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DECEMBER 17, 2003
By Timothy J. Mullaney Is Orbitz' IPO Worth a Flyer? Even though online travel is hot right now, here are four good reasons why investors might want to miss this flight Let's say your broker calls and says: "Have I got a tech IPO for you. Couple of things you should know first though: The company barely makes money, and a bigger, more profitable competitor is growing 60% faster. In fact, our company is growing slower than the rest of the industry. Oh, and also, it has agreed with its five biggest suppliers (of airline tickets, in this case) to cut sales commissions 63% by 2006. Another key supplier (of hotel rooms) is suing to enforce a deal that could keep hotel revenue at about a third of what our company says it should make." There's more, your broker says. "The market cap of the IPO will be 65% of what it was expected to command last year, while the value of its biggest rival has doubled in the meantime. And the airlines that own this company –- and are getting the benefit of those huge commission cuts -- are pulling nearly all of their money out just as it goes public, although they do plan to retain 66% ownership and 95% voting control after the IPO." Want it? It's Orbitz (ORBZ ), whose initial public offering was priced at $26 a share on Dec. 16 after the market closed. But even this year's 37% industrywide growth in online travel may not make this IPO a winner. And of the $317 million raised, Orbitz was slated to get just $104 million before bankers' commissions and fee. Why? The five airlines that own Orbitz -– American (AMR ), United, Continental (CAL ), Northwest (NWB ), and Delta (DAL ) –- are cashing out on virtually their entire initial $217 million initial investment. Orbitz declined to comment for this story. And the airlines have been mum on their role, too, as required by federal securities rules ahead of a public stock offering. QUICK TAKEOFF? Orbitz was set up to shield airlines from the market power of other online travel agencies and to drive down the airlines' own costs -- a goal that has always taken a priority over the site actually making money. As a public company, Orbitz' approach has to change. Yet there aren't any revamping plans in place yet. In a bullish market and with online travel stocks hot, some analysts think an Orbitz IPO could get off the ground quickly. Orbitz is a well-known brand. Renaissance Capital analyst Linda Killian expects shares to spike in first-day trading, though Renaissance's IPO fund won't be buying. U.S. Bancorp Piper Jaffray analyst Safa Rashtchy predicts 2004 revenue of $300 million, with $60 million in profit before interest, taxes, depreciation, and amortization, a big jump from $172 million in revenue and $7.4 million in EBITDA for the first nine months of 2003. Yet those numbers don't tell the whole story. On closer inspection, four key factors make Orbitz an iffy play for many investors. Consider: • One-time budget cuts account for the lion's share of current profits. On its face, Orbitz' third quarter was a milestone –- $3.9 million earned on revenue of $64.4 million. An encouraging rise in hotel-room revenue was one reason. Nonairline travel revenue jumped to $16.6 million, from $11 million in the second quarter. Yet Orbitz cut R&D spending 20% from second-quarter levels and trimmed marketing to 48% of revenue from 52% in the second quarter. That's $4 million right there. And after founding-airline commissions dropped 16% in the third quarter, Orbitz saw its airline-related revenue rise just 2% from a year earlier and shrink from second-quarter levels. By contrast, rival Expedia's air business grew 44% in the second quarter. (Third-quarter figures for Expedia aren't available because the numbers haven't been broken out since its August acquisition by InterActive Corp. (IACI )). • Orbitz' business model is under siege. It was the last major site to figure out that the way to make money in online travel is to enter the so-called merchant hotel business. The logic is simple: If you attract 12 million Web visitors a month, as Orbitz does, you can move business from one hotel to another, and hotels will sell you lots of rooms at wholesale rates. Under the merchant model, you can charge customers the same price the hotel does, or a little less, and keep a fat markup (industrywide, 18% to 30%) instead of a typical 10% commission. Yet Dallas-based Travelweb, which supplies most hotel rooms Orbitz sells, sued Orbitz in October. Travelweb alleges that Orbitz has begun offering its own merchant-hotel deals on Orbitz.com and has tried to get hotels already signed up with Travelweb to switch in violation of their agreement. "Orbitz is poaching," says Travelweb spokeswoman Nicole Hockin. Orbitz alleges that Travelweb breached a contract to supply the cheapest rates available, which Travelweb denies. And Travelweb is determined to enforce the deal through mid-2005. A preliminary hearing began on Dec. 12 in Illinois. Orbitz is hamstrung until the suit is resolved. Even counting rooms owned by Travelweb, but sold through Orbitz.com, only 30% of Orbitz' hotel sales are merchant model, compared to more than 90% at competitor InterActive. In September, Orbitz picked another fight with Atlanta-based Worldspan, a technology company that processes 60% of Orbitz' air sales by connecting the site to airlines' reservation systems. Under a contract between the two, Orbitz must pay costly penalties if it doesn't buy as many tickets through Worldspan as expected. To get out of paying the fees, Orbitz is wavering on a major part of its growth strategy involving connecting its site to founding airlines directly, eliminating Worldspan's average $13 per round-trip charge, paid by airlines, in favor of a $4 fee paid to Orbitz. That delays Orbitz' bid to grab a lucrative new market. Worldspan declined to comment. • Orbitz carries excess baggage. At its inception, the airlines saddled Orbitz with contractual terms that are the most unfavorable in the industry, competitors say. In 1999, the carriers offered Expedia the same deal –- preferred access to low Web-only fares in exchange for commission cuts strung out over several years –- but Expedia refused, seeing little profit potential. The airlines also barred Orbitz from accepting incentive payments to shift market share from one carrier to another. That's a key source of revenue for both Expedia and No. 2 Web agency Travelocity, and Orbitz is the only major agency that won't take such payments. The original setup isn't the only arrangement where Orbitz put the airlines first. In 2001, it wanted to partner with a deep-discount site. It looked at Priceline.com (PCLN ) and Hotwire, a site in which four airlines that own Orbitz had a major interest. According to a source at one of Orbitz' investment banks, Priceline offered better economic terms, but Orbitz chose Hotwire at the insistence of its board. Orbitz declined to comment. And says Priceline spokesman Brian Ek: "We can't confirm that, but you won't get a letter to the editor from us." Even recently, with the IPO looming, Orbitz' board has made hard-to-explain moves. According to filings with the Securities & Exchange Commission, the board changed its certificate of incorporation to prevent management from ending its Worldspan deal. Analysts say they're not sure why, but it might not be a coincidence that Delta, Northwest, and American airlines controlled Worldspan when Orbitz made the deal. (Northwest declined comment for this story.) Even after the airlines cash out their initial investment in Orbitz, they'll have the same strategy: to use it (through their retained majority stake) primarily as a lever to push rivals to lower commissions and pay higher fees for air tickets. • Rivals are gearing up as Orbitz struggles to keep pace. In the first nine months of 2003, Orbitz spent $83 million on sales and marketing. But in October, rival InterActive announced it would boost marketing spending to $900 million in 2004, from $500 million. Such a sizable outlay is expected to drive up the price of search-engine advertising, one of Orbitz' key venues, says Priceline CEO Jeffery Boyd, because Yahoo! (YHOO ) and MSN (MSFT ) auction space atop search results to the highest bidder. InterActive's marketing move could severely crimp Orbitz' plans to build an audience mostly through cheap Web advertising, and Orbitz isn't raising enough money to compete with InterActive on TV. The chief selling point of the Orbitz deal is that online travel is hot. But Internet travel companies aren't all created equal (see BW Online, 12/12/03, "Web Travel Agencies: A Bumpy Ride"). Expedia's IPO earned investors 10 times their money, but those of Travelocity owner Sabre Holdings (TSG ), Priceline, and others have been less than stellar. So when that broker calls offering Orbitz stock, you might want to think twice.  Mullaney covers technology for BusinessWeek in New York Edited by Beth Belton
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