A new (big) baby is born
Barry Diller's InterActiveCorp (NASDAQ:IACI) recently delivered Expedia (NASDAQ:EXPE) to the stock market. The leading online travel website competes with companies including Travelocity, a subsidiary of Sabre Holdings (NASDAQ:TSG); Cheaptickets.com, a subsidiary of Cendant (NYSE:CD); and Priceline.com (NASDAQ:PCLN). The company is on track to generate roughly $240 million in net income for the forthcoming year and about $2 billion in revenues, according to its most recent filing with the Securities and Exchange Commission. By my estimation, that places the company at a forward P/E ratio of 28, with 310 million shares outstanding. Considering that you get a choice collection of Internet properties that includes Expedia.com, Hotels.com, Hotwire.com, and TripAdvisor.com, this sounds quite cheap.
The company generates revenues through two models: an agency model and a merchant model. Under the merchant model, Expedia facilitates the booking of travel services from its suppliers and serves as the merchant of record for the transaction. This approach generates higher net revenues for Expedia, but it also incurs higher costs, since Expedia pays credit card fees based on the entire transaction amount. Expedia naturally has to pay its suppliers the vast majority of the transaction amount, and that decreases Expedia's margins. For example, on a $500 flight ticket on which Expedia takes the full $500 as gross revenue, Expedia may pay Delta (NYSE:DAL) $485, keeping $15 as net revenue, but then may pay out $5 in credit card fees (using a 1% rate), and that leaves profit at only $10.
The agency model, in contrast, is one in which Expedia simply passes the transaction along to a supplier and collects high-margin fees and commissions for doing so. Credit card fees have to be paid only on the fees Expedia collects, as opposed to the entire transaction amount. Using the Delta example above, Expedia would retain $15 in commissions as revenue and pay only 15 cents in credit card fees (1% of $15, instead of 1% of $500), thus keeping $14.85 in profit. Happily for Expedia, agency revenues made up 58.5% of its total gross bookings for the six months so far in fiscal 2005 -- a figure that's up nicely from 57.6% over the same time period in fiscal '04.
Could I recommend this one blindfolded?
It is true that Expedia and InterActiveCorp operate in highly competitive industries, but they are also the largest and strongest players in most of their niches. Expedia.com, Hotels.com, Tripadvisor.com, and Hotwire.com are some of the most popular sites on the Web, far outdistancing their competitors. Today, according to Alexa.com, Expedia is reaching 8% of all Web users, up from just 4% in January 2005, which is when Diller announced the spinoff. That's twice the reach that competitors Orbitz and Travelocity enjoy. The number of eyeballs upon any given site, while not a valuation metric anymore, is still king, and Expedia holds the title.
But a closer look at the biz model reveals that it's not without its faults or potential pitfalls. The largest potential threat lies in the form of a price war. Why? Well, we're not dealing with the sort of situation wherein Expedia or any other service can offer customers a particularly differentiated service -- all of them offer an online site at which you can make travel arrangements. Hence, it's not particularly unreasonable to think that airlines will squeeze the likes of Expedia and its peers on commissions (on agency and merchant fronts), in an attempt to pinch a few pennies here or there. The logical endgame to such a situation, were it to play itself out, would be lower prices across the board.
Further, it's easy to imagine customers who don't see the costs of switching as being too high. Were this to happen, we'd likely see some degree of margin compression, relatively lower earnings growth on a company-specific basis, lower earnings growth, and higher costs of customer acquisition -- i.e., more money at the margin to marketing expenses.
Looking for a parallel? You needn't look too far. Fellow online retailer Amazon.com has seen a similar, though less pronounced, effect in recent earnings releases. In conjunction with price cuts, similarly positioned entities -- or competition, as you might call it -- have taken a bit of a toll on the company. The impact, in my estimation, has come in the form of slowing revenue growth, increased marketing costs (on forays into new arenas and continuous attempts to acquire new customers in its core areas), and slowing return on investment -- which should soon enough manifest in substantially lower operating margins. The company has not lost its lead within its respective realm, but the cost of maintenance has the potential to become prohibitive.
The rationale? Well, it's easily duplicated. The name and brand aren't, but the business is -- to an extent. Anyone can sell goods online, and scalable returns are readily attainable once companies achieve breakeven results. So what keeps an online purveyor -- Expedia or otherwise -- on top?
Well, it's the very thing that has kept Amazon on top -- network effects. We can't be particularly sure of the magnitude or strength of the aforementioned, but it's the kind of thing that keeps eyes on a given site and keeps people visiting a store or trying new services. And in my opinion, Expedia stands strongest among its "travel brokerage" counterparts. The trouble is that network effects are not tangibly measured, and accordingly, we're hard-pressed to determine the extent to which Expedia might grow, or the extent to which it might fall subject to increased competition moving forward.
How does it look now? Well, I think it looks quite all right and that it might continue to. Read on, Fool.
The numbers look good!
The company itself is performing extremely well. Through the first six months of fiscal 2005, revenue has risen 16% to $1.04 billion and net income more than 100% to $121 million. This is a somewhat pedestrian 12% profit margin, but I expect management to cut costs and focus on new growth areas, particularly given the company's ability (in my opinion) to manage itself better without the overhang of InterActive.
The company is pushing hard into international travel, with gross bookings up 66% year to date to $1.8 billion, or 21% of revenue. Since Expedia does not break out income by geographic segment, it is difficult to tell whether the international growth is at a higher margin than the domestic market. I tend to believe that the marketing expenses will tail off after the initial build-out. Expedia's site should be able to scale very well and eventually offer better margins than it does for the U.S. market, if it is not doing so already, since there is no obvious leader in the aggregator market, and because the market is in an earlier stage of penetration.
However, individual international airlines such as Ryanair and EasyJet offer strong competition, so it's not an easy market to break into. While the two airlines do not represent direct competition to Expedia, they do have a large presence in Europe, and they historically book a heavy percentage of travelers through their websites, not through brokers like Expedia. Combined with the fact that Ryanair recently offered free tickets (travelers would pay only about $18 in fees) to just about every major destination in Europe from London, it will be tough to compete.
This is the primary driver of international marketing expenses, which increased substantially as the company works to build its presence outside the U.S. market. Again, like Continental (NYSE:CAL), this is a stock with which long-term growth will come outside the U.S. market, and the company is investing intelligently now to build the groundwork for future growth. As an example, Expedia Italy and Expedia France combined for $135 million in gross booking in their first full year of operation -- not too shabby!
In summary, I believe that we have a compelling investment opportunity with Expedia. The company looks to be mispriced in the market, and it offers a substantial upside, by my estimation. The valuation is reasonable at 24 times trailing-12-month earnings, which is the nearly the same as Priceline's, at 25 times trailing-12-month earnings. Expedia also has 12% net margins versus Priceline's 3.5%, and the two sport comparable growth rates. While Expedia's expected growth for the next five years is 15% according to analysts, I still consider the company to be undervalued, because I think these growth estimates are achievable, and even exceedable. And a small premium on the P/E for consistent growth is worthwhile, in my opinion. I estimate that the company will generate about $900 million in free cash flow this year, a figure that would place Expedia at seven times FCF. To me, on a FCF basis, this seems a reasonable price for what I'd call a blue-chip Internet company that's finally available to shareholders for purchase (again).
Priceline and Amazon are Motley Fool Stock Advisor recommendations. Cendant is a Motley Fool Inside Value selection.
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Stephen Ellis welcomes your feedback . He owns stock in CAL, and he also dances when no one is watching. The Motley Fool has an ironclad disclosure policy.
