Expedia Poised to Take Off

We believe

Investors have an attractive opportunity to build a position in a competitively advantaged name, in our opinion. The current market price implies consistent booking share loss, elevated marketing costs, and lower gross margins, a scenario that seems unreasonable to us, given Expedia’s intact network effect and ongoing investments in international markets, the HomeAway brand, and cloud infrastructure.

Expedia maintains a powerful network advantage that warrants incremental investment, in our view. The company’s network is illustrated by its industry-leading demand (600 million monthly unique visitors) and supply (1.5 million vacation rental listings and 440,000 hotel properties). These are challenged only by narrow-moat companies Booking Holdings BKNG (its Booking.com brand has around 550 million monthly visits and hosts over 1.6 million accommodation properties) and TripAdvisor TRIP (the platform has around 450 million monthly visits and hosts 1.15 million hotel properties and 750,000 vacation rental listings). Meanwhile, Expedia’s network scale is meaningfully larger than its rivals’. Website domains Kayak.com (owned by Booking) and Marriott.com each have only 35 million monthly users, while it has been reported that the Trivago (owned by Expedia) and Airbnb platforms (including all its website domains) get around 120 million and 200 million monthly users, respectively.

We also believe the company’s competitive position remains solid, helped in part by its marketing scale, with incremental spending occurring from a position of strength, not weakness. Expedia’s $5.3 billion in 2017 marketing spending exceeded that of every other competitor, aiding traffic growth for the company, which in turn encourages suppliers to add content to its platform, thereby supporting its network advantage.

In our view, growth of Expedia’s key metrics remains healthy and supportive of an intact network and market position, offering no evidence of intensifying competition as a reason the company is lifting investment spending in international and vacation rental markets. Fourth-quarter overseas bookings (40% of total) growth accelerated to 26%, up from the 22% rate seen last quarter, while HomeAway bookings (10%) ramped to 47% growth versus 44% in the prior three-month period. This demand both aids and is supported by solid platform supply addition, as witnessed in hotel property growth that has averaged 25% the past 10 quarters and Expedia’s expectation that it will accelerate to around 40% growth in 2018. The unwavering network effect is also illustrated by the stable take rate (revenue per booking) that Expedia can charge its customers.

Expedia’s solid network and competitive position alone make a case for incremental spending, but the rationale is greatly enhanced when looking at the large market opportunity. We forecast the leisure and unmanaged corporate travel booking market to be $1.5 trillion in 2018, growing to $2.2 trillion in 2026. We estimate online penetration of this market is currently around 44% and will expand to 56% by 2026, resulting in our expectation of 8.3% average annual online booking growth over the next decade.

While incremental expense will pressure near-term profits, these investments will continue to support Expedia’s network-based competitive position. We expect this will lead to continued booking share expansion and reaccelerating EBITDA growth in 2019, justifying near-term spending, in our opinion. Typically, Expedia has shown single-digit EBITDA growth during investment years, such as its 2015 investment in international markets, when marketing spending as a percentage of sales rose 200 basis points to 50.7%. In years without targeted incremental investment, EBITDA growth has risen by double digits. Against this backdrop, we model Expedia’s 2018 EBITDA to be up by mid- to high single digits, given near-term investment plans that include $250 million in incremental cloud-related expense and marketing expense as a percentage of sales averaging 560 basis points above 2016 levels. We then forecast EBITDA to accelerate to double-digit growth in 2019-21 as this incremental spending unwinds and supports Expedia’s competitive position, which also drives its booking share higher.

Increased International Spending Should Expand Network Advantage One area of incremental investment for Expedia is international market expansion, which we see as a wise use of capital, given the company's success here thus far and the growth opportunity. We expect the company will derive 49% of its total bookings from overseas in 2027 versus 38% in 2017.

Expedia has been speaking for years on its plans to invest aggressively in international markets--spending that has driven share and enhanced its network effect--so we don’t view recent objectives as much of a trend change. Past investments overseas appear to have paid off, witnessed by an acceleration in total hotel properties (Expedia does not break out by geography), and bookings, revenue, and room night growth in foreign markets throughout 2015, with all metrics sustaining healthy levels thereafter. We believe this growth in international markets adds credence to Expedia’s rationale for investing aggressively abroad over the coming years, while also offering support to the company’s network advantage.

Another reason Expedia’s continued push into international regions is warranted is that the opportunity overseas is large and growing, and the company is underpenetrated relative to its U.S. presence. While we estimate that the United States is currently around 25% of the total $1.5 trillion leisure and unmanaged business travel booking market, we expect the region to represent only 15% of total online bookings growth in the next five years, growing 5.4% on average annually over 2018-22. This is due to higher supplier consolidation (hotel brands represent around 70% of rooms in the U.S. versus 35% in Europe) and maturation (we estimate U.S. and international online penetration at 46% and 41%, respectively). We see the opportunity in international markets as much larger, representing the remaining 75% of the total leisure market in 2018 and 85% of total online booking growth the next five years, growing 10.8% on average annually over 2018-22.

Although the company has consistently increased its online booking share in foreign markets, this is still at only a low-single-digit level versus its midteens booking share of the U.S. online travel market. We believe Expedia’s past success in expanding international share--albeit modestly, given the relatively low levels it still maintains--supports its plan for ongoing investment overseas in the next few years.

HomeAway an Appealing Opportunity Investors were concerned when Expedia backed off its 2018 EBITDA guidance for HomeAway in last year's third-quarter conference call, as it intends to increase cloud and marketing spending for the brand. But we think investment in HomeAway and the alternative accommodation market is a strong use of capital for several reasons. For one, we see the vacation rental market as a key area of industry growth for the next several years. The attractiveness of this market is illustrated by the $135 billion in total global bookings we estimate occurred in 2017 (representing over 9% of the $1.4 trillion total leisure and unmanaged travel market), with the online portion growing 18% on average annually the past four years (2014-17) versus 11% for the entire online travel booking market over the same time. Only around 33% of these bookings occurred online in 2017, below the low 40s booked online for the total travel industry. We forecast online alternative accommodation bookings will near a midteens level annually the next five years, higher than the 9.4% growth we see for the total online travel industry over that time.

In addition to the appealing alternative accommodation market opportunity, HomeAway is a brand worth investing in for its well-positioned platform. The dominant vacation rental operators--HomeAway, TripAdvisor, Booking, and Airbnb--have meaningful supply content in the market while other peers have negligible exposure, positioning each of these four players for long-term growth in this attractive industry.

The strong position of these leading vacation rental networks is evident in their combined total and online vacation rental booking share, which we estimate was around 80% and in the high 20s, respectively, in 2017. HomeAway increased its share of total alternative accommodation bookings to 6.5% in 2017 from 4.8% in 2016, which trails Airbnb’s and Booking’s respective 11.6% and 8.2% share but exceeds TripAdvisor’s 2.6%.

A final reason we applaud incremental spending on HomeAway is that the brand appears to be reaching a critical mass inflection point, leading to improving revenue growth. A growing number of HomeAway bookings are occurring online versus offline, where Expedia risks losing commissions on the transaction, and more owners are paying commissions per booking versus annual subscriptions. Because the brand has increasingly become an e-commerce player with variable economics, this allows the company to be more aggressive with marketing. We think additional marketing can drive traffic, which in turn allows the company to more quickly test and identify what changes to its platform can increase conversion, leading to improved sales. The critical mass of the vacation rental brand is reflected in HomeAway’s revenue growth, which has accelerated since the brand was acquired by Expedia in the fourth quarter of 2015.

We see the vacation rental market opportunity and HomeAway’s network, marketing, and technology scale worthy of incremental investment, and we expect HomeAway’s booking growth to average in the high teens annually the next five years, comfortably above the near midteens growth we forecast for the alternative accommodation market. As such, we think HomeAway is poised to grab online booking market share of 24.8% in 2022, up from 19.2% in 2017.

Cloud Spending Rains on Near-Term Profits but Brings Long-Term Gains Accelerated cloud infrastructure spending has hit profits. However, we expect this to result in cost, efficiency, and performance benefits for Expedia as the company shifts its infrastructure mix to the cloud from owned data centers, aiding its profitability and network advantages.

We believe this change is prudent, given that investing in data center infrastructure is costly and inefficient relative to a cloud platform. To assure no downtime, Expedia must maintain and pay for physical data center servers sufficient for any peak traffic period, even though this capacity is rarely used, versus a cloud platform that offers dynamic provisioning to call upon capacity as needed. Further, sustaining an underutilized data center network results in higher power expense versus the pay-for-what-you-use computing expense model of the cloud. Not only is cloud storage more efficient than data centers, but the price of cloud storage consumption continues to trend down, adding credence to Expedia’s cloud investment decision.

The cost of maintaining a data center infrastructure is meaningful for Expedia, given its immense and growing network of traffic and content. Expedia CEO Mark Okerstrom said in November that the company has around $600 million-$800 million in data center assets that need to be maintained and replaced every three to five years, and that such assets were increasing along with the growth of the business. We believe these data center requirements have contributed to capital expenditures (excluding headquarter investment) growing to 7.1% of 2017 revenue from 2.9% in 2009.

These data center requirements also affect Expedia’s cost of goods sold through higher power costs. Because of increasing traffic and look/book ratios (more search queries per booking), Expedia has had to plant more servers in data centers and pay to power and cool these units, which number around 45,000. As a result, Expedia’s data center, cloud, and other cost of goods sold (27.5% of 2017 total cost of goods sold) has risen to $484 million in 2017 from just $134 million in 2009.

The inefficiency and cost of data center infrastructure is also felt in Expedia’s technology and content expense. Coding and product development is easier and faster in the cloud than in owned data center systems, as companies can create applications by linking proprietary data to already-built third-party templates that reside in the cloud. The cost of product development and support of the existing data center infrastructure has contributed to Expedia’s growing technology and content cost, which reached 13.8% of revenue in 2017 from 11.7% of sales in 2009.

To combat the inefficiencies and increasing costs of a data center infrastructure, Expedia is turning to the cloud, where it invested around $100 million in 2017 with plans to spend roughly $170 million in 2018, one half of which is recognized in costs of goods sold with the remainder recorded as technology and content expense. This expense is a headwind to near-term profitability as the company builds out its cloud infrastructure while still having to maintain its existing data center structure. But over time, Expedia will be able to reduce its data center requirements, leading to lower capital expenditures (we forecast 5.5% of sales in 2027 compared with 7.1% in 2017) and operating expenses (we model a 14.5% operating margin in 2027 compared with 6.2% in 2017).

As Expedia begins to remove duplicate data center capacity, it will also reduce power costs that are recognized in its data center, cloud, and other costs line item. With our expectation that Expedia will start removing excess data center capacity in 2020, we expect the company to leverage its data center, cloud, and other costs to 3.9% of revenue in 2027 from 4.8% of revenue in 2017. We had no previous data center, cloud, and other cost forecast, but we now see gross margins approaching 85% in 2027 versus 83% previously.

Although we expect Expedia’s technology and content expenses to benefit from a more efficient cloud-based structure, we expect some of that benefit to be repurposed for product innovation to sustain the company’s network and competitive position in an intensely contested market, resulting in limited leverage of this expense line. We estimate technology and content costs will reach 13.7% of total sales in 2027, down only slightly from 13.8% in 2017.

In addition to aiding cost and driving efficiency, a shift to the cloud improves latency performance, aiding user experience, which in turn supports network advantages. Data center infrastructure involves locally placed servers that at times need to be pinged from a user that resides far away. The cloud structure solves the distance issue by pinging the local data center where the website is hosted/replicated, thereby improving response time and user experience. Additionally, dynamic scaling in cloud data centers allows a company to handle traffic spikes more nimbly, so users don’t see any degradation in processing times, also improving user experience, thereby aiding network effect advantages. Therefore, we see Expedia’s shift to the cloud as not only enhancing profitability longer term but also supporting continued growth in the company’s booking share of the travel market over the next several years, despite a contested landscape.