I am recommending Tree.com (TREE, Financial) as a short candidate. Tree.com's share price has doubled since June with hardly any improvement in the financial performance. The main points of my investment thesis are:
1. Tree.com is a lead generator (mainly mortgages). Tree.com aims to run an online market place for lending (lendingtree.com), but the final result is far removed from the true marketplace (e.g., auto insurance comparison website). Consumers do not get quotes promptly on the screen, but rather in a disorganized fashion (bombarded by lenders’ phone calls) and only from a limited number of lenders (those who agreed to pay the most for the customer lead). Consumer feedback on the business is terrible (see BBB complains).
2. It is not a revolutionary technology company (actually only a simple website with questionnaires) as it uses an 18-year-old business model which has not worked so far and invests almost nothing in innovation (on absolute basis and relative to competitors).
3. Company trades at 3x revenue and is just breaking even in terms of net profit or operating cashflow in some quarters. The business appears to be deteriorating recently. Top line revenue growth is non-existent sequentially and only 10% YoY. Main segment (mortgages 83% of revenue) is in decline. Pricing is under pressure and dropped 29% in the latest quarter. All of this deterioration is happening in the environment where the business is expected to perform at its best. As such, I do not expect Tree.com to ever grow into its current valuation.
4. There is no operating leverage. The company has tripled in size during the last couple of years (due to non-repeatable events, thus not representative of potential organic growth), but there is still no evidence of profitability. The main cost (c. 70%) is variable marketing expenses as Tree.com is fully reliant on advertising to drive consumers to its site. Marketing expenses as % of revenue have increased as the company increased in size.
5. LendingTree.com is very unpopular compared rival mortgage lead generators such as Zillow (Z, Financial) and Bankrate (RATE, Financial). In terms of mortgage inquiries Zillow is already far ahead of LendingTree (Bankrate does not reveal the figures) and growing, while LendingTree mortgage business seems to be contracting. Both Zillow and Bankrate have strong organic traffic whereas LendingTree has to fully rely on advertising to get customers on its site. Recently carried out national ad campaigns, did not produce any meaningful increase in revenues (no growth sequentially). Also worth noting that LendingTree had its patents called invalid by the court in Mar 2014 (Zillow owns the litigation), so now it does not have any intellectual property whatsoever.
6. Competitors have structural cost advantages as they can divert the traffic from their other parts of businesses to mortgage calculators. Thus the marginal cost of customer acquisition on rival mortgage calculators is close to zero, whereas LendingTree.com needs to spend up to 70% of revenue on that. In turn both Zillow and Bankrate are likely to offer far better pricing on borrower’s leads than LendingTree. Recent drop in pricing might be a result of these cost differentials and increased rivalry in lead generation space.
7. Revenues seem to be driven by unsustainable and unethical business practices. BBB complains indicate that LendingTree is selling the lead of a single customer to a very high number of lenders (supposed to be only 5) and also starts selling leads even before consumer finishes the application. This not only alienates the company with potential borrowers, but also reduces the quality of the leads, which likely also add to the drop in pricing. The aggressive practices seem to have intensified lately. I do not believe this type of revenue is sustainable, and would expect even sharper drops in mortgage revenue in the upcoming quarters.
8. Very optimistic growth and margin assumptions lead to valuation of $26/share vs $47 currently. Comparing to Bankrate (far larger, profitable and more efficient lead generator) using adjusted EBITDA multiple leads to valuation of $23/share. Thus significant downside from the current levels whichever way one looks at it.
9. Insiders started selling in large amounts even before the latest price jump.
10. Overvalution is likely the result of promotional management who mislead investors into believing that Tree.com is a revolutionizing technology company which is extremely popular among borrowers and that new products/platforms will result in exponential profitability growth. None of that is actually true. I believe LendingTree perspectives are far less rosy than management portrays –Â new products and supposedly revolutionary user interfaces are unlikely to result in any profitable growth.
