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STREET WISE By Amey Stone June 10, 1999


Online Travel: Looking for a Business Model That Will Fly
For now, electronic middlemen that do the booking seem a better bet for investors than struggling Web travel agencies

By many measures, travel has been a hit on the Internet. Researching vacations is one of the most popular uses of the Web, and in terms of E-commerce, travel is one of the top categories for goods and services sold. Jupiter Communications expects about a quarter of the $41 billion in products and services sold online in 2002 will be travel-related -- more even than electronic gear. Travel sites also boast a ton of traffic: In April a third of all Internet users visited travel and tourism sites, according to Media Metrix.

But when it comes to making travel thrive as a business on the Web, it has been a struggle. Sites that function as travel agencies have only been able to get a small percentage of total visitors to actually book online. Meantime, airlines are slashing commissions paid to online travel agents. "It is a really tough business to be in," says Fiona Swerdlow, a Jupiter analyst.

COSTLY CALL CENTERS. "We thought, if we build it, they will come," says John F. Davis III, president and CEO of Pegasus Systems (PEGS), which operates TravelWeb.com. "We also thought they [customers] would never call," he says. But one-on-one customer service has proved more important than expected. Preview Travel (PTVL) is adding costly call centers as part of an emphasis on customer service. Meantime it is searching for a new CEO and CFO. "It is going to be hard for them to really grow and move forward without a committed management team," says, Sara Zeilstra, an analyst with Warburg Dillon Read who rates Preview a Hold. Advertising is proving to be an increasingly important part of revenues, and the company hopes those ads will help it grow. But for now, Preview's stock is trading about 60% below its high.

And Preview is a success story -- one of the top three sites, behind Microsoft's Expedia and Sabre's (TSG) Travelocity. Some sites, such as PC Travel, have dropped out of the race altogether, and BizTravel.com is struggling, says Swerdlow. "They are all symptoms of a larger issue: How do you build a sustainable business model?"

 

Even in a downturn, the go-betweens -- the reservation systems -- still generate fees
 

Given the hazards of the online agency business, some analysts believe companies that act as intermediaries between travel agents and the airlines, hotels, and rental-car companies, are better opportunities for investors. "I'd rather buy the middleman than the front end," says Jake Fuller, a hotel analyst with Donaldson, Lufkin & Jenrette. He rates Pegasus a Buy, mainly because it dominates the electronic-booking business for hotels, with about a 70% market share. Sabre (TSG) and Galileo International (GLC) are the main public companies that process transactions for the airline industry.

These companies are all profitable, based mainly on their current electronic-booking businesses. Travel agencies (online and brick-and-mortar) use these systems to connect with all the airlines, hotels, and car-rental agencies, and the travel suppliers pay a small fee to the intermediaries for each customer transaction. For the first quarter of 1999, Sabre reported earnings of $93 million, or 71 cents a share (a 29% increase over the prior year), Galileo earned $72 million, or 69 cents a share (a 17% gain), and Pegasus earned $1.5 million, or 13 cents a share (a 44% gain).

These reservation systems have a high percentage of recurring revenues and are protected by lofty barriers to entry. They also aren't as subject to economic ups and downs. "They have a built-in correction mechanism," says Jim Marks, an analyst with Deutsche Bank. That's because they get paid per transaction. When the economy turns down, travel suppliers cut prices to keep traffic up, which means the reservation systems still generate fees.

"A BIG COUP." These companies all have compelling Web strategies. Sabre operates Travelocity.com, one of the top online travel agents. On June 3, it announced gross sales of more than $128 million for the first quarter of 1999, a 156% increase over the prior year. Analysts believe Sabre may spin off Travelocity in an initial public offering. Sabre also does IT outsourcing, providing the technical back end for many airlines, including American and US Air. "They are in discussions with United, which would be a big coup," says James F. Kissane, an analyst with Bear Stearns.

While Galileo's electronic-booking business is similar to Sabre's (and it has about the same market share), its Internet strategy is very different. Rather than launch its own online travel site, Galileo remains behind the scenes. For example, it is the booking engine for Preview Travel. "Sabre has higher growth prospects, but its strategy is much more capital-intensive," says Marks, who has a Buy rating on both Galileo and Sabre. Because it doesn't need to spend on a Web site, "Galileo's strategy lets management stay focused and allows a greater proportion of cash flow to be returned to shareholders."

 

Despite their current difficulties, Web travel agencies could ultimately be very profitable
 

Pegasus operates TravelWeb, plus it touches 85% of all hotel reservations on the Internet and 70% of all electronic hotel reservations. Other electronic reservation networks, including Sabre and Galileo, use it to connect with hotels. "Pegasus is not a cheap stock, but it is going to grow a lot faster than the other transaction companies," says Kissane. That's because only 11% of hotel bookings are currently made electronically, while airlines are already making over 90% of sales electronically. Davis points out that he doesn't have to worry about which travel site proves most popular. "All we care is, will people book hotel rooms on the Internet?" Pegasus also has a growing business processing travel agents' commissions earned on hotels.

By conventional measures, Sabre, Galileo, and Pegasus are not cheap stocks. Sabre and Galileo are both trading at price-to-earnings ratios higher than their long-term growth rate of 15% a year. Pegasus, has the highest p-e, at 37 times Kissane's 2000 estimate. But it is expected to grow at a 35%-40% rate long term (growth stocks are often considered overvalued when their forward p-e exceeds their long-term growth rates.) When compared with other high-flying, money-losing Internet companies, these three are inexpensive. Fuller set a 12-month price target of $56 for Pegasus (it closed at $39 1/8 on June 9), based on valuing the company's core businesses at $45 and its Internet operations at $11 a share.

Just because some of the online agencies such as Preview Travel are struggling to prove they have a strong business model now doesn't mean the travel business over the Web ultimately won't be very profitable, says Alexander C. Cheung, the portfolio manager of Monument Internet Fund, which has small positions in both Sabre and Preview Travel. "These companies are young and new," says Cheung. "Over time, as people gain more experience on the Net, we should see the number of transactions per consumer and the dollar value go up." But if you aren't willing to take the risk of waiting, companies that provide electronic-booking services, already have solid businesses with plenty of upside from the Net.

Amey Stone is an associate editor of Business Week Online


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Amey Stone covers the markets and investing for Business Week Online


WEB POINTERS
To visit the sites mentioned in the story, click on these links:
TravelWeb.com
Expedia
Travelocity
BizTravel
PreviewTravel
Galileo


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