Orbitz Loses Altitude

The airline industry has a lot of experience dealing with disruptive technologies, going back to the early 1950s when the President of American Airlines and a sales rep from IBM hatched an idea for a computer-driven reservation system. The technology was eventually spun-out as a new firm, called Sabre Systems.

The latest airline technology venture is Orbitz (Nasdaq: ORBZ  ) , which debuted in its initial public offering (IPO) yesterday. After much anticipation, the IPO was a whimper. Orbitz's stock fell about 4% on 19.7 million shares traded. Orbitz priced at $26, which was well-above its $22-$24 price range. The company also increased the number of shares issued from 11 million to 12.18 million.

While traders may not have been thrilled, at The Motley Fool we actually think this was a good thing. The stock's lack of movement probably indicates the IPO was priced right and the company maximized its cash yield from the offering. It's far better to see than the ridiculous, speculative IPOs of the late 1990s, where companies without business plans popped 1000% on their first day of trading and individual investors got burned big time.

The original founders of Orbitz include Continental Airlines (NYSE: CAL  ) , Delta Air Lines (NYSE: DAL  ) , Northwest Airlines (NYSE: NWB  ) , United Air Lines, and American Airlines (NYSE: AMR  ) (no, Hooters Air is not a member). The group is known as the Founding Airlines.

However, this ownership structure poses an interesting dilemma: Is the primary goal for Orbitz to maximize profitability or is it to help the airline industry reduce distribution costs?

In fact, it is very clear that the Founding Airlines represent the captain of Orbitz. They hold 70% of the outstanding stock and over 90% of the voting power. Moreover, the Founding Airlines said they will file a Schedule 13G with the Securities and Exchange Commission. This allows Orbitz to waive Nasdaq's independent board member requirement. So, the board will be stacked in favor of the Founding Airlines.

Moreover, the Founding Airlines have veto power on critical corporate decisions, such as for strategic partnership relationships, raising additional capital, and selling the company.

With this incestuous corporate governance, it should be no surprise that there are bizarre compensation arrangements. The CEO of Orbitz, Jeffrey Katz, has a contract that makes him money if the stock price falls after the IPO (by the way, I thought it was illegal for an insider to short the company stock). Well, it looks like he is already is in the money.

Let's take another angle. Suppose you show up at a board meeting. You will see Scott D. Miller (private investor and former executive at Hyatt Hotels), Vincent F. Caminiti (senior vice president - profitability initiatives of Delta Air Lines), Daniel P. Garton (executive vice president - marketing of AMR Corporation), J. Timothy Griffin (executive vice president, marketing and distribution of Northwest Airlines), Douglas A. Hacker (executive vice president - strategy of UAL Corporation), and Jeffery A. Smisek (executive vice president of Continental Airlines).

See a trend? Would you have the guts to propose a motion that would potentially harm the airlines?

There is another benefit of the IPO: the Founding Airlines have essentially made back their initial investment, since they sold a portion of their shares at the offering. As they say in the deal world, they are now "playing with the house money."

There are certainly positives to the Orbitz story. The firm is now the third-largest online travel site based on gross travel bookings. The site is very easy to use and allows consumers the ability to search over two billion fares, over 45,000 lodging properties, and 23 car rental companies.

Since its inception, Orbitz has registered more than 19 million consumers and completed 22 million travel transactions. In the third quarter, the company sold $883 million in gross travel bookings.

Orbitz has made great strides in terms of innovation. In 2002, the company launched the Supplier Link technology. This allows the company to bypass the GDS (global distribution system) when booking airline tickets.

This is a great breakthrough, especially for the airlines that -- you guessed it -- want to cut distribution costs. As stated in the prospectus, the technology "allows participating airlines to distribute tickets at a lower cost to them while generating increased profitability to us."

And yet another benefit: Orbitz signed charter associate agreements with its Founding Airlines. This is the fee structure for Orbitz. It should not be surprising that it is favorable to the Founding Airlines. Rates declined 16% for the year ending June 2003 and will continue to decline 27%, 28%, and 30% for the next three years. With this fee arrangement, Orbitz has no choice but to grow fast.

There is also concentration risk. As of the end of September, about 66% of Orbitz's revenues came from airline ticket sales. To continue its growth path, it will need to expand into new revenues streams, such as lodging, car rental, vacation packages and corporate travel. Although, in October, Travelweb filed for a temporary restraining order and preliminary injunction to prevent Orbitz from pursuing its hotel program.

The accumulated losses for Orbitz stand at roughly $162 million. The company posted losses for the first and second quarters of 2003, but was able to eke out some black ink of $3.9 million in the third quarter.

While investors want to see profits, they should be skeptical of short-term ploys to juice things up. Unfortunately, Orbitz appears to have succumbed to that temptation and reduced expenditures on R&D and marketing.

Online travel is not a fad and the growth will likely remain strong for several years. This has been a critical for Orbitz, despite its corporate governance complications.

Yet, the fact remains that the company is No. 3. in the market. InterActiveCorp's (Nasdaq: IACI  ) Expedia has 40% of the U.S. online travel market and Travelocity, a division of Sabre Holdings Corp. (NYSE: TSG  ) has 20%.

InterActiveCorp's CEO, Barry Diller, has a laser focus on his Expedia franchise, which is growing 60% faster than Orbitz. And Barry is not letting up, as he is committing huge amounts to marketing.

No doubt, Orbitz is a strong company, with good technology and strong management. But looking deep into the company, it looks like a well-crafted entity to support the airlines, not public shareholders in Orbitz.

For more on IPOs, see this Foolish content:

Tom Taulli is the author of six books on investing, such as Investing in IPOs (Bloomberg Press), as well as a professor of finance at the USC School of Business (don't worry, but he does come out of his ivory tower). You can reach him at tom@taulli.com.


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