Tuesday, March 10, 2009 1 comments

Added to watch list: Expedia (EXPE)

Does anyone have any thoughts on Expedia (EXPE)? It looks attractive to me and am thinking of taking a postion after further research.

For those not familiar this used to be the #1 online travel agent (OTA)--it's sort of is still #1 but Priceline (PCLN) has the momentum--whose business is centered on allowing customers to purchase airline tickets, hotels, and so on, through the internet. I looked at Expedia a few years ago (not on this blog) and found it way too expensive so just added it to one of my watchlists. The stock has sold off sharply in the last year and is inexpensive now. Some of the decline is likely due to permanent loss of market share to competitors and potentially decline margins. Nevertheless, it looks like the stock is cheap even under some mildly conservative estimates.

If anyone has any opinions--good or bad doesn't matter--feel free to leave your comments. I wrote up a long comment on the gurufocus.com message board outling my preliminary thoughts and I'm going to reproduce most of it here.

Macro Picture Is Attractive

First the macro stuff. The online travel agent (OTA) business may have huge potential. Kind of like Amazon. This is what attracts me to it. It just makes so much sense to be booking travel, hotels, etc online. So far the OTAs seem to have grown significantly so they are not as high growth as they seem (they have potential outside America though.) Something like 50% of all air travel in America (it's lower in foreign markets) is booked through OTAs so the upside is not that large anymore.

I'm not a traveler but my impression is that the physical travel agent business is largely fragmented with countless agencies all over the place, with low margins and unpredictable growth. However, I am guessing--only a wild guess--that the online business might be better for owners. Right now there are countless players with heavy competition and there will be future threats from companies like Yahoo!, Google, etc.

One of the things that attracts me about this business, or almost any online business for that matter, is the potential for network effects (if you are unfamiliar with network effects check out this Wikipedia entry.) Amazon and Ebay are the best online examples of using network effect to build a huge moat but the classic examples are the telephone and the newspaper.

It's questionable if the OTAs will be able to build their brands, provide complimentary services, cross-sell products, and build enough scale to get the network effect going. Expedia is trying to build some network effect by providing sites like TripAdvisor and allowing customers to post reviews, opinions on various things, etc. I think if the OTAs can get a large number of users for their sites, they can build up a moat and, unlike the physical travel agencies of the past, maintain profitability. If, however, OTAs operate in a cut-throat low margin business then I wouldn't want to own any shares in any of the companies. Commodity-type businesses are fine and some peole make a fortune off them but that's not my goal.

In the grand scheme of things Expedia is highly leveraged to consumer discretionary spending. Weak economy will significantly hurt travel but the impact on OTAs is uncertain since they may be a disruptive technology that actually lowers costs and can grow in a weak economy.


Main Thesis & Valuation

I'm only looking at Expedia, rather than the competition, as a potential investment since it is cheaper than the competition. My understanding is that Expedia is more of a slightly premium provider--this is in a cut-throat business so it can never be a true "premium" business charging a lot--while Priceline is the more economical one. Priceline has been stealing market share given the current economic environment we are in (this is kind of like how value retailers like Wal-Mart/Dollar Tree/etc have been doing well while Macy's/American Eagle Outfitters/etc have not.) However, my expectation is for EXPE to try harder and maintain their market leadership, and to do well once the economy recovers.

Barring a complete collapse of travel and leisure spending in general (I'm talking a long-term collapse, not a short-term one,) I think EXPE is trading at a normalized P/E between 7 and 10 (ignoring 2008 and the large loss, it has earned around $200m for 3 years and has a market cap of around $1.8b right now.) I am happy buying anything at P/E of 10 or less (if earnings are expected to be stable or grow.)

From a free cash flow point of view, ignoring last year, it has earned between $500m and $700m so you are looking at a P/CF ratio between 3 and 4. Company seems to have been buying internet properties that subsequently were wrote-off at massive losses so a lot of the FCF has been destroyed over the years. But I think this is fine for a rapidly growing, internet, company. Almost any online property will be overvalued and it's ok to buy them than trying to build them from scratch. Others may not think of it like I do but I view their misallocation of capital as R&D :)

The valuation numbers are amazing for a company like this. It's cyclical and heavily exposed to leisure spending but how many market leaders in an industry, even a niche one, can you buy for a P/E of around 7 (it's even lower if you assume they won't spend as much buying overvalued internet properties--this will be the case after a while.) Two or three years ago, you would have had to look at small-caps, micro-caps, or distressed firms to find something at this valuation. Right now there are many companies with P/Es around 10 but they have no growth potential like these OTAs.

Debt, equal almost to the market cap, seems somewhat high but I don't think it's a big risk (it will, however, be a big risk if we enter a depression-like environment and travel completely collapses.) EXPE also has negative tangible equity but that's ok.

Like most successful online businesses, Expedia has low capital requirements. Barring a reckless management intent on destroying shareholder wealth through empire building, I suspect Expedia's acquisitions will decline in the future so there will be even greater free cash flow.

I have to dig deeper to confirm this but Expedia seems to be benefitting from running the business with negative working capital (For those not familiar, this is a powerful benefit where you get paid before you have to pay your suppliers. In a simple sense, the interest you earn on the cash until the supplier has to be paid is free money for you. Wal-mart is famous of having negative working capital.) I'm not sure if the negative working capital can be maintained in the long run.

Negatives

The OTAs aren't as out of favour as I would like them to be. Analysts still seem to have a buy/hold rating. Speaking as a contrarian, I would prefer if nearly all analysts had a sell rating or a really low stock price target (for example of a contrarian stock look at Sears, where they have a hold/sell rating and have a target below current price.)

I have to look deeper at management since some past shareholders have shed a negative light on management and insiders. In general, I don't care about management, insider selling, or stuff like that. I'm just a newbie with questionable record but my goal is to invest in a business regardless of management actions. In this regard, I'm more like Martin Whitman than Warren Buffett. I invest with the understanding that I am, what Martin Whitman calls, an OPMI (outside passive minority investor.)

What is a huge concern is the the dual-class share structure. I have been tracking newspaper companies, yes those dinosaurs threatened with extinction ;), for a while now and always felt their dual-class share structure, which is quite prevalent in that industry, was detrimental to shareholders. I have to think hard about the dual-class shares of EXPE, especially in light of some concern over management and insider behaviour. I don't think I have a problem investing in dual-class shares like that of Google since I believe in the founders (founders are the essence of Google) but not sure about Expedia.

My impression is that management and insiders are not very good capital allocators. On top of losing so much money buying overvalued internet properties--admittedly this isn't such a bad thing from a strategic point of view and if you look at these purchases as being equivalent to R&D--it seems that management's strategy of issuing debt and buying back shares back in 2007 has completely backfired. Not only did the share price decline significantly, Expedia is one of the few online companies saddled with sizeable, although manageable, debt. Issuing debt a few years ago is ok in my eyes (since risk premiums were low and EXPE didn't seem to have any debt, other than a revolving line of credit.) But management, as well as insiders such as chairperson Barry Diller, clearly haven't grasped the fact that you build shareholder wealth by buying back shares when valuations are low--not when you need to prop up the shares to placate shareholders. The company seems to have bought back shares when P/E ratio was around 30--this isn't depressed earnings--and that is clearly not when you should be buying shares. Company would have been better off paying a special dividend instead (although that's not tax efficient.) Ideally though, management and insiders should have concentrated on increasing the denominator in the P/E ratio--earnings!--rather than trying to raise the stock price. (All this is assuming that management was indeed trying to return money to shareholders and not trying to mask some of the dilution from issuing shares and options to employees--a popular practice at some tech companies, with perhaps Cisco being the poster-boy of buying back shares to offset dilution.)

The other big concern is if EXPE can maintain their leadership position and profitability. They have been losing badly to Priceline in the last few years and that is a concern. More importantly, I am not sure if the margins can be maintained. If they can't build their brand, or customer loyalty, using network effects or various other means, then this can easily become a competitive industry will literally thousands of competitors. Anyone investing in any of the OTAs is highly vulnerable to shrinking margins.

It is also not clear how much of a competitive advantage these OTAs have against hotels, airlines, etc. These latter parties sell their services through their own sites and if they close the gap with the OTAs, profitability for OTAs will suffer. My impression so far is that OTAs are fine because they aggregate information whereas individual hotels/airlines/venues/etc only have access to their own properties, for the most part. However, the risk is there. There is also a risk of some large technology company like Google or Yahoo building a better aggregation system with better service at a lower cost. Yahoo! has entered the market with some sort of travel search engine but haven't had any success so far.

Summary

This is a beaten-down stock that is leveraged heavily to leisure spending, particularly on travel and hotels. Given the economic outlook and declining consumer spending, this is one of the worst areas to be in. If, though, you are contrarian, it's music to your ears. I'm not certain but it's possible that the market is punishing Expedia due to its cloudy short and medium term outlook. This mispricing may present an opportunity. Expedia has attractive valuations if you believe that its margins won't decline much and/or sales won't decline in the long run. Depending on your assumptions of the stock price and earnings, you are looking at a company trading at a P/E between 7 and 10. If you look at free cash flow, it's even cheaper. One the downside, corporate governance looks poor (dual-class share structure) and past management actions are questionable (issuing debt to buy back shares when peak-earnings P/E ratio is over 30.)

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