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Priceline May Be Just the Ticket

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina. He is the editor of Morningstar StockInvestor newsletter. He recently initiated a position in Priceline (PCLN). We're going to talk about his thinking behind this purchase.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Could you start off by just kind of walking us through Priceline's business? We're probably familiar with the William Shatner commercials, but what else is going on in this company?

Coffina: Fortunately, the whole business isn't William Shatner. Actually, Priceline.com, which is the brand that most U.S. consumers are probably most familiar with, is a very small part of the business. Their core business is really Booking.com, which is very strong in Europe. It's the leading online travel agency in Europe. And then they also have a few other brands like Kayak, Agoda.com, which is strong in Southeast Asia, and so on. But it's really a very international company and very much dependent on the European travel market as opposed to the U.S. travel market.

Glaser: So, there is no shortage of online travel agencies out there. Do you think Priceline has a moat? How has it dug out a competitive advantage?

Coffina: There maybe actually aren't as many as you might think. As I mentioned, Priceline owns a variety of brands. Expedia (EXPE) also owns Hotels.com, Hotwire, Travelocity, Trivago. So, there are a lot of brands out there, but really they are only held by a handful of companies--especially in more developed markets. The emerging markets are still sort of figuring things out, and it's more intensely competitive. But what we have observed is that the online travel agency market has tended to consolidate around just a couple of leading firms, and we think what drives that is that there's really an advantage to being the largest player in a market. So, you have a network effect that develops between travelers who want access to as many hotels as possible and hotels that want access to as many travelers as possible so that they can fill rooms.

There are other advantages to scale. For example, you're able to use your data and also able to constantly test and retest the designs of your sites to try to optimize the conversion process so that the leading brands like Priceline are generally able to outbid smaller competitors like maybe an Orbitz (OWW) that's trying to gain scale on the business. They are generally able to outbid the smaller competitors for Google search results or ad listings on TripAdvisor (TRIP) or wherever it may be. So, it's sort of a positive feedback loop that develops. And again, the market share has really tended to consolidate around the leading few players, and then you have the smaller players out there like Orbitz that tend to be much less profitable and tend to lose market share over time.

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Glaser: So, what makes Priceline different from, say, an Expedia?

Coffina: So, again, Priceline's advantage is really that it's mostly internationally focused. The good thing about being international, as opposed to Expedia who is very strong in the U.S., is that internationally a lot more of the hotels are boutique, small kinds of hotels, which are generally less sophisticated, less able to market themselves directly to consumers, not really capable of bidding on the Google ad listings directly. And generally, those hotels are much more dependent on Priceline to actually fill rooms, which gives Priceline the upper hand in negotiations. It also means that it's difficult for other firms to break into those markets, because often these hotels just don't have the internal bandwidth--they don't have the staff to manage listings across multiple online travel agency platforms. So, they will want to work with the market leader, like Booking.com, because they really need them to fill rooms; but they are much less open or receptive to working with Expedia or a second-tier player within those markets.

Another advantage that Priceline has is its business mix. Priceline is much more focused on the hotel side of the business and also the agency model. So, they are just sending the bookings to hotels without actually being on the hook for the rooms themselves, not having to process credit card payments, and so on. This mix tends to be a much higher margin for Priceline than Expedia's mix, which is somewhat more focused on airlines and the merchant model where the company is actually taking possession of the travel inventory.

Glaser: Shares have sold off recently. [Priceline is] now in 5-star territory. What are the concerns here that have driven the price down?

Coffina: I think there are a few things weighing on Priceline right now. Definitely, the macro environment is not favorable. Europe, as everyone knows, is in or near a recession. Also, the euro has been very weak, which is going to affect international travel by Europeans. That said, I think Europeans are very much committed to their traveling every year. So, instead of not taking that trip, they might just take a trip to a cheaper location, or they might downgrade their hotel room. But generally speaking, they won't skip the trip altogether. That's just sort of a cultural issue in Europe.

But the macro issues, I think, are weighing on Priceline as well as the currency issues. Also, you have fears of increasing competition. Expedia is trying to expand into Europe. As I mentioned, I think that's going to be relatively difficult, but they are certainly trying. Priceline is trying to expand Booking.com into the U.S., which brings it more into head-to-head competition with Expedia. You also have the threat of Google (GOOG) and TripAdvisor trying to get into the online travel agency business. So, they are trying to vertically integrate. These are two very important sources of traffic for Priceline. And to the extent that these companies are successful at selling their clicks directly to hotels and bypassing the online travel agencies, it's a potential disruptive threat that's out there.

The last thing I would point to is a risk that people are probably paying some attention to now, which is Priceline's capital allocation. So, it's a very cash-rich business model; they have a lot of cash on the balance sheet, and they just bought, for example, OpenTable. We think that they paid a pretty full price for OpenTable. It has some clear strategic synergies. The same travelers who are booking hotels are also going to be frequently making reservations at restaurants in their destinations. But that said, we think they paid a pretty full price for OpenTable, and it's always possible that they could come out and possibly overpay for some other companies. TripAdvisor is often rumored as a potential acquisition target, or there are a variety of other targets out there.

So, these are the big concerns that people are worried about right now. I would say, again, the macro and currency risk, the disintermediation from Google or TripAdvisor, increasing competition within the online travel business, and potential capital-allocation decisions.

Glaser: Given that you just picked up some shares, then, it seems like you think it's trading at enough of a discount that you're getting a margin of safety to protect yourself against these risks.

Coffina: Exactly. Priceline has been growing for years now, for basically a decade, at 20%, 30%, or 40% a year, and yet the stock is trading right now for 17 or 18 times forward earnings. Clearly, earnings growth is going to decelerate. It's inevitable. There is going to be increasing pressure on margins as competition picks up. There's really nothing to prevent competitors from bidding up the price of ad space, if nothing else. So far, Priceline has been able to offset that by operating leverage in other areas, spreading other fixed costs over a greater revenue base. But advertising expenditure is ticking up as a percent of total revenue.

More than that, the market is just maturing. Priceline has about 4% of the global travel market right now. That's up from maybe 1% five years ago, and we think that that can expand to maybe 8% five years from now. But inevitably, as you get larger, the growth rates are going to slow as you're growing off a larger base. That said, I think Priceline can still grow earnings at a mid- to high-teens annual rate. And trading at 17 or 18 times forward earnings, it looks very attractive on a risk/reward basis.

Glaser: Matt, thanks for your analysis on Priceline today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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