A Game-Changer for GameStop?

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Video game retailer GameStop (NYSE: GME  ) is fighting a war on several different fronts. Best Buy (NYSE: BBY  ) will soon be offering used video games, while Electronic Arts (Nasdaq: ERTS  ) , Take-Two Interactive (Nasdaq: TTWO  ) , and other developers are expanding their digital delivery capabilities.

In response, GameStop just announced that it's buying Flash-game site Kongregate, which has 10 million monthly unique users, 30,000 games, and more than 1,000 new games every month. So what does the future hold for GameStop? I recently asked Motley Fool Associate Advisor Charly Travers.

Mac Greer: Charly, can GameStop continue to be a dominant player on the video game market?

Charley Travers: Sure, Mac. I think for the next five years, the answer is absolutely yes. This is the No. 1 retailer for video games right now, and they do about $9 billion in revenue with 6,000 stores. I'm not too worried about certain of the threats that you mentioned. Best Buy has tried to do used games going back to 2005, several attempts, and they have failed. Wal-Mart made a foray, and they backed off. Then you've got some more Internet-related sites, where people buy used stuff all the time ... and none of that has dented GameStop's core business, where they make about half of their profits. Now, the bigger problem for GameStop is digital delivery. That's because a retail store is essentially just a distribution point for somebody to pick up a product, and if you're getting your games in a digital format instead of through a physical DVD, that cuts out the need for a retailer.

Greer: And let's talk a little more about that digital delivery. GameStop developed a free game for Facebook users. The game, Gangsta Zombies, allows players to take on the role of an undead gangster. We have seen the incredible success of social games like Mafia Wars on Facebook. Is Facebook the future for GameStop?

Travers: Well, I love Zombies and I love Gangstas, but I have got to say, if free games are your future, you're in trouble ... Social gaming is still in its infancy as an industry. This didn't even really exist two or three years ago, and now it's becoming big business. What the opportunities here for GameStop are largely an unknown at this point --- especially the economics of this, if they can make a profit. But it is good to see that they're taking a few steps to disrupt their own business model a little bit.

Greer: And what is the biggest competitive threat to GameStop, if you had to pick one name?

Travers: I would say any of the online gaming distributors or gaming networks. [One] of those would be Steam, which is for PC games. It's operated by a company called Valve, which created the well-known Half-Life franchise. They have more than 20 million users. I've used Steam myself many times. I can't remember the last time I have actually bought a game at a store, and I'm a pretty hardcore gamer.

Newer to the game, and very interesting in its own right, is a cloud computing platform called OnLive, which was at the recent E3 conference in California this summer. How big is OnLive going to get?  I have no idea, but what On Live does is it really eliminates the need for you to have both a console and a copy of the game itself, because you're playing your game straight out of the cloud. So all the new games like Assassin's Creed II, for example, are available on the cloud.

Greer: And what's the biggest question you have about GameStop as you look at the company going forward?

Travers: They are piloting a program with Microsoft (Nasdaq: MSFT  ) for downloadable content. Games aren't necessarily just a one-off sale anymore; they tend to come with these mini little expansion packs that you pay 10 bucks for or five bucks for, and you can now buy certain downloadable content through GameStop. So if they can continue to participate in the digital world with the publishers in that manner, that would help a lot.

Another big question is, what do they do with their cash flow? This is a very profitable business, and do they divert that into what I think is a dying bricks and mortar model, or do they plow that into what could give them a better future in the digital world? That is a big question for them.

Greer: And does GameStop survive as a stand-alone company, or ultimately do you think it gets acquired?

Travers: If they do survive, I think it would be as a stand-alone company; I can't think of anybody off the top of my head who would want to acquire them. The digital companies, I can't imagine would have any interest in running a 6,000-store retail location. If there would be one, possibly it would be Best Buy, which has kind of stepped back a little bit from selling games in its own stores, but Best Buy has its own growth problems. They did an acquisition in Europe of Car Phone Warehouse, and maybe if their growth doesn't look so hot, they could be tempted to pick up a company like GameStop.

Greer: OK, Charly, and if you could only buy one stock over the next three years: GameStop, Electronic Arts, Take-Two Interactive, or Best Buy?

Travers: I thought pretty hard about this one, and I think I would go with Take-Two Interactive, just because that stock has been beaten down so badly, and they do have some good brands in their own right with the Grand Theft Auto franchise. The 2K games are pretty solid competitors to Electronic Arts' offerings. It hasn't been the best-managed company, but with the stock where it's at, I think it beats these other ones over the next three years.

Best Buy is a Motley Fool Inside Value and Motley Fool Stock Advisor selection. Electronic Arts is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended a bull call spread position on Best Buy. Motley Fool Options has recommended writing covered calls on GameStop. The Fool owns shares of Best Buy. Try any of our Foolish newsletter services free for 30 days

Neither Mac nor Charly own any stocks mentioned in this article. The Motley Fool has a disclosure policy.

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