We are downgrading shares of Expedia Inc. (EXPE) from Outperform to Neutral.

The company reported strong results in the last quarter, but continued to benefit from promotional inventories provided by its hotel partners. When results are stripped off the benefits of promotional activities, a softer demand environment could become evident.

We also do not expect the company to report better than seasonal sales growth in the current quarter.

The company has sacrificed booking fees this year, which is telling on the average daily rates (ADRs). Therefore, ADRs could be the metric to watch rather than room nights at this point of time.

We are also concerned about the incidence of transient occupancy taxes. Although municipalities and governments have decided that they will recover occupancy taxes from hotels if they lose out to online travel companies, we note that Expedia has already lost in Georgia and the company is slated to pay out $55 million to the City of San Francisco.

A fresh suit has now been filed by Florida, and for the first time the company has been charged under the Florida Deceptive and Unfair Trade Practices Act. Five Florida counties have decided to charge Expedia, as well as other online travel companies such as Orbitz Worldwide (OWW), Priceline.com (PCLN) and Travelocity for recovery of transient occupancy taxes. The company made a hefty provision in the June quarter, but we fear that this could be insufficient if the cases continue. Fines of this magnitude have the potential to develop into a constant drain on cash.

The company also burned through cash in the last quarter due to a sudden drop off in deferred merchant bookings, and the interest coverage ratio was barely above 1.

Although the above negatives paint a bleak picture, there are many positives to the stock as well. Expedia has a strong market position, extensive offerings and an attractive balance sheet. Additionally, international initiatives, cost control measures and a favorable online advertising market are expected to play a key role in the growth of both revenue and earnings.

We expect the stock to continue trading in the current range over the next three to six months.

Zacks Investment Research

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