Description

As a matter of principle, any large cap spinoff that occurs in the month of August, when half of Wall Street is out of town probably should be bought, especially if it is in a sector with high negative sentiment.

I am recommending Expedia, once one of the four horsemen of the internet (along with Ebay, Yahoo and Amazon) and now just a lowly travel distributor no longer cool enough to be a member of Barry Diller’s club.

With a market cap of about $7.6 billion (I am using a 350 million fully diluted share count), Expedia is trading at about 12 times this year’s operating income before amortization (OIBA), at about 50 percent of this year’s gross travel bookings, and at less than nine times trailing free cash flow.

The bear arguments on internet travel distribution have been widely circulated and are now widely believed. They include the following:

1) Merchant margins in the hotel business still have to come down a lot
2) Supply of hotel rooms will fall as occupancy rises
3) Hotel chains and airlines will increasingly drive traffic to their own sites and these sites are growing faster than the online travel agencies
4) Renegotiations with the GDS’s will cut margins in air travel for online travel agencies
5) The traditional online players will be destroyed by new competition from new business models like Kayak and Sidestep
6) The online travel companies will be forced to pay hotel room occupancy taxes on their merchant margins
7) The cost to buy travel keywords on internet search engines keeps rising and should cut into profits
8) The deals available on the online travel agency sites are no better than going direct to the supplier (unlike in 2002 when they were better). Consequently people will learn to go around the sites and cut out the middleman.
9) Net revenue margins are declining and regardless of valuation, an internet stock with declining margins can’t be bought.

I am not going to address any of the bear cases in the write up, although I am happy to do so in the message thread. Most of them are at least partially true and they have been partially true for some time now.

I note them here in part because their broadcast has been so wide for so long that they have pretty much all been accepted as conventional wisdom and the profitability of Expedia’s business continues to grow. In other words, there is a lot of fear in the stock. This fear has only been stoked by Barry Diller (the Chairman and CEO of Interactivecorp). Since he announced the spinoff last December, the main reason Diller has given for discarding Expedia has been to encourage investors to focus on the rest of the Interactive grab bag. The silence between the notes in this statement is that Diller is worried about the future prospects for online travel and wants to remove the taint of it from his company.

Interestingly enough, a spin does not in any way divest Diller personally from a business he paid a very high price for less than two and a half years ago. Also somewhat interestingly, the Expedia spin was done without much in the way of road shows or other actions that might have helped stabilize the stock. Instead, as I mentioned earlier, after dismissing the company with his unenthusiastic silence, Diller has spun it off into the deadest part of summer, a very strange move for someone considered to be a master manipulator of markets. To quote Ayn Rand: “Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.”

Valuing Expedia

In a world of a 4.2 percent treasury yield, it ought to be enough to say that Expedia’s market cap is 7.6 billion dollars and its free cash flow was $875 million and less than 9 times free cash flow is way too cheap. In some ways, however, the story is both better and worse than this number would suggest.

As is well known by people who follow the space actively discounted by the analysts who follow it, a good portion of Expedia’s free cash flow comes from negative working capital. The negative working capital arises because a customer pays Expedia when they book a hotel room or an airline ticket and Expedia pays the supplier at a later date. Of the $875 million in free cash flow, approximately $300 million was working capital related and another $70 million was deferred tax related. This portion of the free cash flow clearly deserves a lower multiple. To keep the numbers round, let’s say there s $500 million of “good” free cash flow (there’s just a little more) and $375 million of other free cash flow (there’s just a little less).

With the stock at $21.65, what appears to be in the stock is that the good free cash flow is worth about 12 times and the other is worth 4.5 times. One can argue whether or not 12 is too low a multiple for a business with a 45 percent market share with decent barriers to entry, no leverage and minimal reinvestment requirements. Fortunately, the investment case is easier than this.

Although the company does not break out its profitability by segment, it is reasonable to assume that virtually all of the free cash flow is derived from the domestic consumer business. I think this assumption is reasonable because the European consumer business was not profitable until third quarter of 2004 and the corporate business is still not profitable. In addition, Trip Advisor at this point likely has modest profitability at best (which one can see by looking at the minority interest line on the income statement). In addition, these businesses are the growth engines of the company and consequently require significantly more capital expenditure.

In terms of valuing the international business, there are now several recent comparable transactions that one could look to. These include Sabre’s acquisition of Lastminute.com, Cendant’s acquisition of ebookers, and Priceline’s acquisition of Bookings BV. All of these businesses were either unprofitable or marginally profitable.

Both ebookers and lastminute.com were publicly traded and like Orbitz (which Cendant bought last year at about 15 times forward EBITDA) went for prices well in excess of what they were trading for prior to takeover rumors. Sabre paid about $1.1 billion dollars for lastminute.com, which is estimated by Merrill Lynch to have $2.8 billion in gross bookings this year, or about 40 cents per booking dollar. Expedia International is expected by the same analyst (who is neutral on Expedia for what it is worth) to do 3.7 billion in gross bookings this year. Arguably Expedia International is a better business given that it has profitability, appears to be better managed and is growing faster. More recently, Priceline.com paid $133 million for Bookings BV, which had trailing twelve month bookings of $225 million or about 60 cents per booking dollar. Bookings BV is obviously much smaller than Expedia International and has a little bit of profitability.

Valuing Expedia International at $2 billion puts it just slightly above the midpoint of these two deals on a bookings basis. This valuation is again, likely conservative given that profitability in online travel businesses tends to increase significantly with scale and with good execution.

There are other parts of Expedia that likely are generating very little in the way of free cash flow or OIBA that clearly are valuable. In no particular order, these are Trip Advisor, Hotwire and Expedia Corporate Travel. Diller bought Hotwire in late 2003 for almost $700 million. He clearly overpaid. The cost of the purchase of TripAdvisor was not disclosed but was likely not more than $250 million given the acquisition disclosures in the second quarter 2004 IACI 10-q. Diller may have underpaid. Trip Advisor is clearly growing and apparently at least a little profitable. It is very hard to know how to value Expedia Corporate Travel is a little hard to put any value on given the lack of disclosure (we know that they have served more than 3000 corporate clients). Just as an option, it is probably worth a couple hundred million dollars. These three businesses combined are probably worth more than $500 million.

Finally there is $100 million of cash on the balance sheet.

Thus, taking out the portions of the company that generate very little of the free cash flow and valuing them independently, we arrive at a current market value for the piece of the business that generates almost all the cash of about $5 billion. Again for simplicity, I am going to assume that this business probably generates all of the good free cash flow ($500 million trailing) and about $350 million of the $375 million in other free cash flow.

I would argue that the proper multiple to put on the good free cash flow is actually well in excess of the 12 times I mentioned above. In particular, businesses with little reinvestment required in the business that are leaders in their fields tend to trade somewhere between 15 and 20 times free cash flow, which makes some sense in a low interest rate environment. Expedia’s short-term domestic earnings are somewhat clouded because we are closer to the peak than the trough of the occupancy cycle for hotels (demand has increased and supply hasn’t come on yet) but its long run fortunes are tied to the increase in travel as a whole and the shift of booking to the online travel, both of which ought to be tailwinds. Consequently on a five year view, Expedia’s current free cash flow generating power may actually be a little below trend. Putting a 15 times multiple on the good free cash flow gives a value of $7.5 billion. Putting a 5 multiple on the float, gives a value of $1.75 billion.

Adding these all together ($7.5 domestic plus $1.75 float plus $2 international plus $0.5 other businesses plus $0.1 cash) gives a total of $11.85 billion dollars or about $34 dollars per share. Using a 20 times multiple on the good domestic free cash flow, would put the value sat about $40 per share.

In this valuation, there are obvious various places that I could be wrong. The most obvious would be if the domestic business is actually in secular decline, which is the crux of the bear story. What is interesting, however, is exactly how bad things would have to be for $21.70 a share to be paying too much. In particular, again assuming I am right that the market is saying that the domestic business is valued at about $5 billion, free cash flow would need to fall more than 30 percent for the business to be trading at 10 times free cash flow. While such a dramatic decline is abstractly conceivable in a tight hotel inventory environment, it seems vastly improbable: the inventory cycle has already been tight for quite some time and the effects of Expedia’s domestic business have been significant but the business has still managed to grow.

Conclusion

One has to wonder exactly what is Diller doing? I would argue that the main point of the spin off was to raise the value of his IAC holding company by indirection.

By focusing people on the purpose of the spinoff being to unlock value at the holding company, Diller’s purpose was oddly best served if Expedia traded poorly out of the gate since the value of the remaining holding company is the total value less Expedia. In fact, in what must have been one of the oddest arbitrage situations ever, Diller let both pieces trade on a when issued basis, thereby putting an actual price on the IAC when issued stub.

I would argue that he probably understands that the value of Expedia is going to more or less take care of itself over time as it is a readily analyzable pure play on online travel, whereas the rest of the holding company is still something of a black box, and consequently is far more in need of jawboning. I would say that one should watch what Diller does as much as what Diller says and I haven’t seen him selling stock in Expedia. There were other routes towards ridding himself of Expedia that he could have taken (especially given what was probably a rather high tax basis) that would have let him take an economic exit. These include an IPO, partial IPO, or outright sale.

One can argue what the ultimate market size, scope and profitability of the online travel agency model may be but what is captured in the current price is a quite dire view of the industry. That view is likely to change possibly just with time and certainly with a change in the supply demand outlook for lodging which is cyclical.

Catalyst

Abatement of selling pressure from the spinoff; change in sentiment regarding online travel