Would You Still Buy Alibaba If It Were Two-Thirds Smaller? If 80% of Taobao’s products are fake, illegal, or substandard, look for that site’s gross merchandise volume-the metric Alibaba uses-to shrink by a large percentage

http://www.forbes.com/sites/gordonchang/2015/02/01/would-you-still-buy-alibaba-if-it-were-two-thirds-smaller/print/

Gordon G. ChangContributor

WORLD AFFAIRS 2/01/2015 @ 3:22PM 52,877 views

Would You Still Buy Alibaba If It Were Two-Thirds Smaller?

On Friday, the State Administration for Industry & Commerce, through a spokesman, tried to minimize a damning report it had issued on Wednesday on Taobao Marketplace, one of the main sites of Hangzhou-based Alibaba Group. The Wednesday report created legal exposure for the Chinese Internet giant and, more significantly, highlights the ultimate unsustainability of its business model.The report SAIC issued on Wednesday charged, among other alleged offenses, that Taobao carried a substantial number of counterfeit and substandard products.

SAIC on Friday maintained that what it had labeled a “white paper” on Wednesday was not in fact a white paper. It was only a record of a meeting, “internal reference” is the term it used. The meeting record, the agency maintained, did not have “legal implication.”

Legal implications abound, however. On Friday, law firm Robbins Geller Rudman & Dowd announced it had filed a class-action suit against Alibaba in the Federal district court for the Southern District of New York. The case, Khunt v. Alibaba Group Holding, alleges that the company Jack Ma founded had engaged in instances of wrongdoing including “concealing substantial ongoing regulatory scrutiny.”

On Wednesday, SAIC disclosed that on July 16 it held discussions with Alibaba’s “principal officers and management teams of the core departments” to discuss serious infractions but stated it had not publicly disclosed the matter to avoid disrupting Alibaba’s then-pending initial public offering, which ended up raising a record-setting $25 billion in September. Alibaba’s offering documents contained boilerplate disclosure language but no specific mention of the SAIC meeting.

Alibaba issued a denial of liability in the Khunt suit.

The possibility of handing over cash for inadequate disclosures is not the worst of Alibaba’s problems, however. Its e-commerce business, as can be seen from the SAIC report, depends on high turnover, which in turn depends on large quantities of goods offered.

It’s the nature of the goods that is in question. SAIC’s report on January 28 did not state what percentage of products offered on Taobao are fake or substandard, but on the 23rd of last month SAIC released a survey showing that only 37.25% of them met standards.

Taobao criticized the survey for its extremely small sample, but there are indications that it is indeed reflective of the dismal state of affairs on that site. CNN carried a report indicating the number of non-counterfeit goods on Taobao could be as low as 20%.

Jack Ma in November denied Alibaba sites had a fakes problem. “Do you think we could achieve 6.7 billion yuan in sales daily if the Internet were full of counterfeit products?” he asked in the Chinese city of Wuzhen in Zhejiang province at the World Internet Conference.

The answer is that Alibaba would never have been able to put up such big numbers if it were not for knock-offs. As one Weibo poster, going by the name “Fangfei,” wrote in response to Ma, “Haha, I only shop on Taobao because they have high quality counterfeit products!”

Alibaba up to now has had an almost-anything-goes mentality, and, as CNN notes, reducing transaction volume has not been one of its priorities. “If they prevent listings from being put up, they are essentially cannibalizing their own marketplace,” Haydn Simpson of NetNames, which chases fakes on the Internet, told CNN. “It’s not in their best interest to remove tens of thousands of postings on a daily basis.”

Alibaba, which now says the right things about counterfeits, has not had its heart in ridding its sites of them. “Many people say that Taobao and Alibaba is full of knock-offs, but those who say that have basically never shopped on Taobao,” Ma said at Wuzhen as he raised the mythical example of a Rolex for 25 yuan. It’s true you cannot buy a 25 yuan Rolex on Taobao, but soon after he spoke the Financial Times in just five minutes on that site spotted a Louis Vuitton handbag for $29 and $6 Dior perfume. And if instead of a Rolex you want a Chanel timepiece for an incredibly low price, the FT found one of those too.

Taobao, like other Alibaba sites, does not carry inventory, instead connecting third party merchants with purchasers. And because those merchants are in China, fakes are bound to slip through. Fakes can be found on every such site in that country, but Taobao seems to lead the pack in offering them. Taobao has problems because, if SAIC is correct, the site has even allowed merchants to sell goods without required registrations and licenses, a sure sign of weak supervision.

Alibaba will now have to clean up its act because Chinese media, especially Xinhua News Agency, People’s Daily, and China Daily, have recently publicized the SAIC allegations. And look for Alibaba competitors to remind us that profits can be made without resort to less-than-acceptable practices. “It’s no coincidence that all 20 JD.com products examined for the government’s recent report were authentic,” Josh Gartner, JD’s senior director of International Communications, told Forbes today. “We control our supply chain for direct sales, keep the number of marketplace sellers at a manageable level to ensure strict oversight, and work with international third party experts to track product quality. We are not perfect, but our model is designed to ensure there are no fakes and we are very good at it.”

Beijing-based JD, which makes direct sales as well as maintaining an Alibaba-like platform, is smaller than Ma’s company, partially because it devotes more effort to keeping counterfeit goods off its site. And that means Alibaba, although it has had a great run, is bound to get smaller, as it will be forced to cut merchants offering fake, illegal, and substandard products.

If 80% of Taobao’s products are fake, illegal, or substandard, look for that site’s gross merchandise volume—the metric Alibaba uses—to shrink by a large percentage. Alibaba’s officers may not want to take steps that will reduce GMV, but Chinese regulators, Alibaba competitors, consumer products companies, American lawyers, and Washington watchdogs, in addition to others, will see to it that the Hangzhou-based company scrubs its sites.

Jack Ma recently implied that JD’s growth model would lead to nowhere but corporate death, but perhaps it is his model that is at a dead end.

A Beijing-based analyst last month told me she does not expect Alibaba to exist in seven years. At the time, I thought she was overdosing on pessimism, but now I’m not so sure. Taobao does not look like it has much of a future, which means Alibaba cannot have one either.

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