China's Facebook basks in the glow

February 7, 2012: 1:54 PM ET

In the week prior to Facebook's IPO announcement, Renren's stock leapt by more than 60%, which comes as welcome relief to Joseph Chen, the social networking site's CEO. Here's how he plans to keep things rosy.

By Bill Powell, editor-at-large

Joseph Chen, CEO at Renren

Joseph Chen, founder, CEO, and chairman of Renren

FORTUNE -- Joseph Chen chuckles a bit when asked what the hype surrounding Facebook's announced plans for an initial public offering means for the company he founded and runs, Renren Inc., the so called "Facebook of China." He chuckles because the question is more complicated than it seems.

In the week prior to Facebook's confirmation that it was, in fact, going public later this year, Renren's (RENN) stock (its ADRs trade on the NYSE) leapt by more than 60%. That had to come as a relief to Chen, because ever since it went public last May -- when the stock hit a peak of $24 just after it's IPO -- it s been on an escalator ride straight down, hitting a 52-week low of just $3.20 last month.

The stock price plunge was the result of a perfect storm. There was, let's face it, a bit of hype surrounding its own IPO. When you put the words "Facebook" and "China" together in the same sentence, separated by the word "of," at least a percentage of the investing universe is going to buy first and ask questions later. After all, there are more Internet users in China than anywhere else, and social networking sites are still in their infancy. According to comScore Media Metrix, 38.4% of Internet users in China engage in social networking, compared to 69.8% globally and 81.4% in the United States. Clearly, there is huge room for growth here.

But small cap China stocks were savaged in U.S. markets last year, mainly because of growing concerns about the credibility of their public financial disclosures. Just days before Renren's IPO, Citron Research, whose work is widely read by short sellers, issued a report questioning the numbers of a company whose CFO was also serving on Renren's board as head of its audit committee. The executive, Derek Palaschuk, resigned from Renren's board, a move that several venture capitalist Renren investors welcomed.

Nonetheless, the intensifying focus among short sellers on Chinese small caps has basically led to a rout in the market for them, whether their numbers are legitimately questionable or not. They've been beaten down indiscriminately, Renren among them.

Still, there was more to the beat-down than just widespread nervousness over Chinese stocks. A misunderstanding of the Chinese Internet space in general, and social networking in particular, certainly played a part. Chen, 42, used the Facebook moment last week to try to explain his company and his business. The first thing outsiders need to understand, he and CFO Hui Huang stress, is that even though Facebook is famously blocked in China by the government, that doesn't mean the "Facebook of China" lacks competition.

It's quite the opposite, in fact. China's market for social networking sites is much more fragmented than it is in the United States, with any number of companies not normally identified as "Facebook clones" trying to ease into the space.

Sina.com (SINA), which runs China's pre-eminent micro-blogging site -- typically described as the "Twitter of China" -- is there. So too is Tencent, best known for its instant messaging service, QQ. It already operates a site called Qzone, which, it claims, has 481 million "active users" -- though analysts question what Tencent's definition of "active" is. Last fall, the company invested an undisclosed sum in another social networking site called Kaixin001, with which it intends to create a so-called "real name" site (which means, as with Renren, users are required to register using their real names, not some fake Internet handle). Kaixin's users, like Renren's, tend to be young, urban, and well educated. So when Chen says China's social networking market is "more competitive than the U.S.," he's right.

In China's tech world, everyone is pretty much in each other's kitchen. In addition to dominating the short messaging market, Tencent is the biggest online gaming company. But online games account for a large part of Renren's revenue stream. And last year, Chen spent $80 million buying a Chinese video and photo sharing site, 56.com, which moved Renren closer to the space dominated by Youku (YOKU) and Tudou (TUDO), two companies that are often dubbed as the "YouTube of China." The company also launched a group-buying site last year called Nuomi. The three principal platforms -- social network, gaming, and group buying -- drive traffic to each other, and the hope is that the added services (like 56.com) will make the social networking site stickier, and thus more attractive to advertisers.

Chen says that Renren's phase of tacking on new assets is -- for now, anyway -- finished. The focus now is to make the platforms the company controls profitable. In its third quarter 2011 earnings report (the company's most recent report), Renren reported a loss of $1.2 million, even though revenue jumped by 57% to $34.2 million.

The social networking site clearly has some traction. The site counted 38 million active monthly users at the end of September last year, up from 24 million in the comparable quarter in 2010. Advertising revenue, as a result, comprised 57% of overall revenue in the third quarter last year, up from 42% in 2010.

Chen's aware that in the current, guilty-until-proven-innocent environment for China stocks, the attitude among nervous U.S. investors for the foreseeable future will be, simply, "show me." Generate good numbers -- and make sure they are credible. The euphoria that prevailed over everything China prior to last year was ridiculous. So, arguably, is the suspicion that now trails virtually every China play.

Last September, Chen announced a $150 million stock buyback program at Renren, professing his faith in "our position as the real name market leader" among social networking sites in China. As competitive as the space is, the growth potential remains undeniable. If Chen and Renren can deliver, it's possible that its stock troubles will prove to have been excessive -- something that Facebook's plans has apparently reminded some investors.

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