What Trends Are Behind Expedia’s $69 Valuation?

Expedia (NASDAQ:EXPE) is a leading online travel agency (OTA) that connects travelers with travel suppliers such as hotels, airlines, cruises and car rental companies. It operates several online travel portals including expedia.com, hotels.com and hotwire.com. The company also operates a corporate travel business, Egencia, which seeks to optimize travel costs and improve travel experience for employees of its corporate clients.

Despite persistent weakness in the global economy, Expedia’s has show double-digit top line growth consistently. We expect the company’s expanding geographic footprint and investments in technology infrastructure to drive further growth in the top line. However, we feel the growth rate will steadily decline to 5% by the end of our review period due to high competition from other OTAs and travel suppliers.

In this article we provide a snapshot of how Expedia makes money, the important segments that contribute to its growth and the key factors driving its valuation.

See our complete analysis for Expedia

Who Are Expedia’s Customers? How Does The Company Make Money?

Expedia’s customers include travelers and travel suppliers. Business and leisure travelers book airlines, hotel, cruises and car rental packages while travel suppliers advertise on the company’s website.

Expedia’s business model generates money via:

1) Transaction booking/processing fees per transaction, or buying travel inventory in bulk at discounted prices and selling the same to customers at a premium; an additional account management charge is applicable for corporate clients

2) Advertising fees (pay-per-click or flat fees) paid by travel suppliers for advertising on Expedia’s website

Important Segments That Contribute To Expedia’s Growth

Expedia earned about $4.3 billion in revenues in 2012, with a profit margin of 17%. Since 2009, the company’s top line has grown at double-digit annual growth rates.  On the contrary, operating margins have declined by 5 percentage points as rising competition from other OTAs and meta-search companies pushed Expedia to increase its marketing expenses, and invest in technology and content to stay competitive. While we forecast Expedia’s revenue to increase driven by expansion to new geographical markets, investments in product innovation and growth in mobile bookings, we expect operating margins to remain range bound due to intensifying competition in the industry.

The key segments contributing to Expedia’s growth are:

1) Hotel Bookings Constitute 70% of Expedia’s Value

Apart from being the highest contributor to Expedia’s revenue (74%) among all segments, the hotels division also has the highest revenue margin of close to 20%. Gross bookings at the division grew at a rapid pace of 32% in 2011 and 27% in 2012, as travelers switched from traditional methods to online mode for reservations.

Expedia currently derives 41% of gross bookings and 45% of revenue from international operations, which it aims to scale up to more than half of its revenue. The acquisition of Trivago, a German meta-search company in 2012, has helped Expedia expand its network of hotels and build a stronger foothold in Europe. Trivago has an inventory of more than 600,000 hotels (before Trivago acquisition Expedia had only 200,000 hotels), over 140 booking sites in 23 languages, across 30 countries in Europe.

We expect Expedia’s expanding list of hotels and growing international presence to propel the growth in gross bookings at more than 10% annually till 2016. Thereafter, we forecast the growth rate to slowdown owing to high degree of competition from other OTAs, meta-search companies and hotels that are increasingly selling their services online. We also expect revenue margin to decline as a result of processing, cancellation and change fee waivers from OTAs and travel suppliers in an attempt to gain a competitive advantage.

2) High Industry Competition Putting Cap On Airlines’ Commission

Although airline tickets accounts for 11% of Priceline’s gross bookings, its revenue contribution stands at only 8%. The airline industry has a highly competitive environment with very low profitability. Along with demand volatility, the industry witnesses much higher supply rates than demand, causing overcapacity. Thus, airline companies charge minimal airfares to fulfill capacity.

More importantly, airlines are increasingly selling tickets online directly from their own websites, thereby eliminating the need for OTAs. This leaves less scope for Expedia to earn commission on bookings made through its site. We expect revenue margin for the airlines division to gradually decline from 2.1% in 2012 to 1.5% in 2019.

Even with such low margins, bigger OTAs such as Expedia continue with air ticket bookings as these form an integral part of airline travel. Bigger OTAs can also easily bundle different products and services into a packaged offering.

As global economic conditions improve and consumers move from traditional to online method of ticket booking, we believe the division’s gross bookings to more than double by the end of the forecast period.

3) Cruises & Car Rentals Present Opportunity To Enhance Revenue

The cruises and car rental services division contributes 10% and 8% to Expedia’s gross bookings and revenue, respectively. Historically, cruises and car rental services were bundled with destination services or vacation packages. In recent years, these services have seen higher demand leading OTAs to offer these as stand-alone services. Given that these were earlier often bundled with other offerings, there is scope for charging higher prices in order to enhance revenues. However, we expect suppliers to cut down on distribution costs to stay competitive, which will drive down Expedia’s booking commission on cruises and car rentals.

4). Egencia Corporate Travel Business To Grow As Businesses Recover

Expedia’s Egencia brand, the world’s fifth largest travel management company, offers managed travel services to corporate travelers in North America, Europe and Asia-Pacific. Egencia’s revenue contribution to the company stood at 5% in 2012, and it earned the lowest profit margin (12%) among all divisions of the company, due to cost cutting initiatives by corporations in face of the slow global economic recovery.

As Egencia expands its geographical footprint and invests in technology infrastructure to enhance business travelers’ experience and cost savings, we expect revenues to see high single-digit growth. Additionally, the acquisition of VIA travel, the largest management company in Nordic countries, will help Expedia build a considerable presence in international markets. Also, as recovery from the recession speeds up and demand for business travel rises, we expect booking volumes to increase and fixed costs to decline, leading to higher profit margins in the future.

5) Advertising Revenue To Rise Along With User Traffic

The advertising division contributes the least (3%) to Expedia’s revenue, which we do not expect to change significantly during our review period. As Expedia expands its international footprint and user base, we expect advertisers (primarily travel suppliers) to be attracted to the website, and revenue from advertising to grow at an average rate of 9%.

Our price estimate of $69 implies upside potential of about 10% to Expedia’s stock.

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