Investing in the Online Travel Industry: Does Your Portfolio Need a Getaway?

The online booking option has actually been around longer than you think. American Airlines was an innovator with travel available at your fingertips, and it was only a matter of time before the Internet caught up.

With companies like Expedia (EXPE 2.01%) buying up the underdogs to fuel growth, one could question how it might hold up against current market leader Priceline (BKNG 1.41%).

A full transcript follows the video.

Sean O'Reilly: Pack your bags, Fools! We're talking about the travel industry, on this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly, joining you here from Fool headquarters in beautiful Alexandria, Virginia, just south of the nation's capital in Washington D.C. And to my left is the one and only Vincent Shen. How are you today, sir?

Vincent Shen: I'm doing well, Sean.

O'Reilly: So, we're talking about the travel industry, and I have a feeling we're not talking about travel agents, are we?

Shen: Virtual travel agents.

O'Reilly: Virtual? Oh, wow. Fancy. That's very poetic. We're going to be talking about the Pricelines and the Expedias of the world, but I actually did a little research before we came down here, aided by your friend Wikipedia. I found some interesting tidbits about how all this got started. Guess when the online travel industry actually -- what decade it actually first popped up?

Shen: I'm going to guess that it came around with the advent of the Internet.

O'Reilly: You're half right.

Shen: Half right? Why's that?

O'Reilly: One of these systems -- all of this goes back to online travel booking, getting started long ago in the 1970s.

Shen: Online travel in the '70s? How is that?

O'Reilly: Hear me out. American Airlines began offering travel agencies access to their electronic reservation system that was originally internal, and it's called Sabre. It's S-A-B-R-E.

Shen: I like that name.

O'Reilly: That happened in 1978, and that eventually found its way to America Online in the 1990s.

Shen: Oh!

O'Reilly: The crazy thing is, the Priceline's and the Kayak's and everything today, Sabre is still the internal system that they use to get flight data for searches that people run.

Shen: So, that's lasted 30, 40 years.

O'Reilly: Yeah. It's a 40 year old internal -- it's kind of like the Internet started as a military type -- that's what this was. It was an internal thing for American Airlines. So, they just treated travel agents, and we still use it today to get some of our American Airlines flights through Priceline.com and stuff.

Shen: Oh, wow! That's very interesting.

O'Reilly: The more you know. Ha, ha, ha. So Vince, how big is this industry? I assume we're going to be talking about billions, with a B.

Shen: Yeah. There's some -- it depends on how you look at it. Overall, the U.S. tourism market's $96 billion a year industry.

O'Reilly: Does that include international?

Shen: I'm actually no 100% certain on that. I think that is inclusive though.

O'Reilly: Either way, it goes groceries, cars, then travel.

Shen: Yeah. So, obviously a very big industry and with that in mind, for the online travel agents -- like these Priceline, Expedia, Orbitz (NYSE: OWW) companies -- they're definitely going through a period of very fierce competition. Not just among themselves, but there's new players coming in. ones that I've used recently myself. Things like Airbnb, and even Amazon (AMZN 1.49%) and Google (GOOG 1.43%) (GOOGL 1.42%) are kind of getting into the flight booking business.

O'Reilly: So, who are the major players as things stand now?

Shen: Well, originally people would talk about the big four who controlled about 95% if the online booking market. Those being Priceline, Orbitz, Expedia, and Travelocity. But those are going to quickly become the big two due to some...

O'Reilly: Very soon. We'll get to that in a second.

Shen: Due to the fact that Expedia, in the past two months -- in January and in February -- they scooped up two of the smaller players. Those being Travelocity and Orbitz.

O'Reilly: Yeah. One of the things that sticks out to me when I look at this industry like Priceline, is the number of websites that they'll own, because when we say they'll own the majority of the market, it's not quite a monopoly situation, but they don't do it through just their namesake websites. Like, Expedia.com, and Priceline.com. For example: Expedia, this website was originally owned and created by Microsoft -- fun fact -- it was actually Microsoft's first Internet property.

They own 30 localized sites in 30 different countries. Priceline actually makes something like 60% of its net income -- don't quote me, folks -- but a big chunk of that income in Europe through all these localized sites for each of the countries. But they've kind of perfected this model, because these companies literally mint money.

Shen: Yeah. They're doing very, very well. Like you said, when we talk about an Expedia or a Priceline they have this entire umbrella of sites and brands within their holdings. So, for example: Priceline has their Priceline namesake site, but they also have Booking.com, and they also picked up Kayak...

O'Reilly: RentalCars.com, Hotels.com, they own OpenTable -- booking a little restaurant action there. They just bought Asian based site Agoda.com. So, they've got scores of these sites, and it's just...

Shen: The OpenTable deal was definitely -- I'm glad that you mentioned that. They picked that up last summer for $2.6 billion.

O'Reilly: What did you think about that? It was a little...

Shen: I think the issue is, like I said, very heightened levels of competition, combined with the fact that right now these companies hold, overall, about -- I think it was something along the lines of 45% of total travel sales in the country.

O'Reilly: Oh, wow!

Shen: The issue is that a lot of what remains of that is done through specialist business. Like booking for business travelers where they're not going to be as concerned about their rates and things along those lines. So, they're reaching this point where things are capping off. So, what we're seeing is some of this consolidation, but also companies like Priceline are trying to move into unconventional areas to boost their growth.

O'Reilly: They can certainly afford it. I just hopped over to the S&P Capital IQ earlier; guess what their return on equity was for the last five years, on average.

Shen: For Priceline?

O'Reilly: Yeah.

Shen: Ooh, I've seen these numbers before. They're pretty impressive. 30%?

O'Reilly: Yeah. It's 36.98%. They got as high into the 40s, and for comparison, Warren Buffett, one of his favorite companies -- Coke -- is in the low 30s. So, they are minting money. It is staggering how much they -- free cash flow of $2.8 billion, and all this can be had for the low, low P/E of 21.

Shen: That's really surprising more than anything, actually.

O'Reilly: Well, it's lower than the other guys, isn't it?

Shen: Keep in mind that Priceline's current share price is almost $1200 a share.

O'Reilly: Stock split.

Shen: Market cap's around $60 billion, then they grossed their -- surprisingly, in 2014 -- their gross bookings were very similar to Expedia's. Gross booking around $50 billion and I was really surprised. Considering some of the growth numbers they've been putting up for their 5 year CAGR growth rate for their revenue and earnings were about 5% for the past five years. It's impressive.

So, 21 times for expected 2015 earnings for the multiple is not bad. Just for a little bit of context, Orbitz -- which got picked up in February by Expedia -- that $12 offer per share, which was a 25% premium to the last closing price -- was about 75x expected earnings for Orbitz. So, that's a pretty rich valuation.

O'Reilly: Yeah. That's what I couldn't figure out, because you look at Priceline and Expedia from an investment standpoint and Expedia is awesome as well. They've got a market cap of $13 billion, net income of $400 million, free cash flow each year over $1 billion and you compare that to Priceline. It's like "Okay, they're smaller, but they're doing equally well." Then it kind of staggers off from there because Orbitz are not nearly as strong a business. I'm like "why are they getting acquired?"

Shen: Well, I think it's just the fact that -- for Expedia especially -- the growth avenue is shrinking. So, it's ultimately and additive. I think they're expecting $75 million in cost savings, for example. So, within the industry it works for them. It also pushes them up a little bit so their market share for overall travel is about 6% -- Priceline's about 5% -- they're the two biggest once you factor in the combined entity. Keep in mind that Expedia with Orbitz is going to have Expedia, Hotels.com, Travelocity, Hotwire, Trivago, CheapTickets; that's a lot of...

O'Reilly: I forgot about Hotwire.

Shen: That pretty much is most of the sites that I've considered using when I look up hotels, airfare, and things along that line.

O'Reilly: Yeah. I think I'm a Kayak man. I don't know.

Shen: Well, Priceline likes that then.

O'Reilly: Yeah. They own that. So, what do you think is going to happen with the industry going forward five, ten years? Is this an "Okay, in 10 years it will be a duopoly and it that will be it. Slow growth, making tons of money, paying lots of dividends." Something like that?

Shen: That's tough to say. I think there's some new entrants to the market. There always seems to be something new in the industry. That could kind of shake things up. When we were walking down here I was telling you about Google. They paid $700 million for ITA software, which provided them with the technology that they need to essentially search the web, pull routes, pull fares, for their service called Google Flight Search.

So, that launched a few years ago. I don't think it's taken off significantly, but that's the kind of thing where, if Google decided to push their resources into it...

O'Reilly: What you're saying -- you don't think they want to?

Shen: I think the reason is -- some people argue the reason why they may be reluctant is because Expedia and Priceline, I'm sure you've seen some of their commercials -- they're huge ad spenders. I think the numbers for those two companies, they make up about 5% of Google's advertising revenue.

O'Reilly: 5% of all of Google's advertising revenues.

Shen: So, the issue there being, do they really want to cannibalize, or essentially get on the bad side of...

O'Reilly: Yeah, bite the hand that feeds you.

Shen: Yeah, very substantial customers.

O'Reilly: This is -- unrelated to what we're talking about, but it's kind of interesting how Google always sites non-search engines as a competition, because -- what was it? Sergey Brin -- somebody over at Google -- noted that Amazon is actually their main competition. When you go to look at something -- what a back hat costs, or something -- you go to Amazon, and not to Google. They want you to go to Google.

Shen: Yeah, you're right.

O'Reilly: It's interesting that they can't do the flights -- because logically you should just be able to type in "D.C. to Orlando" on Google, but they might get nervous if you do that.

Shen: Well, I'm glad you mentioned Amazon, too. There's somebody else who's known for having...

O'Reilly: Oh, that's right!

Shen: ...has a reputation for when they want to get into a new venture, into a new market, they're very aggressive. They are kind of testing the waters now with something called Amazon Destination. So, this is focused on a handful of select markets. New York, L.A., Seattle, and it's also focused on the idea of getaway destinations which are basically within a reasonable travel distance of these areas.

They only have -- I'm pretty sure the only offer is hotel bookings at the moment, but if things take off for this and they decide to go to a national level, who know what else that can mean for the competition in the industry.

O'Reilly: That Bezos is pretty much a relentless competitor. I checked that out -- that completely slipped my mine -- but, yeah. I checked that out when it came out. The Amazon new business line they have there.

Shen: Destinations.

O'Reilly: Yeah, and it has a very northeastern-y feel to it.

Shen: Oh, really?

O'Reilly: Yeah. It has a lot of "coastal Maine".

Shen: Well, there you go. That may have to do with, like I said, they're focused on a few of these markets. One of them being New York.

O'Reilly: Yeah. It seems like we've got -- the [..] entry you make a website, or obviously a little bit lower where you need the technology to be able to pull all this data and everything, but yeah. Maybe the Airbnbs and the Amazons and everything could actually generate some modest competition for Priceline's properties, and Expedia and stuff.

Shen: It's definitely possible. I think overall, after this M&A activity starts coming down, you have these two big players between Priceline and Expedia; they're certainly in really good positions though. I don't want to say that their growth trajectory is not good because they're going to be in a good position to sign up more hotels for their services, negotiate good rates for customers, negotiate commissions for themselves. So, the more market share they hold the better they're going to be for any negotiations.

O'Reilly: Yeah. It seems for these companies, at the end of the day, the proof to me that they're going to have bright futures has been their ability to create local websites. The success they've had -- one of the biggest barriers to a Wal-Mart right now for example -- they can't expand outside the United States to save their lives.

Target got destroyed in Canada and these American companies like Priceline where they've been able to create these localized websites in the local language, get locals to create the websites for them, and it's worked super well for them.

Shen: Yeah. The big market for a lot of companies these days -- a lot of them being in China -- I think China is now the biggest spender for tourism and travel, but I'm pretty sure a very small percentage of their bookings in that country are done online. So, there's a huge opportunity there as that develops. I would not be surprised if people are going to be scrambling trying to pick up a piece of that pie.

O'Reilly: For sure. Well, before we go do you have any -- if you had to pick one stock in this industry which one would you pick?

Shen: I think I'd go with Priceline. I really like the valuation. Like you said, some of the RE numbers are very impressive. It's not that I don't like Expedia, it's just that they picked up Wotif last year -- the Australian travel company. They have Travelocity in January, they have Orbitz in February; that's a lot of integration that they're going to need to do.

O'Reilly: Maybe need to slow it down, yeah.

Shen: And that's just a little bit of uncertainty and risk for them. I think Priceline, where it's at, is definitely a good option.

O'Reilly: Very cool. I happen to agree with you, for sure.

Shen: Cool.

O'Reilly: Very good. Well, thanks for your thoughts, Vince.

Shen: Thank you, Sean.

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