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Orbitz Worldwide Inc. (NYSE:OWW)

Q2 2008 Earnings Call

August 6, 2008 12:00 pm ET

Executives

Shannon Barnes – Director, Investor Relations

Steve Barnhart – President, Chief Executive Officer

Marsha Williams - Chief Financial Officer.

Analysts

Jennifer Watson – Goldman Sachs

Douglas Anmuth – Lehman Brothers

Brian Fitzgerald – Bank of America Securities

Mark Mahaney – Citigroup

Vance Edelson – Morgan Stanley

George Askew – Stifel Nicolaus

[Paul Barn] – Renaissance Capital

Michael Millman – Soleil-Millman Research

Operator

I would like to welcome everyone to the Orbitz Worldwide second quarter earnings conference call. (Operator Instructions) Miss Barnes, you may begin your conference.

Shannon Burns

Thank you for joining the Orbitz Worldwide second quarter 2008 earnings call. I am Shannon Barnes, Director of IR for Orbitz Worldwide. On the call this morning are Steve Barnhart, President and CEO of Orbitz Worldwide and Marsha Williams, the company's Chief Financial Officer.

Before we get started I would like to remind you of a few items. First, the rebroadcast, reproduction and retransmission of this conference call or the web cast without the express written consent of Orbitz Worldwide is strictly prohibited. Second, we filed two press releases this morning, one relating to our second quarter results and the other relating to the restatement of certain historical financial information. If you did not receive these press releases, they are available on our investor website at orbitztysonir.com. Additionally, this web cast will be archived on the site for a period of at least 30 days and MP3 file of the call and a transcript will also be posted on our site.

Third, some of the statements made during this call constitute forward-looking statements that involve known and unknown risks, uncertainties and other factors, including the risk factors described in our Form 10K filed with the Securities and Exchange Commission on March 21, 2008. These risks and uncertainties may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements. Also, I'd like to remind you that the media are participating in this call in a listen only mode.

Finally, during the call we will be referencing certain non-GAAP financial measures as defined by the SEC rules. Where required, we have provided in our press release or on our web site a reconciliation of those measures for the GAAP financial measures we consider to be the most possible. The release again, is available on our web site.

In order to give everyone an opportunity to ask a question during the Q&A, we request that you please limit yourself to one question and one follow up question. At this time, I would like to turn the call over to Steve Barnhart, President and CEO of Orbitz Worldwide.

Steve Barnhart

We had a solid quarter. International gross bookings increased 41%. We reported an adjusted EBITDA of $37 million and we delivered against the initiative to accelerate U.S. growth which we had discussed in the last two earnings calls. However, before I go into the quarter, I will turn the call over to Marsha to briefly cover the items in the 8K that we filed this morning.

Marsha Williams

As you can see from 8K we filed earlier this morning, we announced that we're restating certain prior period cash flow segments and balance sheets for two unrelated items. We are not receiving our income statements or our adjusted EBITDA for any period.

The first correction relates to inner company interest we owed to Travel Port on June 30, 2007. Approximately $37 million of inner company interest payables were inadvertently included in both working capital changes and non cash interest expense, therefore, overstating cash flow from operations in the second quarter, 2007 cash flow statement. In turn, this caused an overstatement in our advances to Travel Port in the cash flow from financing section of the cash flow statement.

This error was made at a time when we were in the process of segregating and settling all of our inner company accounts with Travel Port. It was an extremely complicated settlement with a lot of moving pieces and we simply made an error in the geography of where that inner company payable was reported externally. This error had no impact on our net cash position, our income statement or our balance sheet for the second quarter of 2007. The correction of this inner company error impacts the cash flow statements for the six months ended June 30, the nine months ended September 30, and the full year 2007.

The other item that we're changing relates to how we classify credit card receipts in transit from our banks. When a customer books travel using a credit card on any of our websites, we generally receive the cash from the credit card issuing bank within two to three days of booking. In our U.S. businesses, these credit card receipts have always been classified as accounts receivable. Prior to the fourth quarter of 2007, our international businesses classified these receipts as cash because we receive the cash so quickly. While we believe that those accounting methods are acceptable, companies need to be internally consistent in their treatment of these items, and we were not consistent. As a result, we are reclassifying credit card receipts at our international businesses from cash to accounts receivable to ensure global consistency.

The table in the 8K shows the amount by year that we're reclassifying for the credit card receipts. This credit card reclassification impacts all periods included in our 1231 2007 10K. I hope that this gives you a little bit of clarity on the reasons we delayed our earnings release. We simply needed additional time to work through these changes internally and with our external accountants. I'll be happy to answer your questions at the end of the call, but now I'll turn the call back over to Steve to review our second quarter results.

Steve Barnhart

Accelerating growth in our U.S. business has been a key goal for 2008. When we announced our Q1 results in May, we referred to growth initiatives that we expected to drive increased growth in the second half of 2008. These initiatives were effective and based on July results we believe we are on track for higher growth in the third quarter than in Q2.

Some of the initiatives we put in place to drive domestic growth just began to have an impact in Q3. We launched Price Assurance on Orbitz.com in early June, but did not deploy our full marketing support behind it until July. MSN launched on July 1. Then in the fourth quarter, as we begin to lap the strong pull back in search marketing, we started late in the third quarter of last year, we expect further improvement in year over year growth in the U.S.

As a result of these initiatives, our U.S. growth has recently improved in all product areas with transactions for air, hotel, car, packaging and destination services all showing stronger growth in July than they did earlier in the year. With these initiatives now in the market, I am pleased on this call we can discuss them more fully with you, so I will do that first, and then discuss the results at ebookers and Hotel Club. I will then give some perspective on how we see the economic environment and changes in airline capacity impacting our business over the next few quarters. Finally, Marsha will review our financial results and then we will answer your questions.

We have moved aggressively to re-accelerate growth of our domestic business. The key drivers of this again are a new marketing campaign for Orbitz.com which began in mid May, new innovative functionality in Price Assurance that launched in mid June with advertising support beginning in July, and a new partnership with MSN.com.

We told you on the last earnings call that we would be introducing new innovative functionality that we believe will drive both increased traffic to Orbitz.com and also improve conversion. Customers have told us that one of the primary reasons they do not complete a transaction is their uncertainty over whether they might get a better price if they wait. We have responded to this need with Price Assurance. It enables customers to book today with the confidence that if a better price for the same itinerary is sold on Orbitz, they will get that lower price automatically. Our customers do not have to anything to receive the refund. If they qualify, we send them an email telling them that the price has dropped and then we send them a check for the difference after they complete their trip.

Our consumer testing demonstrated that this is a very compelling value proposition for consumers, both for getting them to transact with or on Orbitz.com, and as a reason for them to switch where they book their travel to Orbitz.com. As you know, even in a period of generally rising prices, ticket prices often fall as airlines manage their inventory on specific flights. A significant number of customers have already qualified for refunds since the Price Assurance program launched on June 6. This is consistent with our expectation. This indicates that the program will ramp to where we are mailing out thousands of checks each month to our customers. This is also consistent with our expectations.

Innovation also makes our new ad campaign more powerful. The new functionality that we present to consumers in the ads for Price Assurance and Myidealbeach.com combined with the new marketing campaign, give consumers both a strong new reminder about Orbitz.com and very specific reasons to listen to the ads and go visit the site. The campaign has been running on network and cable TV since mid May, again with the ads on pricing assurance launching on July 7.

The innovation we are providing consumers was also a key reason that Orbitz.com won the opportunity to provide travel for MSN.com. With the ad value we provide, we were able to reach an agreement that is essentially a revenue share providing immediate benefits to both revenue and profits for Orbitz Worldwide. As we noted on our last call, Orbitz had never had a major [inaudible] deal which had caused us to be more reliant than out competitors on paid search.

The ability to win the MSN relationship both in the U.S. and in the U.K. also shows our increasing ability to leverage our assets globally. Our reliance on paid search in the U.S. has shrunk significantly. In July across Orbitz.com and Cheaptickets.com we sourced 20% less of our transactions from paid search than we did a year ago. As we have intentionally pulled back on paid search and focus on ramping our new initiatives, we are increasingly replacing volume from paid search. However, this move away from paid search in the U.S. will continue to have a negative impact on our growth rate until we fully lap the change in the fourth quarter. At that time, we expect that our year over year growth in the U.S. will accelerate as that head wind is removed.

Another initiative that we expect will support our revenue growth for the balance of the year is further optimizing and extending how we monetize traffic on our site through advertising. Advertising revenue increased approximately 25% year over year in the first half of 2008. This growth is expected to accelerate in Q3 and Q4 as we add new advertising initiatives.

The most notable of these, is the introduction of paid search links on Cheaptickets.com. We began testing this in mid May and thus it had no impact on our first half results. We have always been careful not to introduce advertising that detracts from the main purpose of our transactional site, leaving a quality booking experience to our customers and that will not change. We are finding new ways to target relevant advertising to customers who are just browsing on our site, but that does not materially impact the experience for those booking travel.

We have a portfolio of other advertising enhancements that we expect to make over the balance of 2008 and into 2009. As we prove out those enhancements we will have the opportunity to roll them out to our worldwide sites where they are relevant and appropriate.

Another launch in the second quarter was our new co-branded credit card with Capital One in early June. We believe that this no hassle card which offers triple points for bookings on our site delivers real value for our customers. Orbitz For Business also had another successful quarter, coming in close to matching the record for selling new account volume than it had achieved in the first quarter.

Some significant new clients in the second quarter included Career Builder and ICON, and we renewed our relationships with some major clients such as Wendy's. Businesses clearly see travel as an area for potential cost savings and we are seeing existing clients manage travel more actively. The benefit from our corporate travel business is that as companies focus on controlling travel costs, they are looking for exactly the type of cost savings, easy to implement new travel tools that are provided by Orbitz for Business.

Traveling more efficiently is clearly a better solution for corporations than just eliminating trips, which is helping drive new client wins for Orbitz for Business. We are pleased to have added Southwest Airlines to our list of air suppliers available on Orbitz for Business during the quarter, a significant step in adding value to our business customers.

I will now turn to our international businesses. E-bookers continues to demonstrate a very strong growth with gross bookings up 50% in Q2 or 35% excluding foreign currency fluctuations. We have shown an ability to sustain strong growth at ebookers with gross bookings up an average of 43% over the past four quarters, 32% excluding foreign currency fluctuations. The largest portion of this growth continues to come from continental European markets.

As we have communicated since we went public last July, migration to the new global platform remains our top priority at ebookers. We can reaffirm again today that we remain on schedule to complete the migration of all of our ebooker sites to the new global platform by the end of 2008. In June, we launched the site in Belgium and the sites in the Netherlands and Austria migrated to the global platform in July.

At this point, most of the major technology work on the new platform is finished. The basic functionality was complete with the U.K. launch last summer and functionality supporting multiple currencies was complete with the Ireland launch last November. Belgium was our first site with multiple languages. There remain some specific pieces of functionality we will add as we move forward, but the largest technology development efforts required for rolling out the platform across Europe are complete which is why you can expect to see the pace of country migrations accelerating.

We will continue to migrate country by country as there remains specific efforts in each country to revise work processes including customer service, accounting and revenue management in order to fully leverage the new platform in each country. As we migrate sites onto the global platform, we are able to offer customers a greater selection, more than three times the hotel choices that we previously offered as well as better functionality and better service. Better package capability combined with the more extensive hotel selection has driven considerably greater packaging volume and with the increased automation provided by the global platform, we are realizing the operational efficiencies that we expected.

We have seen these benefits in each of the countries that have migrated to the global platform, clearly in the U.K., Ireland and Belgium, and we have every indication that we will see the same benefits in Austria and the Netherlands once they've done the platform long enough to evaluate. We believe that these benefits from the global platform will support strong growth at ebookers over the balance of 2008 and through much of 2009.

Shifting to HotelClub, we continued to build our team of hotel market managers in the second quarter. The international team has grown nearly 30% since the end of 2007 and almost 125% since the start of 2007. This is the team that goes out to develop new hotel sources and manage existing relationships. By the end of the second quarter, HotelClub was selling close to 60% of its volume through direct relationships, up from 20% at the beginning of 2007. Direct relationships allow us to better service and market hotels, and enable us to improve the breadth of hotel choices on our site.

We are continuing to improve connectivity to our hotel partners by consolidating and globalizing our merchant hotel extranet and by providing tools that enable independent hotels to work more easily with us.

While we are making the investments we believe are required to continue building the HotelClub business, we started to see a slow down in the international hotel business in the second quarter that has continued into the third quarter. We have seen some softening in growth and demand and heightened competitive activity both of which we believe have contributed to slowing growth at HotelClub. It is also clear that we are underperforming the growth rates of our largest competitors.

We are not satisfied with this performance and it clearly is not consistent with our goal of expanding our share of the international hotel only marketplace. We are reviewing all of our marketing tactics and operations to enhance performance. However, we also recognize that we have been ramping up investment in this business only over the past 18 months and that we a ways to go before we match the level of market managers, direct hotel relationships and connectivity currently in place at many of our major competitors. And given that, we would not find it surprising if HotelClub was impacted more quickly and more significantly by a change of demand. We plan to continue to make appropriate investments in this business and we expect those investments will enable us to reaccelerate growth over time.

With these Q2 results we continue to make progress on our three strategic initiatives which are; building our presence in rapidly growing international markets, increasing the percentage of our business in higher profit, non air segments like hotels and dynamic vacation packages, and continuing to improve our operational efficiency with the target of an adjusted EBITDA margin in the mid 20's in four to five years.

I'll now share some brief thoughts about the current travel industry environment and how that relates to Orbitz Worldwide. Clearly, the airline industry, particularly in the domestic U.S. air market is going through challenging times. Many carriers are making changes to their business models with unprecedented frequency and scope and that, combined with lower economic growth is creating uncertainty.

In terms of how this might impact Orbitz, it is important to start with the fact that our domestic U.S. leisure air travel accounts for a relatively modest part of our net revenue. In the most recent quarter, the U.S. domestic market for air only leisure travel contributed only 21% of Orbitz total net revenue, and that percentage has been dropping as we deliver on our goal of shifting more of our mix to non air. In the first quarter of 2007, that percentage was 25%.

We expect that this shift will continue as we deliver on our initiatives, thus for evaluating the impact on Orbitz of changes in the U.S. airline industry, the key starting point is that only 21% of Orbitz Worldwide net revenue currently comes from booking tickets flying U.S. leisure passengers to U.S. destinations.

As for the changes the domestic air carriers are putting in place, there is no question there will be fewer seats in the air after Labor Day. We are already seeing consumers travel differently in response to announced capacity reductions and the higher ticket prices that are anticipated. But at this point, it is still difficult to project the impact that will result either on air bookings or any carryover to hotel and car bookings.

Our view assumes a continuation of the economic conditions and competitive conditions in place at the beginning of July and incorporates our estimate of the impact of the capacity reduction that had been announced as of early July. Based on those market conditions, w expect that we will still accelerate growth in the U.S. in Q3 and Q4 by delivering on our initiatives and that we should return to our long term top line growth target range of 9% to 12% growth in gross bookings and net revenue in Q4.

I'll now turn it over to Marsha for some detail about second quarter financial results.

Marsha Williams

For the second quarter we are pleased to report adjusted EBITDA of $37 million which is an increase of 9% over last year's level and a sharp improvement over first quarter of 2007. Our gross bookings grew 4% this quarter as compared to the second quarter of 2007. Again, this growth is an improvement as compared to the flat year over year bookings we announced in the first quarter.

Our international gross bookings growth was strong again this quarter, up 41% over the second quarter of last year. This increase was led by ebookers which posted an increase in gross bookings of 50% as compared to the second quarter last year. Our international non air and other businesses posted healthy increases in bookings of 26% compared to the second quarter of 2007. These gross booking comparisons exclude the impact of Travel bag, the offline U.K. travel business which we sold in July 2007.

As you may recall, we also report adjusted net revenue in order to ensure an apples to apples comparison across quarters that have been impacted by both purchase accounting and the sale of Travel bag. I'm happy to report that this is the last quarter that's affected by these items. There's a schedule on our web site that lays out the historical impact of these adjustments. We have also posted information on our web site that highlights the impact of foreign exchange fluctuations on our net revenue.

Adjusted net revenue increased 4% in the second quarter of 2008, compared to the same period last year. Growth in international adjusted revenue was 39% in the second quarter, accelerating from 28% in the first quarter. After adjusting for foreign currency fluctuations, international adjusted net revenue increased 20% in the quarter, again acceleration from 16% in the first quarter.

Domestic adjusted net revenue was $178 million, 4% lower than the adjusted net revenue for the 2007 second quarter. As we have mentioned, our domestic air business was soft in the second quarter in part due to our cutback late last year in new marketing expense. We posted a 4% increase in non air and other revenue primarily due to increases in advertising and insurance revenue which helped offset the decline in air net revenue.

Globally, net revenue from our air business was soft. Our international air net revenue was basically flat and did not offset the softness in our domestic air revenue when comparing second quarter of this year with second quarter of 2007. However, global net revenue for our non air and other products which consists primarily of hotel, car, dynamic packages, advertising and insurance, increased double digits in the quarter as compared to last year. Our hotel business improved globally and advertising and insurance net revenue also strengthened.

Turning to the rest of the income statement, our cost of revenue was higher this quarter than it was a year ago. This is primarily because we grew our White Label business and therefore increased the commissions and pay to our White Label affiliates. This increase reflects our ongoing efforts to change the mix of our business toward more non air. We also experienced a higher level of GDS connectivity costs as a result of volume increases internationally.

Our cost of revenue also increased early in the quarter by a higher level of credit card charge backs at one of our international locations. As a result of the new security software we installed late in the first quarter, charge backs declined sharply toward the end of the second quarter. We believe charge backs will return to their historically low levels and we saw evidence of this decline in July.

Going forward, we expect our cost of revenue as a percentage of net revenue to be in the 16% to 19% range on an annual basis rather than the general range of 16% to 18% that we've cited in the past.

The G&A expense declined, 21% from the second quarter of 2007. As you may recall, we had higher than normal expenses in the second quarter of last year. We terminated a marketing contract early which caused us to recognize an upfront contract cancellation charge of $13 million in the second quarter of last year. We also incurred $5 million in IPO related audit and consulting fees in the second quarter of last year. We had neither of those expenses in the second quarter of 2008 which explains the year over year decline. This decline was offset by a slight increase in wages and benefits due primarily to higher staffing levels in both our hotel sourcing team and within certain public company functions.

Marketing expense declined $4 million or 5% in the second quarter. Our domestic offline expense declined because we launched our major ad campaign later this year and because we shifted more advertising spend into the third quarter in order to fully support the launch of Price Assurance. Domestically, our online marketing expense decreased in line with our declining transactions and the reduction in the share of traffic we derived from paid search. Internationally, our online marketing expense increased as we continued to drive growth in these businesses.

For the second quarter of 2008, as I mentioned, adjusted EBITDA was $37 million. Our only adjustment to the second quarter related to stock compensation expense and that was $5 million. We have provided a schedule in our press release that reconciles our net loss to EBITDA and adjusted EBITDA.

Net interest expense in the second quarter was $15 million. Interest expense includes cash interest of $11 million, primarily on our $600 million dollar term loan and non cash interest of approximately $4 million primarily due to interest that accretes on our tax sharing liability to the airline.

In the second quarter, we took advantage of the dip in interest rate and entered into an additional interest rate swap. Our new swap fix is $100 million of our term loan at 6.39% for three years. As a result we now have $400 million of our total $600 million term loan on a fixed rate basis. With the new swap in place, the weighted average rate on this term loan was 7.1% at June 30.

Turning to the balance sheet, I'd like to highlight a couple of points. At the end of the second quarter, we had a cash balance of $99 million and no borrowings on our revolver. Because of the seasonal pattern of our business, the first half of the year is when we build our cash position and then it declines through the balance of the year. Our current cash balance is approximately $130 million.

Our merchant payables follow the same seasonal pattern as our cash balance. Merchant payables grew 46% in the first half of the year as compared to our year end balance, and we're relatively flat in the second quarter compared to the level at the end of the first quarter. Our cash and merchant hotel payables grow in the first half of the year as customers book their vacation travel and then decline in the third and fourth quarters as customers complete their travel and hotels bill us.

Finally, our capital expenditures in the second quarter were $14 million which is up approximately $2 million from our capital spending in the second quarter of last year.

Before I close, I would like to address one question that has come up a number of times in the past few months about Blackstone's ownership of our shares. Blackstone and its affiliates control approximately 59% of our shares at the time of our ITL. Currently, that group exercises control over approximately 55% of our outstanding shares. The decrease resultant from the pro [inaudible] distribution of our shares by Travel Port's ultimate parent company, a limited partnership controlled by Blackstone, to that partnerships limited partners, some of which are non Blackstone related entities. It is not the result of the sale of any of our shares on the open market.

And now we'd be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jennifer Watson – Goldman Sachs.

Jennifer Watson – Goldman Sachs

Can you discuss a little bit why you think it's pertinent to just look at the leisure air bookings as a percentage of your total revenue as opposed to incorporating corporate travel as well, and if you did include corporate travel, is that number substantially higher?

Steve Barnhart

We think the dynamics will play out differently across the two groups. As we look at our business class tickets, they are going up more slowly, much more slowly than the leisure prices. The airlines are eliminating their very low price bands and so the price increases we're seeing are having a much more disproportionate impact on the much lower price leisure tickets. And that's why we look at it that way. We've not disclosed a percentage of our mix. In our corporate business, I think we'd be able to make the same point however, even if we included our corporate business in that number.

Operator

Your next question comes from Douglas Anmuth – Lehman Brothers.

Douglas Anmuth – Lehman Brothers

Marsha, did you give an overall free cash flow number, and can you also just comment on whether you're seeing any changes in the timing from hotel suppliers in terms of when they want their payment in the current environment in the merchant business? And then also, can you comment on the advertising insurance revenue and perhaps try to break that out of the overall non air and give us a sense of how big that is?

Marsha Williams

The first question which is cash flow, we will be filing our 10Q probably some time later this week. We can say that our cash flow from operating activity in the quarter was in excess of $100 million, but we haven't filed that Q yet.

Your second question related to the percentage of insurance and advertising. We actually don't break that out individually. I can tell you of our non air and others, those are the two largest components.

Douglas Anmuth – Lehman Brothers

Any comment on the timing with payment to hotel suppliers?

Marsha Williams

The timing on payments to hotel suppliers, we have not really seen any meaningful change in that throughout this year so I would say we just have not seen any accelerated timing in that element.

Operator

Your next question comes from Brian Fitzgerald – Bank of America Securities.

Brian Fitzgerald – Bank of America Securities

.In respect to your SCL optimization work both in the U.S. and Europe, can you give us a sense of how far down the path you are? In the past we've heard vertical companies even such as Web MD and CNN embark on SCL work, many quarters, two years down the road, they're seeing 50% to 60% growth in natural traffic and so I wanted to get a sense for how far into the process you are and how far you have to go.

Steve Barnhart

I think what we can say on that front is that where we've rolled our new platform out in Europe, we are seeing good improvement in traffic from SEO. I don't think we're going to give you any specific growth rate numbers at this point, but we are seeing good benefits from SEO from the new platform, as well as we are seeing the benefits from separate issues that we're pursuing in the U.S.

Operator

Your next question comes from Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

I wanted to ask a little bit about the recessionary impact on access to inventory and to whether you're seeing in some cases in the U.S. market greater access to hotel inventory because of reduced occupancy rates? And then, internationally in Europe, could you comment on the degree to which you're seeing an increase in cancellations in reservations short of bookings window periods starting now and changes in ADR's or hotel room prices?

Steve Barnhart

Inventory, when you look at the U.S. business, we view that really as a retail [inaudible]. We have good access to inventory. Where we're seeing change in the current dynamic is the hotel is being more interested in working to move that inventory. So I wouldn't say that we're getting access to more rooms necessarily, but we're getting additional support from hoteliers as additional partnership in working to market those rooms.

As far as cancellations in Europe, that's typically more of a factor for someone who's in a retail model where there is no cost to cancellation, so you tend to see those rates move around a little more. That's not a number we see move as much in our merchant business. I don't have a specific comment for you on that other than that it's not something that popped up, moving in a way that you might have seen it move in a retail model.

In the U.S., we have clearly seen changes where consumers both on the air side and the hotel side are booking earlier. Air bookings as a percentage of mix, less that 30 days are down as a percentage of mix, greater than 60 days are up as a percentage of mix. On the hotel side, less than 7 days, down as a percentage of booking and greater than 14 days are up as a percentage of booking. So we do see consumers adjusting to the higher ticket prices and trying to book earlier.

Operator

Your next question comes from Vance Edelson – Morgan Stanley.

Vance Edelson – Morgan Stanley

Could you give us a feel for the magnitude of the shift in offline marketing expense in the second quarter to the third quarter? And then as a follow up would the $2 million increase in CapEx both year over year sequentially. I'm just trying to get a feel for how that might trend from here and if you could provide a rough breakout of the largest spending initiatives there.

Steve Barnhart

I don't think we're going to specifically talk about the dollars in the movement of our offline marketing but clearly it was a shift of monies as we wanted to put more weight behind the early July launch of the ads behind the Price Assurance product.

Marsha Williams

We have said that we anticipate spending between probably $55 million to $65 million a year in CapEx and I think that's still a good number to use. We have a number of initiatives that are underway. As Steve said, the majority of the spend for the new platform was incurred in prior years but we do have people working on, continuing to work on the platform and to the extent that they are building out perhaps some additional functionality that will get used on that new platform when we do capitalize that.

We're also for example, we would look at the functionality that we built out to support Price Assurance and as we develop new products, clearly the time of our software developer is that goes into developing those new products would be included in our capital expenditure numbers so we never seem to have a lack of new projects for our software developers to work on that we think will continue to grow and support our business. But the annual guidance we've given about $55 million to $65 million in total CapEx is still a good number.

Operator

Your next question comes from George Askew – Stifel Nicolaus.

George Askew – Stifel Nicolaus

Regarding ebookers, can you give us a sense of the profit improvements that you're seeing from the platform upgrades for example, looking at some of the earliest upgraded countries such as the U.K. and Ireland, are you seeing adjusted EBITDA margins for example at or above the company average following the upgrades?

Steve Barnhart

I think the best way to describe it George, is the ebookers business is one where it's always actually had good gross margins. What it's had is lack of leverage over a lack of leverage over cost structure. It was too large because of the lack of consolidation. So the platform has given us tangible improvements in a few areas. Within our mix, we're expanding the hotel portion and the packaging portion of that mix. So although the gross margins across our products were healthy before, the overall mix is now improved because we're driving even more hotels and packages while sustaining strong air growth.

So we are getting improvement in the gross margin line via mix shift, we're also getting some improvement in the gross margin line because the costs which is above the line, we are seeing real productivity in our customer service costs. We talked last quarter about the fact that even with an increase in transactions we're seeing declines in our customer service costs. So we are seeing good leverage at that level.

The other area where we are seeing leverage is in the countries where we've migrated. We are getting efficiencies in our operating expenses and the ability to get leverage at that level will improve once the platform is fully rolled out and we have the ability to optimize some of the work processes across all of the countries in Europe. So again, we're seeing mix improvements and customer service improvements that are improving what were already solid growth margins and we are getting improvements in our operating cost structure as well.

Operator

You have a question from [Paul Barn] – Renaissance Capital.

[Paul Barn] – Renaissance Capital

I had a question on the long term model that you guys have laid out. And I know you've said a few times four to five years getting EBITDA margins up into the 20's, and I'm looking at where your peers are in terms of their level of profitability and I guess I'm wondering two things. One would be at what level of sales would you require to get margins above the 20% mark the way that you guys look at it.

Marsha Williams

We haven't actually laid out any more specific guidance other than the fact that we expect that we can get to that margin level, and as Steve said, one of the things that has caused us from not attaining that really has been that we simply need to build more scale in our European business, so that as we grow our European business and grow the revenues in Europe, that would take us a good portion of the way toward attaining the margins that we want. Our U.S. business continues to provide us with very attractive margins, but really getting the ebookers revenue line to a stronger and higher price is what will significantly help us attain that goal.

[Paul Barn] – Renaissance Capital

In looking at the offering statement then, is it fair to assume that realizing you might get some benefit over time on the gross margin line, but really it's on the marketing level? What percentage of your cost would you consider fixed at this point and what pieces is variable in looking at your model?

Steve Barnhart

If you look at our operating structure it's really in the technology. The larger segments of our business that are more fixed in nature are the investments in technology where if we can expand our revenues and add more transactions without making any materially larger investment. In every technology development or technology operations, that part of our business is very scaleable as is a lot of our financial HR and legal infrastructure. Again, they're very leverageable in those areas.

Our brand marketing in the U.S. is levereagable, but we do tend to scale that as we grow the business, and then our online marketing will tend to scale with the business. So I wouldn't look in your modeling to get significant leverage off of marketing. I would look to leverage operating costs and we continue to, although we continue to invest in improving service, we continue to get improvements in our cost of goods leverages as we enhance our customer service operations and we have moved from essentially having things at a single brand level to multiple brands and essentially globally. So that is giving us additional leverage at the cost of goods level.

[Paul Barn] – Renaissance Capital

It looks like the business in realizing you're managing through some weakness on the top line, but in general the business should be able to generate pretty significant free cash flow and well in excess of what you're needing to pay down debt. Thinking that if you do get scale, if CapEx stays where it's been over the next couple of years, it looks like at least from my understanding that you'll be able to generate $50 million to $60 million plus in free cash flow a year. Do you have any plans, requirements in paying down that term loan? What exactly are you looking to do with that cash flow?

Marsha Williams

We do in fact, have in our loan agreement, we have a cash flow recapture test that says that we are required at the, shortly after we filed the 10K for the prior year, we are required to pay down to the bank basically 50% of our net free cash flow. So we do have plans and our obligation is to reduce our term loan.

Short of that, we have a fair amount of flexibility as to what we can do with the excess cash that we generate and we do look at a variety of alternatives for using that cash. Our corporate development gentleman [Frank Detito] is always out in the market looking for interesting acquisitions. We've got a variety of things that we could do with that cash. Obviously, we don't have anything to announce today, or we would announce it, but we do definitely have a variety of ways that we could use that excess cash flow.

Operator

Your next question comes from Michael Millman – Soleil-Millman Research.

Michael Millman – Soleil-Millman Research

I wanted to clarify; I think your comments was that the advertising insurance make up the bulk of the non air and other. Did I hear that correctly?

Marsha Williams

They make up the bulk of the other part of the non air and other. Clearly hotel is in that as well, so if you look at the other section of non air and other, I'm not sure whether we break that out. But that's what I was really referring to.

Michael Millman – Soleil-Millman Research

Could you talk about or give us some color as to why we should continue to see the year over year declines in the revenue margins on international?

Steve Barnhart

If you look at the European air business, unlike the U.S. where we have largely fixed revenue per transaction, it is not on a fixed revenue transaction basis in Europe, and as that market is developing between the shifts in the low cost carriers and the full service carriers, and the way the carriers are positioning or including costs in terms of what are taxes, what are surcharges or fees, we are seeing some downward pressure on the revenue per transaction there. But I think that would be the largest factor as you're looking at that.

So the net of that is you're seeing things like fuel surcharge and taxes that are really pushing up what is reported as gross bookings in those markets, but you're not getting any of those shaded increases in revenue from that.

Michael Millman – Soleil-Millman Research

Would it be fair to say that the actual payment is fixed?

Steve Barnhart

No. The actual payments are not fixed. In the U.S. they're largely fixed. In our international operations they are more often but not always calculated as a percentage of the ticket price, but that ticket price generally excludes surcharges and taxes so that those don't come into our revenue calculations.

Michael Millman – Soleil-Millman Research

Can you give us the number of U.S. and international transactions?

Steve Barnhart

No. We haven't reported that detail Michael and we're not going to jump into that today.

Operator

There are no further questions.

Steve Barnhart

I just want to reiterate that we are pleased with the results we've seen to date from our initiatives to re-accelerate our domestic growth including Price Assurance, our new ad campaign and our agreement with MSN. We are also pleased with our efforts to increase advertising revenue. All of these showed a positive impact on growth over the second half of the year. We are confident that we will roll out the new global platform to all of our ebooker sites by the end of the year. We see it as helping to drive growth as ebookers.

And again, based on these expected initiatives, we do believe we will accelerate growth in Q3 and Q4 returning to our long term growth target range of 9% to 12% growth in revenue and gross bookings in the fourth quarter. As I mentioned earlier, this view assumes economic conditions, competitive conditions and capacity reduction similar to what we had building into after the beginning of July. At the same time, we will continue to make progress on our three key long term initiatives, which are; building our presence in a rapidly growing international markets, increasing the percentage of our business in higher profit, non air segments like hotels and dynamic vacation packages, and continuing to improve our operational efficiency with the target of an adjusted EBITDA margin in the mid 20's in four to five years.

I look forward to reporting back to you on our progress in three months.

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Source: Orbitz Worldwide Inc. Q2 2008 Earnings Call Transcript
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