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Investors: Time to Check In to Expedia and Priceline

The market is underestimating the sustainable growth of the online travel industry, and overestimating the risks.

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Competitive risks to  Priceline (PCLN) and  Expedia (EXPE) remain investors’ top concern, but we think the market’s angst here is excessive, and we reiterate our view that the threats are manageable. While we believe large hotel chains could see an incremental 100 million room nights through their direct booking websites over the next year or two, we estimate that only 18% of those would come at the expense of the online travel agent channel. As a result, we see just a 1-percentage-point headwind to Priceline’s booking growth (versus our annual midteens booking growth forecast through 2020); a 1.5-percentage-point headwind to Expedia (versus our annual low teens booking growth forecast through 2020); and a 0.5-percentage-point headwind to  Ctrip (CTRP) (versus mid-30s annual sales growth). This negligible impact is reflected in our forecasts and has no effect on our valuations. We still see the strong competitive positions of Priceline and Expedia leading to market share gains versus current stock prices that imply market share losses in our discounted cash flow model. Further, Priceline’s and Expedia’s potent network advantages continue to support narrow economic moats.

The What, Why, and How of Direct Booking
Large hotel chains are attempting to increase direct booking on their websites through increased marketing initiatives aimed at signing up loyalty members by offering discounted room rates. Hotel operators can only offer rates below those found on online travel agent sites to “closed loop” individuals like loyalty members. Otherwise, rate parity does not allow a hotel to offer a room at a lower rate on its own website than that offered through an online travel agent, or OTA.

Direct booking typically offers better economics than indirect booking, in which the hotel has to pay commissions or advertising fees. Also, direct booking gives suppliers immediate control over managing a customer relationship versus indirect channels, where contact with the traveler may not occur until the time of stay; this allows hoteliers to offer tailored experiences and enhance brand loyalty.

Online travel agencies have become an increasingly important distribution channel for hotels, as they now represent around 18% of the entire hotel industry’s revenue, according to Phocuswright, up from 14% in 2010. Our work shows that the OTA channel represents a smaller high-single-digit/low-double-digit percent for the top 10 brand chains, as these brands have the scale to drive a higher mix of direct bookings and therefore need distribution platforms less than independent and smaller chains do. Still, even the top three global brands--Hilton, Marriott, and InterContinental--have seen an increasing portion of booking from OTA channels over the past several years, which speaks to the strong network advantages of Priceline and Expedia.

OTAs now constitute half of all online U.S. hotel booking, with supplier websites making up the other half; this is up from the 41% that OTAs represented in 2008, despite the U.S. hotel market being the largest brand mix of any region (70% of U.S. hotels are brand chains, versus 40%-50% in international regions). This again shows the power of Priceline’s and Expedia’s network, marketing, and technology scale.

The online hotel market is large and growing, adding incentive for large hotel brands to strengthen their direct online capabilities. We estimate that the global leisure and unmanaged corporate hotel booking market is around $450 billion, with online penetration, which is currently around 35%, increasing.

Hotel Direct Booking Traction Will Remain Limited
Several factors support our view that traction for supplier direct booking will remain limited. First, at around 10%-15% of total bookings, OTAs are and will remain an important distribution channel for large hotel chains. Priceline’s and Expedia’s network advantages have reached critical mass, as witnessed by their leading room inventory and strong customer visitation on which hotels depend to generate bookings. To illustrate, Marriott and Starwood have a combined 1.2 million rooms, compared with approximately 23.7 million rooms on Priceline’s booking.com, of which 16.3 million are traditional hotels and 7.3 million are alternative accommodations. This supply drives strong visitor use.

Second, room discounting is unlikely to be a sustainable strategy for hotels. Hotelier room rate discounts mitigate the favorable economics of a direct booking. Let’s assume that all 71 million room nights we calculate our hotel coverage to generate from direct campaigns are discounted by an average of 10% and represent no incremental volume to hoteliers (rather, they represent a mix shift to direct from OTA and offline channels). This would result in around $65 million of lost EBITDA in total for our hotel coverage, offsetting the $135 million in combined OTA commission savings.

We calculate the impact to Priceline’s and Expedia’s revenue growth from a 10% hotel direct discount at around half a percentage point each, with the average impact to our hotel coverage at roughly 70 basis points of lower sales growth. Reducing Priceline’s and Expedia’s 2017 revenue growth by half a percentage point would result in only a 0.3%-0.4% negative impact to our fair value estimates. Meanwhile, asset-light hotel operators would see only around a 0.1% impact from a 10% discount, as they collect around a mid-single-digit percentage of franchisee revenue. Hoteliers with a large percentage of owned assets would feel a larger impact from any room discount; for example, Hyatt would see around a 0.4% negative impact to revenue, given its 65% exposure to owned assets.

Although the calculated impact to hotel revenue growth from each 10% discount is fairly manageable, there are several other key reasons we believe promotional activity will not be sustained. As brand advantages are a key source of moats in the lodging industry, we think hotel operators will be rational in their pricing strategies. Also, third-party franchise and managed unit growth is a very important driver of growth for asset-light hotel brands, and because promotions can hurt those third parties (which collect a lower room rate, again assuming no incremental volume created from the campaigns), it could cause lower room growth for hotel operators that choose to sustain room discounting. We view direct discounts as unsustainable because Priceline and Expedia also have loyalty memberships they could use to compete with any sustained discounting by the large brands.

Third, there are ways Expedia and Priceline can participate in any shift toward supplier direct booking. For example, Expedia is currently testing offering member rates for hotelier Red Lion on its platform, as the OTA sees itself as a new customer acquisition channel for supply partners; it believes that such initiatives can help hoteliers compete with one another while also sustaining ongoing repeat traveler use on its platform through rewards, product selection, and service.

Additionally, Expedia and Priceline are increasingly providing technology that powers hotel direct websites. Recently, Expedia announced a partnership with Marriott in which it powers the hotelier’s Vacation by Marriott portion of Marriott.com as well as offering in-destination booking, flights, and ground travel. Meanwhile, Priceline continues to offer website, reservation, and inventory management solutions for boutique hotels.

Finally, we believe hotel direct booking will see limited traction because the hotel market is more fragmented than the airline market. We calculate that the top four hotel brands (Marriott/Starwood, Hilton, InterContinental, and Choice) have around 40% of the U.S. market by number of rooms; in contrast, the top four airlines (American, Delta, Southwest, and United) control 85% of U.S. capacity, according to company reports, up from 65% share in 2010. As a result, we find that the airline direct website share of the U.S. online booking market has grown from 68% in 2010 to 75% in 2015, compared with the hotel direct website share of U.S. online booking declining from 55% in 2010 to 50% in 2015.

Given that the room share of the top four hotels in the U.S. is only 40%, versus 85% capacity share for the top four airlines, we expect the supplier share of U.S. online hotel bookings to remain well below the 75% that airlines currently see. Additionally, aggregated platforms like booking.com and expedia.com are much more valuable for comparing hotel content (where amenities, location, price, quality, and availability matter) versus airlines (where typically only availability and price matter).

This supports the powerful hotel network supply of Priceline (we estimate hotel and air are around 90% and low-single-digit percentages of total revenue, respectively) and Expedia (hotel and air are around 60% and 10% of total revenue, respectively). Therefore, we don’t expect a meaningful reversal of the existing trend where OTA has been growing ahead of supplier direct.

Hotel Direct Booking Risk Is Manageable
Given Priceline’s, Expedia’s, and Ctrip’s powerful network, marketing, and technology scale, the unsustainable promotions of hotel direct initiatives, and a relatively fragmented hotel industry, we have seen mixed success of supplier direct booking initiatives thus far, and we expect this competitive threat to be a manageable one for the OTA providers. We do not consider independent hotels to be direct booking threats, as they often don’t have a website, let alone a loyalty program that allows for closed-loop promotion emails. To the extent that independent hotels do drive direct booking in the future, Priceline and Expedia stand to benefit by offering website, reservation, and inventory management solutions for boutique hotels.

We see hotel direct booking having just 1 percentage point of impact on booking growth for Priceline, 1.5 percentage points for Expedia, and 0.5 percentage point for Ctrip. We ultimately believe that large hotel chains could book an incremental 100 million room nights through their direct websites over the next year or two, but we estimate that only 18% of those would come at the expense of the OTA channel. We arrive at 100 million incremental room nights by reviewing trends of nights booked by loyalty members at the major hotel brands, then forecasting 10% growth in those participant nights as a result of recent direct booking campaigns. But even this growth is not guaranteed. Success in expanding the direct booking channel through loyalty membership and booked direct room nights has been mixed among the operators we follow.

Market Underappreciates Priceline’s and Expedia’s Sustainable Market Position
We think that Priceline and Expedia are undervalued and that the market is underestimating the sustainable growth of the companies as well as the online travel industry. We see Priceline expanding its online market share to the midteens in 2019 from the low teens currently, driven by its strong position throughout global regions and in vacation rentals, in-destination restaurant booking, and hotel service software markets, all of which represent meaningful growth in the industry over the next several years. We expect Expedia to maintain its midteens share of global online travel, despite its higher relative exposure to the more mature U.S. and airline segments, as it maintains its strong presence in other key markets of the industry.

We reiterate our narrow moat ratings and fair value estimates on Priceline and Expedia and see both companies as well positioned to benefit from the high-single-digit average annual growth we see for online travel over the next decade. We also retain our narrow moat rating for Ctrip, driven by the firm’s strong position in online Chinese travel, which we expect to be a key region of growth for the overall industry over the next decade.

Dan Wasiolek does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.