China has risen from an economic afterthought to the world's second-largest economy in the span of a few decades. That helps to explain why international companies have long attempted to get a piece of the action, especially given the country's middle-class boom in the last decade. Then again, investors have benefited from a growing number of reputable Chinese stocks in recent years, too.
With that in mind, we recently asked a group of contributors at The Motley Fool for their best Chinese stocks to watch in May. Here's why they chose A.O. Smith (NYSE:AOS), Tencent Holdings (OTC:TCEH.Y), and Baidu (NASDAQ:BIDU) this month.
Slowing Chinese growth threatens this business
Maxx Chatsko (A.O. Smith): Technically, A.O. Smith is an American company, but it's increasingly reliant on its Chinese operations. The business estimates that roughly 10,000 of its 16,300 employees are located in China. It sells water heaters in more than 9,000 retail locations in the country, in addition to 7,500 locations for water-treatment products and 3,500 locations for air-purifier products. Subsidiaries there held nearly all of the $633 million in cash and short-term investments reported at the end of the first quarter of 2019.
While the business has been handsomely rewarded for its ability to carve out dominant market share and sell to China's swelling middle-class population since it first arrived 20 years ago, investors have recently been awakened to the risk of becoming too reliant on the region for growth. The country, which was responsible for 34% of total revenue in 2018, is experiencing its worst market slowdown in recent memory. That's especially true for consumer purchases, a category including water heaters, water-treatment products, and air purifiers.
The only thing A.O. Smith can do is brace for impact -- and tell shareholders to do the same. The company reported that Q1 2019 revenue from its rest-of-world segment, primarily driven by China, declined 21% year over year. Segment earnings fell by two-thirds and settled at a margin of just 5.3%. By comparison, the North American segment achieved a margin of 22.2% in the most recent quarter.
To be fair, management has communicated its expectations for a slowdown in China for several quarters now. But with renewed fears over a full-blown trade war between the U.S. and China -- the likes of which will only exacerbate the latter's economic decline -- investors will be watching how it all shakes out. After all, it could significantly dampen the company's short- and medium-term growth prospects.
Updates coming from China's largest gaming company
Neha Chamaria (Tencent Holdings): Having gained nearly 25% year to date as of this writing, Tencent shares have already made up for their 2018 losses and then some. Management, however, still believes Tencent is undervalued, which is why it intends to seek shareholder approval on May 15 to repurchase as much as 10% of its outstanding shares. That's also the day the company will announce its first-quarter numbers. It'll be an event worth watching.
Tencent doesn't give quarterly guidance, but its last earnings release marked a deceleration in growth. Yet the market paid little heed, because Chinese regulators recently lifted a nine-month ban on gaming approvals and approved several games, including one from Tencent. As the largest gaming company in China, Tencent was bound to take a hit because of the freeze on approvals.
The thing is, China's new gaming rules suggest a tighter control over the kind of games that make it as well as fewer approvals. Tencent's views about this will be worth noting in its upcoming earnings release, more so because the company is markedly pushing other businesses such as cloud services, WeChat (China's leading mobile messaging platform), payments services, and mini programs to reduce reliance on gaming and broaden its revenue base.
Tencent's upcoming earnings call should also carry updates about an important development -- that of the company's partnership with Nintendo to sell the latter's Switch in China. And let's not forget updates about the recent IPO filing in the U.S. by Tencent-backed Douyu, China's largest live-streaming platform. In short, it's one of those months when you'd want to watch Tencent closely.
China's search and AI leader is worth a look
Chris Neiger (Baidu): It's easy to assume that Google dominates the online search market across the globe, but in China, Baidu is king. The company has about 80% of the online search market in the country, and that lead has allowed it to amass a huge advertising business that drives sales. In 2018, Baidu's revenue jumped 28% year over year to RMB 102.3 billion ($14.88 billion), mostly thanks to the company's ad sales.
Aside from Baidu's massive advertising business, the company is also making huge strides in the growing artificial intelligence market. Several years ago, Baidu hired Andrew Ng, a key AI engineer who used to work at Google and started the Google Brain project, to head up its AI pursuits. Now the company has built a huge AI division with more than 2,000 employees.
One area the company's AI team is focusing on is autonomous vehicles (AVs). Baidu has developed a driverless-car platform called Apollo and announced at the beginning of this year that an enterprise version of the platform would hit the roads in 2021. More than 135 AV partners around the world already use a version of Apollo, and with AVs expected to create a $7 trillion passenger economy by 2050, Baidu's Apollo will no doubt benefit.
Baidu will report its first-quarter 2019 results later this month, and the company's management is expecting sales between RMB 23.5 billion ($3.42 billion) and RMB 24.7 billion ($3.60 billion), which would be a 15% increase at the midpoint. With the company already light years ahead of any other search companies in China and leading the march toward AI opportunities like self-driving cars, investors looking for a top Chinese stock should give Baidu more than a passing glance.