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Wednesday, March 31, 1999

An Investment Opinion
by Louis Corrigan


Beam me up, Scottie!

In ordinary times -- that is, Before the Internet (BI) -- one might have said that the stock of e-commerce intermediary (Nasdaq: PCLN) has boldly gone where none has gone before. Initially priced at $12 to $14 a share, Priceline fell into the hands of lucky IPO buyers at $16 a share yesterday and rocketed to $69 once the rabble got their hands on it in the open market. Today, the stock closed up $13 7/8 at $82 7/8. Based on 142 million shares outstanding, the company now sports a market cap of about $11.8 billion. Not bad for a start-up that opened its doors for business just last April and generated a $114 million loss for 1998 (including some major one-time charges) on a measly $35 million in sales.

Such a stunning debut leaves the media playing those fun parlor games. Priceline is now worth more than... (fill in the blank). Bloomberg's list includes RJR Nabisco (NYSE: RN), $9 billion; Quaker Oats (NYSE: OAT), $8.4 billion; Kmart (NYSE: KM), $8.3 billion; and Goodyear (NYSE: GT), $7.7 billion.

Then there's the "How much are the key insiders now worth?" question. Well, given that they still own 79% of the stock, a lot. Founder Jay Walker owns 62.6 million shares; former Citicorp president Richard Braddock, Priceline's Chair/CEO since August, owns 14.6 million; and former Time Warner (NYSE: TWX) co-CEO Nicholas Nicholas, Jr., a Priceline director since July, owns 3.9 million shares. And, oh yeah, Priceline pitchman William Shatner (AKA Capt. James T. Kirk) reportedly owns about 125,000 shares. Other winners include billionaire Paul Allen's Vulcan Ventures, with 9.4 million shares, and venture capital firm General Atlantic Partners, with 26.3 million shares.

Of course, a 331% first day gain is no longer that big a deal. A number of Internet IPOs in the last six months have delivered a better than 200% first-day gain while theglobe (Nasdaq: TGLO) soared 606% and (Nasdaq: MKTW) rose 474%. Still, it's noteworthy that Priceline now has a larger market capitalization than Delta Air Lines (NYSE: DAL), which just happens to be one of three airlines that accounted for 95% of Priceline's airline ticket revenues in 1998. And Priceline today derives most of its revenue from such airline ticket sales.

That's not to say that Priceline isn't an interesting story. It certainly is. For starters, the company has created terrific brand awareness with a relatively modest $24 million in sales and marketing last year. More important, its business model is built for the Web and at least somewhat protected by two method patents and 18 pending process patents (though it is being challenged on this front).

Priceline basically acts as an electronic intermediary collecting demand for discounted products and services and matching these prospective customers with suppliers willing to sell goods or services for the "bid" prices or less. Specifically, if you want to make a roundtrip flight from Atlanta to New York on certain dates, you can enter the price you're willing to pay with Priceline. If there's an airline willing to provide you with tickets for that price, then you're obligated to buy them. You're getting a ticket for less than the lowest posted price but sacrificing the convenience of choosing the exact flight. The airline derives some incremental revenues from tickets that might otherwise go unsold. Yet, it doesn't have to disrupt its normal distribution channel or mark down its official ticket prices to do so. So buyer and seller both walk away happy, and Priceline takes home the spread between what you bid and what Delta, let's say, was willing to sell the tickets for.

So far so good. In 1998, the company generated offers for 1.9 million airline tickets, or $400 million in total demand. Many of these bids were "unreasonable," that is, more than 30% below the lowest advanced fare price. But Priceline did sell 134,900 airline tickets, generating about $30.4 million in revenue. Business is taking flight, too. For the first two months of 1999, Priceline collected offers for 830,300 tickets ($170 million in demand). About 53% of these offers were "reasonable" and 24% of the reasonable bids resulted in sales, for a total of 102,700 tickets sold producing $21.1 million in revenue.

Priceline started by selling airline tickets from Trans World Airlines (NYSE: TWA) and America West (NYSE: AWA), later adding Delta and Northwest (Nasdaq: NWAC). Today, some 18 airlines cooperate with Priceline. But air travel was just the beginning. In July, the company started testing the sale of new cars. In October, it added hotel room reservations, and in January home mortgages. With the car and mortgage sales, Priceline earns a fee for connecting buyers with sellers.

According to Jonathan Cohen, Wit Capital's new director of research, Priceline is the first "Next Generation" e-commerce company. Famously bearish on (Nasdaq: AMZN) while at Merrill Lynch (NYSE: MER), Cohen posted an effusive "Buy" report on Priceline yesterday. Though his target price of $35 to $50 a share couldn't leave Internet speculators very happy, he rightly points out how well Priceline is positioned to leverage its ultralight business model into all kinds of vertical markets. "We believe that Priceline is positioned to fundamentally change the existing model for online commerce," Cohen argues. That's why he sees revenues galloping to $358 million by 2001 and operating margins eventually (but not in 2001) ending up in the 8% to 10% range.

Indeed, while Amazon's current model requires that it carry some inventories and handle the physical processing and distribution of books and CDs etc., Priceline simply connects buyers and sellers. It's a model that's easily scalable and requires little working capital outside of buying technology and ads and sustaining near-term losses while building the business. (To nurture the customer base, Priceline has sold a lot of its airline tickets at less than cost.)

Before jumping on the Priceline bandwagon, though, investors should take a close look at the company's prospectus. Here are a few points worth noting.

* While Priceline has 143.2 million shares outstanding after the IPO, it's got a lot more common share equivalents, including 23.8 million shares issuable based on options that exercise at just $1.25 per share. Delta also has warrants for 18.6 million shares that exercise at $0.93 per share. Even without getting into other potential dilution down the road (the total is on the order of 54.1 million shares), that gets us to 186 million shares, putting the current adjusted market cap at around $15.4 billion. So the company is even more expensive than it looks. A lot more expensive.

* Priceline operates what it calls an "adaptive marketing program." Under this program, for example, a customer who offers to buy an airline ticket can -- at no additional cost -- have her offer price automatically increased by $50, likely assuring she gets the ticket. All she has to do is apply for a credit card. That is, by signing up for another service, a customer gets Priceline to make up the $50 difference with revenue it gets from program sponsors. Though Priceline generated just $4 million in revenue last year from this program, it's very high margin revenue, accounting for a significant percent of gross profits. While almost all this revenue has come from fees paid by Capital One (NYSE: COF) for qualified credit card applications, Capital One is bailing out of the program at the end of April. First USA will take it over, but the terms of this new arrangement appear somewhat more restrictive. Plus, First USA can terminate the deal after the first year.

* Priceline's airline participation agreements also permit the airlines considerable flexibility. They don't require the airlines to make tickets available for particular routes, to provide a specific quantity of tickets, or to provide tickets at any set price discount. These deals can also be "terminated upon relatively short notice." Moreover, Delta signed on only after Priceline gave the firm the right to approve or reject new carriers and to restrict the volume of tickets and routes offered by certain carriers. "Accordingly, Delta could limit our ability to expand our business through the introduction of new carriers or the expansion of the routes for which we offer tickets," reads the prospectus.

While I find Priceline's model and execution compelling, the current market price is another story. Interested investors would do well to study the prospectus and to research whether the company's patents really provide the barrier to entry that the bulls suggest.

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