This Stock is Set for a Hefty Rebound

The year surely got off on the wrong foot for travel site operator (Nasdaq: EXPE). On New Year’s Day, AMR (NYSE: AMR), parent of American Airlines, announced it was pulling its flight information from Expedia’s listing service. AMR’s move was just the latest twist in an airline vs. website battle that started a few months earlier when AMR announced plans to terminate its relationship with Expedia rival Orbitz (NYSE: OWW). Coming to its rival’s defense (for the sake of the entire industry), Expedia ultimately pushed AMR’s flight listings to the end of the queue, leading AMR to take that retaliatory move on New Year’s Day.

Two months later, AMR’s aggressive stance looks increasingly unwise. A diminished presence on those sites has led the carrier to lag behind rivals in terms of bookings in what has otherwise been a robust period for most of AMR’s rivals. Someone is going to blink in this battle, and it increasingly looks as if Expedia will emerge victorious. But the damage is done. Shares of Expedia are off roughly 25% in the past three months, while the S&P 500 is up about 3%. That contrast should reverse course in coming quarters, and Expedia looks like a solid rebound candidate.

Lots of cash now, more later
Until the recent rough patch, Expedia had emerged as one of the cleanest business models in the leisure space. EBITDA margins typically approach 30%, return on equity (ROE) is always in the upper teens and free cash flow (FCF) now tops $500 million annually. That strong FCF has put more than $1.2 billion in cash on Expedia’s balance sheet (or $4.27 a share).

Management is doing three things with all that cash. First, it’s buying back even more stock (the share count has dropped 20% in five years and could drop another 10% this year). Second, the company issued its first dividend in 2010, which may be sharply hiked in 2011 (though the current yield is still too paltry to consider). Lastly, the company is stepping on the gas in terms of international expansion.

It’s that last factor that’s also been a source of concern for investors, beyond the spat with AMR. On the fourth-quarter conference call, management announced plans to boost spending on growth initiatives this year, which will dampen profit growth in the near-term. Analysts have lowered their profit forecasts for 2011 by about 10% to account for that spending.

For my money, stepping up investments while a company is in growth-mode makes clear sense. The short-term hit to profits sets the stage for higher profits down the road. Indeed, analysts predict that Expedia’s profit growth will re-accelerate in 2012.

A large shadow
To be sure, (Nasdaq: PCLN) remains as the industry darling. Its revenue is growing faster as it overtakes Expedia’s dominant position in international travel. Priceline’s $4 billion in projected revenue in 2011 will allow it to overtake Expedia for the first time (which is expected to have $3.7 billion in revenue in 2011).

But are investors getting carried away with their love of and their current disdain for The numbers tell the story. Priceline is roughly three times as expensive on an enterprise value basis. That disparity also exists when you measure these two stocks in terms of free cash flow. Indeed Expedia’s FCF yield of nearly 13% is almost unheard-of for companies that are still in growth mode.

Action to Take –> Simply being cheap is not reason enough to buy shares. Instead, you need to spot catalysts that will move Expedia back into favor. And they surely exist.

For starters, analysts increasingly believe AMR will need to reverse course to stem market share erosion. The carrier would prefer to deal more directly with customers or at least with closely-affiliated travel agents. But sites such as Expedia and Orbitz are here to stay, and AMR is learning that you avoid them at your own peril. Citigroup predicts AMR and Expedia will make peace in the second half of this year, adding that any such deal is not yet incorporated into profit forecasts.

Secondly, investors will start to see that Expedia is developing a powerful ancillary revenue stream in terms of advertising. Ad sales hit $485 million in 2010, and they should top $600 million this year. This revenue comes with especially high margins, which may push Expedia’s gross margins above 80% in 2011.

Third, the newly-cheaper shares imply that Expedia can buy back a larger amount of shares under its current authorization. Any further share price weakness will shrink the share count that much more.

Lastly, Expedia should benefit from a “re-set bar,” which means that analysts have taken their profit forecasts for 2011 and 2012 down to the point where Expedia should deliver estimate-topping results, as has usually been the case in recent years — except for the most recent quarter.

It’s been a tough winter for Expedia, but the company should benefit from its stance as the industry’s underdog. You’d do well to consider this bounce-back candidate for your own portfolio.