Finally, Diller Gets the Message
By Timothy J. Mullaney
Wall Street turned skeptical on IAC/InterActiveCorp (IACI ), Barry Diller's Web conglomerate, almost from the day in 2003 when he stitched together an additional $9 billion in acquisitions. Diller had grand ideas: By marrying the growth engines of Expedia and Hotels.com to IAC's profitable but not-too-exciting assets like the HSN cable shopping channel and Ticketmaster, he figured he could build a Berkshire Hathaway (BRK-A ) of e-commerce. Instead, IAC stock has fallen about 37% from July, 2003, (when it traded at around $43 a share), as investors and analysts focused on disappointing gross margins in the hotel-room business.
That's why the Dec. 21 announcement that IAC will spin off its travel businesses next year under the name Expedia Inc. came as no big surprise. Fact is, the Street never put the same faith in the combined IAC that it extended to other Internet leaders. Worst of all, the combined IAC commanded a much lower valuation than Expedia and Hotels.com as independent entities.
eBay (EBAY ) trades at 101 times estimated 2004 earnings. Yahoo! (YHOO ) gets 126, Google (GOOG ) 72. Until yesterday, IAC got a comparatively measly 28 times earnings -- about half of what Expedia once commanded as a separate company.
Simply by restoring the status quo that existed before IAC bought Hotels.com and Expedia, Diller could make today's IAC shares worth $31, reckons Piper Jaffray Net analyst Safa Rashtchy. That's a nice bump from a low of $19 in October, or even from its most recent close of $27.59 on Dec. 22, up $1.70 since the spin-off announcement. Diller isn't required to change anything about the way he runs Expedia or IAC -- the reason he could tell analysts in a conference call that the spin-off "isn't a transaction, just a reclassification."
More like a surrender. Ultimately, it made little sense to bury the travel group in a company that won't grow nearly as rapidly, since Wall Street puts higher valuations on fast-growth outfits. IAC's "reclassified" travel division is expected to boost profits almost twice as fast as the rest of the company in its current incarnation. Legg Mason analyst Tom Underwood sees travel profits before noncash charges going up 20% next year.
"The reason this happened wasn't necessarily valuation," says Dara Khosrowshahi, the financial whiz who runs IAC Travel and will be CEO of the spun-off Expedia. But as he concedes, IAC was aware that many investors wanted to see the spin-off for just that reason.
Indeed, IAC's complicated profit reports left even pros lost in the details. The huge acquisitions burdened IAC with noncash charges that sucked as much as $288 million out of this year's earnings -- and would have kept generating big noncash hits to earnings through 2008. Sure, Wall Street should have been able to see through the numbers and grasp that IAC was more company than 1-800-Flowers (FLWS ) or Orbitz, the #3 online-travel player recently acquired by Cendant (CD ). Yet both traded at multiples similar to IAC's.
Now, Expedia's valuation should bounce, at least some, almost immediately. Several estimates put the spin-off's value at about $13 billion, or $16 to $17 per IAC share, even though IAC will hang on to most of the combined company's $3.4 billion in cash.
That assumes Expedia trades at only about 16 times to 20 times profits before noncash charges -- less than other Web leaders command. Typical was the reaction of American Technology Research analyst Mark Mahaney: "The transaction will create a fifth pure-play, large-cap Internet stock -- Expedia, along with Amazon.com (AMZN ), eBay, Google, and Yahoo," Mahaney wrote. "We believe Expedia could be of significant interest to investors looking for strong secular growth, a dominant market-share position, high margins, and material new-growth drivers ahead." If Expedia is once more valued like the companies Mahaney posits as its peers, the numbers could well be even higher. By Timothy J. Mullaney
The problem for the combined IAC wasn't just numbers. From the start, Expedia's culture -- built on fast growth fueled by liberal doses of stock options and its origins as a division of Microsoft (MSFT ) -- was a bad fit with Diller's top-down management style. Many employees didn't welcome the acquisition, and some told Diller as much during a face-to-face meeting near Expedia's headquarters in August, 2002, when Diller was out to become their new boss. Nor did it help when IAC scrapped options in early 2003 for smaller bundles of restricted stock.
Even after the deal, sources at IAC indicated there was a running, if polite, competition between IAC's New York headquarters and Expedia's Seattle base. Management defections were widespread: Expedia CEO Rich Barton left first in March of last year and was followed by his successor, Erik Blachford, and Expedia's chief financial officer, general counsel, and the head of its hotel division, among others.
While relations were basically friendly -- Barton visited Khosrowshahi's beach house this summer -- there were also reports of impatience over New York's relative unwillingness to pay for key acquisitions. Sources point to an internal discussion over whether to buy Ctrip.com International (CTRP ), China's leading Web-based travel agency, as one flash point.
IAC balked at Ctrip and instead bought control of No. 2 agency eLong. CTrip went public at $18 in December, 2003, recently hitting a high of $49 before sliding slightly to close on Dec. 22 at $47.32. Khosrowshahi plays down any rifts, saying New York- and Seattle-based execs jointly decided to buy Shanghai-based Ctrip. Says Khosrowshahi: "The East Coast group was just as aggressive on China in general."
Now here's the big question: Is Expedia the same company it was when last independent? In addition to all the outfit's executive departures, Hotels.com co-founders David Litman and Robert Diener also departed last fall. Moreover, Hotels.com also has struggled to redefine itself, since deep discounters Priceline.com (PCLN ) and IAC stablemate Hotwire have overshadowed its image as the premier online hunting ground for cheap rooms.
Expedia also has more competition and different relations with suppliers than when it was last independent. Rivals Travelocity and Orbitz were slow to plunge into the hotel business, but each has made major moves in 2005 to obtain and expand hotel inventory -- and to market themselves harder. Another thing in Orbitz' favor: New owner Cendant has deep pockets, meaning it could match Expedia's industry-leading marketing budget if it chooses to do so.
NO MORE WAITING.
At the same time, hotel chains are cracking down on affiliates in an effort to stop them offering special deals online. That's cutting into IAC's margins slightly, but mostly it's hurting top-line growth. In the third quarter, IAC Travel's U.S. revenue growth was up 16%, vs. the 67% of a year earlier.
The silver lining: Profits are still rising sharply because of international growth and improved financial management, with operating profits of $134 million in the third quarter. "Domestic growth slowed down, and what Travelocity and Orbitz are doing has to get their attention," says Lorraine Sileo, an industry analyst at researcher PhoCusWright in Sherman, Conn.
For the last year, Diller has said he would wait out the Street's skepticism and let the long-term value of the company he was building emerge. But the man is nothing if not a do-it-now manager, and IAC execs have said privately for months that he has been intently focused on the stock price.
Moves like buying back shares and flirting with the idea of paying a dividend weren't enough to appease Wall Street's concerns. So Diller, whose own wealth is mostly in IAC shares and options, apparently understood that he had to give Wall Street what it wanted.
Mullaney is e-business editor for BusinessWeek in New York