Breaking down Expedia

Expedia came into my radar screen when i read the financial times. In it, Barry Diller, the chairman of Expedia Inc actually announced a 3.5 Billion share buyback plan which was to take place through a dutch auction. This would mean that 117 million shares approximately would have been bought back by management. This, to me was an extremely bullish announcement and prompted me to dig further. Buying back 42% of all share outstanding is a fantastic way to create shareholder value when the company is trading below its intrinsic value. It also is a catalyst for moves to the upside. Well, just to illustrate, Expedia's net cashflow per share is approximately $1.95(545 million/279million) and after a buyback, this would value the net cashflow per share a $3.4(545million/160million). This drastic change would largely enrich the existing shareholders of the company.

For those who do not know what expedia actually does, it is an online travel company that focuses on the needs of the the traveling community. It empowers travelers by presenting in capsule format information that allows people to plan and efficiently research their travel itineraries. Its products primarily consist of air, hotel, car rental, destination services and cruise. Essentially, it is an online travel agent which solves all your travel needs.

A brief look at its financial results are not actually that fantastic. It has shares outstanding of 279.33 million. Return on equity for fiscal year is 4.7% and return on assets are 3%. Net income figures are not fantastic and earnings yield are considered too low by any standards too. When i first did research on this company i found that it was trading at a price earnings ratio of 36, extremely high and does not seem like an exciting opportunity.

But what made me dig further was Barry Diller. As i have mentioned in previous posts that management is the one factor that will actually determine the value of the company. Management can bring the company down and they can cause stock prices to soar. Effective management is important for a company's survival and profitability. The motives of mangement can actually be found in some of the SEC Filings.

I did some research on Barry Diller and found that he was extremely bullish about the company's prospects. In fact, in one of the artcles which was written, he mentioned, if i may quote him that he is "confident in the value of expedia and its long term nature" Coincided with the buyback of 117 million shares, this guy must mean something. Furthermore, Barry Diller has affiliations with Warren Buffet. And he firmly believes in a share buyback when a company is undervalued. Do refer to this.. You might get a hint of his philosophy here : http://www.ft.com/cms/s/0/b6eb1774-dd4e-11db-8d42-000b5df10621.html

A further look at his holdings made me excited. Barry Diller actually owns 24% of the company. Wow! Surely, there is this huge incentive for him to push stock prices up. The question is: Is there a margin of safety to be found in an internet stock. Is there really any margin of safety????

As it is, some of its competitors such as Travelocity, Orbitz and Priceline trade at extremely high multiples. For example, priceline traded at 53.7 times earnings when i first pounced upon it. If anything at all, staying away from the industry and the company would be the easier option. However, relative to its competitors, expedia does trade at an approximate discount of 40%.

A look at expedia's numbers suggest that the industry is actually still growing. From year 2004 to 2006, its diluted EPS was $0.48, $0.65 and $0.70 respectively. Its operating cash flow was 792 million, 859 million and dipped in year 2006 which was 617 million.

A look at expedia's cash flow also revealed that Net income was not reflective of the company's true value. For fiscal year 2006, its earnings was 245 million while amortization was 200 million. Operating cash flow was 617 million. This showed that expedia has got some hefty amortization charges and it almost felt that they were wishing to get rid of the amortization charges of the cash flow statement. Amortization was 230 million in year 2005. Clearly, the amortization charges were distorting the financial picture of Expedia. Also, a point to note is that amortization for definite lived intangibles was projected by management to be 78 million and 56 million for 2008. These numbers tell a story of financial engineering for if amortization figures do fall, this will make earnings per share increase assuming everything stays constant and if the market loves to value the internet companies based on earnings per share(P/E), this will be a boon to existing shareholders i feel.

So to sum up the picture:
1) Barry Diller is bullish about his company
2) The share buyback is a catalyst
3) This seems to be a case of financial engineering


Lets make some conservative projections for 2008(Assuming that the net cashflow remained on par to 2006). If earnings for 2008 was 245 million and amortization was 200 million and others being changes in working capital was 200 million, this would leave a net cash flow of 545 million if i do assume that investing and financing cash flow is a negative 100 million. After the 42% share buyback, this would cause cash flow per share to be $3.40. The industry's Price to cash flow is typically 37. Before the share buyback Expedia would approximately trade at a price to cash flow of 15 times.

Conservatively, if Expe traded at 25 times cash flow(which me and manpreet feel is not too demanding a cash flow multiple), the value of the company would be approximately $85(25 x $3.4) And this is ignoring any growth in cash flow that may result from the company's improved operations. Although growth of operating cash flow is expected to be at least 12% p.a for the next 3 years while taking into account the high cost of borrowing, there is still a possible growth in cash flow but for the purposes of conservatism it is extremely conservative to assume no growth in net cash flow within the company. Just for your information at this point, expedia earned $384 million ebit in FY2006 while it is projected to earn 697.8 million ebit in FY2007 . Hence, am i being super conservative in assuming a no growth situation. Yes! In a twist of events, Expedia decided to cut its share buyback programme to only include 25 million of all shares outstanding due to high cost of borrowing. This once again would affect the value of expedia. Recalculating the net shares outstanding after a 25 million share buyback, this would result in a net cash flow of $2.14(545mill/254mill shares outstanding) This would value expedia's price at $53.5 (25 x 2.14)

The price of expedia's stock was approximately $29 then leaving a 46% margin of safety. Me and Manpreet discussed and decided to scoop up expedia warrants(expez) at $17 a piece. Each warrant allowed one to purchase .969375 shares of Expedia, Inc. common stock at an exercise price of $11.56. Nearly every dollar move in the underlying would result in a dollar move in the expedia warrant. Whats better is that the risk reward ratio would drastically improve. For every dollar that i risk if i had bought stock, i might have only made a profit of $0.84 cents while if i had bought expedia warrants, for every dollar that i risk, i would have had the opportunity to make $1.44.(Upside of $53.5 - $29 stock price at which i bought the warrant/17) This made the situation compelling and we scooped the warrants up at approximately $17.

One last point to add though, it is so important to look at the motives of management. Poor numbers may not be poor forever. Things change. Management is the number 1 catalyst to stock moves to the upside and i cannot emphasize this more. John Malone was and still is a stakeholder in Liberty Media. For those who do not actually know his background, what he did was he turned 50 million into a billion in 2 years. How? Just by financial engineering through the spinning off Tele-communications while simultaneously pretending to not be interested in the spin off. Analyst shunned it for it was too difficult a transaction to understand. Numbers were also negative with liberty reporting a loss of $20 million. In the end the spin off took place and because John Malone had a large stake in these companies involved, he turned 50 million in 1 billion in just 2 years. Simple financial engineering. People wanto get rich don't they? For more, Do read Joel Greenblatt's book. Right now, John too owns a 23% stake in expedia and he is backing a new share buyback programme and things are beginning to be more exciting as it unfolds.