Tencent Takes Gaming By Storm

In this episode of the Market Foolery podcast, host Mac Greer talks with Motley Fool analysts Ron Gross and Matt Argersinger about the market’s hottest stories. For a company with $500 billion in market cap, Tencent(NASDAQOTH:TCEHY) just put up some astonishing growth this quarter — and yet, the stock fell a little bit today.

Traditional retail actually saw a bright spot today with Macy’s(NYSE:M) fantastic quarterly report, but investors shouldn’t abandon all doubts about the sector just yet. Starbucks (NASDAQ:SBUX)is ramping up its growth in China to an astounding degree, and long-term investors might want to take a closer look at the coffee powerhouse for the next few years. Tune in to find out more.

A full transcript follows the video.

This video was recorded on May 16, 2018.

Mac Greer: It’s Wednesday, May 16th. Welcome to Market Foolery! I’m Mac Greer, and joining me in studio, we have Motley Fool analysts Ron Gross and Matt Argersinger. Guys, welcome!

Ron Gross: How are you?

Matt Argersinger:Hey, Mac!

Greer: How you feeling?

Gross: I’m great!

Greer: Good. Matt, you?

Argersinger:I’m good!

Greer:I’m trying to grow a beard,but I’m at that scratchy stage.

Gross:Yeah,it looks good!

Greer: Are you just saying that? [laughs]That’s so hurtful. Well,guys, later in the show we’re going to talk Starbucks. They’rereally ramping up in China,which I hear is a pretty big market,so we’re going to talk about that. And we’re also going to talk about some big earnings from China’slargest social network and gaming company.

But, Ron,I want to begin with something that we don’t say every day –good news from a traditional retailer. Shares of Macy’s up more than 5% right now onbetter than expected earnings. Is the turnaround really happening?

Gross: Well,well, well, look who’s not dead yet!

Argersinger:Yet. [laughs]

Gross: Reallyinteresting! It’s been an interesting six months for retail. If you listened to the show a year ago, we left retail for dead.

Greer:Yes we did.

Gross: Shows what we know. Andthere have certainly been some rebounds, helped by tax cuts and bonuses and tax refunds and a strong economyand almost full unemployment. So, it has been interesting.

Specific to Macy’s,they have done what they needed to do, which is close a lot of stores,maybe around 100 stores. They cutthousands of jobs, which is painful,but when business calls for it, sometimes that’s what needs to be done. And it looks like they’rereaping the benefits of that as well asthe good stuff that’s going on in the economy right now. The same-store sales up 4.7% is a huge, huge number. Now,their friends and family promotionshowed up in this quarter, versus last year, it was in a different quarter,so the comparisons are a little wonky, for lack of a better word.

Greer:What is that? What is the friends and family promotion?

Gross: Itused to be that you literally hadto know someone that worked atone of these stores, and they could pass you along adiscount. Nowadays it’s, if you breathe,you get the friends and family discount. No kidding around!

Greer: [laughs]Opposable thumbs.

Argersinger:Everyone is a friend?

Gross: Everyone is a friend of someone. It’s just abig promotion, like the old Macy’s One Day sales. That helped, the fact that it was in this quarterversus a different quarter last time around. If you strip that out, you’re probably somewhere under 2% on a same-store sales growth basis. Butstill, for a company that has really struggled, that’s still pretty darn good. Adjusted profits up 240%. Now,again, from a very low base, because the company was struggling. Still,it’s really nice to see.

They have a lot of things in the works. They’rekind of throwing some things at the wall and seeing what will stick. They have their Macy’s Backstage concept, which is their discount concept. Everyretailer has to have one nowadays, like a Nordstrom (NYSE:JWN)Rack, for example. Theyactually bought a concept store in New York City calledStory,which is a store that revamps its inventory every four to eight weeks to try to keep it fresh. That would be some Inventory management job. Their buyers have their work cut out for them. But, interesting. They’re trying a lot of different things.

They need a new CFO; theirCFO is leaving. Let’s get that in placeso they don’t miss a beatwith respect to that. But, kudos to Macy’s. I don’t know if this carries through,but this is a really strong quarter.

Greer: OK,Matt, a lot there. What do you think?

Argersinger:I mean,part of me thinks this is probably just — I’m sure Ron will agree a little bit — things got a little too pessimistic.

Gross: Yeah.

Argersinger:So, if Macy’s can have a little good news, or any of these traditional retailers can have a little good news,it’s going to spike the stock. I have to look at Macy’s though, and I say, if I’m an investor and I see a P/E of 7X — I don’t know if that’s a normalized number — and a dividend yield above 5% …

Gross: Right? [laughs]

Argersinger:Ron,what do you think? Should I look at this as,this is a deep value type of opportunity here? Maybethis is an opportunity for investors?

Gross:So, they raised guidance. On their going-forward guidance, they’re trading at 8.5X. Measurethat up against a Nordstrom, that’s around 15X, or aJCPenneyor aKohl’sthat are 17X and 12X, respectively, it certainly looks awfully cheap. And itcontinues to be a turnaround play. It’s not the kind of stock you probably want to buyand hold forever. It’s the kind of stock thatpotentially could be mispriced,and when it becomes fairly priced,you would probably want to take your profitsand go home.

Greer: OK, Ron,you mentioned some other names there, including Nordstrom and Kohl’s. Wetalk a lot about Amazon (NASDAQ:AMZN)- proofretailers orcompanies in general. When both of you guys look at traditional retail,is there a company that you think is more Amazon-proof?

Gross: Wealways talk about TJ Maxxas a company that really hasrelationships with thousands of buyers and provides areally strong value on and strong assortment to the customer. So far, that has been Amazon-proof. Itdoesn’t mean it always will be, though.

Argersinger:It’sgoing to be very hard. When I think of a lot of these companies,I think of apparel. And Amazon is making such a big investmentin that area. For a long time, I figured,are people really going to buy clothes online? Shoes? Andsure enough, over the last ten years, that model has been proven. Now,I think something like a Macy’s or Nordstromfeels like a better, more polished brand than yourJCPenney’s of the world, or yourSears, certainly, of the world. Atthe same time,I like what Ron said. There might be some value here, but youlook to get out as soon as you thinkyou have somewhat of a fair valueon these businesses. Youcannot see the outsized growth anymore for any of these brands.

Greer:OK. Ron,as we wrap up here, I know from my boots on the ground researchthat in a previous life,as a younger man —

Gross:Where’s this going?

Greer:– youworked at Macy’s. True or false?

Gross: [laughs]Yes,I will admit.

Greer: OK. What were the highlights and lowlights of Ron Gross’Macy’s career?

Gross: Thebackground is, I was in high school. I worked in the bath shop. The bath shop, for those uninformed, isthe department where they sell bath towels, primarily, and bathroom rugsand things like that. I was terrible at this job. Itmostly revolved around folding things.

Greer: Andwhy were you terrible?

Gross: I’mnot a good folder of things!

Greer: Andyou weren’t passionate about the bath shop?

Gross: Andby the way, this was before the day of bar codes and those guns and scanners. Youhad to key in every little last thing manually at the register. Ifyou made a mistake, you had to go back to the beginning. It wasjust a disaster. Myone recommendation to those kids out therewith a similar type of retail job is,do not call out sick every other week,because they just don’t appreciate when you do that.

Greer: Ah,OK, so you kind of shirked your duties.

Gross: I wasn’t a strong employee.

Greer: OK,duly noted. We like the honesty. Guys, let’s turn our attention toTencent. Tencentreporting better than expected earnings thanks tostrong growth in its mobile games,mobile payments and other digital content. Now, Matt,for those who may not be following this company, Tencent isChina’s largest social networking and gaming company. When we’re talking Tencent, we’re talking WeChat,which has more than a billion users. And,oh yeah, Tencent now has a piece of the action intwo of the biggest games in the smartphone world –PUBG and Fortnite.

Argersinger:That’s right. Youmentioned, biggest social network and video game company in China. Well,this is one of the biggest social network and video game companies in the world. You mentioned the one billion, thefirst time WeChat, which is theirbig social network, hit a billion active users, this most recent quarter.

This is a $500 billionmarket cap company. Huge. It’s one of the biggestcompanies in the world.Revenue up48% to $11.7 billionin the quarter. Operating profits up 59% to $4.9 billion. That’s an operating margin of42%. They’re in Facebookterritorywhen it comes to the profitabilityof their company, of their platform.

Andit makes sense. Like you said, it’s a social network,massive social network. They own some of the biggest video game propertiesin the world. We’re talking League of Legends,Honor of Kings, and oh, by the way, they own 40% of anAmerican company called Epic Games, which happens to publish this game called Fortnite —

Gross: And was started in Potomac, Maryland, by the way.

Argersinger:That’s right!Potomac Computer Systems, or something like that. So,they have their hands in some of the most popular intellectual property in the world. Butif you look at the other parts of the business, we talka lot about their social network and their video games, butvideo and music streaming, up 47%, that business. Advertising, which they really haven’t tapped into –in fact, management has been really hesitant to show ads in the “news feeds” of WeChat users. And yet, that business is up 55%,when they haven’t even really tapped it.

But, it really is the power of that network. You have a billion users, soanything Tencent can do, any game they launch,any video streaming service they launch or new content they create,they can immediatelydistribute that seamlessly across mobile to over a billion users. So,that is an incredibly powerful competitive advantage that Tencent has builtover the last 20 years, and it’s just really starting to shine now as a public company.

Greer:Matt, I just quoted the stock, and I hear these heady numbersand all these untapped opportunities that they’rejust beginning to explore, especially with regards to China. Andthe stock is down slightly today. What gives there?

Argersinger:Well,I’ve seen this play out a little bit with a lot of these large Chinese companies lately.I think, for whatever reason — and, Tencent in particular, because it’s listed on the pink sheets in the U.S. — but, these are all platforms that we knowand hear about and we can invest in, butwe don’t really have any experience with them. And we’renot comfortable, necessarily, with the management of Tencent orJD.comorBaiduorAlibaba, just to go through the list.

There’s a big catalyst, though, coming forward, which is, the Chinese government may soon — as early as this summer — allow domestic Chinese investors to actually buy shares in these companies. Right now, they’renot allowed to invest in these foreign-listed companies,even though these are some of the biggest companies in China. It’s as if we used Amazon in the States, butit was listed in China, and we weren’t allowed to invest in it. Well,imagine that. Imagine what the valuation of Amazon would beif that was the case. That’s what Chinese investors facewith something like Tencent. I think that’s a catalyst. And it could be happening this summer, wherea lot of Chinese investors could suddenly be able to buy shares. That’sgoing to create a huge amount of demand, I think. So,that’s one of the things, I think, that’s waiting to happen before the valuation really goes up for a lot of these companies.

Gross: That’sinteresting, because as a value guy,it has barely crossed my radar. But I do own shares of Facebook,I own shares of Google. So,I am willing to place my bets there. But, Tencent, being a Chinese company, I remain wary of that kind of stuff –to my detriment, [laughs] it would appear,because they are taking it by storm, andand this Fortnite thing is a phenomenonthat I have never seen, at least in my house.

Greer: It’sincredible. I played my first game this weekend,and I couldn’t really figure out how to jump.

Gross: You can dance, too.

Greer: Yeah,I was so far from being able to dance. What I realized is,you really have to be able to jump.

Gross: In real life, you mean?

Greer: Well,in real life, it’s helpful. But in Fortnite, I kept running into the same wallover and over, and then I just got mowed down by someone.

Argersinger:Anddriving your son, I’m sure, crazy.

Greer: Oh,my son was trying to teach me, and it started out with, “This this will be exciting,” and within a minute, he was exasperated. It was the equivalent ofthe 12 o’clockflashing on the VCR. I was that guy.I was running into a wall over and over,I couldn’t jump. I mean, it’s a much more complex game —

Gross: Oh, for sure.

Greer: — than Pong.

Gross: [laughs] Pong!

Greer: Pong,you had to adjust your paddle size. And then, that progressed to Breakout. And the only thing with Breakout isyou had to keep your cool as you broke out.

Argersinger:So,you dominated those games, but when it comes to something like Fortnite —

Greer: There are all thesevariables! You have to jump, you have to move —

Gross: Build, building is the key to Fortnite.

Argersinger:Yeah, building.

Gross: If you’re a strong builder, you can win.

Greer: No.I was just running into a wall over and over.

Gross: These games,this whole genre is called battle royale games, where100 people play at a time in a game of Fortnite.

Greer: Yeah,it’s brilliant.

Gross:It’s brilliant, and don’t forget, Fortnite doesn’t cost any money unless you want to upgrade your outfit —

Greer: Skins, Ron! Not outfits, Skins! Gosh!

Gross: Sorry, skins. Right.

Greer: So insulting!

Gross: You spend money on these microtransactions, $5 and $10 at a time,that actually turns into a real business. Hundreds of millions of dollars’ worth of business. It’s fascinating.

Greer: It’s brilliant. And you can play solo, you can play it in a pair, you can play on a team. Now, they have the Marvel tie-in with Thanos. Oh my gosh, I mean, they’re just printing money.

Argersinger:AndI’m glad Ron just mentioned the model,because it really is a model thatyou saw in nascent stages ten years ago withvideo games, but 90% of the revenue for video games was still selling you the disc,it’s $50 and that’s usually the only transaction that would happen. Now, you layer inall those microtransactions. So,it ends up, gamers spend hundreds of dollars on a single titleover the course of playing the game. And I think, that’s why you look at Tencent, it hasoperating margins above 40%.

Gross: Andjust as an aside, what’s amazing is,you can’t spend money Fortnite,for example, to upgrade your weapon and give yourself an unfair advantageand buy yourself a win. It’sliterally just aesthetics. It just looks cooler. Andkids out there are still willing — not just kids, everyone is still willing to spend those $5 and $10.

Greer: So, you’re telling me kids like to look cool?

Gross: Yeah, I guess so.

Greer: Well,the one tweak I’m going to make based on my experience is, I want a seniors’ division, where 50 and over compete in their own division. Likegolf, right? Then you have a bunch of people running into walls together.

Gross: Nice.

Argersinger:I like that. I like that a lot.

Greer: Money maker. Guys,let’s close with Starbucks, which is really ramping upin China. Matt, these numbers are staggering. OnWednesday, Starbucks announcing plans to build nearly 3,000 new stores in mainland Chinaover the next few years. For those of youscoring at home,that will mean that Starbucks will have around 6,000 storesby the end of 2022. What do you think?

Argersinger:That’s right. Credit toCNBC’s Kate Rogers,who was covering this conference that Starbucks did inChina, its two-day investor conference. Theheadline is really that Starbucks reiterated once again that their business in China isalmost certainly going to eclipse their business in the U.S.in the future. There’s just no doubt about it. And that’s partly, from what you said, they’regoing to have 6,000 stores by 2022.

Right now,they have 3,300 locationsacross 141 cities inChina. They’re opening a new location –this is according to Kate –every 15 hours now in China. So,with the new numbers they’ve put out,I looked back at my own model that I’ve done of Starbucks, looking at store counts, and this is way ahead of where I thought they would be by 2022.

So,if you’re a Starbucks shareholder, I think you probably felt a little frustratedover the last several years. The stock has kind of stagnated. Overall global compshave been low single digits. And the stock has really been stuck in place. Butnow, I look at this and I say, well,Starbucks is trading for roughly 22Xforward earnings, 2% dividend yield,buying back a lot of stock, abusiness that should still be able to grow in the high single digits, sales,especially as China becomes a greater proportion of the business.I think Starbucks looks pretty compellingright now. It’s not going to be a barnstormer,but I think you can do pretty well buying Starbucks today. And if you get the shares under $50,even better.

Greer: Yeah,it was really surprising. Shares of Starbucks down over the past year, butover the past five years, uparound 80%.

Argersinger:Right. It’s still a long-term story. So,I think, if you buy Starbucks today and you look forward to what this business could look like in five years,in China and elsewhere,pretty exciting.

Greer:I confess, when I heard you say you did your model of Starbucks,I first envisioned you building a model of a Starbucks.

Gross: [laughs]A Lego model?

Argersinger:Of aStarbucks store?

Greer: Yeah! And I’m like, “That’s kind of odd.” And then I’m like, “Oh, wait, play it cool, he’s talking financial model. OK, I got it.”I was a little worried there. I’m like, “You know what? Putthe model down, just crunch the numbers.”OKguys, my favorite closing desert island question. You’reon a desert island for the next five years,and you can only hold one of these stocks that we’ve talked about: Macy’s, Tencent, or Starbucks?

Gross:Well,it’s definitely not Macy’s.

Argersinger:[laughs] I think that’s easy.

Gross: Tencent might put upbetter numbers, but I’m just not as comfortable with it. AndStarbucks is just a solid, solid company that I can put in my portfolio andgo to that desert island and not worry about it,so I’ll go Starbucks.

Greer: Notas comfortable with Tencent, is that because of the management, or the business model, or both?

Gross:I’m just not as familiar with it, it’s a little bitmore high-growth, high-flying than I’mtypically comfortable with, and you add in the Chinese piece,and that pushes it over to Starbucks.

Greer: OK. Matty?

Argersinger: I’m going to agree with Ron. The numbers that Tencent isputting up are just staggering,but I feel a little bit less comfortable about where I see the business in five years.I think the business is going to be huge, and it’s growing in all these different areas,but I want to see more of a focus on,eventually, what they can do with this huge WeChat platform.And, whether or not the Chinese government is ever going to step in and say, “Yeah, youguys are a little too influential,” especially as WeChat gets into financial transactions, which,they already have one of the biggest payment platforms. Being able to spread that across a billion users, it makes Tencentthat much more influential in China. So, if I’m going to sleep well at night and, I think, earn 10% a year I’m going Starbucks.

Greer: OK. There you have it. Matt, Ron,thanks for joining me!

Argersinger:Thanks, Mac!

Gross: Thanks, Mac!

Greer:As always, people on the show may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. That’s it for this edition of Market Foolery. The show is mixed by Dan Boyd. I’m Mac Greer. Thanks for listening! We’ll see you tomorrow!