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In the wake of another fraud scandal involving a Chinese company, many investors must be wondering if this rapidly growing economy is even worth their time or capital. David Wei and Elvis Lee, CEO and COO of China's largest e-commerce business, Alibaba.com, were forced to step down after it was found that more than 2,000 sellers on its auction site for business-to-business transactions used fraudulent credentials to sell goods with the help of at least 100 company staff members. Many consumers received fake goods, and in many cases received nothing at all after paying.
While neither executive was directly involved in this fraud, the company’s stellar reputation was at stake -- as was that of the founder and head of Alibaba group, Jack Ma, who takes on a Steve Jobs-like presence in China -- and swift action was taken as a result. The fraud is estimated to account for only about $2.8 million, which from an earnings standpoint really is insignificant. The bigger question is how this will affect Yahoo!'s (Nasdaq: YHOO ) 40% stake in Alibaba, which in a sale would likely be worth up to half of Yahoo's own core assets. The answer is a lot less than most people think, and I believe investors should use the pullback to buy shares in the largest e-commerce site in China, and the only way to do that domestically is by purchasing shares of Yahoo!.
A small setback
To be fair, this isn't the typical Chinese stock fraud case that we have grown too familiar with over the past few years, partly as a result of the rapid increase in small Chinese companies listing shares in the U.S. through reverse mergers. Most recently, RINO International (Nasdaq: RINO ) , a Chinese maker of pollution-control gear, was accused of duping investors by overstating revenue and claiming customers that it didn't actually do business with.
No one is questioning whether Alibaba's business -- or its 56 million members – are real, or that it earned more than $570 million over the first three quarters of 2010, which was a 30% increase over 2009. That doesn't make this fraud any less serious; it is clearly a significant internal management issue that will take time to resolve. However, the problem was indentified through the company's own internal investigation, and was confined to less than 2% of the workforce, and less than 0.001% of its member base. The company has taken immediate action to rid the company of the workers who were complicit and the managers who enabled it.
While the short-term hit to the credibility of this much-loved Chinese company will no doubt leave a scar, its commitment to integrity, as shown through this internal investigation, will also help lead to higher standards.
Another Chinese Internet giant, Baidu (Nasdaq: BIDU ) , had similar internal integrity problems in 2008 when some employees took cash from companies looking to boost their position on Baidu's search engine. Baidu used the opportunity to clean up its internal controls and Alibaba appears ready to make the best of this bad situation in a similar way.
The situation also creates an opportunity for growth in what could be the company's most lucrative product, Alipay. This online payment platform is Alibaba's answer to eBay's (Nasdaq: EBAY ) crown jewel, Paypal, and an extremely valuable add-on to its Taobao site. Taobao offers services that would best compare it to eBay and Amazon.com (Nasdaq: AMZN ) , and has an almost 90% market share in China.
Not using Alipay means buyers of goods have much less recourse if fraud occurs. So the latest dust-up could force more sellers to use Alipay as a payment option at the demand of buyers, which also means more money for Alibaba. Placing a value on Paypal that is comparable to mature and slower-growing payment transaction companies like Visa (NYSE: V ) and MasterCard (NYSE: MA ) yields a stand-alone value of more than $12 billion.
While the Paypal growth story is strong, Alipay recently surpassed it as the world's largest online payment platform. Alipay now averages 8.5 million transactions a day, at a transaction volume of $378 million. It also boasts more than 550 million registered users, compared to Paypal's 94 million active accounts. Combine that with the fact that only about a third of China's population has access to the Internet and you begin to see the value to Yahoo! shareholders of Alibaba, let alone Alipay.
The recent scandal is likely to leave a black mark on the company for some time, and it does point to issues at the top levels of management. However, the internal investigation that led to these charges and the swift and strong changes at the top should show a company that is willing to make difficult decisions to uphold its integrity and maintain its customer base. The business fundamentals remain intact, and Yahoo! remains the best way to play this global e-commerce leader. There will certainly be rumors and innuendo to help drive down the stock, but I believe this will provide a good opportunity to buy the dip.