By The Valuentum Team
Priceline (NASDAQ:PCLN) is a top player in global online hotel reservations and boasts a net-cash profile that is stronger than most: it holds ~$11 billion in cash long-term investments versus $6.3 billion in long-term debt. Why is this important? Well, not only are many dot-coms still beholden to the stigma of a view that they are unhealthy, cash-flow burners, but a net cash position is also a distinct source of intrinsic value.
Think of net cash to a company like you having money in the bank in excess of your debts. Your net worth is higher when you have net cash (your cash is more than debt), for example, than when you have net debt (your debt is more than cash), all else equal. The same is true for companies with a net cash position - they are worth more, all else equal. We think companies that have net cash positions on the books truly have strong balance sheets; after all, they can pay down their outstanding debt in one fell-swoop. Priceline is one company with a fantastic balance sheet, and our newsletter portfolios are full of companies with these wonderful balance-sheet positions.
Also unlike the long-held perception of dot-coms, Priceline is enormously profitable. In the first quarter of 2016, for example, Priceline's gross profit jumped 21%, to $2 billion, with international operations accounting for $1.7 billion of total gross profits, a 23% advance from the year-ago period. Adjusted EBITDA jumped to $676 million in the quarter, a 27% rise on a year-over-year basis. What stood out most in the period was its free cash flow springing ahead more than 60% from the first quarter of 2015, even with capital expenditures nearly two thirds higher than the prior year period. We simply love companies that generate gobs and gobs of free cash flow.
Those that know Priceline know its primary risks well, but let's talk about them. We think the company is more susceptible to an economic downturn than most given its leveraged to business and leisure travel, and of course, the unfortunate increase in terrorist activity may cause travelers to cut back on trips. Priceline's stake in the European hotel sector could be pressured due to this dynamic. Plus, internal issues continue to pop up. For one, recent drama involving the firm's former CEO has given investors a headache. And then there's headline risks. Priceline has built itself a reputation for issuing overly-conservative guidance, but doing so hasn't really caught on, resulting in material share price volatility. Priceline tends to almost always underpromise and overdeliver.
Though we'll have to see how performance is impacted from the recent terrorists attacks in Orlando, Florida, the company's results have remained resilient throughout the scares in Paris and San Bernardino, California. In its first quarter of 2016, for example, Priceline reported total room night reservation growth of 30%+ on a year-over-year basis, reflecting acceleration in the measure for the second consecutive quarter. The company continues to execute on accelerated reservation growth as well, reporting total gross bookings growth of nearly 21% on an as-reported basis from the year-ago period, and gross profit margin expansion of nearly 2 percentage points during the first quarter of 2016.
Investors often punish the firm for its conservative quarterly guidance, but we continue to have confidence in the long-term fundamentals of Priceline. With a truly strong balance sheet, solid free cash flow generation, fantastic growth prospects, high-ROIC with an asset-light business model, and speculation of tying the knot with TripAdvisor (NASDAQ:TRIP) as the kicker, investors can do a lot worse than Priceline as an investment idea.
Priceline.com's Investment Considerations
• Priceline is a leader in global online hotel reservations. The firm is composed of four primary brands - Booking.com, priceline.com, Agoda.com and Rentalcars.com - and several ancillary brands. It recently bought OpenTable. Bookings growth continues to be excellent across its platforms. The company was founded in 1997 and is headquartered in Connecticut.
• Two significant risks have added uncertainty to the path of price-to-fair value convergence. The pace of emerging market expansion and terrorist activity will act as overhangs for the foreseeable future.
• Priceline has made a habit of issuing conservative quarterly guidance, which the market tends not to like. Investors should be prepared for material swings on quarterly reports due to such guidance, and the firm's equity may be better served by management not issuing such punitive quarterly guidance. Nevertheless, we continue to have confidence in the firm's fundamentals.
• As it rides the wave of secular growth in Internet penetration in travel, Priceline will also benefit from expansion into new markets in North America, the Asia Pacific, and South America. The company's strong brand helps prop up share in the mature US market.
• Priceline.com is a stock that is going to experience a tremendous amount of volatility. Shares are trading below our estimate of their fair value, but with any firm that has such a wide range of growth outcomes, caution should always be in order.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Priceline.com's 3-year historical return on invested capital (without goodwill) is 195.5%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not. Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
Image Source: Valuentum
In the chart below, we show the probable path of Priceline's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Priceline.com's free cash flow margin has averaged about 32.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Priceline.com, cash flow from operations increased about 35% from levels registered two years ago, while capital expenditures expanded about 106% over the same time period.
In the first quarter of 2016, Priceline reported cash from operations of ~$344 million and capital expenditures of ~$53 million, resulting in free cash flow of ~$291 million, a 60% increase from the first quarter of 2015.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Priceline.com's shares are worth between $1174-$1760 each. Shares are currently trading at ~$1300, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at the moment.
We're forecasting strong top-line growth in the mid-teens range for Priceline in 2016 and 2017 as its reservations and bookings trends have been solid despite the growing concerns of global terrorist activity. We expect the firm's bottom line to grow at a similarly impressive rate in the coming years, and upside to these forecasts is present if it is able to continue the robust margin expansion experienced in the first quarter of 2016.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $1467 per share represents a price-to-earnings (P/E) ratio of about 29.7 times last year's earnings and an implied EV/EBITDA multiple of about 22 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 12.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 20.6%. Our model reflects a 5-year projected average operating margin of 42.3%, which is above Priceline.com's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 4.6% for the next 15 years and 3% in perpetuity. For Priceline.com, we use a 10.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $1467 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Priceline.com. We think the firm is attractive below $1174 per share (the green line), but quite expensive above $1760 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Priceline.com's fair value at this point in time to be about $1467 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Priceline.com's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $1996 per share in Year 3 represents our existing fair value per share of $1467 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: PCLN is included in the Best Ideas Newsletter portfolio.