Turbulence Alert for Online Travel


By Timothy J. Mullaney As an old Hollywood hand, IAC/InterActiveCorp (IACI) chief Barry Diller knows all about edge-of-the-seat tension -- flicks like 1995's Apollo 13, for example, which reaches its climax with Tom Hanks' damaged spaceship reentering the earth's atmosphere while ground controllers wonder whether a mission that began with such promise will end with a cascade of flaming debris falling back to earth. In real life, Diller's company and other travel agencies are trying to prove they can keep growing in an improving economy -- one that's emboldening newly healthy hotel chains -- and continue to sustain the fast growth and fat profits they began to forge amid the post-September 11 travel-industry crisis (see BW Online, 8/5/04, "Is Global Hyatt About to Go Public?"). Now, weak second-quarter sales and earnings news from IAC, Priceline (PCLN), and Orbitz has skeptics smelling a flameout.

That trio's shares all tanked after news of their second-quarter performance. IAC shares fell 20%, to $21.65, before recovering to $22.80 on Aug. 4. True, it beat its second-quarter forecast on Aug. 3, but said revenue from its Expedia, Hotels.com, and Hotwire travel sites came in about $15 million (or 3%) below expectations. IAC trimmed its full-year forecast for operating earnings before noncash amortization expenses to $1 billion, from a range of $1 billion to $1.2 billion.

Priceline's stock is down 30% in the past month, to $19.35. On Aug. 4, it announced $11.4 million in earnings, or 29 cents a share, to beat consensus estimates by a penny, but then dampened that good news by issuing conservative second-half guidance. And Orbitz, the most troubled of the three, cut its second-half guidance by between 30% and 33%. Its stock fell 9% before recovering Aug. 4, when it closed at $17.31.

FASTEN SEATBELTS. Online travel is still a rising tide, though, so the latest sell-off means some on the Street will likely regard the stocks as cheap. IAC is trading at 7 times to 8 times next year's earnings before interest, taxes, and noncash charges. "There's a disconnect" between the modest earnings misses and the huge punishment the market has meted out, says American Tech Research analyst Mark Mahaney. And Goldman Sachs analyst Anthony Noto, who cut his estimate of IAC's likely annual profit growth to 15%, from 25% to 30%, after its earnings report, advises IAC shareholders to hang on. With researcher PhoCusWright predicting the Net will grab a third of U.S. travel sales by 2006, up from 20% in 2003, there's reason to think that, just like Apollo 13, the leading agencies can withstand the pressure and make a safe landing.

IAC's basic problem is that its travel revenue increased only 34% in the most recent quarter, while analysts expected gains of 38% to 40%. The reasons aren't hard to identify: Growth at Hotels.com cratered, falling to 16%, from 44% in the first quarter. Expedia's European operations, which had been the hottest part of IAC, fell 11% after a white-hot first quarter. And IAC also has problems in its deep-discount Hotwire business, which it bought last year. The result: According to Mahaney, IAC's earnings prospects fell about 5%, much less than the 20% stock dip. "The main thing they can do is smile and ride it out," says Legg Mason analyst Thomas Underwood.

Priceline's revenue numbers are fine -- it expects travel bookings to climb by 44% to 48% during the second half of 2004, after 58% growth in the second quarter. But analysts were bothered by projections of third-quarter costs that will be about $3 million higher than expected. The additional expenses stem from advertising and added personnel for its newly acquired Travelweb.com hotel site. That took third-quarter projections from 31 cents a share down to a range of 25 cents to 30 cents. Says Priceline CEO Jeffery H. Boyd: "When there's good news, it's overblown -- and so is bad news."

KEENER COMPETITION. Indeed, second-quarter earnings reassured online-travel analysts. The bearish case for IAC, Priceline, Orbitz, and Sabre Holdings (), which owns Travelocity.com, has maintained that a resurgent market would lead hotel owners to reduce the rooms they make available to online travel sites, or force them to accept smaller markups than the 22% to 30% they have been able to demand since the post-September 11 travel recession. Yet none of the agencies reports difficulty getting rooms, nor are any making major concessions on margins.

In fact, IAC has made favorable deals with virtually every major chain in the past year. Some chains give Expedia and Hotels.com a fixed allocation of rooms to sell, whether a hotel is otherwise fully booked. Even deals with stronger chains like Marriott (MAR), which refuse to give allocations, demand that the outfits sell rooms through Expedia until a hotel is completely sold out. And Diller says price markups on rooms have fallen, on average, by less than 1%. But because Expedia and Hotels.com are pocketing much bigger gains from automation, operating margins are up sharply. Analysts "keep asking the same thing, and we keep answering the same way," Diller says.

One potential problem for Hotels.com is that the recovering economy has diminished its calling card -- a reputation as the absolute cheapest, rock-bottom place to book accommodation. IAC says consumer traffic to the site is up at least 20% on last year. But as more competitors enter the online hotel market, low rates are showing up elsewhere.

BUYOUT SCENARIO. More important, Expedia's fast-rising profile in the hotel market limits Hotels.com's options. It has trouble moving upscale without running into its corporate cousin -- which has all the room rates Hotels.com does, but whose marketing stresses price less than it does the convenience of buying total vacation packages -- hotel, airfare, and ground attractions -- at a single site. "It's tough when you have two brands selling the same product," says industry analyst Lorraine Sileo of PhoCusWright. She expects Hotels.com to focus on cost synergies with Expedia if it can't revive sales growth.

Orbitz is the problem child of the group. In a July 22 note, Underwood argued that Orbitz stock would beat the market over the next year, if only because a sale or restructuring is likely if management can't fix its problems. Goldman Sachs's Noto wrote that Orbitz shares will reliably find support when the company's value falls to a possible buyout level of between $500 million and $650 million -- well below today's market cap of around $700 million. Goldman was the lead manager of Orbitz's IPO, with Legg Mason in a supporting role.

CEO Jeffrey Katz says Orbitz is beginning to turn things around, saying 27% of the rooms Orbitz sold during July were high-profit merchant rooms, which Ortibz buys from hotels and marks up for resale, rather than settling for a much smaller agent's commission. That's up from 21% in the second quarter. But getting near IAC's 90% will take until 2006, when Orbitz's deal with TravelWeb expires. "We're pleased with the operating improvements in July and quite confident in our outlook," Katz says.

SAFE ARRIVAL? Meantime, not everyone thinks IAC's problems are easily reversed either. In a note today, Noto says IAC's profits will grow 15% a year over the next two to three years, a figure that includes results from slower-growing businesses such as Ticketmaster, the HSN cable-shopping network, and Web loan exchange Lending Tree. Previously, he expected 25% to 30% growth. Noto says IAC will boost profits only 14% in the second half of the year -- down from the 40% he thinks it should have been able to achieve. As for the share price, he sees it sitting pat until Diller & Co. demonstrate better execution.

This week's bumps won't be the last as online travel agencies cope with change. But they are still growing several times faster than the travel industry as a whole, and their ability to dictate terms to suppliers is holding up under pressure. Like Tom Hanks in Apollo 13, it will be a rough ride -- but one with enough reasons for investors to hope for a safe landing. Mullaney is a writer for BusinessWeek in New York


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