Shares of Chinese e-commerce company Pinduoduo (NASDAQ:PDD) recently plunged after Chinese regulators launched a probe into allegations of counterfeit goods and intellectual property infringements. Pinduoduo went public in late July, closing on its first day of trading at $26.70.

Pinduoduo, which is sometimes dubbed the "Groupon of China," offers shoppers discounts on bulk orders. Shoppers are encouraged to form "teams" with their social networking connections on WeChat and QQ to score bigger discounts. The platform mostly caters to lower-income shoppers in lower-tier Chinese cities.

Close-up on two keys on a computer keyboard, one with a Chinese flag and the other one displaying the word buy.

Image source: Getty Images.

Thanks to the power of bulk orders, Pinduoduo sells very cheap products at discounts of up to 90% per item. Bed sheets and umbrellas on the platform cost about 10 RMB ($1.50), while low-end PCs cost just 1,000 RMB ($150).

That low-end strategy has attracted plenty of critics, who claim that the platform is flooded with counterfeit versions of name-brand products. Companies like Chinese audiovisual equipment maker Skyworth and US diaper maker Daddy's Choice both sued Pinduoduo shortly after its IPO over those claims, which sparked the recent regulatory probe.

These headaches won't end for Pinduoduo anytime soon, and they raise red flags for another controversial e-commerce player -- NetEase's (NASDAQ:NTES) Yanxuan. Let's take a closer look at why regulators could also slam Yanxuan in the near future.

What Yanxuan does

NetEase is generally known as a video game publisher, but it also owns two e-commerce platforms: Kaola and Yanxuan. Kaola focuses on cross-border purchases, but it failed to gain much traction in China's crowded e-commerce market.

Yanxuan, however, gained more attention when it arrived two years ago. The platform sells clothing, furniture, appliances, and other products from Chinese suppliers of international brands like Burberry and Deckers' (NYSE: DECK) UGG. Like Pinduoduo, Yanxuan targets lower-income shoppers in lower-tier cities.

Instead of selling brand-name products, Yanxuan sells unbranded "private label" products that are purported to be identical to their branded counterparts. For example, a pair of unbranded UGG boots from an "UGG manufacturer" costs less than $50 on Yanxuan, while the authentic version costs about $200 on Alibaba's Tmall.

Dollar signs rising out of a smartphone.

Image source: Getty Images.

Yanxuan's marketplace now includes over 10,000 of these unbranded products. Yet the business model looks like a house of cards: Critics claim that these "private label" goods are simply first-rate knockoffs. Moreover, companies like Burberry and Deckers could terminate their relationships with suppliers who sell unbranded versions of their products on Yanxuan.

Yanxuan hasn't been sued or investigated like Pinduoduo yet, but it's probably only a matter of time. Speaking to Forbes earlier this year, a UGG spokeswoman stated that Yanxuan could "mislead consumers to believe they are buying authentic UGG products." American Apparel & Footwear Association VP Steve Lamar complained that Yanxuan was engaging in the "potential theft of intellectual property," according to Forbes.

Why Yanxuan matters to NetEase

NetEase repeatedly touts the growth of Yanxuan as one of its core growth engines. The growth of Yanxuan, along with Kaola, boosted NetEase's e-commerce revenues by 101% annually to 3.7 billion RMB ($595 million) during the first quarter.

That figure, which accounted for 26% of NetEase's sales, offset an 18% decline in the company's online gaming revenues. During the conference call, NetEase CFO Charles Yang claimed that there was "no bottleneck or any slowdown in the development of Yanxuan," and that the platform's "user loyalty remains very strong."

Yang also stated that Yanxuan had a solid reputation for providing "cost-effective, high-quality and trustworthy products," but he didn't address the growing concerns that the platform is a knockoff marketplace. If Chinese regulators are serious about stamping out counterfeit goods and IP violations, Yanxuan looks like an easy target.

Why investors should worry

NetEase's support for Yanxuan reflects a troubling shift in the company's strategies. NetEase published many well-received video games in the past, but many of its newer titles are clones of more successful games.

PUBG Corp. recently sued NetEase for allegedly cloning its hit battle royale game, PUBG, with its mobile games Knives Out and Rules of Survival. In a bizarre response, NetEase threatened to sue everyone else who cloned its own PUBG clones.

NetEase's decision to let an e-commerce marketplace for "unbranded" products flourish reflects a habit of turning a blind eye toward potential IP violations. Therefore, NetEase investors should see the probe of Pinduoduo as a stern warning about the company's future.

 

Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends NetEase. The Motley Fool has a disclosure policy.