Alibaba (NYSE:BABA) recently launched Taoxiaopu, a new platform that encourages its 693 million annual active shoppers to become dropshippers -- middlemen who peddle goods for other merchants without stocking any physical inventories.

Users who join Taoxiaopu gain access to various products sourced from Alibaba's core marketplaces like Tmall. If they convince other users to buy those products, they earn a small commission. Alibaba handles all the payment, shipping, and logistic costs.

The entire platform is gamified to persuade its dropshippers to sell more products. New sellers start on a trial basis and gain access to 30 products, which range from fruits to cosmetics. If they make five or more successful sales, they're promoted to an "L1" status and gain access to over 10,000 products.

Tiny parcels on a laptop keyboard.

Image source: Getty Images.

Alibaba initially tested Taoxiaopu last April among a small group of users, and it was expanded to nearly a million users at the time of its official launch in early January. About half of those users reside in China's lower-tier cities.

In theory, Taoxiaopu represents a promising way to counter the discount marketplace Pinduoduo (NASDAQ:PDD), which thrives on bulk sales of cheap products, across lower-tier cities. But in practice, converting its customers to dropshippers could backfire and hurt Alibaba's margins.

Why Alibaba believes in dropshipping

Alibaba's Tmall and Taobao platforms are the largest online marketplaces in China. However, Pinduoduo gained a firm foothold in lower-income cities over the past four years by encouraging shoppers to team up on bulk purchases via social networks like Tencent's (OTC:TCEHY) WeChat.

By encouraging users to share product links with their friends, family members, and co-workers, Pinduoduo drove down the prices per unit for bulk orders. Pinduoduo also convinces big brands to sell their products at a loss on its platform, then subsidizes the difference out of its own pocket.

Those aggressive strategies enabled Pinduoduo to surpass JD.com (NASDAQ:JD) as the second largest e-commerce retailer in terms of active shoppers (but not revenue) last year. Its total number of active buyers rose 85% annually to 429.6 million last quarter, compared to JD's 334.4 million annual active buyers.

Alibaba and JD both generate slower growth in top-tier cities like Beijing and Shanghai, so they're expanding more aggressively into lower-tier cities to offset that slowdown. Alibaba launched a discount and flash sale platform called Juhuasuan last August, and JD launched a similar platform called Jingxi last September.

Taoxiaopu is clearly an extension of that push against Pinduoduo. If Alibaba converts more of its users in lower-tier cities into dropshippers, its marketplaces could sell more products via social networks and steal shoppers away from Pinduoduo.

A cloud of social networking connections.

Image source: Getty Images.

Why Taoxiaopu could backfire

Alibaba likely thinks that building a viral dropshipping network will boost its core commerce revenue, which accounted for 85% of its top line last quarter. However, investors should recall that Alibaba is increasingly using lower-margin strategies to prop up that unit's growth.

Alibaba's core commerce revenue grew 40% annually last quarter, but a significant percentage of that growth came from lower-margin businesses like brick-and-mortar stores, cross-border marketplaces like Tmall International and Kaola, and its growing stake in Cainiao logistics. If we exclude all those businesses, Alibaba's core commerce revenue only grew 28% annually.

That strategic shift caused the adjusted EBITDA margin of Alibaba's core commerce unit to slide 300 basis points annually to 38.1% last quarter. The launch of Taoxiaopu will likely exacerbate the decline because it contradicts Alibaba's traditional dependence on higher-margin revenue.

Alibaba's traditional business model urges merchants and brands to pay listing fees for higher-ranked search results on Tmall and Taobao. That strategy makes it China's top digital advertising platform by annual revenue. Its marketplaces also earn commissions from each sale.

On Taoxiaopu, Alibaba is paying dropshippers commissions for each sale. The payout varies, but a recent Tech in Asia report claims that selling a five kilogram box of apples priced at 28 yuan ($4.03) yielded a commission of 5.2 yuan ($0.60) -- which equals a rate of nearly 18%.

In other words, Taoxiaopu flips Alibaba's high-margin business model upside-down and mirrors Pinduoduo's model of hefty subsidies. That's a dangerous idea, since Pinduoduo isn't profitable and its losses are widening. To make matters worse, Taoxiaopu could cannibalize sales from Alibaba's Juhuasuan discount marketplace.

The bottom line

Taobao and Tmall will remain the core growth engines for Alibaba's core commerce business. However, investors should be aware that a lot of its growth comes from lower-margin initiatives. Taoxiaopu marks a continuation of that strategy, and its growth could eventually weigh down the unit's margins.