Alibaba (NYSE:BABA) generates most of its revenue from its e-commerce marketplaces in China, but it's also gradually expanded its brick-and-mortar presence in recent years. It opened its first Freshippo grocery store in early 2016, and the chain now operates 214 stores across China.

But that's not all: It also invested in brick-and-mortar giants like the electronics retailer Suning, the supermarket chain owner Sun Art (OTC:SURRY), and the home furnishings retailer EasyHome. It also formed a joint venture with brick-and-mortar store operator Bailian Group, launched showcase stores for its online products, and acquired the department store chain Intime.

A Chinese family goes shopping in a supermarket.

Image source: Getty Images.

That's why it wasn't surprising when Alibaba recently doubled its stake in Sun Art, which it initially established three years ago, to 72%. That takeover will give Alibaba control of Sun Art's 481 hypermarkets and three mid-sized supermarkets across the country. 

Shortly afterwards, Alibaba took a 6.1% stake in the Swiss duty-free retailer Dufry (OTC:DUFRY), and formed a joint venture with the company to combine its digital platforms with Dufry's travel-oriented shops. Let's see how these latest moves strengthen Alibaba's brick-and-mortar ecosystem and expand its Core Commerce business, and why they might weigh down its margins and earnings.

A growing dependence on "New Retail"

Alibaba generated 87% of its revenue and all of its profits from its Core Commerce business last quarter. 76% of the segment's revenue came from the China Commerce Retail segment, which is split into three divisions: customer management, commissions, and others.

The segment generates most of its customer management fees and commissions from its top e-commerce platforms Taobao and Tmall. However, both of those segments grew at a much slower rate than its "others" segment during the first quarter:

China Commerce Retail Segment

Revenue

Growth (YOY)*

Customer Management

$7.3 billion

23%

Commissions

$2.8 billion

17%

Others

$4.3 billion

80%

Total 

$14.3 billion

34%

Source: Alibaba Q1 2021 Earnings. YOY = Year-over-year. *RMB terms.

That "other" revenue mainly come from Alibaba's New Retail and Direct Sales businesses, which include Freshippo, its online grocery platform Tmall Supermarket, Intime, and its direct import business (which was expanded by its takeover of Kaola last year). 

Alibaba's brick-and-mortar investments all feed the growth of the Others unit. If we exclude the Others unit from both periods, Alibaba's China Commerce Retail revenue would have only risen 21% year-over-year.

The remaining 24% of Alibaba's Core Commerce revenue came from its domestic wholesale, overseas, and Cainiao logistics business. Total revenue from those businesses also rose 34% year-over-year last quarter. 

Sacrificing its margins to widen its moat

Alibaba is expanding its brick-and-mortar presence for three main reasons. First, it boosts the combined revenue of its Core Commerce business as its online marketplaces face tougher competition from rivals like JD.com (NASDAQ:JD) and Pinduoduo.

Second, it expands its logistics network. Unlike JD, which takes on its own inventories and fulfills its orders via its first-party logistics network, Alibaba's online marketplaces don't retain any inventories. Instead, Alibaba links merchants to customers, collects the service fees and commissions, and directs the orders to Cainiao.

Packages in a warehouse.

Image source: Getty Images.

Cainiao and JD Logistics are already two of the largest logistics networks in China. But Alibaba can expand Cainiao's reach by adding more brick-and-mortar retailers, which serve as fulfillment or pick-up locations for online orders, to its Core Commerce ecosystem. Adding those stores to its network would also expand its overall selection of online products.

Lastly, Alibaba's brick-and-mortar expansion ensures its affiliate Ant Group, which runs the online payment platform Alipay, remains competitive against Tencent's (OTC:TCEHY) WeChat Pay. The two platforms hold a near-duopoly in China's digital payments market, and tethering Alipay to more brick-and-mortar retailers could prevent Tencent from gaining ground.

Those moves will all widen Alibaba's moat, but they'll also squeeze its margins. Last quarter, the adjusted EBITA margin of the Core Commerce segment declined year-over-year from 41% to 38%, mainly due to an "increased revenue contribution from our self-operated New Retail and direct sales businesses" and its takeover of Kaola's cross-border marketplace.

Many of Alibaba's New Retail businesses, including its brick-and-mortar stores, require it to take on inventories. That lower-margin revenue, along with the higher operating costs of physical stores, will weigh down its Core Commerce margins as its "Other" business expands. Alibaba's takeover of Sun Art and its new stake in Dufry reflect its commitment to that strategy.

Why this matters to investors

The gradual contraction of Alibaba's Core Commerce margin is worrisome, since it's the company's only profitable segment. Alibaba usually subsidizes the growth of its unprofitable Cloud, Digital Media, and Innovation Initiatives segments with its Core Commerce profits. 

Alibaba remains a lucrative long-term investment, but investors should monitor its brick-and-mortar investments to make sure it doesn't bite off more than it can chew.