Can GameStop Survive?

GameStop (NYS: GME) made $9.6 billion in sales in 2011, but everyone keeps kicking it around like a $5 soccer ball. Investors are worried that the coming video game revolution will cripple the company's core business. GameStop is worried too, which is why it's starting to make changes across its business. With some power-ups and sidekicks, the company could live to see 2015.

This map is full of monsters
Forecasts of GameStop's imminent demise are not due to a lack of earnings. Investors kick the company around because they're concerned about what's coming next. GameStop has traditionally operated as a brick-and-mortar storefront that makes most of its money from the sale of new and used video games. But that model is starting to see the end of its days, and GameStop needs an extra life to survive.

These days, whole video games can be downloaded directly from distributors. Even in games that are purchased in-store, additional components can be bought through iPods, Xboxes, and PlayStations. You can be a serious gamer without ever setting foot in a physical store. GameStop owns 6,683 of those could-be obsolete stores.

The company has been struggling to explain to the investing world how it's going to get the job done when the next generation of consoles is released. The problem is that the fundamental model is changing. In 2013, we'll be seeing the first set of systems that don't need discs, cartridges, or any other media to operate. Since GameStop relies heavily on reselling media, it looks like the company is out of luck.

Where's that red one going to go?
Leave the thought of failure to one side for now and consider the options. GameStop could continue to rely on used game sales and work the long tail. This strategy would probably drive revenue slowly and steadily right into the ground. Or, it could continue to be the same store it's always been in a slightly different way.

GameStop could think of itself as an entertainment seller. If the company tries to ride used games forever, it will need more and more used games to be available. When we're all downloading games, there's nothing for GameStop to sell. If, instead, it were to focus on digital sales, cut a few deals with game companies, and work with console producers, it might find a way to keep selling entertainment.

Oh wait, hold on
That's exactly what the company is already doing. GameStop made it clear in their 2011 earnings report that it's moving toward a consolidated brick-and-mortar system that focuses on selling downloadable content in store. This means that customers can come in and purchase a special code to download content in the game. This gives the company a firm place in the minds of gamers who want to purchase additional content.

By working with video game developers, GameStop is offering exclusive content through the stores. In 2011, it struck a deal with Activision-Blizzard (NAS: ATVI) to sell downloadable content by issuing receipts with activation codes printed on them. This technology will be used with the release of Activision's Diablo III title, a PC game that is expected to sell 5 million copies in its first year.

When the good guys become the bad guys
The long-term problem with this plan is that the major console producers -- Nintendo (OTC: NTDOY), Sony (NYS: SNE) , and Microsoft (NAS: MSFT) -- can offer the same downloadable product. Nintendo has already launched downloadable content for its 3DS handheld device and has plans to use the same infrastructure to support the next-generation Wii U.

Rumors have it that both Microsoft and Sony are taking things one step further, designing next-generation systems that may not even allow games to be played on multiple machines. This effectively kills the used media market without moving to a download-only system.

Becoming the paperboy of used games
The resale market isn't going to disappear overnight. GameStop has planned to refine its distribution and inventory management system in 2012 to help boost sales and availability of popular titles. If it can run that side of business more efficiently, then it will have more resources free to invest in its own digital channel.

In 2011, GameStop did well in the digital realm, growing sales 57% through an increase in add-on content sales. When watching for success over the next few years, keep a close eye on the digital segment. GameStop has said that it's looking for 50% digital sales growth through 2014. The ambitious goal for 2012 is $675 million, and if the company starts to fall behind, there's good reason to worry.

To give itself a buffer to its digital growth goals, GameStop is getting into the iPod, iPad, and Android refurbishment business. This seems like a good use of existing resources as the company already refurbishes gaming consoles. While it can't expect massive growth in this undertaking, the increase in sales should give the company some breathing room.

Final boss
This is all hypothetical. GameStop could blow this opportunity in grand fashion and become the next market dinosaur, slowly fading away as more competent competitors eat up its market share. There needs to be an increasing number of exclusive deals, like the one with Activision, for the digital model to play out in GameStop's favor.

If those contracts fail to materialize, the whole thing could collapse. If the next generation of consoles works too well, the whole thing could collapse. If Amazon makes a move on GameStop's turf, the whole thing could collapse. I think you see where this is going. GameStop can succeed, but it has a lot of small pieces that need to be managed in order to do so. If anything ends up out of place, I'd run.

Big things are coming for the video game industry but it's not the only place due for a shake-up. Check out the Fool's free report, "The Only Stock You Need To Profit From the NEW Technology Revolution," to get a leg up on the future of tech. Read it here now.

At the time this article was published Fool contributor Andrew Marder has no stake in any of the stocks mentioned in this article. The Motley Fool owns shares of GameStop, Microsoft, and Activision Blizzard. The Fool has written calls on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Microsoft, Activision Blizzard, and Nintendo. Motley Fool newsletter services have also recommended writing covered calls on GameStop, creating a bull call spread position in Microsoft, and creating a synthetic long position in Activision Blizzard. The Motley Fool has a disclosure policy.
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