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In my article, Sohu: Underappreciated Company in the Midst of Brand Reinvention, I pointed out that one of the reasons why Sohu.com (SOHU) is underappreciated is the lack of awareness and familiarity North American investors have with Sohu’s product offerings. Like Sohu, I believe that Ctrip.com (CTRP) is also underappreciated by investors based on the company’s industry leadership and growth potential, partially due to lack of familiarity investors have with CTRP’s products. As readers will see later in this article, one of CTRP’s competitive advantages lies in its customer service, which is similar to a company's brand equity in that it is difficult to quantify. In this article, I will attempt to give investors a deeper look at China’s leading online travel agency (OTA), Ctrip.com.

Ctrip.com (CTRP) is offers hotel reservations, airline tickets and packaged tours. The company has a market cap of approximately $6 billion and is trading at 28x FY2011. CTRP could be an attractive investment for the next 5 to 10 years due to China’s continued economic growth, the structural shift from export-driven to a more consumer-driven economy, the company’s competitive position within the OTA industry, and a solid management team.

From 1999 to 2009, China’s 10% GDP growth has created a middle class consisting of between 100 million to 250 million people. According to the National Bureau of Statistics, per capita urban household disposable income grew at a CAGR of 11.4% to $2,514 while rural household incomes grew at a CAGR of 8.8% to $754. The combination of strong GDP growth and rising disposable income, coupled with the government’s effort at boosting domestic consumption by adding public holidays, has increased the number of domestic tourists from 719 million to 1.9 billion while total travel expenditure increased from $41 billion to $185 billion over the same period.

Aviation infrastructure also saw nationwide expansion. The number of civil airports in China increased from 142 to 175 over the past five years, and the Civil Aviation Administration plans to have more than 230 airports by 2015 under the 12th Five-Year Plan. Air passenger volume increased at a CAGR of 14% from 67 million to 267 million over the past ten years and is expected to grow at a CAGR of 13% over the next five years.

The hotel industry also capitalized on the growing travel industry by increasing the number of hotels to meet the leisure and business demand. According to the National Tourism Administration of China, the number of star-rated hotels doubled to 14,099 from 1999 to 2008. Over the same period, the number of star-rated hotel rooms tripled to 1,591, representing a CAGR of 13.1%.

According to the Boston Consulting Group, China’s tourism industry is expected to grow at 14% per year over the next 10 years, driven by increasing leisure and business travel demand. The evolution of the industry will most likely follow the path of the US tourism industry in that growth in the airline, auto, and railroad travel sectors mirrors that of the US in the 1950s, 1910s, and 1940s, respectively.

China’s tourism industry is still very different from that of the US and still has significant future upside (see table below):

China

US

General Information

35% of online payment by credit card

Universal adoption of online payment using credit card

35% of reservation via online

~100% reservation via online

Oligopolistic Market

Multiple Competitors

Hotels

Major hotels accounts < 10% market share

Major hotels account ~ 50% of market share

Lack Global Distribution System (GDS)

Has fully operational GDS

Airline

Regulated by the government

Deregulated

Emergence of E-Ticket

E-Ticket mostly used

Tickets issued by travel agents

Tickets issued by airlines

Packaged Tour

New concept.

Already exist

Age group

25 – 50

All age group

Corporate Account

New concept

Already exist

Like other “non-strategic” industries, such as technology, media, and education, China’s travel industry is highly fragmented and competition is intense. There are over 20,000 online and offline travel agencies, the majority of which are local mom-and-pop size shops. None of these agencies has more than 5% market share, which makes room for industry consolidation.

CTRP focuses on online travel services and dominates the OTA market with 56% revenue share. Other competitors within the OTA market are eLong (LONG) with approximately 10% market share; this space is also partially owned by Expedia (EXPE), Mango City with 6%, and the others occupying the rest.

CTRP offers hotels and flight information and reservations, through its website www.ctrip.com and customer service centers. In addition, the company offers packages and guided tours that include transportation and accommodations. CTRP covers 100% of 5-star hotels, 90% of 4-star hotels, and 50% of 3-star hotels in Tier 1 and 2 cities. Approximately 75% of hotel operators guarantee room allotments for CTRP. As of the company's most recent quarter, 41% of the revenue came from hotel reservations, 39% from airline ticketing, 12% from packaged tours, while corporate travel and others made up the rest.

CTRP prides itself in understanding the needs of its customers. Unlike in the developed countries where people take customer service for granted, customer service is not well emphasized in China, and CTRP is determined to change that. CTRP books most of its orders through its call centers, which house over 5,000 sales representatives. The efficiency of the call centers is the key to the company’s underlying success. A caller usually gets a live representative on the phone in less than 30 seconds and has the booking done in less than 3 minutes (new customers could take longer).

The emphasis on providing the best customer service for each individual traveler creates a good user experience, which drives word-of-mouth and builds CTRP’s brand. The company then leverages its growing customer base to negotiate hotel room allotments with hotel operators and expand its product offerings. The increase in brand awareness and products attracts additional users, resulting in a virtuous cycle. Last year, CTRP started a new call center in Nantong, expanding its total headcount by 15,000 to continue its focus on customer service.

CTRP’s management is a critical component of the company’s success. The company was founded by Mr. James Liang, Mr. Ji Qi, and Mr. Neil Shen in 1999. Prior to Ctrip, Mr. Liang was head of ERP consulting at Oracle China; Mr. Qi was a local entrepreneur; and Mr. Shen was Head of Debt Capital Markets for China at Deutsche Bank. Mr. Fan Min, the fourth co-founder, joined the team after CTRP acquired Shanghai Travel Services in 2000.

Because of their overseas education and previous experience in multinationals firms, the management was influenced by data-driven decision making processes based on Management Information Systems. CTRP was keen on improving its technological infrastructure and it has considerable technological superiority over its smaller rivals.

In 2003, CTRP incorporated Six Sigma methodology, the first Chinese company to do so. The company refined staff training manuals, improved internal training, and incentivized employees. They also set up 34 quantifiable key performance indicators for their call centers and average time per call was reduced from 240 seconds to 180 second as a result.

Management’s entrepreneurial success in CTRP led to other business establishments by Mr. Qi such as Home Inn (HMIN), founded in 2001 and 28% owned by CTRP and its founders, and Hanting Inn (HTHT), founded in 2005 and 65% owned by CTRP and its directors. CTRP’s focus on building strategic stakes in budget hotel chains highlights management’s ability to be ahead of the market. For example, when Home Inn was established with 100 hotels, Mr. Min planned a back-office infrastructure for 800 hotels, which was 4 to 5 years ahead of the competition. Consequently, when budget hotels in China started to gain traction, HMIN’s competitors faced capacity limitation, which allowed HMIN to expand and become a leading budget hotel brand in China. Management’s ability to think two steps ahead of the market is an indication that management is capable of identifying industry trends and capitalizing on the opportunity through sound execution.

CTRP is currently trading at 28x FY 2011 earnings, 24x EV/EBITDA, and approximately 1x PEG. Below is a comp table with Ctrip and several OTA pure plays:

Mkt Cap (mm)

P/E

EV/EBITDA

EV/Total Sales

Priceline (PCLN)

25,039

23x

16x

6x

Expedia (EXPE)

7,890

15x

7x

2x

eLong (LONG)

700

40x

-

5x

MakeMyTrip (MMYT)

728

73x

-

4x

CTRP

5,914

28x

24x

10x

All figures from Capital IQ and are based on FY2011E, except MMYT which is FY2012E

In 2Q11, CTRP reported $129 million in revenue (+20% y/y). Gross margin was 77%. Net income was $41 million (+12% y/y). Excluding share-based compensation charges, net income is $54 million (+20% y/y). Fully diluted EPS was $0.26, compared to $0.23 a year ago.

Strong booking volume drove sales from hotel reservations (+16% y/y) and air ticketing revenues (+13% y/y). Sales of packaged tours were up 62% y/y.

Cumulative customers jumped 31% to 13.5 million, which is less than 3% of China’s online population, indicating significant upside potential.

Management guided 3Q11 with 15 – 20% revenue growth, which is weaker than the Street’s expectation and spurred a selloff post earnings announcement. However, CTRP has a history of underestimating its forecast and has beaten its sales guidance by an average of 14 ppts over the past eight quarters.

Online transactions account for over 40% of CTRP’s total sales, compared to 30% last year. Online transactions are more profitable and scalable than call centers. A gradual shift towards online transactions is likely to improve margins by lowering operating costs. According to management, CTRP aims to generate half of its revenue from online transactions within the next few years.

Its quarterly results were solid despite a 20% revenue increase since it was compared to a higher base from last year’s Shanghai World Expo. In addition, the recent floods in China also had a negative impact on sales growth. However, I believe that we will see more favorable comparisons starting 4Q11 or 1Q12.

On the balance sheet, CTRP has $611 million in cash and no debt.

There are several areas that CTRP can develop to continue its growth by focusing on outbound flights and hotel bookings, corporate clients, travel-related information, railway tickets and group buying.

Currently, all of CTRP’s revenue is derived from services in China. However, this distribution is likely to change in the future due to the population's increasing wealth and government relaxation that have spurred the incidence of Chinese traveling overseas. Last year, the National Tourism Agency estimated that there were 51 million Chinese traveling overseas, compare to 10 million in 2000.

To capitalize on the improved cross-strait relationship with Taiwan in 2010, CTRP acquired the Taiwanese OTA EZ-Travel. The number of tourists between China and Taiwan has increased from 400k in 2008 to an estimated 1 million in 2010. CTRP also acquired a 90% stake in Hong Kong-based WingOn Travel to expand product offerings and gain market share in Hong Kong and possibly the US and Europe. In 2Q11, both acquisitions contributed 4% of the company's annual growth and 40% sales growth in packaged tours, according to management. CTRP has a strong relationship with many international carriers and hotel operators, and should benefit from overseas growth.

Corporate travel is another attractive area for growth in that corporate clients are less price sensitive than leisure travelers and this segment is becoming a key catalyst for CTRP’s future prospects. By targeting customers from both large corporations and SMEs, CTRP has surpassed American Express (AXP) to become the largest corporate travel services provider in China. Over the past three years, corporate travel revenues have grown at a CAGR of 40%.

Back in January, CTRP launched Lvping.com, which is similar to TripAdvisor, a unit of Expedia (EXPE) that offers hotel reviews, travel blogs and forums. Lvping.com is likely to create good user experiences and stickiness for CTRP users as they seek travel experiences and advice from other travelers. Lvping may also attract travel service providers that wish to advertise their travel services on Lvping.com. This would generate new sources of revenue for CTRP. Lvping could add value to CTRP in similar way as TripAdvisor, which constitutes 10% of Expedia’s profits and has a 50% margin.

Railroads have been and will be a major transportation tool in China and CTRP should consider expanding its railway ticketing services. CTRP recently invested in 99pto.com, an OTA that specializes in railway tickets, and offers high speed railway tickets in four regions, including Shanghai, Jiangsu, Zhejiang, and Anhui. Unlike airline ticket sales, in which CTRP generates commissions based on price, railway ticket sales are fixed with an ordering fee and a shipping fee. Because this service is in a testing phase, CTRP should not experience any significant financial impact from it in the near term. However, I believe that railway ticket sales could be a major component of CTRP’s revenue in the future because there are approximately 1.4 billion railway passengers in China compared to only 267 million airline passengers, allowing CTRP to sell in greater volume.

Finally, CTRP could expand its deal publishing/group buying-model which is similar to that of Travelzoo (TZOO). A positive sign: CTRP’s group buying service for hotels is starting to gain traction. As of 2Q11, over 100 participating hotels are offering group discounts via CTRIP. Additionally, CTRP partners with 19,200 hotels, of which 75% providing guaranteed room allotments to CTRIP. CTRP could also expand its product offerings for the group buying program that includes airline tickets, tour packages, dining, nightlife, and cruises.

Many investors cannot fully grasp CTRP’s significance partially due to their unfamiliarity with the company’s product offerings and customer service, and therefore are limited to its quantitative aspects, such as financials and ratios. But in order to fully appreciate any company’s growth prospects, it is essential to understand both the quantitative and qualitative aspects before making an informed investment decision.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Ctrip.com: Industry Leader With Promising Growth Potential