FOOL ON THE HILL

Online Travel Still Soaring

Online travel sites like Expedia and Hotels.com may have tenuous competitive advantages, but that hasn't stopped them from growing by leaps and bounds. The industry is starting to see some consolidation and a strong move toward the merchant business model.

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By Rex Moore (TMF Orangeblood)
October 30, 2002

When you're planning a trip, do you start by booting up your computer? If so, you're among a growing number of travelers worldwide who head for the Internet to check airline flights, hotel accommodations, rental cars, and other related items. According to Forrester Research (Nasdaq: FORR), six in 10 U.S. households now research their travel online.

Despite the huge hit all things travel took following the 9/11 terrorist attacks, online sites rebounded quickly, and business is now as brisk as ever. And stock prices have followed suit: After an initial 40% drop, Expedia (Nasdaq: EXPE) and Hotels.com (Nasdaq: ROOM) were back to even just one month later and have since jumped about 70% in value.

Competitive advantage
A year ago, former colleague Mike Trigg wrote a column lamenting the lack of a sustainable competitive advantage for these companies. A traveler can choose from Expedia, Travelocity.com, Orbitz, Cheap Tickets, Priceline.com (Nasdaq: PCLN), and other such sites; up to this point, there's not been much to distinguish one from the other. (With the exception of Priceline's "Name Your Own Price" shtick, which doesn't seem like it will ever appeal to more than a small segment of consumers. I thought the method worked very well when used to sell gasoline, but the company stopped doing that long ago. I wish they would try it again.)

Because none of these businesses has attracted a majority of users, there's no "network effect" advantage for the leader. As such, "barriers to entry are low, and more than one company should be able to operate profitably," Trigg wrote. "That leaves the door open for new players to enter the market and quickly start growing in key metrics."

Looking back over the past year, however, no new major competitors have emerged, and it's looking more and more like none will -- barring a radical new method or some unforeseen pricing advantage. In fact, the industry has seen some consolidation, with Sabre Holdings (NYSE: TSG) -- which provides an airline database and related marketing services -- buying up Travelocity. Plus, Barry Diller's USA Interactive (Nasdaq: USAI) just abandoned its attempts to purchase all shares of Expedia and Hotels.com it didn't already own (settling for buying out Ticketmaster (Nasdaq: TMCS) instead).

Expedia's rally
Besides the consolidation and lack of new players, there's another interesting thing happening in the industry: Expedia is making a move that even Secretariat -- who won the 1973 Belmont Stakes by 31 lengths and driving -- would appreciate. Once the No. 2 player behind Travelocity, the former Microsoft (Nasdaq: MSFT) subsidiary pulled even a year ago. Now, Expedia has stormed ahead, doubling Travelocity's revenue. Profits, meanwhile, are up 100% over year-ago levels.

Why the huge move? The company will tell you it has a "technology advantage" over the competition, in the form of its fare-searching and information-management software. Its Expert Searching and Pricing (ESP) platform offers more priced itineraries to travelers and allows them to combine different elements to build vacation packages.

Still, that's not enough to explain the big growth spurt. Revenues and profits are, more likely, climbing because of well-placed advertising and attractive prices for travelers who shop around. In short, Expedia is becoming the most recognizable name in the game and may start to recognize some network effect benefits even if it will never entirely dominate the sector.

Light business model
What makes online travel sites so attractive at a time when the airlines and traditional travel agents are struggling? A light, high-margin business model.

Air carriers have to pay thousands of employees and spend huge amounts of capital just to get their planes in the air. In turn, they've made things hard for travel agents by drastically cutting or eliminating commissions, which has caused many of the agents to charge travelers fees for each ticket.

The major online sites still receive commissions, however, because of the large amount of business they send to the airlines. And because they don't have to charge a fee, they'll usually have better prices to offer consumers.

Mmmm... merchant model
The commission model is fine, but the so-called merchant model is even better. Under this method, a company receives inventory of blocks of airplane seats, hotel rooms, or rental cars at wholesale rates from travel suppliers. Then, acting as the merchant of record, it sells the inventory at a price it sets, pocketing the difference. This is usually a win-win situation, providing more profit and higher margins for the company and a lower price for the consumer. What's more, the business still carries no inventory risk because unsold rooms or seats are returned to the supplier within a certain time frame.

The merchant model has another advantage over the commission model in that it doesn't have to swim against the tide of lower and lower commissions from the travel suppliers.

It's obvious online sites prefer the more attractive alternative. Expedia's management, for instance, has expended great effort to shift its business in the merchant direction, and it's really paying off. For the six-month period ended June 30, 2001, revenue from commissions (or "agency revenue") nearly doubled merchant revenue. But just one year later, the company collected 35% more from the merchant model than the agency model:

                             Expedia
                    Six months ended June 30:
                      2001           2002
                     ------         ------
Agency revenues     $77,249        $106,541    
Merchant revenues    40,180         143,377    
Advertising and
other revenues       18,267          10,966
                   ---------       ---------
Total Revenues     $135,696        $260,884

For all of the online sites, you can expect merchant revenue to continue to grow, not only in an absolute sense, but as a percentage of revenues, as well. Those that aren't able to grow will suffer consequences, should the airlines ever decide to go the final mile and cut out commissions entirely.

Rex Moore just flew in from Chicago... and boy, are his arms tired! At time of publication, he owned shares of Microsoft. You are invited to view all of his holdings, as well as the Fool's disclosure policy, if you don't track in mud.