The Amazing Race 14, Episode 9 (Online hotel discounts)

Bangkok (Thailand) - Guangzhou (China) - Guilin (China)

The most conspicuous feature of the last few broadcasts of The Amazing Race 14 has been the seemingly endless repetition of the same Travelocity.com advertisement for “Hundreds of hotels under $100”.

Is this for real? Is it really such a great deal? And why are online travel agencies focusing so much of their advertising lately on hotels (and on hotels at this particular price point)?

Yes, hotel discounts through online travel agencies, in general, are currently for real, and a good deal — although they are nothing unique to Travelocity.com, and although Travelocity.com isn’t usually the place to find the lowest price for any given hotel.

To understand why, and why the big advertising push, requires some background in the workings of the online travel industry and the history of online hotel bookings:

Sales volume doesn’t necessarily make for profits, if the margin for the retailer (the difference between retail and wholesale prices) isn’t enough to cover the retailer’s costs. That was the problem for online travel agencies like Travelocity.com, Expedia.com, and Orbitz.com, which grew to billions of dollars a year in sales, mainly of airline tickets, at the same time that airlines were eliminating or drastically reducing commission payments to travel agencies.

Travel agencies’ fees of US$5-10 for each ticket purchased online weren’t (and still aren’t) enough to cover their huge marketing and technology costs, not to mention the growing cost of providing even minimal post-sales customer service. Only a continuous flood of dot-com investment money could — and for a time did — cover their losses. That ended, though, with the “dot-bomb” collapse of the stock market bubble in 2000-2001. By 11 September 2001, travel (which had gotten a large but temporary boost from dot-com business travel) was already in decline. Despite their growing market share, online travel agencies were rapidly burning through the remaining reserves of cash they had left from their stock sales.

Surprisingly, rather than being put out of business, online travel agencies first became profitable as a direct result of the (further) decline in travel after September 11th, and the desperate situation in which that placed hotel owners in particular.

Before September 11th, online travel agencies sold (and advertised) primarily airline tickets. As a profit center, though, sales of airline tickets at published fares (prices set by airlines) are at best neutral to a travel agency’s bottom line. More often they are a loss leader, whose cost is accepted only as a marketing expense for other products and services. When all of their expenses for customer service, etc. are factored in, mainstream online travel agencies like Travelocity.com and their competitors sell published-fare airline tickets below cost in order to get you to book your accommodations through them.

If they thought they could get away with it without alienating too many potential hotel bookers, most travel agencies — online or offline — who sell airline tickets at published fares would probably prefer to sell you an airline ticket only as part of a package, or in conjunction with a hotel booking. That’s why they put such emphasis on trying to get you to book bundled travel services, rather than pricing different services (like airfare and hotels) separately.

That doesn’t mean you can’t sometimes save money by buying a travel package. Airlines, hotels, and other suppliers of travel services often give travel agencies and tour operators (both online and offline ones, it’s important to note) lower prices for services on condition that those prices be used only for constructing packages or bundles of services sold for an inclusive price, and not sold for separate one-off sale.

Why would suppliers offer lower wholesale prices “for construction purposes” like this? As long as the prices of components aren’t itemized, packaging keeps both consumers and competitors from knowing just how deeply any given travel service provider is discounting. Bundling of services from multiple suppliers serves the suppliers’ goal of price opacity. Equally important, it serves the agency’s goal of opacity: packaging makes it impossible for either consumers or suppliers to know how much the agency has marked up the total price of the package.

Instead of selling products or services at prices set by suppliers, and having their margin limited to either a publicly-disclosed transaction fee (typically limited by competition to an unprofitable minimum) or a commission fixed by the supplier, packaging and its inherent price opacity permits a travel agency or tour operator to set its own selling price and thus, more importantly, to set its own markup.

This system of pricing and sales based on an opaque markup set by the agency, rather than a commission set by the supplier, or a transparent agency fee, is called the “merchant model”, because in this type of sale the agency is the “merchant of record” who processes the sale, and thus whose name appears on the credit card charge receipt and statement. As the merchant, the agent collects the full payment from the customer, pays a contracted wholesale net price to the supplier(s) of travel and other services, and keeps the balance of the markups its profit, rather than having the supplier collect the full payment and remit a commission or fee to the agency, as had traditionally been the system.

Among the important but little-noticed implications of the “merchant model” are that (1) it subjects the agency to many state consumer protection regulations governing tour operators (most of which don’t apply to entities that function solely as suppliers’ agents), and (2) it makes the agency liable, as merchant, for the actions of travel suppliers, instead of the agency being merely an agent for the supplier. In the merchant model, hotels, airlines, and other providers of travel services are subcontractors of the merchant, for whose fulfilment of the contract the merchant (i.e. the agency) is responsible. Online travel agencies may try to evade or disclaim their responsibility, but the bottom line is this: The company against whom to request a credit card chargeback, or to make a claim against in small claims court if your chargeback is denied, is the company whose name appears on your credit card statement as the merchant.

But I’m getting ahead of myself. Online travel agencies invested in developing the technical ability to sell dynamically generated packages (airline ticket + hotel+ car rental, for example, for an inclusive, non-itemized price generated on the fly for your specific trip) only after the merchant model had proven itself, through merchant-model hotel bookings, as online agencies’ path to profitability after 11 September 2001. Merchant-model hotel bookings proved to be the killer app, or at least the first killer app, for online travel agencies.

Why hotels and not airline tickets? After all, airlines and travel agencies already had a well-developed (offline) system of merchant model airline ticket sales, in the form of so-called consolidators . But consolidator airfares were, until recently, limited to international routes, and the first wave of mass-market online travel agencies in the USA dismissed international travel as too small a niche to bother with, at least initially. For this and other reasons, mainstream online travel agencies in the USA largely failed to recognize the potential market for consolidator (merchant model) airline ticket pricing and sales.

(There are online agencies in the USA that specialize in international and consolidator tickets, but they remain smaller niche companies. Some of the largest online travel agencies in other markets, however, such as eBoookers.com in the UK, have made consolidator airfares their core business.)

A dip in demand is, in any event, more of a problem for a hotel than for an airline.

An airline can choose not to renew expiring leases for planes in its current fleet, and not to exercise options to purchase new planes. It may be able to postpone deliveries of new planes, or sell its planes or its slots in aircraft manufacturers’ delivery schedules to other airlines (perhaps in other regions of the world, where demand is growing). As a last resort, it can minimize its operating costs by grounding unneeded planes, or even mothballing them.

Hotel owners don’t have the same options as airlines. Some motels can be (and have been) converted to rental housing, and some hotels can be (and are being) converted to condos. But you can’t relocate a hotel, and it’s more difficult and costly to mothball a hotel than to park an unused plane in the desert. Fixed costs (mainly real estate) are a much larger fraction of total expenses for a hotel than for an airline, while marginal operating costs (such as fuel, skilled labor, airport fees, etc.) are proportionately greater for airlines.

When demand for travel goes down, airlines can do more, more quickly, to adjust capacity to demand and thus to maintain prices. And below a certain price point, it makes no sense for them to sell tickets at all, even if seats are empty. (Last week JetBlue Airways was offering transcontinental tickets for US$69 one way, including taxes and fees. I’m surprised that would even cover the marginal cost of the extra fuel required to carry an additional passenger that far.) Hotels are more likely to be stuck with a glut of empty rooms, but relatively low marginal costs to service each additional guest. So the least costly choice for a hotelier in hard times may be to take in guests, even at rates barely above marginal cost, to cover the cost of remaining open and to at least slightly offset the carrying cost of the real estate until times improve.

This is the situation that hotel owners found themselves in after September 11th. They were willing to accept much less than their regular rates if the only alternative was for rooms to remain empty, but anxious not to reduce the prices (or the expectations for future prices) paid by those still willing to pay as much as ever, or at least something close to their previous rates.

Online travel agencies seemed to offer hotels a way to market their “distressed inventory” of empty rooms to new customers, at fire-sale prices, in a way that would generate incremental revenue for the hotels without diverting their traditional higher-paying customers (as the hotels would have if they had openly cut their rates across the board). Hotels offered online agencies their lowest net wholesale prices ever, and let the agencies charge whatever they could get, as an incentive for these agencies to fill as many rooms as possible.

Hotels authorized these rates, and at least covered their marginal costs, but the real winners were the online travel agencies. The wholesale rates that hotels set were so low that the “merchants” in the merchant model were able to mark them up by 25%-40% (compared with traditional agency commissions of 10% to at most 15%) and still undercut the rates being offered by hotels themselves or though other marketing channels. Since 11 September 2001, online travel agencies revenues from the markup (not the wholesale price) on merchant model hotel sales have been measured in billions of dollars a year.

Microsoft spin-off Expedia.com become profitable sooner than Travelocity.com because it already owned a merchant model online hotel booking company (Hotels.com), and was quicker to refocus its main Expedia.com Web site from airline tickets to merchant model hotel bookings. Travelocity.com, a spinoff from American Airlines, was slower to move away from what it saw as its core airline ticket business and its commission model hotel bookings.

Since then, Travelocity.com has refocused on the merchant model, especially through dynamic packaging. This time around, they are determined not to miss out or be left behind by Expedia.com in the rush of online travel agencies to profit from hotel discounting. Hence the current saturation advertising for Travelocity.com as the place to find hotel discounts.

Hotel owners resented watching the online travel agencies get rich reselling their rooms at a markup, while the hotels themselves struggled to stay out of bankruptcy. But hotels couldn’t afford to raise their wholesale room prices to the agencies, or opt out of these marketing programs, lest they lose even the bottom-feeder business to competing hotels that had just as many empty rooms.

The high markup on merchant model hotel bookings, a direct result of the desperate financial situation of many hotel owners after September 11th, was the financial windfall that made online travel agencies profitable — and hugely so — for the first time. Once the first agencies showed what a gold mine merchant model hotel bookings could be, others began to mimic their focus on them, and to expand the merchant model to travel packages and other services.

Agency margins on merchant model hotel bookings declined as people began travelling again and the economy recovered. But they remain much higher than agency hotel commissions, and online travel agencies haven’t forgotten the lessen.

When demand for travel crashed again with the current economic crisis, online travel agencies were quick to see in other travel companies’ distress the opportunity for a potentially even larger windfall from hotel bookings than they got after September 11th. “Merchant’ model” hotel bookings can be hugely profitable for the merchant, even when the hotel is barely covering its marginal costs. And the more distress for hotels, the more “distressed inventory” of otherwise unsold rooms for those merchants to sell. Online travel agencies have been quick to negotiate lower wholesale rates with hotels, and equally quick to advertise them (at suitably profitable markups) — as they’ve been doing so heavily during broadcasts of The Amazing Race 14 . Since this is the type of sale on which they earn the highest profit margin, they have every reason to make it the priority in their ads, even if regular viewers are probably sick of those ads by now.

The race will be in China for a couple more episodes. So I’ll have more in my next installment about current China travel issues (including hotel and visa advice), as well as more on what sorts of hotels are being discounted most heavily and a directory of my favorite Web sites (not just, and not primarily, Travelocity.com) for finding the best deals on accommodations in China and in other parts of the world.

Stay tuned.