The Steep Price of's Pricing War

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Five years ago, Chinese online travel agency (NASDAQ: CTRP) was a rising star, a momentum stock that was blessed by a growing Chinese economy and the 2008 Beijing Olympics. American analysts continually recommended Ctrip, along with Internet search leader Baidu, as the premier ‘stocks to own’ as China became the second largest economy in the world.

Since that blissful heyday, the stock has dropped 20%, and short interest has risen to 17.6% as of this writing. Ctrip plunged 13% on January 25 - its worst decline since July 2010 - forcing the SEC to trigger a short sale restriction on ADRs.

What happened?

In short, became a textbook example of the perils of a prolonged pricing war. 

What is is China’s largest online travel agency, which offers similar services to Orbitz or Priceline (NASDAQ: PCLN) The company generates revenue primarily from hotel room and airline bookings. It also offers self-packaged and guided tours, which tend to be more popular in China than individually booked flights and room reservations.

It also has a partnership with Priceline, which allows it to mutually share search results. Priceline customers are granted access to Ctrip’s domestic offerings, while Ctrip customers can search Priceline’s database of international hotel rooms - powered primarily by its subsidiary,

Macro Growth

Analysts believe that China will surpass the United States as the world’s largest travel market by 2020. The market will be worth an estimated $277 billion, contributing to 22% of total global traffic. A third of the world’s travel spending will originate from the Asia-Pacific region.

In a sign of the times, Beijing Capital International Airport is now forecast to become the world’s busiest airport by the end of 2013, surpassing Atlanta’s Hartsfield-Jackson Airport, which has been the busiest transit hub since 1998.

Over the next decade, 20% of all commercial jets manufactured by Boeing will be delivered to China. That’s a lot of aircraft and a lot of air travel. So why is the market so bearish on Ctrip’s growth prospects?

The Foolish Fundamentals

Ctrip trades at 23.4 times forward earnings with a 5-year PEG ratio of 3.01. Those are remarkably mellow fundamentals for a former Chinese momentum stock. Let’s take a look at just how much its momentum has slowed over the past five years.

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CTRP PE Ratio TTM data by YCharts

That’s not to say that a loss of momentum is a bad thing. Baidu, for example, has grown fairly well into its current P/E of 24, in a similar “soft landing” trajectory to Google. But value needs to replace momentum. Otherwise it’s just a broken momentum stock without the fundamentals to hold it up.

That brings us to Ctrip's biggest problem - eLong (NASDAQ: LONG).

Enter the (Electronic) Dragon

eLong, Ctrip’s largest competitor, is majority owned by Expedia (NASDAQ: EXPE) and has a 7.9% share of the Chinese online travel market. Until recently, eLong had never been regarded as a serious threat to Ctrip, which controls 46.3%.

Let’s take a look at how Ctrip has held up against its primary domestic competitors over the past three years.

<table> <tbody> <tr> <td> <p><span><span><span><strong>Company</strong></span></span></span></p> </td> <td> <p><strong>Market Share </strong></p> <p><span><span><span><strong>3Q 2010</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Market Share</strong></span></span></span></p> <p><span><span><span><strong>3Q 2011</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Market Share</strong></span></span></span></p> <p><span><span><span><strong>3Q 2012</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em><strong></strong></em></span></span></span></p> </td> <td> <p><span><span><span>47.3%</span></span></span></p> </td> <td> <p><span><span><span>46.1%</span></span></span></p> </td> <td> <p><span><span><span>46.3%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em><strong>eLong</strong></em></span></span></span></p> </td> <td> <p><span><span><span>8.0%</span></span></span></p> </td> <td> <p><span><span><span>7.8%</span></span></span></p> </td> <td> <p><span><span><span>7.9%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em><strong>17u</strong></em></span></span></span></p> </td> <td> <p><span><span><span>2.7%</span></span></span></p> </td> <td> <p><span><span><span>4.4%</span></span></span></p> </td> <td> <p><span><span><span>5.3%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em><strong>114</strong></em></span></span></span></p> </td> <td> <p><span><span><span>6.7%</span></span></span></p> </td> <td> <p><span><span><span>5.0%</span></span></span></p> </td> <td> <p><span><span><span>3.9%</span></span></span></p> </td> </tr> </tbody> </table>


At first glance, Ctrip seems to have held up very well against its competitors - and it looks like it should be more worried about 17u - which nearly doubled its market share over the past three years - than eLong, which slightly declined.

But it appears that eLong has found Ctrip’s Achilles' heel - rebates. eLong introduced cash rebates for most of its listed hotels in 2010. These coupons led to a surge in room bookings on eLong - rising from 32% to 56% between the first quarter of 2010 and the second quarter of 2012.

This turnaround impressed Chinese Internet giant Tencent so much that it increased its stake in the company to 16% by purchasing $84.4 million in shares, making it eLong’s second-largest shareholder after Expedia.

A Clumsy Counter

Ctrip panicked, and introduced its own hotel rebate system in the second quarter of 2012 to regain lost ground. After Ctrip announced hotel coupon rebates in the second quarter of 2012, operating margins plunged from 40% (at the time of its IPO) to 19%. This led to an all-out pricing war against eLong that reduced both companies’ margins.

Despite that painful blow, Ctrip is about to introduce a cash rebates program for airline tickets as well - which will prolong its long and damaging price war against eLong. Airline tickets generate approximately 40% of Ctrip’s revenue - and rebates could sharply reduce net profit per sale with no guarantee of increased sales volume.

Margins would drop even more - possibly flatlining. Simply put, double the rebates means double the margin pressure. But Ctrip apparently believes this is a price it’s willing to pay to retain market share.

So far, Ctrip’s efforts have been futile.

eLong’s third quarter earnings showed continued strength, with hotel booking volume surging 70% on a 24% revenue increase, handily topping Ctrip’s 40% gain in hotel bookings and 11% revenue growth.

Ironically, Ctrip’s user base grew at a faster rate than 2011, but it’s making so much less profit per customer that the gain is fairly pointless. In a note to investors, Citigroup analyst Murzh Li stated, “Ctrip’s additional price cut is roughly 10 percent of ticket prices, which couldn’t be covered by 4 to 5 percent of commission rates. Therefore, Ctrip would lose money on each discounted ticket sale.” Li maintains a target price of $11.40 for Ctrip’s ADR shares.

The Bottom Line

Ctrip is scheduled to report its fourth quarter earnings on Jan. 31. Expectations are understandably low, since its profit margin was sliced in half last quarter, dropping from 33.4% to 16.5% in a single year.

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CTRP Revenue TTM data by YCharts

In my opinion, Ctrip and eLong are playing a dangerous game. Investors should stay clear of both of these combatants until the pricing war has ended, and enough blood has been shed.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends International and The Motley Fool owns shares of International and Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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