TREE.COM INC TREE W
June 18, 2012 - 2:45pm EST by
Lukai
2012 2013
Price: 8.85 EPS $0.00 $0.00
Shares Out. (in M): 11 P/E 0.0x 0.0x
Market Cap (in $M): 101 P/FCF 0.0x 0.0x
Net Debt (in $M): -94 EBIT 0 0
TEV ($): 6 TEV/EBIT 0.6x 0.6x

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  • excess cash
  • NOLs
  • Internet
  • Asset Sale
  • Media

Description

We don't often come across a household name with positive cash flow, tangible near-term growth opportunities, and a nearly zero enterprise value. Tree.com is one such opportunity. TREE has a $6m adjusted enterprise value, is unlevered, and will generate $8-12m of EBITDA this year. In addition, TREE has a valuable internet property and sizeable NOLs. Management is transforming TREE into a premier, pure-play, lead generation business and we believe that the stock can ultimately command a multiple closer to lead-gen peers (RATE, Z, etc.) We think the stock is ultimately worth $18 per share, more than double today's price tag. In a takeout scenario (aaaggghem) we think TREE could be worth $50+ per share.
 
Why does this opportunity exist? To start, it's a small, relatively illiquid name so most investors probably aren't looking. Even if one did come across TREE, they'd see an online media company confusingly married to a mortgage company (until June 7th). If they were still willing to look, one would have to dig deep through filings, press releases, and potentially speak with management to understand what the balance sheet will look like at the end of this quarter. We've done the work and believe it'll look good. 
 
Until two weeks ago, TREE operated lendingtree.com, a high-quality mortgage lead generation business, and Lending Tree Loans (LTL), a mortgage company. The majority of this report was originally dedicated to supporting our conviction that Discover (NYSE:DFS) would ultimately purchase the mortgage business, despite several delays. On June 7th, Discover closed on the LTL purchase, thereby significantly shrinking the word count of this report.
 
Now that the LTL sale has closed, TREE has a $100m market value and we estimate $94m adjusted cash post transaction, resulting in a $6m enterprise value. Management has guided to $8-12m EBITDA generation for the remaining business representing 0.6x at the mid-point. This low valuation, coupled with the intangible yet highly valuable lendingtree.com Internet property, is enough to take a position in the stock, in our view. We think the catalyst to realize value to this point is the filing of their 10-Q in mid-August. Additionally, there are significant growth opportunities that management can now focus on. 
 
First and importantly, we review the moving pieces on the balance sheet in respect to the LTL sale.
 
BALANCE SHEET POST LTL SALE
In TREE's most recent earnings release, management guided to ~$60m net cash post-close. We know this is conservative for three reasons:
  1. TREE will receive a $10m payment from DFS on the first anniversary of the sale;
  2. In the current, historically low interest rate environment, LTL was generating gobs of cash flow. In 1Q12, LTL generated $16.4m of net income. Given that rates have remained low and housing activity has held-in q/q, we estimate that LTL would have contributed roughly $7m to TREE in the first two months of 2Q12 before being acquired by DFS.
  3. Management's ending cash estimate is net of the full $33.5m loan loss reserve on mortgages they've sold through LTL. This is a GAAP calculation based on historic experience and not an actual existing claim. Although many loans that would be considered in this calculation haven't been put to TREE, management is working with loan buyers on a global settlement whereby buyers would ostensibly settle for a discount to face and take payment up front. We think TREE can be aggressive in negotiations as they no longer operate a mortgage business and so have less of a need to concern themselves with maintaining relationships with loan purchasers. DFS imposed their own calculation on the loan loss reserve of $20m to be escrowed. We use the DFS escrow amount in our calculation. We also note that the loans in question are only from 2011 and forward - TREE is not exposed to a bunch of worthless paper from mid/late-decade. Further, if management believes they can settle for an amount less than the DFS escrow, they can dividend cash up to the parent company from the HLC subsidiary before any settlement takes place.

Here is a summary of the moving pieces and resulting cash balance ($mm):

     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
  ($mm)  Note
Unrestricted Cash $59.0  
Restricted Cash 11.1   ~3/4 of restricted cash balance ($14.9m) becomes unrestricted
Positive Loan Spread 16.0   Delta b/t loans held for sale and TREE's warehouse line of credit (not risk adjusted)
DFS Purchase 37.9   DFS purchase ($55-10 on first anniversary, $8m already paid)
Loan Loss Reserve Escrow (20.0)   Loan loss to be escrowed per DFS Asset Purchase Agreement
HLC Subsidiary Expenses (25.0)   Negative working capital,, hedge on secondary, wind-down obligations, deal cost, etc.
Other (2.0)   Other litigation, misc.
Subtotal 77.0  
     
Anniversary Payment 10.0   Consulting fee flowing through income statement. Would be taxable if not for NOLs
Cash Generation 7.0   2Q12 cash generation from LTL prior to deal close
Total Cash (Post LTL) 94.0  
Per Share 8.23   11.4m shares outstanding
% of Current Price 92.8%  

Incidentally, TREE filed a pro forma 31-March balance sheet showing $114m of cash and $26m net liabilities for discontinued ops. Add $7m of cash flow generated in 2Q12 and we arrive at our total cash number before the $10m anniversary payment. While there will be some liabilities to wind down over the course of several quarters, we believe that TREE's 2Q12 10-Q will reveal a substantial cash position.

WHAT DOES THE BUSINESS LOOK LIKE FOLLOWING THE SALE OF LTL?

"When Banks Compete, You Win." That is the highly recognizable slogan behind the popular website, lendingtree.com. The popularity of lendingtree.com, coupled with high quality long-form leads, allows TREE to offer some of the most valuable mortgage leads in the industry at premium prices. We think it would cost a newcomer multiples of TREE's current enterprise value, and at least of couple of years, to build a similar level of brand awareness. An investor in TREE today is getting the web property, and $8-12m of EBITDA, for $6m.

With the sale of LTL, TREE is transitioning back to a pure play comparison shopping lead-generation business. Over the past several quarters, TREE has been reporting "Adjusted Exchanges" figures to give investors an idea of what the business would look like in the absence of LTL. This is important due to the fact that a portion of go-forward lead-gen revenue will be for leads that would otherwise have been given to LTL with intercompany eliminations. Given the quality of lendingtree.com's leads, we think lenders would scale back other lead sources which would drive significant efficiencies on TREE's marketing spend. Diligence suggests that some lenders will "take all they can get" from lendingtree.com. Over the past several months TREE has aparently been working on taking market share. We're hearing that, for example, a lender that was buying 500 leads per day from TREE is being offered 750 per day; the 250 delta offered at the competitor's price to shut them off.

Below is a summary of "Adjusted Exchanges" figures from the company. 

$millions Mar Jun Sep Dec FY Mar
Adjusted Exchanges Figures 1Q 2Q 3Q 4Q 2011 1Q
             
Mortgage 20.0 20.2 15.6 14.1 69.9 19.9
Non-Mortgage 3.9 4.5 3.9 3.9 16.2 4.2
Total Exchanges Revenue 23.9 24.7 19.5 18.0 86.1 24.1
             
Exchange Marketing Expense 20.0 18.4 10.8 8.5 57.7 12.8
Other Marketing Expense
0.9 1.4 1.0 1.2 4.5 1.5
Total S&M Expense 20.9 19.8 11.8 9.7 62.2 14.3
             
Variable Marketing Margin 3.9 6.3 8.7 9.5 28.4 11.3
             
Exchanges EBITDA (4.2) (2.3) 2.3 3.3 (0.9) 4.3
Margin % (17.6)%   (9.3)%   11.8%   18.3%   (1.0)%   17.8%
             

As the FED has signaled a low interest rate environment for at least the next couple of years, management felt comfortable in guiding for adjusted exchanges EBITDA this year in the $8-12m range. EV/EBITDA is 0.6x at the mid-point.

WHAT DOES TREE LOOK LIKE LONGER TERM, AND WHAT'S IT WORTH?

We believe TREE will transition itself into a growing media company in the next 2-3 quarters. On the mortgage side, TREE has recently hired high-level sales executives from bankrate.com and leadpoint.com and has closed some large lenders. TREE has also begun laying bets in home services, education, autos, legal, insurance, etc. We believe they can achieve brand and marketing synergies in these and other verticals (degreetree.com, lendingtreeautos.com, etc.)

An additional opportunity is in rate tables, such as those employed by Bankrate (RATE) and Zillow (Z), that allow a consumer to shop a list of offers and then click on a link or call a phone number (pay per click / pay per call). TREE has both long- and short-form offerings (input personally identifiable information) but they don't have a rate table offering. We believe they'll roll out a table by the end of this year and that we'll hear more about this on TREE's upcoming quarterly results conference call. We know that TREE has recently hired the rate table architect from build.com - at this point we think they'll either build, buy or partner on an offering in the near-term. Rate tables expand the market for TREE and are easier to operate at scale.

RATE and Z both command astronomical multiples - EV/S of 4.5x and 10.5x, respectively. We view both of these businesses as deserving of healthy multiples. While we don't take a view on whether either one is currently fairly valued, we also don't ascribe these multiples to TREE for our ultimate target price; rather, we use them for reference purposes. RATE has quality traffic through decades of editorial content, a syndication network, and rate tables. Z effectively has no marketing costs; they've built a site that generates traffic through SEO and mobile and are not dependent on third parties. We think TREE can claw their way to a healthy third place. Assigning TREE just 1x EV/S results in a $16 share price using our pro forma cash balance and assuming no growth. A 2x EV/S multiple gets us to $24 per share. A pure play, growing internet media business trading for 1-2x EV/S if fair, in our opinion. 

Even more interesting, from a valuation perspective, is the takeout scenario. TREE's "variable marketing margin," (VMM) or the amount of money they make on the lead gen business before corporate overhead, is $30-40m per annum. We think that the vast majority of corporate overhead (executive team, sales force, legal, public company costs, etc.) can be fully eliminated. CEO Doug Lebda has conceded that TREE could be run on someone else's platform with just a handful of people. Here, we contemplate a scenario in which RATE realizes the current bargain and makes a bid for TREE:

  Lo Hi
Bankrate's EBITDA Multiple 15.0 15.0
TREE Annual VMM 30.0 40.0
Implied Enterprise Value 450.0 600.0
+Net Cash 94.0 94.0
TREE's Value to Bankrate   544.0   694.0
Value Per Share   $47.66   $60.80

A takeout scenario notwithstanding, we think $18 is a reasonable number to put on TREE at this stage of the company's progress. $18 represents 3.7x EV/VMM, 1.2x EV/S, and 11.1x EV/EBITDA using our adjusted cash number. This target also assumes no sales growth and no value for the $51m NOL ($32m tax adjusted).

RISKS

The primary risks are in the moving pieces that get us to our adjusted ending cash balance. First, our estimate for ending cash includes a $10m payment that TREE will not receive until June 2013. Second, we're only assuming $20m for the ultimate loan loss reserve. This could be higher (or lower) though we note that TREE doesn't have to settle anything - they can argue them one-by-one in the years to come. Third there is litigation risk if TREE tries to get too aggressive on the loan loss reserve negotiations.
 
There is always the risk that management will do something stupid with the cash but TREE announced the resumption of a share repurchase several days ago and the CEO owns 19% of the company thereby aligning his interests with equity holders.
 
Liberty Media owns 25% of the equity though we believe they're relatively in alignment with our assessment of the underlying value of the company.
 
There is the risk that the world falls apart, rates skyrocket and housing takes a dive. In this scenario however, TREE can quickly pull back marketing spend (TREE has daily VMM targets with real-time monitoring) and lendingtree.com leads would become substantially more valuable.
 
Operationally, we know that TREE had begun diverting leads from LTL to the market 45 days in advance of deal close. Loans typically take at least 45 days to close so TREE wouldn't have been able to capture the value from the lead inside of 45 days of deal close. This could impact both the performance of LTL, and average lead pricing in the quarter.
 
DISCLAIMER
This report is neither a recommendation to purchase or sell any securities mentioned. The authors may or may not have a position in any security discussed in this report. Further, the authors may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report.  The authors undertake no obligation to update this report based on any future events or information.

Catalyst

2Q12 - 10-Q balance sheet / earnings results
3Q12 - Clarity into lead sales absent LTL and (?) global loan loss reserve settlement.
4Q12 - Rate table introduction
2Q13 - $10m anniversary cash payment
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