Here we are, deep in the earnings season forest. And we come to a tree. Ah yes, LendingTree (Nasdaq: TREE), the Portfolio's most recent purchase and a featured company in the May 2002 issue of The Motley Fool Select, reported Q2 earnings last week.

I listened to the conference call on replay, and so can you by visiting the company's website. Unfortunately, the replay stops with eight minutes to go. (Shades of the Nixon tapes -- kidding! It's a glitch.) When I contacted the company, it kindly provided me tout de suite with a call transcript, which I have posted on the LendingTree and Rule Breaker -- Companies discussion boards. I encourage LendingTree and all companies to post conference call transcripts on their websites, as does Quality Systems (Nasdaq: QSII), a company Matt Richey dissected in -- you guessed it! -- the June 2002 issue of Select.   

Taking 44 minutes to check out a company's management may yield a high return. Investors in Rule Breakers need to trust, respect, and have confidence in management, because there usually isn't much financial (or profitable) history. You learn a lot about management on calls. Do they sound arrogant? Sincere? Do they answer questions fully and respectfully? Do they point out strengths and weaknesses of business performance (some areas are always stronger than others)?

Or do you react as did Queen Gertrude watching a play, turning to Prince Hamlet and observing, "Methinks the lady doth protest too much"? The only way to learn is to listen to these calls and review company material with critical eyes and ears. Company management is the public face, and you can bet boards of directors hire not only excellent managers but those who are presentable. "Streetable." Yes, even actors. Most are so smooth they can sell ice to Eskimos. Listen between the lines. You know what I mean.

In the last two quarter calls, LendingTree's CEO Doug Lebda and CFO Keith Hall come off well. They're confident without being cocky and raise the good with the bad -- such as the softness in their subprime credit card lending exchange segment. They're patient with questioners and willing to explain the details of the business as many times as it takes. Execution will be the true test, but, at least on the calls, my crap detector (available for $19.95 from Ronco) hasn't yet buzzed. But don't rely on my reaction -- I tend to be excited about Rule Breaker businesses, and enthusiasm can cloud judgment. Investors should satisfy their own such devices.

There were many important points on the call -- too many to detail here -- so let's concentrate on the highlights.

Top line up 
Revenues keep climbing:

                 Current Q Revs. Versus:
        Revenues  Prior Q  Year-Ago EPS   EBITDA
Q2 '02  $24.5 mil. 15%       55%         $(0.05)  
Q1 '02   21.3      13%       73%          (0.15)
Q4 '01   18.8       9%       95%          (0.28)
Q3 '01   17.2      11%       90%          (0.20)

Nice. Second-quarter revenues increased at the highest sequential rate in a year. The number of participating lenders increased to 178, a 10% increase over Q1 and 33% over the year-ago Q2. This is key to the company's business goal to provide every consumer that fills out a Qualification Form four lender offers, regardless of geography or loan type. In Q2, the average number of offers per request exceeded three. The more offers, the more revenues to the company. Lenders pay LendingTree $9 for each loan request that passes its filters and is transmitted to a lender -- regardless of whether it leads to a closed loan or not. But if closings result, CFO Hall notes that they "turbocharge" revenues because they generate a $300 commission to the company. 

This quarter the company began two new ways to increase this income. The first is "retry." If the company's software determines from the consumer's request that it's unlikely to generate offers -- that it's unlikely to get past any company's filters and be transmitted to the lender -- the lending exchange suggests specific ways modification could improve results. If, after the retry, the request still fails to pass filters and be transmitted to lenders, the company runs the request through its "choice" program. This is a second set of broader filters that screens only for loan amount, loan-to-value ratio, and FICO credit score (the lending industry standard for quick, objective assessment of consumer credit risk).

Take a moment to ponder the marvels of software. Think how long this would take humans. (I'm all for people, by the way, except when it costs me more as a shareholder and consumer.)

The retry and choice efforts have reduced the $9 average fee per transmit figure to $8.58 -- but, of course, there's greater volume to compensate.

"Unreported loans" -- deadbeats!
The company's average collection period is 47 days, but it has an ongoing consultant contract to check for unreported loans. These are real estate mortgage loan closings, where the consumer connects to the lender through a LendingTree request and transmission, but the closing payment hasn't shown up "yet." In response to a question, management said they don't see fraud, just the need for an occasional nudge. They do charge penalties, but are willing to negotiate in the context of the long-term business arrangement. Penalties amounted to $190,000 in Q2.

As the company's results improved in Q2, management decided to spend another $1.3 million experimenting with different ways to acquire website visitors. You may have seen the huge increase in ads on CNBC, for example, battling those from direct lender Which do you think is more effective in branding?

Finally, the company is scaling back its efforts to license lending exchange software to the big banks, such as Bank of America, and concentrating on building its exchange business through partnerships, such as those it formed with Yahoo!, Priceline, and MSN.

Revenues from LendingTree's newest business, its realty services referral exchange, doubled from Q1 to $2.7 million in Q2, over 10% of total quarterly revenues, because sale closings as a result of LendingTree referrals doubled. Management forecasts this segment to yield $2.6 million in Q3 and $2.3 million in Q4 (remember that home sales vary by season), for a total of $8.9 million in realty services revenue in 2002.

Furthermore, management projects a 46% increase to $13 million in 2003. I've been skeptical because I don't associate this business with the LendingTree brand, and because anecdotal evidence -- never persuasive -- suggests the real estate industry's dominates realty services referral exchange. But Q2 results show that, with 17% repeat business, LendingTree may be attracting some loyalty and familiarity. Stay tuned.

Interest rate fears?
Anyone you talk to about an Internet lending exchange would ask, "What will happen if and when interest rates increase?"  In theory, interest rate increases lower the supply of buyers because at a lower rate, people qualify for smaller loan amounts and may be priced out of certain markets. CEO Lebda responded on last quarter's conference call that when business becomes tougher for lenders, they increasingly turn to online sources. He cited the example of online travel businesses in Q4 2001.

Despite a travel collapse after 9/11, Expedia (Nasdaq: EXPE), (Nasdaq: ROOM), and others had fine quarters because outlets were forced to turn to these distribution channels, and with better deals. Lebda also posits that lenders increase their efforts in leaner times, leading to more personal service and more closings -- the big money for his company. We have to wait for evidence of this, because it's still an excellent mortgage interest rate environment. Also, at the first upturn in rates, there will be a rush for people to board the low interest train they fear is leaving the station.

This may actually be a sideshow for investors. The real possibility for Rule Breaker returns -- something on the order of a possible 10 times our investment in five years -- is only possible if the company snares ever-larger shares of the $2 trillion residential real estate market. It originated loans for 1% of that amount last year. Sure, at some point (we hope far into the future), LendingTree may hit a market share ceiling, then become more susceptible to the effect of rate changes on its market. But if it happens sooner rather than much, much later, it's a big, bright, red flag that its business model may be running out of gas. (Or that we didn't buy this company betting that mortgage interest rates would decline from current levels, or fearful that they would increase.)  

The icing on the cake, or leaves on the tree...
There was more on the call, and it was fun. The company stands by its forecasts of Q3 positive EBITDA, Q4 positive net income, and -- ta da! -- EPS of $0.33 per diluted share in 2003, which would give the stock a forward price-to-earnings ratio of about 33 at yesterday's close. That's a lotta growth priced in, and quarterly revenue growth, compared to the prior year, is super but declining. We'll want to see the free cash flow next year -- EBITDA, schmeebitda (we ignore it) -- but for now, things are looking pretty darn good.    

Have a most Foolish week! Updated Port returns are below. By the way, the numbers immediately below reflect Monday's close each week, while the table farther down is updated each Tuesday to reflect that day's close.

Tom Jacobs owns shares of LendingTree and Quality Systems. Go figure. You may view his stock holdings through his profile, prepared neatly and tied with a yellow ribbon, as specified by The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 8/04/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      -7.15%**   -7.16%   --      -9.68%
Month     -8.20%**   -9.45%   --      -9.20%
Year     -34.82%**  -27.30%   --     -38.17%
 8/4/94   19.04%      7.77%   8.29%    6.65%

*Dividends added.

**Please keep in mind that these figures will be distorted for the RB Port once a quarter when we deposit $12,500 in new cash. See next note! 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure accounts for the periodic deposits. Total return wouldn't be meaningful, because we started adding cash to the portfolio in July 2001. In a total return calculation, or (Current Value - All Cash Deposited)/All Cash Deposited, cash added shows up as returns.