Yesterday, LendingTree (Nasdaq: TREE) announced a green, profitable fourth quarter and increased sales and earnings guidance for 2003. The stock rose, right? Uh, no. The stock declined 12%. Welcome to investing, 2000-2003. May it end with 2003.

Since our purchase of LendingTree on June 3, 2002, the stock is down 8.8%, while the S&P 500 has lost 17.3%. We'll have to celebrate that as a small victory. Much more importantly, the business appears on the right track.

The biz
Ironically (if I'm using that term correctly -- it seems nobody does), LendingTree is not a lender. It's not a tree, either. It's a matchmaker, or facilitator, or "exchange." Nearly 200 lender partners supply LendingTree customers with loan offers on items ranging from mortgages to auto financing to personal loans.

LendingTree typically provides each visiting customer who fills out a loan application (without cost) four competing loan offers from its lender partners. Just like the prom, you get to choose your favorite. Except in this case, they won't turn you down.

How does it make money? With a model not too unlike eBay (Nasdaq: EBAY) or Priceline (Nasdaq: PCLN), LendingTree collects a fee for every referral that it provides to lenders, and it collects an additional fee when a loan goes through, when a house sells (the site also connects to realtors), or when any other transaction it facilitated is completed.

Additionally, it markets its exchange platform technology, called Lend-X, to outside parties. However, this software revenue is shrinking in importance beside exchange revenue. Lend-X only accounted for 3.6% of revenue in 2002, down from 10% in 2001.

Recent results
Referral fees add up. LendingTree's fourth-quarter revenue rose 85% from last year's same quarter, to $34.7 million, and net income for the quarter (after dividends on preferred stock) was $5.6 million, or $0.19 per share. For all of 2002, revenue rose 75% to $111 million and net income was $0.20 per share.

This was earned on $22 billion worth of loans closed through LendingTree last year, up 80% over the value of loans closed in 2001. Equally heartening, its free cash flow became positive to the tune of $10.7 million.

For 2003 projections, management increased net income guidance by 15% to $13.3 million (again after dividends on preferred stock). They expect earnings per share of $0.46, representing 130% earnings growth. They expect revenue of $136.9 million, representing 23% revenue growth.

The price
At a recent share price of $12.50, the company has a market value of $279 million. Subtracting its $27 million in cash and equivalents, LendingTree's enterprise value is $252 million.

Management didn't provide guidance on 2003 free cash flow, but given that free cash flow was nearly twice net income in 2002, and net income of $13 million is projected in 2003 (while capital expenditures shouldn't soar), we're comfortable projecting that free cash flow could range from $20 million (nearly double last year) to as high as $26 million. It could be higher, but we'd rather be conservative.

A free cash flow of $20 million would put the stock's enterprise value, at current prices, at only 12.6 times 2003 free cash flow, well below the average 19 multiple on S&P 500 companies. A free cash flow of $26 million would put LendingTree at only 9.6 times free cash flow. That'd almost surely need to be considered a bargain price if the company continues to grow free cash flow at a reasonable rate from 2004 onward.

On an earnings-per-share basis, the $12.50 stock is at 62 times trailing-12-month results and 27 times the 2003 earnings estimate. So, it's mainly when you look through to potential free cash flow that you notice a potentially very low stock price on your hands.

Will the stock market value the company on free cash flow? Eventually, yes, we think so. Most companies are eventually valued on free cash flow more than on earnings per share, despite investors' focus on the P/E. (That's one of our long-term goals: Get investors, including newspapers, to start tracking P/FCF much more prevalently than, or rather than, P/E, given how misleading earnings can be.)

The concerns
There aren't many that are daunting. LendingTree is ramping its telephone service (you apply for loans on the phone rather than online) and that's performing well. Management plans to use new marketing channels and invest further in its realty services. There are no real cash concerns.

The largest concern may be that of rising interest rates. Everyone expects interest rates to rise again eventually (yet we can't know when, or even that they will anytime soon). Many fear that climbing rates would chop enthusiasm for LendingTree's mortgage refinancing service. Naturally, refinancing will slow significantly after interest rates increase for several months (the first few months will likely drive many procrastinators to finally refinance).

However, management says that higher interest rates would boost demand for its home equity products, and the company earns higher fees for those services than it does from refinancing. Additionally, as rates rise, customers will likely be more selective and competitive in finding better rates, and therefore they'll want several offers to choose from, just as LendingTree provides. So, its customer base should grow in an environment of rising rates, too, and should be focused on higher-income services.

That said, be forewarned that a high-priced, institutional stock newsletter has reportedly been talking down LendingTree on fears including rate worries, as has now's Herb Greenberg. Volatility could increase.

A strong conclusion
LendingTree has a strong business model, producing 84% gross margins and free cash flow even while still young. The stock is priced at 23 times trailing free cash flow and a potential 10 times to 13 times 2003 free cash flow. This seems unjustifiably low given both the near- and long-term prospects.

Jeff Fischer (TMF Jeff) didn't chop down the cherry tree and doesn't own LendingTree. LendingTree is a sponsor on the Motley Fool's Home Center, which Jeff will use should he buy a home. You can read Jeff's in-depth analysis of stocks off the beaten path in The Motley Fool Select (subscribe now and get our Stocks 2003 free!). The Motley Fool has a disclosure policy.

Rule Breaker Portfolio Returns as of 02/03/03 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week       -2.86%     1.52%    --     -0.11%
Month       0.93%     0.54%    --      0.22%
Year 3.59% -0.22% -- -0.88%
using IRR** since 8/4/94*** 20.57% 7.68% 9.45% 7.42%
10/20/98*** 0.12% -4.91% -4.46% -6.14%

*Dividends added. Or, danger ahead. Whatever.

**Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!

***What's this? The Rule Breaker Portfolio's precursor, the Fool Portfolio, was born Aug. 4, 1994. In a 10/20/98 column, David Gardner announced the name change of the Fool Portfolio to the Rule Breaker Portfolio. Here we provide returns as if the RB Port started on either date. Remember, don't mimic any online portfolio. Most individual investors should restrict any positions as risky as these to under 20% of their portfolio -- and could have a long and happy investing life with 0%.