Network effect will boost Expedia's market share

We continue to expect Expedia's share of the US$1.2 trillion travel industry to approach high single digits in five years from mid-single digits in 2015. Within travel, we expect global online penetration to increase to the high 40s in 2020 from roughly 40% in 2015. We forecast annual online travel booking growth of 9% to 10% the next few years, driven by vacation rentals, in-destination bookings, emerging markets and mobile--areas where we believe Expedia is well positioned.

Expedia continues to expand its network scale via acquisitions (Travelocity, Wotif, Orbitz and HomeAway) and organically through its more aggressive push to build international hotel content, the launch of rail inventory in 2016, and continued mobile growth. The company has 3,000 workers who focus on lodging relationships, and recent results have shown that Expedia's international room nights and property count are growing. However, this growth is coming at the expense of lower take rates. We don't mind this strategy, as we think it is important to invest in the network in the near term and then leverage later. We think this points to the barrier Priceline has in the fragmented international hotel industry.

We think Expedia's rail launch has good strategic merit. Similar to air, rail should be able to increase traffic to the platform, which can then generate attach rates of hotel and activities. Because mobile is increasingly important in the travel booking market, we are encouraged that Expedia is seeing improving mobile conversion and that direct-path booking growth has been accelerating over the past few years.

We have been impressed by the company's execution on Travelocity. Expedia took a brand that was experiencing declining revenue and turned it into one that is now increasing sales at a double-digit rate as the company leveraged its strong technology and marketing expertise. This has increased our conviction in Expedia's ability to replicate this success with Orbitz and HomeAway.

China crucial to continued growth

We do see some headwinds to Expedia's network advantage in developed markets, where  TripAdvisor's (TRIP) Instant Booking initiative is an obstacle to overall booking growth. In addition, replicating Priceline's leading network in Europe, while not an insurmountable hurdle, is proving costly, as boutique hotels (a substantial portion of the region's market) face labour and expense constraints to joining multiple distribution channels.

In emerging markets, the company has improved its position by selling majority-owned subsidiary eLong and replacing it with a Ctrip collaboration. This is crucial, as we think China will contribute 30% of industry online booking growth over the next decade. Finally, the acquisition of HomeAway gives Expedia a leading share in the fast-growing online vacation rental market.

Companies with the customer traffic and budgets to replicate Expedia's network pose the main risk. Focused entry from  Google (GOOG),  Facebook (FB),  Amazon (AMZN) and others could double the current handful of players with dominant scale. This would have a meaningful impact on Expedia's profitability, especially if they focus on U.S. markets, where Expedia generates around half its revenue and is more highly penetrated relative to emerging markets. That said, replicating Expedia's network would require significant time and expense.

Strong property network drives strong traffic and bookings

As a result of the strong network effect, Expedia and Priceline each have more than 30% share of the global online travel agency booking market. Beneath these two, share is highly fragmented, making it extremely challenging for smaller new entrants to gain customer traffic and supplier scale. Potential entrants would need substantial human capital to build relationships with hotels and gather crucial information/pictures from those hotel properties. They would also need to spend heavily on advertising to attract customers to the website, and any customers obtained would require IT, data center and 24/7 customer support to retain. Expedia is able to advertise well in excess of competitors, which helps drive its network advantage. As scale is built, understanding of consumer behaviour also increases, which leads to improved customer experience and conversion.

We don't believe Expedia has a wide moat, given potentially meaningful competition beyond the next 10 years from new entrants that already have the customer traffic and budgets to build network scale, including Google, Facebook, Amazon, TripAdvisor's Instant Booking, and hotel consortiums. Focused entry from these competitors would double the current handful of players that have dominant scale, leading to commodification of the industry and a meaningful impact on margins. We do expect the market to support some level of increased competition over the next several years, however, given the size of the travel booking market (US$1.2 trillion) and the currently low rate of online penetration of the travel market, at 40%.

Attractive market could lure heavyweight competition

Rate parity regulation prevents hoteliers from offering cheaper rates on their websites than are offered on the online travel agency websites. The removal of rate parity would create an environment for competition, although we believe any margin impact would be limited to the near term, as Expedia's large scale would allow it to price out competition and emerge in a stronger position over the intermediate to long term.

The travel industry is cyclical and affected by changes in economic growth. In a downturn, consumers have less income and therefore look to cut back on discretionary expenses like leisure travel. Expedia is not immune here, as revenue growth was essentially flat in 2009 excluding TripAdvisor. At that time, the still-low penetration of online travel bookings in developed markets helped prevent a more severe decline. If an economic downturn were to occur now, developed markets would not offer the same cushion as they did in 2009 because of more mature penetration and increased competition. The nascent penetration of emerging and mobile markets would probably offer some cushion to a weaker economic growth environment. In any event, an economic downturn would result in Expedia's growth slowing.

Expedia has meaningful international exposure, and as a result foreign currency has at times presented a headwind to growth. Over the past three years, with the euro having depreciated more than 5% year over year versus the U.S. dollar, the headwind to Expedia's international growth has seen a positive correlation of around 0.70.

While we think Expedia can generate enough free cash flow to pay down all its debt over the next several years, we expect share repurchases, dividends and international acquisitions will be cash priorities. The outlook for online travel booking growth remains strong, and we would prefer that the company allocate capital to additional acquisitions in the online restaurant, tour and attraction, and emerging markets, which we see representing large nascent growth opportunities.