For the past three years, the narrative surrounding (NASDAQ:TCOM) -- China's largest online travel agency (OTA) -- has been simple: After years of pricing wars with the competition, Ctrip merged with its largest competitors to create a force to be reckoned with in the travel sector.

As the only major player providing a one-stop shop to book air, train, bus, and hotel accommodations, Ctrip began to benefit heavily from network effects. Merchants knew the best way to get customers to see their services was by listing with Ctrip, so they flocked to it,  which only attracted more customers -- and hence, more merchants. That virtuous cycle has put Ctrip in the driver's seat, and rewarded shareholders with returns of 660% since mid-2012.

But the most recent quarterly results -- released this week -- show some cracks in the foundation.

A plane flying over Shanghai

Image source: Getty Images. earnings: The raw numbers

Let's first look at the headline figures for the company.

Metric Q4 2017 Q4 2016 Growth
Revenue 6.4 billion RMB 5.2 billion RMB 23%
EPS* 1.56 RMB 2.24 RMB (30%)

Data source: *Presented on non-GAAP basis that excludes share-based compensation.

At first blush, those results appear somewhat concerning. It's never good to see earnings dip while revenue soars. And while revenue grew at a healthy clip, 23% was a substantial slacking from the 39% growth rate the company sported just three months ago. 

On the earnings front, it's important to note that much of the decline was due largely to the performance of affiliates, plus a substantial increase in Ctrip's taxes. In fact, non-GAAP operating income (which ignores stock-based compensation) was actually up 14% -- thanks in large part to gross margins expanding by more than 500 basis points to 83%. That's evidence of Ctrip's enviable spot in the value chain.

At the same time, however, operating expense growth far outpaced revenue growth -- even after backing out stock-based compensation. Spending on product development (35% growth), sales and marketing (42%) and G&A (55%) combined to nudge the the company's total spending 40% higher year over year.

A key division's growth slows markedly

Of course, this wouldn't have been an issue if Ctrip had maintained its growth rates near 40%, but that didn't happen. Here's how the company's four divisions performed.

Division Q4 2017 Q4 2016 Growth
Accommodation 2.3 billion RMB 1.8 billion RMB 25%
Transportation 2.9 billion RMB 2.4 billion RMB 20%
Packaged tour 623 million RMB 467 million RMB 34%
Corporate tTravel 207 million RMB 179 million RMB 15%

Data source: Growth percentages are exact but may not match when compared with revenue figures since the latter were rounded to the nearest 100 million RMB.

The key stat to focus on is the transportation number. Last quarter, growth from the segment came in at 41%. Management cited two reasons for the slowdown.

First, a consumer watchdog group alerted Chinese officials that Ctrip was automatically selling its customers high-margin value-added services (VAS) they might neither want nor need -- like insurance -- along with their airline tickets, unless they actively opted out. The government made the company end the practice; customers now have to specifically opt in to buy the lucrative add-ons.

As you might expect, far fewer of them did. It also put management in the unenviable position of stating on its conference call that "transparency" was a "fundamental principle" while simultaneously having to walk back its previous VAS policy.

The second issue came after a pair of videos from a child-care center run on Ctrip company grounds -- for its employees -- went viral in November, showing mistreatment of children.

While the providers weren't Ctrip employees, management said the "unfortunate PR crisis [had] ... some negative impact on Ctrip brand and traffic in the short-run starting from later part of last quarter last year and the first quarter of 2018."

What else happened during the quarter?

  • Management spent a good deal of time on its earnings call talking up Ctrip's growth via flights outside of China. The number of such tickets accounted for 30% of all international flights booked on Ctrip.
  • The company passed the 1,000-location threshold for its branded Ctrip and Qunar brick-and-mortar locations, which are helping it establish a presence in second- and third-tier Chinese cities.
  • Newly acquired Skyscanner's direct booking revenue almost doubled from the same time last year.

Looking ahead

Investors may have been disappointed by the company's outlook. Revenue growth for the first quarter is expected to clock in at just 9% to 11%. Management claims that Beijing's edict on unbundling its add-ons, and the damage its image has taken will continue to be the most direct culprits. 

CFO Cindy Wang reassured investors, saying, "We strongly believe that the pain process that we are now going through will be in the short term." When analysts pressed management on whether competition from Alibaba-backed Fliggy or other sites was concerning, Chairman and founder James Liang said, "Even with all the competition, I think Ctrip is going to capitalize ... both domestically and internationally."

The coming fiscal year will go a long way toward proving or disproving that thesis.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.