GameStop Is Bulking Up to Battle New Rivals

GameStop (GME) is a fast-growing retail chain specializing in sales of entertainment software, where users often battle to the death. Now it's fighting for its own survival. Within weeks, consumer-electronics retailer Best Buy (BBY) hopes to take a hammer to GameStop's highly profitable used-games business by launching a similar service. Meanwhile, Electronic Arts (ERTS), Take-Two Interactive (TTWO), and other game developers are expanding digital delivery of add-ons, which are mini-sequels to games, reducing the need for people to visit GameStop's stores. "If they don't act now, ultimately it puts them out of business," says games analyst Michael Pachter of Wedbush Morgan Securities.

Chief Executive Officer J. Paul Raines says GameStop can repel such threats. To ensure that the Grapevine (Tex.)-based retailer remains a premier destination for gamers, Raines has been adding to his network of 6,500 stores and upgrading flagships into high-tech outlets with touch-screen kiosks where customers can browse the store catalog and pods where they can test-drive games. In November, GameStop purchased Jolt Online Gaming for an undisclosed sum and agreed to invest at least $22 million in game development over two years. "The video game industry is evolving into different platforms beyond the console, and GameStop is well positioned as a multichannel retailer and aggregator for all things gaming," says Raines.

The specialty chain's investors aren't as confident it will survive the transition. Sales have tripled since 2006, to $9.1 billion, with much of the growth coming from used games, which now account for 27 percent of all revenues. Gamers trade in old titles for store credit and the company then resells each game for nearly twice as much. Best Buy plans to one-up GameStop by letting customers exchange old games for gift cards that can be used to purchase merchandise at any of its stores. GameStop's shares fell as much as 9.5 percent during intra-day trading on June 15, the day Best Buy announced the move.

GameStop executives say they aren't concerned. Teens and young adults looking to trade in their games often come to GameStop because it is close to home, while many Best Buys are located in more distant malls, says Bob McKenzie, senior vice-president for merchandising. McKenzie also believes Best Buy will be hard-pressed to replicate his stores' customer experience: "We respect Best Buy, but because we are a specialty retailer that focuses solely on gaming, people really value coming in and talking to our associates." Best Buy's Chris Homeister, senior vice-president for entertainment, responds that gamers will be drawn to the wide assortment of products at the company's 700-plus stores. "Consumers are looking for alternatives," he says.

If Best Buy were the only threat to GameStop's gaming empire it would have less to be concerned about. But like Blockbuster (BBI) and Hollywood Video, GameStop has been struggling to adjust to the shift to online sales of games and other content. It also faces a revolt from game publishers, who derive no benefit from sales of used games. To counter the trend, developers now include one-time-use coupons for downloadable content and upgrades to reward people who purchase a new game. People who buy used games from GameStop or elsewhere must pay an extra $10 or more for the same goodies. That can boost the price of the used game to more than that of a new one. "It's clear publishers will continue to combat used-game sales, likely taking more aggressive tactics in the future," said Janco Partners analyst Mike Hickey in a research note in June.

Raines believes the used-game business will keep growing but says GameStop is on the hunt for acquisitions that will help solidify his digital strategy. Media and entertainment analyst Tony Wible at Janney Montgomery Scott figures targets could include OnLive, a Palo Alto (Calif.)-based startup that streams games through broadband, Bellevue (Wash.)-based Valve's Steam online game platform, which has about 2 million members, and French digital distribution company Metaboli, which owns U.S.-based download service GameTap.

With its light debt load and free-cash flow, GameStop has the luxury to shop around. Those same assets could turn the company into an attractive takeover target itself. That's one reason the stock has been on a roller-coaster ride this year. One potential suitor is the same guy looking to eat GameStop's lunch: Best Buy.

The bottom line: With a powerful new competitor in Best Buy, the video-game retailer GameStop is racing to build up its digital offerings.

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