Ctrip Priced At Greater Than Perfect In An Inherently Risky Chinese Market


Q2 earnings were disastrous and solidify the bear thesis of lack of scalability predicated by declining profitability despite strong sales growth.

Given the recent extreme margin declines exposed in the Q2 report, the stock should be re-rated lower as growth comes at a very high cost and is unsustainable.

Recent deal with Priceline was initially received very well by the market and took the stock to new highs, but the inability to hold the gains signals a top.

On July 30 Ctrip (NASDAQ:CTRP) reported Q2 earnings which demonstrated a YOY operating margin decline of a whopping 1100 basis points to a measly 5%. Even worse, operating income was down 54% compared to the same period last year. The stock now trades at a forward PE of about 100. And that is using favorable analyst estimates. During the Q2 call, management insisted that the earnings and margin weakness is simply a blip as the company pursues breakneck growth. While sales are up an impressive 38% YOY, marketing spend was up 77%. So clearly we know that if you spend more money on advertising you will make more sales, but if you spend so much that you are not seeing a viable return on the incremental spend, then the model must be deemed unsustainable. That is where Ctrip is right now, overpaying for growth.

Management says that it is "achievable" to get to the 20%-30% operating margins that it would need to sustain its valuation. Let's take the 20% lower end of that range as 30% is just pie in the sky and let's use the FY2014 revenue estimate of $1.18B. A 20% operating margin would give Ctrip $236M in operating income this year. With the tax rate at 32% this quarter, that would leave roughly $160M in net income. At the current market valuation of the company of $8.92B, this would return a PE of about 56. Unfortunately for Ctrip, its operating margin is only 5%. I don't see any way it can get to 20% and even if it does, it will still be overvalued by all conventional metrics. This does not even include the inherent risk of investing in a Chinese company, as that should discount the valuation further.

I do understand the bull case and owned Ctrip only a couple years ago in the low teens when everybody hated it and all the other Chinese companies. No question that the company dominates its market in China. Ctrip now claims that it is pursuing rapid growth to gain more market share fast. In fact, the word "growth" was used 56 times on the Q2, more than I've ever seen before. That concerns me. Ctrip asks investors to remain patient for profits and let the company simply generate sales at whatever cost necessary. This would be a reasonable explanation with the stock trading in the teens. However, at historic highs I would expect everything to be firing on all cylinders, including actually being able to make a reasonable amount of money to justify an incredible valuation.

Accordingly, there is really no evidence that Ctrip can improve its operating margins sufficiently to ever justify its current market valuation, even if you look several years out as an extreme optimist. For this reason, it should be re-rated. A more reasonable valuation puts the stock somewhere between where it is trading now and the low teens where it bottomed out only 2 years ago under extreme pessimism. What is ironic is that the same bear arguments from 2 years ago about low operating margins and lack of profits are still valid, yet the stock has somehow appreciated over 500% off its lows. It is funny how a simple change in sentiment can cause investors to overlook what was once considered vital metrics. However, allow me to explain why I think that Ctrip stock has topped out.

On August 7, sending the shorts into panic mode briefly, Ctrip announced that Priceline (NASDAQ:PCLN) will invest $500M in the company. It was a puzzling announcement as Ctrip has never historically done well with partnerships. Doug Young does a good job explaining Ctrip's checkered past with such deals. Also, Ctrip already has $1.7B in cash reported at the end of Q2, although the balance sheet is weakened by nearly $1B in debt. So why does Ctrip need this $500M? More specifically however, the stock shot up over 15% AH on the news on August 6, taking it over $70. Analysts rushed in to upgrade and praise the deal, with CLSA, Brean Capital and Oppenheimer leading the charge the following morning.

This was shaping up to be a historic day for Ctrip stock, one that would surely propel it to new heights. And it did, the stock hit as high as $68.20 on the short-lived euphoria before it fizzled out and tracked its way down to close below $66, which is well off its original $70+ AH highs on the news. Simply put, the market will not allow the stock to go any higher on this seemingly phenomenal news. I was short before the news broke and I remain short and much more confident now that it appears we are at or near a long-term top in Ctrip stock.

Up until now, Chinese stocks have been considered risky for simply being Chinese. Given the amount of fraud that has been uncovered among Chinese publicly traded companies, the risk is real and there should be a risk component to any Chinese stock that must devalue it accordingly. It concerns me that Ctrip management is suddenly being taken at face value when only 2 years ago nobody trusted them at all. Since mid-2012, we have now moved from extreme mistrust in Chinese companies to extreme blind trust. Extremes are never healthy and history tells us that a revision to the mean is likely in the cards. I expect the bottom to fall out of the Chinese tech bubble soon. Given the unsustainable valuation based on a business model that simply can't make a lot of money on new incremental revenue, Ctrip makes for a compelling short opportunity anywhere above $60.

Disclosure: The author is short CTRP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.