Online Travel Leaders Under Threat - An Industry Primer (CD, EXPE, PCLN, TSG, TZOO)

Citigroup analyst Mark Mahaney initiated coverage on Expedia (ticker: EXPE) with a Hold rating. His 17-page initiation of coverage report contained a particularly useful discussion of the evolution of the online travel industry and the resulting challenges to the current leaders. Here are the "Risk Factors" from the report that discuss the industry generally:

EXPEDIA INVESTMENT RISKS

1. Material structural challenges to online travel agencies – We see at least four negative structural developments for online travel agencies: 1) Deteriorating terms from hotel suppliers, who have sought to regain marketshare from the agencies; 2) Declining revenue per air ticket as airlines and other suppliers have sought to reduce or eliminate distribution expenses; 3) Growing market share of low cost carriers, who have had limited reliance on agencies to date; and 4) Rising online ad rates, which have impacted all ecommerce companies.

On the deteriorating terms from hotel suppliers, this has translated into lower merchant hotel raw margins for Expedia, as well as for other online travel agencies. Especially as hotel occupancy rates have gradually rebounded post 9/11, hotel suppliers have increasingly gained leverage vis a vis the agencies and have become much more selective about the terms and conditions and inventory of rooms they have been willing to distribute via the agencies. In a high profile move, InterContinental stopped distributing rooms via Expedia. There is a cyclical element at play here, and a downturn in hotel demand will likely increase the agencies’ leverage with the suppliers. In essence Expedia could be a very interesting counter-cyclical investment, and a deceleration in hotel occupancy rates may be a positive catalyst at some point in the future.

Granted, Expedia’s merchant hotel business has a much greater dependence on independent hotels (80% of its merchant business) than on major chains (20%). But there has been a clear negative structural shift for online travel agencies that appears likely to continue in the future. Translating this challenge to the P&L, we estimate that Expedia’s merchant hotel margin has declined from approximately 25% in 2003 to 22% today. Going forwards over the next three years we believe hotel merchant margins may come down further to the high teens level.

The declining revenue per air ticket is also a multi-year trend that has included reduced or eliminated commissions to travel agents for air ticket purchases. This has been part of a longstanding distribution expense reduction effort by airlines. A new compounding factor has been the increasing possibility that GDS fees – which have comprised perhaps 50%+ of online agencies’ air ticket unit economics – may come under threat as agencies are required to direct connect to airlines. (According to Air Transport World, GDS fees average approximately $12.50 per ticket. So if you assume that online agencies get about half, that would make the fees a significant portion of an online agency’s revenue per ticket based on our estimated agency revenue per ticket of $15-$25). New, low-cost GDS alternatives like G2 Switchworks and ITA Software may become viable options to direct connects, but we imagine that the reduced cost structure may result in lower air segment fees for online distributors as well as lower costs to the airlines. It seems clear that segment fees may be under pressure for some time to come. Finally, there is the possibility that the customer service fees charged by agencies may also come under long-term pressure, as travel suppliers advertise their no-fee policies. The growing market share of low cost carriers (LCCs) such as JetBlue and Southwest Airlines in the U.S. and RyanAir and EasyJet in Europe has posed a structural challenge for online travel agencies in that these carriers have had minimal reliance on online travel agencies to date. Both JetBlue and Southwest have consistently booked well over 50% of their tickets on their own sites. Jet Blue reported that 75% of total sales were booked at www.jetblue.com for 2004, while Southwest booked almost 60% on its own website in 2004. Expedia recently announced a distribution deal with Southwest that covers corporate travel, but material exposure to the LCCs’ leisure and unmanaged business travel business appears a limited opportunity for online travel agencies at this time.

Finally, rising online advertising rates, which have been up as much as 20% Y/Y, have been a significant margin headwind for many ecommerce companies over the past year. Travel has been one of the largest search word sectors, and Expedia as one of the largest online players has had to adjust to rising ad rates. We believe that these rates will continue to rise, albeit at a more modest rate than in the past, and that this increase will continue to create opex challenges for Expedia in the future.

2. Increasingly significant competition from travel suppliers – The Bear case against Expedia is that it’s stuck between the proverbial rock and hard place. Its supplier partners are now among its biggest competitors, their U.S. online businesses are now growing faster than the online travel pure plays, and this relative growth performance is expected to continue. As one piece of evidence for this trend, we look at the online traffic trends for a select group of online travel agencies and suppliers. Per the exhibit below, we see that online agencies, such as Expedia, Orbitz, and Travelocity, saw Y/Y online visitor growth of 23% in the June quarter. This is a strong growth rate, but it is lower than the 39% that suppliers, including American Airlines, Marriott, and Hertz, experienced.

Although the shift has been gradual, over the past three years, travel suppliers have been able to increase their share of online travel bookings from 46% in 2002 to 48% in 2004, per PhoCusWright. We believe that this trend will continue through the foreseeable future, as suppliers continue to seek to reduce their distribution costs and build up a more direct relationship with their customer base. However, we also believe that there is an upward limit to the share that suppliers can take, given the one-stop shopping and packages advantage provided by the online agencies.

3. Increasing competition from online agencies and potentially metasearch engines – The Bear take here is that Expedia is marginally losing share to other online agencies like Travelocity, Orbitz, and Priceline. Per Exhibit 4 above, we don’t believe the data supports a major marketshare shift away from Expedia. But there clearly is very intense competition among the travel agencies, highlighted by aggressive marketing campaigns and significant M&A activity in the sector. Recently, Sabre, which owns Travelocity, completed its acquisition of lastminute.com in July for $1.1B in cash and stock. And Cendant just completed three large acquisitions: Orbitz for $1.25B in November 2004, ebookers for $404MM in February 2005, and Gullivers Travel for $1.1B in April 2005. Even Priceline got in on the act, announcing the acquisition of Bookings N.V. in July for $133MM. Investors should note that all of these acquisitions with the exception of Orbitz are in the faster-growing international market, indicating that the battle lines have already been drawn overseas. One of the implications of these transactions is that they will likely increase the cost of future acquisitions. On its June quarter earnings call, Expedia disclosed that its Sales & Marketing expense grew 60% in International markets. We believe that this increased spend level was in part a necessary response to competitive moves in international markets. There is also the potential competitive risk arising from travel vertical search engines like SideStep, Kayak, and Mobissimo. Our sense to date is that the risk from these engines has been overstated. We have yet to see material traction from these engines, in the sense of significant online traffic trends. But we acknowledge that this is a potential long-term risk factor for Expedia and other online travel agencies.

Not subscribed to this blog? You can get updated headlines for free by adding any of the Seeking Alpha Network Blogs to your My Yahoo page. Just log into your My Yahoo page, then go to this blog and click on the "+ My Yahoo" button on the top right of your screen.