I sold Ctrip.Com International (CTRP) out of my Jubak Picks 50 portfolio back on January 18, because I thought that the company’s operating margins were eroding as it had to spend more to fend off competition. (The stock is down 40.1% from January 18 through the close on December 5.)
That’s exactly what the company reported on November 14 when it released third-quarter financial results. Operating margins for the third quarter of 2011 fell to 31%, from 38% in the third quarter of 2010.
And you didn’t have to look far to figure out why. Product development costs rose 31% from the third quarter of 2010 and 18% from the second quarter of 2011. Sales and marketing expenses climbed 39% year to year and 23% from the second quarter. General and administration expenses grew 37% year to year and 13% from the second quarter.
But what I hadn’t anticipated was that Ctrip.com’s business model would leave it so vulnerable to rising labor costs in China. There’s a lesson here for investors in all of China’s stocks.
Ctrip.com is China’s biggest online travel agency. To many, of us that conjures up images of ticket sales through Internet sites without much, if any, human intervention.
But in reality, Ctrip.com gets 50% of its travel bookings through call centers, and call-center staff account for half of the company’s 13,000 employees. Having all those employees means that as wages have climbed in China, so have Ctrip.com’s labor costs.
And that has eroded Ctrip.com’s gross margins to 76.8% in the third quarter, from 78.3% in the third quarter of 2010 and 77.2% in the second quarter of 2011.
If you can remember back to your time in Accounting 101, Ctrip.com subtracts costs like product development to get the income-statement line called operating margin from a larger number on the gross-margin line.
Gross margin is simply revenue minus cost of goods sold. Stuff like product development and general and administrative expenses then get subtracted from gross profits (gross margin as a percentage) to give you operating profits.
Given that wages in China are almost certain to keep rising over the next five years—the most recent five-year plan mandates a 15% annual increase in the minimum wage, and that should drive up wages for more highly paid workers as well—investors are looking at a significant long-term drag on Ctrip.com’s business model.
That wouldn’t be as much of an issue—after all, gross margins of better than 75% can absorb rising costs for quite a while—if the company didn’t face intense competition from Internet travel companies with less labor intensive business models.
Wall Street is projecting that Ctrip.com’s earnings growth will slow to just a bit over 4% in the 12 months ahead. If that’s right, even the trailing-12-month P/E ratio of almost 9 is too expensive.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares in Ctrip.com as of the end of September. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.