Two Foreign Tech Stocks for Your Watchlist

Tencent and MercadoLibre (MELI -0.54%) are both already pretty big, but their growth runways are far from over. Wrapping up International Week on Industry Focus: Tech, hosts Dylan Lewis and Motley Fool contributor Danny Vena take a deep dive into the Chinese video game/social media Goliath and the Latin American e-commerce giant and what investors should know about the future for both companies.

Tune in to find out how these companies make their money, how a $500 billion market-cap company still has plenty of room to grow, the biggest risks and challenges facing MercadoLibre lately, how Tencent's investment arm is taking advantage of growth outside China, which company looks like the more exciting long-term investment as of today, and much more.

A full transcript follows the video.

This video was recorded on May 18, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 18th, and we're talking international tech stocks. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com's Danny Vena. Danny, we're wrapping up International Week here on IF. Before we start talking stocks, have you ever been abroad?

Danny Vena: Oh, goodness, yes! I spent 13 years in the military, so I was in several foreign countries, most notably Berlin right before the wall fell. After that, my wife and I are prolific international travelers. We've been to Paris, London, Dublin, Rome, Venice, you name it. And we went on a mission trip to Kenya at one point.

Lewis: So, you're a man of the world, Danny.

Vena: I am.

Lewis: Our man behind the glass, Austin Morgan, is not so much a man of the world. [laughs] 

Austin Morgan: You could say that. I've been to Jamaica one time, and it was the most terrifying place I've ever been. I think I was 15, and we were on a cruise. We got off in Jamaica. We were going tubing. We had to drive up the mountain to go tubing. And on this trip, A, there's no road rules. None at all. It's terrifying. You just honk your horn and go. And, I saw a man chasing another man up the street with a machete. And that was the last time I went to Jamaica.

Lewis: [laughs] And the only time you've traveled abroad, right?

Morgan: And the only time I've traveled abroad.

Lewis: Well, that doesn't normally happen when you travel abroad.

Morgan: No, probably not. But.

Lewis: But. But, we need to get you traveling more of the United States.

Morgan: Yeah, I haven't really gone that far. I went to Colorado once for X Games. But, not much travel.

Lewis: We'll get you there. And I'm thinking about some of my own travel, because after the awful weather we've been experiencing here in D.C., I'm thinking about traveling quite a bit. It's wet here at HQ, Danny. It's also wet in the studio because I spilt water all over the table before we started taping. So, I'm thinking about traveling quite a bit. 

Why don't we at least mentally travel a little bit and talk about some foreign businesses here? We're going to be talking about two fairly big international companies on the show today. While they're both large, they face totally different challenges. Why don't we start off talking about a company that we mentioned last week, Tencent?

Vena: Dylan, Tencent is a company that's probably not that well-known to U.S. investors unless they have a particular focus on China. Tencent is one of the largest video game and social media companies in the world in terms of revenue. And it bears saying that there's a dynamic, when you talk about the United States, you talk about apps, we have a different app for everything. We have apps for social media, we have separate apps for messaging, we have separate apps for each video game. In China, the dynamic is a little bit different, particularly with Tencent. Tencent has what's called a social messaging app. This app has over a billion users. A billion. That's of the 1.3 billion population of China, so that's pretty substantial penetration, there.

Lewis: Yeah, that's a pretty big installed base to work off of. And not only do they have this WeChat app, they're also the largest video game publisher by revenue, and they have a lot of very successful titles in the Chinese market.

Vena: They do. Chinese consumers are truly taken with the game Honor of Kings, which is one of the largest video games in the world, and a game that most Western gamers have never heard of. However, they may be familiar with a game called Fortnite, the Battle Royale, Hunger Games-style game that has taken the world by storm lately. It's a free-to-play game, however, it's been making hundreds of millions of dollars each month as gamers that are playing buy add-on things within the game itself. They're buying skins for their players. Mind you, this is not loot boxes. I know there are a lot of folks that are not into the whole loot box thing. They're not buying extra lives, they're not buying weapons, but they're buying clothes and other things for their players.

Lewis: Yeah. I was down in Florida visiting my family a couple of months ago, and my cousin has kids between eight and 12, and Fortnite is all they wanted to talk about. As someone who doesn't have children, it's kind of a good reminder of how popular things can be outside of the core demographic that you're in. 

Now, this is a rare instance where they have exposure to something that's in the United States and is not yet in China. Actually, Tencent is accepting pre-registration for Chinese gamers for the Epic Games title, Fortnite, but they don't currently have access to that. So, for all the growth that we've seen with this particular title, it's not yet in one of the biggest gaming markets in the world.

Beyond the gaming and social media stuff, though, I think something that makes Tencent a very interesting business is, they also have a pretty sizable investment arm.

Vena: They do. And you would be surprised, I read some statistics on this, and they were pretty fascinating. According to the Wall Street Journal, Tencent has stakes in 277 start-ups just since 2013, and it has invested in 80 public and private companies just in the last year alone. Now, you hear a lot about big companies like, say, Google, investing in a lot of start-ups. But, in this particular case, you would be surprised to know that Tencent has substantial stakes in some very well-known U.S.-based companies. It has a 5% stake in Activision Blizzard, a 5% stake in Tesla. It's done a 10% share swap with Spotify, owns 12% of Snap. These are big companies. Estimates are that the company has spent probably $25 billion acquiring stakes in other companies.

Lewis: And it's kind of an interesting offshoot for their business. If you think about it, they're a large company at around a $500 billion market cap, so these investments are a relatively small portion of the overall company. But, you think of the sheer breadth of the number of start-ups they've invested in, it kind of has that Google feel to it, where it's like, "We're putting our money into a whole bunch of different baskets here, almost like a venture capital fund. And if any of these take off, they could become really significant segments of our business." Or, the investments side of their business could become a lot more interesting. 

Looking at a company this size, often, you don't expect them to be putting up really impressive growth rates. And yet, Tencent just continues to grow. Last quarter, they grew revenue at 48%, and the other numbers were even more impressive. Operating profit was up 59%, net profit was up 61%. A year ago, the company posted 54% year over year growth. So, this isn't a business that growth is slowing meaningfully. It's still posting pretty impressive results. It's not like anything is falling off a cliff as it gets bigger.

Vena: It isn't. Because it has the combination of your social media and video games -- and as I started to say earlier, this is the everything app in China. Rather than having separate apps for all these different things, using this app, it's social media, you can play games, you can order food, ride-hailing, do flight ticket check-in, all without ever leaving the app. So, it has a huge advertising business within all of this social media and gaming. 

It's ridiculous, their online games revenue grew 26% year over year to $4.5 billion. Their social media revenue was up 47% to about $2.9 billion. But, then, they have several other really quickly growing sidearms, most notably cloud computing and digital payments, which both doubled in the last quarter year over year to a total of about $2.5 billion for the segment.

Lewis: And we talked about streaming video in China last week. They also have a streaming video business. In the most recent quarter, their video customer base grew 85% year over year. So, that's growing, too. This looks like a company that's seeming to do everything pretty much right. They just posted earnings, I think, yesterday or two days ago, and the market was very pleased with these results. They're up, I think. 7-8% since they posted. 

When I look at this company, Danny, I'm not so much worried about what's going on in China with them. I think they have the massive installed base there, to borrow what you said before, they're like the Facebook, PayPal, you name it, they are that company for China. What really becomes interesting to me is, can they grow this business outside of China, as well? They already have a huge runway within their domestic market, but if they can get outside of that, then the growth opportunities become even more interesting.

Vena: And I think one of the things that you can look at is, with all of the other investments that they've made in companies outside of their core market, that gives them an in in so many different countries. They may not be able to replicate that type of success in their international markets as they have in China, just because the way we use apps is so segmented compared to China. 

But, that said, they have so many ways into other countries -- for instance, Activision Blizzard and Epic Games. They're around a 40-45% owner of Epic Games, which is all around the world. So, they have ways to grow in international markets.

Lewis: And I think this company is a really great bet on a lot of trends that we really like in the tech space. We've talked a ton in the past on the show about the gaming industry and how successful Take-Two, Activision, EA have been as investments over the last five years. We look at esports as a megatrend that's really rising. This company has exposure to that. This company has exposure to mobile in general, but also the payments industry. I think that's really interesting. 

This is a big business. Recently, I've tried to look for smaller tech players, just because I think the growth opportunities are better and the opportunities for returns are a little bit better. But I also look at them and I'm like, yeah, they're a $500 billion company, but out of any company that size, I think this is the most realistic double in the next five to ten years, that I can see.

Vena: I think you're right. This is a company that I'm looking to make a meaningful investment into. I only started studying this company in the last few months, and I'm really impressed with, like I said, not only the massive penetration that they have in the social media space, in the gaming business, in their native China; but also, they're investing in streaming video, they're investing in cloud computing, they're investing in digital payments. You put all that together, and I think they still have a massive opportunity ahead of them.

Lewis: We're going to talk about another company that has a massive opportunity in front of it, at least in our view, but some slightly different risks in front of it, as well, on the second half of the show. 

Alright, Danny, turning our attention to a company that we both currently own, why don't we talk about MercadoLibre? I know this is one of your favorite businesses, it's one that you turned me onto, I think, about a year ago, and I've been following it since. Why don't we break down for people that aren't as familiar with the business?

Vena: Well, for folks that have never heard of it, MercadoLibre is the leading e-commerce platform in Latin America. When you think about e-commerce, you think about companies like Amazon (AMZN 0.19%), that's the e-commerce leader that sells products; you think about Shopify, that helps set up websites and manage them for business owners; you think about companies like eBay, that has a platform for people to sell things to each other; you think about PayPal, that's actually one of the more widely used digital payment sources. If you take all of those companies and you take the best of them and meld it all together, that's what you have in Latin America with MercadoLibre.

Lewis: Yeah, much like our earlier conversation about Tencent, this is a company that does a whole lot of different things and seems to do it very well. One of the issues with the space that it operates in is, they wind up getting hit with a lot of volatility. They're in a lot of developing markets, they wind up getting hit with a lot of currency fluctuations. This is something that can really put a damper on their quarterly results. So, there can be some disappointments there. When we're looking at the results for this company, I know you and I tend to focus on some of the more operational business metrics.

Vena: That's true, Dylan. And because they operate in 19 different foreign countries, and the currencies of those countries, and they report in dollars, like you said, there are severe fluctuations that happen with their financials due to changes in foreign currency rates compared to the dollar. So, we look at some of the operational metrics. 

Three of my favorites are user growth, items sold, and payment transactions. And the reason for that is because they're not currency-denominated. So, looking at those, that gives you a good proxy for growth in a number of different areas, and it strips out the foreign currency effect. And, this company has really done well looking at those operational metrics. When you look at user growth, it's grown its user growth for about 20% going back every quarter for, like, six years. Its items sold has grown 40% year over year on average for, like, the last nine quarters. Payment transactions have exceeded 60% growth year over year every quarter going back to early 2015. So, if you look at the non-financial part of the growth story, this company is growing gangbusters.

Lewis: Of course, we do have to also look at the financial part of the story, because that's what the market pays attention to, as well. Things have not been particularly rosy for MELI over the past few months. I believe shares are down something like 25% since March, and that really has to do with the top line, bottom line numbers that they have to report.

Vena: Well, there is one other small thing that has affected this stock. If you go back several months, there were reports that Amazon.com is making a meaningful move into Brazil. Now, for the last several years, Amazon has been available. Folks in Brazil could access the website, they could buy books and, I believe, electronics. Now, they're moving to develop a meaningful website in Brazil. Of course, any time Amazon enters the conversation, any other company that's competing in the space really has to ramp up their game in order to compete.

Lewis: Yeah. Just ask Blue Apron about that, right? [laughs] 

Vena: Who?

Lewis: Exactly. But, what about some of the tax stuff that's impacting their financials? Sorry, that's what I was teasing at before.

Vena: Sure. Well, one of the things that happened is, the United States changed generally accepted accounting principles. And one of the things that they changed had to do with revenue recognition -- specifically ASC 606, for you accounting buffs. How that affects MercadoLibre is that, in the past, when they gave incentives for people for shipping -- and, to back that up just a little bit, MercadoLibre has been breaking out free shipping in many of its markets for the last couple of years in anticipation of Amazon moving into the market. So, they're working to take market share, and by offering free shipping on many of their orders, they'll be able to compete meaningfully before Amazon even gets there. 

What they have done in the past is that, for accounting purposes, the cost was shown under cost of goods sold. That recently changed. In the first quarter of this year, that now has to be a reduction from revenue. Now, that may not sound like it's that big of a deal, but in the most recent quarter, MercadoLibre had revenue of $433 million, and they had given away $112 million in shipping incentives. So, instead of having 60% growth for that quarter, it showed 19% growth under the new standard, even though nothing had changed.

Lewis: Right. It's more of a recognition thing than an actual core business cost issue, right?

Vena: That's right. Because of this, it's going to take a couple of quarters for people to wrap their mind around this. People that follow the company had gotten used to seeing 50-70% growth in a quarter year over year. Now, they're looking at 19% growth. Just from a psychological standpoint, that has an effect.

Lewis: There was a silver lining to all of this, though, wasn't there, Danny?

Vena: There was. The company has been working to institute a program that it calls Fulfillment by MercadoLibre.

Lewis: I wonder where they got that idea. [laughs] 

Vena: Does that sound familiar at all? They've taken a page from Amazon's playbook. What they're doing is they're setting up warehouses and fulfillment centers within Latin America. What happens is, some of their merchants will bring in product and set it up in these fulfillment centers to be shipped out directly to customers. That takes out a lot of the middle man. 

In the most recent quarter, the national postal service in Brazil raised their rates pretty significantly. In just local and regional shipments, the cost went up by 8% or more. But in national shipments, the cost went up by between 30-50%. So, that took a toll on MercadoLibre's financials during the quarter. They didn't really have a lot of time to react to that. 

They did say on their earnings conference call that this was a short-term situation, and because they have been working to move their merchants to Fulfillment by MercadoLibre, the costs associated with shipping going up that significantly was kind of an incentive for those merchants to accelerate that process and start moving over to MercadoLibre's shipping system.

Lewis: So, to sum up the last three months for MercadoLibre, you have the impending entrance of Amazon to one of its core markets, you have this major change in how they state their financials, and that makes their growth rates look a lot less rosy, and you have some costs rising for them. There's a lot of things to be concerned about with this company that maybe people wouldn't have been as worried about, maybe, six months ago. 

We actually got some questions from one of our listeners, Simon, about some of these issues. He asks us, "I was interested to know what your thoughts are on Mercado. Specifically because of the deal Walmart announced for Flipkart, I can't help but think South America is emerging as another battleground for e-commerce." I think that speaks to the move that we saw with Amazon coming to Brazil a little bit. How do you feel about Mercado in Brazil and South America with a potentially larger player coming in there, Danny?

Vena: I think that you have to understand the market in Latin America a little bit in order to understand the dynamic. And one of the things that you're going to see is that, in Latin America, they are a population that doesn't have that much in terms of credit cards and in terms of checking accounts. This is, by large, one of the few remaining cash-based markets in the world. A lot of people still pay for things by cash. 

Now, MercadoLibre set up their payment system, called Mercado Pago, and folks can stop by a local convenience store, they can pay money at the counter and reload their account, similar to what PayPal did years ago. This is something that they set up years ago, so it's very well-penetrated within the region. Folks are not only using that to buy things on MercadoLibre's website, but they have also expanded off of the platform, so folks now use this to pay utility bills and at other stores, as an example. 

This is one thing that MercadoLibre has going in its favor to compete with somebody like Amazon. Another is the hometown factor. When you talk about the region, Latin America is much earlier on the road to internet penetration, to e-commerce, to online shopping. So, when you look at these, this is a hometown company that the folks that live there trust. And at least for the time being, that's going to give them more of a competitive advantage. And, I think they can still compete with Amazon because they have such a head start in many of these areas.

Lewis: Simon asked us a second question. I think this speaks to the value of what MercadoLibre has already built there. Would MercadoLibre make a good acquisition target for a giant e-commerce company that wanted to establish a footprint in that region? He specifically notes Walmart, Alibaba, possibly JD.com. With what you just laid out, I would think the answer would have to be yes.

Vena: I agree with that, absolutely. I think that one of the things that you're going to see is consolidation in a lot of these international markets as Amazon ramps up. As big as the business is, and it accounted for something like 44% of the e-commerce growth last year, and maybe 4% of all online sales in the United States, it has not penetrated that far into international markets yet, although it's ramping up. One of the things that you're going to see is, there are going to be more mega deals like you saw with the bidding war between Walmart and amazon.com. And I think that Latin America is one of those areas in the world that's ripe for this type of consolidation. And I think there may be offers made for MercadoLibre in the near future, from one of these large e-commerce players.

Lewis: Particularly when you look at the size of the company, right? This is a $15 billion company, is that right? Somewhere in that neighborhood?

Vena: It is. It's firmly in the large mid-cap to small large-cap range. I think this is an easy acquisition to swallow for a large company. If you think about, I believe Walmart just paid, what was it, $16 billion for Flipkart?

Lewis: Something like that.

Vena: That puts MercadoLibre right in the same range in terms of how much somebody would have to pay to scoop up this company, plus whatever premium they had to pay. So, I think that's definitely a possibility. I don't know if they're interested in being acquired, but I think that there are definitely going to be companies out there that are interested in making such an acquisition.

Lewis: And, to be clear, there are some stocks that you buy because you think that there's an acquisition coming down the road, and it's that, this is more valuable in someone else's hands, basically. I think, with Mercado, this is a business that works, and it's a business that can continue to operate pretty well over the next five years. I'm a little worried about Amazon coming into that space, but I think that they've done enough to install themselves there that it's not a huge, huge worry for me.

So, when someone's buying this business, it's appealing in its own right. It's not like you're buying this stock thinking, ohh, someone will think it's more valuable than it currently is. You're buying a good business if you're owning this company.

Vena: I think that MercadoLibre will prosper whether or not Amazon gets into this space. Amazon may seem like they're invincible, but there are several historical precedents -- the Fire Phone, for instance -- where Amazon has not only failed, but failed spectacularly. And that's something that Amazon CEO Jeff Bezos has embraced. He understands there are going to be some places that he's going to fail. I think, if there's an area where Amazon has a tough time succeeding, I think Latin America is probably one of those, and I think MercadoLibre would be the reason.

Lewis: OK, looking at the two companies we've talked about today, do you have one in particular where you're like, three or five years out, this is the one that I'm putting my money on?

Vena: Well, I already own a substantial position in MercadoLibre. I think last time I looked, it was, I don't remember, 5-7% of my portfolio, so, a pretty large chunk. I will be looking to establish a position in Tencent here in the next few weeks. But, I think either one of them is a buy at this point.

Lewis: Yeah, for my money, it's funny, because as a Mercado shareholder, I think I actually think Tencent is the better business to own over the next three to five years. So, like you, I'll probably be establishing a small position fairly soon. I'm glad that we had the excuse to do some homework on these companies with International Week.

Vena: You have to love learning something about companies that you may not know so much about, particularly if they're outside your current sphere of knowledge.

Lewis: Yeah. And listeners seemed to really enjoy this week. We got a lot of notes saying that people appreciated us getting out of our core coverage area and talking about some lesser-discussed businesses. If you have any names that are international companies and you want to hear about them, listeners, please let us know. We're probably going to be doing another one of these weeks down the road, just because the listener response was so strong. Danny, anything else before I let you go?

Vena: No. Watch that weather out there in wet and slushy D.C.

Lewis: Yeah. We're supposed to have our Fool outing today for a Nats game. I'm not sure if that's going to happen. Austin Morgan, what do you think? Do you think it's in the cards?

Morgan: No chance.

Lewis: [laughs] No chance!

Morgan: There's so much rain.

Lewis: We've gotten rain for five straight days. That field has got to be soaked.

Morgan: Yeah. I mean, they definitely have it covered, and I'm sure the grounds crew is living at the park, but ,no way.

Lewis: Well, I guess my Friday night just opened up. Danny, have a great weekend! I'll chat with you soon.

Vena: Thanks, Dylan! Thanks for having me on!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Danny Vena, I'm Dylan Lewis. Thanks for listening and Fool on!