By Dan Su
Online travel bookings have grown by leaps and bounds over the past decade as consumers increasingly shift their travel research and reservation activity online for better price transparency and convenience. Online travel bookings ballooned to an estimated $385 billion globally in 2012, or about 40% of total travel spending (up from 32% four years ago), according to research firm PhoCusWright. As an important source of product innovation and data analytics that help better match travel suppliers with end users, online travel agents, or OTAs, and travel media have maintained impressive growth trajectories for revenues and profits over the past few years. And this has not escaped investors' notice. The stocks of Expedia (EXPE) and Priceline (PCLN) -- each with a narrow economic moat--posted cumulative gains of 230% and 520%, respectively, over the past five years, compared with a 20% increase in the S&P 500 Index. TripAdvisor (TRIP) saw its stock price rise by more than 80% in a little over one year following its spin-off from Expedia in December 2011.
During the next few years, we expect global players that benefit from economic moats (stemming from strong network effects) to remain attractive investment ideas. Growth prospects look particularly appealing in emerging markets such as Asia Pacific and Latin America, where online travel is still in an early phase and can benefit from favorable income growth trends, improving transportation infrastructure, and expanding travel inventories. In the coming years, online travel firms will continue to prioritize investments in mobile platforms and diversified marketing channels, which we view as essential to fortifying a long-term competitive position.
Major online travel players have carved out defensive economic moats
We believe major online travel players with extensive coverage in key geographies in the U.S., Europe, and Asia have defensive economic moats supported by network effects. Although switching costs may appear low in online travel at first glance, we believe travel suppliers and consumers gravitate toward large OTA platforms that consistently showcase their ability to consolidate the largest collection of travel inventories and distribute them efficiently. Huge transaction volumes (measured in billions of dollars each year) run through the Expedia and Priceline family of booking sites, which have made their platforms a highly coveted distribution channel for travel suppliers that are eager to list their services. This, in turn, increases the appeal of the booking sites to corporate and leisure travelers, thus setting off the virtuous cycle.
We expect network effects on these sites to grow in the coming years, driven by global network expansion, better connection with travelers via online/offline marketing campaigns, and technology upgrades that boost conversion for suppliers and further improve user experience. In our view, as OTAs and travel media firms expand their coverage globally, the scale and operational expertise built over the past decade will make them the preferred online distribution platform. We believe this applies not only to global brands but also to regional players keen to showcase their inventories for branding and to connect with new consumers who were more difficult to reach previously.
Thanks to strong balance sheets and free cash flows, leading OTAs and travel media firms are also in a better financial position to invest in online and offline campaigns to deliver differentiated messages and build better connection with travelers globally. Priceline alone spent $1.3 billion in online and offline marketing in 2012, a marketing budget that is hard to match by smaller rivals.
Robust technology platforms can also amplify the competitive position of top online travel firms as they expand globally. While these firms tend to standardize user experience on localized websites targeting different geographical markets, they can quickly integrate best practices from more established markets to fuel product innovation, and leverage technology know-how and data analytics to provide more precise marketing that better serve both suppliers and travelers.
Online travel companies benefit from secular tailwinds
Online travel companies have benefited from secular tailwinds in recent years, as travelers shift to travel research and booking on the Internet for better price transparency and convenience. We attribute robust growth in online travel bookings in recent years to (1) technology advancement, (2) aggressive online expansion of travel suppliers and hotels, and (3) the appeal of price transparency, wide selection, and smooth user experience that OTAs strove to provide. Also, we think airlines and hotels deserve credit for embracing the Internet as a distribution channel to drive up load factor and occupancy rates and for leveraging technology to dynamically manage their inventories with the OTAs.
That said, airlines tend to control a significantly higher portion of online bookings through their own websites compared with hotels, given a concentrated supplier base and the commoditylike nature of air travel. As a result, major OTAs usually rely on hotel bookings for the bulk of their revenues. Expedia, for instance, generated over 70% of revenues from hotel bookings in 2012, and we suspect the percentage is even higher at Priceline.
Over the next five years, we project booking volumes at Expedia and Priceline to increase at a 13.1% and 19.3% CAGR, respectively, thanks to share gain from offline channels and underlying travel demand growth (mainly in the emerging markets). We expect moderate contraction in revenue margins (revenues as a percentage of bookings) as the two leading OTAs move into each other's home courts, potentially driving down commissions on hotel bookings. In addition, commission rates can be less attractive in emerging markets, so a rising volume contribution from those regions in the future can also affect revenue margins. We have modeled revenues at Expedia and Priceline to grow at a five-year CAGR of 11.1% and 17.6%, respectively.
International markets offer attractive growth opportunities
The U.S. market has been a front-runner in online travel spending, accounting for about 45% of worldwide travel spending online in 2012. Secular tailwinds will continue to buoy online booking growth in the U.S. in the coming years, but we think the U.S. market will probably take a backseat compared with international markets owing to an already-high penetration rate of online travel (close to 60%), and fairly stable overall travel demand in air and hotel bookings. Easing visa restrictions for travelers from emerging economies such as China and India may be a near-term positive to travel demand in the U.S., although we expect the lift to overall volume and pricing levels to be fairly limited, with the benefits concentrating on a handful of international gateway cities such as New York and Los Angeles and on regions hosting major tourist attractions including the Disney theme parks and Las Vegas casinos.
We expect international markets to be a strategic priority for OTAs and travel media in the coming years, owing to solid volume growth potential and attractive commission opportunities. After several years of investments in technology infrastructure and localization efforts, we think these firms are poised to further expand their reach in the $700 billion international travel market. Volume growth in Europe will continue to be driven by share gain from offline distribution, while transaction volume growth in emerging markets will be fueled by a number of factors including the online shift, a boom in underlying travel demand, and growing travel inventories to distribute.
Attractive commission rates available internationally are another motivating factor. We attribute Priceline's faster volume and revenue growth compared with rival Expedia in past years mainly to its heavy exposure to international markets (80% of 2012 bookings compared with 41% at Expedia), where a less concentrated supplier base allows for higher commissions. In terms of booking revenue margins (booking revenues divided by booking volume), Priceline is consistently ahead by about 400 to 500 basis points. This explains why Expedia continued to reign in gross booking volume ($34 billion in 2012 compared with $29 billion at Priceline), but fell behind its main rival in revenue terms.
We see further room for growth in Europe, given lower penetration of online travel (compared with the U.S.) and resilient travel demand across the continent. Despite economic headwinds in recent years, Europe remains a massive travel market with an estimated total spend of over $300 billion (compared with about $290 billion in the U.S., according to PhoCusWright). The current penetration of online travel on the continent is about 42%, compared with 60% in the U.S. As various studies indicate that European consumers exhibit similar online shopping behaviors to their U.S. counterparts, we think online travel adoption will likely converge to U.S. levels in the coming years, which bodes well for travel booking and travel media sites.
We think Europe is shaping up as the next battlefield between Expedia and Priceline's Booking.com. As Expedia is keen to expand internationally, the first logical low-hanging fruit is Europe, and our view is supported by management comments, as well as the recent acquisition of Germany-based metasearch firm Trivago, which can feed high-quality travel shopping traffic in Europe to Expedia.com and Hotels.com. Competition will likely focus on hotel booking in Europe, as short-haul intraregion flights, budget airlines, and competitive rail and coach bus transportation make commission opportunities fairly unattractive in air ticketing.
We expect Expedia to have little problem matching Booking.com in hotel coverage for large cities such as London and Paris owing to its relationship with chain hotels, but Expedia will likely face tougher competition from Booking.com outside of major urban centers, where boutique hotels and bed and breakfasts account for the bulk of supply. In addition, we think Expedia will need to shift from the merchant model it used in the U.S. market to an agency model that is widely used in the Europe by Booking.com and other OTAs. Expedia moved in the right direction by introducing the option of booking through merchant or agency model on a selected number of hotels (less than 5% of total hotels). We expect Priceline to maintain a stronger presence in Europe compared with Expedia in the coming years.
Emerging markets offer attractive volume growth opportunities, but global OTAs may need to rely on acquisitions and strategic alliances with local players to make inroads into these promising markets. Thanks to the proliferation of Internet access and online payment systems, favorable income growth trends, and notable improvements in transportation infrastructure and travel supply, online travel spending in Asia Pacific and Latin America took off in the past few years, growing at 23% and 29% CAGR, respectively, between 2008 and 2012 (compared with growth rates of mid single digits in the U.S. and Europe). That said, online travel spending remains low in absolute dollar terms, and we see plenty of growth in online booking volume in the coming years, as transactions completed online now account for only 24% and 21%, respectively, in the two regions.
Global OTAs and travel media have all invested heavily in localized web properties catering to travelers in the emerging markets. Priceline, for instance, disclosed in quarterly filings that its websites can support 41 different languages. So far, we have not observed any meaningful success in growing organically in emerging markets. Instead, Expedia, Priceline, and TripAdvisor have all announced acquisitions and partnership with local players in Asia Pacific to quickly tap supplier relations and local knowledge of travelers.
In our view, Expedia is positioned relatively better than Priceline in the Asia Pacific region, thanks to its majority stake in eLong (LONG) (China's number-two OTA) and a 50-50 joint venture with AirAsia (the largest budget airline in Asia Pacific), allowing Expedia to build differentiated hotel and air packages. Priceline was an early mover in Asia with its acquisition of Bangkok-based Agoda in 2007, which has served the firm well in Southeast Asian markets, but Priceline continues to have difficulties gaining traction in the China market (where online booking volume was an estimated $30 billion in 2012, according to iResearch). Priceline's Booking.com recently partnered with Ctrip (CTRP), the largest OTA in China. However, we think the partnership is aimed at distributing the inventories on Booking.com to outbound travelers from China, but will offer little help for Priceline/Booking.com to grow within the country.
Mobile and diversified marketing channels are investment priorities to reinforce long-term competitive position
Resulting from the proliferation of smartphones, tablets, and other devices, travel-related traffic and transaction volume originating from mobile devices have been on a steady rise in recent years. Mobile traffic as a percentage of total traffic/transaction volume was in the low- to mid-single digits on the online travel platforms three years back, but the ratio jumped to about 20%-30% according to management comments on the most recent earning calls.
In our view, top online travel players deserve credit for investments in optimized mobile sites and mobile apps (through in-house development and acquisitions) that position themselves competitively for the rapid mobile traffic growth. Better brand awareness of incumbents compared with startups also helps, as consumers are much more likely to download an app from a well-known provider. Expedia, Priceline, and TripAdvisor all have top-ranked free mobile apps in the travel category on the Apple iOS and Android platforms. We also note that Kayak, which will soon be acquired by Priceline pending regulatory approval this year, has mobile apps that rank among the top 10 on both iOS and Android, ahead of apps from Priceline and its subsidiary Booking.com. We think Kayak's strong mobile apps are an important factor in the valuation equation for the $1.8 billion acquisition.
At the moment, we think contribution from mobile devices in terms of booking volume and revenues is still fairly low, given behavioral differences of travelers on their mobile devices. This is particularly true on smartphones, where travel-related traffic tends to be on-location and the demand usually leads to last-minute bookings. The usage pattern on tablets, meanwhile, tends to more closely resemble that on PCs for travel research and booking. It may take online travel firms some time to recalibrate monetization strategies in the mobile Internet to better leverage the robust mobile traffic growth in the coming years. We think it's reasonable to expect mobile terminals to account for one third of total revenues for online travel firms over the next three to five years.
Another strategic priority for online travel firms in the coming years will be building multichannel marketing, which we view as crucial in sustaining long-term competitive position in the fast-evolving online travel space. The strategy involves incorporating new channels including metasearch, social media, and offline media outlets, in addition to search engines (Google in particular) that used to account for the bulk of advertising spending at top OTAs. Executed properly, the strategy should help deliver coherent and effective messages via multiple touch points with travelers that eventually drive loyalty, user experience, and traffic conversion.
We think online travel firms are consciously shifting the mix of ad budget away from search advertising, although the shift is likely gradual and executed based on specific market conditions in different geographies. Historically, search advertising has been a meaningful traffic acquisition tool for OTAs and travel media firms. According to comScore data, Google accounted for about 10%-25% of global traffic on major online travel sites. Recently, we noted comments from OTAs that pointed to less attractive ROIs on search ad spend, probably as competition for traffic drove up cost per click. We think this could motivate these firms to explore other channels for efficiency. Just as important, given Google's apparent ambition for online travel (with the acquisition of ITA, Zagat, and Frommer's, and the release of flight and hotel search products), we believe the move to limit dependence on Google makes good sense for online travel firms. That said, we think search advertising will remain an important component in the marketing strategies in the coming years due to measurable results, especially in emerging markets, where brand recognition is a near-term priority.
Metasearch is clearly perceived as another attractive alternative channel. In our view, the fact that Priceline and Expedia announced acquisitions of metasearch firms Kayak and Trivago within the span of two months at the end of 2012 was not mere coincidence, but a clear signal that the attractive positioning of metasearch firms in the funnel of travel shopping traffic appeals to OTAs. Once Priceline and Expedia integrate their traffic management tools and travel inventories with the metasearch platforms, we expect to see a boost to conversion rates of research and shopping traffic into transactions on the OTAs.
Social media such as Facebook (FB), Twitter, Tumblr, and Pinterest are gaining influence as a branding and marketing channel in online travel. OTAs and travel media admit they are still experimenting with various strategies to explore the social graph of social media users, emphasizing that traffic growth and revenue contribution are not near-term goals, but they all expect to tap social media to build brand affinity, connect with travelers, and create a sizable database for opt-in marketing. TripAdvisor, the most aggressive in social media marketing among the online travel firms, sees Facebook as a platform to drive membership, increase review contribution, and spread the concept of "wisdom of friends" to deepen engagement with users. Currently, Facebook users account for 35% of new reviews on TripAdvisor sites, and Facebook marketing has helped TripAdvisor double marketable members to 44 million in the past year.
Top online travel players are well-followed growth stories that are fairly valued
The online travel names on our coverage list are fairly valued in our view, with a median price/fair value estimate ratio of 1.07. Given impressive revenue and free cash flow growth in recent years, and continued secular tailwinds globally, we think top players in the online travel sector are well-followed growth stories, and that profit growth potentials over the next several years are reflected in the current valuation.
With shares trading at a 13% discount to our $780 fair value estimate, we view narrow-moat Priceline as offering a relatively more attractive risk/reward balance. Our $780 fair value estimate on the stock is based on assumptions that Priceline can grow travel bookings and revenues at 19.3% CAGR and 17.6% CAGR, respectively, over the next five years and maintain operating and EBITDA margins in the mid-30s. The stock trades at 21.3 times our 2013 EPS and at a price to fair value ratio of 0.9. Historically, Priceline traded at a valuation premium to its closest rival, Expedia, given more attractive international exposure, but the stock was under pressure in 2012 related to investor worries about European consumers and currency headwinds.
A string of statistics out of Europe in recent weeks seems to suggest that although local economies are still in the doldrums, risks of a severe, broad-based recession in the near future are not high. In addition, we think investors are not as preoccupied with worries of a catastrophic collapse of the euro monetary union. Both trends bode well for more stable operational results for Priceline, in our view. We'd also note that Priceline was able to post a 40% increase in hotel booking volume in 2012 (compared with 26.4% at Expedia) despite heavy exposure to Europe, which supports our view that a well-established supplier network and strong track record can continue to buttress Priceline's position in Europe and that travel demand on the continent is more resilient than many investors had expected.
The biggest risk to our fair value estimate remains the economic conditions in Europe, which can weigh on hotel booking volume, average daily rates, and commissions that Priceline and its Booking.com subsidiary can earn. In addition, Expedia may prove to be a tougher-than-expected incumbent in the U.S. market, given its solid supplier base and recent efforts to woo travelers by offering the choice of booking with either merchant or agency model.