First off, TREE is a company with very little fundamental financial strength to support its stock price. Shareholders’ equity – including convertible preferred stock – totaled only $23.6 million at September 30 and unrestricted cash totaled only $4.1 million. In contrast, the market value at $12.90 per share is $365 million. This market value calculation assumes that the remaining 6.0 million shares of Series A convertible preferred stock convert into common stock since the conversion price is only $3.50 per share.
Second – and most importantly – TREE’s current performance is strong because of the massive amount of mortgage refinancing that’s underway, but its medium-term outlook is highly suspect. TREE reported third quarter diluted earnings of $0.12 per share (after losing $0.20 in the first half) and is guiding to $0.07 for the full year 2002 and $0.40 for the full year 2003. Even if TREE wasn’t in a highly volatile business, it wouldn’t be cheap at 32 times next year’s estimated earnings and 15 times book value. Because of the factors discussed below, though, the current valuation appears to be extremely high.
TREE’s primary business is facilitating loans backed by single family residential properties. In 2001, mortgages accounted for 40% of TREE’s revenue and home equity loans accounted for 28%. In the first half of 2002, these figures rose to 44% and 31%, respectively. In total, residential loans accounted for 59% of TREE’s loan “transmittals” in the first half of 2002 and 75% of its revenue.
The company’s guidance for 2003 is highly dependent on its ability to maintain high volumes of residential loan applications, even in the face of what may well be rising mortgage rates and lower refinancing activity. For example, TREE is forecasting that its Loan Exchange business (which is mostly residential loan activity) will generate $56.8 million of revenue in the first half of 2003, an increase of 6% from the $53.5 million estimated for the second half of 2002.
If mortgage rates rise and refinancing volumes decline, TREE will quite likely undershoot its 2003 targets and may do so by a large margin. Illustrating the potential impact, TREE’s competitor, E-Loan (EELN) noted in its third quarter press release that the Mortgage Banker’s Association is forecasting a decline in refinancing volume of 60% (!) from 2002 to 2003. EELN plans to counter this downturn by dramatically increasing its market share of the refinancing market as well as of auto and other “diversified” loans.
It’s always possible that TREE will be able to significantly increase its share of a declining market or that mortgage rates will decline once again and the refinancing boom will continue for a while longer. The odds seem to be growing, though, that the refinancing boom will bust as it has so many times before and I don’t see any particular reason to believe that TREE will perform nearly so well when the wind shifts from its back to its face.
It may be worth noting that higher mortgage rates may also slow the rates of home construction and home sales and may cause home prices to moderate. Such trends would likely reduce the volume of purchase-money mortgages and home equity loans, though these volumes are probably less volatile than are those of mortgage refinancings.
While there is uncertainty about the direction of TREE’s earnings and stock price in the near-term, it seems likely that shorting the stock or buying longer-term put options will, over time, prove to be profitable. In particular, any sustained spike in mortgage rates could well cause investors to dump TREE rather than wait around to see how well the company manages itself in less favorable business climates.
Rising mortgage rates cause loan volumes to dip, possibly leading to lower expectations for revenues and earnings.