Priceline.com Inc. (PCLN) spiked higher after reporting third quarter earnings, but even at $635 it's arguable that the stock is still conservatively priced. Before getting into the numbers I want to discuss Priceline's qualitative factors.
Growing Competitive Advantage
Priceline has consistently increased its market share, and CEO Jeffery Boyd believes that the company continues to do so. During the Q3 2012 earnings call he said:
We look at our growth rates, and they're faster than our competition so I think we continue to gain share. We look at the various distribution channels that we are active in and I think we're doing well from a share perspective in those channels.
It is reasonable to expect Priceline to continue capturing market share because of an advantage that the company has as a result of its size and leadership position - deep pockets. Advertising is an essential to driving sales for online travel companies. As the industry matures and the competition heats up the biggest winner may be the one with the deepest pockets, and that is Priceline. Advertising is truly an investment in the company's brand, because it builds recognition, familiarity, trust, and a networking effect. All of these factors, when executed well, spur sales growth thereby further allowing the company to strengthen its position. In other words, size begets size.
Industry Trends, Consolidation, and the CTrip Partnership
Early in August Priceline's Booking.com and CTrip (CTRP) announced a partnership whereby Ctrip will now, "be able to reach Booking.com's global portfolio of over 235,000 participating hotels through Ctrip's hotel reservation services." This is important for two reasons. First, the South China Morning Post writes that price wars are currently consolidating China's online travel agency industry. According to CTrip's CEO, Fan Min, the price competition is more cut throat than he has ever seen. He went on to say that:
The profitability of all the players is under great pressure, and the longer the price war persists, the deeper the consolidation will go. At the end of the day, only a few players will remain.
It is safe to say that CTrip will be one of those few since the company is the largest online agency in mainland China. With fewer players CTrip will only become more dominant.
This matters to Priceline because there is rapid growth in the number of Chinese tourists traveling globally. In fact, the UN World Tourism Organization predicted in 2005 that 100 million Chinese citizens will travel internationally in 2020. That prediction date has since been revised to 2015. More importantly to Priceline is where all of these tourists intend to visit. According to UNWTO, Europe has more than 50% of the market share of worldwide tourism, "a position which, according to long-term forecasts, it looks likely to retain." These trends surrounding the CTrip partnership should be a boon to Priceline since a majority of Priceline's business stems from European hotel bookings.
Stabilizing Macro Conditions
Finally, the company has a strong management team and a no-nonsense CEO. I value candor in a CEO, and Jeffery Boyd is not afraid to tell it how it is. There was no sugar coating the news of the deceleration in Europe that sent Priceline shares tumbling in Q2. If we believe that management will continue to be forthright with investors then it is nice to hear when they say things like, "We were pleasantly surprised to see conditions in Europe stabilize," and, "Our forecast does not assume any material change in macroeconomic conditions in general and conditions in the consumer or travel market in particular." However, investors should use their own judgment about Europe's economic condition. Though Priceline's management does not anticipate further deterioration in the foreseeable future, it is always possible that circumstances in a volatile environment can change overnight.
Valuation Assumptions and Adjustments
My valuation of Priceline began by estimating Q4 revenue, EBIT, capex, depreciation, and interest expense figures. I estimated these figures based upon the growth rates posted in the first three quarters of 2012 and then conservatively applied those rates to Q4 2011 in order to arrive at Q4 2012. For example, I estimated 15% revenue growth, 19% EBIT growth, a 14.5% increase in depreciation, etc. While not an exact science, estimating these numbers should provide a better forecast than using the trailing twelve months because of Priceline's high growth rate.
After that I estimated Priceline's cost of capital to be 11.35% based on geographic exposures and a beta of 1.22. I also had to separate the company's convertible debt into a straight debt portion and equity portion. I calculated the straight debt portion to be worth $1.38 billion and the equity portion to be $920.5 million. These numbers were added back to the book values of debt and equity. Moreover, the present value of the company's operating leases was also converted to debt.
Finally, and most importantly, I capitalized Priceline's advertising expenses, amortized them over two years, and made corresponding adjustments to the company's EBIT and assets. I feel this is appropriate because advertising is a very important aspect of Priceline's business. By strictly following standard accounting procedure it would appear that the company has virtually no reinvestment needs. That simply is not true. They are making an investment in their brand in order to provide a future benefit to the company. This is the true economics of the business. By capitalizing advertising their reinvestment rate came out to be 22.17%. This is an important figure because it helps determine Priceline's fundamental EBIT growth rate, which came out to be 20.8%. This number is low historically speaking, but it is a good estimate of near-term future growth accounting for the deceleration that comes with size.
The valuation I performed utilized a 5-year high growth period. Years 1 and 2 grew operating income at 20.8% and continued with conservatism by decelerating growth evenly in years 3 and 4 to arrive at a 3% terminal rate in year 5. This deceleration makes the overall growth rate 14.18% per annum over the five year period. From year 6 onward I valued Priceline as if the competition would eat away all excess returns so that the company's return on capital would equal its cost of capital. In other words, there is no value creation so growth rates no longer matter.
If the assumptions I made here sound to you like I am low-balling Priceline's future potential then you are absolutely correct. Yet, my valuation gave Priceline a current fair value of $646, which is relatively close to the current price. Personally, I believe that Priceline will earn returns above the cost of capital for a long period of time thanks to secular industry trends and a strengthening competitive position. Moreover, when the company fully matures then share buybacks and the assumption of more debt in the capital structure could moderately raise the price of the stock. In addition, the repricing of risk could provide a short-term catalyst to the stock if and when it is shown that Europe is, in fact, stable. A combination of all the above factors result in today's fair price being $790.
On the other hand, if the situation in Europe gets substantially worse then $540 is a realistic possibility, and, of course, a full-on crisis could even drop the price much lower. However, I remain optimistic that Europe's troubles will be resolved in time, and I trust Priceline's management when they say that conditions are stabilizing. Therefore, I feel that Priceline is a good long-term buy at today's prices, which would make any dips due to interim volatility a great buying opportunity.
Disclosure: I am long PCLN.