Checking In on China

Long-term investors in the BAT stocks -- Baidu (BIDU 0.72%), Alibaba (BABA 0.64%), and Tencent (TCTZ.F 0.09%) -- have probably been pretty happy with their returns...until about this year. What comes next for these massive companies?

In this episode of Industry Focus: Tech, host Dylan Lewis talks with Motley Fool premium analyst and resident China expert Ben Ra about investing in China and the BAT stocks. Learn about some of the country's unique growth dynamics, how the government plays into the investing thesis for giant companies like Tencent, the differences between Alipay and WeChat Pay, why JD.com (JD 1.13%) isn't exactly the Amazon of China, how WeChat fits in, why investors should pay close attention to Baidu's moves in the next few years, and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Sept. 25, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, September 27th, and we're checking in on China. I'm your host, Dylan Lewis, and I've got Motley Fool premium analyst Ben Ra with me in the studio. Ben, how's it going?

Ben Ra: Good, pretty good. This is my first time here and I'm excited.

Lewis: You're kind of The Motley Fool's resident expert on all things China. You have an overview on China that is very well attended for a lot of our member events. I think it's one of the more popular events that we put on when we do some of those member meetups. So you were the natural choice to have on when we were going to be checking in on China today. I'm excited to have you on the show.

Ra: Thank you very much!

Lewis: Why don't we start out with a what has interested you with China? There have been so many headlines, there have been so many stories -- some of it trade war related, some of it related to the stuff going on in Hong Kong. What have you been paying attention to in the region?

Ra: Currently it's mostly Hong Kong, what's going on in Hong Kong. That's a totally different story. It's going to take a whole 'nother podcast to go into that. I've been paying a lot of attention on the macro stuff. Also the companies. We're going to talk about the BAT companies today. It's interesting to look at what's going on with them. I think they've reached a point of maturity a little bit quicker than people have probably thought in the past.

When I look at China, generally, as far as the wider market, I see it as a place that's industrially young but technologically mature. It's almost like if the U.S. in the early 20th century, when we were industrially young, we were given somehow 21st century technology. Just imagine that kind of world. That's China. China was industrially young, and somehow they got a hold of the most advanced Western technology, and not only that, but Western business models. And they're able to apply it on an industrial young, not very well developed country. That's one of the reasons why you can have a company like Alibaba, that was able to use Western business models, Western technology, and use it on zero competition. Here in the U.S., you have Amazon. Amazon may be the most innovative company in the world, but it still has to go against Walmart. That's generations of retail experience. In China, you don't have that.

I think we're reaching a point where the technology has spread to a lot of different companies. It really is a big question mark, what's going to happen in the future? I definitely don't have the answers. But I'm just looking at the numbers and observing.

Lewis: I think one of the frustrations for investors that are looking at China and own some Chinese stocks -- we talk about a lot of them regularly because so many of them have been great performers over the last five to 10 years. That story has changed a little bit if you're looking over the last year or two. And they look at that slowdown, some of it related to macro factors, some of it related to specific issues within China, and they say, "Where are the returns? What's going on with these companies?"

Ra: Yeah. If you look at something like Alibaba -- Alibaba, I think, out of the four companies that we're going to talk about, probably shows the best numbers. The revenue growth is pretty strong. The commerce growth is at like 40%. But it's still at a stage where it's investing. It's reached a point where, as far as the core revenues go, it's at a fairly mature state, but they're definitely investing in what they call new retail. It's pretty exciting, but it's still a question mark, how that's really going to go.

The thing about Alibaba that we have to understand is this -- it's really the biggest advertising platform in China. We think of it as an e-commerce platform, which is true, but it really is the core online advertising platform. Some people have called Amazon here in the U.S. a search engine for advertising. We see this segmentation going on here, where Amazon controls product search. If you're looking for a product, you go direct to Amazon. Google is more like services search. That segmentation is actually much more net in China, where Taobao really is the search engine for products. Even their revenue model is really in advertising. It's like a Google AdWords model.

You can ask yourself, "Is that really advertising?" The thing about the current age is, commerce and marketing have joined. Retail has always had an advertising aspect. If you go to your local supermarket, there's end tables. As a brand, you can pay for shelf space. That's marketing. That's always been part of retail. But I think, especially what you're seeing with Amazon now, and with Alibaba, the difference between commerce and advertising, it's really difficult to see.

Alibaba has that, but it's going into what it calls new retail. It's going into the online to offline, where it's using its online capabilities, its logistics, combining it with brick and mortar retail establishments. They've made a lot of acquisitions in that regard. Their revenues have gone up. Out of the BATs, it's gone up in the healthiest way. But its margins have suffered. That's probably going to continue. It is a question mark, how it's going to look going forward. But at the same time, in terms of online to offline retail -- new retail, as they call it -- they've probably made the most progress than any company in the world.

Lewis: It seems like this is a perfect example of what you're talking about, with taking concepts or business models that have worked in the Western world and bringing it there, with both the vertical integration of logistics, and what you're talking about with new retail. I also think about that when I look at new spaces for them, like food delivery.

Ra: Yeah. They got control of ELEME. Baidu had a fairly big stake in it, which they bought up. That's an interesting acquisition. Alibaba, if you compare with Tencent, which we're going to talk about more later, Alibaba has more of a presence in the online space, and Tencent has more of a presence in the offline space with their WeChat. A lot of businesses use WeChat and WeChat Pay. This is kind of a generalization, but Alipay is more used for online transactions; WeChat Pay more for offline transactions. Definitely, if they want to get into that online to offline, they need those offline customers. ELEMA, which is a food delivery business, is one way to get a whole bunch of those offline customers. You do see that competition between Alibaba and Tencent. You see it everywhere, but food delivery definitely is one of the places where you see that.

Lewis: I'm glad you drew that line there with the different payment services and what they're most often used for. I know as an outsider looking in on this market, I'm like, "It all sounds very similar." If you have mobile payments, it is akin to a Square Cash app versus Venmo. And you're trying to figure out who uses what and for what purpose. Having someone that's very well versed in the space is obviously super helpful for making that happen.

OK, why don't we get back to this discussion talking about Tencent? We named-checked them in the first half and talked a little bit about the payments side of what they do. But that's just a very small portion of what's going on with that business.

Ra: Yeah. A big part of its revenues comes from the games. Online gaming is a huge part of their business. That's been under difficulty at the moment. The recent numbers that I've seen, PC client games actually went down 9%. Overall games revenues went up only 8%. It's under difficulty. Mainly because of government regulation. I think one thing we definitely have to understand about China is that the Chinese government do take a very hard interest in what's going on with their youths. If they see something like addiction with gaming, they're going to step down on that. In the U.S., we have a tendency to think that regulatory risk is ... it's there, but we really don't see companies that completely die out because of regulatory risk. There may be a couple, but it's not as common as we see in China. It's definitely possible in China for the government to crack down, even on a company as big as Tencent, if they do feel like gaming addiction is a huge problem. And they have done that, to some extent. For example, one of their major games was PUBG, which was recently canceled. They came out with a replacement game, Game for Peace. It's like a socialist replacement for this fighting game, basically. It's supposed to be less violent. When the players die, instead of blood spurting out, you see them flying off into heaven.

Lewis: That's an elegant rebranding.

Ra: [laughs] Yeah. So, it's really a question mark, whether it's still going to succeed going forward. I do see that as a risk. The numbers definitely show that revenues have slowed down.

That being said, of course, there's WeChat. WeChat is what a lot of U.S. investors have been looking at. If you're living in China, it's something that you really can't do without. It's food delivery, it's social media. It's like PayPal, Twitter, all of these combined. What Tencent has been trying to do over the last year is basically a huge business reorganization. They started about a year ago, actually, to do this. Probably because of the slowdown with games because of the regulatory risk. They're turning more into an enterprise-facing company. They're looking at advertising, they're looking at cloud. They want to use that huge user base of WeChat for advertising revenues and also for e-commerce. You may have heard of mini-programs. It's a pretty interesting innovation. It's basically an app within the WeChat universe that has some Shopify-like features, so e-commerce features. All of that definitely has possibility.

There is competition from companies like ByteDance. You may have heard of TikTok, which is a super annoying app that you see here in the U.S.

Lewis: [laughs] People under the age of 15 would disagree with you.

Ra: I've tried using it just to get an experience of it, and as a 36-year-old man, it's almost impossible to use for me. But it's really popular. At the end of the day, companies are fighting for share of time spent. ByteDance in China has been taking some of that share. At the same time, Tencent's metric is not purely time spent. It's more of the functionality of WeChat. I think that's not going to go away.

Generally speaking, I'm pretty positive on Tencent. The online advertising, that's something that they were hyping up, it's slowed.

Lewis: Some of that's related to regulation as well. A lot of these businesses, as China has become much more aware of the products that were being advertised, particularly in the healthcare and supplements space, have decided they're going to regulate that industry a bit more. I think it's bitten a lot of these companies.

Ra: Yeah, absolutely. It's really hit everyone. But Tencent has so many moving parts. There's Tencent Video, which is No. 1, No. 2 with iQiyi, which is majority controlled by Baidu. There's a bunch of possibilities there. There's also its venture capital investments. Tencent, people have called it the Chinese SoftBank. They own stakes in Spotify, I think they own a 5% stake in Tesla. They're just buying stakes all over the world, and also in China itself. If you're a start-up with an amazing idea, there's a pretty good chance that Tencent is going to get a piece of you, especially because of WeChat. WeChat is almost an entire universe by itself.

Lewis: Tencent seems like it's almost in that "too big to fail" category for tech.

Ra: Yeah, I think it's definitely there. In terms of the stability of its revenues, the risk that it's going to go away, that's very, very minimal.

Lewis: When we were doing our prep for the show, you said that Baidu was probably one of the more interesting ones out there to watch.

Ra: I think Baidu, when you think about it, may be the most important of the BATs for U.S. investors to look at. When you look at Baidu, it's really valued as a classic value stock. You're talking about $36 billion in market cap. Net cash, right around $10 billion. The company, if you take out the excess cash, is really selling for about $26 billion and right around 10X earnings at that level. So it's really a value stock. The growth definitely has slowed. So the question is, has it really reached a point of maturity? I know they're investing in autonomous driving. They want to be a leader in artificial intelligence. A lot of funds are going into these moonshot projects. But it's a question of, when the Chinese company reaches maturity, when companies are probably expected to return capital in some fashion -- whether it's dividends or buying back shares -- what is Baidu going to do? Going forward, it's going to be important for U.S. investors. It's going to teach U.S. investors a lot of lessons. Is Baidu going to do what's best for investors? Or is it just going to keep on pouring money into whatever projects they see fit?

Lewis: I think it's interesting, when you hear narratives like, "the middle class is expanding dramatically in China," theoretically, you have more purchasing power, you have more disposable income, all these things -- you assume that a lot of the businesses where most of that money is going to go to are still going to be in hyper growth mode. Based on what you've said so far, it sounds much more to me like they are in a similar place to where maybe the Amazons, Googles, and Apples of the world are now, where you shouldn't be expecting these stocks to be putting up 30% returns each year. They're fairly mature.

Ra: Yeah, I think that's definitely the case with Baidu. We talked earlier about health. Alibaba dominates product search. There's a segmentation between product search and services search. Baidu, that's really their world. It's more limited, I think, for Baidu, in terms of its growth prospects of purely its search advertising business. It's definitely looking for other ways to expand. They are buying other companies, but it's much more strategic. It's much more focused on the AI and autonomous driving. They recently opened up these robo taxis. I forget exactly which city they opened it up in. They have a lot of good technology. We'll see.

Lewis: They just came out of nowhere in the smart speaker market, too. I don't know if you've been following that story at all. They went from not even being on the map to being in the top three in this most recent quarter. So they're clearly making those smart home investments, too. The other companies that are there, no surprise, Amazon and Google. All these companies are very much starting to look like each other.

Why don't we wrap up talking about jd.com? This is a company that has faced a lot of scrutiny over the last year or so.

Ra: jd.com is really interesting. It's still mainly a first-party e-commerce retailer. Still a company that takes inventory risk, buys up inventory and sells it. When you ask yourself how many e-commerce companies in the world are first-party e-commerce retailers and also are making a profit, or in general are successful, I can't name very many. jd.com is still in that model. They're building the third-party marketplace, but the first-party side of the business is really price competitive. A big part of it is electronics, which is a very competitive industry in China. There's competitors like Suning, for instance, which was recently partially acquired by Alibaba. There's a lot of competition in electronics, computers space, where they really haven't made any profits. They recently made an operating profit. People have compared jd.com to Amazon, but Amazon made an operating profit back in 2001, and I don't think they stopped making operating profits since then.

Lewis: Also, Amazon has Amazon Web Services, which is a 35% margin business.

Ra: Yes, absolutely. jd.com really doesn't have that. They're really banking on their third-party business, plus something to do with their logistics, whether they can sell those kinds of services to a third party. That's very much a question mark.

I would say, if I were to choose between jd.com and Alibaba, I would definitely have to choose Alibaba, even though Alibaba is so much bigger.

Lewis: Of the four that we've talked about today, which one's top of your list?

Ra: I would still say it's Alibaba and Tencent. Maybe Tencent's slightly ahead. But those two, I think they're definitely -- well, maybe not definitely, because you can't say that. But they're somewhat in the "too big to fail" category, as you said. Something like WeChat, I just can't see it going away anytime soon. Maybe the time spent could go down, but as far as the value in terms of daily life of people, I just see that being quite strong in the future.

Lewis: With all these stocks becoming seemingly more mature businesses, possibly getting to the point where they're thinking about either buying back shares or dividend programs -- the types of things that more mature businesses tend to do -- it sounds to me like if you're looking for really big growth, you have to go with small companies in China.

Ra: Yeah, I definitely think so. There's a lot of exciting companies that are coming out in China.

Lewis: We'll have you on again to talk about all that. How about that, Ben?

Ra: Absolutely.

Lewis: Alright. Thanks for hopping on today's show!

Ra: Sure.

Lewis: Listeners, that'll do it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. I also want to give a shout out to the Smarter, Happier and Richer contest that we are currently running over on Instagram. If you go to our Instagram page, @TheMotleyFoolOfficial, you will see a picture of Fool swag. Go answer the trivia question there and tag a friend, and you can be entered to win a Fool hat, shirt, and signed copies of the Motley Fool Investment Guide. Like I said, just head over to our Instagram page and check that out. If you want more of our stuff, you can subscribe on our iTunes or check out videos from the podcast over on YouTube.

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 all his work behind the glass today. For Ben Ra, I'm Dylan Lewis, thanks for listening and Fool on!