Back in 2008, Alibaba (BABA 0.18%) co-founder Jack Ma mocked China's video game market and declared his company "would rather starve to death than live on games." Ma reiterated that stance two years later, declaring Alibaba wouldn't invest a single "penny" in video games.

But in 2014, Alibaba changed its tune and launched its first mobile games platform. It expanded the business by buying UC Mobile (previously UCWeb) and its gaming platform 9Game, and acquiring stake in American game developer Kabam, that same year. In 2017, it bought the gaming company Ejoy and used the subsidiary to launch a new gaming division led by former NetEase (NTES 0.25%) former chief operating officer Zhan Zhonghui.

A young man plays a mobile game.

Image source: Getty Images.

Alibaba's video game unit was subsequently bundled with its other experimental businesses in its tiny "innovation initiatives" segment. But last quarter, Alibaba moved the online gaming unit into its larger "digital media and entertainment" segment, declaring it had grown too large to be incubated with its other smaller businesses. Let's take a closer look at this oft-overlooked segment and see why Alibaba is expanding its online gaming business.

What does Alibaba's gaming business actually do?

In 2014, Alibaba's fledgling gaming business launched mini games inside its Taobao Mobile shopping app and Laiwang chat app. However, Alibaba's initial push flopped due to intense competition from Tencent's (TCEHY 0.32%) larger chat platform, WeChat, and its massive portfolio of mobile games.

In 2017, Alibaba's Ejoy subsidiary invested 1 billion yuan ($145 million) in the development of a global distribution network for mobile games. The following year, it bought the exclusive distribution rights for the hit Japanese mobile game Travel Frog and integrated it into its Taobao app. The move brought gamers to Taobao's e-commerce platform, and Alibaba capitalized on the game's popularity by selling tie-in products.

A young woman plays a mobile game.

Image source: Getty Images.

Alibaba also continued to launch other mini games, including Go and various puzzle games, for Taobao. In 2019, it launched a social game called Taobao Life, in which users customized their own avatars and bought virtual clothes and accessories with points. Players earned those points by shopping on Taobao and Tmall or completing daily challenges.

Ejoy also launched two well-received standalone Romance of the Three Kingdoms games. Those games gave Alibaba a firm foothold in the mainstream gaming market, but its gaming strategy still mainly centers on strengthening Taobao's mobile app, which also lets merchants sell products via live videos, with integrated games.

Alibaba doesn't regularly disclose Taobao's number of mobile users, but mobile monthly active users across all its Chinese marketplaces grew 3% sequentially to 874 million last quarter. During the conference call, CEO Daniel Zhang mainly attributed that growth to Taobao's "strong consumer mind share, healthy user stickiness, and engaging user experiences." CFO Maggie Wu also briefly noted its online gaming business was "growing well" without elaborating on the strength of its individual titles.

It's an ecosystem play, not a revenue play

Alibaba's digital media and entertainment revenue rose 9% annually to 6.99 billion yuan ($990 million) last quarter, and it attributed most of that growth to the shift of its gaming division to the digital media unit.

However, the entire digital media unit -- which also includes its streaming media platforms, its movie production studio, and its mobile apps -- accounted for only 4% of Alibaba's top line. Alibaba didn't disclose how much revenue Taobao's games bring in, but the shift reduced its innovation initiatives revenue by 1.19 billion yuan ($168 million) sequentially -- so we can estimate Alibaba generates $150 million to $200 million in gaming revenue each quarter.

By comparison, Tencent and NetEase generated 38.3 billion yuan ($4.9 billion) and 18.2 billion yuan ($2.6 billion) in online gaming revenues in their latest quarters. Therefore, it's doubtful Alibaba's gaming unit will be mentioned in the same breath as those gaming giants anytime soon.

Instead, Alibaba's games will expand Taobao's ecosystem and widen its moat against Tencent's WeChat -- which locks users in with mini-programs for games, online shopping, deliveries, payments, and other services. It can also shore up its defenses against its top e-commerce rivals, and Pinduoduo.

The key takeaways

Alibaba will still generate most of its revenue from its core commerce and cloud computing businesses for the foreseeable future. However, investors shouldn't neglect the smaller businesses in its digital media and innovation initiatives segments -- since they could gradually expand its e-commerce ecosystem and lock in more shoppers.