The dark clouds of Alibaba and Tencent

Just over a year ago, with Alibaba under antitrust investigation and political pressure on founder Jack Ma, CFO Maggie Wu was quick to speak to investors of the company’s booming and uncontroversial cloud business.

“China is going to be the biggest economy in 10 years, companies and millions of companies will migrate to the cloud,” she said at a Goldman Sachs conference last February, according to notes provided to the Financial Times.

But Wu’s suggestions that Ali Cloud’s 50% annual growth rate was sustainable proved overly optimistic. Today, growth has stalled in its cloud computing division, with sales up just 12% in the first quarter of 2022 from a year earlier. Main rival Tencent reported that its cloud arm had shrunk over the same period.

Tottering cloud companies reveal how Chinese tech giants are struggling to regain their footing as they battle a regulatory onslaught from Beijing and a slowing economy caused in part by a draconian coronavirus regime that has halted the commercial activity in much of the country.

The lackluster growth defied expectations that cloud computing could transform Chinese technology groups in the same way that Amazon Web Services revamped the US e-commerce giant and Azure bolstered Microsoft.

Competition from politically favored providers such as national champion Huawei and state-backed telecom companies including China Telecom-led Tianyi Cloud and Tsinghua Unigroup is adding to the pressure.

Unlike its Silicon Valley peers, growth at Alibaba’s cloud unit has slowed significantly over the past 12 months as earnings remain nascent. Tencent, meanwhile, has shifted from maximizing growth to pursuing profitability.

One piece of the slowdown puzzle is the structure of China’s cloud market. The country’s public cloud accounts for around 60% of the market, with Alibaba and Tencent being the two biggest players.

In the public cloud, multiple companies share a vendor’s platform. This part of the market is so dominant in the United States that it is generally known as the “cloud”, with Amazon, Microsoft and Google dominating the sector.

However, in China, 40% of the market is in the private cloud, where companies use dedicated and often highly personalized computing resources, according to the China Academy of Information and Communications Technology, a think tank run by the government. Customers in this part of the market include large public companies and governments. The main suppliers are Huawei, public suppliers and also Alibaba.

In the public cloud, internet industry customers make up about half of all end users, which has left the cloud arms of Alibaba and Tencent vulnerable to China’s tech crackdown. Alibaba cited dwindling use of information technology companies, whose business model has been banned by Beijing, and online entertainment companies, which have faced tougher rules.

China's cloud industry by end user and supplier

The regulatory change has also prompted venture capitalists to abandon the consumer internet space. “A lot of small internet businesses with less than 100 people have closed this year,” said a person close to Alibaba’s cloud division. “These are the main users of the cloud, if they disappear, we suffer.”

Yi Zhang, an expert at Canalys, said growing competition and slowing demand in the public cloud market meant tougher times for cloud providers. “The global market is becoming saturated,” she said.

In the 12 months to March 31, Ali Cloud’s growth slowed, with sales up just 23% year-on-year to Rmb75 billion ($11 billion) and an operating loss of 5 billion Rmb. By comparison, Amazon grew its cloud revenue by 38% over the same period, contributing $21 billion in operating profit on $67 billion in sales.

“The cloud is Alibaba’s second largest business after e-commerce, so the slowdown is concerning,” said Shawn Yang, managing director of Blue Lotus Capital Advisors. “Alibaba said it was because of the loss of a key customer, which was ByteDance’s TikTok, but there are clearly other reasons as well,” he said.

Along with losing TikTok, Alibaba chief executive Daniel Zhang last month also blamed the Covid-19 outbreak for delaying projects, the faltering economy and falling demand from internet companies, while claiming that the slowdown in growth was only temporary. “The digitization of other industries is just beginning and we see many opportunities,” he said.

But analysts said structural issues and growing competition will remain at least short-term challenges for Alibaba and Tencent.

“Only small businesses want to use the public cloud,” said Evan Zeng of Gartner. Large enterprises “don’t trust public cloud providers. . . they want to control security and the whole environment”.

Boris Van, senior software analyst for China at Bernstein, added that Beijing’s rollout of a series of cybersecurity and data privacy policies last year convinced more companies to opt for cloud computing. private. “They want better control over their data environments,” he said.

Tencent, meanwhile, said it was turning away from loss-making services such as offering discounted cloud infrastructure and highly customized projects, which dragged its sales down in the first quarter.

James Mitchell, Tencent’s chief strategy officer, said many cloud providers provide “expensive solutions” akin to an IT consulting business. “Although this is achievable in an infinite capital type environment. . . it’s not sustainable,” he told investors last month..

With growing competition from telecoms and Huawei, Tencent and Alibaba are moving away from low-value private cloud work, said Robin Zhu, China internet analyst at Bernstein. “They are focused on higher margin cloud services – we expect slower growth in the coming quarters.”

Recent government procurement contracts reviewed by the FT show dozens of suppliers competing for government contracts. Several local governments, such as the city of Changsha, granted renewals to Huawei in competitions without tenders, but tenders showed fewer automatic deals for Alibaba or Tencent.

An official from Alibaba’s home province of Zhejiang says the company did well in winning government contracts before 2020, when founder Ma crossed a political red line with a speech in Shanghai criticizing regulations .

“Those days are over as Alibaba fell out of favor with President Xi [Jinping]“These days, we are leaning towards state-backed cloud services like Tianyi because they are seen as more politically reliable. This will be the trend in the years to come.”

Additional reporting by Nian Liu in Beijing

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