Gaming

GameStop: Can it brave the digital storm?

December 7, 2012: 10:48 AM ET

Can the gaming company learn from the likes of Blockbuster and Borders and avoid a common fate?

Gamers wait in line outside a GameStop in Burbank, Calif. to buy Activision's

Gamers wait in line outside a GameStop in Burbank, Calif. to buy Activision's "Call Of Duty: Black Ops II."

FORTUNE -- For a good time, check out a GameStop store at midnight when a new hit game is about to drop. People line up outside, dressed like their favorite characters -- cloaked assassins, storm troopers, aliens. They are excited in a way that's rare for retail customers -- people don't camp out outside of a Kohl's to get the latest sweater, for example.

As for the fanaticism, "we love that, that's something you have to feed," GameStop (GME) CEO Paul Raines said during a recent visit to Fortune's offices. In fact, GameStop's survival depends on its ability to retain the patronage of avid gamers while gaming itself changes. GameStop sells, buys, and trades video games, mostly on physical discs, while more and more people are downloading digital versions of games.

Giants have fallen to the tangible thing-gone-digital trend. Blockbuster filed for bankruptcy in September 2010, ending a slow, painful decline that began when Netflix (NFLX) introduced a better video rental model. In 2011, Borders went bankrupt, unable to survive after Amazon (AMZN) digitized the bookstore.

But if GameStop plays its cards right, it has a shot. According to an analyst report from Credit Suisse, GameStop is "one of the more interesting names in retail," though the video game industry is approaching an inflection point. "Tough industry trends will continue, but GameStop remains well positioned," at least until the end of next year, according to a Baird Equity Research report.

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The third quarter of 2012 was good for GameStop, thanks to the release of a new gaming console, the Wii U. But that is a sales bump, not a trend, and GameStop needs to get out in front of obstacles in the industry.

They're trying, Morningstar analyst Liang Feng says. "They seem to be more proactive than most physical retailers." GameStop has also paid most of its debt, so it has more cash on hand than, say, Blockbuster did when it tried to revamp its business and file Chapter 11 simultaneously.

The key will be for GameStop to effectively use its cash to refashion its business model. Now, the company very much depends on customers trading in old games. GameStop gives them store credits in return. The company then puts the game back on the shelf at a discounted price, but a higher price than the amount of credit given to the customer who traded it. The same game can pass through the store, multiple times, says Feng, and it's very profitable. "I like to refer to the used video game segment as basically the company's lifeblood," he says. Indeed, "the used video game category directly generates almost half of the company's gross profits," Feng wrote in a Morningstar report.

But video game publishers don't profit from used game sales, so they are looking to limit this activity. One way to do this is to add artificial limits to games, which publishers are already starting to do, says Blake Israel, a 27 year-old software engineer and avid gamer based in Norwalk, Conn. For example, a game called "Uncharted 3" comes with a code that gamers have to use if they want to be able to play it with friends. "The code is single use, so if you use it, it diminishes the value of the game disc," says Israel. Limiting certain features throws a wrench in GameStop's resale model, since it weakens consumers' incentive to buy used games.

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Still, Feng believes that management at GameStop is doing what it can. GameStop's strength in its loyal customers, called "PowerUp" members. PowerUp members access perks including exclusive offers and bonus points for buying and trading games. GameStop is trying to remain a destination for these members, 20 million strong as of this summer, and push them to buy games from its own digital platform.

But the company is racing against time -- it needs to build a solid digital property for its customers before game makers squash the store-based game trading business. Gamers are loyal to GameStop, but they are more loyal to games. They will go to whichever company sells those games seamlessly at the best prices.

If it can keep those gamers happy, GameStop will likely survive. After all, it seems like far less fun to dress up like a ninja while shopping for games online.

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