Priceline's Price Is Right

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In our opinion, these results indicate that the network advantage is intact. Total bookings were up 17% in the fourth quarter (23% constant currency), and the currency headwind of 6 percentage points was slightly below the midpoint of guidance (which called for 7.5). International fourth-quarter constant currency bookings rose 27%, well ahead of management's 16%-23% guidance and our 21% estimate, while U.S. bookings growth was 3.4%, in line with company guidance for 0%-5%. In total, 2014 bookings growth of 28% was in line with our estimate. Our view that Priceline is well positioned in the growing mobile, China, and restaurant markets is intact. Highlights in performance include mobile, which continues to drive an increased mix of lower-cost direct traffic and some days represented 50% of total bookings; OpenTable revenue, which increased 43% over last quarter; and Ctrip CTRP, Agoda, and Booking.com, which experienced very strong growth in China. Additionally, Booking.com property growth was 41%.

Profitability remains strong, as fourth-quarter agency revenue margins of 13.7% were up from last year's 13.2% (impressive, given the lower trend experienced at key peer Expedia EXPE). Additionally, fourth-quarter adjusted EBITDA growth of 23% exceeded the 13% midpoint of guidance. This profitability came despite increasing investment in sales and marketing, which we think is warranted. 2014 online and offline advertising as a percentage of total revenue was 28% and 2.7%, respectively (versus last year's 26.5% and 1.9% and our estimate of 28.4% and 2.9%). Priceline noted that the offline TV campaign continues to yield positive results. We forecast continued increases in marketing for Priceline and the industry over the next few years, but may have to raise our spending outlook further.

Priceline's first-quarter international constant currency bookings growth guidance (which typically proves conservative) is 17%-24%, which implies a continued healthy trend and is in line with our 21% constant currency estimate. That said, the currency impact is forecast to be 12 percentage points, which is above the high-single-digit rate we modeled in early January. We do not find the higher currency headwind as shocking, but will be adjusting our near-term agency bookings to account for this.

Priceline announced a $3 billion share-repurchase authorization, around 5% of shares outstanding at current levels. This is the largest authorization amount ever for the company, and we believe it is a good use of capital as the shares are trading at an attractive price compared with our fair value estimate.

During the conference call, we were encouraged by the response to a question regarding the implications Priceline sees in Expedia's proposed acquisition of Orbitz OWW. Management spoke highly of Expedia, but noted that Priceline's strategy continues to focus on organic growth and acquisitions of premium brands in new verticals (such as restaurants) and geographies (emerging markets). We applaud this strategy, which is one reason we view Priceline as best positioned for long-term growth in the online travel agency space. That said, given the increased use of loyalty programs in the industry, we would like to see some increased capital allocated here, although management says it is interested in loyalty and that the experience it provides has continued to drive increasing return visits.

Positioned Well to Expand Leadership We expect Priceline's global online travel agency leadership position to expand over the next decade at a much faster rate than that of primary competitor Expedia, driven by a superior position in China, continued leadership in Europe, and expanding presence in the United States. We see the company's global share of online bookings reaching the high single digits in 2019 from 3.7% in 2013.

The company has built a leading network of hotel properties and other services, which drives an increasing user base. We see this network effect continuing to expand in both developed and emerging markets. In developed markets, the successful "booking.yeah" TV campaign has helped drive improving U.S. bookings growth, while in Europe, replicating Priceline's leading network is proving costly and challenging, as boutique hotels (a substantial portion of the region's market) already signed with Priceline face labor and expense constraints in joining multiple distribution channels. In emerging markets, the firm is expanding its leadership in China with its Ctrip partnership, which is crucial, as we see China representing 28% of total industry online bookings growth over the next decade. In addition, the recent acquisitions of Kayak and OpenTable extend the network globally.

This expanding network positions Priceline well for the increasing global shift to booking via mobile applications. Booking.com is a top-five travel application in 28 markets around the world, while Expedia ranks second highest among online travel agencies, ranked in three markets as a top-five travel application.

Companies that already have the customer traffic and budgets to replicate the network Priceline has built pose the main risk. Focused entry from Google GOOG, Facebook FB, Amazon AMZN, and others could double the current handful of players that have dominant scale, leading to commodification of the industry and a meaningful impact to profitability. That said, replicating Priceline's network requires significant time and expense. For instance, Google's Hotel Finder has not gained traction, as evidenced by its 100 thousand-500 thousand mobile app downloads versus Priceline's Booking.com app downloads of 50 million-100 million.

Network Effect Sustained by Size, Market Position We see Priceline as having a narrow moat driven by its sustainable network effect in the online travel industry. Priceline established its moat beginning with the Booking.com acquisition in 2005. Using its size, Priceline was able to increase spending to promote Booking.com to both hoteliers and travelers. For travelers, Booking.com was intriguing because it offered agency bookings, which allowed them to pay after a hotel visit versus having to pay up front with merchant bookings. This helped drive increased customer traffic (the demand side of the network effect equation), which in turn drove hotel inventory to the website (the supply side of the network effect equation). This created a positive virtuous cycle at a time when no other competitor had begun to build scale in Europe; customers joined and hoteliers joined, which drove further hotel inventory and customer traffic.

As of the third quarter of 2014, Priceline had 540,000 (not including 170,000 Ctrip) properties on its network. The number-two and number-three players in the online travel agency industry are Expedia and Orbitz, with 210,000 (not including 155,000 eLong) and 100,000 properties, respectively. On the demand side, Priceline's May 2014 worldwide monthly unique visitor traffic was 80 million versus Expedia's and Orbitz's unique visitor traffic of 63 million and 10 million, respectively, as measured by ComScore. Also on the demand side, customers booked 95 million room nights through Priceline brands versus 54.5 million on Expedia brands in the third quarter.

Both Priceline's size and market position will sustain its network effect. Priceline and Expedia each control about 30% of the online travel agency market, and Orbitz controls around 8%. Beneath these three's 70% share the market is highly fragmented, making it extremely challenging for any smaller new entrants to gain customer traffic or supplier scale. Smaller new entrants would need substantial human capital to build relationships with hotels and gather crucial hotel information and photos from those hotel properties. They would also need to spend heavily on advertising to attract customers to the website, and any customers they did get would require IT, data center, and 24/7 customer support services to retain. Priceline is able use its strong and sustainable cash flows to acquire and partner with attractive products and brands, which builds out the supply offering. Priceline also is able to advertise well in excess of competitors, which helps drive brand and customer traffic. In 2013, Priceline spent more than $1.9 billion on advertising, or 28.4% of its total revenue. Expedia and Orbitz spent $1.7 billion and $292 million in 2013, or 36.1% and 34.5%, respectively, of total revenue. As scale is built, understanding of consumer behavior also increases, which leads to improved customer experience and conversion.

Unique to Priceline is its strong position in international markets, hotel travel, and agency bookings (versus merchant). International markets are less penetrated than domestic markets and have more boutique than branded hotels. For example, in Europe, independent hotels represent about 60% of the market versus only 30% in the U.S. Because these boutique hotels are too small to effectively market, their dependence on the online travel agencies for marketing and distribution is greater and stickier. These boutiques are unlikely to use multiple online distribution channels, because their size does not allow staffing to actively manage inventory and relationships with multiple partners. This boutique dynamic also holds true in most emerging markets, where Priceline has a strong presence through its Ctrip partnership. Hotel bookings are less penetrated online than air (30% versus 50%) and are less brand oriented than air (online travel agencies have a stable 50% share of online hotel bookings versus a declining 30% share of online air bookings). Hotel exposure offers faster growth (low-double-digit hotel bookings growth versus mid-single-digit airline bookings growth), and higher negotiated commission fees (midteens for hotels versus mid-single-digit for air). Finally, Priceline generates a higher level of its bookings from agency, which is preferred by travelers and doesn't require the processing costs that merchant does.

Priceline's position in these relatively attractive markets is higher than the other first-tier online travel agencies, which results in higher returns on invested capital and market share. We project adjusted ROICs to average 107% over the next five years for Priceline versus our forecast of 32.7% for Expedia. Additionally, we forecast Priceline's share of global travel bookings to reach high single digits in 2019 from 3.7% in 2013 versus Expedia's share reaching midsingle digits in 2019 from 3.7% in 2013.

Despite Priceline's very high ROICs, we don't believe the company has carved a wide moat, given potentially meaningful competition beyond the next 10 years from new entrants that already have the customer traffic and budgets to build network scale, which include Google, Facebook, Amazon, and hotel consortiums. Focused entry from these competitors would double the current handful of players that have dominant scale, leading to commodification of the industry and a meaningful impact to margins.

That said, we expect the market to support some level of increased competition over the next several years, and we currently see Priceline has having the strongest network. The travel booking market remains large at $1.1 trillion, and online penetration of the travel market remains low at 36%-38%.

International Expansion Brings Currency Risk Priceline derives the vast majority of its revenue from international markets. This exposes the company to foreign exchange rate fluctuations that are often near term in nature, yet can meaningfully affect sales and profitability.

Rate parity regulation prevents hoteliers from offering cheaper rates on their websites than are offered on the online travel agency websites. The removal of rate parity would create an environment for competition. That said, we would view any margin impact as near term, as Priceline's large scale in the industry would allow it to price out competition, only to emerge in a stronger position over the intermediate to long term.

Growth of the online travel bookings market remains attractive, and there is an ongoing threat that large companies with sizable user traffic could enter the industry. Focused entry from companies such as Google, Amazon, and Facebook would have a meaningful impact to Priceline's growth.

The travel industry is cyclical and affected by changes in economic growth. In a downturn, consumers have less income and look to cut back on discretionary expenses like leisure travel. Priceline is not immune here, as revenue growth did slow in 2009; however, revenue still grew 24%, as the low penetration of developed markets and limited competition for the firm's Name Your Own Price offering provided some offset. If an economic downturn were to occur now, developed markets and Name Your Own Price would not offer the same cushion as they did in 2009 due to more mature penetration and increased competition. That said, the nascent penetration and Priceline's position in emerging and mobile markets would probably offer some cushion to a weaker economic growth environment. In the event of an economic downturn, we expect Priceline's growth to slow but remain comfortably above Expedia's.