Priceline (NASDAQ:PCLN) is set to release its results for Q2 FY2014 on Friday, August 1. Despite the large size of its business and uncertain global economic conditions, the leading Online Travel Agency (OTA) grew robustly in the first quarter, registering top-line growth of 26% year over year. This remarkable growth came on the back of a rapidly expanding presence in the international markets and a stronger foothold in the domestic U.S. market. For the second quarter, the company has provided guidance for revenue growth in the range of 19% to 29%.
Priceline delivered a 340 basis point expansion in operating margins in Q1, owing to advertising and operational efficiencies. Advertising efficiencies resulted from the acquisition of Kayak, a company that spends less on online and more on offline advertising; ROI (return on investment) on online advertising is lower than on offline advertising. Further, the amount spent by Priceline’s brands for ad placements on Kayak is eliminated from the consolidated results.
Although the revenue outlook is good, margins are another story. We believe that Priceline will not be able to substantially grow its margins in the future, due to increasing competition in the OTA space, falling returns on investments on online advertising and the anniversary of Kayak’s acquisition on May 21. Additionally, the company recently launched offline advertising campaigns for its Booking.com brand in Canada and the U.K. It expects to incur between $220 million and $240 million on offline advertising expense in 2014, which will put increased pressure on margins.
We will update our $642 price estimate for Priceline after the upcoming results announcement.
Strong Growth In Both Domestic And International Markets To Fuel Bookings Growth
Priceline’s stellar growth in recent years has come primarily from its expansion initiatives in international markets. The company posted 37% year-on-year growth in international gross bookings in Q1, as high growth in the Asia-Pacific region and the Americas boosted hotel room nights by 32% to 83.4 million. Booking.com’s dominance over the core European market also contributed significantly. Booking.com is the leading OTA in Europe with 31% share of the market. The brand is now expanding its presence in Australia, Canada and the U.K. through its Booking.yeah advertising campaign. It also increased its hotel supply by 54% in 2013, to end the year with an inventory of 425,000 hotels and accommodations in 195 countries. These initiatives should help Priceline to meet its international gross bookings growth target of 24%-34% for Q2.
While Priceline has successfully gained share in the international markets, it has lost out to Expedia (NASDAQ:EXPE) in the domestic landscape. Priceline has 16% share of the U.S. OTA market, on the other hand Expedia has over 40% share. However, Priceline is taking different routes to increase its share. The company launched its first offline advertising campaign (Booking.yeah) for Booking.com in the U.S. last year. It entered into a partnership with NYC and Co. to power bookings on New York City’s official tourism website. It also completed the acquisition of Kayak. Kayak is the leading meta-search engine in the U.S., with over 50% share of the travel search market.
Domestic bookings account for about 14% of Priceline’s total gross bookings. The company registered 19.5% year-on-year growth in domestic gross bookings in Q1 and expects to clock 15%–20% growth in Q2. We feel that Priceline’s growing strength in the world’s largest travel market will help offset the slowdown management anticipates owing to the increasingly large size of the business.
Revenue Margins To Face Pressure Owing To High Competition And High Proportion Of Agency Model Bookings
Accounting for over 85% of Priceline’s valuation, the hotel bookings business forms the most important division in the company’s portfolio. Priceline’s hotel revenue margins have declined, however, from 39% in 2007 to about 20% in 2013, according to our estimates. The primary reason for the decreased profitability is the rapid growth in international markets, where the agency model of bookings is more popular. Priceline’s derives over 80% of its gross bookings from the agency model. Revenue margins under the agency model are lower as Priceline simply acts as a travel agent and earns a small commission on bookings, while under the merchant model revenue margins are higher as the transaction is completed on Priceline’s website itself.
Despite the continuous decline since 2007, Priceline’s margins are healthier than that of its closest competitor, Expedia. Priceline does not intend to increase commissions on hotel bookings in order to maintain its competitive position among OTAs. We expect commissions to continue declining due to both, intense competition from other OTAs and supplier websites, and the increasing proportion of bookings coming from international markets.
Disclosure: No positions