China's booming video gaming industry has turned out to be a big moneymaker for NetEase (NASDAQ:NTES) in recent years. From operating Activision's popular games such as World of Warcraft and Diablo to building a solid portfolio of self-developed mobile games, NetEase has kept its finger on the pulse of the video gaming market to clock terrific growth.

NetEase also has been gradually building its e-commerce presence over the years. This is a smart move because China's online retail market is the largest in the world, surpassing an estimated $1 trillion in sales last year as per eMarketer's estimates.

The good part: NetEase's e-commerce business is already gaining scale. E-commerce supplied almost 22% of its total revenue in 2017, up from 12% in the prior year. What's more, NetEase's e-commerce sales shot up 156% last year to $1.8 billion, outpacing the gaming business' 29% growth. The company is now looking for ways to grab a bigger pie of the Chinese e-commerce space, which is dominated by the likes of Alibaba and right now. Here's how.

Cartoon denoting mobile e-commerce.

Image Source: Getty Images

NetEase works to hamstring the competition

Yanxuan, the online marketplace launched by NetEase in 2016, has been instrumental in the company's booming e-commerce business. Yanxuan is NetEase's private-label e-commerce brand that aims to offer quality products to Chinese customers at a cheap price. This is evident from Yanxuan's slogan: "A better life doesn't have to be costly."

For instance, a pair of shoes sold for around $205 on can be bought for less than $57 on Yanxuan. The only difference is that while the shoes on are from the well-known UGG brand, the ones sold by Yanxuan are a lookalike that's made by an original design manufacturer (ODM).

These ODMs are generally big contract manufacturers in China that make items for well-known global brands. NetEase contracts these ODMs directly, which allows it to cut the premium commanded by the brands, while also eliminating other overhead costs as it sells directly to the customer through its online portal. So, customers can buy a lookalike of a well-known product at a fraction of the price.

NetEase has struck gold with this model, so it has expanded the product selections that it offers through Yanxuan. It was selling 7,000 items on Yanxuan in September last year, which it has now expanded to 10,000. Not surprisingly, NetEase management now expects to earn $3 billion in revenue from Yanxuan this year. This would be a massive jump from the monthly average sales of $9 million that the site was reportedly clocking a year ago.

Additionally, NetEase is looking to open up offline Yanxuan stores in the next few months. This means that the company will be going up against Japanese lifestyle retailer Muji, which has already been slashing prices to try and fight cheap offerings from the likes of NetEase.

Cross-border e-commerce another huge opportunity

Kaola, the company's cross-border e-commerce arm, can also contribute meaningfully to its e-commerce ambitions thanks to its strategy of making a play on Chinese consumers' interest in imported goods.

In November last year, Bloomberg reported that NetEase will be buying $11 billion worth of inventory from Europe, Japan, and the U.S. over the next three years for sale through Kaola. The company has also sidelined funds to purchase goods from Australia and South Korea.

Adding such massive inventory of imported goods to Kaola will help NetEase carve a bigger slice of this e-commerce pie, driven by the growing thirst of Chinese consumers for foreign items. For instance, foreign products accounted for 63% of total sales during the recent Spring Festival that concluded in February. This trend favoring purchases of imported goods will continue as a quarter of the Chinese population is expected to make cross-border purchases by 2020, according to eMarketer.

Kaola is already the leading player in China's cross-border e-commerce space with an estimated market share of 24% in the first half of 2017. NetEase believes that this market could be worth as much as $75 billion in the next three years, and the company's decision to buy such huge inventory from foreign markets should ensure that it doesn't miss the opportunity.

More importantly, NetEase has been shoring up its distribution channels to ensure that consumers don't have to wait long for its goods. Starting this year, Kaola plans to use a massive automated facility to improve logistics so that it can bring down delivery times from as long as 15 to 20 days to as short as one to three days.

Such improvements are necessary if Kaola wants to maintain its lead in the Chinese cross-border space, where Alibaba's Tmall Global reportedly held the second-largest position with a 20% market share. Alibaba has been aggressively pushing cross-border e-commerce, recently collaborating with Thailand to launch a distribution hub that will be built at a cost of $352 million.

The downside of e-commerce growth

NetEase's rapid e-commerce growth is coming at a cost -- weak margins. This business had a gross profit margin of 10.3% in 2017, down from 12.2% in the previous year. Now, it is well-known that e-commerce businesses have very thin margins as they require a lot of investment in the form of inventory and distribution channels.

So, NetEase's e-commerce business will be a drag on its profitability as mobile gaming business carries a 60%-plus gross margin. Not surprisingly, NetEase's net income in fiscal 2017 fell nearly 8%, driven by a massive 53% jump in operating expenses that was primarily attributed to the growth of the e-commerce business.

In fact, NetEase's shipping and handling costs more than doubled in 2017, and they will keep increasing as the company goes all out to boost its e-commerce presence. The e-commerce business can only contribute toward NetEase's bottom line when the company is able to generate enough volume here.

Investors need to be patient

These aggressive investments in e-commerce should eventually boost its bottom line. For instance, if the company retains even 20% of the cross-border e-commerce market in 2021, Kaola could contribute substantially to the company's top line if the end-market turns out to be as big as NetEase projects.

Kaola, in fact, could be a serious driver of NetEase's sales as the average customer transaction value on the site is "more than double the average transaction value in the cross-border e-commerce industry," according to the company. Yanxuan, on the other hand, is set to report impressive growth this year, which it should be able to sustain in the long run thanks to its smart business model.

In all, NetEase investors need to remain patient. NetEase's strategy could reap rich rewards in the long run given the size of the Chinese e-commerce industry.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.