JD.com (NASDAQ:JD), China's largest direct retailer and second-largest e-commerce company, recently partnered with Cloudflare (NYSE:NET) to strengthen its cloud and AI business.

Cloudflare, which secures internet traffic between clients and servers, entered the Chinese market in 2015 and currently operates in over 90 countries and 200 cities worldwide. It runs data centers in 17 Chinese cities and maintains a long-standing partnership with online search leader Baidu (NASDAQ:BIDU).

JD will expand Cloudflare's network to an additional 150 data centers across China. Cloudflare will design the network, while JD Cloud & AI will provide the capital and infrastructure. The companies expect to complete the project within three years.

JD's partnership with Cloudflare could expand its oft-overlooked cloud business -- which offers public, private, and hybrid services with over 300 products -- to compete more aggressively against Alibaba (NYSE:BABA), which leads China's e-commerce and cloud platform markets.

A man "touches" digital connections on servers.

Image source: Getty Images.

Understanding JD.com's cloud business

JD formed the new Cloud & AI unit last December to develop and integrate new AI, analytics, and cloud computing services into its e-commerce and logistics platforms. That ecosystem is powered by the Neuhub open AI platform, which was launched two years ago to process language, speech, computer vision, and machine learning services for retail and supply chain tasks.

JD's cloud platform serves its own marketplace as well as enterprise and government customers. In its latest annual report, it stated the platform delivered "solid operational performance" throughout two major shopping events in 2019 with zero outages, and was certified as an "AAA trusted cloud provider" by the China Academy of Information and Communications Technology (CAICT) for two years in a row.

A visualization of network connections across the world.

Image source: Getty Images.

JD was ranked 10th in China's public cloud service in the first half of 2019, according to IDC. That makes it a distant underdog in the market compared to Alibaba, Tencent (OTC:TCEH.Y), China Telecom, Amazon Web Services (AWS), and Huawei -- which together controlled 75.3% of the entire market.

JD doesn't disclose its Cloud & AI revenue separately yet, but it noted the expansion of that business would likely increase its R&D expenses as it hired "additional senior and experienced technology employees."

How does this deal benefit JD and Cloudflare?

JD's deal with Cloudflare will initially weigh down its margins as it builds the network. But after the new data centers come online, Cloudflare will pay JD to use that infrastructure -- which will generate a fresh stream of recurring revenue for the cloud and AI business. Cloudflare, which already reroutes traffic for Baidu, will further strengthen its role as a "middleman" for internet traffic in China.

Cloudflare's network keeps Chinese data centers separate from overseas data centers to boost connection speeds and allay security and privacy concerns. For example, a website's visitors in China would be served by domestic Cloudflare data centers, while overseas visitors would be served by their nearest data center instead.

Should Alibaba be concerned?

Alibaba's cloud revenue rose 62% annually last quarter and accounted for nearly 7% of its top line, fueled by robust demand for its public and hybrid cloud services. That feverish growth should continue for the foreseeable future, and widen its moat against underdogs like JD.

However, Alibaba's cloud business is also unprofitable, and it relies heavily on the profits from its core commerce business to keep growing. That's different from Amazon, which subsidizes the growth of its e-commerce business with AWS's profits.

Unlike JD, which expects its revenue to rise at least 10% annually in the first quarter as lockdown measures paralyzed most of China, Alibaba expects its core commerce revenue to decline. That slowdown could throttle the expansion of Alibaba's cloud business in China and overseas markets.

JD Cloud won't threaten Alibaba Cloud on its own, but Tencent -- the second-largest cloud player in China -- is also one of JD's top investors. Tencent's share of China's cloud infrastructure market rose from 15.4% to 18% between the first and fourth quarters of 2019, according to Canalys, as Alibaba's share dipped from 47.3% to 46.4%.

Tencent's ecosystem is already deeply intertwined with JD's, so it's certainly possible that the two companies could pool their cloud resources to challenge Alibaba. Alphabet's Google, which also owns a major stake in JD, could also lend a hand.

The bottom line

JD and Cloudflare's team-up won't move the needle for either company anytime soon, but it could light a slow-burning fire under JD's cloud business, and extra fuel from Tencent could help it gain ground against Alibaba. Alibaba's investors don't need to worry about JD yet, but they should keep an eye on that strategic shift.