By John Zhang from seeking Alpha

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)

Summary
Spiraling costs indicate multiple risks and headwinds.
Search-to-revenue conversion rate is reaching saturation.
Qunar is operating the Baidu ZhiXin platform at a significant loss.
Qunar is significantly overvalued compared to peers.
Given key risks, deteriorating fundamentals and overstretched rally, Qunar is a strong sell.

Previously, I cautioned investors to stay away from Qunar’s shares as their parent company Baidu (NASDAQ:BIDU) was acting against the interests of public shareholders. Though Baidu’s control over Qunar (NASDAQ:QUNR) already poses key risks for shareholders, our criteria for a good short candidate includes having deteriorating fundamentals and downside catalysts. Hence, we examine Qunar’s operations to determine whether they are a potential short candidate.

Business Model

Qunar is essentially a third party platform that collates travel-related product listings from merchants. These commonly include hotel room bookings, plane tickets, transportation or tour packages. Think of them as the Kayak or Expedia (NASDAQ:EXPE) of China, operating in a less mature market.

The main source of Qunar’s revenue comes from their “pay-for-performance” services. Qunar takes a “charge-per-click” fee from merchants for every “qualified click” generated from their search results, text links or other products, on both mobile and webpage platforms. They also charge commissions on certain bookings on a “charge per-sale” basis. For billing, Qunar requires the majority of their P4P clients to deposit funds in advance from which they will deduct charges on an as-incurred basis.

In essence, the main drivers of Qunar’s revenues are web/mobile traffic, transactions/spending per user and commission rates.

Why The Spiraling Costs?

Though Qunar’s revenues have been growing strongly, ballooning expenses have far outpaced revenue growth, leading to a widening loss.

Expenses in every category has grown larger as a percentage of revenue, particularly sales and marketing and product sourcing expenses. Moreover, the fall in gross margins and the new marketing expense for the Baidu Zhixin platform adds more concerns to the list.

Sales and Marketing Expenses

A key concern is how quickly sales and marketing expense is rising, on an absolute basis and as a percentage of revenue. In essence, sales and marketing expense comprises of advertising expenses and headcount related expenses of operational staff. This includes call center staff, editors and photographers. Qunar’s latest filing suggests the expense rose dramatically due to increased spending on acquiring mobile and web traffic, and rising labour costs due to higher headcount and salaries.

However, increased spending on headcount and acquiring traffic has not yielded a proportionate return in terms of revenue growth. To explain why this is occurring, we look at some non-GAAP measures, specifically revenue per 1000 web and mobile queries.

Qunar’s efficiency in converting web search traffic to revenue is reaching a cliff, as revenue per thousand web search queries for flight tickets barely increased from 2012 to 2013. Curiously, Qunar stopped reporting this metric in 2014 even though they clearly stated in previous filings that this was a key non-GAAP metric used to determine performance. I suspect the conversation rate for both hotel and flight bookings have flattened from 2013 to 2014, and hence were left out of the annual filing as it may have indicated slowing growth and deteriorating profitability. This would explain why increased spending on acquiring traffic did not boost revenue growth to the same extent as previous years.

Other Expenses

When we examine trends in Qunar’s expenses, nearly every single line category increased due to higher “headcount” and “salaries.” I suspect this is related to Qunar’s cooperation with Baidu on the Baidu ZhiXin platform. The deal was signed in late 2013, making 2014 the first year that Qunar was obligated to operate, maintain and improve the platform. It is likely that majority of these increased costs stem from the ZhiXin platform.

Not only does this pose massive risks for Qunar’s public shareholders, it is also a long-term headwind for Qunar’s bottom line. Due to the structure of the deal, Qunar’s earnings from the Zhixin platform is essentially capped as Baidu is entitled to 76% of all earnings below a benchmark revenue, which is set at RMB 480 million, RMB 630 million and RMB 800 million for 2014, 2015 and 2016 respectively. To put these numbers in perspective, Qunar has already paid Baidu RMB 700M for marketing expenses related to the ZhiXin platform in 2014. Bear in mind this does not include the other costs of operating the platform. If our hypothesis that increased labour costs are mainly due to the ZhiXin platform is accurate, then Qunar is running the platform at a significant loss. The data fits our hypothesis as net income loss widened considerably from (RMB 146 Million) in 2013 to (RMB 1.83 Billion) in 2014.

Hence, whilst we have previously identified this agreement between Qunar and its parent Baidu as a huge risk to public shareholders due to conflicts of interest, we can also see how it has an extremely negative effect on earnings. The terms of this agreement essentially allow Baidu to exploit Qunar’s resources and funnel money into their coffers through paying Baidu for marketing expenses, payment processing fees and other ancillary services. Given that the agreement has an auto-renewal clause and is likely to be a long-term project, we believe this is a long-term headwind for Qunar’s overall profitability.

Strength In Flights, Weakness In Hotel Revenue

As mentioned before, Qunar charges clients on a cost-per-click and cost-per-sale basis. Looking at revenue per flight booking and per hotel room night booking, we spot continued strength in the first segment while weakness in the second.

The increase in revenue per flight ticket was mainly due to higher effective charges implemented by Qunar. This is a positive development as it demonstrates Qunar’s pricing power as one of the largest OTAs in the Chinese market. However, the hotel segment continued to suffer mainly due to their strategy of offering rebates through their e-coupon programme. In 2013, Qunar offered rebates of over RMB 48.8 million to users. Though this statistic was not reported in 2014, we presume this number has risen given the continuing drop in revenue per booking.

Whilst the increased revenue from flight searches sufficiently compensate the weakness in hotel bookings, Qunar’s hotel segment still acts as a significant drag on earnings. This is particularly worrying in the context of a company that has never been net-income positive.

Lack of Profitability

We acknowledge that Qunar’s overall revenue growth rate is still incredibly healthy, and that they have a dominant position in the Chinese OTA market. However, the question always boils down to whether they are able to convert their position and revenue into profitability. In this aspect, we believe Qunar is not likely to achieve a profit in the foreseeable future due to ballooning expenses and saturation in their conversion efficiency of search traffic to revenue.

Moreover, it is highly probable that Qunar will continue operating the Baidu ZhiXin platform at a loss. Given that the unfavorable conditions of the 2013 agreement with Baidu, Qunar’s potential growth stemming from the ZhiXin platform is essentially capped, and expenses may rise further as they continue to operate the platform.

Valuation

What appears most shocking to me is the surge in Qunar’s share price. Essentially, the market is pricing Qunar’s stock largely on the basis of revenue growth, which remains robust. However, the market is ignoring the fact that Qunar’s margins are deteriorating and that losses continue to widen year on year. The rally from their Q4 revenue and EPS beat is far overdone considering the long-term profitability outlook is still weak.

Furthermore, the market is viewing Qunar’s Q4 beat in the context of EPS without adjusting for share dilution. Note that at the end of Q4, Qunar had 84.7M shares outstanding, but that figure would increase to over 351.1M shares after adjusting for dilution from share warrants. When put into context, the Q4 results were terrible.

Looking at the earnings forecast, the market essentially expects Qunar’s losses to narrow gradually over the next few quarters. This is unlikely to occur given that Qunar’s search-to-revenue conversion rate has flat-lined, and continues to expect higher costs.

Comparatively, Qunar is significantly overvalued to its peers, especially when viewed against Ctrip’s (NASDAQ:CTRP) statistics. Ctrip has been profitable for many years, growing revenues and net income at a healthy pace. Yet on a price/sales and EV/sales basis, Ctrip is almost three times as cheap as Qunar, despite having a greater share of the Chinese OTA market and being more profitable.

Essentially, there are very high expectations for revenue growth rates baked into Qunar’s valuation, and given their widening losses and unprofitable tie-up with Baidu, they are likely to disappoint in the near future.

Conclusion

Given the key risks posed by the unfavorable conditions of their agreement with Baidu, the flat-lining of search-to-sales conversion, the ballooning of expenses and the overstretched rally, we believe Qunar is a high-conviction short. Essentially, the market has digested all the points of the bull case, focusing on revenue growth and favorable macro conditions (as the Chinese market is nowhere near maturity), but ignoring the key risks outlined in the bear case. The confluence of these conditions makes Qunar’s stock a ripe short.

For more on this story go to: http://seekingalpha.com/article/3214726-qunar-overvalued-with-numerous-risks-and-skyrocketing-costs
IMAGE: topic.chinadaily.com.cn