The Short Case on Priceline

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

Comments

[bafnotrad]

What is the status of the proposed FSP APB 14-a and EITF Issue no. 07-5 from FASB? Here is a statement from their 10K.

The Financial Accounting Standards Board (“FASB”) is considering accounting rule changes that would significantly impact the accounting for our convertible debt.



During the third quarter 2007, FASB issued for comment a proposed FASB Staff Position No. APB 14-a, “Accounting for Convertible Debt Instruments that May be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-a”) that would significantly impact the accounting for convertible debt. The FSP would require cash settled convertible debt, such as our $570 million aggregate principal amount of convertible senior notes that are currently outstanding, to be separated into debt and equity components at issuance and a value to be assigned to each. The value assigned to the debt component would be the estimated fair value, as of the issuance date, of a similar bond without the conversion feature. The difference between the bond cash proceeds and this estimated fair value would be recorded as a debt discount and amortized to interest expense over the life of the bond. Although FSP APB 14-a would have no impact on our actual past or future cash flows, it would require us to record a significant amount of non-cash interest expense as the debt discount is amortized. As a result, there would be a material adverse impact on our results of operations and earnings per share. In addition, if our convertible debt is redeemed or converted prior to maturity, any unamortized debt discount would result in a loss on extinguishment. FASB is expected to begin its redeliberations of the guidance in the proposed FSP in February 2008.



FASB’s Emerging Issues Task Force (“EITF”) is reviewing Issue No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock.” This Issue addresses the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock. Under current US GAAP, the conversion options embedded in our convertible debt are considered to be indexed to our stock. If certain of the views being discussed by the EITF are adopted, we may be required to account for our embedded conversion options as derivatives and record them on our balance sheet as a liability with subsequent fair value changes recorded in the income statement. Although EITF 07-5 would have no impact on our actual past or future cash flows, it would require us to record a significant liability on our consolidated balance sheet. Subsequent fair value adjustments could result in significant charges or credits recorded in our consolidated statement of operations. As a result, there would be a material adverse impact on our financial position and results of operations and earnings per share. The EITF is expected to continue discussing EITF 07-5 at future meetings .

[greencapitalist]

when you were short from. when pcln reported gangbusters @ $88 and jumped to 102 or when it again report chartbusters @ 102 and jumped to 125 and now consistenly breaching 125 and touching 150's. and now again it has guided super high and will beat it too and go to $145.

try holding your short before earnings too and please don't cover it.

a lean and mean company that is #1 in its segment. i hear it all the time - fslr, ma, pcln, rimm and i am tired. these guys beat, eat and chew the earnings.

let's not thrash good stocks. seekingalpha is becoming notorious for this of late giving space to every tom, dick and harry who KNOW NOTHING.

[rufusmcbufus]

Greencap...Yeah, well, CROX used to do that too. Amit called them out on Oct. 31....Go look and see what happened.

[forest]

"it was the first to eliminate booking fees on airfares which forced competitors Expedia ("EXPE") and Orbitz Worldwide ("OWW") to follow suit" - Actually, the other two didn't follow suit.

More importantly, you missed the fact that Priceline is the place people go looking for fares in a tough economic environment. Just check Alexa and you will see that trend playing out as of late. They will report a very strong Q1 in my opinion (airline load factors and hotel occupancy rates for March were healthy)

[greencapitalist]

dude, crox is fantasy. anybody can see it. no need for anybody to tell it is a short. maybe deck is a short too as in the same fancy space.

pcln is not fancy. a solid company with proven model. i use it all the time for travel. booked tickets via that for my l.a. tripe.

i would bet this. be short till earnings and please DONT cover after earnings.

and the next afternoon please file for bankruptcy :-)

[Igor TheGreat]

PCLN is a piece of garbage. Customer no-service is a joke. The only reason this stock is up is because the pumpers think that Google will bid for it. PCLN is worth $200/sh after next 1-50 split.

[fxtrader07]

greencap, you seem to follow the classic logic great company=great stock. Tha validity of that equation depends upon stock price and earnings power going forward. It's not by conicidence that you mention fslr along with pcln. both have overly optimistic expectations built in their stock prices that will be hard if not impossible to come true. the point is, that there is a huge probability for something to go wrong along the way (with fslr it's almost a certainty, btw) that will require a substantial reduction in expectations. now, holders of these stock are in not because of valuation (these stocks are expensive by valuation metrics) but because of growth and momentum. if either one slows, the case is gone and so will be the holders of the stock. value-oriented folks will not come in unless the stock dropped considerably.
imho fslr and pcln will be roughly cut in half from current levels over the course of the next 18 months

[rufusmcbufus]

And look at that, PCLN down $10! Amit does it again!!! Greencap, the only fantasy around here is PCLN's P/E. Poised for perfection and unable to take the slightest perturbation.

[greencapitalist]

entire market is down dude. pcln @ 125 (25% gallop from close to 100 after last earnings) is just down 5. why did not you look at goog. down huge. what about rimm after blockbuster earnings down huge and rimm is infact 2 or 3 earnings before stock now.

if market is bad no stock will survive. once banks come okay or not disaster kind of thing, you will see pcln back at 130.

and hey my bet still stands. short before earnings and DONT cover after earnings!!!!

[DanielJacome]

Greencapitalist, clearly you are messing with the wrong guy -- I'll put my money with Amit anyday -- look at his past calls. He writes lucid, cogent articles -- where are yours?

Also, you are wrong in saying CROX is an "obvious short" -- if it was, how come you never said it months ago when the stock was ripping and Amit was the only one to call it a time bomb. Futhermore, although I PERSONALY think CROX is a sell, there are a ton of people on SeekingAlpha that disagree with the bears, so no need for you to make hasty generalizations.

CROX was a great short call.

[greencapitalist]

dudes,
i will tell one thing. you cannot compare an roadside stone that was shining briefly with a diamond.

i have seen this. ma, fslr, rimm and pcln - all abused by daytraders and all of these guys questioned everytime during their earnings.

they beat and chew and spit out the so called analysts who are gasping every qtr to catchup.

crox - i was never browsing seekingalpha previously. i was in barrons, realmoney and other website that give both sides of the story and not one side to bash pcln, fslr, ma and visa.

if you had looked at pcln they are expanding aggressively in europe and asia with eu promising more than 100% growth again. i booked my brother in law ticket just 1 hr back from florida to l.a via priceline. go figure. with america slowing down and travellers pinching each dollar, pcln will again be a winner in coming qtr.

please don't tell me american economy is going to crash and burn. if that's the case only wmt and cost stocks are worth purchasing!!!!

my bet still stands. short pcln, fslr, ma and now visa before earnings. and don't cover please after the earnings.

[AmesTiedeman]

These travel stocks seem fully hyped. Agreed.

[DanielJacome]

CROX - 30% after guiding MUCH MUCH lower. Clearly, the sell side was duped, the clowns at Piper were pumping up a dog, and Amit is right -- AGAIN.

We know so many people on the buy side who got burned on CROX and will "give up altogether" tomorrow. It's over - HLYS part duex

[Maulik Nagri]

Hello Bafnotrad:

In its March 26, 2008, FASB notified FASB Staff Position No. APB 14-a, “Accounting for Convertible Debt Instruments that May be Settled in Cash upon Conversion (Including Partial Cash Settlement)”. I understand that this FASB ratification makes FSP APB 14-a a part of U.S. GAAP applicable from fiscal years starting from December 15, 2008. In case of PCLN, interest expense will increase (thus reported EPS will decrease) because of non-cash accretion in the carrying value of debt. However, debt equity ratio (on accounting basis) will decrease, because fair value of the conversion bond is included in equity. This is a classic case of financial engineering that does not impact PCLN's operations or future business in any way. Except for the decline in EPS because of the convertible debt instrument, this disclosure in PCLN's 10K should not affect your decision to invest in PCLN.

I also want to commend Amit on an excellent analysis of why PCLN should be shorted.

[greencapitalist]

did you all see the massive short cover after earnings. am waiting to see the same in pcln after the lean and mean machine blasts away again onto 145.

my friend's comment: "i search all travel websites, google and what not, but only pcln gives me the best deal"

he booked his tickets to vegas for next week via pcln.

let's see how it pans out. i am bull here. bull on ma, pcln, rimm, fslr (aka the monster which will be 500 pretty soon once so.cal plant comes into its fold), visa.

[greencapitalist]

the first para should read
"did you all see the massive short cover in goog after earnings. am waiting to see the same in pcln after the lean and mean machine blasts away again onto 145."

[greencapitalist]

ha ha...folks, busy covering huh? pcln at 129

but stay true. dont cover. cover when it hits 150 after this quarter mean, lean and gargantuan earnings.

[mpharbold1]

Just compared prices for Vegas trip from BWI - checked Priceline, Expedia, and Orbitz. Prices similar, but Expedia was cheapest. Not sure exactly why greencap likes PCLN so much. I always check PCLN and haven't used them yet in 7 years of frequent traveling. I like Amit's analysis, but would rather look into PUT options instead of shorting. Shorting can be painful.

[greencapitalist]

folks, cover your short. BIG TIME...

did you listen to the master ma. cross border credit card travel volume at RECORD transactions.

guess who is leading in cross border website bookings. as usual the lean mean machine PCLN.

but stay true. when you tell boldy that you are short, stay short and cover 2 days after earnings!!!

[forest]

Told you guys. Now you're roasted.

[greencapitalist]

fools - that's the one word.

i am seeing ma, pcln, rimm everyday in life and they are beaters all the time.

dont cover fools.

cover once it reaches 160 tomorrow

and dont cover again. it will be 200 in next earnings

when you say you are short, you got be real careful about the stock, its management, its track record, past conference calls, etc

DONT COVERRRRRR MA, PCLN, RIMM and FLSRRRRRRRR and make lots of money....