Ctrip 2Q2014: Short-Term Pain, Long-Term Gain

Summary

Ctrip 2Q14 beat top and bottom line, with outlook in line with consensus on higher investment in the broader OTA space.

Mobile growth a major positive, as it allows Ctrip to gradually wind down its obsolete call center operations.

M&A a more practical strategy rather than broader investments in OTA niche verticals. Continue to favor Tuniu on M&A potential. Remain cautious on Ctrip on higher investment.

Ctrip (NASDAQ:CTRP) reported a both top and bottom line that exceeded consensus. Consolidated revenue of US$ 278m (+38% y/y) was above consensus of $269m, driven by stronger hotel reservations (+47% y/y). EPS of $0.26 beat consensus by $0.02.

Strong top line and positive signs in mobile and margins

The strong topline growth was driven by the hotel segment, where revenue was up 47% y/y to $121m. Ctrip once again benefited from volume growth as hotel coupon continue to exert downside pressure, and I expect mid-single digit commission impact to continue throughout the year as eLong (NASDAQ:LONG) and Qunar (NASDAQ:QUNR) ramp up on their own promotional activities.

The positive out of the quarter was that 80% of the volume transactions was from online or mobile, compared with 60% a year ago. Total mobile transaction value more than tripled to approximately RMB 220m during the quarter. Moreover, half of the 200m accumulated app download (+60% q/q) was activated. As online and mobile account for greater number of Ctrip's transactions, I believe that Ctrip could eventually wind down its call center operations, as they pose a significant operating cost burden. The value behind a live service representative was tremendous during the pre-mobile internet days, but such value is waning as users can readily look up hotels and travel plans on their mobile devices, and change routes/destinations at their fingertip. Despite management's insistence that the call centers will become a critical part of the travel experience by offering after-sales services (i.e. flight change during a delay), I believe the value of the call center, along with its >4,000 staff, is gradually diminishing.

As Ctrip invests in its baby tiger program (see below), the company will be likely to incur increasing costs in terms of SG&A, so a gradual wind-down of the obsolete call center operation could offset some of the cost from the baby tiger program.

Finally, margins have stabilized on a q/q basis. I believe that it is an encouraging sign, but it is still too early to see whether margins have bottomed, as management clearly indicated that this year will be a year of investment, so we could see further downside risk to margins.

Baby tiger or throwing darts?

Ctrip is keen on pushing in its so-called "baby tiger" initiative, in which the company will invest in several new business segments ranging across the online travel vertical. For example, Ctrip is looking to expand into areas such as cruise lines, car rental, bus tickets, train tickets and even special ticketing for young student programs so it can nurture a loyal customer base at the university level.

This initiative could bear fruit if any or some of the baby tigers eventually gains a foothold in the specific vertical, but I do not expect any of the baby tigers to succeed in the near term, as the investments are still in their early stages. What's more concerning is the breadth of the investments Ctrip is willing to make, which I see is tantamount to throwing darts with the hope of eventually landing on the bulls eye. This initiative is pushing Ctrip's product development cost to 3x-5x that of its peers, with no certainty of market share gain, strong network effect, high volume or pricing power. Rather than investing internally, I believe the capital can be better utilized on proven businesses via M&A.

Tuniu (NASDAQ:TOUR) remains the most likely M&A candidate given that it already has an established relationship with Ctrip and its expertise in overseas packaged tour is complementary to Ctrip's overseas growth. At the end of the quarter, Ctrip expanded its air ticketing service by adding 70 international low-cost carriers, and is now working with over 160 international airlines covering over 3,600 cities in 220 countries. Ctrip's scale and Tuniu's customer base could create synergy, in my view.

Reiterating my cautious view on Ctrip going forward. At 51x forward earnings, the stock is expensive given the declining earnings outlook on higher investment (and potential M&A). I continue to like niche vertical player such as TOUR given its exposure to overseas travel and the potential of becoming a takeout target.

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