Why China's cloud is different
- China’s 14th Five-Year Plan made the development of cloud computing a national priority
- Alibaba and Tencent are the two biggest cloud providers, but the nation’s three biggest telecoms companies also play a major role
- Demand for ‘private cloud’ services, in which companies require bespoke hardware and software, is also greater than in the US
Behind the scenes, cloud computing powers many of the online services we depend on. From streaming video within social media apps to automating the retail titans’ logistics operations.
It lets companies avoid the cost of maintaining their own computer server infrastructure and helps them quickly make adjustments to meet surges or dips in demand. In addition to processing power, that can involve adjustments to memory, storage, networking and other resources required to carry out a task. Clients can also buy access to useful software tools rather than developing their own.
You might be surprised to learn that cloud computing was conceived long before the internet was born. A memo that first floated the idea dates to 1963. Its author, a US official, described what he only half-jokingly called the Intergalactic Computer Network.
But it took decades and considerable effort to bring the idea to fruition. In an interview, the founder of Alibaba Cloud, Dr Wang Jian, recalled his engineers being repeatedly woken in the middle of the night to deal with bugs after its 2009 launch. He said some of the homesick workers set the voice of their kids as their mobile phone ringtones as they sometimes worked away from their families for weeks or months at a time.
Today, ‘the cloud’ is a vast industry. Market intelligence provider IDC predicts spending on the sector will exceed $1.3tn in 2025, of which $150bn will be in China.
The Chinese government’s current Five-Year Plan, covering the years 2021 to 2025, introduced the development of its ‘digital economy’ as a standalone goal for the first time, demanding that efforts be accelerated. Cloud computing sits high among the listed objectives, alongside 5G, the Internet of Vehicles and other targets.
China’s progress, however, looks set to follow a different path to the US.
Bigger population but smaller demand
China’s ‘public cloud’ market – in which a provider offers a menu of computing capabilities to clients over the public internet using the same servers and other resources – is only about 15 per cent the size of the United States’.
At first glance, that seems excessively low, given that China’s GDP is almost 75 per cent of the US’s.
A closer inspection reveals another telling divergence. To recognise it, you need to appreciate that the public cloud can be divided into three offerings:
- Software as a service (SaaS)
- Platform as a service (PaaS)
- Infrastructure as a service (IaaS)
Details of what distinguishes them are covered in more detail in the box below.
But for now, the key point is that SaaS and PaaS jointly account for about 80 per cent of the public cloud in the US but only 26 per cent in China, according to 2021 figures published by the China Academy of Information and Communications Technology.
Moreover, the two segments have been losing ground to IaaS in the world’s most populous nation, rather than catching up.
Public cloud development in ChinaSource: CAICT, Cloud Computing White Paper 2021–2022
A brief explanation of SaaS v PaaS v IaaS
SaaS (software as a service) refers to a cloud provider hosting a software application and making it available to a business or to individual subscribers, saving them from the complexity of installing and maintaining it themselves. Examples include the word processing tool Tencent Docs and the video chat service Tencent Meetings.
PaaS (platform as a service) refers to a cloud provider delivering the hardware and software tools required for a firm to develop, test and run its own app or other online services. It effectively means the client can run everything off-site. For example, China CITIC Bank’s app uses Alibaba’s mobile PaaS service to offer its customers various financial services.
IaaS (infrastructure as a service) refers to a cloud provider supplying specific services, such as storage, networking and processing power, which the client can pick and choose from as ‘building blocks’, giving them more flexibility. For example, the short-form video app Kuaishou uses Baidu AI Cloud’s content delivery network to load images onto users’ smartphones at speed.
Of note for investors is that cloud providers’ margins are generally highest for SaaS services and lowest for IaaS.
Explaining the divide
I’ve identified five reasons why Chinese companies shy away from the more elaborate SaaS and PaaS cloud services:
1. Government-set GDP targets have encouraged growth over efficiency
Many companies in China use IT service providers to increase their sales but have had less interest in making cost savings or introducing best practice into workflows.
That’s mainly because their priority has been hitting growth targets set by the central government. Those same targets have also encouraged large numbers of companies to compete against each other in almost every traditional industry.
By contrast, competition had already whittled down many sectors to fewer players in the US before its IT revolution began.
It’s typically only after industries have become sufficiently consolidated and overall growth has slowed that companies adopt best operational practices.
The good news is that China’s central government is now driving industry consolidation to address the issue.
2. Many Chinese companies have yet to ‘digitalise’ their records
Documents either exist only in paper form or, if turned into data, are not accessible to employees in an easy-to-visualise way that could help them make day-to-day decisions.
In the US, companies including IBM, Oracle, SAP and Microsoft defined how to manage IT systems before the cloud emerged. In China, both are happening in parallel.
Although this poses a challenge, it also presents an opportunity for companies to ‘leapfrog’ setting up on-premise IT systems and go straight to the cloud.
3. China has a very different attitude towards intangible assets compared to the US
Media piracy remains common. Intellectual property protection is improving, but even businesses are reticent to pay for intangible digital services, including those provided by cloud computing.
Many state-owned enterprises (SOEs) prefer to own assets that appear on their balance sheets. And IT department decision-makers often view spending millions of renminbi a month on renting a service as being a career-risking prospect.
Change may require a generational shift. Surveys suggest that those born after 1995 are more willing to pay for digital assets for personal use.
4. Small and medium-sized private companies are younger than those in the US
The average lifespan of Chinese private companies is about three years. That’s less than half that of their American equivalents.
Younger firms tend to prioritise spending on marketing and relationship-building, waiting to optimise back-end operations until they have secured revenue streams.
The good news is that the Chinese government’s ‘little giants’ policy is encouraging private sector companies to specialise in doing one thing well for a long time.
If this can increase their average lifespan beyond five years, they should be willing to spend more on software.
5. China’s labour costs are much lower than the US’s
Chinese IT engineers earn about a quarter of their US equivalents’ wages. So when SOEs think about spending their budgets, they can often get a higher return on their investment by hiring staff rather than subscribing to a third-party product.
However, it’s clear that the price of computing power is dropping, the number of good software providers is increasing, and domestic labour costs are set to rise at a high single-digit rate as China’s economy becomes more service-oriented.
The trends identified above indicate that Chinese companies will increase spending on more lucrative SaaS and PaaS services over time.
But there are two other characteristics of the market that suggest that Alibaba and Tencent’s public cloud offerings might not replicate Amazon Web Services (AWS), Microsoft Azure and Google Cloud’s joint dominance of the US market.
Firstly, there is greater demand for the ‘private cloud’ in China, in which companies use reserved computer servers and bespoke software rather than tapping into a broader offering.
Secondly, China’s three leading telecom operators and Huawei play a role that isn’t mirrored in the States.
The private cloud
The private cloud accounted for about a third of China’s overall cloud mark in 2021. I had initially supposed this share would shrink because of the cost savings and other benefits of tapping into hardware and software shared with others. But I now think the reverse could be true.
The reason is that efficiency seemingly ranks behind two other priorities in many key decision makers’ minds: stability and safety.
That's particularly true of three heavily regulated sectors that make use of sensitive information:
- Government administration
Companies involved in these sectors are mostly state-owned in China, which adds to their caution. They also tend to have bigger IT budgets than private sector businesses, which means they are likely to be the critical driver of cloud computing growth in China over the next five to ten years.
So what does that mean for us as investors?
The private cloud is less attractive than the public cloud because it involves creating a bespoke solution for each client. As a result, scale doesn’t drive returns to the same extent.
It is also likely to lead to a more fragmented market in which relationships are more important to clinching a deal than providing a superior service.
That’s not to say there aren’t still investment opportunities, but expectations should be tailored accordingly.
The ‘national team’
The country’s top three telecom providers – China Mobile, China Telecom and China Unicom – alongside the unlisted technology conglomerate Huawei are all growing their cloud businesses.
In 2021, the three telcos reported a combined RMB68.4bn ($9.8bn) of annual cloud-related revenue with a year-on-year growth rate of more than 90 per cent. That puts their merged sales at a similar level to AliCloud’s once you exclude the latter’s cross-division revenue.
Tencent does not break out its cloud revenue but reports it mixed in with ‘other business services’. However, it is estimated to be about RMB25bn ($3.6bn) a year.
The telcos’ advantages include:
- SOEs perceiving them as more trustworthy partners
- Ownership of large fibre and cellular networks, in addition to their data centres. That gives them the potential to bundle services, as well as to control more of the infrastructure involved in delivering tomorrow’s ‘metaverse’ experiences
- Ownership of about half of China’s internet data centres. Building new ones in high-tier cities is almost impossible due to space and electricity quota restrictions
- A deep, comprehensive sales and service network that covers even small countryside towns
The telcos’ disadvantages include:
- Insufficient understanding of their clients’ data use. Their analytics are relatively basic, and their organisations are more siloed. Many local governments have picked AliCloud to handle their administrative tasks as a result
- Insufficient understanding of their clients’ businesses. So it’s harder, for instance, to advise customers on ways to sell more or cut costs
- Weak cloud-related technologies, especially at the PaaS level. So they’re less able to serve clients looking for help with AI analytics, database management, streaming of real-time videos etc
Huawei has invested heavily in the cloud over the past two years. The firm has been through upheaval after the US imposed sanctions in 2020 that prevented semiconductor companies from developing or producing chips for it using US software or other technologies. That cut off the supply of its own high-end smartphone processors, limiting its handset division’s prospects.
Analysts estimate Huawei’s cloud revenue was similar to Tencent Cloud’s in 2021. It has mainly made inroads in the private cloud market, where relationships and security are valued, and is believed to have made a loss in the endeavour to help keep its prices low.
Pushing back with proprietary products
All this helps explain why AliCloud and Tencent Cloud have focused on offering self-developed products to clients rather than trying to outbid the telcos and Huawei. Proprietary offerings from one or both the companies include:
- Computer chips (AliCloud’s Cloud Infrastructure Processing Units and Tencent Cloud’s AI accelerators)
- Cloud operating system (AliCloud’s Aspara)
- Databases (AliCloud’s PolarDB and AnalyticsDB, and Tencent Cloud’s CynosDB)
- Data intelligence
All of these provide Alibaba and Tencent with high gross margins while allowing them to offer clients a way to lower their own costs.
Tencent Cloud also has the potential to boost its profits in the years ahead by selling digital tools related to its WeChat communication platform as ‘SaaS building blocks’. These can help enterprises showcase their identities, manage customer relationships and foster worker collaboration, among other tasks. That, in turn, could help it cross-sell its IaaS and PaaS products.
AliCloud said in 2019 that it wouldn’t get into SaaS. But its recently announced Ling Yang service sounds like something very similar by another name (Alibaba refers to it as DaaS – data intelligence as a service).
Ling Yang’s solutions include tools to boost customer satisfaction and improve inventory efficiency. These are reminiscent of Salesforce’s products and could have potential.
But perhaps of more note is the firm’s Ding Ding service (also known as DingTalk), which is heading towards becoming China’s most used office app.
The firm launched Ding Ding in 2015 as a messaging and collaboration tool, similar in scope to Microsoft Teams, and targeted it at small and medium-sized enterprises.
But the Covid lockdowns turbocharged its adoption, giving it a vital role in remote learning, teaching and working, while its integration into AliCloud spurred its use among larger corporations. Alibaba said Ding Ding crossed the 500 million user count in October 2021 and more than a third of its active users were from companies with more than 2,000 employees.
Moreover, the company has taken advantage of its popularity to transform Ding Ding into a platform.
Today the firm is pitching it as a ‘low code’ development PaaS for third parties to develop enterprise-related microservices “without worrying about access to servers or infrastructures”. In other words, they can use it to distribute and run their software more simply than by creating a standalone app.
Existing examples include:
- easy-to-use databases to let employees view performance-related information about their company
- staff appraisals
- team rotas
At the time of writing, more than 1,000 third-party SaaS companies were developing additional apps for the platform.
Chinese internet users are already accustomed to using ‘superapps’ in the consumer domain, thanks to WeChat, Meituan and AliPay. AliCloud now has a chance of pulling off a parallel feat in the workplace. For now, the primary way it is monetising the service is via a 10 per cent commission taken from developers’ revenues.
Teaming up with the telcos
It’s not always a case of either Tencent/Alibaba or the ‘national team’.
For example, after China Telecom won the Zhengzhou Government Smart City Project tender, it procured the use of AliCloud’s Aspara cloud operating system. Likewise, when China Telecom won the Beijing Haidian District Government Smart City project bid, it subcontracted work to Tencent.
In cases like this, it might seem like the telcos aren’t doing much except signing the initial contracts. But SOEs like to know they can hold them to account if there’s a problem.
Finding a niche in the cloud
This paper has focused on China’s leading cloud computing providers. But there are smaller, more specialised companies that investors should also keep in mind.
- Glodon – the leading software provider to China’s construction industry
The firm started by selling software to help quantity surveyors calculate costs and quantities accurately to help them bid for projects. It now offers these products on a SaaS basis. The company has also developed an online platform to help users manage their relationships with customers and suppliers.
- Longshine Technology – a provider of software and IT services to the utility industry
The company established dominance in software to help electricity providers sell their services and bill customers. It has also developed a cloud-based PaaS to help grid operators deal with the complexity involved in supporting electric vehicle charging points and renewable energy.
- Yonyou Network Technology – China’s foremost enterprise resource planning (ERP) software firm
The company provides products for human resources, business information analytics and customer relationship management, among other functions. It recently launched a cloud platform that digitalises supply chains and helps companies find commercial opportunities.
China’s cloud computing sector is fast-growing and should benefit from government recognition of its strategic importance to economic and social development.
However, as detailed above, it would be a mistake to forecast its growth based on a US model. Instead, familiarity with the local market and the forces driving it are critical to sound investment decisions.
On that basis, I’ll end with six takeaways:
1. China’s cloud computing sector is smaller than the US’s, and its Saas and Paas markets are less developed. This means the market leaders’ growth is more likely to be organic than based on acquisitions as there is a lack of good supply-side companies to buy.
2. The private cloud is more highly valued in China and could grow to represent as much as 40 per cent of the industry.
3. China's telcos are taking a decisive role in providing the physical infrastructure for its cloud. AliCloud and Tencent Cloud can also invest in data centres but are increasingly becoming technology service providers to the three largest providers.
4. That means Alibaba and Tencent’s revenue share might fall, but they could still dominate profit share over the next five years:
2026 market forecast
Source: Figures estimated by the author.
2026 net profit share
5. AliCloud’s technology leadership gives it an advantage when pitching to customers, which is enhanced by the widespread adoption of Ding Ding. Going forward, its Ling Yang platform could also be vital to developing a profitable SaaS/PaaS business.
6. Tencent Cloud has a robust suite of SaaS products related to WeChat that differentiates it from other vendors and should help it cross-sell its IaaS and PaaS line-up.
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in November 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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