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Priceline Has a Brilliant Business Model

Image source: Priceline.

Priceline (NASDAQ: PCLN) stock has been an incredibly profitable investment over the long term. Shares of the online travel agency were trading at less than $40 per share in October of 2006, and they are currently in the neighborhood of $1,440 per unit. In percentage terms, this means an accumulated total return of approximately 3,500% for investors in Priceline over the last decade.

One of the main reasons why the stock is doing so well is that Priceline is a market leader in a remarkably promising industry, and management knows how to translate the company's smart business model into growing sales and cash flows for shareholders. 

A market leader in online travel

Online travel agencies are the platforms that allow consumers around the world to book hotel rooms, flights, car rentals, and even restaurants via web and mobile applications. Demand for these kinds of services has boomed over the past several years, as consumers are getting increasingly used to buying all kinds of products and services online.

Online travel platforms facilitate access to all kinds of information and customer reviews on different alternatives in a particular market, which allows customers to make better-informed decisions. Besides, these platforms can many times offer massive pricing discounts, and costs are a key decision driver for most travelers nowadays.

In industries such as hotels and airlines, occupation is key to maximizing business profitability. For this reason, it makes financial sense for companies in the sector to offer big pricing discounts on last-minute deals if the room or the plane has excess capacity. But this can tarnish the brand over time, so companies need to be careful not to hurt pricing power too much. Priceline provides an opportunity to clear excess inventory rapidly and under special conditions, offering a valuable service to both travelers and industry operators. 

Priceline and Expedia (NASDAQ: EXPE) are the two leading players in the sector, and the industry is under consolidation via acquisitions over the past several years. Priceline has acquired platforms such as Agoda.com, Kayak, Rentalcars.com, and OpenTable, while Expedia bought Trivago, Travelocity, Orbitz, CheapTickets.com, and HomeAway, among others. Consolidation keeps pricing competition in the segment under control, allowing Priceline and Expedia to make attractive profit margins on revenue.

As of September 2016, Priceline's main platform, Booking.com, features 1 million available acomodations, an increase of 30% year over year. The size of the platform attracts customers in search of more options and better deals, and industry operators need to go where the customers are. Travelers and companies in the sector attract each other through the leading online travel agencies, so scale is a major source of competitive strength for Priceline.  

A smart business model

One of the main areas in which Priceline and Expedia are different is international exposure. Priceline generated $2.4 billion in gross profit last quarter, and $2.1 billion of that money came from international markets. Expedia, on the other hand, produced nearly 65% of its gross bookings in the U.S. during the second quarter of 2016.

Priceline's global exposure can have negative implications in the short term. Many economies in emerging markets have been weak over the past several years, and terrorism risk in Europe can hurt travel demand. However, the online travel industry is much younger in international markets than in the U.S., and this means superior growth potential for Priceline compared to Expedia over the long term.

Online travel agencies can basically operate under two different kinds of business model. The agency model is when the company acts as intermediary between customers and companies such as hotels. Industry operators can list their own prices and conditions on the platform, and the online travel agency makes a commission on every sale. When it comes to the merchant business model, the online travel agency purchases the room inventory from the hotel, and then resells it to customers on its own terms.

Based on data for the second quarter of 2016, Priceline made 86% of its gross booking from the agency business model, while rival Expedia made 56% of gross bookings from the agency segment and the remaining 44% from the merchant division. This allows Expedia to have more control on prices and overall supply conditions, but Priceline makes higher profit margins, since it has almost no associated cost of inventory on sales.

Capitalizing on its opportunities

Priceline is not just a promising growth story; the company has proven its ability to deliver over time. The following chart shows revenue, free cash flow, and earnings per share for Priceline and Expedia over the last decade. A picture is worth a thousand words, and Priceline has produced impressive financial performance while leaving its main competitor in the dust.

PCLN Revenue (TTM) data by YCharts.

Priceline is a top player in a remarkably promising sector, with solid competitive strengths, a profitable business model, and financial performance over the long term that leaves little to be desired. With these factors in mind, it's easy to understand why Priceline stock has produced extraordinary gains for investors over the years.

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Andrés Cardenal owns shares of Priceline Group. The Motley Fool owns shares of and recommends Priceline Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.