Here's Why We Feel Expedia's Stock Is Capped At $63

| About: Expedia, Inc. (EXPE)
This article is now exclusive for PRO subscribers.

From around $30 in January 2012, Expedia’s (NASDAQ:EXPE) stock price has steadily increased to the current level of $60. Despite persistent weakness in the global economy, the company has registered a sequential increase in revenue so far this year, though the growth rate has slowed down.

Defying macro headwinds, Expedia posted a stellar Q3 2012 with 17% y-o-y growth in revenues, though its net income decline by 17%. While the short-term macro environment remains uncertain, Expedia claims that a strong global brand name has helped it perform well. (Read Our Earnings Article: Expedia Shows Growing Strength In Hotels & International Markets)

With good execution, innovative technology, expanding international presence and a robust hotel business, we believe in Expedia’s long-term growth potential. However, while there are many favorable trends driving its valuation, we feel that the company might not be able to sustain the current growth rate in the future.

Our price estimate of $63 for Expedia is almost in-line with the current market price. In this article we discuss the various factors driving its valuation as well as certain potential risks/drawbacks in the same.

International Expansion To Drive Growth

Expedia is the biggest U.S. online travel agency in terms of gross bookings, and the company has been focused on expanding its leadership position in international markets as well. Expedia’s revenue contribution from international markets has nearly doubled in the past five years, from 24% in 2007 to around 42% at present. For the first time last quarter, the international points of sale accounted for 50% of total room nights booked.

The fragmented European hotel market and rising per capita income in emerging economies provide tremendous growth opportunities for travel agencies. Additionally, Internet penetration in these economies is relatively low but is expected to grow at a rapid pace, which leaves immense potential for growth for the online travel industry as a whole.

The acquisition of VIA Travel by Egencia, the Air-Asia Expedia joint venture, rising popularity of, the collaboration with Fotopedia Paris & Fotopedia Japan, and the eLong partnership to expand presence in China are factors that have contributed to Expedia’s growth in international hotel bookings, and we believe these will continue to be the guiding factors for its future growth as well.

Potential Risks – Decline In Revenue Per Room Night: Despite a 27% increase in global room nights booked in Q3 2012, Expedia posted only a 20% year-over-year growth in hotel revenue as it registered a 6% decline in revenue per room night. We believe a greater mix toward hotels outside U.S. will put downward pressure on revenue per room night in the future as well. However, international markets, particularly Europe & Asia-Pacific, present a tremendous growth opportunity for Expedia and the company feels that the robust increase in volume will more than compensate for the decline in revenue per room night.

Growing Strength In Hotel Bookings

Contributing over 66% to Expedia’s valuation, as per our estimate, hotel bookings is the most important division in the company’s portfolio. In addition to accounting for majority of its revenue, hotel bookings offer around 23% revenue margin, which also makes it the most profitable division, compared with airlines (3%) and car rentals & cruises (9%).

Backed by a 27% increase in global room nights booked, Expedia’s hotel revenue registered a 20% y-o-y growth in Q3 2012. Despite macro headwinds, the company posted a 17% increase in domestic hotel bookings while international bookings witnessed robust growth of 38%. Driven by increasing collaborations in international markets, we estimate a marginal increase in Expedia’s market share in hotel bookings.

Potential Risks – The increasing shift toward the agency model could have a negative impact on margins. As the merchant of record, Expedia has the discretion to establish prices charged to travelers as opposed to “agency” transactions in which Expedia does not set prices but merely collects a commission on prices set by the travel product supplier. During 2010-11, while agency revenue grew at 8% y-o-y, merchant revenue registered 16% growth. Though Expedia expects the merchant model will continue to have a significant impact on its business, the broader acceptance of the “Expedia Travelers Preference” (NYSE:ETP) program is likely to drive back growth in agency model and reduce the share of merchant model revenue.

Increasing Usage Trends In Mobile

With an increasing number of people using mobile devices to go online, we believe the mobile platform offers immense growth potential for travel services. Eying growth in the mobile travel space, Expedia added yet another dimension to its growth strategy last year by launching a number of applications for iPhone and Android users.

In October this year, Expedia launched a new update for its mobile application. The Expedia application, which previously featured only hotels, now offers millions of flight options for users to view and book from, on more than 200 airlines in the U.S. The updated application also offers better visuals for more than 140,000 hotel properties worldwide. Additionally, people using Expedia’s mobile application have access to exclusive deals (only for mobile users) which offers lucrative discounts, which can go up to 60%, on hotel bookings.

Currently, Expedia receives around 4% of its traffic via mobile devices. The company claims that the Expedia hotels app has been downloaded approximately 5 million times in 220 different countries and territories, and 10% of its customers today are engaging in mobile [Expedia Mobile Takes Flight: New App Update Combines Simplicity of Mobile with Robust Flight and Hotel Booking Intelligence, Expedia Media Room, November 14, 2012]. It aims to continue investing and innovating in this segment as it forecasts a significant expansion in its mobile user base in the future.

Potential Risks – The conversion rate (percentage of people browsing Expedia’s website who actually make a booking) for mobile could be much lower compared with PCs. Additionally, developing the mobile platform poses a number of challenges in terms of design and developments and requires a significant amount of investment.

Pressure of Investments To Restrict Growth In Margins

The online travel services is a highly competitive niche segment with stiff competition among OTAs. In an effort to gain competitive advantage, travel companies are creating new promotions and consumer value features such as eliminating processing fees, waiving cancellation and change fees, etc.

The intense price competition affects operating margins in two ways:

  • it puts a downward pressure on prices, and
  • it increases the company’s promotional spending to lure more customers to its websites.

The macro headwinds have led to lower revenue margins and high promotional spending, in turn further squeezing operating margins. Despite solid top-line growth in Q3 2012, Expedia’s net income decline by 18% on a sequential basis. Nevertheless, the company intends to continue innovating and improving its products and services to drive growth across geographic segments.

The high expenditure puts pressure on the company’s operating leverage and we estimate Expedia’s EBITDA margin to register a marginal decline by the end of our forecast period. However, we believe that high expenditure incurred would help drive Expedia’s future growth.

Disclaimer: No positions