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Expedia Inc. (NASDAQ:EXPE)

Q3 2007 Earnings Call

November 7, 2007 11:00 am ET

Executives

Stu Haas - IR

Dara Khosrowshahi – President, CEO

Michael Adler - CFO

Barry Diller - Chairman

Analysts

Mark Mahaney - Citigroup

Justin Post - Merrill Lynch

Jake Fuller - Thomas Weisel Partners

Aaron Kessler - Piper Jaffray

Marianne Wolk - Susquehanna

Chris Gutek - Morgan Stanley

Brian Fitzgerald - Banc of America Securities

Anthony Noto - Goldman Sachs

Robert Peck - Bear Stearns

Doug Anmuth - Lehman Brothers

Imran Khan - JP Morgan

Operator

(Operator Instructions) I would now like to turn the conference over to Stu Haas, Senior Vice President Investor Relations and Treasurer. Please go ahead.

Stu Haas

Good morning and welcome to Expedia Inc.'s financial results conference call for the third quarter ended September 30, 2007. I'm pleased to be joined on the call today by Barry Diller, Expedia's Chairman and Senior Executive; Dara Khosrowshahi, our CEO and President; and Michael Adler, our CFO.

The following discussion including responses to your questions, reflects management's views as of today, November 7, 2007, only. As always, some of the statements made on today's call are forward-looking including our comments on financial expectations, operational performance and margins, planned investments and spending, platform improvements, systems upgrades, growth of business lines, financial performance and dilution. Actual results may differ materially. We do not undertake any obligation to update or revise this information.

Please refer to today's press release and our Form 10-K for the year ended December 31, 2006 for additional information about factors that could potentially affect our financial and operational results.

During this call, we will discuss certain non-GAAP financial measures including OIBA, operating expenses excluding stock-based compensation, free cash flow, adjusted net income, and adjusted EPS. In our press release, which is posted on the company's IR website at expediainc.com/ir, you will find additional disclosures regarding these non-GAAP measures, including reconciliations of these measures with the most comparable GAAP measures.

Finally unless otherwise stated, all references to gross margin, selling and marketing expense, general and administrative expense and technology and content expense exclude stock-based compensation. And all comparisons in this call will be against our results for the comparable period of 2006.

With that, let me turn the call over to Dara.

Dara Khosrowshahi

Thanks, Stu and thank you to everyone for making the time to join us on the call. The third quarter was Expedia's best since our 2005 spin-off from IAC, with strong performance across the organization. We saw acceleration in all key metrics including 16% transaction growth and 21% bookings growth, our highest rates of growth since 2005.

Revenue increased 24% with revenue margins stabilizing for a third straight quarter. Our primary operating metric, operating income before amortization, or OIBA, grew 18% to reach a record $213 million.

Expedia continued to expand its global presence with international bookings reaching 32% of total bookings, driven primarily by growth in Europe, where Expedia Germany, France, Italy, the Netherlands and Hotels.com Europe, all posted growth in excess of 50%. Most importantly, we continued to make progress towards our goal of maximizing cash flow over the long term while efficiently managing dilution. Expedia's free cash flow on a trailing 12-month basis was $777 million, up 40% from a year ago and our diluted share count for Q3 was down 8% year over year, reflecting our share repurchases and measured equity awards.

While these are certainly meaningful internal sign posts for our progress, it's also nice to have external validation and this quarter's addition of Expedia Inc. to the S&P 500 Index is an indication of Expedia's status as a global leader in travel.

Now last quarter I gave you an update on Expedia.com and the factors driving our flagship's improvement. You'll recall that these were better execution, more effective marketing, expanded supply, increased site availability and strong telesales. I'm happy to report that these trends have continued, and we again saw positive growth in year-on-year transactions at Expedia.com with strength in both our hotel and air businesses.

In addition, with the recent launch of our co-brand credit card with Citi, we now offer travelers even more ways to earn thank you points. Card members can earn points on everyday purchases, miles flown on any airline and increased points for travel booked on Expedia.com, all on top of any rewards they might earn through suppliers' programs. While I know we're all fatigued with card offers, you really ought to give this one a look at Expedia.com/thank you.

Turning to the rest of our brand portfolio, our European points of sale had another strong quarter with 39% FX neutral growth; an acceleration from Q2. Our continued experiments with fee reductions and aggressive marketing spend including Hotels.com's first European brand campaign, were certainly significant factors behind Europe's growth. Given the positive results to date and the long-term opportunity in Europe, we plan to accelerate our marketing spend growth in Q4.

Hotwire had another great quarter with an all-time high profit contribution. Hotwire continues to benefit from enhanced supply and an increased mix of non-air bookings while continuing to innovate on its air products. Hotwire's latest feature, the Airfare Savings Hub, proactively suggests alternative airports and dates of travel that users can consider for air ticket savings and has offered travelers average savings of 25%, enhancing its reputation for delivering deals you won't see anywhere else.

Expedia Local Expert, our destination services business with over 100 activity and concierge desks at hotels, resorts and retail locations drove transaction growth of 35%. Orlando Magazine recognized the Local Expert desk at the Orlando World Center Marriott as the best concierge for its consistent and knowledgeable service. We actually tied with the Ritz-Carlton so I think we are in good company.

We believe Local Expert has legs on a stand-alone financial basis and from a strategic standpoint as it enables us to improve travelers' experiences in destination, as is clearly the case in Orlando.

TripAdvisor is testing a new, more user-friendly site UI, now live on its UK site. The new design is clean, simple and organized making it much easier to find what you are looking for. Trip also expanded its reach with two new apps on Facebook, a Traveler IQ game, and a City's I've Visited map, both of which are among the top three travel applications on Facebook as measured by activity.

Overall, our ad and media businesses grew revenue 106%, reflecting returns from continued innovation and traffic gains at TripAdvisor, SmarterTravel and our other content sites. We're also seeing solid growth in advertising and innovation on our transactional sites. For example, Expedia.com recently launched travel ads allowing hotel users to bid for sponsored treatment at the top of hotel search results. It's very early for travel ads and we'll continue to test and fine-tune it to better serve our hotel partners.

As we look to capture near-term growth opportunities, we plan to aggressively invest in developing our various internal salesforces. On the media front, this relates to supporting continued growth at TripAdvisor as well as ad sales efforts at Expedia.com and Hotwire's Travel Ticker. We will also be actively hiring to support further growth for our ECT and Expedia Local Expert businesses.

On the supply front, PSG signed agreements on the air side with British Airways, Air France KLM, and Sky Europe, an Eastern European LCC. We continue to expect more flattish comparisons beginning in '08 on the non-booking fee portion of our air compensation.

On the lodging side, we inked deals with Extended Stay America and Harrah’s. Based on everything we know thus far, we continue to believe hotel economics will remain largely similar to what we achieved in the last round of major chain negotiations and we expect year-on-year fluctuations going forward to remain modest.

We remain keenly focused on expanding our selection of hotel properties and improving the quality of supply for our global travelers. As a result, we expect to make additional investments in lodging supply. These investments may not show an immediate return, but we expect over time they will extend our global leadership position in supply.

Now we won't provide specific expectations for 2008 until our Q4 call but I think it will be helpful to set the stage for investments that we do expect to make. We've essentially completed Phase 1 of our new platform positioning us to begin to leverage our data warehouse and make improvements in terms of merchandising, CRM and segmentations. You never move as fast as you like in these efforts but you'll see us migrating different parts of the sites onto the new platform and enhancing the data warehouse throughout 2008. At this point it's too early to forecast the material conversion improvements until late '08 when we have most Expedia branded sites onto the new platform.

While we are still finalizing our 2008 planning, we expect to invest to capture additional growth opportunities in our businesses including improvements to our call center technology and processes, supplier connectivity, building out data centers for disaster recovery and testing purposes, and supporting our growth with additional office space. We absolutely believe these are appropriate uses of capital for creating long-term shareholder value.

It's worth pointing out that we're making these investments and aggressively supporting our brand portfolio at a time when there is some uncertainty around the economy and more importantly in our case, the consumer. Thus far, based on what we've seen in our business and heard from our supply partners, demand trends remain healthy here in Q4.

That said, we certainly recognize this could change. Investors should recognize that while some of our planned spend is flexible and could be pulled back if demand softens, some is not, which could apply short-term pressure to our top-line and in turn, OIBA should sentiment turn. We will keep a close eye on this and hopefully provide more insight on our Q4 call in February when we anticipate providing full year 2008 financial expectations.

In closing, we're pleased with our record performance in Q3. Expedia is on a growth path again as we continue to build out our brands, bulk up our local presence, expand our media business and innovate and lead. There's a ton of work to do and always a ton of competition but we sure like where we are headed.

Michael Adler

Thanks, Dara. Good morning, everyone. I'd like to provide you with some commentary on our results and close with our updated financial expectations for 2007. Worldwide gross bookings were up 21% during the quarter, boosted by 13% growth in North America. This acceleration reflects not only the improvements at Expedia.com Dara touched on, but also our second consecutive quarter of accelerating bookings growth for each of our North America points of sale.

While we're encouraged by the improved growth profile of our brands, we're also aware that we are comping 2% growth in the back half of the year in North America and remain focused on achieving sustainable growth in the region.

Revenue increased 24%, led by 22% growth in our merchant hotel revenue and 106% growth in advertising and media revenue. Revenue this quarter was also supported by a 9% increase in air revenue, the first increase we've seen in air revenue in two years. Revenue per air ticket decreased 5%, the lowest rate of decline since our '05 spin-off from IAC, primarily reflecting lower air service fees. We've been pleased to see continued acceleration in ticket volumes make up for the increasingly modest decline in our per unit air compensation.

On the operating expense side of things, G&A was up 28% year on year due to a higher incentive compensation accruals and legal expenses. In addition, prior period G&A was light by a few million dollars due to some incentive compensation reductions. We do expect to leverage G&A for the full year of 2007.

Selling and marketing expense grew 30% in Q3 and again was the primary reason we saw OIBA margin degradation this quarter, despite continued revenue and gross margin improvements. The increase in spend was driven in part by incremental spend at our recently acquired media businesses under TripAdvisor, Hotwire's Orbitz relationship, spend at our new international points of sale and in Europe, we invested in our Ryanair relationship and branding campaigns for Expedia France and Hotels.com. We also continued to increase our global online spend including marketing deeper into the quarter in the U.S. than we have historically on paid search. As has been the case for a while now, we continue to see meaningful keyword inflation.

Looking ahead, we expect selling and marketing growth to accelerate above 30% in Q4. This reflects a conscious decision to allocate spend more evenly through the year rather than significantly ratchet down spend in Q4, as we have done historically. In addition, we plan to continue spending aggressively across our points of sale including brand spend at a wider swath of our portfolio than last Q4.

As it relates to 2008 OpEx, I wanted to mention that we will be relocating various offices whose current leases are due to expire in the near term, including our Bellevue headquarters as well as expanding some of our other current offices. As a result of these plans as well as rate increases, we expect our facilities expense to increase by approximately $16 million in '08, most of which will be reflected in sales and marketing and G&A. Of the $16 million, a little less than half is related to overlapping rent expense through the transition and move-related costs which are non-recurring.

CapEx in Q3 was a $19 million down sequentially as we shifted some planned spend related to our data center build out into the fourth quarter. As a result, we expect to see total CapEx approximately double in Q4 as compared to Q3. While year-to-date CapEx results are running below our initial expectations due to the timing shift I mentioned earlier, we continue to expect CapEx will increase approximately 10% in '07. We expect CapEx will grow at a higher rate in '08 as we continue to invest in technology and infrastructure.

In addition, we will be making significant leasehold improvements to build out our new office spaces. We hope to give you more clarity on our CapEx plans and expenditures on our Q4 call after we complete our annual planning process.

I will close with our updated expectations for OIBA and free cash flow for 2007. We now expect full-year OIBA will grow in the low double-digits. Free cash flow for the year is going to increase based on strong year-to-date performance but we do expect to see negative free cash flow in Q4 driven by seasonality, increased capital expenditures and tax-related payments.

Regarding taxes, we now expect to cash taxes will be $100 million or less for the year. This is down from our prior expectations, primarily reflecting higher stock-based comp deductions resulting from the increase in our stock price. Finally as a reminder, we will make a $30 million Q4 payment to Microsoft related to a tax sharing agreement which payment will reduce cash flow from operations.

I want to thank everyone for your time today and I will now turn the call over to Barry.

Barry Diller

Thanks, Mike. I am hopefully not going to be too redundant. Somehow I think that scripted part of these calls – you should probably deny anyone the ability to use scripts and just present, otherwise it sounds a bit canned.

In any event, the steady improvement that we've had is definitely gratifying. The results also are. As nice as it would be for us to just stand and stare and pause for a minute with pleasure, the truth is that we all feel that we've got to forcefully move forward. We're going to continue to allocate capital to better position Expedia for growth that is going to be able to be sustained over a very long period as time.

The business model that we've got, this really truly great business model, does afford us the opportunity and we are going to be aggressive because we've got an advantage without any question and we should push it. Investment for us is going to remain a key piece of our story and in the area of technology, to think that you've mastered the science of development is foolish. We've had our starts and stops mostly starts, but in the area technology, we've made big investment. We think we have to continue to do so. We think it is very much a competitive edge. I think it's going to help to extend the lead that we have all over the world.

In addition to that, as I think you all know, we want to have an efficient capital structure. We've been making progress in that. Since the spin-off, we've generated $1.4 billion of total cash flow and over the same period, we've put about $1.7 billion into our own stock at a price of less than $23. We've been able to reduce the share count by 20%.

We wish to have done more. As I think you all know, the capital market is willing. We were a bit criticized because we announced the buyback and the amount that we were going to borrow to get there adjusting the moment that markets collapsed and credit completely dried up. But it certainly signaled our intent. As I think you also all know, we want to keep a liquidity of $1 billion and so probably near-term purchases are unlikely. But we've always said we're opportunistic and over the long term, I think you can count on that and count on us to continue to be buyers of our shares.

So we've made a lot of progress but there is no question that we really have to push ahead on all the fronts and that the plans that we've got now, the plans we're making now, the plan for '08 which is very aggressive in all areas is I think going to set us further apart from our competition.

The only thing I want to add before we take questions is something that I'd said in an employee email to Expedia, given the announcement that IAC made this week on the spin-off into five separate publicly traded companies and an awful lot of normal media and other speculation that surrounds that relative to what would happen with the spun-off companies and its relationship to Liberty Media, I want to state it formally, just because I want to be very clear.

This is what I wrote on June of this year and I simply want to reiterate it, which is that I had seen reports from security analysts and others regarding my plans for Expedia and I want to say clearly that I have no intention to transfer control of Expedia to Liberty Media Corporation under any circumstances. I don't want any of you to wonder or worry that the company is being tossed around between me and Liberty as a pawn on a chess board. It is not. I would prefer there be no speculation but since I can't prevent anyone from doing so in various conferences and meetings, I'd rather be on the record with clarity. So, now I am, again.

With that, Stu, why don't we go to questions?

Stu Haas

Thanks, Barry. Let's move onto the Q&A portion of the call with Barry, Dara, and Mike. As a reminder, please limit yourself to one or two questions so we can fit more questioners into the call today.

Question-and-Answer Session

Operator

Your first question comes from Mark Mahaney - Citi Investment Research.

Mark Mahaney - Citi Investment Research

Barry, with all of the spin-off news from a few days ago, is there anything out of that you think that could have a material impact on Expedia in terms of potential synergies? And/or is there a rationale for at one point bringing Interval into part of the Expedia family?

Dara, just on the service fees and the air service fees, there is clearly competitive pressure to reduce -- possibly even eliminate -- convenience service fees. How much of a potential is that and how much risk is that to the financial model? Thank you.

Barry Diller

Mark, it surprises me but you can't imagine how many phone calls and e-mails I have received from different people with different ideas of what to do with all of proposed spin-off entities as well as IAC. I mean it has been as I say a bit surprising. We haven't given any thought to anything other than everything is open. As I said when we did our conference call the other day, that all options are open and Dara and I have, on occasion, discussed Interval. There are some arguments that it makes sense to be part of Expedia, some that it doesn't. If it makes sense to do, we will certainly consider it.

As I say, the great thing about this is having now made this declaration because that's all we've done; we haven't done any of the capital structuring for any of these companies nor did we want to. When we made our announcement we wanted to just make the announcement and then start the process which will take a couple of months to form the entities as they should be formed.

In that interim or during or after the spin, everything is possible. So with that, Dara, do you want to take care of the other part of this?

Dara Khosrowshahi

Mark, as far as the fee question goes, I realize that it is being treated as new news by the market but it really isn't new news at all. Priceline has not had fees on its site for more than a quarter now. I think they took off the fees initially during the summer. Hotwire did the same thing and Hotwire’s fees remain off and we are happy with the results that we're seeing on Hotwire on the air portion of that business as well as the other portions of the business.

From an operating standpoint, I realize that it may be Wall Street news from an operating standpoint, Priceline's actions are not new news. We've gone for about a quarter with Priceline and Hotwire not having fees on air tickets. As I think you see by our results today, the number of air tickets that we've sold this quarter were up 15% on a year-on-year basis. It's a little bit of an acceleration from a sequential basis.

From a defensive standpoint, it hasn't had an effect on us. Obviously, we will watch to see how air does on a go-forward basis. I actually am much more sensitive to air ticket prices. If you ask me what I worry about. I worry about air; obviously the air carriers have to pass on some of the increases that they see in fuel prices and air ticket prices, and some of those air ticket prices have stuck.

I'm more worried about kind of the overall cost of travel to consumers than really the Priceline actions which were in effect a quarter ago and really didn't have any effect on us.

So in general, I like where our air business is heading. It's the first time that revenue has grown for a number of quarters. We're going to watch, we're going to learn. We're certainly experimenting on our own in Europe, but right now, I don't see any kind of change from our perspective.

Operator

Your next question comes from Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

First, you don't really guide revenue, but I do think your OIBA guidance is up for the year now in low double-digits. Could you talk about what is really working for you and what is really ahead of your forecast? It looks like some nice acceleration. Just a housekeeping on the other expense it looks like that prevented some of the EPS upside from flowing through. Is that hedging and what's your outlook for that going forward?

Dara Khosrowshahi

As far as what is up, I'm almost afraid to say it in that the strength that we see at the business is broader than I've ever seen it. So what is up is most of our business is doing actually quite well. The media and advertising business, obviously from a growth rate standpoint, you see already high growth rates accelerating up over 100%. On an organic business, the businesses are accelerating as well. On an organic basis, they are growing over 60%. So really, really healthy growth there. Expedia.com and Hotels.com are looking really strong, and it's a combination of just good ground execution, driving conversion, and then being pretty aggressive on the marketing front as well and actively trying to push our share in the marketplace.

Obviously, Europe is doing quite well. Now I think that the European marketplace in general is just a great marketplace to be operating in right now. I think we had a long, long runway in Europe and I think it's a combination of a great environment and really, really good execution from our team. So the strength that we see is pretty broad.

I think the acceleration and revenue versus where we were last year, last year I think we were growing revenue up 5%, the strength is pretty pleasing to see and obviously the challenge for us next year is the comps we had this year were not very difficult. The comps next year are going to be more difficult and we're pretty focused on that.

Mike, do you want to talk about the other?

Michael Adler

So you are absolutely correct that the flow throughs from OIBA down to adjusted EPS was impacted by FX losses in this quarter of about I believe $12 million. That situation arises for us when our net liabilities and foreign currencies are greater than our net assets in foreign currency and that is more typical for us in the second half of the year based upon the seasonality of the business.

So if the dollar weakens, our liabilities in foreign currency go up more than our assets increase and that leads to a loss running through that line. So for Q4, there may possibly be some pressure again based upon normal seasonality but it depends on what the dollar obviously does versus other currencies.

I would also point out that in this quarter and really go forward as Europe and international becomes a bigger part of our business we become more exposed to this. On the corollary side, we do run FX gains through the revenue lines when the actual stays occur. So more or less over time it all balances out but on a quarter-by-quarter basis, they are definitely ins and outs that impact the flow through.

Justin Post - Merrill Lynch

Dara, could you just do a quick update on where you are at in Europe and how your progress is in China and Japan?

Dara Khosrowshahi

Europe, we are happy with the progress in Europe. You've seen very healthy growth and accelerating growth on an FX neutral basis. France, Italy and Germany are particularly strong spots for us. The Hotels.com business is growing nicely and accelerating on a quarter-on-quarter basis. So we look at the European environment and we're quite encouraged with what we see and I think that we're executing quite well. Some of the fee activity that we've taken on are the air fees, we're staying with and the growth that we are seeing there is quite healthy. Also the package business in Europe is actually doing quite well.

So I think in general, Europe, we're continuing to execute and we're happy as far as the business goes on a broad basis. We really don't see any problems there. We're going to be pretty aggressive as far as supply acquisition in Europe. We're behind Bookings.com on that basis. So when you look at 2008, we're going to be pretty aggressive as far as trying to add to the number of hotels that we have available in secondary and tertiary cities as well. So that is going to be a focus going forward.

In Asia, Japan, specifically China with eLong, we have a new CEO in place and we're very excited about his first month, so to speak. He is very action oriented, making decisions very quickly and I think that you're going to see eLong returning to call it an entrepreneurial Chinese company moving as fast as you have to in that country. So it is very early as far as Guangfu goes and as far as his activity but we're pretty excited there. He is very much focused on call center execution, customer service over there; real focus on sales and marketing and customer acquisitions. So I think he is focused on the right things.

Japan is starting to get some traction. Actually we're pretty encouraged by the conversion trends that we see in Japan. It's the #2 travel market in the world so it is a big market. We've got a hotel-only product, it will take a significant amount of technology work to get an air product up which is something that we're working on but in the meantime, the hotel-only product in Japan is actually starting to execute pretty well so we are quite encouraged there with that.

Also we've got a nice private-label partnership as well. So it is very early in Asia. We are still pushing.

Operator

Your next question comes from Jake Fuller - Thomas Weisel.

Jake Fuller - Thomas Weisel Partners

Could you give us a sense what the organic growth rate might be at TripAdvisor? How much of your overall ad revenue is that and what does the margin structure of that business look like?

Dara Khosrowshahi

The organic growth rate at TripAdvisor is more than 60%. So when you look at the 100% growth, that includes some of the new acquisitions that we brought in. As far as the percentage of the total goes, Mike, do you know what percentage of the total is?

Michael Adler

It is more than half, close to two-thirds including the acquisition.

Dara Khosrowshahi

And then one-third is media and advertising coming into our transactional sites. It is a media business so it's a very high margin business and it's got EBITDA margins over 50% is the way I put it.

Jake Fuller - Thomas Weisel Partners

As you think about the future of that business, is there any change in the ownership structure potentially down the road? Does that benefit from being a standalone company?

Dara Khosrowshahi

I think that if you look at TripAdvisor's performance, its performance is ever increasing and I think that it is very comfortable and executing very, very well inside the Expedia family. If you look at where we are trying to take our company strategically, the media and advertising portion of our revenues is going to become an ever more meaningful portion of our revenue.

When we look at our business five, ten years from now, really the value that we bring to our travel partners is a worldwide audience that is ready to buy travel. Ultimately, I believe as to how we monetize that, whether it is through transaction or media advertising, we will be fairly neutral. It will depend on what our travelers want who are coming to our various sites and what our suppliers want us to do. I think that really puts us in a unique place amongst kind of our comp set. We are thrown into a comp set of OLTAs, online travel agencies. We went to be the OLTC, the online travel company.

We think that TripAdvisor is a fundamental part of that long-term strategy and we think it's a pretty differentiated strategy from what anyone else has. So I don't see any kind of change in TripAdvisor ownership going forward. We are very happy to have it part of our family.

Operator

Your next question comes from Aaron Kessler - Piper Jaffray.

Aaron Kessler - Piper Jaffray

First, can you comment on maybe how the lower hotel prices may have changed your conversion rates internationally? Do you think your strong international growth was due to market share gains? If so, was that more from an online competitors or more to some strong online penetration gains?

Dara Khosrowshahi

It's difficult to tell right now whether our growth internationally was market share gains. If you look at it as a share of the overall travel market, certainly we are taking share. That is not a surprise as far as our growth rate goes. We don't have a lot of visibility into what our competition is doing other than Priceline. Priceline is announcing tomorrow so we will see how they've done tomorrow.

My belief is that the market is doing quite well and I think you'll see great results from them just like you saw great results from us. I do think that when we look at Travelocity last-minute and we look at eBookers, I think those businesses are starting to execute a bit better but they've gone through some painful integration activity. So I wouldn't be surprised if we're taking a bit of share from them. But again, I've got very limited visibility into what is going on there.

We're pretty focused on our own execution and we're pretty happy with our execution so far and we've got some work ahead for us.

Aaron Kessler - Piper Jaffray

Can give us a sense year over year how much maybe Ryanair or maybe the Orbitz Hotwire deal contributed to the growth of those segments?

Dara Khosrowshahi

We don't disclose Ryanair.

Michael Adler

It's a small number.

Dara Khosrowshahi

I think ex-Ryanair, you would still see very healthy growth. If you look at the UK, Germany, France and you separate out the pieces of the European business, you are still seeing very healthy growth across the board. It's not because of Ryanair, so to speak.

Did you ask on Hotwire?

Aaron Kessler - Piper Jaffray

Yes, just give me a sense with Orbitz, Hotwire how much that contributes to Hotwire growth dollar or percentage-wise?

Dara Khosrowshahi

Hotwire is up, revenue is up well over 50%. I'm guessing that it is more in the 70% range on a gross bookings basis and I'm guessing that Orbitz is responsible for less than one-quarter of that growth. It's a good contributor. It's lower margin than our other business but they've been a good partner for us.

Aaron Kessler - Piper Jaffray

Just to clarify on the airline booking fees, it sounds like at this point you have no plans to change maybe the Expedia airline booking fees. Any reaction?

Dara Khosrowshahi

It's been around for a quarter and we haven't seen any adverse results as it relates to our own business. So I don't think right now there are any plans to react one way or the other. Obviously we're going to test and learn and we're doing some testing and learning in Europe.

Operator

Your next question comes from Marianne Wolk - Susquehanna.

Marianne Wolk - Susquehanna

Just on that testing and learning, to what extent have you eliminated air service fees in Europe and when did you do it? Was there a positive result in terms of ticket growth in Europe?

Also last quarter you were nice enough to tell us how many properties were in your merchant program in Europe. Given the fact that you want to invest there, can you talk about whether that figure grew this quarter sequentially and maybe even provide that figure to us again?

Dara Khosrowshahi

Sure. As far as the booking fees in Europe, depending on the geography we have either reduced them or eliminated them totally. It depends on geography. So for example in Spain, we don't have any booking fees. There are some geographies in which if we may have matched the booking fee of call it the dominant carrier in the market. Germany is an example of that.

In the UK, booking fees remain and in the U.S. booking fees remain. As far as the experience that we've had in Europe, so far the experience has been positive in that we have certainly where we have reduced booking fees in Europe and we've kept those booking fees down, we have seen positive results. I'd say on a near-term basis, we are probably not getting a near-term economic benefit but we think from a long-term position, it is a good position to have low booking fees or no booking fees because we think it is very, very early in Europe. If you look at our relative share in Europe to the incumbents; if you look at our share relative to the market overall, we think this is a good time to invest to grow aggressively and quickly and that is a position that we're taking as far as European booking fees go.

On European merchant hotels, we have around 13,000 merchant hotels. It is up 12% on a year-on-year basis and we hope to add significantly to that amount in the next quarters.

Operator

Your next question comes from Chris Gutek - Morgan Stanley.

Chris Gutek - Morgan Stanley

A follow up on the booking fee issue. If hypothetically the pricing pressure in this regard were to spread such that the booking feet were eliminated globally across all your product lines, hypothetically, how much revenue and profit would be at risk?

Dara Khosrowshahi

The revenue that we get from booking fees on a worldwide basis now is around $100 million. Now to the extent that we drop the booking fees on a worldwide basis, you would expect to see conversion lift, so you would expect to see recapture of some of that moneys in the air business itself and then you might see of course some recapture as far as being able to upsell hotels, packages in addition to the users you are capturing for your kind lower booking fees.

Again, I will repeat: based on business trends that we've seen and we make decisions based on business trends, the booking fee issue is not new. It has been around for a quarter and we're very happy with our trends on the air side of the business so we don't see doing it. But there is nothing wrong with you having the information.

Chris Gutek - Morgan Stanley

Just to be totally clear, so when you talk about increasing conversions, if you do eliminate the booking fees, is the assumption that a lot of that increased conversion comes at the expense of supplier direct bookings or conversely do you assume that some of your competitors won't match the elimination of the booking fee and therefore you gain share and get better conversion?

Dara Khosrowshahi

I think that the conversion will be different based on whether competition matches or not. I think that if other OLTAs match there's a whole world out there whether it's supplier direct or offline travel agencies that we would take share from, so to speak, at least on the near term. Again, I think it's a theory right now and again the Priceline action really has not had any kind of broad effect on anyone.

Operator

Your next question comes from Brian Fitzgerald - Banc of America.

Brian Fitzgerald - Banc of America Securities

A question on market share from the North American perspective. Your bookings accelerated there. Do you think you are taking share from Orbitz or Travelocity? And then a quick clarification on the renegotiated GDS contracts, is that a one-time reduction in fees or is there any annual component that decreases over the life of the contract? Thanks.

Dara Khosrowshahi

As far as share from Orbitz or Travelocity, we don't know yet. I think Orbitz is going to announce the results in a week or so. Their growth rate has been decelerating on a sequential basis. Again, we will see this quarter as to whether our increased growth is taking share from them.

I think the environment for us in general, the travel environment you hear it from our travel partners, it's a pretty good environment out there. So I do think that we may be taking some share and I think that we may be benefiting from a generally positive environment and we have a pretty broad exposure to both the European markets and the U.S. markets.

I think that it's a combination of being in a pretty good position and executing pretty well.

As far as GDS economics go, the economics have gone to one particular level and we anticipate that that level is not going to change on a go-forward basis. So I think I talked about how on the non-booking fee portion of our air deals, you are going to see that non-booking fee portion be flatter in 2008 and beyond. These are really long-term deals that we have so these go out to 2010 plus. So we are pretty confident as far as the per unit air economics for the company going forward go.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Dara, I was wondering if you could comment where your pricing is on hotels in Europe given some of the price reductions, not necessarily prices but your take with your hotels your margin there and where you think that can go? Because you commented about next year being a little bit more aggressive on the hotel inventory acquisition.

Secondly, as you think about what you've done so far this quarter in Europe, do think that you could use an alternative branded strategy in Europe? Priceline obviously has done some acquisitions that are different brands than Priceline. Is it possible for you to penetrate that market more aggressively if you had more than the brands that you currently have?

Dara Khosrowshahi

As far as European margins go, our European margins on the hotel side have gone down but that as a result of fee reductions so to speak, fee reduction activity that we took in Europe I think it was either this quarter or one quarter ago. In general I think we're pretty focused on using our scale to kind of take away reasons for consumers not to book. The number one reason why consumers don't book is price, convenience, flexibility. So you see us taking all sorts of actions fairly broadly across our portfolio and understanding how that affects consumer behavior.

So in Europe, we've taken down air fees, in Europe we've taken down hotel fees. In the U.S. for example, we've eliminated change cancel fees for Hotels.com. For Expedia, we've introduced the thank you program. So we are very broadly and systematically going at reasons why consumers may not book and we're taking action on them.

So the European action was a pricing action to our consumers as far as European margins go in general, or hotel margins, they are relatively stable to the extent that you see revenue margins for Europe going down, it is based on our taking down air fees and our taking down hotel booking fees as well.

Michael Adler

I would say one more component of that for this quarter is a change in the book to stay pattern in Europe as well.

Anthony Noto - Goldman Sachs

Your revenue is split there now. How is it comparable to your next largest competitor, which is actually bigger then you, as we know. But are you still in the 20% range and they are in the 10% range or has that narrowed?

Dara Khosrowshahi

It is a lot closer that you might think because our intelligence tells us that Priceline has or Bookings.com has been increasing their revenue margins. What is not included in the revenue margins which is a real cost for the hotel is the credit card fees that we take care of as part of our merchant margin prod and those two together can be anywhere from 200 to 300 basis points and then also VAT as well is something else that we take care of so to speak, is included in the merchant model versus the agency model. So when you look at kind of the total cost to hotels, the total cost to Priceline versus ours, we don't believe that they are as far apart as you might think.

As far as a multiple brand goes, Anthony, we absolutely believe in a multi-brand strategy in the U.S. and Europe. And in Europe, there are three big brands that we're executing on: there's Expedia brand in Europe, there's a Hotels.com brand in Europe, and the TripAdvisor brand in Europe as well. We are going to be expanding in Europe with some of our other brands as well, but as far as our inventory of brands that we have in Europe on a worldwide basis, we are pretty happy with it and we're pretty excited that we have the opportunity to be the only travel company that is actually building three worldwide brands.

I think that there is really no other company in our position. Obviously our competitors have different brands in different places around the world, but I think we're in a position over the long term of building three worldwide recognized brands in Expedia, Hotels.com and TripAdvisor.

Anthony Noto - Goldman Sachs

So my other question about consolidation ties to the branded question but it also ties to your comment that you are trying to leverage your scale to help overcome some of the inhibitions of consumers or hotels or airlines to participate. The question is about consolidation. Do you see that as strategic of you heading forward in terms of both gaining additional scale and gaining additional worldwide brands?

Dara Khosrowshahi

I think that we fundamentally believe that scale matters, Anthony. Hopefully you are seeing it in some of our results and our economics and our margins in general. We are able to invest very aggressively in technology. We are able to invest very aggressively in consumer facing benefits. We have a loyalty program at Expedia.com which is the best loyalty program out there. We think we have a differentiated service and we're hoping that the service becomes more differentiated as time goes on.

So we fundamentally believe in the value of scale in this business and I think you are starting to see the flywheel of scale work for us as we're executing better. That said, we already have the scale that we need. So to the extent that there is a consolidation opportunity, we're going to look at it on an opportunistic basis and we will look at it based on is it a good allocation of capital or would we rather allocate capital for growth or would we rather allocate capital for buying back some more of our stock? I think so far we've kind of spoken with our dollars and the capital allocation we have done internally but we will continue to be opportunistic based on the pricing that we see out there and the specific opportunity.

Operator

Your next question comes from Robert Peck - Bear Stearns.

Robert Peck - Bear Stearns

Dara, I wanted to think a little bit past 2008; obviously for 2008 you've given some guidance about percent of revenues going up, CapEx accelerating as well as you make certain investments in 2008. As we think about coming out of 2008, should we expect those items to pull back down to their current run rates or continue off 2008?

A second question on marketing spend. You mentioned that you saw a dramatic keyword inflation. I'm curious about your thoughts there on your ROI of your marketing spend. Is your ROI going down or are you seeing increased conversions based on the higher CPCs?

Dara Khosrowshahi

On the first one, past '08, it’s pretty difficult to tell. I do think that we are in the middle of pretty aggressive technology and platform investments as a company and that's certainly going to happen in '08 as well. Are we going to be completely done in '09? I don't think so. But I don't anticipate you seeing the kind of acceleration let's say that you've seen our technology and content investments that you have seen and will see over the next two years or '07 versus '06 and '08 versus '07.

So right now, I don't see continued acceleration at the same rates but it is really, really early and either fortunately or unfortunately things change pretty quickly in this industry. If you think about where we were a year ago and from a competitive standpoint and how people were talking about us versus now, it really is a different world. So it's difficult for me to right now predict six months into the future.

What was your second question?

Robert Peck - Bear Stearns

The effectiveness of your advertising spend.

Dara Khosrowshahi

On the advertising spend there are a couple of factors coming into that as it relates to us. First of all, there is keyword inflation and part of that keyword inflation is simply related to ADRs increasing in the industry so you've got ADRs increasing in the hotel business, you now have air ticket inflation as well which relates to suppliers and agencies being able to pay more on a unit basis for keywords, so to speak.

As it relates to our activity and keywords, we are through execution on a number of fronts. We are enjoying higher conversion in a number of our brands. The increase in conversions then allows us to bid more aggressively on travel keywords as well; travel keywords that were not profitable for us say a year ago are now more profitable. That allows us to then more aggressively bid on those profitable keywords, well that is going to create keyword inflation for us. But that is because we're climbing up the value chain as far as keywords go.

Robert Peck - Bear Stearns

Your ROI at the end of the day remains flat or maybe even improves?

Dara Khosrowshahi

The ROI, the last keyword that we buy is going to have a lower ROI than the first keyword that we buy. So in general, as you are increasing your conversion and you are climbing up the value chain, your ROI isn't quite what your base keyword was, but it is still attractive and it's something that we're working on.

So, I would say ROI and SEM, we're still happy with. That said, you have to do a lot of really, really good things just to stand still in that travel keyword world. Now the good thing about our business is that we have a hedge because we have a whole bunch of businesses in the media business that actually are taking advantage of strong keywords in the business, strong CPM advertising et cetera. So as a business, we're building a nice hedge for ourselves as well.

Operator

Your next question comes from Doug Anmuth - Lehman Brothers.

Doug Anmuth - Lehman Brothers

Thank you very much. Dara, just following up on your last comments about building a hedge. Could you talk more about the travel ads platform? How these ads are being implemented and what the early results have been? Do you think that this signals a potential shift in the long term, in terms of how the platform is going to work and how your hotel listings can potentially be shown? Thank you.

Dara Khosrowshahi

Sure, Doug. It's very early on travel ads. I'd encourage you to look at Hawaii, for example. It is a market that we've launched. New York is another market that we've launched. Maui is the specific market in Hawaii, for example. What travel ads does right now is it allows hotels to bid for effectively better placement amongst the hotels listings. To the extent that a consumer then clicks on the specific sponsored results of a travel ad, you go into the hotel page and you can book travel at Expedia on that hotel. So it allows hotels to shift their share within the Expedia marketplace and that is the implementation.

It is really, really early but we think it is pretty revolutionary. It's pretty innovative and it will allow our hotel partners to in a live way move up or down the chain and test what kind of demand they get from us very similarly to what they do in Google. It is very simple and we're going to test and learn.

Operator

Your next question comes from Imran Khan – JP Morgan.

Imran Khan - JP Morgan

I think you've talked about the keyword pricing and the keyword conversion. What can you do or what are you doing to reduce the dependence on the keyword marketing and maybe create a brand or drive more trust to other channels and how is that trending?

The second question is packaged revenue growth rebounded 12% year-over-year I think following last quarter growth rate of 1%. Can you give us some sense what is driving the reacceleration? Thank you.

Dara Khosrowshahi

Sure. Imran, if you look at search engine marketing in general it is not our fastest-growing channel of the company. The fastest growing channel for us on the company is the email channel. It is the lowest cost channel that we have. So it is really CRM initiatives, email are very, very healthy channels for us and that is to some extent why we built the data warehouse infrastructure that we built in order to create a better one-to-one relationship with our traveler, being able to offer specialized deals on a segmented basis to our travelers versus mass mailings. We are seeing really, really nice results from that channel.

So actually our fastest-growing channel is our cheapest channel and SEM is, while an important part of the business, by no means the most important part of the business on a go-forward basis.

The other note that I would say and I've talked about this before is the search engine optimization as a channel for us for Expedia and Hotels platforms, for example, we think are an underutilized channel for us. So when we look at search as a channel while SEM may be a channel where we have to execute very, very effectively on just to stand still, we think on SCO, we're going to get increased traffic from SCO over a long-term basis and that traffic is obviously pretty attractive traffic as far as cost goes.

I think we're doing a lot as far as execution on our customer acquisition and we're pretty confident about what we've got on the cooker so to speak. I'm going to let Mike talk about packages.

Michael Adler

The packaged revenue growth of 12% has been driven by Europe. It is an acceleration from 1% in the last quarter. Europe grew I believe 28% and that is very much volume based, both dynamic packages on the site and also third-party packaged volume. North America actually grew its revenue this quarter on packages for the first time in a while. However, that was not volume-based and it was really due to the year-over-year comp and there was significant discounting last year in the business.

So we don't feel like we've turned a corner yet on the North American packaged business and that still is a substantial portion of the business. There's a lot of work still to be done. We still have the merchant air issues that we have discussed over the last several calls as well.

Dara Khosrowshahi

Imran, I would say the one area that we're really focusing on in this business is just really optimizing the various segments of our business, optimizing how do we put forward offers to our travelers? When someone gets a result set off of a search, what is the best result set to give to that particular consumer?

There is a lot of optimization that you can do behind the scenes that is not let's say a flashy UI, but we think over the long term can really affect how you monetize a particular consumer and the way that you monetize the consumer to the extent that you can create an advantage in monetizing them at let's say 5% or 10% or 15% creates real advantages then when you turnaround and try to acquire customers and try to build scale.

I think in our business in general, we are very focused on that behind the scenes optimization. What I will tell you is that in our packaged business we are still working with a dull blade and there is a lot of back end technology work that has to be done in order for us to really be able to optimize this segment of our business.

Right now we are trying to build the business on a brute force basis. I think our folks are doing a really good job with the tools that they have but I anticipate that two years from now, we're going to have much better tools to play with than we have today.

Operator

At this time, I will turn the conference back to Stu Haas. Please go ahead.

Stu Haas

Thank you for joining us on the call today and for your questions. I want to remind folks that a replay will be available on the IR website shortly after the completion of this call. We certainly appreciate your interest in Expedia, Inc. and look forward to speaking with you again next quarter.

Dara Khosrowshahi

Thank you very much. We appreciate your support and we are looking forward to telling you all about what we are up to next quarter.

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Source: Expedia Q3 2007 Earnings Call Transcript
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