The Steep Price of priceline's Latest Airline Deal

Fun With Math

SAN FRANCISCO -- In the first three trading days of this week, priceline.com (PCLN Quote) shares rose 35.8% to Wednesday's close of 76 7/8, stemming a steady decline that had seen them fall to as low as 52 5/8 on Nov. 5 from as high as 162 3/8 on April 30. Today, the shares fell 6.7% to 71 7/8 (more on that in a minute).

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The gains earlier this week were largely attributed to the anticipation of, and reaction to, Wednesday's announcement that the operating units (a.k.a. "airlines") of UAL (UAL Quote), AMR (AMR Quote) and US Airways (U Quote) will offer seats on priceline's site.

Nabbing those three carriers is certainly a win for priceline. In its press release, the company said the new carriers will increase priceline's ticket inventory by 94% and "almost double" its capacity to fill ticket requests, which have "tripled" this year according to Brian Ek, a company spokesman.

That's all fine and dandy, but at what price hath priceline made this deal with the devilish airlines?

The company said it will take a $1.1 billion one-time, noncash charge in the fourth quarter as a result of the deal, about which investors seemed to care nary a hoot. The charge accounts for the cost of warrants issued to each of the eight major airlines now affiliated with the "name your own price" company. The warrants, which total 20.5 million shares (or about 10% of priceline's common stock), are exercisable at $56, but not for five years unless certain sales goals are met.

Yesterday, I asked Ek about the wisdom of selling something for $56 that the all-powerful, all-knowing marketplace said was worth some $20 more.

"But look who we sold it to," the spokesman replied, suggesting the airlines' participation is a validation of the priceline model (and maybe he's right). Also, "the name of the game is not so much airline tickets as cross-sales," the spokesman said, noting the company has a widening variety of "high frequency" items, such as groceries, and "low frequency" items, such as cars, to entice consumers.

As for the $1.1 billion charge, Ek pointed out enthusiastically that it's of the noncash variety and thus "didn't cost us anything."

Funny, I was always taught there's no such thing as a free lunch -- and $1.1 billion buys a lot of hoagies, subs or grinders (depending on where you're from). So, just for fun, let's pretend that $1.1 billion is real money and figure out how many airline tickets priceline would have to sell to recoup it, shall we?

We shall.

The New York Times quoted priceline Chairman and CEO Richard Braddock as saying airlines accounted for about 80% of the company's revenue, which totaled $152.2 million in the third quarter: 80% of $152.2 million = $121.76 million.

priceline sold 624,000 tickets in the quarter, which -- divided by $121.76 million -- yields an average cost of $195.13 per ticket. (We know from past reporting that priceline books the entire cost of tickets sold as revenue, a controversial practice I'll readdress momentarily.)

priceline doesn't provide a breakdown of margin by various product offerings, but its overall gross margin was 12.2% in the third quarter. It's doubtful airline tickets are the company's highest-margin business (licensing software is probably No. 1), but let's give priceline the benefit of the doubt and assume it earns 12.2% on every ticket sold. Thus, 12.2% of $195.13 = $23.80.

Which brings us to the payoff (and I use the term loosely): priceline will have to sell about 46.2 million tickets to recoup the $1.1 billion charge, assuming the company incurs no additional costs to process those transactions.

If priceline were to double its recent output of 624,000 tickets a quarter, it would sell about 5 million tickets a year. Thus, shareholders can count on over nine years of subs (with onions) before the charge is earned back.

The Fault, Dear Reader

Ek's assertion the $1.1 billion charge costs priceline nothing is a "fair" and "legitimate" statement, according to Jeff Brotman, adjunct professor of accounting at the University of Pennsylvania Law School. But "it's almost a tacit acknowledgment [the company's stock] is not worth anything. General Electric (GE Quote) would never say that."

Additionally, "from a shareholder perspective, there is that question of dilution," Brotman said. "Whatever value was there for existing shareholders, there's 10% less. How do you make that back?" (See above.)

Brotman, who has been critical of priceline's accounting practices in the past, did not question the legality of the charge. But he did take a short position in the stock for his personal account because of the dilutive effect of the warrants, as well as the restructuring of Delta Air Lines' (DAL Quote) ownership position.

It's Byzantine, but in the end, Delta's ownership stake will be reduced by approximately 50%, to 8.4 million shares. But the airline has been freed from lockup provisions, meaning the shares could hit the Street at any time.

"But I don't fault [priceline] in the least," the professor said. "Start-ups have stock valued for perfection and are using it. They'll build market share and revenue whether or not they achieve perfection."

This gets to the rub. You can question the financial acumen of priceline's deal-making, but the investment community is rewarding the company for the promise of future revenue. Apparently, ever-increasing one-time charges (they totaled about $90 million in the third quarter) are less important to investors than increasing revenues and market-share gains.

But time may be running out for the pricelines of the world. The Securities and Exchange Commission has asked the Financial Accounting Standards Board to tighten standards for Internet companies' accounting (including how companies book revenue for sales), The Wall Street Journal reported, citing a report from Credit Suisse First Boston.

Stricter revenue recognition rules "could have a significant impact on the valuation of some less conservative companies," the report said.

priceline's accounting has been called a lot of things, but "conservative" is not among them. And, as mentioned above, the stock slid 6.7% today. Maybe that's just a normal giveback after the stock's big run-up the prior three days.

Or maybe not.

Postscript

Another day of big volume and records for the major averages. Joy all around.

Meanwhile, traders reported another Instinet shutdown and delays with Nasdaq's reporting system at the open.

Instinet's spokesman failed to return my call for the second straight day. (Is it something I said?)

I caught up with Nasdaq's spokesman today, and he was trying to arrange an interview with the exchange's chief information officer. It didn't happen, but we're going to try again tomorrow.

The saga continues...