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 (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 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 International (CTRP), all of which are good buys here.

Subscribe to China Strategy here…

Related Reading:

Related Articles
  1. Stock Analysis

    8 Solid Utility Stocks for a Bear Market

    If you're seeking modest appreciation, generous dividend payments and resiliency, consider these eight utility stocks.
  2. Stock Analysis

    Why Phillips 66 (PSX) is a Solid Long-Term Bet

    Here's why Phillips 66 will likely remain one of the world’s largest and most profitable companies for a long time to come.
  3. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  4. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  5. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  6. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  7. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  8. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  9. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  10. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!