Will Priceline Take Off After Kayak Deal?

After the market close Thursday,  Priceline.com  (PCLN) announced a friendly cash and stock acquisition of  Kayak software for a total consideration of $1.8 billion ($1.65 billion net of cash acquired), or $40 per share, representing a 29% premium to Kayak's closing price Thursday. Priceline will pay $500 million in cash (out of its $4.6 billion cash hoard at the end of September) and another $1.3 billion in new stock. As the boards of Priceline and Kayak have unanimously approved the acquisition, the deal is expected to close at the end of the first quarter of 2013, pending a vote from Kayak shareholders and regulatory approvals. The current Kayak management team will run Kayak as an independent operation in the Priceline family.

This acquisition was a bit surprising to us. Strategically, the air booking referral business that accounts for the bulk of Kayak's profits is often viewed as less desirable (because of lower margins and greater volatility) than Priceline's bread-and-butter hotel booking business. More important, we are concerned that Kayak's being under the Priceline umbrella may discourage competing travel agents like   Expedia (EXPE) to continue using Kayak as a lead-generating channel when existing contracts expire in the near future. According to Kayak's prospectus, the Expedia family of brands accounted for 23% of Kayak's revenue in the first quarter of 2012. We believe travel media site  TripAdvisor (TRIP) had a similar problem before its spin-off from parent  Expedia. Uncertainties surrounding Kayak's access to the database of ITA (now a  Google (GOOG) subsidiary) when the current terms expire in a couple of years may be another risk factor weighing on investors' minds. Priceline's management declined to comment on either of these two issues during the conference call after the acquisition announcement.

In our view, the biggest potential benefit from the Kayak deal is expanding coverage of travel-related online traffic, as traffic on Kayak may not have much overlap with the hotel shopping traffic that Priceline tends to receive. This may help Priceline improve efficiency of its U.S. traffic acquisition spending and gain some exposure to the travel advertising market (both display and cost per click advertising) in which Kayak currently operates. On the conference call, Priceline's management highlighted international growth opportunities and said Kayak can benefit from Priceline's technology infrastructure and local knowledge, which we don't dispute, given Priceline's strong record internationally and the fact that international markets accounted for less than 20% of Kayak's revenue in the first six months of 2012. However, we are less enthusiastic about the prospect of Kayak gaining meaningful traction internationally in the near future, given the hurdle of accessing air ticketing data in the overseas markets and tougher competition for air travelers from budget airlines (which run their own direct sales websites) and from short and medium-haul train transportation, especially on the European continent.

The deal's valuation does not look appealing, in our view, with the $1.8 billion price tag implying 52 times consensus non-GAAP earnings per share for 2012, whereas Priceline's closing price Thursday implied 20.3 times consensus 2012 earnings. That said, based on financial results from both firms, we estimate that Kayak will account for about 5% of revenue and 3.5% of adjusted EBITDA for Priceline after the acquisition, so we don't think the acquisition will move the needle on our $660 fair value estimate for Priceline.

Historically, Priceline has not been a serial acquirer, although it has certainly not been shy when it sees good value. Major deals over the past eight years include the acquisitions of Active Hotels, Booking.com, and TravelJigsaw (later renamed Rentalcars.com) in Europe as well as Agoda in Asia, and we think these acquisitions are crucial in helping Priceline expand footprint globally and have put the firm on an impressive growth trajectory over the past years. The key difference with the Kayak acquisition is that previous acquisition targets were small, private firms in underpenetrated international markets that fetched valuations in the $100 million-$200 million range, whereas Kayak is a well-known brand in the United States, publicly listed recently, and valued significantly higher at $1.8 billion. We think Priceline's management deserves credit for identifying those attractive acquisition targets in the past and executing growth strategies to drive substantial investment returns from those transactions, though it might take a longer time to prove it has snatched another bargain with the Kayak acquisition.

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