Technology

Beth Kindig

Predicted Facebook's Q2 '18 drop & Roku's meteoric rise

Tech Growth Opportunity in China: Hiding in Plain Sight 

Pop quiz: what is the biggest growth driver for the world’s two most valuable companies? I’ll give you a hint. More than half of Amazon’s operating income comes from this specific revenue segment at 58% with over $7 billion in revenue. In Amazon’s most recent earnings report, the company clocked 45% sales growth and 61% operating income growth year-over-year from this category. Even with the law of large numbers, these percentages have been going strong for nearly 13 years.

Microsoft also relies heavily on the same growth driver as Amazon, posting 76 percent year-over-year in the last quarter for $4 billion in revenue with the overall category growing 48 percent to $9 billion. 

By now, you may know that I am not talking about Amazon’s e-commerce business or Microsoft’s enterprise software. I am describing cloud infrastructure-as-a-service (IaaS). The cloud infrastructure market is expected to reach $83.5 billion by 2021, up from $40.8 billion in 2018. Amazon Web Services was formally launched in 2006, which means it took twelve years for the infrastructure-as-a-service (IaaS) market to reach $40 billion – but will take only three years for the next $40 billion to accumulate. Three years ago, Microsoft was barely on the map for cloud IaaS, but Satya Nadella has dedicated his leadership to this segment (his background is cloud IaaS) and now Microsoft’s Azure is number two in the world.

In April, IaaS will be in the headlines as the Pentagon contract is going to be announced, which will usher in renewed trust for security and cloud IaaS. You can read my analysis here for more information on the $10 billion contract to be announced by the Department of Defense. 

In a separate analysis, I wrote about the IaaS revenue segment as a safe, secular bet. On a micro-level, the tech industry is in a state of transition. Mobile is hitting saturation, social media faces privacy regulations, chip makers were hurt in the trade war, and meanwhile, 5G, artificial intelligence, and autonomous vehicles are too nascent to see returns in the near term. One reason I have covered IaaS extensively is because companies are going through a major transition right now by transferring workloads to the cloud. IaaS is secular because companies who have transferred to the cloud cannot exist without budgeting for this expense, while companies who have not transferred at least some of their on-premise servers to the private or public cloud risk losing on competitive advantages from AI, ML and are not able to scale quickly through server virtualization.

Despite the incredible, secular growth this segment has experienced, the market has not caught onto one of the biggest growth potentials in the IaaS space that is occurring right now. There are a few key reasons this tech stock is hiding in plain sight, which I discuss below. First, however, it’s important to understand how Amazon’s AWS came about. 

Tens of Billions of Dollars in Serendipitous Revenue

To understand the growth story behind the stock that this article is about, it’s a good idea to first review how Amazon became the predominant provider of cloud infrastructure. Prior to 2002, Amazon.com struggled with scalability as the e-commerce site experienced massive peaks in traffic on popular shopping days. The rumor in tech circles is that the first iteration of AWS, which was between 2002 and 2006, was designed to help Amazon.com minimize the costs of holding too much server space for traffic peaks that only occur a few days per year[1]. 

To illustrate, let’s say Amazon needed 200,000 servers to handle e-commerce traffic back in 2002 during its busiest days, like Black Friday, but needed only 50,000 servers to handle traffic on average shopping days, like in the middle of July. The additional 150,000 servers were a lot of infrastructure to financially carry year-round to handle those rare traffic spikes. 

Amazon.com, an ecommerce company, has made a lot of money from renting out cloud server space, and serendipitously discovered a burgeoning market in 2002. By 2006, for the official launch of Amazon Web Services, many services were added that helped startups and small to medium businesses (SMBs) scale quickly while avoiding high IT costs. Over the next decade, Amazon built out a full-on cloud infrastructure business and its IaaS business now nets more operating income than its e-commerce business.

The Next Geo to Have Explosive IaaS Cloud Growth is China

According to Chinese cloud executives, the China enterprise IT market is five to seven years behind the United States and Western European markets. When combining all cloud services (PaaS, SaaS and IaaS) China’s market is expected to reach $100 billion by 2020. However, Bain puts the potential in the near-term for the IaaS segment at $20 billion [1].

Once fully mature, China’s need for cloud infrastructure should one day rival the United States as China has 3x the population of the United States at 1.3 billion people, and the country has a bottomless appetite for smart cities, artificial intelligence and machine learning (I’m sure you’ve heard of the surveillance measures going on in China, for instance). The range of services expanding in China that require data-intensive computing and cloud infrastructure include AI, the Internet of Things (IoT), Virtual Reality (VR), Online-to-offline services (O2O), Smart Cars and Online Payments. 

China has been more than fashionably late to cloud infrastructure with a total market size of $1.2 billion in 2018 compared to the United States’ $40 billion in 2018, which is why there’s a window of opportunity right now with the IaaS market expected to grow substantially due to China’s efforts in artificial intelligence. It is my prediction that the majority of the 20x growth of this segment in China will funnel into one specific tech stock.

Monkey See, Monkey Do: E-Commerce & Cloud IaaS

What company has a solid e-commerce business in China and is now steadily climbing in the cloud IaaS revenue segment with the CEO stating cloud IaaS will surpass its e-commerce segment to be the majority of its business? Alibaba. 

If you wish you could have bought Amazon when it was priced below $1000 per share, then you may have a second chance. The parallels are easy to see. Alibaba, like Amazon, is an e-commerce company that specializes in cloud infrastructure server space and has to handle traffic spikes and large work-loads. Naturally, Alibaba Cloud has modeled itself off of Amazon’s strengths, and in the past few quarters in 2018, has launched over 600 products and services for Alibaba Cloud. 

Beyond the growth of this specific revenue segment in China, there are a few more key reasons Alibaba stock is well positioned. It’ll be nearly impossible for a Western cloud infrastructure company like Amazon or Microsoft to gain market share in nationalistic China due to its policies that ban American tech in what has been dubbed the “Great Firewall of China.” This is a boon for Alibaba Cloud while China becomes the biggest growth story in cloud IaaS over the near term. In addition, Alibaba Cloud will seek market share from Eastern geos such as Indonesia and India.

One key metric that I look at is developer response, and tech developers are responding positively with Alibaba attracting 120,000 people to its cloud conference last September compared to AWS attracting 50,000 to its cloud conference. This is important intel that financial statements don’t reveal. 

The window of opportunity here is that Wall Street still sees Alibaba as an e-commerce player. The cloud growth story has been remarkably under-reported. Next week, I’ll break down specifics on Alibaba as an individual stock including its forward growth rate. Follow me on FATRADER for updates.

[1]Bain originally put this estimate for 2020. It will clearly take longer than this, however, China will at minimum reach $20 billion in this segment. 

[2]A few employees who were at Amazon at the time insist that AWS came from a paper that described a way to provide an integrated suite of core web services for developers, websites and client-side applications – and not due to traffic spikes. However, the web services this paper describes launched in 2006 under the name AWS, while the original server infrastructure business launched in 2002. There’s a bit of a battle on the story behind AWS’s origin, however, Amazon would have only been able to provide server space … if it had, well, extra server space. The fact it was an e-commerce company with huge amounts of servers going unused for the majority of the year is an essential piece to the story even if it’s not the piece Amazon highlights when telling of its origin.

Beth Kindig, is a contributing analyst to FATRADER covering technology. A prolific tech analyst from San Francisco with over 700 articles in the last 7 years, she has held senior-level product marketing and developer evangelist roles at tech companies in Silicon Valley.
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