Why China's cloud is different

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
• Healthcare
• Energy
  
  

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
• Cybersecurity

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
• e-signatures
• 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.

They include:

• 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.

Conclusion

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:

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.

Risk factors    

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.

Potential for profit and loss

All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.

The allocations of investment securities set forth herein are hypothetical. There is no assurance that any specific security will be allocated to you. Allocations may ultimately change for various reasons, including among others the need to comply with applicable legal and regulatory requirements in certain jurisdictions, such as US Executive Order 13959 of November 12, 2020 (EO 13959), which prohibits US Persons from engaging in any 'transaction in publicly traded securities, or any securities that are derivative of, or are designed to provide investment exposure to such securities, of any Communist Chinese military company' as defined by EO 13959.

This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this communication are for illustrative purposes only.

Important information

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.

Persons resident or domiciled outside the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.

Financial intermediaries

This communication is suitable for use of financial intermediaries. Financial intermediaries are solely responsible for any further distribution and Baillie Gifford takes no responsibility for the reliance on this document by any other person who did not receive this document directly from Baillie Gifford.

Europe

Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018. Baillie Gifford Investment Management (Europe) Limited is authorised by the Central Bank of Ireland as an AIFM under the AIFM Regulations and as a UCITS management company under the UCITS Regulation. Baillie Gifford Investment Management (Europe) Limited is also authorised in accordance with Regulation 7 of the AIFM Regulations, to provide management of portfolios of investments, including Individual Portfolio Management (‘IPM’) and Non-Core Services. Baillie Gifford Investment Management (Europe) Limited has been appointed as UCITS management company to the following UCITS umbrella company; Baillie Gifford Worldwide Funds plc. Through passporting it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Similarly, it has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions ('FinIA'). The representative office is authorised by the Swiss Financial Market Supervisory Authority (FINMA). The representative office does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co. Baillie Gifford Overseas Limited and Baillie Gifford & Co are authorised and regulated in the UK by the Financial Conduct Authority.

China

Baillie Gifford Investment Management (Shanghai) Limited
柏基投资管理(上海)有限公司(‘BGIMS’) is wholly owned by Baillie Gifford Overseas Limited and may provide investment research to the Baillie Gifford Group pursuant to applicable laws. BGIMS is incorporated in Shanghai in the People’s Republic of China (‘PRC’) as a wholly foreign-owned limited liability company with a unified social credit code of 91310000MA1FL6KQ30. BGIMS is a registered Private Fund Manager with the Asset Management Association of China (‘AMAC’) and manages private security investment fund in the PRC, with a registration code of P1071226.

Baillie Gifford Overseas Investment Fund Management (Shanghai) Limited
柏基海外投资基金管理(上海)有限公司(‘BGQS’) is a wholly owned subsidiary of BGIMS incorporated in Shanghai as a limited liability company with its unified social credit code of 91310000MA1FL7JFXQ. BGQS is a registered Private Fund Manager with AMAC with a registration code of P1071708. BGQS has been approved by Shanghai Municipal Financial Regulatory Bureau for the Qualified Domestic Limited Partners (QDLP) Pilot Program, under which it may raise funds from PRC investors for making overseas investments.

Hong Kong

Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 and a Type 2 license from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 can be contacted at Suites 2713–2715, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. Telephone +852 3756 5700.

South Korea

Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.

Japan

Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.

Australia

Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth) and holds Foreign Australian Financial Services Licence No 528911. This material is provided to you on the basis that you are a 'wholesale client' within the meaning of section 761G of the Corporations Act 2001 (Cth) ('Corporations Act').  Please advise Baillie Gifford Overseas Limited immediately if you are not a wholesale client.  In no circumstances may this material be made available to a 'retail client' within the meaning of section 761G of the Corporations Act.

This material contains general information only. It does not take into account any person’s objectives, financial situation or needs.

South Africa

Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.

North America

Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.

The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission ('OSC'). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.

Israel

Baillie Gifford Overseas is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755–1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This material is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.

Ref: 27200 10015614