Shares of Priceline.com ("PCLN" or the "Company") have been on a tear in recent years as the Company has become a dominant player in online travel. The stock has consistently outperformed Street estimates as it has been able to achieve rapid top line and bottom line growth. While PCLN has generated impressive operating results over the past two years, the Company is facing considerable headwinds which could result in a substantial correction in the coming year when factoring in its premium valuation.
PCLN's main travel sites are Priceline.com, Booking.com, and Agoda.com with other sites including Travelweb.com, Lowestfare.com, RentalCars.com, and BreezeNet.com. The Company covers over 200 airlines and over 60,000 hotel properties using price-disclosed services and its Name Your Own Price ("NYOP") system, which is available only in the U.S. PCLN also has a 49% stake in PCLN Mortgage Company ("PCLNMC") which offers mortgages through the NYOP business model. The majority owner of PCLNMC is Everbank.
Over the past two years PCLN's operations have transformed considerably as the Company integrated its acquired businesses such as Booking.com and Active Hotels which were respectively acquired in 2004 and 2005. PCLN has mostly benefited from the success of Booking.com, which operates across 60 countries and offers access to over 40,000 hotels in Europe. Booking.com was much smaller when PCLN first acquired it in 2004 but since that time has come to account for a significant portion of PCLN's total gross bookings. In addition, the growth in Booking.com has helped blunt the impact of slower growth in PCLN's U.S. operations.
The Company has also benefited from the growth of Agency revenues relative to Merchant revenues. Merchant revenues are from travel transactions where PCLN acts as the seller while Agency revenues are from travel transactions where third parties are the sellers. Unlike Merchant revenues which are reported on a gross basis, Agency revenues are reported on a net basis resulting in no associated costs on PCLN's income statement. As a result, the growth in Agency revenues has resulted in a significant increase in PCLN's gross profit margins which in turn has driven overall profitability.
CHART I: HISTORICAL REVENUES (USD MM) AND GROSS PROFIT MARGINS (click to enlarge)
The success of Booking.com placed PCLN in a commanding position amongst its peers in European hotel booking services. Europe has 2.5x the population of the U.S. and Europeans generally average longer vacation days than Americans. European countries are also experiencing greater online travel growth compared to the U.S. since the online travel market is less mature compared to the U.S. Perhaps the most important aspect of the European travel industry is that there are more independent hotels compared to the U.S. The presence of large hospitality companies in the U.S. can often result in pricing pressure on PCLN's offerings and even disintermediation of PCLN's services as some airlines have done, but the prevalence of boutique hotels and small, independent chains in Europe benefits PCLN from a pricing perspective.
The Company hopes to replicate its success in the European market in Asia through its 2007 acquisition of Agoda.com. Agoda is based in Thailand and Singapore and is similar to Booking.com in that it offers hotel rooms and ancillary content (user reviews). While Agoda is not expected to be material to PCLN's operations for a few years, it offers further diversification and upside for the Company. Aside from the global travel service PCLN is working to build, it was the first to eliminate booking fees on airfares which forced competitors Expedia ("EXPE") and Orbitz Worldwide ("OWW") to follow suit. The Company is also developing new additions to its services to capture more market share, as demonstrated by its Inside Track initiative in March. With all of these apparent positives, one may think shorting PCLN makes little sense. However, there appear to be a few catalysts in place that could result in a significant correction in PCLN's richly valued stock.
Maturation of Booking.com: Much of the growth from Booking.com has already occurred, at least the part most responsible for the increase in PCLN's valuation. Over the past few years, Booking.com blew away analysts' expectations and international bookings, which mostly are from Booking.com, are now greater than U.S. bookings as illustrated in Chart II. While there is still upside in the European business, the growth is not likely to be anywhere near as pronounced as in previous years. More importantly, as Booking.com approaches maturity, additional growth will require greater marketing expenditures and the Company has also stated that the European advertising model is costlier relative to the U.S. model. Now that Booking.com is approaching critical mass, additional sales growth is likely to require greater incremental ad dollars, which could pressure margins. Another secondary aspect to consider is that growth in Booking.com is unlikely to catch the Street by surprise at this point resulting in less of a numbers "beat" going forward.
CHART II: QUARTERLY INTERNATIONAL AND DOMESTIC BOOKINGS (USD MM)
High Expectations for Agoda: PCLN has stated that Agoda is not expected to be a significant contributor until 2010 and the business is quite small with YTD 10/31/2007 gross bookings of just $36MM. While the Company expects Agoda will be slightly accretive to 2008 pro forma earnings, analysts at firms such as Credit Suisse are looking for "a more material contribution" (January 2008 report) from Agoda in 2009. It's also important to understand that entering the European online travel industry in 2004 was a different experience than entering the Asian online travel market in 2008. Between lower industry focus and lower internet and online travel penetration in Europe in 2004, there was considerably less resistance and the Company capitalized on this opportunity. However, the Asian online travel market already offers some competition in the form of China-based services like eLong ("LONG") and Ctrip.com ("CTRP"). PCLN was able to get ahead of competition and the Street with its acquisition of Booking.com but those types of surprising gains could be much more difficult to come by as the Street already is expecting strong contributions from Agoda in what looks like a much more competitive market.
Reduced Impact of FX: PCLN's exposure to European currencies such as the GBP and EUR has had a significant benefit to its reported operating figures. In 2007, $373MM or 26.5% of the Company's $1.4B in revenues was generated from international operations. This was more than double the $183MM or 16.3% of PCLN's $1.1B in revenues in 2006. However, what's important to note is that $30MM of 2007 international revenues were the result of currency appreciation relative to the USD. With parts of Europe starting to experience an economic slowdown, European currencies may reverse the multiyear trend of appreciation relative to the USD which would negatively impact PCLN's international results.
Convertible Debt Dilution: The Company has over $500MM of convertible debt which has resulted in the prospect of dilution to common shareholders. PCLN has initiated hedges that have effectively raised the conversion price for the convertible debt but current share prices would still result in 4% dilution by FYE 2008.
Forward Guidance: PCLN's 2008 guidance has been processed through various Street models but it appears that the market is ignoring a crucial caveat provided by Company management in that its guidance is based on current trends and does not incorporate any assumptions that these trends will deteriorate in future months. The U.S. is experiencing economic difficulties and PCLN's domestic bookings have grown at 8% and 9% in 2006 and 2007, reflecting a mature market. Given economic conditions, it's very possible that bookings grow in the mid single digits.
The Company's move to eliminate booking fees on domestic and international airfares may offset some of the organic slowdown in domestic bookings but, based on the Q4 conference call, will also eat into profit margins. Aside from the U.S., Europe is also experiencing economic challenges which should result in a drag on Booking.com. Given that Booking.com's network has been largely ramped up over the past few years, its future performance will hinge less on network growth but also - like its domestic operations - broader economic issues. Economic difficulties in both of the Company's key geographic locations, a likely reduction in currency benefits relative to 2006-07, and other factors that could compress margins such as the elimination of booking fees and the need for greater marketing costs in Europe could result in an adverse change to forward guidance in 2008.
Valuation: Table I presents PCLN and its relevant public peers and it's clear that PCLN commands a significant premium to the industry. Relative valuation is not a reason to establish a long or short position as PCLN deserves a premium to its competitors. However, running a basic discounted cash flow valuation using aggressive growth rates, margin expectations, and limited capex yields share prices not far off current levels, which would imply that shares are overvalued considering the aggressive and unrealistic assumptions used in the DCF analysis.
TABLE I: PCLN COMPS (click to enlarge)
Another aspect to consider is that analysts are having a growing level of comfort with 2009 estimates (forward estimates in Table I). Despite all of the economic headwinds facing consumers that could crimp leisure travel and the overall lack of positive catalysts as Agoba's contribution is two years off, analysts continue to maintain a Buy or Hold rating on PCLN and are comfortable with valuing the stock at 20-22x 2009 pro forma EPS and 12-13x 2009 EBITDA.Lastly, Table II shows that PCLN's quarterly earnings have been beating Street estimates at a decelerating rate. With a momentum stock like PCLN, the only thing that really matters is whether quarterly results exceed expectations by a substantial margin and Table II indicates that the Street is "catching up" to PCLN. Heading into 2008, if the Company's actual results just match or slightly exceed estimates, the stock price could react as though results missed estimates due to the expectations impounded in the current valuation. TABLE II: 2007 QUARTERLY CONSENSUS V. ACTUAL (SOURCE: THOMSON FINANCIAL)
To summarize, PCLN is facing economic headwinds in its two key geographic markets, is unlikely to witness the same level of appreciation from the GBP and EUR v the USD in 2007 that accounted for 8% of PCLN's 2007 international revenues, has to contend with a dilutive security, will have to spend more in advertising in the European market, will experience pressure on its gross profit margins that may not be offset by volume growth due to the elimination of booking fees, and is exceeding quarterly Street expectations by a declining margin. With shares currently valued at roughly 25.0x 2008 EPS estimates, any slight hiccup could result in a major drop in shares and significant downward revisions which could take the wind out of PCLN's sails.
DISCLOSURE: AUTHOR MANAGES A HEDGE FUND THAT IS SHORT PCLN