China's e-commerce market is dominated by Alibaba (BABA -0.39%) and (JD -1.64%). Alibaba's Taobao is the country's largest C2C (consumer-to-consumer) marketplace, and its Tmall platform leads the B2C (business-to-consumer) market. JD ranks second in the B2C market.

Many smaller C2C and B2C rivals have faded away over the past few years. However, an overlooked underdog, NetEase (NTES 1.16%), has been quietly gaining ground. NetEase is known primarily as a video game publisher, but it also owns the e-commerce platforms Kaola and Yanxuan.

Shanghai, China.

Image source: Getty Images.

NetEase's bizarre (but effective) strategy

Kaola, which focuses on cross-border purchases, is often dismissed as an also-ran in China's crowded e-commerce market. But two years ago NetEase launched Yanxuan, a private label marketplace that sells clothing, furniture, and appliances from Chinese suppliers of international brands like Kering's Gucci, Burberry, and Deckers' (DECK -4.12%) UGG.

Instead of selling brand name products like Alibaba and JD, Yanxuan sells unbranded products that are identical to their branded counterparts. For example, an original pair of UGG boots costs about $200 on JD and Tmall. However, a pair of unbranded, identical boots from an "UGG manufacturer" costs about $45 on Yanxuan.

Yanxuan's portfolio now includes over 10,000 products from these manufacturers. The marketplace's growth boosted NetEase's e-commerce revenues by 160% to 11.7 billion RMB ($1.8 billion) last year, which accounted for 22% of the company's top line. NetEase expects its e-commerce revenues to hit $3 billion this year.

$3 billion is a tiny figure compared to the $39 billion and $74 billion in revenue which analysts expect Alibaba and JD to generate, respectively, this year. Nonetheless, Alibaba and JD already responded to Yanxuan with their own private label sites.

Alibaba launched Taobao Xinxuan last year, while JD introduced its Jingzao brand in January. However, neither Alibaba nor JD claims that its private label products are made by suppliers of top international brands.

Is NetEase's strategy legal?

Alibaba and JD avoided that claim for an obvious reason: They didn't want their marketplaces to be associated with counterfeit goods. Yanxuan's claim that its products are made by the same manufacturers of leading international brands suggests that their suppliers are stealing designs and IP to sell unbranded products -- which would likely violate their manufacturing contracts.

Speaking to Forbes, American Apparel & Footwear Association VP Steve Lamar raised concerns about Yanxuan's "potential theft of intellectual property," while an UGG spokeswoman noted that "Yanxuan's promotion would mislead consumers to believe they are buying authentic UGG products."

Two young women go shopping.

Image source: Getty Images.

NetEase's strategy with Yanxuan also contradicts Alibaba and JD's attempts to purge their marketplaces of counterfeit products. JD often claims that its tighter control over its fulfillment and logistics network blocks out more counterfeit products than Alibaba, which mainly relies on C2C and B2C transactions fulfilled by third-party logistics providers.

That's why JD's stock tumbled in mid-March after renowned Chinese novelist Liu Liu accused JD's cross-border marketplace, JD Worldwide, of selling counterfeit products to a friend. JD stated that the customer received the wrong product with a similar name rather than a "fake", but the damage was done.

NetEase's strategy is short-sighted

As Chinese consumers with rising incomes start scrutinizing the authenticity of their products, the flaws in Yanxuan's business model will become more apparent. Lower income shoppers might still buy Yanxuan's goods, but NetEase is shouldering a lot of risk to grow the business.

International brands could drop Yanxuan's suppliers, customers could demand proof that their goods are actually made by those suppliers, or the company could be pilloried by the Chinese government, which has been cracking down on counterfeit goods over the past few years. Alibaba and JD -- which likely see Yanxuan's reckless strategy as a threat to their own businesses -- could run marketing campaigns likening "unbranded" goods to counterfeits.

NetEase will likely generate big gains from Yanxuan over the next few quarters, but that growth could quickly evaporate. Instead of expanding Yanxuan's marketplace, NetEase should figure out how to legitimize it before it becomes the "Tmall of knockoffs."