And then just obviously, the EBITDA really nice. It seems like you would come in even stronger. There was an increase in underlying cost of repairs. Was that just not using prime contractors? Or what drove that kind of underlying increase?

Yes. We had -- this is Brian. We had $1 million to $2 million of tariff impact. So that's driving part of that.

Our next question comes from the line of Cory Carpenter with JPMorgan.

Two, if I may. First, just following up on the last dynamic pricing question in the rollout. Could we see dynamic pricing have an impact on gross margins in the second half of the year? Or is that still more of a 2020? I know you mentioned 100 basis points in 2020. And then on the direct-to-consumer channel, you had a nice acceleration this quarter. Just looking ahead, you mentioned the second half marketing spend ramping and then, of course, you have price increases that will continue to flow through. So I guess my question is, how should we think about the growth in this channel through the year? Is there any reason it wouldn't continue to accelerate?

Yes. Certainly, we don't see any reason why direct-to-consumer wouldn't continue to accelerate. And then in terms of the gross margin improvement, I think until we get the systems built, you're really not going to see that improvement until 2020. Certainly, as we get some of the other pieces in, there might be some small improvement. But I don't think it will be material.

Our next question comes from the line of Michael Ng with Goldman Sachs.

I have 2, if I may. The first is, given the fairly wide range of growth trends across your acquisition channels, can you think about how much the new price increase has played into some of those differences? For instance, is the elasticity of pricing better among renewing customers relative to some of the first year new customers? And then should we see real estate revenue accelerate into the rest of the year given that I believe that some of the price increasing -- price increases in real estate didn't kick in until, I think, earlier this year?

Yes. So in terms of real estate tenants because it's usually tied to existing home sales, contract tends to be a little less price sensitive and then -- so it's just more about expanding into and deepening our relationships with our existing brokerage firms, adding some of the other leading brokerage firms who are taking a very analytical approach in terms of who we're targeting. And then for direct-to-consumer, certainly, as others begin to follow the price increases, price becomes less of an issue from a competitive perspective, but we're continuing to monitor our -- both the renewal channels as well as the direct-to-consumer channel and it's as modeled. So we're pretty pleased with -- given the increase in price relative to our ability to continue to sell, we're pretty pleased with the results.

Great. And a follow-up, if I may, just on weather. Should we see more normal weather this year in '19? Should that be helpful to claims costs given that 2018 saw such unusual weather? And could you just remind us which were the months that were particularly hurtful to claims costs last year?

Well, certainly, last year, we had a very cold winter and a very hot summer. So I would say that most of 2018 was tough. We think not just back to October -- October is one of the worst months we've had on record, right? So certainly, as we -- we're trying to kind of joke, we don't have the algorithm for weather, but that's something we're actually trying to develop. I think beyond a quarter, it would be tough to kind of model the year. Certainly, most weather services, I think, have difficulty doing that beyond the kind of 90-day period. But that's something we are looking at. And if weather gets better, that's always a good thing for us and then we will continue to focus on process improvements and running the business outside of weather.

Ladies and gentlemen, that concludes the question-and-answer session. I will now turn the call back over to Rex Tibbens for some closing remarks.

Thank you. Our vision for 2019 and beyond remains the same. We will continue to build a solid foundation to improve the customer experience drive our financial performance and position us to continue to grow our core business and new on-demand services in 2020 and beyond. Unchanged with our plan is our obsession with taking the hassle out of owning a home for our customers. Thank you, again, and we look forward to updating you on our progress on our second quarter 2019 earnings conference call. Thank you.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.