A Dose of Reality Needed for China Fever

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

BEIJING ( TheStreet) -- Despite the fact that nothing has fundamentally changed in the China internet space over the past two to three weeks, U.S.-listed China Internet stocks have skyrocketed across the board. Some of the larger benchmark names such as SINA, SOHU and BIDU were clearly oversold at the end of 2011 and have rebounded substantially. However, it should be cause for concern when even the weakest names in the space rip higher along with the major players, even as these weak players are showing deteriorating financials.

Some of the largest gains have been seen for companies with the weakest fundamentals and weakest prospects for profitability. This clearly smacks of an unsustainable short term bubble, much of which has been fueled by short covering. Once the boost from short covering ends, these names could all see quick and substantial drops back to their December levels. Most notable are the mostly misnamed "catch phrase" stocks shown below:

Arguably Renren ( RENN) was too cheap at $3.21, a price that valued the entire company only for the cash it had on hand -- over $1.2 billion. RENN could easily build a future through a series of acquisitions and has plenty of cash to do it. But that doesn't change the fact that RENN is simply not the Facebook of China, but rather will likely prove to be the Friendster of China and not last in the long run. The share price certainly reflects this sentiment by investors. In the $4 to $5 range, RENN is probably priced about right, as a cash rich company without strong business prospects going forward.

Follow TheStreet on Twitter and become a fan on Facebook.

At a price of nearly $21, Youku ( YOKU) is a $2.4 billion dollar company that has never turned a profit and is seeing losses accelerate. The stock saw a strong run up above $20 heading into its last earnings call and then plunged when it was revealed that costs for content had increased dramatically and losses therefore widened significantly. Now the stock has rebounded again to above $20 without any meaningful developments to drive it higher. YOKU is simply riding the rising tide for China internet stocks. I was previously short YOKU from $21, but covered my position once the stock started to rebound from its lows. If the stock gets back to $23, I will eagerly short it again and hold through the next earnings call.

Jiayuan.com ( DATE) recently posted its first quarterly profit, but only as a result of dramatically cutting marketing expenses. It has already announced that there will be no growth in revenue in the fourth quarter, so it is expected that DATE will swing back to a loss once again. The company did recently announce a share buyback plan, which helped to support the share price. But with less than $100 million in cash, buying back shares could be a very risky strategy and it is unlikely the company will pursue this. The company currently trades on a trailing P/E of over 200. I was previously short DATE at just over $6.00, but scrambled to cover once the stock took off.

Most noteworthy is E-Commercre China DangDang ( DANG). Shares of DangDang are up a stunning 83% as investors seem to be experiencing a relapse of China Internet fever. Since the time of its IPO, DANG has been labeled as the Amazon.com of China. However in the same way that RENN is not Facebook, DANG is not AMZN. The simplifying analogy may be useful in selling an IPO to investors, but it is far from useful in valuing the company. The following summary income statement speaks for itself.

As can be seen above, growth in revenue is decent but not spectacular. Everything else is downright terrible. Gross margins have fallen in half and are approaching single digits. Moreover, despite being previously profitable, DANG has swung to losses and these losses are accelerating. Revenue is expected to grow substantially in the fourth quarter, but once again the net loss is expected to widen. It is worth noting that even when it was a profitable company, DANG could only achieve a net margin of 2% to 5%.

It is the beginning of a new year and many investors are trying to make up for a difficult 2011 by chasing names that have potential to be multi-bagger stocks. A number of recent articles have touted that buying DANG at $6 to $7 is like buying AMZN at $6 to $7 many years ago. However, this just isn't the case.

I have purchased products from DANG in the past and was exceptionally satisfied with both the price and the service, which I would say are equivalent to AMZN in every way. The difference is that AMZN pioneered a business model and secured a first-mover advantage, mastering logistics and eliminating bricks and mortar (along with its competition as well). This business model is no longer new or novel and can be studied by anyone in various MBA case studies.

A major reason why DANG is losing money at an increasing rate is that ecommerce competition in China is already fierce. While Americans like to think of DANG as the Amazon of China, the reality is that there are many "Amazons of China," but only one that is listed in the U.S. and familiar to Americans. Two such competitors are well-known 360Buy.com and Taobao. And for that matter, there is also the real Amazon of China -- Amazon itself. Yes, AMZN has its own site in China, Amazon.cn. On a strictly anecdotal basis, I have found that when people shop online, Taobao is by far the most popular site in China. If I were to make an AMZN analogy, it would certainly be Taobao over DANG.

One unfortunate disadvantage that DANG has is that some of its competitors sell pirated products, especially books (which are still the major seller for DANG). It is my understanding that DANG does not sell pirated goods, but for consumer who do their shopping online, they can easily compare prices and get effectively identical goods from DANG's competitors at a discount of usually around 75% to 80%. That is very difficult to compete with.

In short, DANG is not the AMZN of China, but investors are eager to believe that they are getting in early on a massive bargain. Average daily volume in December was less than 2 million shares per day, but there were over 6 million shares sold short. On Thursday and Friday over 10 million shares traded and the stock was up by 20% in two days alone. As a result, I attribute much of the recent run up to short covering, which obviously is not a sustainable factor in keeping the share price elevated. Following a run up of more than 80%, DANG is one I will be watching from the sidelines.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

More from Personal Finance

3 Apps Than Make Retirement Planning Fun for Millennials

3 Apps Than Make Retirement Planning Fun for Millennials

What the Fed Rate Hike Means For You

What the Fed Rate Hike Means For You

What Is Drew Brees' Net Worth?

What Is Drew Brees' Net Worth?

The Best Places to Live in the U.S. if You're Young and Broke

The Best Places to Live in the U.S. if You're Young and Broke

What Is Matt Ryan's Net Worth?

What Is Matt Ryan's Net Worth?