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Casey Hoerth
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Contributing columnist for Real Money and BA in History from Bemidji State in Minnesota. I went on to learn Chinese at National Taiwan University in Taipei. I worked in mortgage sales at Countrywide and Bank of America until 2010 when I decided to relocate to Taiwan.
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  • Ctrip - Vast Upside, But Shallow Moat

    Ctrip - Vast Upside, But Shallow Moat

    Ctrip's recent earnings announcement was more of the same trend: continued impressive revenue growth outstripped by even higher growth in expenses. The ADR shares hit a late July low of $12.48 and have since recovered to over $20.00 but have since dropped a bit in the last week. Although there are serious headwinds and the trailing twelve month earnings are back up over 20, I still believe that Ctrip could be a calculated risk worth taking.

    (click to enlarge)

    Ctrip is the largest travel agent in China with subsidiaries in Hong Kong and Taiwan with a total market cap of about $2.7 billion. One of the reasons I like Ctrip is because I have used it when I lived in China and I felt there was a lot of good sentiment towards the company among Chinese travelers. (This was 7-8 years ago) There's no doubt that Ctrip is in a market with enormous potential, but most importantly its management is long tenured and has a history of responsible actions.

    The Pros

    One thing I learned from living in China is how much Chinese people love to travel. At the time I didn't quite realize one of the reasons is that those with money to burn have little else to do with it. Real estate prices are prohibitively high for most. The financial markets leave little avenues for the middle class. There is no bond market that I know of for savers to get a return, and it almost goes without say that nobody trusts the stock market! I believe this diverts a lot of middle class money into travel among other things.

    Despite the fact that China's growth has been hot for over two decades, the Chinese travel market is still in its early innings. This is because consumption and wages have been held down in the earlier stages when Beijing was interested mostly in keeping China an export-driven economy. Of course, that has been changing recently. Wages and consumption, which is what the travel market is levered to, are generally outpacing even higher inflation rates. As wages go up, the travel market and Ctrip's earnings will go up in greater proportion.

    Ctrip, like a lot of Chinese technology companies, has very little debt. This might not be out of choice! Bank loans are often only accessible for state-owned and well-connected companies. Nonetheless, Ctip's $630 million pile of cash with only a little debt is reassuring. It can fuel buybacks and minor acquisitions. In fact, in the last couple of years they've done both.

    The Cons

    First of all, Ctrip's 12-month trailing PE is still pretty high. As of today, it stands at 22.5 and unfortunately pays no dividend.

    Last year, Ctrip accounted for 47% of China's online travel market. They now account for only 41%. Market share has stopped declining from last quarter, however, likely due to its coupon and promotion campaign. However, this has eaten into the company's margin, as we will see.

    Source: China Internet Watch

    What has especially worried investors, however, are the vastly contracting margins which have pressured earnings downward. In the latest earnings release, operating margins were down to 16% from 31% last year! On the surface that seems very, very daunting! Is Ctrip having a problem controlling expenses? Are they getting their lunch eaten by the other guys? What the heck is going on?

    The declining margins have three contributing factors: higher wages, head count and expenses, promotions and discounts, and finally increased money for product development. Lets itemize them and take a look at the impact of all three. Total expenses have increased by about 253.4 million RMB.

    • Sales and marketing expenses have increased to 303 million RMB from about 174 million twelve months ago. An increase of 129 million RMB. This accounts for 51% of the expense increase. This increase is largely due to increased competition, a bad thing for investors.
    • Product development expense has increased to 243 million RMB from about 161 million twelve months ago. An increase of 82 million RMB. This accounts for 32% of the expense increase. I would classify this as a "good" increase.
    • Administrative expenses have increased to 151 million RMB from about 108.6 million twelve months ago. An increase of 42.4 million RMB. This accounts for 17% of the expense increase. This is due to rising wages and increased headcount, also a "bad" increase for investors.

    This is significant when looking at Ctrip's return on Equity and Assets. In 2011, return on equity and assets were 16.38% and 11.49% respectively. For me, this is an acceptable ratio and a positive reflection on management's effectiveness. Therefore, their investments in product development, mainly expanding coverage to more and more hotels, is a move that I can trust. We want a company with a higher return on assets and equity to use earnings to fund growth.

    The remaining 68% of increases, especially the 51% due to promotions and discount, however, are indeed worrisome. As a Graham-inspired investor, amateur as I may be, I look for companies with an economic moat of competitive advantage, brand name, customer loyalty or at least a barrier to entry.

    And believe me when I say that travel agents in China struggle to have any of those! Having lived there and here in Taiwan, I can confirm that Ctrip competes with not only increasing large-scale competition with the likes of Taobao, Tencent and Qunar, but also hole-in-the-wall travel agencies. There is almost no barrier to entry. Also, Chinese consumers seem to have no problem switching agents on a whim. There seems to be little brand loyalty here. This is the biggest concern for investors and the best argument for Ctrip bears. It is a valid one.


    I figure Ctrip management knows about this. In the short term, they are combating this by offering pricing and promotion. In the long term, they are trying to build a competitive advantage by having a bigger footprint and wider array of hotel deals than the others. I believe management can do it. but I remain skeptical and will keep a sharp eye on return on assets and equity to monitor effectiveness.

    In addition, they are acquiring luxury package travel companies (HH Travel) as well as Hong Kong (Wing On Travel) and Taiwanese (EZ Travel) agencies. I believe in all of these acquisitions. All three have been small and measured. The Wing On stake was bought for US $88 million. While the other two were for undisclosed amounts, they couldn't have been much more than the first. All three acquisitions serve Ctrip's long term goal of having a unique value offering for Mainland travelers.

    Management has a track record of effectiveness. The company is run by its founders, which is a good sign. However, I can see the bears' case and am concerned about the overall market despite its growth. There is no economic moat to speak of. The bottom line is, we really don't know what the Chinese travel market will look like five to ten years from now.

    I believe Ctrip's current market share of 41% could continue to drop given all the new competition. However, I would hope that in five years it still has a very significant piece of a much larger travel market pie. If that is the case, Ctrip investors will be rewarded handsomely for their patience.

    I have decided to hold onto my shares of Ctrip despite the capital loss and long-term concerns because I believe that the management is great and knows more about the travel market than these newcomers. In addition, it is comforting to see that the stock has created a bottom of some $12 this past July. I will be closely monitoring return on equity and asset metrics. A large, sustained drop in those metrics in 2012's annual report would cause me to seriously reevaluate my thesis.

    What do you think about Ctrip? Am I missing anything important?

    Disclosure: I am long CTRP.

    Nov 18 12:09 AM | Link | 2 Comments
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