Expedia’s $62 Fair Value: Expansion Opportunities Outweigh Margin Pressures

Leading online travel agency (OTA), Expedia’s (NASDAQ:EXPE) stock lost one-fourth of its value after it announced its Q2 2013 results on July 25. The quarterly results disappointed investors as net income declined by more than 30% y-o-y despite 16% growth in revenues. The impact on the bottom line was attributable to operating expenses that grew faster than revenues to counter competitive forces and retain market share. (Read: Expedia’s Stock Shows Warning Signs As Competition Sinks Results)

In the first half of 2013, while Expedia’s EBITDA margin faced high pressure owing to heavy advertising from competitors, the company’s ADR (average daily rate) growth remained flat due to the growing contribution from low ADR hotel bookings in Asia. As competition gets more intense in the future and slow growth in the US market compels Expedia to pursue international expansion, we believe the company’s EBITDA margin and ADR will grow slower than our initial estimate.

Our price estimate of $62 for Expedia marks our valuation at a premium of about 25% to the current market price. In this article we highlight the key factors behind our downward revision from $70.

International Expansion Will Lower ADR Growth

With over 40% market share, Expedia is the dominant OTA in the U.S. and the world’s largest travel market. However, the slow growing and highly competitive US market is pushing Expedia to pursue international markets for future growth. International points of sale currently account for 43% of total gross bookings at the company, up from 41% in 2012. Expedia is rapidly growing in Asia via its partnership with the Chinese OTA, eLong. Despite the ADR at US hotels reaching their all-time high in Q2 2013, Expedia’s ADR remained flat in the quarter as the company’s growth in the low ADR Asian market was much higher than other regions. ^[1]

Expedia plans to continue expanding aggressively in the highly lucrative and vast Asian travel industry. While the growth in Asia and the company’s pursuit of international expansion will increase booking volumes, we believe it will counteract ADR growth achieved by Expedia in the U.S. and Europe.  Hence, we have lowered our forecast for annual ADR growth from the average of 4.5% earlier to 2%, for the rest of our review period. Since the OTA space is highly sensitive to fluctuations in ADR, the change led to approximately 15% decline in our price estimate for Expedia.

Rising Competition To Put Continued Pressure on EBITDA Margins

Expedia admitted that it faced escalated competitive forces, particularly in TV advertising, in Q2 2013. Its Hotwire.com and Hotels.com brands were adversely affected in the quarter as Priceline (NASDAQ:PCLN) heavily advertised its Express Deals offering and the booking.com brand. Additionally, extra dollars were spent on the recently acquired Trivago and eLong to fuel growth in these businesses. This hurt Expedia’s EBITDA margins in the quarter. ^[2] With Priceline continuing to heavily advertise as well as Travelocity and TripAdvisor (NASDAQ:TRIP) increasing offline advertising activity in the U.S., there seems to be no respite for Expedia this quarter as well. ^[3]

In Q1 2013, the company estimated full-year adjusted EBITDA to grow in low double-digits to low teens. However, it has now lowered the guidance to mid to high single-digits. ^[2] Following this, we have lowered our forecast for full-year EBITDA margin to less than 17% from about 20% earlier.

We expect competition to be a major factor influencing EBITDA margins in the future as well. In addition to growing sales and marketing expenses, we believe Expedia will have to increase investments in building technology and content. Thus, the company’s EBITDA margin might only see slight growth in our view as booking volumes and efficiency rise. We expect Expedia’s EBITDA margin to cross the 17% mark in 2015 and remaining around these levels thereafter. The revision in EBITDA margin forecast led to 5% decline in our price estimate for the company.

Rising Agency Model Revenues Will Drive Down Revenue Margin On Hotel Bookings

In the back half of 2012, Expedia launched the Expedia Traveler Preference (ETP) program that provides customers with an option to choose between paying at the time of booking (merchant model) or at the time of checking out of the hotel (agency model). Under the agency model, net revenues are generated in the form of commissions and bookings fees which results in lower revenue margins. On the contrary, in the merchant model a user bids for services and the booking is completed on Expedia’s website itself, which offers scope for charging higher margins.

During 2010–2012, merchant model revenues grew faster than agency model revenues. Consequently, the revenue contribution of agency model declined from 24% in 2010 to 22% in 2012. ^[4] However, hoteliers (especially in Europe) are now showing a growing preference for ETP as it offers their guests the option to pay at check-out. More than 30,000 hotels have signed up for the ETP program since its launch. This has resulted in agency model revenues growing faster (25% y-o-y) compared to merchant model revenues (14% y-o-y), in the first half of 2013. ^[5]

With a large number of independent hotels and a highly fragmented hotel industry, the Asian landscape is similar to that of Europe where guests prefer the agency model as it does not eliminate scope for cancellations. We believe Expedia’s customers will adopt ETP program at a fast pace as the program is rolled out fully across the region and internationally, leading to further increases in revenue contribution from the agency model. Since revenue margins are lower under the agency model, we estimate Expedia’s overall revenue margin to decline to about 17.5% by 2019, compared to our earlier forecast of 18.3%. The revised forecast lowered our price estimate for the company marginally.

Understand What Drives a Stock at Trefis

1. Expedia Misses Again, Shares Crash, Zacks Equity Research, July 26, 2013 [↩]
2. Expedia Q2 2013 Earnings Call, Seeking Alpha, July 25, 2013 [↩] [↩]
3. Unprecedented TV Advertising Blitz By Expedia, Priceline and Travelocity, Skift, August 31, 2013 [↩]
4. Expedia 10-K, www.sec.gov, 2012 [↩]
5. Expedia 10-Q, www.sec.gov, Q2 2013 [↩]