INTERNET: Audit Spotights Counterfeit Risk For E-Commerce

Bottom line: A new audit reveals how widespread counterfeit goods are on Chinese e-commerce sites, which will remain a major risk for site operators and their shareholders.

Taobao slammed in piracy audit

A new audit from State Administration For Industry and Commerce (SAIC) is showing just how pervasive fake goods are on the Chinese Internet, underscoring the huge risk that consumers face when purchasing online. The results underscore the huge risk to e-commerce firms as well, since many of China’s top names including Alibaba (NYSE: BABA) and JD.com (Nasdaq: JD) operate so-called “open platforms” that are simply online marketplaces where third-party merchants can sell their goods. Such merchants are notoriously hard to police, and these latest results show that they frequently offer fake and substandard products to buyers.

According to the newly released audit results, only 58.7 percent of goods randomly selected by the SAIC were genuine, and the rest were fake. (English article; Chinese article) The SAIC tested 92 batches of products purchased online in the second half of last year for its audit. Of that group, only 54 were found to be genuine goods.

Equally surprising was the fact that Taobao, the C2C trading platform operated by Alibaba, had one of the lowest rates of authentic goods among companies selected in the audit, at just 37.25 percent. Alibaba’s popular B2C Tmall platform, which lets larger merchants sell goods to consumers, fared much better with an authenticity rate of 85.71 percent.

Others in the audit included JD’s open B2C platform, with an authenticity rate of 90 percent, and Wal-mart-backed (NYSE: WMT) Yihaodian, with a rate of 80 percent. Both companies also operate platforms where they sell their own goods directly to consumers, and presumably those had authenticity rates of 100 percent. One other company tested was online cosmetics seller Jumei (NYSE: JMEI), whose open platform had a 100 percent authenticity rate.

Jumei knows all too well the big risk that fakes can create, and was exposed last year for having counterfeit products on its site just months after making a New York IPO. The company’s stock plunged after the reports came out, drawing a flood of shareholder lawsuits that have now become a major headache for the firm. Jumei shares at one point were up more than 70 percent from their IPO price as investors embraced a flood of new Chinese Internet companies to list last year. But since then they have tumbled steadily on all the bad news, and now trade at nearly 40 percent below their IPO price of $22.

Alibaba and JD.com stocks weren’t immediately affected by the results of the audit, with shares of both companies rising in the latest trading session. The news actually looks positive for JD, since its 90 percent authenticity rate was relatively high and its B2C platform only accounts for a small part of its business. The picture was more cloudy for Alibaba due to the high rate of fakes on Taobao, and I expect the stock could come under pressure as the market absorbs the magnitude of the problem and the risk it poses for the e-commerce giant.

From a bigger picture perspective, these results aren’t that unexpected, though the poor showing for Taobao came as a bit of a surprise because Alibaba loves to tell the world how tough it is against piracy. The e-commerce companies aren’t the only ones that have to deal with the issue, and online video site Xunlei (Nasdaq: XNET) was recently hit by a Hollywood for hosting pirated content.

All of this shows that piracy continues to be a big problem in China, especially on the Internet where merchants can easily open and close shops and consumer protection is relatively weak. From the investor perspective, this kind of risk is always worthy of major consideration, and Jumei and Xunlei provide very real examples of what can happen to stocks of companies that are exposed for large-scale piracy issues.

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