GameStop won't stop

August 3, 2012: 11:11 AM ET

Electronics retailers and video game makers are facing bleak times. That puts game seller GameStop in the crosshairs.

By Don Reisinger, contributor

gamestopFORTUNE -- The retail industry is littered with companies that failed to see changing times and suffered for it. Best Buy (BBY), the top technology retailer in the U.S., certainly knows that story. Video game retailer GameStop (GME) seems to have taken note. In order to survive, it has shifted its focus.

A brick-and-mortar retailer with over 6,600 stores, GameStop is forced to incur costs that online competitors, such as Amazon (AMZN), don't. That hurts its margins and makes it difficult for the company to compete on price. To make matters worse, GameStop, which has historically sold physical game media and consoles, is being presented with another major challenge: the rise of digital gaming.

In March, research firm NPD Group announced that in the fourth quarter, consumers spent $3.33 billion on non-physical gaming products, including full game downloads, social network titles, and downloadable content. That report was followed by research from DFC Intelligence last month, indicating that the global market for video games will grow from $67 billion this year to $82 billion in 2017. The "biggest driver of growth," according to the research firm will be digital game distribution -- not the discs and cartridges GameStop's business was largely built on.

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DFC Intelligence estimates that by 2017, $35 billion of the game industry's total revenue will be comprised by digitally delivered titles, up from $19 billion in 2011. And the console market, which was once driven by physical game sales, will increasingly turn its eyes to the Web. "By 2017, we forecast 39% of console game revenue will be via online distribution and online revenue sources," DFC Intelligence analyst David Cole said in a statement.

GameStop, seeing the digital craze coming, invested heavily in that market by acquiring three companies -- Kongregate, Spawn Labs, and Impulse -- to bolster its digital distribution. Among its many digital initiatives, GameStop offers digitally delivered downloadable content. The company also sells credits customers can redeem in popular digital marketplaces, such as Microsoft's (MSFT) Xbox Live and Sony's (SNE) PlayStation Network. All of that has combined to make GameStop a considerable presence in the digital space. In fact, according to Wedbush analyst Michael Pachter, GameStop will increase its digital revenue from $675 million this year to $1.5 billion in 2014.

But simply appealing to digital gamers won't be enough to save GameStop. In June, sales of new game discs were down 29% year-over-year, extending a long, negative streak. And although industry-wide digital revenue was strong in June, hitting $491 million, according to NPD, it isn't enough to drive GameStop's growth.

So, the company has tried something else: buying and selling used mobile devices from the likes of Apple (AAPL) and Google (GOOG). It might sound odd that GameStop would get into the iPhone and iPad trade, but it underscores the company's willingness to shift strategy to maintain growth. During an earnings call following its first-quarter financials release in May, GameStop revealed that it was selling so-called "iDevices" in over 2,200 stores, and planned to expand that to more locations in the coming months. The company expects to generate between $150 million to $200 million in revenue this year on mobile devices alone. Better yet, it secures a 30% margin on those sales.

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In order to achieve such high margins, GameStop buys Apple products at a reduced price. It then resells them to GameStop customers at a price that still comes in lower than new options available in other stores. GameStop also currently offers Android-based tablets in over 1,600 stores that come bundled with the digital games and their own Bluetooth controller.

GameStop faces plenty of challenges. In a note to investors in March, Morningstar (MORN) Equity Research analyst Liang Feng cautioned that the company's "long-term outlook remains cloudy due to a rapidly shifting industry landscape," adding that the company's digital focus and used game sales should be expected to hurt its still-important new game sales. Not surprisingly, investors haven't found much to cheer either. This year, general video game stocks have been among the worst performers in the tech. GameStop, for one, hit a new 52-week low Thursday a week ahead of announcing second quarter earnings. Still, if nothing else, the company's willingness to adapt is giving it a fighting chance.

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