Orbitz' Heavy Baggage

Why it's unprofitable--and why the IPO may have to wait

When Orbitz Inc., the Web travel agency owned by five of the nation's biggest airlines, filed financial documents with the Securities & Exchange Commission to go public in May, investor reaction ranged from respectful to giddy. After all, Net travel site Expedia Inc. and discount hotel-room player Hotels.com have shown that the business can be solidly profitable. "Expedia has been a really hot company and a good investment," says William Smith, president of IPO Plus Fund in Greenwich, Conn. "Orbitz is a nameplate IPO, and it will be a hot deal."

Maybe not. An examination of Orbitz' newly disclosed financial information raises questions about the company's prospects. For starters, it still loses money--$8.9 million in the first quarter, on sales of $32.2 million--even though every other public Web travel company is profitable. And Orbitz could have trouble growing its way to the level of profitability that Expedia and Hotels.com have. The SEC filings reveal that Orbitz' contracts with the company's five founding airlines call for the per-ticket commission rates the airlines pay Orbitz to fall 15% to 30% annually through 2007.

Worse, Orbitz is running low on cash. It had only $39 million as of Mar. 31. The company expects to raise $125 million in its offering, but the IPO market has cooled considerably since Orbitz filed with the SEC. Without new money, Orbitz could face a cash crunch as early as next year. "I think the reason Orbitz is doing an IPO is that it has no other choice," says Philip Wolf, president of Web travel consulting firm PhoCusWright Inc.

Nonsense, says Orbitz. Jeffrey G. Katz, the company's chairman and chief executive, makes the case that Orbitz is plenty healthy. He says the summer travel season and Orbitz' rising sales of hotel rooms will head off any cash squeeze, with or without the offering. He also says that Orbitz will have at least one or two more quarters of financial results to show its growth plans are working before it goes public. "When we're on our road show, we'll have data to answer questions" about growth, he says.

Still, Katz may face a tough sell once investors understand how Orbitz' corporate governance is structured. The company was set up by United, American, Delta, Northwest, and Continental, and the airlines will control six of nine board seats after the IPO. Katz says the airlines have a vested interest in Orbitz' success. But the partners' control raises questions about possible conflicts of interest. If the interests of the airlines and Orbitz' other shareholders diverge, which group will Orbitz try to satisfy?

The SEC filings suggest that so far, the airlines are the top priority. Example: Orbitz's decision, implemented last December, to begin charging consumers a $5 per ticket reservation fee--a charge that rivals, such as Expedia, don't levy. That fee serves a long-standing goal of the airlines to shift more of their distribution costs to consumers.

But the $5 fee could hurt Orbitz' popularity. While the company has positioned itself as the lowest-cost travel site, consumers are finding that's typically not the case these days. In a June 6 report, Consumer Reports wrote that Expedia, not Orbitz, is now the low-price leader for airfare. A BusinessWeek analysis of 10 hypothetical weekend jaunts reached a similar conclusion: Including the $5 fee, Expedia was cheaper than Orbitz for eight trips, while Orbitz was less expensive in two cases. That's dangerous because Forrester Research Inc.'s analysis shows that 6 out of 10 customers aren't loyal to any one travel site. "You're only as good as your last deal," says Forrester analyst Henry H. Harteveldt. Katz says the fee has not cost Orbitz market share.

A more important strategic lapse is Orbitz' failure, so far, to enter the most profitable part of the travel business. Instead of simply selling airline tickets and hotel rooms for commissions, successful sites such as Expedia also use what they call a "merchant model." They negotiate discount prices for large blocks of hotel rooms or vacation packages, then mark up the prices and sell them to consumers. Although travel agencies forego commissions, the merchant model is far more profitable because a typical $6 airline ticket commission is dwarfed by markups that can hit $500 on a vacation package. Orbitz had no merchant-model revenue in the first quarter, though it's inching into the business. "That decision came back to bite them on the tuchus," says Phil Carpenter, vice-president of travel-shopping service SideStep.

Analysts chalk up Orbitz' slow entry into the merchant business to airlines' resistance. Why? The key to success in the merchant model is for the travel agency to force down the price it pays for hotel rooms or airline tickets. "The merchant business is not so great for airlines," says analyst Mark Rowen of Prudential Securities Inc. Katz says Orbitz will get into the merchant business eventually. Meantime, the company started into the business indirectly in June: It began listing hotel rooms on its Web site that are offered by Travelweb.com, a hotel-industry-backed merchant site that pays Orbitz a commission for each sale.

Certainly, there are reasons to like Orbitz' prospects. Launched last June, the Chicago-based site sold $542 million worth of travel in the first quarter, making it the third-largest online agent, behind Expedia and Travelocity.com Inc. Orbitz began with one big advantage: access to special low-cost fares that were available only on Orbitz and the airlines' own Web sites. Those "Web fares" terrified rivals, who are trying to get them declared an antitrust violation. The Transportation and Justice Depts. are evaluating the claims, and a report from Transportation is due by July 1. But, analysts say, Expedia and Travelocity now get most of the Web fares that Orbitz does.

Katz argues that Orbitz can overcome the business and antitrust challenges it faces. He has high hopes, in particular, for a technology, set to be introduced later this year, that will overhaul the arcane economics of selling airline tickets. Right now, travel agencies rely on technology from companies such as Sabre Holdings Corp. to sift through the airlines' ever-changing fare schedules to find itineraries. Airlines pay about $10 per ticket to let travel agencies conduct such searches. Katz says that Orbitz' new technology, called supplier link, will let the airlines cut out Sabre and its peers. Orbitz and the airlines plan to split the savings from such fees, which total about $1.5 billion each year.

With all its challenges, Orbitz may have a hard time living up to its billing as a hot IPO. Even Katz says he may not rush to go public. "When we go public is a function of when the timing is right," he says. Holding off may make the most sense for Orbitz--and for investors.

By Timothy J. Mullaney in New York

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