A Pricey Acquisition for This Online Travel Firm

On June 13, the  Priceline Group (PCLN) announced that it has agreed to acquire online reservation platform  OpenTable  for $2.5 billion net of cash acquired, or $103 per share. Priceline cited three strategic reasons for the deal: (1) benefiting from geographic synergies, as OpenTable's leading position in North America (where it has been installed in 23,900 of the United States' 55,000 reservation-taking restaurants) is complementary to Priceline's exposure to Europe, Asia, and Latin America, (2) spurring demand creation between the company's traveler and diner customer bases, and (3) accelerating mobile innovation for its lodging and restaurant customers, an area of investment for both companies in recent years.

We believe management's rationale has some merit. The tie-up could help OpenTable gain traction in its existing international markets and build relationships in new territories while helping Priceline build out its U.S. presence. We also view the deal favorably from a moat perspective: Priceline can bolster its network effect by giving its hotels, airlines, and other travel providers the ability to cross-market to a wider number of potential customers.

However, even factoring in potential synergies, we believe Priceline overpaid. The purchase price represents 39 times OpenTable's 2013 EBITDA of $63.6 million, and represented a 71% premium to our $60 fair value estimate (which assumed a midteens revenue growth term and adjusted EBITDA margins in the mid-40s over the next five years). We plan to raise our fair value estimate to the offer price, as both boards have signed off on the deal. There is no immediate change to our $1,592 fair value estimate or our narrow economic moat rating. The deal represents just 3% of our implied equity value. However, if Priceline struggles to extract synergies from the acquisition or continues to pursue value destructive M&A, it could result in a modest reduction to our fair value estimate, based on the steep purchase price.

Continued Strong Growth Ahead for Priceline
Priceline is poised to become the world’s largest online travel agent in 2014, yet it still has global market share of all travel bookings of less than 4% (compared with less than 1% five years ago). We expect Priceline to grow significantly faster than  Expedia (EXPE) during the next five years, as it has a stronger presence in faster-growing international markets that have lower penetration rates and more boutique hotels, which are more likely to be booked through an online travel agency. Booking.com generates more than 60% of revenue, and our outlook is for this brand to generate over 15% of revenue growth the next five years, driven by continued penetration of the European market, a partnership with  Ctrip.com (CTRP) for outbound travel from China, an acceleration in revenue per available room, or revPAR, growth in Europe, and Booking.com starting to make inroads in the U.S. Augmenting growth are Priceline’s growing Agoda brand and Kayak, a travel search engine.

We think Priceline’s growth is sustainable through the end of the decade, and that investors bearish on the stock are ignoring two important factors that we think will act as tailwinds that will enable over 20% average annual EPS growth over the next 10 years. First, Priceline benefits from a powerful network effect that is becoming stronger over time (and will be bolstered by the recently announced OpenTable deal). As the supply on the company’s websites increases, it increases the attractiveness of booking through Priceline’s websites to customers looking for one-stop shopping for booking travel, which further enhances the attractiveness of Priceline to hotels. Booking.com has more than 430,000 properties in its network and more than 200,000 in Europe alone, compared with only 75,000 for Expedia in Europe. Second, Booking.com uses an agency model, in which hotels are the merchant of record and pay Booking.com a fee, which helps it capture market share from online travel agents with a merchant model. The agency model is attractive to hotels in that the commission is typically in the low to midteens, compared with 20% or more for the merchant model. Priceline’s agency revenue has no associated cost of revenue, and Priceline’s margins are likely to increase significantly in the next several years.

Enviable Network Effect Snags the Firm a Narrow Moat
We view Priceline as possessing a narrow economic moat due to a strong network effect. Travelers are attracted to Priceline.com because of its massive inventory of hotels, airlines, and other travel providers, which for Booking.com alone includes 430,000 properties in more than 190 countries and territories in 42 languages, including more than 110,000 vacation rental properties. Travel companies are attracted to Priceline.com because of the company’s more than 30 million unique visitors to its portfolio of websites each month. A new market entrant in the industry faces the challenge of developing an adequate level of supply, which is difficult without a meaningful number of customers, and customers are drawn most to an online travel company with a deep inventory of hotels and participating airlines. We view Priceline as having a wider economic moat than rival Expedia because of its strong presence in Europe, the Asia Pacific region, and Latin America. These markets, relative to the U.S., have a much higher percentage of boutique nonbranded hotels, which are more likely to depend on an online travel agency than branded hotel chains that receive substantial bookings directly from their websites. Priceline’s economic moat is evidenced by an adjusted return on invested capital of over 500% in 2013. We do not think that major Internet companies, such as  Google (GOOG) and  Facebook (FB), will enter the online travel agent business, as it would put them in competition with their customers in the travel segment, which generate a material level of their advertising revenue.

We think Priceline has the potential to become a wide-moat company, but because of the potential for disruptive technologies to change the competitive dynamics of the industry, we’d like to see the company continue to build market share and for the industry to become more mature, and then re-examine our economic moat rating. In addition, the growing network effect for Priceline is not exclusive to the company (a hotel in the Priceline network of hotels can also be in Expedia’s network).

We recently changed our economic moat trend rating to positive from stable because of the company’s network effect becoming more pronounced over time, the company continuing to capture market share in all of its major geographic markets, the astute acquisition of travel search engine/fare aggregator Kayak, and higher usage of the company’s mobile apps, which make for stickier customers. Our current outlook is for the company to increase its market share of all travel bookings from 4% to over 8% in the next five years. The acquisition of Kayak enabled Priceline to gain more access to high-quality travel shopping traffic, thus increasing the conversion rate for transactions and boosting marketing efficiency, and strengthened the company’s network effect. Priceline is investing heavily in off-line branding activities and its mobile apps, which drive more transaction activity relative to customers booking through the company’s desktop websites. A potential threat that would cause us to re-examine our moat trend rating, is the potential for  TripAdvisor (TRIP) to shift from a meta-search business model to an agent business model.

Costly OpenTable Acquisition an Atypical Move for Management
Darren Huston assumed the CEO position at Priceline in early 2014, following Jeffery Boyd's tenure as CEO from 2001 to 2013. Huston had been CEO of the company's Booking.com division, which generates the majority of the company's revenue and cash flow. Boyd continues to serve as chairman of the board. When Boyd took over as CEO in 2001, the company primarily consisted of Priceline.com in the U.S. and an opaque "name your own price" service that appealed to budget travelers. Boyd saw the massive opportunity in international markets, and acquired Booking.com in 2004 for only $135 million and Agoda in 2007. With our stand-alone valuation for Booking.com at over $60 billion, the acquisition is one of the most successful acquisitions of a foreign company by an American company in the past 50 years. The company has bought back more than $1.2 billion in stock in the past three years for an average price well below our fair value estimate, and Priceline’s stock price has increased to more than 52 times the stock price at the end of 2001. We do believe that management overpaid for OpenTable, but it remains to be seen what the manifestations of the acquisition will be and whether the company will stick with more cautious M&A decisions in the future.