In this episode of Industry Focus: Wildcard, Emily Flippen is joined by Motley Fool advisor and gaming aficionado, Aaron Bush, to talk about gaming in China and the companies leading the way. Some of the largest and fastest-growing gaming companies in the world are Chinese. Our hosts talk about the challenges they are facing as a result of the geopolitical situation and privacy concerns, among other things, and how it may affect them. They also talk about their operations and what the future holds for them and much 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 August 12, 2020.

Emily Flippen: Welcome to Industry Focus. It's Wednesday, August 12th, and I'm your host Emily Flippen. For this Wildcard Wednesday, I'm joined by Motley Fool advisor and gaming aficionado, Aaron Bush, to talk about gaming in China and the companies leading the way.

Aaron, thanks for joining, how are you doing?

Aaron Bush: I'm doing good. Thanks for having me, Emily.

Flippen: Yeah, it's always a treat whenever we get to snag you. But before we get in today's topic, I want to establish you as the expert that you are on this topic. Obviously, Fools here are aware of you as a resident in-house gaming expert, among a host of many other things, but for all of our listeners out there, where might they know you from, or where might they be able to find more information about you?

Bush: Yeah. So, at The Motley Fool, I focus on the Blast Off portfolio, I've spent time in Supernova, Rule Breakers, a few other services. You can find me [laughs] on Twitter @aaronbush100. And as for gaming itself, I run a blog called Master the Meta, you can find it at MasterTheMeta.com. It's just a side hobby, but I, and a handful of other writers that I'm working with, we dig into the business strategy of the video game industry. So, I'm not, I'm not a China expert, I'm not a geopolitics expert -- Emily, probably has me beat there -- but gaming is a global industry that I think without a doubt and I'm excited to talk about it today.

Flippen: It makes my job as a host really easy, because I signed up for your newsletter, and whenever I'm struggling to find a topic, I always just check, oh, what did Master the Meta write about this week, right? That's an easy starting point, so I'm kind of having a copout here by having you on. But I do think it's an important conversation to have, because whenever we hear about Chinese companies in particular, obviously, there's a lot of geopolitical tension happening right now. But when you think about gaming as well, that's largely been driven by news around the pandemic, and it's something you've written and studied extensively, especially as companies have started to come out and report earnings. So, the pandemic is still very much shaping the way that we are viewing gaming companies right now, right; there's no denying that.

But I do want to talk about some of the other risks that we're seeing, just apart from the pandemic. The amount of news and noise there is around geopolitical risk between Chinese companies' potential delistings, TikTok acquisition. I want to dig into gaming companies in China more specifically.

So, you've kind of mentioned that we've been headed into what you call, Cold War 2.0 [laughs] with China. And before we jump into gaming specifically, I'm interested to know, broadly speaking, how do you think a Cold War 2.0 would impact Chinese companies listed here in the U.S., even if they only do business within China?

Bush: Yeah. So, I think the Cold War 2.0, so to speak, really kicked off when the ban of Huawei escalated. And so, it very much was about preventing spying and protecting data, but the narrative is also very much a war of ideology, where China is looking to reclaim the title of No. 1 country, No. 1 economy, and using that influence to spread its ideology, both through nation states, like we're kind of seeing in Hong Kong and Taiwan now, but also through businesses. Which I think is a difference between Cold War 1.0 and, potentially, Cold War 2.0. That might be too strong a phrasing, but that's increasingly how it's starting to feel to me.

So, again, I'm not a China expert, but there are ripple effects on how businesses operate and there will, I think, be more striking changes to come, both for foreign companies operating in China and Chinese companies operating outside of China.

Specific to your question about Chinese companies that are listed in the U.S. but solely do business in China, that's not something the U.S. would probably take action on. It's favorable to the U.S. to capture value that's being created elsewhere. But it's the type of situation where China would probably want to change that a bit, so I think that's part of why we're seeing a bunch of Chinese companies starting to dual-list on the Hong Kong stock exchange, and we might get to a point where Chinese companies decreasingly IPO in the U.S., that might already be starting to some degree. And I think that there's a non-zero chance political threat of Chinese companies delisting from U.S. stock exchanges, but that doesn't strike me as super-likely, at least not anytime soon, I don't think.

Flippen: I want to dig into that more, before I do, I just want anybody who's listening either over our podcast or listening to us live as you record this, you have drilling happening in your condo right now. So, if you hear a little bit of noise in the background, unfortunately, that's the reality of the COVID situation we're in right now. So, apologies for that. [laughs]

Bush: I'm trying my best, we'll pull through.

Flippen: Definitely. So, we've heard a lot of news about the potential sale of TikTok and WeChat, among a host of other potential Chinese companies here in the U.S. And I won't ask you to comment on that unless you want to, you mentioned you're not a geopolitical expert, that's not your job. But in that same vein, do you think there's an existential spinoff threat for gaming companies that are operating here in the U.S., like we've seen in social media?

Bush: I don't think it's that strong a threat. So, I guess starting with the big picture and then narrowing down, there's a lot of political theater going on, but as I understand it, TikTok and WeChat were banned/forced to sell because of data concerns and algorithm concerns, which is totally fair.

With TikTok, for example, the algorithm is a black box, [laughs] so pretty much everyone that can, both, keep users from seeing things, AKA, censorship; and forcing users to see things, AKA, propaganda. And that might be happening, it might not be happening. It's just hard for us to tell, because again, the algorithm is a black box. And when it comes to games, that censorship propaganda concern doesn't really exist, because, like, it's not that type of platform. So, it mostly boils down to data privacy, as I understand it. So, I do think it's probably worth investigating [laughs] the data practices of companies, like Riot Games behind League of Legends, and Supercell behind games like Clash of Clans, Clash Royale.

And it's worth understanding what data gets passed back to the Tencent level, the parent company level, and therefore, what is accessible to the Chinese government. But it's hard to see how something like League of Legends is a national security risk, in my opinion. But as we've seen with lots of apps, there can be lots of tracking going on, which has implications for what military people are allowed to use, what employees of certain companies are allowed to use.

So, all in all, I don't really see spin-offs as an immediate threat, but it certainly is a possibility if things escalate further, but it's not even just about spinoffs, though, too. So, Tencent, for example, they have opened new gaming studios in the U.S. and other countries. And, in general, I think we should support foreign companies working in the U.S. if they follow our laws and if they don't pose security threats. And I think, for the most part here, that's probably not too much of an issue, but it is probably time to reexamine those laws and be more proactive about just making sure that we as a country understand these things.

So, for example, Congress should have looked into ByteDance's acquisition of Musical.ly before it converted into TikTok, [laughs] not now that TikTok has taken the world by storm. I think that just being more proactive in how we view these things will save us from a bunch of headaches down the road.

Flippen: So, with that out of the way, now let's talk about some of these Chinese gaming companies, which is much closer to what your bread-and-butter is. You mentioned Tencent and League of Legends, for instance, and Tencent being the largest gaming company in the world. Although, really at this point, [laughs] it's more of an investment house, but let's stick with that title for the time being. How does geopolitical tension affect Tencent's gaming business?

Bush: Yeah. So, I think, if countries crack down on what games are allowed, what Tencent can acquire or just where the company can open new studios, then I think it could have a sizable impact on Tencent. So, if India, for example, bans PUBG MOBILE, which is a massive game, it's a massive game owned by Tencent that has a large player base in India, that's a pretty big blow to that game. And that's totally possible. That said, China itself has historically been Tencent's larger threat, which is kind of counterintuitive in some sense. But China is the one [laughs] who banned game approvals for several months, they're the ones who frequently do not approve games. And of course, China's laws also give Tencent a huge advantage as foreign publishers, like, they need to partner with someone like Tencent or NetEase to operate and make money on games in China. So, it still works in their favor.

But because all of this still is a risk, both China's rules themselves and geopolitics as a whole, I think that it very well may limit Tencent's international expansion. But I don't think it stops the company from dominating in China itself, and that's important to remember. As for their portfolio of gaming investments, it's also important to understand that Tencent is extremely diversified. So, failure of any one business or any one thing that they can't do, it doesn't really move the needle too much in and of itself.

And again, this isn't just a gaming business too. So, it has even less of an impact on Tencent as a whole, which has a giant Social division, it has tons of other businesses and investments going on, so. I mean, think about how they own something like 40% of Epic Games and have a good stake in Sea Limited too. And both of those are big companies that aren't China-based but are doing important innovative things, growing quickly. So, the main risk is less about any particular investment, less about, like, any one thing going wrong, and more the possibility that Tencent will no longer be able to acquire or publish their games in important markets like the U.S. or India. That would decelerate growth. But again, it's not an existential risk to Tencent's business.

Flippen: I'm happy that you mentioned Sea Limited, it's a company that gets a lot of attention here at The Fool, and honestly, a lot of investor attention as well. It's grown to become [laughs] a very large business, and largely built itself off of as one game, really, which is Free Fire, and I think it escapes a lot of people's minds that Tencent owns such a significant portion of a company like Sea Limited.

Now, let's play out a worst-case scenario here for Tencent's gaming profile. Let's say their ability to license or publish games in a handful of countries, the U.S. and India being only a couple of examples, let's say that happens, they can't expand. Does having ownership of companies like Sea Limited, that are not based in China, yet publish their own games, does that help mitigate some of that risk?

Bush: Yeah, I think it does. I mean, Sea Limited, they don't report into Tencent, [laughs] and therefore, a lot of those concerns around, like, what data does the parent company get, therefore what data is the Chinese government going to get. Those risks don't really exist, so I don't foresee any of that being too much of an issue. So, it is lower risk for Tencent I think.

Flippen: I wonder if at some point in the future, we don't see Tencent taking the same stance that we saw SoftBank take earlier this week when they announced they were going to stop breaking out operating income. Not that you can't find that on your own, but more of a testament to say that, hey, look, the real value of our business here is not the operating assets that we have, but rather, the handful -- really in Tencent's case, the dozens by dozens of investments that we've made. They're not quite there yet, but I do have to wonder, five, 10 years from now, if that's not the direction that they're going.

And I don't mean to harp on Tencent too much, it's hard not to talk about Tencent when you talk about Chinese gaming, though. They've taken this very investment-heavy approach to gaming. And what spurred me to want to have this conversation with you is actually a message you sent me regarding a potential merger that Tencent could be spearheading between two big streaming giants in China; that's Huya and DouYu. We'll include the tickers for these companies in the description of today's episode, because I know that's a question we get a lot, it's much easier to read than it is to say. But what do you make of the news that these two big streaming companies, that's Huya and DouYu, could be merged together?

Bush: I think it's really interesting. I've always been bullish on the future of live streaming domestically [laughs] in the U.S., and China and everywhere, it's an inevitable trend. But what's kept me from investing in China's game streaming market, besides the obvious geopolitical risk that we keep on talking about, it's just that it felt competitive.

So, companies like Huya and DouYu have been fighting for market share for a long time, and they've been competing for talent and users, and that's been a really expensive undertaking for them. So, the merger of those two businesses is really interesting. I'm unsure of how exactly that's going to go, like, how will the platforms themselves merge, how will the cultures themselves merge, but in either case, this move creates the definitive top-dog in China's gaming live streaming market; with some presence globally too. So, it's creating a mega Twitch, [laughs] and that's just fascinating. So, I think it means good things for the business.

Over time, as they gain clear operating leverage and pricing power, they can probably decrease marketing spend and talent spend as a percentage of revenue, that's my hunch, which will have a profound effect on margins. We will see. And I guess I would just say, like, they're not alone, like, others operate live streaming platforms too. But this merger strikes me as [laughs] a very good move for these two businesses, with the main risk just being execution risk. When bringing together two leadership teams, two completely different cultures. Both companies have had some differences in their approach to scaling, the technology platforms are different, so there are still a lot of questions. But if there is a path forward in a way to do this, it's going to be really fun to watch. And again, it's a testament to Tencent's power and influence to be able to make deals like this happen. So, [laughs] if anything it's a fascinating case study, but I lean more on the bullish end of the spectrum on the deal.

Flippen: So, you might not know the answer to this, I selfishly am going to ask it anyway, because it's a company that I follow and I'm a big fan of, that's Bilibili. Bilibili is a competitor, in some sense, to Huya and DouYu, although it is also invested in by giants that include Tencent. It's a more niche play on the streaming market. They target a younger, what they call the Generation Z of China, young audiences. They got their start in anime, comic and gaming, although they've been making some aggressive expansions into esports, which puts them in direct competition with the giant that may eventually be the Huya and DouYu combined entity.

Now that the streaming market seems to be consolidated in Huya and DouYu, whatever that merger ends up looking like, if it even happens, seems to be consolidated in their favor. Do you think that negatively affects the smaller players, Bilibili being one of them?

Bush: I think so, that would be my guess. So, in reality, live streaming isn't just about games, but it's a really strong foothold. So, when Huya and DouYu merge and have a massive combined audience, my guess is that they'll pretty quickly leverage that audience. [laughs] And a lot of the spend that they had, that was going to acquiring people interested in gaming, competing against each other, that'll then probably shift over to competing users that are interested in other adjacent markets, like other parts of ACG [Anime, Comic and Games] and music and other things.

So, I do think that there is an existential threat to other platforms. And it's really [laughs] important that a company like Bilibili moves as fast as they can to differentiate and build a moat around something that is distinctly Bilibili, [laughs] so that their users don't even really think about going to other platforms to whatever Bilibili is best at.

So, with that logic, I don't know if I feel great about Bilibili spending a ton of money to compete in gaming. Like, they've spent millions and millions of dollars to get exclusive rights to certain League of Legends tournaments, for example. But, [laughs] I mean, I would just caveat that by saying their management knows this market much better than I do, so I could very easily be wrong, but I wouldn't want to compete with what this combined Huya and DouYu entity is. So, I would be doing everything I can to quickly move into a place that, like, I have defined strengths, and I don't see them necessarily doing that to the best of their ability. Do you agree with that, Emily; curious to hear your take on that too?

Flippen: Yeah. I am a shareholder in Bilibili. I'm also a shareholder in Huya. I was not such a big fan of DouYu; nothing explicitly wrong with it, but to your point, I didn't see anything that made the DouYu platform special. Clearly, having the scale that could be theirs, with a combination of Bilibili and Huya is really compelling.

I really want to root for Bilibili here. They've always been the underdog, if you will. Their founding story, which I've talked about in the past, I won't repeat here, it's a really compelling story, and I bought into the story. Their new CEO, relatively new CEO, has made numerous statements that he is convinced the only way that streaming platforms in China will survive is if they get scale. And in his mind, he's quoted to say that he expects that to be somewhere around U.S. $50 billion in market capitalization, is a size that he wants Bilibili to be.

I think it is going to be much harder to reach that scale going up against a formidable competitor, especially one that has the backing of a company like Tencent in terms of merging the two entities. It's interesting that Bilibili was left out of this combination, I have to wonder if it is because of the community that they've built, they have an entrance exam essentially you have to take to become a full member of the community. So, there is some argument to be made that they could create a moat, just in the sense of having exclusivity on their platform. But to your point, the moves they've made and the money they spent to get into esports is very different from what their core competency was, an ACG, that's the anime, comic and gaming content that was their founding story.

I'm not sure if this is going to compel me to sell my shares in Bilibili, but I do think that it's going to be really interesting to watch. I would say, the situation with Bilibili, and honestly a lot of other smaller streaming sites in China are in right now, is very different if this merger does go through. Not a ton of insight there, mostly a wait-and-see approach on my end.

And the last question I really want to ask you before letting you continue [laughs] with your day was mostly, again, about political tension and about whether or not we'd see innovation coming out of Chinese companies given the concerns that we've seen on a macro scale, but I think we've hit that point to death [laughs] at this point. I guess the question I'll lead you off with is, when you're looking at the gaming industry -- maybe I'm a little bit of a Chinese apologist here for the companies that are innovating in China, but having a tough time because of the tensions internationally -- do you think that there are more compelling opportunities in gaming just by looking at some of the really popular U.S. gaming companies, Activision, EA, Take-Two, or do you think there's an opportunity for Chinese gaming companies, whatever the combined entity of Huya and DouYu is, or Bilibili, to really become that next big thing?

Bush: So, I think there's opportunity everywhere. I would say, when you asked the question, who is innovating? I think the big U.S. publishers, they're great businesses, but they're not the ones who are doing the most innovation. And if you look at gameplay and the speed of development, Chinese developers, from what I can tell, are doing a pretty good job of moving quickly and building things that matter. And I think the days of U.S. dominated, or even just, like, Western dominated apps and websites, like, that's probably over. And so, my guess would be that we will continue to see a rise of Chinese developers and their apps; games, first-and-foremost. They're going to take the world by storm.

And I think ultimately, just from a global perspective, having more people compete, whether it's in the U.S. or China or elsewhere -- because it's not just those two companies, it's the whole world involved -- that's a good thing.

I would also say that, I mean, Tencent, they're innovating a lot. Like, it's just because of the ecosystem that they've built. A lot of the innovation that's going on, I would say, the step-by-step pattern is this. First, it starts with technological change, and then once new technology is built that enables new things, new business models are enabled. And then, once those two pieces are clicked-in, there's new technology that enables new business models, then the actual creators go out and build new types of games or new types of experiences. So, I think that a lot of -- like, the public companies that are out there, they're kind of in that third step, just kind of waiting for other people to innovate on the technology and pioneer new business models.

But it's really a lot of the private businesses, like Epic Games, that are doing really interesting things at the infrastructure level that [laughs] potentially have much bigger effects on the industry as a whole. And Tim Sweeney, the CEO of Epic Games, he's a huge proponent of what he calls the metaverse, which essentially is, kind of, like an evolution of the internet, where it's more immersive, more digital, like you go through different devices have -- like, you can work online, play online, lots of different things. And I think the enablers of that are going to be really big winners, but we're still waiting to see who those are and waiting for some of those companies to go public.

Game engines, like, that's a big piece of who is innovating. So, we might see a Unity IPO in the next year or so, and that's the dominant game engine for mobile, which is the largest and fastest-growing corner of the gaming industry. So, I think that we will see more things as gaming goes more mainstream, which COVID has accelerated, and a lot of these companies start building bigger brands and going public, it's going to get more interesting to public market investors.

But for now, I mean, the big gaming companies, there's nothing wrong with them, really, like, EA, fantastic business; Activision, fantastic business; Zynga, Take-Two, they're all fantastic businesses. So, [laughs] I can quibble about I don't see enough innovation from those companies compared to who else is innovating, like, I have my money in those companies, I think all four of those companies I just mentioned. So, I still think the opportunity is pretty strong there.

Flippen: I can't wait to see what the future holds for a lot of these companies, especially if we end up having a Unity IPO, you will definitely have to make a reappearance here on Industry Focus if that happens, but until then, Aaron, as always, thank you so much for taking your time to join today.

Bush: Thanks for having me, Emily, it was fun.

Flippen: Listeners, that does it for this episode of Industry Focus. If you want to hear more from Aaron, definitely check out Master the Meta; I'll include that link in the description for today's episode. And if you have any questions just for us, for our team here, you want to reach out and say, "Hi!" you can always shoot us an email at IndustryFocus@Fool.com or tweet us @MFIndustryFocus.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for his work behind the screen today. For Aaron Bush, I'm Emily Flippen, thanks for listening, and Fool on!