Expedia (NASDAQ:EXPE) is a provider of online air travel, hotel room, cruise ship and car rental booking services through its websites which include expedia.com, hotels.com, hotwire.com and venere.com; and of travel advertising services through its websites which include tripadvisor.com, bookingbuddy.com, holidaylettings.co.uk, and cruisecritic.com. This company presentation gives a good overview of the business. In FY10 the company generated sales of $3.3bn, EBITDA of $870m and net income of $426m. The company came to my attention (as an investment opportunity) after appearing in the Glenview Capital Management investor letter which was published on market folly, though I’ve been a satisfied Expedia customer for a number of years. Glenview noted of Expedia:
- Healthy organic revenue and profit growth;
- Recurring revenue streams with repeat customers and strong brand recognition;
- Highly cash generative, with free cash flow exceeding net income;
- Modest cyclicality with an ability to maintain profitability in a downturn;
- The company is now significantly overcapitalized with dry powder of $1.6 billion to $2.2 billion, or approximately 30% of the company;
- Their TripAdvisor business is growing rapidly but may benefit from faster growth post 2011 as an independent company. We believe the sum of the parts of Expedia is well in excess of a 50% premium to current trading prices; and
- Management and the board have acted before, making significant share repurchases at meaningfully higher valuations.
Looking at the company’s capitalisation (as at FY10) in the table below, we can see that Expedia does indeed have a rock-solid balance sheet and is in my opinion significantly over-capitalised. As can be seen, the company has $1.7bn in gross debt, but offset against this is $1.25bn in cash and near-cash assets. Essentially, Expedia is paying ~$100m per annum in interest charges simply to keep cash in hand. Given the company already has $723m of liquidity available in the form of the undrawn portion of the RCF, a strong argument could be made that the existing cash balance could be used to pay off the debt (saving $100m in interest), for acquisitions, or for share-buybacks.
The chart below shows Expedia’s EBITDA and operating free cash flow (defined as cash from operations less capital expenditures) earned in the years FY05-10. What is immediately noticeable from the chart is: (1) remarkably stable EBITDA given that Expedia is a relatively fixed-cost business operating in the highly-cyclical travel industry; (2) conversion of EBITDA into free cash flow is very high at an average of 87%; and (3) operating free cash flow is very high relative to the market capitalisation at a yield of 9.4%.
We can see from the chart below how management has historically allocated capital. This shows that share buybacks and debt repayments have been the major uses of funds, with the company making only one significant acquisition in the last five years. However, net debt/EBITDA has declined from 1.3x in FY08 to 0.5x at FY10, meaning that further reductions in net leverage are relatively unlikely. Consequently, this makes shares buybacks much more likely. Indeed, the company spent $41m on share buybacks during 1Q11.
On 7th April Expedia announced that the board had decided to spin-off Tripadvisor by way of a distribution in new Tripadvisor shares to existing Expedia shareholders. So how might Expedia and Tripadvisor each be valued once the spin-off is completed? I’ve run some numbers based upon the segmental split outlined in the latest 10-K filing and using the assumption that all the debt remains with Expedia and that Tripadvisor takes $200m of the cash balance. Over the past few years Expedia itself has shown negligible growth in earnings but has been highly cash generative. However, this period includes the recent recession which hit the travel industry particularly hard, meaning to show flat earnings was quite an achievement. Now the USA is recovering from recession we have a good reason to expect the business may begin to grow again. In addition, the international division, which has continued to grow strongly, now represents a greater proportion of the business. What might you pay for such a business? The core Expedia business has seen a flat top-line over the last three years, but this has obviously been a period when the travel industry was in recession. For example, hotelier Marriott International Inc saw revenues decline from $12.9bn to $11.6bn and airline AMR saw revenues fall from $21.6bn to $19.8bn. This suggests that: (1) Expedia achieved market share gains during the period; and (2) when the travel industry returns to steady growth, Expedia should again see positive sales growth. In my opinion, given this expectation that growth should return and the company’s strong cash conversion, this business would be an absolute steal at 8x trailing earnings and still very good value at 10x earnings. Depending on where the tax rate normalises (it has averaged 31% of PBT during the last six years), this suggests a market capitalisation of $3.7-5.3bn for the Expedia business.
Tripadvisor is a very different beast of a business, relying on user-generated content to provide reviews of hotels, holiday apartments, restaurants and tourist attractions. Tripadvisor then generates revenue by selling advertising space on its websites. Given the low operating costs, margins are very high at 83%. The growth rate of net income is also very impressive, at 36% per annum in each of the last two years. For a business with a 36% per annum growth track record operating in the “hot” web 2.0 market segment (recently IPO’d Demand Media trades at 65x forward earnings), I reckon a conservative estimate of value for the Tripadvisor unit might be 25-30x trailing earnings. Depending on the tax rate, this would value the business at $4.0-5.6bn.
Combining the estimated stand-alone valuations of Expedia and Tripadvisor produces a valuation estimate of $7.4-10.9bn, which represents an upside of 8-60% versus the current share price (note how the upper-end of this estimate tallies with the opinion of Glenview Capital Management). Why the difference between the current market price and the upper-end of the sum-of-the-parts estimate? I believe two factors could be at work here: (1) the conglomerate discount; and (2) the clientèle effect. The conglomerate discount is well-known and discussed in more detail here. With regard to the clientèle effect, value investors who might otherwise purchase Expedia stock will be turned-off from paying a premium for what they would see as an overpriced Tripadvisor business, while those investors seeking high-growth, high-risk investments such as Tripadvisor stock will be put off by the mature, slower-growing Expedia business. The result is that the combined business appeals to neither growth nor value investors.
Looking at the recently-released 1Q11 financial results, Expedia recorded revenue of $822m (+15yoy), driven by 31% growth in International revenue and, somewhat coincidentally, 31% growth in the Tripadvisor segment. EBITDA declined by 9% due to a rise in operating costs. This was previously flagged by management who claim they are stepping-up marketing and operations staff in order to support growth, in addition to transitioning the Expedia business to a new technology platform. If they are correct, this step-down in margins should be gradually reversed as growing revenues and operating leverage take effect. Free cash flow increased by 15% yoy, but this is not particularly useful given 1Q generally sees a large working capital inflow and we will need to see how much of this is reversed in the remainder of the year. Sell-side analysts seem to think the outlook is pretty good, forecasting $1.86 per share in FY11 (vs $1.49 in FY10) and $2.10 in FY12.
I see a two major risks with this investment. The first relates to the potential for increasing competition impacting revenues and earnings, while the second relates to weak corporate governance policies. Expedia competes both with rival booking services (such as bricks & mortar travel agents and other online rivals including Orbtiz [NYSE:OWW] & Travelocity) and also with its own suppliers – the airline and hotels – who allow customers to book direct. These factors limit Expedia’s ability to increase prices and could also force prices down if competition becomes particularly intense. While I recognise this issue, I feel that Expedia’s brand and loyal customer base mean that it will continue to be an important route to market for airlines and hotels. After all, it saves consumers a significant amount of time to search once on Expedia rather than many times on each hotel & airline website. With regard to corporate governance, Chairman & Chief Executive Barry Diller has control of the board with 61% of the voting stock under his control (including 29% under an agreement with John Malone‘s Liberty Media Inc), giving him almost free reign to make decisions as he sees fit. In addition, Diller is also Chairman & Chief Executive of IAC/InterActiveCorp (NASDAQ:IACI), an internet conglomerate that owns businesses including Ask.com, Match.com, Vimeo.com and The Daily Beast. This, in my opinion is both too great a demand on his time and a potential conflict of interest. Further to this, footnoted* has reported how Barry Diller has been milking both Expedia and IAC/InterActiveCorp for perks, which included a total of $1.7m spent on his personal air travel. Overall, this is a pretty poor corporate governance set-up.
However, despite the potential for greater competition to impact returns and the weak corporate governance procedures, I’m willing to take a chance with Expedia. The huge operating free cash flow yield of 9.4% limits the downside risk, particularly since the near-term outlook is relatively positive and cash flow is being used to reduce the share count. The investment case is further supported by the rock-solid capital structure (which provides the platform for more significant value-enhancing corporate actions) and the upside potential provided by the planned spin-off of Tripadvisor, which may well see a significant re-rating once it begings to trade as an independent company.
Disclosure: I am a shareholder in Expedia Inc.
- Expedia to spin off TripAdvisor (bbc.co.uk)
- Will Investing In TripAdvisor Take Your Money For A Ride? (benzinga.com)
- UPDATE 4-Expedia plans to split into 2 companies (reuters.com)
- Expedia Spinoff: Analysts Like (blogs.wsj.com)
- Stifel Nicolaus Upgrades Expedia to Buy (EXPE) (benzinga.com)
- Expedia shares gain on TripAdvisor spin-off plan (reuters.com)