Alibaba (NYSE:BABA) is the largest cloud player in China, but a recent Canalys report indicates Tencent (OTC:TCEHY) is gaining ground. Alibaba's share of China's cloud infrastructure market dipped from 47.3% to 46.4% between the first and fourth quarters of 2019. During the same period, Tencent Cloud's share rose from 15.4% to 18.0%.

Tencent won't catch up to Alibaba any time soon, but its renewed focus on its cloud business -- which started after a restructuring effort in late 2018 -- could spell trouble for the market leader. Let's dig deeper into Tencent's cloud business and see what its growth could mean for Alibaba's future.

An illustration of a cloud on a computer chip.

Image source: Getty Images.

How big is Tencent's cloud business?

Tencent's cloud revenue topped 17 billion yuan ($2.4 billion), or about 5% of its total revenue, in 2019. It now serves over a million paid customers.

Tencent doesn't disclose its cloud growth every quarter. It claimed that its cloud revenue rose 80% annually to 4.7 billion yuan ($670 million) in the third quarter but didn't update that quarterly figure in the fourth quarter.

Instead, Tencent lumps the cloud business together with WeChat Pay and other fintech services in its "fintech and business services" segment. The unit's revenue rose 39% annually in the fourth quarter and accounted for 28% of the top line.

Tencent attributed that growth to higher payment volumes and Tencent Cloud's "deeper penetration in key verticals" as it "consistently expanded" its market share. During the earnings call, CEO Pony Ma declared that Tencent Cloud continued to "outgrow [its] peers with increasing scale and higher operating efficiency."

A battle of cloud-based ecosystems

Alibaba's cloud revenue rose 62% year over year to 10.7 billion yuan ($1.5 billion) last quarter and accounted for 7% of its top line. Over the past four quarters, the company generated 35.5 billion yuan ($5.1 billion) in cloud revenue.

Two IT professionals walk through a data center.

Image source: Getty Images.

Alibaba Cloud is an attractive choice for companies, because it's deeply integrated into its own e-commerce marketplaces, its affiliate AliPay's payment services, and other digital services. However, Tencent also tethers its own digital offerings -- including WeChat, the top messaging app in China; WeChat Pay, which competes against AliPay; and its streaming media services -- to Tencent Cloud.

WeChat, which hit 1.16 billion monthly active users (MAUs) last quarter, is an essential app for Chinese citizens -- it's used to pay bills, access medical services, utilize public transportation networks, and collaborate remotely with co-workers. Tencent Cloud's enterprise customers get access to those users and can easily integrate their services into Tencent's broader ecosystem -- which includes the world's largest gaming business, China's fourth-largest advertising platform, and its largest social network.

Tencent has more room to maneuver ...

Tencent and Alibaba are both subsidizing the growth of their cloud services with higher-margin businesses. Tencent feeds the growth of its cloud and fintech units with the higher-margin revenue from its gaming and advertising arms, which generated nearly half its revenue last quarter. Alibaba subsidizes its unprofitable cloud operations with its profitable core commerce business, which generated 88% of its revenue last quarter.

However, Tencent's gaming business will likely continue growing throughout the coronavirus crisis (and possibly offset a slowdown in its ad business) as Alibaba anticipates a slowdown in its core commerce segment. Therefore, Tencent could have more room to cut prices and launch aggressive promotions than Alibaba, which could struggle to punch back until its core commerce business fully recovers.

... but don't jump to conclusions

Tencent's cloud growth is encouraging, but its lack of full financial transparency makes it tough to tell how aggressively it's sacrificing its margins to challenge Alibaba. Moreover, both Tencent and Alibaba's operating margins expanded annually last quarter -- which suggests that both companies are well-positioned to battle it out for a long time.

Tencent will likely remain China's second-largest cloud player for the foreseeable future, but that doesn't mean it can't keep gaining market share against Alibaba. Until then, Alibaba investors should keep a close eye on this aggressive rival.