Expedia's Big Miss: Mark Mahaney's Take (EXPE)

Citigroup analyst Mark Mahaney on Expedia's (NASDAQ: EXPE) disappointing quarter:

Expedia reported March quarter revenue of $494MM, OIBA of $88.5MM, and Adjusted EPS of $0.15 vs. our estimates of $534MM, $127MM, and $0.22, respectively. That’s a BIG MISS.

Working through the results, total gross bookings came in slightly weaker than expected at $4.65BB vs. our $4.70B estimate -- around 1% lower than we expected. U.S. gross bookings Y/Y growth of 10% was below our forecast of 12% Y/Y, while International gross bookings growth of 26% (34% ex-FX) was only modestly lower than our 27% estimate.

Interestingly, that 34% “organic” International gross bookings growth was stronger than the 28% Y/Y growth in H2:05.

The company cited two factors behind its soft domestic bookings performance. First, a traffic shortfall, which the company blamed both on a non-effective “Enjoy Your Trip” marketing campaign and on material underperformance with 3rd party distribution deals, singling out MSN. The second factor was a lower than expected conversion rate due to reduced site availability, increased competition, higher supplier pricing, and tight inventory in select markets. While there’s an element of cyclical challenge in here, we believe there is clearly a large element of negative structural factors at work. Near-term fixes seem improbable.
The biggest issue, however, was with the revenue, as EXPE reported revenue that was $40MM or 8% lower than our $534MM estimate. Domestic revenue was $371MM, DOWN 4% Y/Y and down 2% Q/Q. That’s around $41MM or 10% lower than our $412MM estimate. Key point: the Domestic take rate, defined as revenue divided by gross bookings, was much lower than we expected at 10.6% vs. our 11.6% estimate due to significant margin pressures in hotels (7% decline in revenue per room night) and air (9% decrease in revenue per air ticket). One benign factor here has been rising airfares. As Expedia’s air unit economics are mostly fixed, an increase in airfares has the effect of lowering take rates.

International revenue was $123MM, up 24% Y/Y and up 7% Q/Q, and essentially in-line with our estimate.

The disappointing revenue results drove the OIBA miss. Gross margin was modestly weaker than we expected (76.5% vs. 77.5% est.) and core opex was roughly in-line with our estimates ($289MM vs. our $287MM estimate). Accordingly, OIBA of $89MM was $38MM or 30% lower than our/Street estimate of $127MM. That’s a huge miss and explains the company’s downward revision to OIBA guidance for full year 2006.

Did EXPE’s fundamentals improve? No, they got a lot worse. Organic revenue growth of 2.2% (ex-FX and acquisitions) was materially lower than the 10.5% Y/Y growth in the December quarter. OIBA margins were down 1,030 bps Y/Y and 900 bps Q/Q to 17.9%. Both the organic revenue deceleration and the OIBA margin contraction are awfully steep on a Q/Q basis.

Were fundamentals better than the Street expected? No. Revenue of $494MM, OIBA of $89MM, and Adjusted EPS of $0.15 missed Street expectations for $544MM, $127MM and $0.22, respectively.

Did the company raise guidance relative to the Street? No. Last quarter EXPE provided broad OIBA guidance of negative high single-digit OIBA “growth” in 1H:06 and positive OIBA growth in 2H:06 which implied flattish-to down OIBA growth (depending on just how positive that positive actually is). Now the company is guiding to NEGATIVE Y/Y OIBA
growth of 5%-15% for 2006.

Positives From The Quarter
1. Hotels.com gross bookings strength – Hotels.com continued its turnaround, with gross bookings up 20% Y/Y to $582MM, the highest total we’ve seen. Naturally we’d like to know what this means on the bottom line, but it sure beats the Y/Y bookings declines back in March and the single-digit growth rates of the June and September quarters.

2. 20MM share buyback – EXPE’s Board did authorize a 20MM share buyback (around 5% of shares outstanding). The company has around $509MM in cash and equivalents or around $1.37/share.

3. Strong FCF/EBITDA conversion – FCF/EBITDA conversion on a TTM basis was 119%, which is pretty good (although FCF declined 9% Y/Y).

4. No negative Core Opex surprises – Core Opex, defined as Sales & Marketing, G&A, and Tech & Content, was roughly in line with our estimate ($289MM vs. our $287MM estimate). In the current environment that’s a positive, although management did highlight issues in its marketing spend.

Negatives From The Quarter
1. Deteriorating fundamentals – Organic revenue grew 2.2% Y/Y (excl acquisitions and FX), down from 10.5% Y/Y in December, 13.6% Y/Y in December, and 8%Y/Y growth in June. OIBA margins were down 1,030 bps Y/Y and 900 bps Q/Q. We highlight below our organic revenue growth calculations:

2. “This year will be a rough year for Expedia” – These were Chairman Barry Diller’s words, not ours. Worst case scenario, they’re guiding to full-year OIBA of around $533MM, down 15% Y/Y. The magnitude of the revision is surprising. EXPE clearly has a lot of issues to work through, including a disappointing MSN relationship, continued supplier pressure in air and hotel (lower margins as well as reduced merchant inventory in select markets), lower conversion rates, and weak traffic trends. Want to get away? We empathize.

3. Revenue margins continue to trend down – The overall take rate (revenue/bookings) this quarter was 10.6% this quarter, down 130bps Y/Y. That’s 80 bps lower than we expected, and we believe that revenue margin will continue to decline going forward. Domestic revenue margin declined 150bps Y/Y while International declined 20 bps Y/Y. As we noted in our EXPE quarterly preview, overall revenue margin likely understates weakness in the core business, as EXPE has made acquisitions that generate revenue with no corresponding gross bookings (most notably Trip Advisor, acquired for $210MM in March 2004). And ongoing negotiations over GDS (Global Distribution System) economics are almost certainly going to add additional pressure later this year to these margins.

4. Cyclical challenges, yes, but clearly structural factors as well -- Increased competition, higher supplier pricing, and tight inventory (for both air and hotel) in select markets...and GDS fee compression will only add to the mix. While there’s an element of cyclical challenge in here, we believe there is clearly a large element of negative structural factors at work. Near-term fixes seem improbable.

Based on March quarter results and the company's outlook, we have changed our estimates
as follows: