BKNG - Expedia: Poor Unit Economics Will Subsist

2023-09-26 09:45:25 ET

Summary

• Expedia's ability to generate significant value for shareholders is questionable due to execution issues and industry features.
• Expedia's shift towards focusing on higher-value customers may not result in positive outcomes unless marketing efficiency improves.
• Expedia's loyalty program is not a significant differentiator, and Booking's premium over Expedia is likely to be sustained.

Any stock's performance will be dependent on the underlying business' ability to create value.

Due to both unique execution issue and unattractive industry features, I believe Expedia ( EXPE ) will not generate significant value for shareholders, despite what may appear to be an opportunity created by its recent multiple compression.

A New Strategy

Comparing Expedia's and Booking's ( BKNG ) Gross Bookings metrics, we see that Expedia has underperformed its competitor in their post-COVID recovery:

It is in this context that Expedia's CEO has been discussing how they aim to reposition their marketing efforts towards higher booking value individuals:

As we continue to move from a purely transaction room night focused world, to one in which we focus on customers and lifetime value, we've been able to build a bigger, more valuable base of these high ROI travelers

Looking at Expedia's earnings calls transcripts, it seems like this strategic shift took hold in Q1 22.

I doubt that the decision to focus on value per transaction instead of total transaction would have taken place had Booking not been performing better than Expedia in transaction capture.

Nonetheless, the logic here is that if this strategy is successful, Expedia's LTV/CAC would be increased, producing better unit economics and long-term profitability.

Unless these better unit economics are proven, this could simply be a way to give management control over the narrative surrounding underperformance.

Any Improvements In Unit Economics?

Online travel companies like Expedia and Booking ((BKNG)) have most of their expenses directed toward advertising, and their share of revenue has seen a sustained increase:

My consideration of unit economics will therefore mainly be focused on the returns Expedia sees on its advertising costs as they represent the main growth driver.

While their revenue generated per night stayed showed an encouraging increase, operating income per night has not seen the same increase (to note is also the returns to scale in operating income through the past decade):

This shows that while Expedia is reaching towards the targeted higher value per booking, they may simply be redistributing the same dollar figure of bookings over fewer nights while spending the same per night in advertising etc.

If unit profitability is not improved given that higher value customer require proportionally larger expenditures from Expedia, only increased loyalty from these customers can justify an upside from this strategy. As cited above, management has been explicitly claiming this higher loyalty exists.

Is Loyalty Worth Anything?

As a measure of their strategy's success, management will often tout their growth in loyalty member base. However, I don't believe their loyalty program is a material factor in value creation.

The first indication are the non-existent returns to scale: it seems like customers need to be reacquired no matter if they transacted on your platform before.

One reason why could be the nature of the online travel booking market: the industry is mature, customers are all aware of its existence, but most are infrequent users of its service, and when they do are only looking for whichever platform gives the best price. Therefore, comparison shopping is done on the basis of price, and if all prices are equal, then the effect of marketing can come into play.

Essentially, selling a commodity product where customers are highly price sensitive should unsurprisingly have little room for brand marketing returns. This is the business-level dynamic which I believe is driving the flat returns to scale.

Even in general, loyalty programs membership numbers should be taken with a grain of salt: a 2017 study shows more than 3.5B loyalty program memberships in the U.S. with more than half inactive. Yet I believe online travel booking loyalty makes even less sense.

As mentioned, due to the high degree of comparison shopping in travel accommodation booking, Expedia is not positioned to benefit from a more mindless or habit-based purchasing decision like coffee shops or grocery chains, where loyalty programs can be more effective.

Painting Itself Into A Corner

What hurts Expedia's unit economics most seems to be at the operational strategy level, as Booking shows better unit economics, both historically and since Expedia's more narrow target customer focus:

If unit economics are better when targeting customers transacting at higher bookings per night, we should expect to see a narrowed unit economics delta between the two companies in recent history. Yet we do not see such a narrowed spread.

This goes against management's expectation and seems to indicate that more efficient control of unit expenses would be in order, as while they have currently succeeded in increasing bookings per night, the nearly unaffected operating income per night indicates that they had to spend more to reach these results. Instead, if management is content going after fewer but higher-bookings customers, it seems the unit profitability improvement they expect will not materialize unless these customers can be acquired for less going forward. Otherwise, management could simply be reducing its TAM while having little profitability improvement to show for it.

Then again, this is assuming this strategic decision was truly internal and not a response to Booking stealing some of its bookings market share post-COVID.

Returns on Marketing

The following chart shows the annual dollars in bookings generated per advertising expense for both Expedia and Booking:

What we see are not only worsening unit economics (less bookings generated per marketing spending across the board), but also that Booking has outperformed Expedia in its return on advertising.

Booking has also been better at generating more earnings per dollar of bookings.

Again, Booking is doing so without narrowing its client pool focus to certain high value customers.

BKNG's Premium Should Sustain

All the above could be reasons why the market has virtually erased Expedia's long-standing premium multiple over Booking. From a quick look at both share price charts, we can see that the market has shifted to rewarding holders of Booking above Expedia's.

If you agree with my conclusions that Expedia's operations will underperform Booking's and that management will have much less to show for its new strategy than most may be anticipating, then it's not a far stretch to assuming this Booking premium will be sustained.

Reevaluating Free Cash Flow Yield

It's important not to take Expedia's FCF reported at face value: their operating cash flow includes "deferred merchant bookings" which is essentially like cash in transit.

This liability increase also increases cash on their balance sheet, but that cash balance doesn't come into play in calculating the change working capital for FCF (cash balances are always excluded).

Therefore, the increase in deferred merchant booking boosts the operating cash flow but is not actually a cash flow available to Expedia.

Instead, if we do a back-of-the-napkin cleanup of cash from operations by excluding deferred merchant bookings, and subtracting share based compensation as an expense, we get a much lower yield on revenue, as shown by the graph below:

This is a minor accounting note that I thought worth mentioning in case some using as-reported figures are overestimate Expedia's FCF.

Executive Compensation Issue

Peter Kern, Expedia's CEO and Vice Chairman, received a compensation package of $296mm in 2021 , which I think is quite excessive, especially when put against the background of Expedia losing ground to Booking in many historically core metrics as discussed above.

In fact, he was the highest-paid CEO in 2021 among S&P 500 companies.

While according to the same proxy, that year's compensation was outsized relative to 2020 and 2021 (~$4.2mm and ~$1.1mm), even the average of those 3 years brings him to the 6th highest-compensated in 2021, right above Apple's Tim Cook.

Voting shareholders clearly noticed this and voted accordingly. Shareholders vote every 3 years on executive compensation. In 2020 , approximately 94% approved the compensation plan. In 2023 , only 57% did.

I believe most shareholders are aware of this, but I thought it worth mentioning as a clear lack of shareholder alignment can be a headwind to value-creation.

Outsized executive pay in general is a clear example of reducing the funds available to companies to generate growth for shareholders.

What Could Go Right

For reasons laid out above, more membership and more active members would not be enough for me to reconsider Expedia's value creation prospects.

Instead, even if the amount or activity of existing members were reduced, Expedia could outperform my expectations if their LTV/CAC is improved due to higher rates of repeat customers reducing the need for continuous marketing spending.

We haven't seen such a phenomenon yet, but improvement of operating income per night would be a clear indication that the value Expedia expects its loyalty program to create is legitimate. Otherwise, unit economics improvement could come from a change in marketing approach that yields higher returns.

Bottom-Line

Expedia is operating in an industry with unattractive returns on investments. However, due to operational underperformance, Expedia is now painting itself into a corner by targeting only "high value customers" and has nothing to show for it so far.

Loyalty programs are not something I expect to become more effective going forward, and the fact that Booking is more effective at generating bookings and earnings from a less restrictive focused client pool should be a red flag that management is probably crafting this strategy in response to Booking beating it flat in generating bookings post-COVID.

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