Jul 24, 2012 · 3 minutes

Tencent is the world's fifth-largest Internet company by market cap, but much of its revenue has come from one sector: games. A new report, however, shows that the company is plotting to expand its empire by moving aggressively into ads and ecommerce.

In a "War of Internet Dominance" in China, Tencent's margins will suffer in the near term, but increase by a third in 2013, according to RedTech Advisors' report "Tencent: Building an Empire", released yesterday. "Despite lower margins and the cutthroat nature of ecommerce in China, we agree with the company’s overall expansion strategy," said the report. Tencent's gaming strategy is sound and its expansion into ads and ecommerce offers "opportunities for pockets of earnings acceleration once scale is reached."

Ecommerce is now an extremely difficult sector in China, with Alibaba's Taobao sitting pretty at the top with smaller players fighting each other to the death by under-cutting each other in ongoing price wars. Tencent, however, is well placed to take some heavy blows. RedTech expects the company to sustain an operating loss of $119 million (RMB 760 million) in ecommerce through 2014, but that figure represents just 1.5 percent of its net income over the same period. By ramping up its existing ecommerce offerings – including Mall.qq.com and Shop.qq.com, and its payment portal Tenpay – it is taking a "might as well try" approach to the market, the report said.

"We’re less concerned about financial impact than the opportunity cost in terms of diversion of management’s attention," said the report. "Ultimately, if Tencent can’t successfully ramp its agency business via a merchant marketplace, then we expect management will throttle back rather than double down – like they did in C2C with Paipai." Paipai is Tencent's underperforming eBay-like platform.

Meanwhile, along with search giant Baidu, Tencent stands the best chance of succeeding in targeted advertising, because it has the financial and engineering resources needed to build huge data centers, and sufficient traffic to accumulate enough data for deep analysis. It can take advantage of its social graph – which has hundreds of millions of users – to deliver precision advertising, a practice that is already wide-spread in the US. So far, advertising makes up only 7 percent of Tencent's total revenues.

"It’s a wonder that Tencent hasn’t tried to do this before," the report said. "It reminds us of the early days at Google when engineers put so much focus on indexing the web that they ignored the data logs showing what users were actually searching for."

"In Tencent’s case, we believe the social revolution and Facebook’s early success has finally awakened it to the possibilities of the data sitting at its doorstep, long overlooked because of its outsized success in gaming. "

The RedTech report also made special mention of Tencent's star mobile messaging app Weixin, which it called "by far the most promising of Tencent's new social assets." Weixin has amassed more than 100 million users in less than a year. While it is only getting started on monetizing the app, early signs look good. In late June, the report noted, Tencent enabled Weixin users to sign up for offline shopping discounts. More than 1,000 brands have are taking part in the scheme, called "Wei-life". In the next few months, Tencent will launch a partnership scheme with shopping malls in the country's top-tier cities. RedTech also expects Tencent to experiment with location-based services soon.

The report highlighted the business threat Weixin poses to other social networks in China, including the Twitter-like Sina Weibo. "This type of large-scale project puts the pressure on Sina Weibo to figure out monetization, particularly with the quickening migration to mobile use."

It would also be smart for American companies such as Facebook, Foursquare, and Twitter to watch very Weixin very closely.