Expedia Downgraded to "Hold" (EXPE)

| About: Expedia, Inc. (EXPE)
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scott devittStifel Nicolaus analyst Scott Devitt downgraded Expedia Inc. (NASDAQ: EXPE) to "Hold" yesterday. Extract from his report to clients:

Lowering Rating to Hold

• We are downgrading our rating on shares of Expedia from Buy to Hold based on the following events - (1) a reinvestment cycle outlined on 4Q05 conference call, and (2) renewed GDS incentive risk. We note that the shares are supported by a reasonable valuation and the possibility that Expedia management could initiate a buyback given the positive cash flow characteristics of the business.

• The reinvestment cycle at Expedia consists of (1) increased agency, tour operator, and supplier competition, (2) public company costs and headcount additions, and (3) platform improvements, data aggregation and mining capabilities. In 2006, we expect Expedia to report full-year cash operating income that is flat with 2005 and a cash operating margin decline of more than 300 basis points.

• Recently, Worldspan announced that it had signed a five-year content distribution agreement with American Airlines. We believe that the economics of the new Worldspan deal could be well below historical GDS deals. We also believe that American could be using the Worldspan deal to improve its negotiating position with Sabre. Given our belief that Expedia generates more than $100 million from GDS incentives, we believe the ongoing negotiations should be watched closely. In our view, the Worldspan deal reestablishes the GDS incentive risk which had recently trailed off following Sabre's early deals with US Air and Northwest.

• We expect Expedia to report inline 1Q06 results with a negative operating income comp in the 8% range year-over-year. With the difficult first half outlined in the 4Q05 call combined with the renewed GDS risk, we believe it makes sense to await a lower entry point.

We are downgrading our rating on shares of Expedia from Buy to Hold based on two reasons – (1) reinvestment cycle outlined on 4Q05 conference call, and (2) the GDS incentive risk.

Reinvestment Cycle

The reinvestment cycle at Expedia consists of (1) increased agency, tour operator, and supplier competition, (2) public company costs and headcount additions, and (3) platform improvements, data aggregation and mining capabilities. In 2006, we expect Expedia to report full-year cash operating income that is flat with 2005 and a cash operating margin decline of more than 300 basis points.

Increased Agency and Supplier Competition. Expedia continues to experience competition from Sabre, Cendant, and Priceline, as well as various small travel distributors in the United States. A general lack of differentiation and like access to inventory makes it difficult for an intermediary to differentiate an offering. Also, the supplier direct competition continues to be intense and now accounts for more than 55% of total online bookings, by our estimate. Given suppliers ability to offer loyalty points and equivalent pricing on their own sites without a booking fee, it has made it more difficult for intermediaries to compete for customers. We believe the shift to supplier sites has mostly abated, but believe it will continue to be an overhang for online travel agencies as they battle not only amongst themselves but with those that supply them with inventory to sell.

In Europe, the same competition exists from other online travel agencies and suppliers with an additional constraint coming from large tour operators. We note that the penetration of independent hotels is much higher in Europe than the U.S. which is good from an economic standpoint for the sector and the reason why we continue to recommend Priceline shares as Priceline is fully levered to this category in Europe. In the case of Expedia, the dynamics of Europe have both slowed top line growth and forced an additional layer of investment to compete.

Public Company Costs and Headcount Additions. Over the past year, Expedia has invested heavily in its sales force, customer service, finance, HR, technology, and operations. We believe the investments were necessary but, given that the costs do not annualize until the second half of 2006, are contributing to the first half decline in margins.

Platform Improvements, Data Aggregation and Mining Capabilities. Over the next two years, Expedia intends to invest aggressively in product innovation. The company is investing in and building a scalable, extensible, service-oriented technology platform that will cross its numerous brands. This should allow for cost savings and improved flexibility, as well as merchandising, search, and personalization. We agree that the company will benefit from investments in this area; however, we do believe the overall returns from incremental investment in technology in the online travel sector will be lower than historical returns.

GDS Incentive Risk

Recently Worldspan announced that it had signed a five-year content distribution agreement with American Airlines. We believe that the economics of the new Worldspan deal could be significantly below historical GDS deals. We also believe that American could be using the Worldspan deal to improve its negotiating position with Sabre. Given our belief that Expedia generates more than $100 million from GDS incentives, we believe the ongoing negotiations should be watched closely. In our view, the Worldspan deal reestablishes the GDS incentive risk which had recently trailed off following Sabre's early deals with US Air and Northwest.

We should note that historical segment GDS fees have been in the area of $3.85 per segment. We have assumed that approximately $12 per air ticket is paid from the airline to the agency of which an incentive payment is made to the agency that booked the ticket. In the case of Expedia, the incentive fee per air transaction is in the range of $6-$7. Last year, Expedia generated 38.8 million transactions of which we assume somewhere in the range of 18 million – 20 million were air transactions. Based on these assumptions, we believe Expedia generates between $100 million and $140 million in air incentives. We do not know what will happen with GDS agreements in 2006, but we do believe Expedia would have exposure if deals were materially changed from current GDS pricing. We were beginning to become comfortable with the risk until the announcement of the Worldspan deal earlier this week.

Conclusion

We expect Expedia to report inline 1Q06 results with a negative operating income comp in the 8% range year-over-year. With the difficult first half outlined in the 4Q05 call combined with the renewed GDS risk, we believe it makes sense to await a lower entry point. We note that the shares are supported by a reasonable valuation and our rating downgrade is driven by a lack of positive fundamental catalysts and a possible negative catalyst (NASDAQ:GDS) occurring within the next several months.