There were three big warning signs about the Internet portal well before its dramatic boom-and-bust IPO, writes Robert Hsu in China Strategy.

Because of China’s large user base and fast-growing economy, leading Chinese Internet companies have attracted great interest from global investors in the past several years.

Considering the incredible performance of many Chinese Internet stocks, such as well-known Baidu.com (BIDU), investors are constantly seeking the “next Baidu.”

And recently, Renren (RENN), the hottest Chinese IPO this season, made its debut—surging 28% from its $14 IPO price in the first day of trading. RENN hit a high of $24, but closed the week at $16.80. Entering freefall soon after, the stock has now fallen below $7. [Under $6.50 in midday trading on Thursday—Editor.]

Renren combines two of the hottest Internet stock concepts: social networking and group purchasing. It operates a large social network in China that is similar to Facebook in the United States, and it also operates a group-purchasing site in China that provides daily deals on local services and cultural events.

The company’s IPO created a sell-off in many Chinese Internet stocks, as institutional investors sold shares of the established companies to raise capital for Renren shares.

Let's take a closer look.

Renren’s founder is Joseph Chen, a veteran Internet entrepreneur who graduated from Stanford University in 1999. After graduation, Chen returned to China and started ChinaRen.com during the dot-com boom, which he eventually sold to web portal Sohu in 2001.

Chen continued his entrepreneurial efforts in China, focusing on social networking Web sites. Perhaps borrowing an idea from Facebook, in 2005 and 2006 Chen formed an online social network called XiaoNei—or “In School”—which was the precursor to Renren.

Unlike Facebook, however, Renren has not spread much beyond its student user base.

Renren is currently valued at around $6.5 billion on paper, a lofty valuation for a company that only had $76.5 million in revenues and barely any profit.

I don’t mind paying for expensive stocks if they are world-class companies with true growth potential. But Renren has certain issues that would have made me hesitate to recommend the stock:

  1. Slowing growth: Like its larger Chinese Internet portal rivals, Renren has expanded into online gaming, and recently added a Groupon-type service as well. Renren posted strong growth in the past three years, with revenue climbing from $13.8 million in 2008 to $47 million in 2009 and $76.5 million in 2010. However, growth is slowing down more recently, as its userbase only grew by 19% in the first quarter of 2011 from a year ago.
  2. Lack of critical mass: Renren currently has around 160 million registered users, less than a third of China’s Internet user population. And out of those, only about 31 million are actually active users that have logged on in the last month. Like many other types of Web 2.0 services, the big generally grow bigger in social networking.
  3. Accounting issues: The head of Renren’s audit committee, Derek Palaschuk, recently resigned his position after another company he was involved with, Longtop Financial Technologies (LFT), was accused of accounting fraud. RenRen has also had to downwardly revise the number of its userbase on the IPO filing in last week.

Overall, the valuation of Renren is too high given these risks. Competition from other Chinese Internet companies such as SINA Corporation (SINA) and NetEase (NTES) is high, and each of these companies have a much larger userbase.

For instance, Sina’s Weibo—similar to Twitter in the United States—doubled its userbase in the past four months, and recently broke 100 million users, taking traffic from Renren.

For now, I think Renren is simply too hot to handle, and I recommend avoiding the company for your portfolio. Instead, consider stocks like SINA, NetEase, or Ctrip.com International (CTRP), all of which are good buys here.

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