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Expedia Inc. (EXPE)

Q4 2005 Earnings Call

February 15th 2006, 5:00 PM.

Executives

Stu Hass, Vice President of Investor Relations

Dara Khosrowshahi, Chief Executive Officer

Mark Gunning, Chief Financial Officer

Barry Diller, Chairman, Chairman - USA Networks Inc., Chief Executive Officer - USA Networks Inc.,

Analysts

Brian Egger, Harris Nesbitt

Marianne Wolk, Susquehanna Financial

Michael Savner, Banc of America Securities

Safa Rashtchy, Piper Jaffray

Anthony Noto, Goldman Sachs

Scott Devitt, Stifel Nicolaus

Justin Post, Merrill Lynch

Robert Peck, Bear Stearns

Mark Mahaney, Citigroup Investment Research

Michael Millman, Soleil Securities

TRANSCRIPT SPONSOR
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Operator

Good afternoon, ladies and gentlemen. And welcome to the Expedia Incorporated Fourth Quarter 2005 Conference Call. At this time, all participants are in a listen-only mode. Followings today’s presentation instructions will be given for the question and answer session. Operator Instructions I would now like to turn the conference over to Mr. Stu Hass, Vice President of Investor Relations. Please go ahead, sir.

Stu Hass, Vice President of Investor Relations

Good afternoon and welcome to Expedia Inc. Financial Results Conference Call for the Fourth Quarter and Year-Ended December 31, 2005. Joining me on today’s call are Barry Diller, Expedia’s Chairman and Senior Executive, Dara Khosrowshahi our CEO, and Mark Gunning our CFO. The following discussion and responses to your questions reflect management’s views as of today, February 15, 2006 only.

As always, some of the statements made on today’s call are forward-looking, including our comments on guidance, our operational performance and margins, plan 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 to reflect future events or circumstances. Please refer to today’s press release and to the Company’s filings with the SEC including our Form 10-Q for the quarter ended September 30, 2005, 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, free cash flow, adjusted net income and adjusted EPS. In our press release which is posted on the 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. We encourage you to review the section entitled "Basis of Presentation" in today’s earnings release for more details on how we are presenting results for the periods presented. Finally, unless otherwise stated, all comparisons in this call will be against our results for the comparable period of 2004.

And with that, let me turn the call over to Dara.

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Dara Khosrowshahi, Chief Executive Officer

Thanks, Stu. And thank you to everyone for making the call and the time to join us today. Expedia ended the solid year with over 15.5 billion in annual gross bookings and generated nearly 800 million in free cash flow for our stockholders. We launched our Australian site the eighth Expedia branded website in the world and our Hotels.com brand reported four straight quarters of accelerating growth in 2005. And we singed an innovative three-year agreement with Marriott, but for the first time our OIBA fulfilling rooms want our chain partners most need them.

And we successfully completed our spin-off from IAC with a minimum of disruption to our core operations. On the plus side, 2005 was not without its challenges including our results for Q4. Now, Mark will cover this in greater detail during his remarks, but I wanted to briefly speak to it. On the top line, we saw the impact of foreign exchange and reduced growth in Europe. From our product standpoint worldwide air revenue was down 4% year-on-year as we saw a reduction in our revenue per air ticket, especially in our merchant air business.

On car side in Q4, we saw that year-on-year selling and marketing increased that we mentioned throughout 2005, as well as significant increases in our fixed G&A cost as a standalone public company. We talk a little bit about Europe, after adjusting for foreign exchange and acquisitions our organic international gross bookings did decreased from 44% in the first half of ’05, and 28% in the second half of ’05, while we don’t think that 28% is significantly different from other healthy online travel players are seeing in Europe in the back half of the year, we do think that there are several challenges in the region.

Specifically we’re seeing those facts on increased agencies and supply direct competition, which we mentioned on the last call as well as an aggressive push about a traditional and European tour operators to grow their online share as their offline business floats.

We also realized that we need to do a better job of complimenting our core guide business with more inventory in airlines along with better merchandizing into the European as I mentioned on markets something that will be focused on in 2006 and beyond.

Unfortunately the challenges in Europe have been most pronounced in the U.K, which they had generally weak consumer sentiment and as many of you know that’s our largest European point of sale.

Looking back from Q4 now, I think it’s safe to say that from a challenges perspective worldwide competition from suppliers and travel agencies only intensified in 2005, and differentiation amongst travelers’ online experiences narrowed. We address this challenge of Expedia that set out or transformed away travelers plan purchase and enjoy the trip again, as we appropriate 10th anniversary into Octorber, we are in the early stages of transitioning the company from an efficient first class transaction processor to the world’s leading retailer and merchandiser of travel experiences.

Let me be clear that we fully recognized that this is much easier to say than done and we also acknowledge that there are many able companies pursuing these traveled hours. We expect it to be a multi-year evolutionary process. Of course, we don’t begin this journey from a standing start we have a significant foundation of traffic, royal travelers with strong brand recognition. 75% of U.S. travel shoppers online visit one of our sites prior to making a purchase 75%.

Yet at the end of the day to 5% of total U.S. travel expenditures incurred at Expedia.com, we have to do better. We saw many piece of progress planted in 2005 including Expedia.com’s first home page redesign in several years, Hotels.com re-branding from low prices at hotel experts, including stock buyback comparison features, compelling email campaigns, project shopper behavior and segmentation, ship adviser reaching over 3 million to review their opinions and early in 2006, we introduced Expedia Promise and Expedia Best Price Guarantee offering the industry’s broadest and richest price guarantee across nearly all products, purchase of Expedia with not only a price match, but a $50 of travel coupon on top on it.

On the supplier or partner services front, we have strong relationships with nearly every major hotel chain in addition to Marriott we’ve also signed the hotel with Kimberly Hotels and Accord North America. And we also made strides in the car rental business with strong preferred relationships with budget and perks and enterprise with we recently signed an agreement, we hope that have much more good news in this area going forward.

We focus on investment in three significant areas as we take our company to the next level; our people, our international business and our technology and operations.

First people, we made great strides in 2005 and put in place what I think is the most talented driven focus team in the travel industry. This excellent extends across our organization from our worldwide point of sale, the staff function such as finance, HR, partner services, technology and operations in travel care. This investment doesn’t just stop at senior management, it goes deep into our organization from attracting and retaining great talent at all levels, to putting training programs in place to improve our employee skills across the board.

We are continuing to invest in our international markets, organically building a global business for our competitors that have to establish their presence through acquisitions. This year we expected to invest over $30 million in incremental marketing dollars in some of our newer markets, France, Italy as well as our Asia-Pacific region while we already have a presence in China, have launched Australia and our aim to open up shop in Japan hopefully by year-end.

Turning to technology and operation, as we mentioned last quarter you should expect to see the pace and significant of product innovation increase going forward, and feeling that acceleration will be some significant platform improvement that were targeting to complete over the next two years.

First and most importantly, we are investing in and building a scalable, expansible service oriented technology platform that will extend across our transactional brands resulting a long-term cost savings, improved flexibility, faster go-forward innovation. This transition will allow us to improve our site merchandising, browse and search functionality and have significant personalization features and ultimately improve our ability to drive higher return on investment in our online and offline advertising. The expected transitions occur in a face approach with worldwide point of sale migrating for the new platform over the next 2 years or so.

We’re also adding a significant upgrade to our data aggregation and mining capabilities across Expedia Inc. With installation of a robust enterprise data warehouse, this is a $20 million to $25 million undertaking with about 10% of that investment already incurred and the remaining split between ’06 and ’07. We are also making investments in systems and operations to integrate and significantly improve the customer experience of our travelers going forward.

And last but certainly not least, by this time next year we anticipate that we will have launched the significant royalty effort for our travelers. I don’t want to say anything more on this program as yet or we will update you on our progress as we move later into the year.

Before I move to some comps on 2006, I want to update you on three specific items, our GDS integration, the Hotels.com re-branding and our progress at Expedia Corporate Travel. As we mentioned in prior calls, we’ve been having multiple distribution options in a deregulated air environment is just good business. And we remain committed to the GDS model for air connectivity. As such, we are preceding our technical integration of two new GDS partners. The first is Amadeus with whom we expect to complete our initial integration by the beginning of Q2. The second is Sabre with whom we expect to complete our initial integration by the beginning of Q3. These integrations afford us the option but not the obligation of flowing segment to multiple GDS vendors. The estimated timing and distribution of actual segment among the vendors is not something we are going to comment on at this time. That said, I do want to stress that we continue to value our relationship with Worldspan and anticipate that they will remain a meaningful part of our GDS mix going forward. Regarding GDS economics, which I know is a great interest for our investors. Sabre’s recent announcement of pioneer deals with several carriers reinforces our belief that the fundamental GDS airlines model will remain intact at likely at reduced compensation level.

As a result, we continue to believe that Expedia will experience reduced revenue per air ticket in ’06 as we did in ’05. In Q3, we mentioned that early results from the Hotels.com brand transition were promising. This trend continued in Q4 as gross bookings grew 50% its highly quarterly rate of growth since Q1 of ’04. Hotels.com a significant online travel brand with traction is 1.9 billion in annual bookings, will make it the 5th largest online travel brand in the world. As importantly from the brand portfolio standpoint its travel base is complementary to the core Expedia traveler, more value concepts more likely to drive to their destination, more likely to book by phone and partial to a short of booking window.

Turning to Expedia Corporate Travel, ECT grew its 2005 gross bookings more than 90% year-over-year to over $700 million. We also recently expanded the geographic footprint of ECT’s Canada and we continue to build our client roster during the quarter including adding CVS-America's largest retail pharmacy. While ECT has become a leading travel management company in three short years as we certainly aren’t anywhere near satisfied with our progress.

We continue to believe that thousands of our clients reinforce that there is market demand for their industry leading technical solution that we offer, that said we need to improve our worldwide supply and point of sale reach, these are areas on which we will be focused in 2006 and beyond and we hope to report final progress in these dimensions and quarterly across the comp. It’s our expectation that ECT will grow from less than 1.5% of our worldwide gross bookings in 2005 to 10% over the next few years.

Now, let me talk a bit about our expectations for 2006, our management team proactively decided that it was emphatically worthy to increase our investments in people, technology and systems, yes Expedia is the leading online player in this vast industry that is travel, products and services, but despite our need we still account for small percentage of total travel transactions, which we regard as our marketplace.

Along with our ongoing investments we outlined we also added cost of being an independent public company in 2005 which we believe will be very much in our long-term benefit, but these factors will combine for typical year-on-year comp comparable in 2006 especially early in the year which we will not offset with direct marketing ups. We believe that the investments I’ve outlined will begin to separate us from the pack in 2007, but we don’t expect that they will have much effect in the current year.

Stating together we believe that these factors will result in high single-digit negative OIBA growth in the first half of 2006 but we expect positive OIBA growth in the second half of the year. We are positioning ourselves for what we hope will be a great 2007 and beyond, and we certainly believe that we are making the right best for our company going forward. With that over to you Mark.

Mark Gunning, Chief Financial Officer

Thanks Dara. Rather than reiterate our release figures in detail, I prefer to spend some time analyzing a few key pieces of our business model and then talk to some longer-term shareholder issues around working capital, taxes, uses of cash and dilution, as Dara indicated in his open, gross bookings growth was down from 21% in Q3 to 17% in Q4 based on the domestic and international factors, he mentioned.

Further, revenue margin decreased 59 basis points year-over-year, building revenue growth of 13%, in addition to the pressure on air revenues per ticket and higher air fares we witness 125 basis points of decline in our merchant hotel raw margins from 2004 to 2005. Based on the recent deals we’ve signed to many of the top chains and our existing arrangements with independent and smaller chain hoteliers, we think more of the margin erosion is behind us and ahead, as such we are expecting half as much raw margin decline in our worldwide merchant hotel business in 2006 than in 2005.

I want to reemphasize that internally, we are much focused on driving absolute profit dollars in maximizing profit margins. We are certainly mindful of margin, but more important are the absolute level of transactions to the various Expedia points of sale. Part and Parcel that its effort is increasing our packages mix though we make significantly more profit dollars per transactions. And many of the initiative Dara laid out earlier are designed to improve our packaging volumes. Despite 13% revenue growth in Q4 we saw our Company’s primary operating metric for measuring success, operating income before amortization or OIBA declined by 7%.

Reasonable questions for investors to ask are one, why do we see this degree of deleveraging in Q4? And two, what can we expect going forward? Beginning with gross margin, gross margin was down just 33 basis points year-over-year accounting for 1% of the difference between revenue and OIBA growth. As the gross margin going forward some of our in Apollo efforts are focused on reducing fulfillment cost on air ticketing as well as our transaction in fraud cost on credit cards. But we are also captured data center travel service cost in COGS. You know only well the efforts outlined earlier in the call, put pressure on these cost but these cost tend to move with gross bookings versus revenue.

Moving to operating expenses, in total OpEx increased from 45% of revenue in Q4, ’04 to 51% in Q4 ’05 with each of our operating expense line items growing 20% or more. Selling and marketing for the quarter was up over 20% which is consistent with our emphasis on prior calls that we would see a significant increase as we elect Q4 ’04 spend the level which we felt we understand in marketing.

But digging in a little deeper our direct ad spend, affiliates paid search, total spend in offline media was up 15%. Fairly inline with revenues but certainly an acceleration from the 3% decrease in direct spend we saw in the first three quarters of ’05. A personal spend in selling and marketing was up 40% this is primarily fixed cost we added by ramping our market management staff in our partner services group in ’04 and ’05. Expanding the team to over 350 across the globe by year-end. Our market managers are critical touch points in building successful supplier relationships this was an exclusive decision we made to ramp this team aggressively. These relationships combined with our scale can make Expedia the most important online partner for our air, hotel and other supplier partners. We are already seeing benefits from our partner services group as witnessed by a recent hotel deals in our expectation of lower margin elusion in 2006. But this hiring, another hire in marketing was costly and did significantly impact our leverage in 2005. For the full year over 90% of the year-over-year increase in sales and marketing dollar expense was due to people cost. And we not made deals in other personal investments, selling and marketing as a percentage of revenue would have decreased from 35.4% to 30.8% generating 460 basis points of leverage, moreover 200 basis points more efficiently in the improvement we actually showed for the year.

Going forward, we are only have the increased fixed cost of market management I mentioned, but we also anticipate lower efficiency gains in our direct spend versus 2005. We also expect to see some inflation in both our online and offline media buys which include a full year of increased rates from our renewed MSN deal given all these factors we anticipate selling and marketing expense increasing as a percentage of revenue in 2006.

G&A expense is the next biggest budget of OpEx and was up 39% year-over-year. Increasing to 13.2% of revenue from 10.7%, also the increase have been building in Q2 and in Q3 as you ramped up our staff functions and leveraged external staffing providers to support becoming an independent public company, particularly in areas of legal, finance and accounting. In Q4 our people cost was relatively flat from Q3, but we will see some additional hiring and increased G&A in 2006, particularly in the first half on a year-over-year basis.

Lastly is technology and content expense, which grew from 5.3% of revenue to 6.3% in Q4. As with G&A the bulk of this year-over-year increase is due to hiring on our technical teams, adding software engineers, product managers, program managers, Q&A and other technical staff. Given the technology initiative outlined at the outset of this call investors should expect our absolute level of spend in technology and content to increase in 2006 and beyond.

I do want to address four areas of interests to our long-term shareholders. First, is the role of working capital in our free cash model. Our business is unique in that we have a negative operating cycle as it relates to merchant transactions. We collect cash from our travelers significantly ahead of the time that we pay our suppliers. Our higher book to pay window for merchant hotels in 2005 was over 60 days, up slightly from the cycle time in 2004. Roughly 1/3rd of this time window is from the time travelers’ book their travel to when they stay. And 2/3rds is related to the time for when travelers stay to when we pay our hotel suppliers. As long as the cycle is not compressed due to short of booking windows from travelers or tighter terms from our supplier partners. We would expect working capital to be a meaningful component of our free cash flow growth going forward. Our taxes anticipate full utilizing our net operating losses or NOLs in 2006. We are not forecasting our effective tax rate at this time and we would expect it to be in excess of the standard federal rate of 35%.

Turning to uses of cash, our senior leadership is very mindful of our investor returns on equity. We would therefore intend to return excess cash to our shareholders in the form of stock repurchases or maintaining a prudent level of flexibility in the event of changes in a competitive and macro economic environments. And as always our decision depends on the specific opportunity, i.e. our stock price for relative evaluations of potential acquisitions or other uses of cash, which we feel, will enhance long-term stockholder value.

And lastly is the matter of dilution. We think dilution is an often overlook by key piece of information in helping long-term investors forecast their expected returns. Expedia is committed to efficiently managing dilution to our owners. More specifically we are targeting net dilution from employee equity awards for the grant net of cancellations to an average of 1% or less. Assuming present capitalization, to may be years where will be above or below this level but on average we are targeting 1% or less.

I now turn the call over to Barry for some closing thoughts ahead of Q&A.

Barry Diller, Chairman, Chairman - USA Networks Inc., Chief Executive Officer - USA Networks Inc.,

Look I really do hope that no one mistakes our message today. Expedia had a good year in 2005 certainly wasn’t without a lot of challenges both within and without and that’s because we decided to take on every issue and deal with them straight away. We knew it would cause some rough ways here and there but hard cementing our leadership is an opportunity we really shouldn’t pass up. It is simply the nature of the ecosystem that we in have it, no Internet company is beyond the clutch of increasing competition. Transparency, relentless expansion and continues innovation is what we have to do every day.

What I think is really important for our long-term investors to take with them, is that we are by conscious choice and from our position of strength, choosing the path that Dara and Mark have articulated. We are laying the technical foundations for significant improvements throughout or worldwide points of sale both for our travelers and our suppliers. My colleagues and I strongly believe that these investments will afford us an opportunity to transform today’s largest online travel engine by far into tomorrow’s leading provider of travel experiences. And from that I would expect would come meaningful value for our shareholders.

So, I think we now want to move on to questions, I am sure you all have a lot of questions we’ll take as much time as you need within anybody’s level of rationality. So Stu, why don’t we proceed?

Stu Haas, Vice President, Investor Relations

Great, thanks Barry. Let’s move on to the Q&A portion of the call with Barry, Dara, and Mark. As a reminder, please limit yourselves to one or two questions. Operator, would you please remind our listeners how to ask a question?

Questions-and-Answer Session

Operator

Thank you sir. Ladies and gentlemen, at this time we will begin the question and answer session. Operator Instruction Our first question comes from Brian Egger with Harris Nesbitt. Please go ahead.

Q - Brian Egger

Hi guys, can you talk about specifically in your merchant business or both airline business and hotels, was there any specific change in the total business in the fourth quarter, I know you talked a lot about lower hotel – low margins and I am wondering if that was anything that was the sort of an ongoing trend or something that may be changes in back half of the year. And maybe tell us a little bit more on maybe the market trend, the margin trend is related to airline merchant business?

A - Dara Khosrowshahi

Sure, talking about the airline business in general. I think the trend that we are seeing in Q4 are not that different from the trends that we have seen at least for the past couple of quarters which is the airline declining is very, very high -- low factors. The low factors continue into this year and as a result the per-ticket air pricing is up significantly. I think in Q4 we saw increases in kind of our agency, ticket prices on average of 8% to 9% at least in the U.S. businesses. What that does for the increase in gross bookings value for ticket so to speak is great for the airlines, doesn’t benefit us because we get paid on a per-ticket basis. So certainly while it’s the pricing is healthy, it’s not something that translates to our bottom-line and again we are seeing the same trends going forward. In addition to that, it doesn’t look like the domestic carriers are adding a significant amount of volume to at least their domestic groups. They are adding volume to the international routes and we are seeing benefit from that, but the domestic routes they are not adding much – much low to the domestic routes. On the hotel side of the equation, I think our hotel business is very solid, we’ve seen reports from different hotel companies out there. And I don’t think that we’ve seen any significant trends that are different this year than last year. We are pretty confident on the progress that our team is been making as far as our chain relationships go in the partners services group. And what we’ve essentially seeing are long-term deals that we’re singing up with the large chains that go on for multiple years, Marriott is just an example where we are walking in kind of what I recall, the merchant rate of record. So as market, and I recall we do think that the rate of decline in our merchant hotel margin is going to decrease as the year goes on in ’06. Probably you will see decrease in the first half, and again the rate will as the year goes on, I think things will get better there. And that is a very, very important metric for us, and something that we are pretty pleased with the progress that we are seeing.

Q - Brian Egger

And I guess if you takeaway from this that the – merchant markup that which these for sort of the entire relationships you negotiated, probably well within previous years that we seem to be maybe approaching some type of top year, you think stabilize a bit?

A - Dara Khosrowshahi

I think we are certainly seeing stability as far as the kind of conversation that we are having with the big chains. They recognize the value that we bring to table and more and more we’re talking to them about I think more value added relationships, one transaction doesn’t fit all sizes, we’re actually sitting down with them, we really understand our business a lot better now than we used to, and we’re setting up deals with them where if we help them, do encourage them which they have high need so to speak, they make it as higher margins and to the extend that we need them during certain period we make a lower margins that’s allows us to optimize kind of the demand in the supply coming into our correspond a lot better going forward than we have in the past.

Q - Brian Egger

Okay, thank you.

A - Dara Khosrowshahi

You bet.

Operator

Thank you. Our next question comes from Marianne Wolk, with Susquehanna Financial. Please ago ahead.

Q - Marianne Wolk

Thank you, I just wanted to get back to your comment about cash flow and working capital benefit, implied that the cycle is actually improving for you in ’05, you also indicating that based on performance recently that we see that improved again in the first half of ’06?

A - Mark Gunning

Yeah, this is Mark, no I don’t think is to be assuming as is going to, not only the guidance, what happens in ’06 from cash flow so much of our cash flow is due to timing of working capital and so again one point in time at the end of the year when you’re, when you have pre-pays, when you are paying off your merchant payables, there is lot of fluctuation there, its very difficult to guide some, one period of time, I think that’s the business cycle itself, but you have announced, there is no changes as far as the standpoint of, few changes and let me pay our merchants that it should be a time initiative at the end of the year.

Q - Marianne Wolk

So, just to confirm based on the long-term contract you are signing with your merchant itself there should be no change in the term that would hurt your ability to capture cash flow?

A - Mark Gunning

Low contract, there is slight changes, any consigned we negotiate contract, but that’s enough significant changes at all at this point in time going forward.

A - Dara Khosrowshahi

Yeah, at this point we don’t see any changes to the model, to the fundamental model, is that what you are asking?

Q - Marianne Wolk

Exactly. Thank you very much.

A - Mark Gunning

You are welcome and Marianne we just remind you, as we said earlier we did see an expansion of negative operating cycle days in ’05 versus ’04. Operator, if we could take the next question please.

Operator

Thank you. Our next question comes from Michael Savner with Banc of America Securities.

Q - Michael Savner

Hi, thanks very much. Two questions, one a continuation on working cap, just to make sure I am understanding correctly and maybe I am not, but when you talk about free cash flow from working capital part of the growth of overall free cash going forward, we should assume though that’s a diminishing contribution unless we were to assume that your gross bookings continue to accelerate its growth rate because if you’re – if you are growing your bookings at a slower rate then that should decline over time, so I just want to make something about that correctly. And number two, maybe just touch on the balance sheet from many kind of what the optimal balance sheet is obviously, you have basically no debt and so what are your uses of free cash flow, you’ve got, aligned some investments in ’06 and going forward but certainly not a meaningful number, I mean meaningful percentage of free cash flow you’re going to be generating, so just how you think about the optimal balance sheet? Thanks very much.

A - Barry Diller

Yeah I think, and Mark correct me if I’m wrong, on the working capital question I think what we’re saying is our working capital will be a positive contributor, how positive a contributor will it be depends on not only the growth rate but the incremental growth dollars, gross booking dollars, growth that we’re seeing year-over-year and we certainly don’t think that the portion of the free cash flow that you’re seeing from working capital is been a growth as fast at the portion of free cash flow kind of growing as a result of operation.

Q - Michael Savner

Yeah thanks that make sense, so I think the way it was rewarded was it will be a meaningful component of free cash flow growth?

A - Mark Gunning

Yeah, I think its free cash flow.

Q - Michael Savner

Thank you.

A - Mark Gunning

Okay, and on the second question I think was on balance sheet, and I think our attitude on balance sheet is that we want to retain a significant amount of flexibility first and most importantly, and we do have a revolver to that effect but we certainly do want to have some cash on the books to the extent that an unforeseen circumstance happens. We do have a fair amounts of, significant amount of deferred merchant bookings on our balance sheet and we always want to have the flexibility and the liquidity just in case something happens to either credit or customers back or for payables et cetera. I think, we’re happy with the amount of liquidity that we have now, and to the extent that we have excess liquidity we’ll look to alternative uses of that cash, those could be acquisitions, it could be stock buybacks or other users of capital certainly we deal through our bunch of cash from operation. So later in the year I think we’ll be addressing this.

Q - Michael Savner

Thank you very much.

A - Dara Khosrowshahi

Go ahead Mark.

A - Mark Gunning

Okay, we also, I think you mentioned that we did not have any debt but we do have $230 million of debt at the end of the year.

A - Dara Khosrowshahi

That’s not net and I guess is the – close to that.

Q – Michael Savner

Okay.

A - Stu Haas

Okay, operator we could take the next question.

Operator

Thank you. Our next question comes from Aaron Kessler with Piper Jaffray. Please go ahead.

Q - Safa Rashtchy

Hi, it’s actually Safa Rashtchy from Piper Jaffray. Couple of questions, first Dara, you mentioned that you’re embarking on investments, fair to size on investments in ’06 which you feel is the greater strategy and will help you differentiate from the competition from what we’ve seen and that your initial comments as well, the difficulties that you face in ’05, entering Q4 were more because of the broader market conditions. Do you feel that differentiating from competition will help alleviate that and if so, can you give us some more color, in what way these investments will help you offset for instance declining airline revenues or more inclination by the hotel suppliers to go direct?

A - Dara Khosrowshahi

I think on the, Safa we are not saying that the environment isn’t difficult, I think it is difficult it is competitive, when you got to look at the overall size of the travel market, $800 billion it’s huge. All right, so it is natural that you are going to have a ton of competitors going after this larger market and will about some 5% of the total marketing in the U.S., so we think the size of the market is very large although we do think it’s going to be competitive. I think the course that we are taking going forward is really moving from trying to gather call it new users; they are trying to convert the users that are coming to our front-end more effectively. And in the little bit of work that we’ve done and kind of the website we designed and some of the direct marketing work that we’ve done, so that the emails that we are sending out to our consumers are specifically segmented, they are targeted rather than one email for our consumers. We are seeing really nice conversion benefits, unfortunately we are just getting started on this and our persistence that we have in place can’t really scale the way we want them to in order to get these conversions on a broader scale and on a global scale. So, we got to make the systems investments which are kind of upfront investments, we already know that the stuff works we just have to execute on it.

Q - Safa Rashtchy

Okay and a follow-up if I may, could you give us some color on how the package business was in Q4. And overall also in ’05 you mentioned that you are pretty positive and hopeful on it given that the air component and I think you mentioned the merchant air was also under pressure, how should we look at the year package margins going forward? And overall what do you see in terms of the demand dynamics for packages?

A - Mark Gunning

I think the demand dynamics and packages are good although I don’t think what we are not doing is effectively as we can is to move the shoppers who are coming into the Expedia or Hotels.com or Hotwire sites to move them from booking individually and booking individual components to have them shop on a package path. So that’s really what we’re focused on, its merchandising better and pushing our consumers to packages much more aggressively. And mid-year for example we have a bit of a site redesigned that’s focused on that more. So, I say our package performance in ‘05 was okay. I think we have a long way to go and clearly our, the profitability for a package customer is significantly, significantly more. And the revenue for package customer significantly more than the customer that tends to shop on a standalone basis.

A - Barry Diller

Great Safa, this is Barry Diller, I think it’s in packages and in every other area, the area that Dara just spoke to the areas that too varied in terms of differentiation. These investments are were late, they should have been made before but for whole positive reasons they went, so the operating management run by Dara and by great group that he has brought in the end of last year have really put these investments down towards differentiation and overtime they are going to allow Expedia to be a value add to the ITP ideal is to be a value add service. You come to Expedia not just for information because compellingly you are going to have a better experience all the way through and that towards and other things that are going to be part of that is I think that thing that is going to take this leadership that we have and really truly hard to manage for the future that’s the motivation for doing this, and that it – it is being done, of course what is a very though environment, but it’s a though environment where we maintained our leadership and this is what I think is going to allow us to expand it.

Q - Safa Rashtchy

That’s helpful, thanks Barry. Thanks Dara.

A - Barry Diller

You bet.

A - Mark Gunning

Thank you.

Operator

The next question comes from Anthony Noto with Goldman Sachs. Please go ahead.

Q - Anthony Noto

Thank you very much. Dara you read out a lot of different areas of investment and challenges I was wondering on this differentiation question, we ask consumers every year what charge of the purchase that one side versus the next in its prioritized price selection information and I was wondering against those three dimensions which do you think you can really dominate, and if you give us the prioritization of the things you’re trying to accomplish in 2006 with the spending to accomplish that, and the last question is the returns on invested capital for Expedia using a strict definition is about 7% in 2005, 2006 currently won’t go up given the growth that you made out for net operating profit after tax, I mean level invested, making the invested capital, where do you see that going overtime after you get a benefit from these investments? Thanks.

A - Dara Khosrowshahi

Anthony, actually when we looked at, we booked our customer segmentation as well and I think the price, price is kind of a common denominator out there, we have to be able to get competitive pricing with everyone else and I don’t think that price is necessary something that you can differentiate, you can make claims about price but we think our base job is to get the best prices out there. I don’t think that that’s going to be able to both as ahead of anyone out, I think that’s kind of a ticket to play so to speak.

Q - Anthony Noto

All right.

A - Dara Khosrowshahi

When you do take price as a base. Now that said, when we look at our customer segmentation around 20% to 25% of our customers are almost totally price will without almost any other consideration go to the lowest price. They will spend hours and hours and hours on the web to save 10 bucks and tell their neighbor about how they saved 10 bucks. We are very focused on that segment with Hotwire that is kind of made true to its opaque groups and its trying to move from just being opaque to being a real price leader for that specific segment. Now while Expedia will certainly serve that segment, there is 75% of the population that’s looking for what you talk about selection, information, convenience et cetera. And honestly, we want be best of breed across all of those factors, you’ve seen the investments that we made in the content that we have on the website, the kind of hotel content that we have, I think internationally the best of breed. I think the selections that we’ve bring to there is a best selection out there. The customer service that we provide to our travelers, we’ve done a lot of studies there is leading, although we don’t think that it’s nearly where it can be, so we certainly want to improve on our customer experience as well. And I think more than anything we want to change the way that we merchandise to our customers. We want our travelers when they come to Expedia to feel an experience were Expedia talking to them and it talking to that particular customer in a different way from other customer. So a lot of the advances that there you will see are actually on how we talk to customers and how we reach out the customers. I think there was the – what was the second question?

Q - Anthony Noto

Oh it was, I am sorry, it was about returns.

A - Dara Khosrowshahi

Okay. I think our return on invested capitals, the numbers that you see the 7% it certainly not something that we are satisfied with from a long-term, it’s the result of Expedia coming together as a result of the number of acquisitions. So, there is a significant amount of goodwill on the books and that goodwill is defined as invested capital. As we go forward and we certainly do expect to grow kind of net after-tax profits which is the numerator of that formula. I think that our return on invested capital will increase fairly significantly. And Anthony, if you take a look at what I will call incremental return on invested capital, remember that on our organic basis virtually have a negative working capital cycle. So I think if you look at the business on the increment, there aren't that many business that, that gets you better returns on invested capital than this one.

Q - Anthony Noto

Thank you.

Operator

Thank you. Our next question comes from Scott Devitt with Stifel Nicolaus. Please go ahead.

Q - Scott Devitt

Thank you, I have a question about Europe, I was wondering if you can just go into a little more detail in terms of what is going on there. And I am just particularly interested in, you noted economic environment as well as more aggressive actions by airlines directly as well as tour operators. And I was wondering if you can give us some color as to the distinction between the two and whether or not you think Europe is becoming similar to what the U.S. was two years ago where suppliers began to aggressively pursue direct opportunities, thanks.

A - Dara Khosrowshahi

Well, I certainly weren’t expected to be any difference from a supplier perspective. Now the first thing that I would point out to you is that, a significant amount of the difference in the growth second half versus first half for Europe was because of FX, you really should take those numbers out. It’s certainly a reality of our business but it’s not, that’s not something that we can do about. But we do see in Europe that same supplier dynamics that we have in the U.S. slightly different. The airlines are as aggressive as the airlines in the U.S. where kind of now and where a year or two year ago – two years ago. It changed on the hotel path or much less of a factor, the factor in Europe are not nearly as larger factor. And as we know the penetration of independent hotels in Europe is much larger which is good for us from an economic perspective. But the players however that you see in Europe which are the tour operators, the tees of the world, the Thompson's of the world, they are confidence on the world. They are very, very larger leisure players, they are significantly larger in Europe than we are; they are getting much more aggressive on the online side of the business as kind of a offline side of their business slows down. So we do expect to see similar dynamics in the Europe though as we saw in the U.S. two years, I think we are up for, we’ve learned some lessons. But what I also mention that, Europe is a bigger market than the U.S. and we are pretty positive on where we can take it.

Q - Scott Devitt

And just one another question, could you update us on direct connect or the percentage of merchant partners that are actually on direct connect? And also if you could give a percentage of merchant bookings that are from direct connect at hotels? Thanks.

A - Mark Gunning

It’s approximately 30% is direct connect right now.

Q - Scott Devitt

What percent of bookings? Of merchant?

A - Mark Gunning

30% of the merchant. Merchant hotels are fully direct connected, Scott.

Q - Scott Devitt

Okay.

A - Mark Gunning

And then, just a quick follow-up on Dara’s point, we’ll also point out in Q4 that international rev margin was above domestic revenue margin, it’s something that to think about as you think about those dynamics internationally. Operator, can we take the next question, please.

Operator

Thank you. Our next question comes from Justin Post with Merrill Lynch. Please go ahead.

Q - Justin Post

And really actually in the international outlook and how things have changed there, was there any events in the U.K. that really made a difference in the second half versus the first half, ex-currency. And then secondly are there any other countries that are building scale that could be meaningfully helpful as we look forward in 2006 and 2007?

A - Dara Khosrowshahi

It’s difficult to point to a specific events in the U.K. Justin, that cause the slowdown but we’re definitely, we definitely saw the slowdown. We have, we think that it is something that has have affected our competitors, you’ve seen kind of dependent announcements and there write-downs of the brokers. I think Sabre has said that they have challenges in the last minute business, but they are good operators I’m sure they worked their way through it. And as we kind of ask some other folks about what they see in Europe and what they see specifically in the U.K., they are seeing some slowdown as well. Now I do think that some of the slowdown is probably a little greater as it relate to us because of the supply direct kind of dynamics that I talked about but just the U.K. just seems kind of slow right now. As far as other markets that are getting to scale, there aren’t any markets in the Europe that are nearly the size of the U.K. but certainly taking together Germany, France, Italy are starting to get to pretty good sizes. Germany for example, this year was profitable for the first time and while we are planning significant amounts of incremental marketing dollars into Italy and France. We think those are kind of investments that will pay-off, we certainly saw them pay-off in the U.K., we saw them pay-off in Germany and we expect to see similar pay-offs in those markets as well.

Q - Justin Post

Okay and two quick housekeeping things, did you get any benefit from deferred income taxes, I didn’t see it in the cash flow statement for cash flows in ’05 will that change next year. And then you didn’t mention project Palo is there, is that still going on?

A - Dara Khosrowshahi

Mark you want to take those?

A - Mark Gunning

Yeah, I am starting with, starting with the Palo first. First of all yeah, there is lot going on with the Palo. We’re focused as we mentioned before on the integration, Dara mentioned and I’d mentioned about the investments for making a lot, it’s also tied to a Palo. We should, this is an ongoing, we haven’t integrated, it’s an on going process, it’s not something that happens within 3 or 6 months. We’re starting to see savings, we should start to see savings in ’06 to Palo we should talk about integrating the businesses which is a big part of it. This is a 12 months type 18 months process you go through, particularly we started talking about integrating systems, back offices, it look scenes are developed, again detailed work plans were executing against those plans and as we said we’ll start seeing benefits in 2006. So, there is a laser focus on this right now as we push with our business on Palo.

A - Dara Khosrowshahi

And Justin, just that upfront cost for this stuff are pretty significant. So even though we’ll see the agents come on, to some extent in ’06, they are going to be offset by cost of doing this kind of integration work, right Mark?

A - Mark Gunning

That’s right.

Q - Justin Post

And then on taxes, did you get any benefit in ’05, sorry the NOLs or cash flow?

A - Mark Gunning

Yes, the answer is yes.

Q - Justin Post

Okay, can you quantify that at all?

A - Mark Gunning

No, I no.

A - Dara Khosrowshahi

What was the number for that.

A - Mark Gunning

No, I don’t. We can get back to you with the detail offline.

Q - Justin Post

Right thanks. Thanks Dara, thanks Mark.

A - Dara Khosrowshahi

You bet.

Operator

Thank you. Our next question comes from Robert Peck with Bear Stearns. Please go ahead.

Q - Robert Peck

Hi Barry or Dara, I was wondering if you could comment a little bit about the meta-search engines and what Kayak and Sidestep have meant to your, any imitation its had on the business so far. And well, could you talk a little bit about the Google relationship, when you type Philadelphia to New York into search engine, it gives bunch of choices back. How was that implicated in your financials as well?

A - Dara Khosrowshahi

Just quickly, Barry I’ll start I don’t know if you want to continue. But with meta-search engines really, certainly a less of a deal in reality for us than they have been made in the press. I can’t, its – I think Kayak and some of the others have a nice product out there. But fundamentally I think if we do our job, which is to get great and broad pricing across our air product, across our hotel product, across our car product. I don’t see what they are offering other than kind of an economic model that doesn’t match our economic model. And I don’t see how they can gain any kind of real brand awareness or broad brand awareness. Are they going to go away no, are they going to compete with it, absolutely, I think it keeps us on our toes and I expect them to get better and better as time goes on, but I don’t see them as any kind of a fundamental threat to our business. So, I think that our business model is better and I think there is much, much more that we can do as far as improving our customer experience in getting broader selection, better information from our customers with our model. As far as Google goes, Google is a great partner of ours. We, they are a significance kind of a source of transactions for us across our brands they are doing excellent job with us. Our the amount of business that we do with them grows year-over-year very significantly, so we’re obviously interested in what they do from a product standpoint going forward and for example what you mentioned the New York to Philadelphia you know we are partners that works with them on those kinds of products and hopefully we will be partnering with them going forward which certainly a very big client. We have seen search terms and travel increased mostly due to supplier direct that is being out there the increases are up 5% a year, so its what we’ve seen so far, frankly its something that we expected and is the cost for doing business.

Q - Robert Peck

And can you may be give us a quick follow-up on your look to book ratio as well as some people have talked about one of the benefits of Expedia that it could be potentially be a counter set for goal play as well, you sort of see as potential positive for Expedia?

A - Dara Khosrowshahi

I think on the look to book ratio is, the conversion rates actually on Expedia slightly up year-on-year, so we are pretty happy with what we’ve seen and again it’s a result of the merchandizing team that we put together and a lot of their effort going on there, the email marketing efforts that are going on. So we think that we turn the corner on conversion and hopefully with the platform and investments we will continue to see that trend improve. What was your second question it was on the counter-cyclical tally right?

Q - Robert Peck

Correct.

A - Dara Khosrowshahi

Yeah I think that, well – we actually have kind of typical elements in our business which is, if you think about it any distributor is going to have less power in an up market so to speak when suppliers can get access to demand and access through to customer eagerly and in down markets, when suppliers need us more part of our market power increases so to speak. So I think you’ve seen it in our raw merchant margins that as the travel industry has improved our raw merchant margins have gone down that has been largely offset by ADR growth. So we would expect the opposite to happen in a down travel market ADR growth will go down which referred us but we would expect to see some raw margin expansion, obviously the industry is really young, we haven’t gone through a bunch of cycle. So, a lot of this is theory and we’ll, -- believe it when we see it so to speak. But theoretically that should be the case.

Q - Robert Peck

Thanks Dara.

A - Dara Khosrowshahi

You bet.

A - Mark Gunning

Hey Justin, this is Mark. And you want to add a comment since around taxes, I know that its, I was trying to figure out, when we’re going to be a full taxpayer when slightly remodeling. As I point out on my call it’s important to understand that in 2006, we’ll no longer have any NOLs, if you were thinking through how to model. When we will be a full taxpayer? Maybe sometime, in 2006.

A - Stu Haas

Okay operator, if we could take two more questions please.

Operator

Thank you our next question comes from Mark Mahaney with Citigroup Investment Research.

Q - Mark Mahaney

Thank you, on Expedia Corporate Travel. Of the different investment priorities for 2006 how high does that range and where – what kind of impact should that have on the revenue margin, is it, grows from 5% of total bookings to 10% over time, thank you.

A - Dara Khosrowshahi

Honestly it’s hard to rank the various initiatives that we are undertaking. We are a very big company, we are trailing our significant cash flows and one of the great spots that we are in is that we can invest across multiple fronts, and we can invest aggressively across multiple fronts. We think long-term and that’s absolutely the right thing to do. So it’s hard for me to rank it but the corporate business in the U.S. is half, it is close to half the total travel market in the U.S., it is a very, very large market. It’s a large market in Europe as well and we have a great technology solution, we put together a great management team there, and we are competing against competitors who I believe have to fundamentally revolutionize their business processes and their business model to compete against us. I am much more bullish on ECT than most people around here, I think that we got a great team and I think we can drive that business. The great kind of side benefit to that is that ECT brings very high yielding traffic to our supply partners. So if there is one potential kind of, I would say misconception of Expedia that some of our suppler partners have had is that we only bring price sensitive customers to the table. That’s no longer true as the internet becomes mainstream and also as we add in an element of corporate travel very high yielding kind of customers and exact percentage of our business increases as a percentage of the whole, we think that our value to suppliers increases as well. As it relates to supply margin, I am sorry revenue margin, revenue margin will go down, revenues margin at ECT on average is lower than the revenue margin for the whole business. That’s because we have a lower percentage of merchant hotel mix so to speak. But again, we think the dollars are incremental, we think its great for our relationships with our suppliers and we think it’s a huge opportunity.

Q - Mark Mahaney

Thank you.

A - Dara Khosrowshahi

You bet.

Operator

Thank you. Our next question comes from Michael Millman with Soleil Securities. Please go ahead.

Q - Michael Millman

Thank you. It looks like there is disconnect I mean Internet traffic which looks like for the fourth quarter was up about 40% for you. And that seems to translate into the gross bookings and the revenue numbers that you given out and that’s compares with Travelocity that was in single-digits in internet traffic but had substantially higher growth from lower base but substantially higher growth in bookings and in a revenue as well and they also seems to suggest that they had some very high efficiency in their marketing. Could you talk about what seems to disconnect here and whether their relationship program is really taken hold and has allowed them to get seemingly much higher marketing efficiency?

A - Dara Khosrowshahi

You know Mike the – it’s very difficult to -- it’s very difficult to tell kind of what the internal data is with Travelocity versus internal data with ours. I can tell you that while the long term trends in these numbers tend to whole true at times there are very, very large diversions between what these external services say about traffic and what our internal traffic metrics tell us either on a monthly or a quarterly basis. So, there may be a disconnect there and I wish I could explain it, we got together with you and Travelocity, I think that the justice department might say comparing notes, it might be a bad idea, but again, I just don’t know. That said, we are seeing similar efficiencies as Travelocity and for the year if you don’t include kind of a direct investments that Mark talked about in the PSG group and marketing mangers, we actually saw around 450 basis points in overall marketing efficiency for the year. So we are seeing good efficiency there, certainly from what we see Travelocity is getting good result there and they are doing a good job and as is our intention going forward.

Q - Michael Millman

And I guess, a quick follow-up, they also continue to say that they see adequate inventory and that they see that their raw margins are stable and sustainable. Can you comment on whether this, what the disconnect is there?

A - Dara Khosrowshahi

Well I think that, I would guess that our raw margins in general on as far as the level that we’re starting off with, my guess is that our raw margins are actually significantly higher than theirs. So I believe that the raw margins that they get from suppliers, may be not every single suppliers, it’s actually lower than ours, and that’s simply because of the market power that we bring to there, and the number of customers that we bring to there, and the diversity of the brand that we bring to there. So they may be starting from a lower level than where we are; remember that we’ve been in the market in the merchant hotel business a much longer time than they have been. And also again the trends that we see in the raw margin area especially in the hotel raw margins are actually pretty encouraging that the decrease in raw margins is declining and I think we are seeing really, really good work there from the partner services group.

Q - Michael Millman

That makes them to saying low 20s sustainable margins.

A - Dara Khosrowshahi

That’s what they said and again we don’t comment on the specific margins but we do believe ours are high.

Q - Michael Millman

Great, thank you.

A - Dara Khosrowshahi

Okay

A - Stu Haas

Thanks Mike.

Stu Hass, Vice President of Investor Relations

Thank you for joining us on the call today and for your questions. A replay will be available on our investor relations website following completion of this call. We appreciate your interest in Expedia and look forward to talking with you again next quarter.

Dara Khosrowshahi, Chief Executive Officer

Thanks very much.

Operator

Thank you. Ladies and gentlemen this concludes the Expedia Incorporated fourth quarter 2005 conference call. At this time you may now disconnect.

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