2017 Q4 - Investment Letter (Priceline)

Europe’s hotel fragmentation not only increases Priceline’s value proposition to its hotel travel partners and thus its pricing power, but it also creates a very large competitive moat. Would-be competitors must engage in the extremely time-consuming task of forming literally hundreds of thousands of relationships with small boutique hotels while also designing websites and apps that offer enough benefits to switch customers to their platforms.

Therefore, in our view, Priceline’s commanding lead in global hotel bookings and its stranglehold on the uniquely attractive European market are the main reasons that Priceline’s market capitalization, at $93 billion, is four to five times that of its next largest competitors, Expedia ($20 billion) and Ctrip ($25 billion), despite Expedia’s equivalent share of gross travel bookings and Ctrip’s dominant position in fast-growing China.[11] Another contributing factor to this market capitalization gap is the fact that, outside of Europe, Priceline’s next most attractive market is Asia, where hotels ownership is also fragmented and where it has strong market share through its properties Agoda and Booking.com as well as through its partnership with and ownership interest in Ctrip.

The fourth reason we believe Priceline is a great business is its management, which we believe is the best in the industry. Priceline has demonstrated this advantage in numerous ways over the years. First, Priceline made a brilliant strategic decision in 2005 when it acquired Booking.com for $100 million. Since Booking.com accounts for the vast majority of Priceline’s profits and Priceline is worth almost $100 billion, this acquisition was clearly one of the best ever made. Second, while not yet generating another windfall like Booking.com, management has continued to acquire strategic, value-enhancing travel properties such as the Asian OTA Agoda, the restaurant booking platform OpenTable, and the metasearch engine Kayak, all of which have strengthened Priceline’s network effects in the online travel booking space. Third, instead of sticking its head in the sand, management has aggressively built up its non-hotel offerings to compete with Airbnb and its disruptive, sharing economy brethren, growing this category at a 58% annual rate to 816,000 properties as of September 30, 2017.[12] Fourth, the company is conservatively capitalized with almost $9 billion of net cash and investments on its balance sheet as of September 30, 2017. Fifth, in addition to making acquisitions, management has opportunistically used its prodigious cash flow to buy back stock. Given the long-term performance of the business and the stock, these share repurchases have been massively accretive over time. Finally, in probably the clearest example of Priceline management’s culture of long-term thinking, the company recently decided to purposefully depress short-term profits in order to protect the business’s long-term competitive advantages. In fact, as we discuss below, the stock price weakness that resulted from this decision was actually the catalyzing factor for our recent investment.

As we mentioned at the outset of this letter, we believe great businesses are generally undervalued by the market. Moreover, we believe great businesses can become even more mispriced when they experience temporary macroeconomic or operational problems. In Priceline’s case, a string of bad results from other travel players caused concern about the industry’s future profitability prospects. Then, when Priceline provided disappointing earnings guidance of its own, investor fears about the travel space seemed confirmed, and they sold aggressively. However, in our view, a closer examination of the industry suggests that Priceline was the proverbial baby being thrown out with the bathwater.

Though a simplification, it’s helpful to think of the online travel industry as comprising three levels. At the top of the travel pyramid is the search engine, which is most people’s gateway to the internet and their preferred method of filtering the vast amount of information and resources available to them there. Google, with the exception of China, essentially possesses a global monopoly of this level. Below this level are the metasearch engines such as TripAdvisor, Kayak, and Trivago. These sites aggregate reviews of vacation destinations, dining choices, accommodations, and travel activities. They began primarily as review sites that had no direct booking relationships with travel providers, and they made money by charging advertising fees in exchange for prominent placement on their site. Below the metasearch engines are the online booking sites. Priceline, Expedia, Ctrip, and the travel providers’ own websites are the main competitors at this level.

Over time, as the land grab in online travel has progressed, these three levels—the search engine (Google), the metasearch engines (TripAdvisor, etc.), and the online booking sites (Priceline, etc.)—have increasingly attempted to compete with each other. Google, with its virtually insurmountable advantage at the top of the travel food chain, has had the most success in these efforts. With continued refinements of its search algorithms and of its Google Travel platform, Google has steadily taken market share from the metasearch engines. Because of pressure from Google and the lower competitive barriers to entry at their level of the travel market, the metasearch engines have experienced shrinking margins. In order to protect their profitability, the metasearch engines have been attempting to vertically integrate into the OTA market. These efforts to take share from Priceline and Expedia have been largely ineffective, but Priceline, quite correctly, in our opinion, appears to be taking nothing for granted. The main reason for its guidance reduction was a strategic decision to pull back on advertising through the TripAdvisor, Trivago, and other metasearch engine platforms. Thus, rather than a sign of weakness, as market participants appeared to believe, Priceline’s reduced guidance was actually, in our view, a sign of a dominant company operating from a position of strength to further constrain other players’ ability to invest resources in their own competing OTA offerings. Since Priceline’s high returns and large cash flows provide no such constraints, we believe this decision is likely to enable the company to widen its already commanding lead over these upstarts.

While Priceline’s move may increase its dominance over a number of its competitors, it also increases Priceline’s reliance on Google. So, a reasonable question to ask is what’s to stop Google from taking not just the metasearch engines’ business but Priceline’s as well. To us, it seems clear that Google’s focus on dominating search has led over time to an unmatched global user base and an unrivaled ability to track and predict these users’ behavior through the information it obtains from its mobile operating system Android and apps such as Google Maps, Gmail, and, of course, Google Search. Thus, any companies whose economic models rely primarily on providing relevant online information to consumers are likely to find that Google performs these functions more efficiently and effectively over time. We believe this fact explains why metasearch engines have been losing share over time. After all, the industry category even has “search” in its name! In contrast, while Google certainly has the financial resources to take on the OTAs directly, we believe the OTA business model requires skills that are less aligned with Google’s historical strengths. In particular, it requires tremendous time and effort to successfully negotiate OTA agreements and maintain ongoing relationships with hundreds of thousands of hotels and literally millions of non-hotel lodging properties around the world.[13] Furthermore, for Google to successfully compete against the incumbent OTAs, the company would also need to develop OTA apps, websites, and other touchpoints with large enough benefits to break consumers out of their current online travel booking patterns. A famous attempt by the wireless phone companies to steal share from Mastercard and Visa provides a good historical example of the difficulty of these tasks. In 2010, AT&T Mobility, T-Mobile USA, and Verizon Wireless formed a joint venture with the unfortunate name Project ISIS to “fundamentally transform how people shop, pay, and save”—in other words, to disintermediate Mastercard and Visa.[14] However, this effort was never able to achieve much success, in no small part because of the difficulty of replicating a massively distributed network by signing up millions of merchants and attracting millions of consumers, especially when the existing system was already fairly low cost for the merchants and worked very well for consumers. In another example that’s closer to home, Amazon has unsuccessfully attempted to enter the online travel market twice, with the most recent effort, Amazon Destinations, lasting a mere six months.[15] Thus, from Google’s perspective, we believe developing new skills that are orthogonal to its main search business in an attempt to achieve uncertain profitability gains is an unappealing prospect. This course-of-action seems even more foolhardy when one considers that Google’s current travel business is already incredibly profitable. In fact, it’s arguably worth more than Priceline’s.[16] Because Google is the gateway to the internet and customers have limited loyalty to any particular booking platform, Google is able to extract a large piece of the online booking economics through the advertising dollars that the OTAs and other travel accommodations providers must spend to maintain their customer traffic.

The last potential threat to Priceline comes from Airbnb. Airbnb has catalyzed a rapid increase in the supply of travel lodging through its sharing economy model, causing concern among analysts that this extra supply will increasingly pressure hotel revenues. While there’s little doubt that the sharing economy has had an impact, with one recent study of Austin, TX, quantifying the effect at 8 to 10% of hotel revenues over the last decade,[17] it is still quite unclear whether this industry disruption will turn out to be a large initial reset followed by slower future hotel market share losses or whether it’s just the beginning of a much more severe pricing deflation and market share shift. In trying to evaluate this threat, we would note a few key facts. First, hotels do provide a unique value proposition of privacy, security, and consistency when compared to alternative accommodations. Second, they often provide lower-priced access to amenities such as pools, exercise rooms, spas, and dining services since they can amortize their costs across far more customers. Third, perhaps contrary to perception, millennials appear to value these attributes about as much as prior generations, as the following 2017 survey from Expedia demonstrates.[18]