Shares of Priceline.com (PCLN) are making an attempt to break through the magical $1,000 level following the release of its second quarter results.
While I expect shares to breach the level on the back of a continued strong momentum, I am really cautious. Shares remain vulnerable to an unexpected slowdown in gross bookings, increased competition, or increased customer awareness of the true cost of its services.
Second Quarter Results
Priceline.com generated second quarter revenues of $1.68 billion, up 27% on the year before. Total gross booking rose by 38% to $10.1 billion. Revenues came in just ahead of consensus estimates of $1.66 billion.
Non-GAAP earnings rose by 26% to $508 million, or $9.70 per diluted share. Consensus estimates for non-GAAP earnings stood at $9.36 per share.
Net earnings rose by 24% to $437.3 million, resulting in GAAP earnings per share of $8.39.
CEO and Chairman Jeffery H. Boyd commented on the developments over the past quarter, "The Group's international and domestic businesses performed well in the quarter as the summer travel season got off to a strong start for our brands. We are particularly pleased by the Group's steady hotel room night growth and improving rental car unit growth, and with the growing momentum at the U.S. business of priceline.com."
Looking Into The Results
Revenue growth was driven by agency revenues which rose by 38% to $1.06 billion. Merchant revenues rose by a much more modest 5%, while advertising revenue ten-folded compared to last year, adding some $35 million in revenues.
Despite the revenue growth, the absolute cost of revenues actually declined. This boosted gross margins by an impressive 670 basis points towards 82.4%. The impressive margins gains were made undone by rapidly increasing operating expenses across all major categories. Operating expenses rose by a full 8 percent points to 49.3% of total revenues.
Looking Into The Rest Of The Year
Priceline.com remains optimistic about the future prospects, driven by a further expansion of its operations and integration of KAYAK.
For the current third quarter gross bookings are expected to increase between 27 and 34%. Growth is driven by international operations which should show a 32-39% increase in bookings, compared to growth of just 5-10% in the domestic operations.
Consequently, revenues will increase between 23 and 30%. All this will result in third quarter non-GAAP earnings between $15.30 and $16.30 per share. GAAP earnings per share are expected to come in between $13.75 and $14.75 per share.
Priceline.com ended its second quarter with roughly $6.0 billion in cash, equivalents and short term investments. Priceline.com operates with $2.25 billion in short and long term convertible debt, for a net cash position of around $3.7 billion.
Revenues for the first six months of 2013 came in at $2.98 billion, up 37% on the year before. Net earnings rose by 27% to $682 million. At this rate annual revenues could come in between $6.6 and $6.8 billion. Earnings could come in between $1.6 and $1.8 billion.
Trading around $970 per share, the market values Priceline.com at roughly $48.5 billion. This values its operating assets around $45 billion. As such, operating assets of the firm are valued around 6.7 times annual revenues and 26-27 times annual earnings.
Despite the immense profitability and strong balance sheet, Priceline.com does not pay a dividend at the moment.
Some Historical Perspective
Long term shareholders in Priceline.com have seen incredible returns. Shares traded at just $20 per share back in 2003 and have gradually moved to levels just above the $100 mark in 2008.
Shares fell back towards $50 in the second half of 2008, and have ever since shown an impressive performance as they gradually rose to all time highs, just below the $1,000 mark at the moment.
Between 2009 and 2012, Priceline.com has increased its annual revenues by a cumulative 125% towards $5.3 billion. Net earnings nearly tripled to $1.42 billion.
Investors and analysts remain widely enthusiastic about Priceline's prospects. The 38% increase in gross bookings remains really impressive, especially for a company the size of Priceline.com. Over the past quarter, Priceline.com reported gross bookings which exceeded the $10 billion mark for the first time in its history.
The international activities, which generate the vast majority of revenues, reported a 44% increase in gross bookings while the smaller domestic operations saw gross bookings increase by 12%. In hindsight, the 2005 acquisition of Booking.com has been a great deal as it has been the driver behind Priceline's international operations. The international performance is impressive given the continued troubled economies in Europe.
Competitor Expedia (EXPE) saw a 27% drop in its stock when it blamed weakness in Europe for the modest quarter. Yet its revenue growth rates and profit margins are inferior compared to that of Priceline.com. Consequently, Priceline.com's market capitalization is roughly 7 times that of Expedia.
Priceline.com's size is incredible. It saw hotel room reservations increase by 38% to 69.4 million, as it expanded the platform to 330,000 hotels. Priceline.com notes that it can still find new hotels to add to its platform, but diminishing returns are in sight as newly added hotels are typically smaller.
I remain impressed with the rapid growth in gross bookings which is entirely driving Priceline.com's valuation. I applaud management for generating these growth levels, yet I am a bit concerned. Gross bookings growth of 38% roughly matched the 40% expansion of the platform to 330,000 hotels.
This implies that growth at existing hotels is flat, assuming new additions generate the same number of bookings. In reality, "existing" hotels will most likely show modest comparable growth, while new additions are already experiencing diminishing returns in terms of gross bookings. These diminishing returns will continue going forward.
Another worry is the fact that total revenues make up an incredible 16.6% of gross bookings. This means that when you book a $100 hotel room, you will pay a very high $16.60 commission to Priceline.com. I would expect that increased competition and awareness among customers will push this ratio down.
As such, revenue growth will be trailing gross bookings growth into the future. The impact on the bottom line is more interesting. For now, Priceline.com has been using operating leverage to keep net earnings margins up, despite a declining revenue/gross bookings ratio. With net income totaling 4.3% of gross bookings, the company remains really vulnerable to negative operating leverage as "relative revenues", defined as total revenues divided by gross bookings, could come under pressure.
While Priceline.com is a dangerous short, and the psychological barrier of $1,000 will continue to create momentum in the coming weeks in all likelihood, I remain cautious. The absolute valuation is very high given some of these dangerous developments outlined above. Shareholders should not be surprised to see the stock lose a quarter of its value, just like happened to Expedia, in case one of these factors mentioned above materializes in a significant way.