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Stock Analyst Update

Warning Points to Bigger Problems for Priceline

Even with sharp drop, the stock may not be a bargain.

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On the surface, the 40% drop in Priceline.com's  (PCLN) stock Wednesday morning is a rather harsh reaction to the company's revelation that third-quarter revenue will be 10% below projections. CEO Dan Schulman's refusal to take any questions in Wednesday morning's brief conference call is one factor, since such reticence is seldom a good sign. However, the miss also highlights some of the weaknesses inherent in Priceline's business model, of which we've been skeptical for some time. For that reason, we think most investors should continue to avoid the stock. 

The revenue shortfall came entirely from Priceline's core airline-ticket business. Priceline ran promotions in August and September emphasizing low prices, so customers made lower bids for airline tickets in an attempt to get bargains. At the same time, the airlines tacked a fuel surcharge onto ticket prices, forcing Priceline to raise the lowest prices it would accept. As a result, the percentage of accepted bids plummeted--and when a bid is not accepted, Priceline gets no revenue.

We've always believed that the number of people willing to put up with Priceline's restrictions and hassles to save a few bucks is inherently limited, and that the growth of the company's airline business would eventually hit a wall. Wednesday's revenue warning suggests that the wall may be approaching, as fickle customers turn their attentions elsewhere. The forthcoming launches of Hotwire.com and Orbitz.com, airline-owned discount-travel sites that will offer more flexibility than Priceline, are likely to put a further dent in Priceline's airline-ticket sales.

Another issue bedeviling Priceline is customer service. It has been hit with a slew of complaints about shabby treatment of customers, resulting in its being kicked out of the Connecticut Better Business Bureau earlier this month. Negative stories in SmartMoney magazine and on the TV show 48 Hours have broadcast these problems to a wide audience and tarnished the company's image. Priceline's response to the complaints hasn't been reassuring, and we think the company needs to do some major rehabilitation of its image if it hopes to become a major retail powerhouse.

Until now, the most pressing question about Priceline's long-term prospects has been whether it can expand its model beyond airline tickets into other businesses with fatter profit margins. Its 20% growth in nonairline revenue is encouraging, but airline tickets still account for more than 80% of revenue. If that business continues to falter, it would have major consequences for the viability of Priceline's entire model. Until the company shows that it can make the name-your-own-price model work on a wider scale, its stock is best left to gamblers.

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