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.

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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're really 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's largest 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 on better than expected earnings. Is the turnaround really happening?

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

Argersinger: Yet. [laughs]

Gross: Really interesting! 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. And there have certainly been some rebounds, helped by tax cuts and bonuses and tax refunds and a strong economy and 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 cut thousands of jobs, which is painful, but when business calls for it, sometimes that's what needs to be done. And it looks like they're reaping the benefits of that as well as the 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 promotion showed 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: It used to be that you literally had to know someone that worked at one of these stores, and they could pass you along a discount. 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 a big promotion, like the old Macy's One Day sales. That helped, the fact that it was in this quarter versus a different quarter last time around. If you strip that out, you're probably somewhere under 2% on a same-store sales growth basis. But still, 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're kind of throwing some things at the wall and seeing what will stick. They have their Macy's Backstage concept, which is their discount concept. Every retailer has to have one nowadays, like a Nordstrom (NYSE: JWN) Rack, for example. They actually bought a concept store in New York City called Story, 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; their CFO is leaving. Let's get that in place so they don't miss a beat with 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? Maybe this is an opportunity for investors?

Gross: So, they raised guidance. On their going-forward guidance, they're trading at 8.5X. Measure that up against a Nordstrom, that's around 15X, or a JCPenney or a Kohl's that are 17X and 12X, respectively, it certainly looks awfully cheap. And it continues to be a turnaround play. It's not the kind of stock you probably want to buy and hold forever. It's the kind of stock that potentially could be mispriced, and when it becomes fairly priced, you would probably want to take your profits and go home.

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

Gross: We always talk about TJ Maxx as a company that really has relationships with thousands of buyers and provides a really strong value on and strong assortment to the customer. So far, that has been Amazon-proof. It doesn't mean it always will be, though.

Argersinger: It's going to be very hard. When I think of a lot of these companies, I think of apparel. And Amazon is making such a big investment in that area. For a long time, I figured, are people really going to buy clothes online? Shoes? And sure enough, over the last ten years, that model has been proven. Now, I think something like a Macy's or Nordstrom feels like a better, more polished brand than your JCPenney's of the world, or your Sears, certainly, of the world. At the same time, I like what Ron said. There might be some value here, but you look to get out as soon as you think you have somewhat of a fair value on these businesses. You cannot 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 research that in a previous life, as a younger man --

Gross: Where's this going?

Greer: -- you worked 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: The background is, I was in high school. I worked in the bath shop. The bath shop, for those uninformed, is the department where they sell bath towels, primarily, and bathroom rugs and things like that. I was terrible at this job. It mostly revolved around folding things.

Greer: And why were you terrible?

Gross: I'm not a good folder of things!

Greer: And you weren't passionate about the bath shop?

Gross: And by the way, this was before the day of bar codes and those guns and scanners. You had to key in every little last thing manually at the register. If you made a mistake, you had to go back to the beginning. It was just a disaster. My one recommendation to those kids out there with 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 to Tencent. Tencent reporting better than expected earnings thanks to strong growth in its mobile games, mobile payments and other digital content. Now, Matt, for those who may not be following this company, Tencent is China'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 in two of the biggest games in the smartphone world -- PUBG and Fortnite.

Argersinger: That's right. You mentioned, 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, the first time WeChat, which is their big social network, hit a billion active users, this most recent quarter.

This is a $500 billion market cap company. Huge. It's one of the biggest companies in the world. Revenue up 48% to $11.7 billion in the quarter. Operating profits up 59% to $4.9 billion. That's an operating margin of 42%. They're in Facebook territory when it comes to the profitability of their company, of their platform.

And it makes sense. Like you said, it's a social network, massive social network. They own some of the biggest video game properties in the world. We're talking League of Legends, Honor of Kings, and oh, by the way, they own 40% of an American 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. But if you look at the other parts of the business, we talk a lot about their social network and their video games, but video 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, so anything Tencent can do, any game they launch, any video streaming service they launch or new content they create, they can immediately distribute that seamlessly across mobile to over a billion users. So, that is an incredibly powerful competitive advantage that Tencent has built over 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 numbers and all these untapped opportunities that they're just beginning to explore, especially with regards to China. And the 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 know and hear about and we can invest in, but we don't really have any experience with them. And we're not comfortable, necessarily, with the management of Tencent or JD.com or Baidu or Alibaba, 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're not 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, but it was listed in China, and we weren't allowed to invest in it. Well, imagine that. Imagine what the valuation of Amazon would be if that was the case. That's what Chinese investors face with something like Tencent. I think that's a catalyst. And it could be happening this summer, where a lot of Chinese investors could suddenly be able to buy shares. That's going 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's interesting, 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, and and this Fortnite thing is a phenomenon that I have never seen, at least in my house.

Greer: It's incredible. 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 wall over and over, and then I just got mowed down by someone.

Argersinger: And driving 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 of the 12 o'clock flashing 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 is you 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 these variables! 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, where 100 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: And I'm glad Ron just mentioned the model, because it really is a model that you saw in nascent stages ten years ago with video 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 in all those microtransactions. So, it ends up, gamers spend hundreds of dollars on a single title over the course of playing the game. And I think, that's why you look at Tencent, it has operating margins above 40%.

Gross: And just as an aside, what's amazing is, you can't spend money Fortnite, for example, to upgrade your weapon and give yourself an unfair advantage and buy yourself a win. It's literally just aesthetics. It just looks cooler. And kids 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. Like golf, 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 up in China. Matt, these numbers are staggering. On Wednesday, Starbucks announcing plans to build nearly 3,000 new stores in mainland China over the next few years. For those of you scoring at home, that will mean that Starbucks will have around 6,000 stores by the end of 2022. What do you think?

Argersinger: That's right. Credit to CNBC's Kate Rogers, who was covering this conference that Starbucks did in China, its two-day investor conference. The headline is really that Starbucks reiterated once again that their business in China is almost 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're going to have 6,000 stores by 2022.

Right now, they have 3,300 locations across 141 cities in China. 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 frustrated over the last several years. The stock has kind of stagnated. Overall global comps have been low single digits. And the stock has really been stuck in place. But now, I look at this and I say, well, Starbucks is trading for roughly 22X forward earnings, 2% dividend yield, buying back a lot of stock, a business 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 compelling right 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, but over the past five years, up around 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 a Starbucks 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? Put the model down, just crunch the numbers." OK guys, my favorite closing desert island question. You're on 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 up better numbers, but I'm just not as comfortable with it. And Starbucks is just a solid, solid company that I can put in my portfolio and go to that desert island and not worry about it, so I'll go Starbucks.

Greer: Not as 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 bit more high-growth, high-flying than I'm typically 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 is putting 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, you guys 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 Tencent that 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!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Mac Greer owns shares of Alphabet (C shares), Amazon, and Facebook. Matthew Argersinger owns shares of Alphabet (C shares), Amazon, Baidu, JD.com, and Starbucks and has the following options: short July 2018 $42 puts on JD.com, long January 2020 $50 calls on JD.com, and short January 2020 $50 puts on JD.com. Ron Gross owns shares of Alphabet (C shares), Amazon, Baidu, and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Baidu, Facebook, JD.com, Starbucks, and Tencent Holdings. The Motley Fool recommends Nordstrom and The TJX Companies. The Motley Fool has a disclosure policy.