How to Invest in China's Cloud
So how should one invest in the “walled garden” that is China’s cloud?
A couple of weeks ago, we published a detailed breakdown of China’s cloud industry’s current state of development, which resonated with many industry analysts and technologists. We combed through the official whitepaper published by the government-affiliated think tank, China Academy of Information and Communications Technology (CAICT), and combined our own domain knowledge.
The one-sentence answer to the rather broad, complex question of “how is China’s cloud industry doing?” is: China’s cloud transformation is still in its infancy and starting to permeate industries beyond the Internet tech sector.
With this observation in mind and as an investor, I could not help but think about how to “place bets” on China’s cloud. As news like the US government banning Nvidia from selling its cloud data center chips to China continues to complicate the future, how should one invest in the “walled garden” that is China’s cloud?
This post outlines my current thinking.
(The standard “this is not investment advice” disclaimer applies to this post and all Interconnected posts. Please do your own research before making any investment decisions.)
Gross Margins: IaaS vs PaaS vs SaaS
Before I name specific companies and discuss why they are either good bets or bad bets, it is important to first lay out the architectural differences between the three layers of a cloud (IaaS, PaaS, SaaS), their respective gross margins, and the business logic that connects these layers. These fundamentals are important for analyzing the potential of any cloud platform.
Here’s my plain language definition of these three layers:
IaaS (Infrastructure-as-a-service, aka processors like CPUs/GPUs, storage units like SSDs or hard drives, and networking bandwidth for rent)
PaaS (Platform-as-a-service, aka database, application development, big data analytics engine, AI/ML frameworks for rent)
SaaS (Software-as-a-service, aka user-facing applications like email, workplace messaging, video-conferencing, document-sharing for rent)
In terms of gross margins, SaaS has the highest margin (more than 80%), PaaS the second highest (between 50-70%), and IaaS has the lowest (between 30-50%). While gross margins may vary by vendor and could be higher than the range I laid out, depending on economies of scale of data centers and the extent of automation implemented, these three ranges generally hold true. These gross margin differences also reflect the relative “value-add” that these three layers offer to their users – IaaS being the most commodity-like and least value-add, SaaS being the most, while PaaS sits in the middle.
With these fundamentals in mind, I want to revisit this chart in the CAICT whitepaper that breaks down the relative size and growth rate of IaaS, PaaS, and SaaS.
According to this chart, IaaS (in blue) makes up almost 75% of China’s entire public cloud and is growing rapidly (67.4%, 97.8%, 80.4% respectively in the last three years). SaaS (in yellow) is the second largest though significantly smaller, while PaaS (in gray) is the smallest of the three layers.
On the surface, this picture suggests that most of China’s public cloud growth comes from the adoption of low-margin IaaS with a long (long) road ahead to evolve into the higher-margin SaaS and PaaS layers. This stands in stark contrast to the more mature US cloud market, where SaaS makes up the largest share, while PaaS and IaaS equally split the rest.
However, the biggest IaaS providers tend to become winners of tomorrow, even though they have to endure losing money on the low-margin business today. That’s because IaaS holds strategic importance as the first step a given large enterprise needs to take on their cloud transformation journey. IaaS is basically the “gateway drug” of cloud. Once an enterprise chooses a particular cloud platform’s IaaS, it is much easier for the same cloud platform to sell higher-margin PaaS and SaaS solutions later – dramatically increasing this enterprise customer’s lifetime value. By the same token, it is also difficult for an enterprise to migrate from one cloud to another, once it is committed to a cloud’s IaaS layer. Such “lift and shift” efforts happen rarely and are typically a multi-year decision followed by another multi-year migration process.
While I would not go as far as to say you're stuck on a cloud once you choose its IaaS, the reality is pretty close to a “lock in”. That is also why cloud platforms tend to offer steep discounts when selling its IaaS solution – artificially driving down the gross margin of this layer further. It is a worthwhile discount, because the profit generated later with PaaS and SaaS will be hefty.
Thus, the strongest IaaS players tend to have the best chance of long-term profitability, if they have high-quality, follow-on PaaS and SaaS products to offer.
The Fastest “Cloud Horse”
With these cloud fundamentals and business logics in mind, let’s see which Chinese cloud has the largest IaaS market share. Again, according to the CAICT’s research (graph below), the top five public cloud IaaS providers by market share in 2021 are:
CTyun: 14% (China Telecom’s cloud)
Tencent Cloud: 11.2%
Huawei Cloud: 10%
Mobile Cloud: 8.4% (China Mobile’s cloud)
Furthermore, the CAICT data shows that the leading public cloud PaaS players are: AliCloud, Huawei Cloud, Tencent Cloud, Baidu Cloud. The whitepaper did not provide a percentage breakdown for the PaaS category, likely because this layer is too small, as previously noted.
AliCloud – as the largest IaaS player by a wide margin, a leading PaaS player, and the maker of an emerging enterprise SaaS product in DingTalk – is likely China’s fastest “cloud horse” to bet on. Even though AliCloud’s current growth rate has been hobbled to 10% year-over-year, due largely to a slowing 2022 Chinese economy that’s teetering on a recession, its long-term growth and profitability potential remains intact, as long as cloud computing’s fundamental economic and business logic continue to hold. Alibaba also has its own cloud semiconductor design division, called PingTouGe, making it less vulnerable to events like the Nvidia ban (more on that below).
Similarly, Tencent Cloud could also be a good bet on China’s future cloud industry evolution, though it has a much smaller IaaS base to grow from compared to AliCloud. Huawei Cloud is also becoming a formidable competitor and expanding well, while other parts of Huawei contracts. Unfortunately, it is a private company and off limits to an average retail investor.
The two state-owned telcos, China Telecom and China Mobile, have become legitimate IaaS providers as well. However, they are both tricky investment targets, having been forced to delist from the US in early 2021 during Trump’s “lame duck” period as president for their connections to the military (for more on that delisting, see previous post “Lame Duck Delisting”). SOEs like telcos also tend to have a harder time attracting top-tier technical talent to build appealing PaaS and SaaS products, so the likelihood of these two telcos moving up the cloud “value chain” is low.
The challenge of investing in China’s cloud growth is there are very few “pure play” options. To invest in AliCloud or Tencent Cloud, you would have to be exposed to the volatilities of the other business units of the parent company. Of course, a similar situation exists in the US market as well; to invest in AWS or GCP, you would have to buy Amazon or Alphabet stocks. However, when it comes to the PaaS or SaaS layer, there are only a handful of public companies that are purely exposed to the Chinese cloud market, e.g. Kingsoft and UCloud. With multiple IPOs last year and a mature cloud market overall, the choices are plentiful on the US side.
There is one upside to investing in China’s cloud, which is its walled garden nature. There are few real foreign competitors on the scene, so the most important factor is how quickly can the leading cloud platforms evolve while competing against each other.
X-Factor: Nvidia Ban
Even though direct foreign competition is not a major factor, US sanctions can still undermine China’s cloud growth. The recent ban of Nvidia’s A100 and forthcoming H100 chips is a prime example. Being able to acquire high-end processors like A100 and H100 is a key component to building more powerful data centers, so they can, in turn, enable more powerful PaaS and SaaS products – the higher margin cloud solutions. This is especially crucial for laying the cloud computing foundation necessary to build cutting-edge technologies like self-driving.
The Nvidia ban certainly opens up more opportunities for domestic chip startups, like Cambricon, Iluvatar CoreX, and Moore Threads, vying to get into the data center business. But becoming a credible alternative, not just the next available less quality alternative, to the best chip company in the world, will take more than just a few billion dollars of VC money. As I shared in a tweet thread when the Nvidia ban news first came out, one of the second order effects of the ban could be that China’s cloud evolution takes a major step back and has difficulties leveling up beyond IaaS.
These confluence of factors make investing in China’s cloud a tricky game, though by no means impossible. Globally, cloud digital transformation is a macro trend. As China’s own technical talent pool continues to become more expensive, cloud-based PaaS and SaaS solutions will become attractive over time, and the industry will eventually resemble similar maturity that the US is experiencing now.
Thus, it is a question of “when”, not “if”. Then again, in the world of investing, the question of “when”, not “if”, is always the harder (and more valuable) one to answer.
p.s. the bilingual (English/Chinese) version of this post is published on interconnected.blog