Two Ways To Make Tall Profits From A Short Position

• There are times when successful investors need to become willing to step beyond their comfort zone to take advantage of compelling opportunities.
• The problem with short side, sell analysis is predicting when a business’ performance will falter.
• A business that is already degrading at a rapid pace and is still priced beyond perfection.
• There are two excellent ways for investors to position themselves to profit from the decline that has already begun.

I want to start with a confession that is very important to the readers. I am not an experienced short-seller of stocks. I am a value oriented analyst and investor. The aversion that I have always had to short-selling stocks is you must be able to pick the market top and also have the timing right since you have to pay interest on the shares of stock that you borrow to sell short. I have seen stocks that appeared to me to be seriously overvalued stay that way for years and even enjoy huge price increases; increases that would have been enough to crush me had I been short the stock. For one of the few times in my life, I learned from what could have been a disaster without a huge amount of pain.

However, one of my stock screens that I run on a regular basis is designed to alert me as to the number of individual stocks there are in the market that are priced beyond perfection at a given time. I use this to help me quickly assess the degree of excessive optimism that might exist at a particular moment. Today, for some reason, I noticed that a business name I was familiar with was on the list. That business is Ctrip.com International, Ltd. (CTRP, Financial). Even though I knew I would have no interest in making an investment, I decided to take a bit of a closer look to see why it appeared on this particular screen.

Ctrip.com and its subsidiary businesses provide a full range of travel related services and corporate travel management products in China. These products and services include independent leisure packaged tour products that can be offered to individuals and groups with various means of transportation from self-driven to charter buses or cruises. The company also offers assistance with paperwork requirements and other value added services as in various types of travel insurance. While this might sound like a pretty simple function to most readers, keep in mind that China is not the United States and not everyone can simply go wherever they like whenever they choose and assistance with the process can be quite a value added proposition. Therefore, Ctrip appears to be a business that provides products and services that fill a real need for its customers.

Over the past several months, a great deal has been made in regards to the slowing economic growth in China. It makes perfect sense when there is a sluggish global economy and China is an export driven economy. It also follows that slowing economic growth would have a dampening effect on the demand for travel related services, for both business and pleasure. However, what my continued investigation into the current valuation of Ctrip revealed was shocking.

The business has been reasonably successful

Over the past five years, Ctrip has grown its revenue at an annualized rate of 32.58%. This is exceptional growth in sales over an extended period. However, the whole purpose of growth in revenue is to achieve growth in profits. In well run businesses, sales can grow at a faster pace than the other fixed expenses involved in operating a business and result in earnings that grow at a faster pace of percentage increase than the sales. When we see this occur, it indicates that management is focused on controlling expenses during growth periods and also highly concerned with maximizing profits for shareholders. Sadly, as illustrated by the chart below, that has not been the case with Ctrip’s profits.

While revenue growth has soared over the past 5 years, earnings have only expanded at an annualized rate equal to 56% of the growth in sales. This 18.29% annualized rate for earnings growth is less than I would like to see in relation to the sales growth but it is still a very impressive number and indicates the business has experienced strong success in the past. Also, the annual growth in free cash flow of 21.2% over this same period is really impressive.

This almost sounds like a business worth owning

Well, it “almost sounds like a business worth owning” but first impressions are not always correct. As the famous disclaimer goes: Past performance should not be construed as being indicative of future results. In the case of Ctrip, past performance is not even a good indicator of present results. For the year ended December 31, 2013, Ctrip earned $1.10/share, and increase of 37.5% over the $0.80/share earned in 2012. Unfortunately, it appears that is where the good news ends for the earnings performance.

Through September 30, 2014, the last quarter for which financial results have been reported, the trailing twelve months (TTM) earnings for the company are only $0.76/share or 31% below the 2013 earnings/share. Furthermore, the consensus 2014 earnings estimates from the 18 analysts covering the stock is a mere $0.27/share representing a stunning decline of 75% from 2013. Even if the most optimistic estimate of $0.71/share is used, the year over year decline will be 35%. This is catastrophic news for a business priced as a high growth stock.

Looking at the current year’s projected results predicted by the analysts covering this business, the picture doesn’t improve much. The average earnings projected by the 18 analysts providing earnings guidance is for $0.30/share in 2015, only an 11% increase from 2014’s expected results. These are not the kind of numbers investors expect from a growth stock investment and they can be expected to react accordingly.

As we look further into the future, the outlook does not appear to get much brighter for the company either. Projected long term earnings growth for the business is currently estimated at 8.18% annually over the next 5 years. This kind of growth does not in any way imply that the business is distressed in any way; it simply indicates a slow growth business that will achieve future growth that is likely to be closely aligned to the overall market.

It all boils down to valuation, present, future and fair.

Ctrip does not appear to be a bad or distressed business in any way. But successful investing is about buying assets that are either priced below their intrinsic value and waiting for them to become fairly valued or buying businesses with exceptional future prospects at prices that do not accurately reflect those prospects in the current price. This is where Ctrip actually presents an opportunity for me that is outside of my normal approach to investing.

Ctrip has a current valuation that is completely disconnected from any semblance of fair value but in a negative way. Rather than being undervalued with superb upside potential based on conservative performance criteria, Ctrip is valued at an obscene level as if current investors have completely overlooked the dismal TTM earnings performance and current projections for 2014 and 2015. This also completely ignores the projected long-term prospects for the business.

With a current share price of $46.75/share, Ctrip trades at a very aggressive P/E ratio of 42.5 times 2013 earnings. This would be an aggressive multiple for all but the strongest growth stocks in the market. However, as the analysts’ projections indicate, this is no longer one of the premiere growth stories in the market, it is not even much of a growth story at all. And, based upon the 90-day trend in earnings predictions over the last 90-days as shown in the table below, we should not have any firm level of confidence that the story will not continue to deteriorate further.

Based on the numbers shown in this table and the projected long term growth estimate of 8.18% currently in place for the business, a pure value investor such as myself might wish to assign a valuation of the earnings growth rate of 8.18 times the current year’s earnings of $0.30 or the TTM earnings of $0.27. That would produce an estimated fair value for this stock of between $2.20 and $2.50/share. Even if we were to double this valuation in consideration of the fact that the business does not appear to be at risk of insolvency, we would still wind up with a fair current value of $4.40 to $5.00/share. Even if we were to apply a P/E multiple of 18.58 times 2015 earnings (the same as the market assigns to shares of industry leader The Priceline Group (PCLN, Financial)), we would end up with a fair value estimate of $5.57/share. I have little doubt that Ctrip is a nice business and run in a fairly efficient manner; but, I would never even consider saying it deserves to be valued as highly as one of the great travel businesses of our day. It seems the market agrees with my assessment; but not in the way you might expect.

How does the market value Ctrip today?

On Feb. 13, shares of Ctrip closed trading at $46.75/share. This share price produces P/E multiples of 42.4 times earnings for 2013, 61.5 times the TTM based on September 2014 results, 173 times the projections for 2014’s earnings and 155.83 times projected 2015 earnings. Is there anyone in their right mind who believes there is a rational argument for this business to carry a P/E valuation 8.4 times greater than The Priceline Group, that could very well be the industry’s best business?

Where PCLN is expected to expand its earnings per share by 19.13% per year over the next five years, it is trading at a price to earnings growth ratio (PEG) of 0.97 based on 2015’s projected earnings. Simply compare this to the PEG of 19 currently being assigned to Ctrip and you will clearly see how excessive the current valuation of this business is. Ctrip’s PEG ratio is almost 20 times higher than PCLN’s. Even if Ctrip manages to expand its earnings at three times the projected level of 8% and the price did not move upward at all, it would take approximately 9 years for the earnings to reach the level required for the P/E multiple of 16.7 or a PEG ratio of 2 times the current estimate of the long-term earnings growth rate. This is not a stock that is priced for perfection, it is priced well beyond that expectation.

What catalyst could initiate a fall in the share price?

One of the aspects of short-selling that has always given me pause is trying to figure out how to “call a top” in a stock everyone seems to love. When a stock is priced beyond any reasonable valuation, how do we ever know that it will not just continue to be driven higher? This has always scared me. But not this time.

On September 30, Ctrip hit its 52-week high of $69.74/share and began to decline from there. While it might appear to the casual observer that has already fallen 33% in 4.5 months has been punished enough and must be poised for a bounce, the valuation metrics reveal otherwise. The level of the current decline has simply served to create fear among existing shareholders and push them closer to a decision to sell. As we move through the remainder of this year and 2016 and existing shareholders are forced to face the fact that the glory days are over, at least for a while, they will sell and that selling will force the price lower and generate more selling. Think back about 15 years and you might recall a stock called JDS Uniphase that fell from about $1,000/share all the way down to a low of $2.21 in 2009. Always remember, no matter how far a stock has fallen, the downside is still 100%.

There is an old adage in the stock market that you should never try to catch a falling knife. However, there is no old adage that you should not hop on top of a falling knife and ride it down. Again, I do not mean to imply that I think this company is going to go out of business; I just believe it is priced at an insane valuation and that the market has begun the process of correcting that error.

What is the current fair value of the business?

When it comes to businesses based in China, it can be a bit difficult to accurately assess true fair value as we must always be at least a bit skeptical of the numbers provided. Although, it does seem to be at least a reasonable assumption that the numbers provided will not be any worse than the reality; thus, making a sell-side analysis a bit safer than working on the buy-side.

However, just to be cautious and assure ourselves any error will be on the conservative side, we will assume that the earnings estimates for this year are off by 50% to the low side and will come in at twice the projected level of $0.30/share for 2015. I will also assume that the forward growth estimates are off by 50% and that earnings will grow at 16%/year over the next 5 years. And, just to add one more level of safety, I will assign a PEG ratio of 2 which is twice the level assigned to the industry leader PCLN. This criteria results in the following fair value estimate:

$0.60 X 16 X2 = $19.20/share fair value.

Keep in mind that this figure requires the doubling of every number used to achieve it and still produces a fair value for the shares that is 59% below the current price. If you simply use the actual projected earnings/share of $0.30 for 2015 times the projected long-term growth rate of 8.18%/year and assign the same PEG ratio of 1 as PCLN, the fair value estimate for the shares then declines to $2.45/share or 97.4% below the current price.

Final thoughts and actionable conclusions

If there is any way to calculate a fair value for shares of Ctrip that reveal it to be anything other than insanely valued at today’s price, I have not come close to finding it. Based on the price movement over the last 4.5 months, it seems the market agrees with me. The real question is, how do we best position ourselves to profit from the existing situation. Two prospects jump out at me.

The first possibility for profit is to simply sell the shares short in the market. To accomplish this approach, your brokerage account must be set up to allow short selling. With most brokerage accounts this is a pretty simple process and can be handled with a phone call and possibly filling out a form online. You broker would then “borrow” the number of shares you wish to sell short and sell them to a willing buyer in the open market. You will be charged interest on the value of these shares each month that the trade is open. In this transaction, I believe the safest approach would be to sell the shares short and use a 10% stop loss that is tracked outside of the market. My broker has automatic price alerts I can set that will send me an email alert based on price movements of specified stocks. I would then leave the trade open until there was a 10% move up in the stock price from its lowest level since I entered the trade. Once the shares broke $20, I would tighten my stop to 5% in order to protect my profits.

The second possible position could be opened by buying put options on the stock with a strike price of $40 and an expiration date of January 15, 2016. These options are currently priced with a bid of $4.20/share and an asking price of $4.80/share. I would not pay more than $4.80 for these contracts. Each option contract represents 100 shares of the stock so each contract purchased would cost up to $480 and would give you the right, but not the obligation to sell to the buyer 100 shares of Ctrip stock at a price of $40/share at any time between now and January 15, 2016. With this trade the potential downside risk would be the value of the options purchased or 10.26% of the current value of the underlying shares.

The breakeven point in the option trade would occur if the stock trades at $35.20/share between now and January 15th (the $40 strike price less the $4.80 price of the options). However if the shares fell to $30.40, these options would be worth at least $9.60/share ($40-$30.40) and the profit on the trade would be 100%. At that point, 50% of the position could be closed and the remaining options could continue to be held with none of your original capital exposed to any risk.

Both trades carry approximately the same percentage of risk as related to the value of the shares traded. The options trade has the potential of a higher percentage return but carries the additional risk of time decay as the expiration date approaches. I normally strongly advise against buying options on stocks because the probability of profit is normally in favor of the seller. However, in rare circumstances, such as this, they can offer compelling opportunities.

Most investors will never sell stocks short and I used to be one of them. However, when the opportunity is this compelling, I am willing to make exceptions to my normal practices and act according to the facts with which I am faced.