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Priceline.com Incorporated (NASDAQ:PCLN)

Q3 2006 Earnings Call

November 8, 2006 4:30 pm ET

Executives

Jeff Boyd - President and CEO

Bob Mylod - CFO

Analysts

Aaron McCann - Goldman Sachs

Aaron Kessler - Piper Jaffray

Mark Mahaney - Citigroup

Heath Terry - CSFB

Chris Gutek - Morgan Stanley

Justin Post - Merrill Lynch

Bridget Wysha - JP Morgan

Scott Devitt - Stifel Nicolaus

Presentation

Operator

Welcome to priceline.com’s Third Quarter 2006 Conference Call. Priceline.com would like to remind everyone that this call may contain forward-looking statements, which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those expressed, implied or forecasted in any such forward-looking statements. Expressions of future goals and similar expressions reflecting something other than historical fact are intended to identify forward-looking statements.

For a list of factors that could cause priceline.com’s actual results to differ materially from those described in the forward-looking statements, please refer to the Safe Harbor statements at the end of priceline.com’s earnings press release, as well as priceline.com’s most recent filings with the Securities and Exchange Commission. Unless required by law, priceline.com undertakes no obligation to update publicly any forward-looking statements, whether as result of new information, future events or otherwise. A copy of priceline.com’s earnings press release, together with an accompanying financial and statistical supplement, is available in the Investor Relations section of priceline.com’s website located at www.priceline.com.

And now I would like to introduce the priceline speakers for this afternoon, Jeff Boyd and Bob Mylod. Go ahead, gentlemen.

Jeff Boyd

Thank you very much, and welcome to priceline’s third quarter conference call. I’m here with priceline's CFO, Bob Mylod. Priceline reported solid gross bookings growth in both our domestic and European operations for the third quarter. Gross bookings of $903 million, were up 48% year-over-year. Pro forma gross profit of $122 million was up 51% and pro forma net income was $30 million, or $0.72 per share.

Third quarter results surpassed the high end of our updated guidance, due to better than forecast September results and exceeded First Call consensus estimates of $0.67 per share. Third quarter results include results from Bookings B.V. acquired in July of 2005.

Priceline's organic gross bookings growth rate, assuming acquired businesses, were owned for the full period in question and excluding the retail hotel business on Orbitz, for the third quarter was 45%, a sequential increase from 43% in the second quarter, marking our fifth consecutive quarter of accelerating organic growth.

Priceline Europe had an excellent quarter with $398 million of gross bookings, and an organic growth rate of 121%, accelerating from 117% in the second quarter and significantly in excess of that reported by our competitors.

Priceline's domestic organic growth rate was 13% in the third quarter, a slight decrease from 17% in Q2. Merchant gross bookings were up 13% in the third quarter, an improvement from 5% growth in the second quarter. Improving merchant results were attributable to strong growth in retail hotel merchant room night sales, growth in unit sales of opaque services, and higher air fares and room rates.

Our business in Europe continues to benefit from positive e-commerce market trends in Europe and success in the faster growing continental markets, which are accounting for a growing portion of total sales. We also continue to see benefits from integration activities, including combining the hotel inventory of Bookings and Active, and creating European demand for US hotels and US demand for European inventory.

Priceline Europe is also benefiting from growing repeat business, and business coming to our branded sites, particularly Booking.com and other booking branded sites, where we are focusing our online brand building. Business through these channels represents approximately 75% of total bookings, including approximately 15% of the business received from co-branded affiliates. The remaining business comes through affiliate channels that do not show our brand on their sites.

We are also bringing our supplier-friendly model to more destinations and hotels with the network now including over 25,000 hotels. If there is mentioning that with $398 million in European gross bookings this quarter, Priceline Europe has reached the size where it will be difficult to match the high growth rates of the previous three quarters and our forecast accordingly are based on lower targets.

Priceline's Domestic business had another good quarter. Our diverse selection of retail and opaque services provides consumer choice for changing travel market conditions, which benefits Priceline's business in the long run. Our opaque services had a good quarter as evidenced by the growth reported in merchant bookings.

Our opaque airline ticket service showed growth in the quarter versus the third quarter of 2005, as our airline partners took advantage of revenue management opportunities when advanced booking softened coming into the fall. Although keep in mind second half 2005 provides very soft comparables for this business.

We were also pleased with growth in opaque hotel and rental car bookings in the quarter, especially as I have mentioned before, given that our website now gives dramatically more prominence to the retail service compared to last year. Since our last call, there have been some developments on the subject of GDS incentives. Priceline is now booking tickets through both Sabre and Worldspan. Sabre has signed a long-term agreement with American Airlines and now offers its agencies access to content from all US mainline carriers. We also announced a long-term agreement with Northwest Airlines covering both opaque and retail tickets. We've also made good progress in talks with a number of other airline partners to strike the right balance of full content for our customers and low cost for our airline partners, and we'll work to complete those agreements through year-end.

As I mentioned on our last call, we have been seeking greater efficiencies in our on line marketing spend, tipping the scales more in favor of return on investment versus volume. We began this process in the third quarter and saw a positive impact as online marketing cost came in at the low end of our forecast range. Looking towards next year, we decided not to renew our online partnership with Orbitz. While Orbitz is a good source of traffic when you factor in the likely dilution, meaning customers that we paid Orbitz a commission for that would have shopped at Priceline anyway. The transaction did not meet our ROI hurdles. While this decision may cost us up to approximately 5% of merchant volume next year taking into account estimated dilution. It frees up substantial dollars for investment in other online channels, and we intend to aggressively seek opportunities providing a better return on our marketing dollar.

We are taking other steps to build on our domestic momentum next year. We are working on a number of enhancements to our website and email programs to deliver a more personalized experience to our customers. While we believe providing lower prices than our competition drives significant customer loyalty, these enhancements also provide a platform for value-added promotions and services targeted at our most loyal customers. These initiatives were aimed squarely at customer retention and conversion.

As previously reported, we are in the final stages of a thorough review of Priceline's brand position and offline advertising. We met with a number of highly qualified agencies in an effort to refine our distinctive market position and develop an impactful and flexible creative approach, we hope will help expand the market for our services. We are excited with the results and should have news on this front in the coming days.

Priceline's objective domestically is to be the leading online destination for value-conscious leisure travelers. We believe our solid domestic growth is helping us consolidate that positioning and we make good progress against our marketing and airline supply objectives during the third quarter. Our objective in Europe is to be the leading online hotel reservation service. We continue to show superior growth and profitability in Europe, and I believe our team in Europe is doing an excellent job integrating the business and building our brands.

We are pleased with Priceline's combined financial performance which has made possible an attractive refinancing and share repurchase transaction which Bob will describe in detail together with the financial review Bob.

Bob Mylod

Thanks, Jeff. I am going to start with a brief review of our Q3 results and then, I'll go over the highlights of that recently completed recapitalization and then, finally I'll finish with some forward-looking guidance. Jeff pretty much covered the details of our top-line results, so I won't repeat them here. I did however want to once again highlight that the results from Priceline Europe exceeded the highest end of our expectations.

In our last earnings call, we projected that Priceline Europe would generate approximately $360 million to $390 million of gross bookings in Q3. This was based upon an assumption that the Q2 annualized organic growth rate of 117% would represent the peak growth rate for our European business. And that the law of large numbers in the difficult comps would start to work against us, thereby causing this growth rate to decline in Q3. But in fact this didn’t happen, instead Priceline Europe's annualized organic growth rates actually accelerated in the quarter to 121%, which drove total European gross bookings of nearly $400 million for our seasonally strong third quarter.

Gross bookings were particularly strong in the month of September, which in turn translated to higher gross profit and earnings than expected.

As Jeff also mentioned, the forward guidance that I'll give in a few moments for Priceline Europe assumes that are annualized growth rates will decline starting in Q4 and continue to decline throughout 2007. I have said on past call that this decline is a mathematical certainty given this sheer size of our European operations. Moreover our comparables will get increasingly difficult as the next several quarters unfold, and in fact while we are generally very pleased with our October gross bookings in Europe, as expected they grew at significantly lower annualized rates than in Q3, and we expect that trend to continue for the remaining two months of the quarter.

As per gross profit dollars, the strong gross bookings performance allowed us to deliver gross profit dollars that came in substantially ahead of the high-end of our guidance, again the upside was driven primarily by our strong results in Europe.

As for our Q3 operating expenses, our Q3 advertising expense of $41.2 million came in towards the lower end of our prior guidance, which was very contributory to our earnings upside, given that the relatively low advertising number obviously did not come at the expense of gross bookings or gross profit dollars. This was particularly the case during the last half of the quarter for our domestic business, whereas Jeff just mentioned, we began to more proactively manage our ad spend to achieve a more optimal balance between gross bookings growth on the one hand and earnings growth on the other.

Personnel costs of $18 million came in above our prior guidance, due almost entirely to higher than expected accruals for employee performance bonuses that are accrued throughout the year and paid at year-end based upon full year profit results.

Our Q3 general and administrative results of $8.3 million also came in above our prior guidance. This was principally caused by approximately $500,000 of fees and expenses that we incurred for professional services associated with the secondary offering of stock by our two largest shareholders Hutchison Whampoa and Cheung Kong during the quarter. All of our other operating expenses came in within or below our prior guidance.

Pro forma income tax expense came in higher than expected due to the strong pre-tax income performance out of our European operations. We reported pro forma net income of $0.72 per share, which as Jeff mentioned, came in above the high-end of our previous range of guidance and was also in excess of First Call consensus estimates of $0.67 per share.

We reported GAAP net income of $1.05 per share for the quarter, which also came in substantially above the high-end of our prior range of guidance and, in fact, exceeded our pro forma results. The main contributor to this earnings upside related to an additional reversal of our balance sheet reserve against our deferred tax asset associated with our historical net operating loses. You may recall that in last year's third quarter, we for the first time, reversed a portion of what had been a full reserve against our NOLs, because we'd demonstrated sustained pre-tax income and we had concluded that this income would continue to be sustained in future periods.

During the third quarter of this year, we reevaluated the level of the remaining balance sheet reserve to take into account among other things. First, the impact that our third quarter recapitalization is expected to have unprojected domestic operating income. Second, current business prospects; and finally, additional NOLs that we believe we are more likely than not to recognize from state income taxes payable.

The net impact of this valuation exercise caused our deferred tax asset to increase by approximately $44 million during the quarter. Out of this amount, approximately $28 million came as a result of balance sheet reserve reversals that flowed through our income statement. The remaining $16 million came as a result of a balance sheet adjustment to our paid-in capital and did not impact earnings.

As was the case last year, when we first recognized income associated with our deferred tax assets, we are eliminating this positive impact from our pro forma EPS, because the benefit is non-cash in nature, and will only truly be realized as we generate future taxable income within the United States.

On a go forward basis, our GAAP net income will continue to be reduced by income tax expenses that will be booked against this deferred tax asset. Both the increase in GAAP net income this quarter as well as the decrease in GAAP net income in subsequent quarters from income tax expense will be non-cash in nature. Accordingly, as has been the case for many quarters, we intend to continue to report pro forma net income on a cash tax basis, and this event that I've described will have no impact on either our historical or projected pro forma earnings.

GAAP results were also positively impacted by two additional tax related items. First, we received a favorable ruling from the IRS on whether or not Federal transportation excise taxes are due and payable on the gross profit that we earn on the sale of merchant airline tickets. Prior to receiving this ruling, we had maintained a balance sheet reserve of approximately $1.6 million for this exposure. Because the IRS ruled in our favor, we reversed the entire amount of the reserve into revenue. However, we remove this item from our pro forma results because of its one-time nature. Second, we received approximately $1.7 million of state franchise tax credits in the quarter, and again we removed this item from our pro forma results because of its one-time nature.

GAAP results were negatively impacted primarily by approximately $6 million of acquisition-related amortization expenses, primarily associated with our acquisitions of Travelweb, Active Hotels and Booking, B.V. $3.5 million of stock-based compensation expense, which reflected the impact of the adoption of FAS 123R earlier in the year, and $1.1 million impairment charge that we recognized on the carrying value of our investment in priceline mortgage, all of these expenses were non-cash in nature.

GAAP results were also negatively impacted by the inclusion of 5.76 million shares of un-issued common stock associated with our two convertible note offerings that we will require to use in the calculation of GAAP EPS. These shares were not issuable, unless our stock were to reach a level of approximately $40 per share. The average trading price of our stock during the quarter was $30.62 per share.

As for cash and cash flow, we generated approximately $35 million in operating cash flow during the quarter thereby bringing our operating cash flow for the first nine months of 2006 to approximately $80.3 million, which represents a 63% year-over-year increase. Total capital expenditures in the third quarter were approximately $3.3 million. Also during the quarter, we expended approximately $18 million of cash to purchase a portion of the minority interest in Priceline Europe from the minority shareholders of Priceline Europe. As of the end of the quarter Priceline owns approximately 94% of Priceline Europe.

And that brings me to a discussion of our Q3 recapitalization activities.

There were quite a number of transactions in the quarter that impacted both our debt and equity capital structures. I am going to discuss them in the order in which they took place. First in the beginning of September, our two largest shareholders Hutchison Whampoa and Cheung Kong Limited sold approximately 9 million shares of our common stock pursuant to a secondary common stock offering. As a result of the transaction, Hutchison Whampoa and Cheung Kong's combined ownership in Priceline dropped from approximately 33% to approximately 10%.

We believe that the sale of the Hutchison-Cheung Kong stake will help to alleviate some of the perceived overhang associated with such a concentrated position by one shareholder. It also increased the public float in our common stock which hopefully overtime will lessen the volatility in the trading of our common stock.

In mid September, we launched and then later completed a private placement of $345 million of convertible notes. We decided to pursue this form of financing to take advantage of what we believed were very attractive terms available in the convertible debt markets. Half of the notes or $172.5 million have a 50 basis point annual interest rate and a five-year maturity. The remaining half, have a 75 basis point annual interest rate and a seven-year maturity. All of the notes have a stated conversion price of $40.38 per share and call for cash settlement of the principal amount and settlement in shares of Priceline common stock for the conversion value above the principal amount if any.

Simultaneously, with the closing of the note offering, we entered into a hedging transaction pursuant to which we effectively increased the conversion price of the new notes to $50.47 per share.

The purchase price for the convertible note hedge was approximately $37.4 million. Also simultaneously with the closing of the note offering, we purchased approximately $130 million of our common stock pursuant to our stock buyback program. And then finally, we paid approximately $9.3 million of fees and expenses associated with the note offering.

Then in early October, we launched an offer to exchange 100% of our outstanding 1% and 2.25% convertible notes with a total principal amount of $225 million. For new notes that have substantially identical terms as the outstanding notes, other than conversion features that call for cash settlement of the principal amount and settlement in shares of priceline.com common stock for the conversion value above the principal amount, if any.

The exchange offer expired last Monday night, and I am pleased to report that 100% of the note holders elected to exchange their old notes for the new notes.

So to summarize, sources and uses of cash, we had $345 million of cash inflow from the new note offering. We had $37 million of cash outflow from the purchase of the convertible note hedge, $130 million of cash outflow from the stock repurchase and $9 million of cash outflow from fees and expenses. Because the exchange offering resulted in a liked for like exchange, there was no cash expended in that transaction other than a $350,000 exchange fee that we paid to the note holders in order to induce them to exchange.

Thus we had net inflows of cash of approximately $169 million as a result of our recapitalization activities, thereby bringing our current cash balances to approximately $400 million. Our total gross debt outstanding is now $570 million and therefore our net debt; i.e., our gross debt minus our cash balances is approximately $170 million.

Now that's a fairly clinical summary of what we did, and I would like to now highlight two critical goals that we think the recapitalization allowed us to achieve. The first has to do with increasing our financial flexibility. Prior to the recapitalization, our cash balances were roughly equal to our debt balance yet the maturities of our debt was starting to loom on the horizon specifically our $125 million of 1% convertible notes become due in the summer of 2008 and our $100 million of 2.25 convertible notes become due in January of 2010.

By completing the new note offerings we were essentially able to extend out the average maturity dates of our convertible notes and increase our cash balances such that we still expect to have very significant cash balances even after we repay the $225 million of convertible notes that mature over the next three years.

The second goal pertains to limiting shareholder dilution. Prior to the recap our outstanding convertible notes had approximately 5.8 million underlying shares that were to become issuable in the event that our stock traded to levels of approximately $40 per share. For years, our stock had traded very significantly below the $40 per share level and, therefore, we excluded these shares in our calculation of pro forma EPS. However, with our stock trading up substantially in recent months, the likelihood of those 5.8 million shares becoming issuable had greatly increased. By completing the exchange offer, we effectively eliminated 5.8 million share overhang that was to occur at a stock price of $40 per share.

On the new issue of notes, we further limited shareholder dilution by purchasing the convertible note hedge such that our shareholders will experience no economic dilution whatsoever with respect to the $345 million of newly issued notes, unless and until our stock trades at prices above $50 per share. And then finally, our $130 million stock repurchase in the quarter had the effect of reducing our outstanding share count by almost 4 million shares, or roughly 10% of our shares outstanding.

I think it demonstrates our confidence in the long-term prospects of our business, and it also helped to eliminate potential short selling of our stock in the open market by the buyers of our convertible note offering. I hope you agree that all this activity very much resulted in the achievement of our goal to limit shareholder dilution. And as you might imagine, it is expected to have a significantly positive impact on our projected earnings per share, which now leads me to a few comments on guidance.

As you may recall, prior to the launch of our recapitalization in September, we provided preliminary EPS guidance for both Q4 of this year, as well as for full year 2007. That guidance did not take into account the prospective impact from the all the recapitalization activity that I just described.

While the operating assumptions associated with our prior guidance are for the most part fundamentally unchanged, we are now updating the guidance to reflect the impact of the recapitalization activities, as well as to provide more granular detail for our projected Q4 results. We are looking for fourth quarter gross bookings to grow by approximately 30% on a year-over-year basis.

We expect Q4 gross booking from Priceline Europe of approximately $280 to $300 million, which represents 77% to 89% year-over-year growth, and is very much reflective of our earlier comments regarding an expected quarterly sequential decrease in the annualized growth rate of Priceline Europe. We expect revenue to grow by approximately 15% on a year-over-year basis. We expect pro forma gross profit dollars to grow by approximately 35% to 40% on a year-over-year basis.

As for Q4 operating expenses, we are targeting consolidated advertising expenses of approximately $33 to $36 million, with approximately 85% of that amount being spent on online advertising. We expect sales and marketing expenses of between $10 and $11 million. We expect personnel cost to come in between $16 and $17 million. We expect G&A expenses of approximately $7.2 to $7.7 million. Information technology costs of approximately $2.6 to $2.8 million; and depreciation and amortization expense, excluding acquisition-related amortization, of approximately $2.7 million.

We are targeting pro forma EPS of approximately $0.36 to $0.42 per share and our pro forma EPS forecast includes an estimated cash income tax of approximately $2.8 million comprised of alternative minimum tax in the United States and income taxes in Europe.

As for expected GAAP results, we expect to report GAAP net income of approximately $0.13 to $0.19 per share. The difference between our GAAP and pro forma results will be driven primarily by the inclusion of acquisition-related amortizations, stock-based compensation and certain income tax expenses, all of which are non-cash in nature.

While we are not going to give detailed line item guidance for 2007; again, we are updating our 2007 pro forma EPS forecast, primarily to take in to account the impact of the recapitalization activities.

To summarize where we were before today's update, we have been forecasting full-year 2007 pro forma EPS of between $2.15 and $2.40 per share. We are now targeting pro forma EPS of approximately $2.37 to $2.67 per share. GAAP EPS is expected to be approximately $1.24 to $1.54 per share, primarily as a result of the same non-cash items that will impact Q4.

It is important to note that the EPS guidance that I just gave for 2007 is based upon our current diluted share account of approximately 39 million shares, that share account is in turn based upon a calculation of the dilutive impact, if any, of all of our outstanding convertible notes and stock options based upon yesterday's closing stock price of approximately $40 per share. Because all the conversion prices of our convertible notes are roughly the same price as the current trading price of our stock, our convertible notes currently have very little dilutive impact on share count and EPS. However, in the future, if in the future our stock trades above the current share price, our diluted share count will increase by the net number of shares that would become issuable to our convertible note holders.

To try to put some numbers against these words. If our stock would trade up to $50 per share, being the money value assignable to our convertible notes would under the treasury stock method result in a 2.8 million share increase to the current diluted share count of approximately 39 million shares.

Now, I just mentioned earlier that we purchased a convertible note hedge to protect ourselves from some of the potential dilution associated with our new issue of convertible notes. However under GAAP, the impact of the convertible note hedge is not recognizable until the maturity dates of the convertible notes. Said differently under GAAP, there is a temporary timing difference between the immediate inclusion of additional common shares underlying our convertible notes on the one hand and the deferred reduction of shares associated with our convertible note hedge on the other.

When factoring this bond hedge into the $50 stock price example that I just went over, the 2.8 million share increase in diluted shares outstanding will ultimately be offset by a 1.6 million share reduction in diluted shares from our bond hedge. While some of the math here is somewhat complicated, the basic point I am trying to convey is that because of the large increase in our convertible notes outstanding, our future EPS will be more affected by the trading price of our common stock than it has in the past.

And then finally, I want to point out as I have done on previous calls, that all of our aforementioned forecast are based upon an assumption that we will continue operating in a consumer travel market that is roughly similar to the current one and any geopolitical instability or terrorist event particularly within the United States or Europe, would in all likelihood have a negative impact on the travel market in general and our operating results in particular.

And with that we would be happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Anthony Noto of Goldman Sachs. Sir, your line is open.

Aaron McCann - Goldman Sachs

Sorry. Thank you very much. This is Aaron McCann for Anthony Noto. I am wondering if you could give us your perspective on penetration of the European market from on hotel bookings and what year would that be similar to in the US, if we were to try to make it an analogy. And then secondarily, how do you think about the next opportunity to expand internationally and which markets are potentially appealing, for example, South America versus China versus other possible opportunities? Thank you.

Jeff Boyd

I think for purposes of the first question, I don't have exact statistics at the tip of my fingers but online hotel penetration in Europe is significantly behind what we have experienced here in the United States. We've said very roughly speaking on average, its three years or potentially even more behind and I think the level of penetration is very different depending on what country you are talking about, in a more matured market like the UK; the penetration of online hotel sales would be higher and as you move through Western Europe towards Eastern Europe, I think it gets lower and lower, there is some published data out released by Focus right recently, which I could get for if you wanted to look at their estimates on it.

In terms of the next markets, we've identified Eastern Europe and Southern Europe as the most immediate opportunities at this point in time. We have a joint venture in Hong Kong as many of you know that it represents an opportunity to participate in a very small way in that market at this point in time, but we are certainly over a longer period of time interested in China in particular, and I think the great thing about the model in Europe is it can't be expanded to other geographies even if the market opportunities are little bit smaller can still be expanded efficiently by opening up an office and building some supply and opening up a website in a local language.

Aaron McCann - Goldman Sachs

Great, thank you very much.

Operator

Our next question comes from Aaron Kessler of Piper Jaffray.

Aaron Kessler - Piper Jaffray

Hi guys, thanks, good quarter and couple of questions. First, can you give us an update on what you see in terms of the competition if you believe you are still taking share on Europe in the quarter? Also I think over the last maybe two to three quarters you've been talking about expansion into Eastern Europe, and what have we seen sort of plan point terms of the expansion or is that really more of an

story? Then finally, on the convertible with -- share reduction with bond hedge, does that affect pro forma shares as well the GAAP shares in a similar manner? Thanks.

Jeff Boyd

I'll take the first two and then, Bob can address the last. With respect to share in Europe based on the results that have been released by Sabre Group so far it seems clear that for online hotel sales we've taken very significant share at least from lastminute.com and the most recent quarter, and based on the numbers that historically have been reported by the others. It's hard for me to believe that their growth rates in the third quarter will be anywhere near what our growth rate was in Europe; so I think we are still taking significant share in online hotel sales from the other large online travel agents. With respect to Eastern Europe, we have inventory and a distribution in a number of the Eastern European countries today, but the size of the business is not large compared to the size of our business in Western Europe. So, while we are operating there now, it represents in terms of a growth opportunity, more of an opportunity in the future than a huge contributor to what we are reporting now.

Bob Mylod

And then, Aaron, I think our plan with respect to share count is to essentially treat the bond hedge under the GAAP method, but to make sure that we highlight to investors very clearly what the reduction would be. So, for pro forma purposes, we don’t necessarily intend to back that out, but we certainly, given that from an economic perspective, those shares are not expected to ever be issued. We will certainly make sure that we highlight that and we will leave it up to the investment community to make their own decision about that.

Aaron Kessler - Piper Jaffray

And finally one quick question. Any update on the estimate of what international Europe will account for percentage of profits in 2007? I think you said at least two-thirds in the second half of this year. Any outlook what '07 may look like?

Bob Mylod

Not right now. Obviously, we gave that number for 2006. We are trying to just limit our guidance for 2007 for now to EPS, but I think as we get closer to the end of this year and into next year, we will start giving more guidance on those lines. But obviously, given that Europe continues to grow at very rapid rates, we certainly expect that they are continue to represent an increasing percentage of profits.

Aaron Kessler - Piper Jaffray

Great, Thank you.

Operator

Our next question comes from Mark Mahaney of Citigroup.

Mark Mahaney - Citigroup

Great, thank you. Congrats Bob. I am going over the recapitalization, that clinical survey actually was extremely helpful, lot of detail there. Couple of real quick questions. Your advertising mix is clearly veer towards online advertising. It sounds like your -- as part of a branding or rethinking of branding or looking at new initiatives is, would one of those be rethinking the marketing mix and possibly shifting some of that back to offline? Secondly, what are the current NOLs? And third, for your EPS guidance for next year, what tax rate is assumed for that? Thank you.

Bob Mylod

I am sorry. Just on the -- can you repeat the last part of that question, Mark, I didn't --

Mark Mahaney - Citigroup

For your EPS guidance for next year, what tax rate is assumed? Thank you.

Bob Mylod

Okay.

Jeff Boyd

On the marketing questions, Mark, I think that we have seen a very significant shift of our spend towards online, and that’s been related to two very specific things. The first is the rapid growth of our business in Europe that advertises primarily through online channels; and the second is, increasing online spend here in the United States. And I think what we have said in the last call and in this call is that we are focused much more on getting efficiencies out of our online spend. I don't think that means necessarily that we are going to take significant amounts of money from online channels and move them to offline channels, but we are going to be much more opportunistic as to our online spend and I think we will continue to look for ways to do more than just pure customer acquisition through online channels, but rather customer acquisition, a very efficient branding which has been successful for us in Europe as we are getting a larger percentage of our business through repeat users now, but that’s basically because we have started to get some success in building our brands through our online advertising there.

Bob Mylod

And as for your question about deferred taxes, Mark, I think you know that for cash tax purposes, the very substantial majority of the income tax that you see relates to income taxes that we are paying in Europe. The NOL deferred tax asset does not shield us from taxable income in Europe. In the United States, it does and we have a very large NOL. It's many hundreds of million of dollars that we have available to us to use, although it is somewhat limited by an annual use of approximately little north of $60 million for US domestic purposes. As I think you probably also can surmise, we are earnings far less than that domestically. So we do not have on our balance sheet the full amount of that tax asset, given we are not currently earning anywhere close to that rate. So, part of the exercise that we go through annually is to look at our deferred tax asset relative to our earnings power and make sure that that differed tax asset fairly represents what we think we are going to earn in the US. We think we are more likely that not to earn in the US. As for tax rates for next year, again, a lot of that’s going to come down to what the mix of business is from Europe versus the US, and we are not in a position yet to give, sort of, specific geographic guidance on that number.

Mark Mahaney - Citigroup

Thank you.

Operator

Our next question comes from Heath Terry of CSFB

Heath Terry - CSFB

Great, thank you. I was wondering if you could just talk a little bit, as you look to optimize your return on investment on your -- the advertising side of things, can you talk about the channels that are becoming most effective for you? Obviously, online is the biggest one, given that’s where you are spending. But as a specific verticals within online, whether its search or portals or certain other types of sites that you find to be more effective or have a better ROI for you?

Jeff Boyd

Yeah, I think we certainly, like everybody in this space are significant players in search and a very significant piece of the optimization activity there really has more to do with what we do with the quick ones we get it, then with the search terms that you buy because they are essentially public and everybody is buying the same term. So, we are spending a lot of time trying to improve our conversion. There are also a lot of non-search channels that we are in and are interested in. I don’t want to go through a detailed listing of them because I think there's some competitive sensitivity to that information, but we are certainly opportunistically looking for other channels, and we are very active in the ones that everybody is aware of, an example being TripAdvisor and sites like that.

Heath Terry - CSFB

Great, and, so within search even though at least anecdotally keyword pricing is going higher, it's what you are doing on your end, want to get one of those clicks, it's actually delivering a higher return high on investment there?

Jeff Boyd

I don’t want to make a comment about where keyword pricing is going, but there is no question we have been spending a lot of time this year and we will continue on trying to build content and do things that improve our conversion once we get the customer over to our sites.

Heath Terry - CSFB

Great, thanks. And then, from a competitive standpoint, how would you characterize the differences, the competitive differences between the European and US markets, and do you see Europe eventually evolving more towards what we see in the US now or is that just going to be a different market for the foreseeable market?

Jeff Boyd

I think specifically with respect to hotels, there is a significant difference in the competitive landscape for a couple reasons. One is that the supply environment is very complex and it's dominated much more so by small independent hotels who are not going to have as much money to invest in their own direct online distribution. So, the suppliers are not going to be so directly in competition with the online travel agents in Europe as the major hotel chains are here in the United States.

I think the second difference is that our product and our business in Europe is uniquely positioned to really provide help to hotel companies that can't really reach the demand. The hotel company here in the United States can get business from anywhere in the United States simply by buying an advertisement in Google. In Europe, you have to be in a position to not only understand what to buy in 15 or 20 different foreign languages, but translate your content into those different languages and have the bandwidth and the expertise to optimize your advertising and your offering in all of those different countries to get the same kind of impact and customer flows and efficiencies that we can deliver to you for a very, very reasonable commission while allowing you to maintain your pricing and keep control over your business. So, I think the service that we provide to the hotels is just much more valuable in Europe than it may be perceived to be just to the major chains here.

Heath Terry - CSFB

Great, thank you.

Operator

Our next question comes from Chris Gutek of Morgan Stanley.

Chris Gutek - Morgan Stanley

Thanks. I have got a couple of quick questions. Bob, recognizing you've given a very detailed guidance for Q4, I am just kind of curious to drill a bit deeper, specifically the results you've seen already in October, and the advanced bookings you've seen for holiday period. Is that consistence with kind of the midpoint of the guidance range for Q4 or conversely, do you assume some deceleration, and if that deceleration doesn't happen, are you likely to again beat your guidance.

Bob Mylod

I don’t want to answer that -- I don’t want to answer the first question Chris about where we think we can come out within our range. What I can say is that seasonally -- from a seasonal perspective, October is the strongest month of the quarter and November is less strong than October, and December is less strong than November from a bookings perspective. So, said differently with October done, a higher percentage of the quarter is of what we expect the total quarter to be is booked, so I guess you could argue that we have slightly more visibility in the whole for the quarter. But that’s -- I sort of leave it at that.

Chris Gutek - Morgan Stanley

Okay, fair enough. And maybe switching gears, the press release mentions, as for the US merchant business, the gross bookings organically were up about 13% in the quarter and then, the sentence in the release goes on to say, that talks about strong results in opaque versus the retail merchant, but doesn’t quantify. Could you give us a little bit of sense in terms what the US merchant opaque business is doing versus the retail price disclosed business?

Jeff Boyd

Let me try to answer that, I think if you looked at the things that contributed to the growth, sort of by product, by priority, I think the biggest contributor was the merchant retail hotel business, and I think after that I would put hotel and rental car in terms of top-line growth and then after that, I would put opaque air.

Bob Mylod

Yes as per retail, Chris, retail hotel and retail rental car have also been -- have been behaving very strongly. So, to the extent we had any weakness of any individual product would have been in retail airline tickets, but we obviously think there was probably somewhat of the mix shift there, as we have the value-conscious consumers in the face of some higher airline ticket prices that did come back and name their price. So it is -- that business is very, very small now, relative to what it used to be. But as Jeff mentioned, it did grow on a year-over-year basis in the quarter, which we were very cautiously optimistic and happy about.

Chris Gutek - Morgan Stanley

Okay, great. And then finally, the tightness of inventory issue. I would assume in the summer, this past summer, you did see tightness of the inventory more so domestically versus Europe. If you could comment about that, domestic versus Europe? And then as we go into the fall and winter, and as you look forward to next year; how are you thinking about the differences and tightness of inventory, US versus Europe?

Jeff Boyd

When you hear us talking about tightness of inventory in the United States, a lot of times we will be talking about airline load factors, which were very, very high in the summer and had an impact on our opaque business and I think had an impact on packages, bookings across the industry. In terms of hotels, our experience here in the US has been that high occupancy has driven higher prices, but our inventory position has generally remained pretty strong here in United States and we haven't identified on this call or any previous call an inability to find rooms for people in our hotel business domestically. I think that we expect there to be high occupancy rates here next year, and I think the hotel business is expected to be strong in Europe too. I think that we are very well positioned however, to continue to get good inventory from our hotel partners, because we provide the most supplier friendly alternative to them among the distribution options that are available. We are much lower cost in Europe and consolidators, we have much lower cost to the hotels than the other online travel agents, and so even in a constrained environment I think we stand a good chance of having good availability.

Chris Gutek - Morgan Stanley

Great. Thanks.

Operator

Our next question comes from Justin Post of Merrill Lynch.

Justin Post - Merrill Lynch

Hi. First going back to the US growth rate. We have got you better than the competition and better than the industry this quarter. Do you think your air percentage, which seems to be a trouble area for some of your competitors, is actually lower than some of your competitors as far as percentage of revenue or percentage of profitability? And then going over to Europe, have you seen any new competitors trying to duplicate your model as far as the low price provider for the hotels at this point?

Jeff Boyd

On the air question, as we believe and I think it's not debatable, but as a percentage of our total business, our airline ticket business is way smaller for priceline than for our competition. The amount of exposure that our income statement has to the air business is smaller than our competition. But I'll just add to that, it's my belief that the competitions airline ticket business over the last couple of quarters have all grown more rapidly than ours have, and I think that that’s part and parcel of the way we manage our business and how much money we spend on advertising air. But I think that’s probably true. And I am sorry your second question?

Justin Post - Merrill Lynch

Yes, Jeff, in Europe have you seen any competition offering rates in like the 12% to 14% rate as far as the charge the hotels have, any new competition in Europe?

Jeff Boyd

I am not aware of any new competition. There is certainly a lot of businesses in Europe that have been operating for several years that have an agency model and have competitive commission structures. They have been there and they are still there. They tend to be strong in particular countries versus having a Europe wide business, but they have been there. I haven’t seen any evidence of major US online travel agent affiliates doing that.

Justin Post - Merrill Lynch

Okay, and then last two. The tax spending, I don’t know it's round about $10 million this year. Any new tech projects around the corner for the next couple of years? Any new areas you need to invest in? And then, any quantifications of the cross border impact on revenues over the last couple of quarters?

Jeff Boyd

Yes, I would say, Justin, our quarterly tax spend, it's been fairly stable and static for a number of quarters. Now having said that, with the growth that we are experiencing, especially in Europe, we are buying equipment and adding more licenses. So I think it's certainly reasonable as you are looking to next year to expect that that number will go up, but I wouldn't -- I certainly wouldn't articulate that we are looking at any sort of dramatic step function increase. I think that we are trying to manage the business very carefully from the expense perspective and get the leverage of that. That's one of the line where we are looking for, a lot of leverage, I think, we've gotten that historically and it's our expectation we will continue to get that on a go forward basis. And same goes true for capital expenditure, I think one of the things we are most proud about both here in the US and in Europe is that even though our business is very, very substantially bigger today than it was three years ago. If you go and look at our cash flow statement, you can see that we've managed our capital expenditures very, very carefully and very, very efficiently, and I think that's a real testament to our technologists, both here and in Europe and we think that’s one of our core strengths and that's something that we hope to continue to leverage next year as well.

Justin Post - Merrill Lynch

Okay. And then cross-broader has that helped your US sales growth rate materially at all over the last couple of quarters?

Bob Mylod

You know, that cross-broader business is primarily booked in Europe, because it represents whether it's a US hotel or a European hotel, it's booked in the European system and in the European environment. So, that's primarily located on their gross bookings.

Justin Post - Merrill Lynch

Great. Thank you, Jeff.

Operator

Our next question comes from Imran Khan of JP Morgan.

Bridget Wysha - JP Morgan

Hello. This is actually [Bridget Wysha] calling in for Imran. Two quick questions; one, has there been any shift in strategy for offline advertising, either the TV campaign is going to continue? And then the second question is there any update in the GDS negotiations?

Jeff Boyd

Sure. In terms of strategy shift in online, as I'd mentioned in my prepared remarks -- sorry, excuse me, offline, and as I have mentioned in my prepared remarks, we have been through a process of interviewing agencies and looking at different approaches for our account. And that process is going well. We had a number of highly qualified agencies come see us and we have seen some exciting ideas, and where we haven’t finalized our decision on that front. But as I'd mentioned in earlier, we will have something to say about that over the coming days, and we are excited about what we intend to do. I wouldn’t anticipate any huge shift in our approach to using television. We'll continue to be advertising on television, and I think you can expect us to continue to try to push and capitalize on what makes us different from the other online travel agencies, which is our great savings and value positioning.

In terms of GDS update, we -- as I mentioned in the prepared remarks, we've got deals with Sabre now, G2, we are continuing to work with Worldspan. So, we have got alternatives that will allow us to book in the channels that our airlines partners prefer and where we can find the best economics. And we are continuing to work with the airlines to enter into long-term agreements that provide us access to their full content and meet their cost reduction needs. And I mentioned the deal that we recently announced with Northwest Airlines that brings them back into retail after being out for several years as well as into our opaque product.

Bridget Wysha - JP Morgan

Thank you.

Operator

Our final question comes from Scott Devitt of Legg Mason.

Scott Devitt - Stifel Nicolaus

Thanks. It's actually Stifel Nicolaus. Hey guys. I had two questions. The first is a follow-on to an earlier question; regarding the strengths in the merchant business in the US which is a positive surprise given how strong the travel market is. So, I was wondering if you could talk about any incremental supply that you've received in that area or possibly changes in conversion rates in the hotel business on a year-over-year basis, and possibly how contributory Orbitz was to the opaque business in the US.

Jeff Boyd

The way that I would answer that, Scott, is that we have seen in the hotel and rental car business consistent use by our partners of the opaque product as a revenue management tool. It has allowed them to increase their prices and increase, in the case of hotels, their RevPAR while providing us with inventory that has delivered solid conversion for us. So, conversion has been strong in hotels and rental car. On the airline side, earlier this year conversion was tough with very high load factors, but as we came into the fall season, there were some revenue management opportunities for the airlines that they avail themselves off.

Now I mentioned in the call, that with respect to Orbitz we said that next year taking into account dilution, we thought that maybe 5% of merchant gross bookings were in play for next year. That’s a rough estimate; what it tells you is that Orbitz was certainly contributory to our merchant business this year, but what I also would say is you saw an acceleration of the growth rate between the second quarter and the third quarter, and we do not believe that the Orbitz business played a significant role in that acceleration.

Scott Devitt - Stifel Nicolaus

Okay. And then on acquisitions, you've been very successful with the two that you've done in Europe, and I was wondering just with the change in the valuation of the company, the willingness for future acquisitions, and if that’s a positive signal, what the intentions would be in terms of size small tuck-in deals versus larger strategic acquisitions? Thanks.

Jeff Boyd

We've been fairly consistent in our acquisition strategy over the past three or four years. We've looked for transactions that provided us with new products like Travelweb and retail hotel business like the European hotel business in the case of Active and Bookings, new distribution, again all three of those deals met that criteria because they provided us with access to customers that we were not currently transacting with, new markets; and they were accretive. And I think that our approach to transactions would be similar. We will look for things that provide us access to new distribution, to new products that allow us to get into new markets that we are not currently involved in and that will be accretive to the business and that’s something that served us well so far, and I think we are going to keep going down that path. I wouldn’t make a comment as to size. We are opportunistic, we don’t have any rules that say it has be this big or it can't be any bigger than that. We will look at transactions that we think makes sense and that we think we can digest and we can afford and represent a good balance of risk and reward.

Scott Devitt - Stifel Nicolaus

Thanks.

Operator

This concludes the question-and answer-portion of our program. Gentlemen, would you like to continue with any closing remark?

Jeff Boyd

Thank you all very much for attending the call.

Operator

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. Everyone have a great day.

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Source: Priceline.com Q3 2006 Earnings Call Transcript
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