Alibaba Group Holding Ltd.'s $3.6 billion acquisition of a controlling stake in China's largest hypermarket chain, Sun Art Retail Group Ltd., will help the e-commerce company strengthen its position in one of the fastest-growing segments of e-commerce.

Since the outbreak of the virus, the surge in online grocery sales has significantly outpaced the overall e-commerce market, rising 35.4% for the year to September compared to 9.7% in all online retail, according to data from the National Bureau of Statistics. It also marks an acceleration from the 28.9% increase in online food sales in the year-ago period.

Sun Art-operated RT-Mart is China's largest hypermarket chain by sales with a 14.1% market share, according to Euromonitor International. The addition of its 481 hypermarkets and three supermarkets to Alibaba's more than 200 Freshippo supermarkets will create the largest operator in the combined hypermarkets and supermarkets space, surpassing China Resources Vanguard Co. Ltd. and JD.com Inc.-backed Yonghui Superstores Co. Ltd.

Alibaba's ability to digitize offline retailers and the support of the Taobao and Tmall online marketplaces, which have a combined 742 million annual active users, will enable the company to meet the rising demand for online groceries, especially in smaller cities, and will pose a formidable challenge to JD.com's position as the biggest online and overall retailer. Alibaba also holds a majority stake in electronics retailer Suning.com Co. Ltd. and an 18% interest in Lianhua Supermarket Holdings Co. Ltd.

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With more than 76% of Sun Art's stores located in third, fourth and fifth-tier cities as of the end of June, the deal will increase Alibaba's access to the smaller urban areas that have been instrumental to the rise of community buying platform Pinduoduo Inc. Sun Art intends to open 30 mini-stores in 2020 as it sees expanding its footprint of smaller, community-based sites as an "inevitable" path to growth.

"We are all well aware that the COVID-19 outbreak has shifted the sales of daily necessities online. Daily necessities have become high-frequency purchases after the pandemic, so the acquisition will help Alibaba to secure a stable supply chain for these items," said Danny Law, analyst at securities brokerage Guotai Junan, in an interview.

Crowded field

In 2017, Alibaba acquired a 36% stake in Sun Art, one of its first investments in the brick-and-mortar grocery space as part of its "new retail" strategy of taking physical stores online.

The $2.9 billion investment led to the digitization of RT-Mart's operations in line with Alibaba's Freshippo, which includes omnichannel features such as in-store fulfillment of online orders and interactive kiosks. All of Sun Art's hypermarkets and supermarkets are now integrated into Alibaba's platforms, including its online grocery platform Taoxianda, online food delivery platform Ele.me and logistics arm Cainiao.

For the second quarter, Alibaba said its half-day delivery service helped Sun Art capture new online customers and accounted for about 15% of revenue.

Yet Sun Art may find itself jostling with other Alibaba-backed supermarket entities and rivals in an increasingly crowded space, industry observers said.

It is unlikely that Freshippo and Sun Art's stores will be merged in the future given their vastly different positioning and operations, said Shawn Yang, managing director of Blue Lotus Capital, in an interview. With its slick cashless checkouts and greater variety in the fresh produce category, Freshippo is aimed at higher-end consumers.

Emerging players like Tencent Holdings Ltd.-backed online grocery platform Missfresh, online food delivery company Meituan Dianping and Beijing Byte Dance Telecommunications Co. Ltd.-owned news aggregation app Jinri Toutiao have all launched fresh produce offerings to meet the increasing demand for online groceries in the wake of the COVID-19 pandemic.

"Sun Art is likely to undergo cannibalization between its online and offline sales amid its new retail transformation. In addition, the grocery market in China is very fragmented with a lot of room for online players to consolidate," Morningstar analyst RJ Hottovy Jr. wrote in an Oct. 20 research note.

Cutting costs

Given the existing relationship with Alibaba, few of Sun Art's operations will change post-acquisition. However, Alibaba may integrate the supply chain and inventory of Sun Art and its entities like Freshippo, said Guotai Junan's Law.

The full integration of sourcing, logistics and operational systems will give Alibaba improved bargaining power and the ability to cut costs at a scale that its closest competitors "can hardly catch up with," Morningstar's Hottovy Jr. said.

JD.com's self-operated logistics remains its key advantage and it will continue to have lower sourcing costs in the premium categories preferred by consumers in first and second-tier cities, he noted. The online retailer also has an inventory partnership with Walmart.

Alibaba, on the other hand, is far ahead of its rivals in the game of digitizing brick-and-mortar grocery retail, said Law from Guotai Junan.

"Alibaba has spent a lot of time building the ecosystem. It is very hard to replicate and that is its strength compared to its rivals," he said. "It enjoys the first-mover advantage and it hasn't stopped investing, creating a chained effect to its business model."