A Marginal Business

The used game business works like this: A gamer shows up at GameStop with a few games he’s tired of and wants to trade in. GameStop offers him a lowball price – much lower than what he’d get if he sold his games on eBay, just high enough to keep him in the store – and since he’s already there and wants the cash, he accepts it. More than likely, since he’s a gamer in a game store with cash in hand, he spends the cash on something else, maybe something secondhand that he can pick up for $20. Meanwhile, GameStop marks up and sells the used games it just bought for three times what it paid for them.

GameStop executives describe this as a “margin growth” business – because they make a much higher profit margin on the sale of every used game than they do on the comparable sale of a new game. And in the highly competitive retail trade, margins matter. How much?

“Used games are keeping the entire ship afloat,” a vice-president of marketing for Electronics Boutique tells me. “EB and GameStop make basically no money from new product.”

No money from new product? But everybody knows the retailers are the real profiteers of the interactive entertainment industry, brutally extracting marketing development funds and ruthlessly returning product in the name of the all-mighty dollar.

Right?

The Savagery of Sellthrough
Throughout most of the entertainment and media industry, when publishers want to make sure first-run entertainment sells in droves to the public, they charge what’s called “sellthrough prices” – and for virtually every form of media, including books, movies and music, that price is between $15 and $25. You can get the brand-new Feast for Crows hardcover for $16.80, the Star Wars: Revenge of the Sith DVD for $17.98, and Madonna’s Confessions on a Dance Floor for $18.98.

But you have to pay $49.99 for Perfect Dark Zero, or any other new release videogame. In comparison to its closest substitutes from other industries, videogaming isn’t priced to sell through.

And yet, selling through is the one thing a videogame must do. Videogames suffer from the shortest shelf life of any media. You can walk into a record store and buy CDs from the ’60s, ’70s, ’80s and today. You can visit Barnes & Noble and pick up books written in the Renaissance. You can buy movies made in the black and white era. But you would be hard pressed to find a GameStop sellingmore than a handful of games older than a couple years, and the vast majority of shelf space will be for titles released in the last six months.

Facing this short shelf life, game publishers have strategically adopted a tiered pricing model. They start the games off at the highest price point they can – right now that’s $49.99 – and they extract as much money as possible from the avid, got-to-have-it-now consumer. They then drop the price to hit the next tier of consumers and keep moving units.

The tiered pricing model works well for the publishers, and if they can convince enough consumers to buy at the $49.99, it works really well. Think Halo 2. It’s great for big box retailers like Wal-Mart, too. Wal-Mart only takes a title that is a proven seller, and any title that doesn’t sell gets dropped instantly. Wal-Mart doesn’t care if it has the biggest inventory of games, or covers every genre of game. It just sells the big hits.

For specialty retailers like GameStop, the tiered pricing model sucks. GameStop can’t compete on price with the likes of Wal-Mart, so to differentiate itself, GameStop has totake risks on unproven new product, and keep a wider inventory of older product. But unlike music and book sellers like B&N, GameStop has no evergreen products that it can reliably keep on the shelves. So, its inventory management is a constant struggle, with price points continuously adjusted, and product constantly moved around the store depending on its age. GameStop ultimately suffers because its shelf space is devoted to games that are, by definition, less popular and lower priced than what Wal-Mart stocks.

So, imagine you’re running GameStop. Imagine you owe $36 wholesale for $50 games, leaving around $14 profit. And imagine you owe $12 wholesale for $20 games, leaving around $8 profit per sale. Obviously, you’d like to sell more $50 games than $20 games, and so you’re going to organize your storefront to push the hot new product as much as possible. But to differentiate your business, you have to keep that broad catalogue of older, cheaper games around – otherwise you’re not offering anything different than Wal-Mart or Best Buy.

Now imagine that with used games, you only pay $3 for your $20 games. Suddenly you make more money from a $20 game than you do from that $50 copy of Perfect Dark Zero. This is the solution to all your problems. You can offer a wider inventory, stock older games and even still profit! Set the prices right and you can even manage to do trade-in and resale of brand new games for really big profits.

Got that? Good. Now you understand why GameStop is transforming itself, right before your eyes, from a specialty boutique into a secondhand store.

Biting the Hand
It’s a transformation fraught with peril. In adopting used games as the solution to the inexorable logic of the new game retail business, GameStop is alienating its customers, infuriating its suppliers and arming its competitors.

Let’s start with customer. As a specialty retailer, GameStop has long catered to the enthusiast. The enthusiasts’ desires are simple. He wants to be able to buy new games for a reasonable price. If the games are good, he wants to keep them. If the games are worth playing but not worth keeping, he wants to be able to trade them in. And if the games are bad, he wants to be able to return them and get new ones.

Unfortunately, today’s retail marketplace offers no way to return bad games and limited value on trade-ins. Barnes & Noble will give you store credit for opened music and DVDs if you have a receipt, but GameStop will just offer to buy an opened game from you for a few bucks – even though they’re going to turn around and sell it for $30.

When used game sales were a minor aspect of the GameStop business, itwas easy for regular customers to overlook the trade-in to sale price ratios; no big deal. But as every consumer purchase is presented with a potentially money-saving used game purchase, those consumers have a constant reminder of exactly how much a used game is going for – and, by comparison, how little the consumer gets on trade-in.

Hardcore gamers are nothing if not web-savvy, and eBay is out there as a viable alternative to trading in. Exposés on the economics of trade-ins have already begun to erect the virtual equivalent of “Keep Out” signs on GameStop. As consumers become more informed, GameStop will either have to increase its trade-in values, or watch its inventory supplies ofdesirable used games plummet.

An even more pressing problem comes from GameStop’s suppliers, the videogame publishers. The relationship between game publisher and game retailer ranges from Détente to Cold War, with continuous low intensity conflict over “price protection,” “marketing development funds” and “return rate.” Used game sales threaten to make the Cold War heat up – because publishers see no revenues at all from the sale of used games.

Is it really worth fighting over? It’s interesting to note that both Activision and Electronic Arts are reporting that fourth-quarter revenues will fall well below expectations due to unexpectedly low sales. Meanwhile, GameStop has announced “strong margin contributions supporting forecasted earnings” because “used videogame sales growth continues to solidly meet our goals.”

And so the war drums have started beating. In an interview with Computer and Video Games, Mark Rein of Epic Games was blunt:

“If you walk into EB in the U.S., they try and sell you a second hand version of a game before a new one. I think that’s bad. It would be fine if they share that revenue with us. They can also be marketing partners with us, as well. We can have an official refurbished games policy. That’s the problem. Those resold games use server resources, tech support. The majority of guys calling up saying “I don’t have my serial number,” I’m sure a lot of those are resold. It costs us money. Those customers think they paid for it, and they’re entitled to support. The reality is we didn’t get paid. They didn’t pay us.”

Of course, GameStop doesn’t have to.

“It is 100% legal to re-sell videogames. The publishers have no leg to stand on,” explains Jason Schultz, staff attorney at the Electronic Frontier Foundation. Because of the First Sale doctrine, publishers have no legal right to get paid for used games, anymore than book publishers get paid from secondhand bookstores, or music companies from used record sales. This won’t stop them fromfinding another way to strike back at GameStop, however.

Even as the publishers make war-plans, Best Buy and Blockbuster have joined the fray. Most Blockbuster stores now not only rent videogames, they buy and sell used games, too, usually offering significantly better trade-in values and charging less. Blockbuster is largely ignored in discussion of game retail, but it needs to find a new business as TV on-demand catches on, and looks willing to fight hard for games revenues.

Best Buy is still testing a pilot program for used games, but industry insiders seem to expect it to go forward. As a big box retailer, Best Buy isn’t suffering from the tiered pricing model the way GameStop is, and it can accept lower margins on used games. And if Best Buy succeeds with used games, Target, Wal-Mart and the rest might follow.

What does it all mean?

The New Model
GameStop’s margins in the used game business are almost certain to erode, as consumers seek alternatives, whether peer-to-peer likeeBay, or from competitors such as Blockbuster and Best Buy.

At the same time, the uneasy alliance of retailer and publisher that has long dominated the interactive entertainment industry will crumble. This, in turn, will open the way for publishers to aggressively embrace digital distribution. Up until now, the publisher’s fear of channel conflict with retail has obstructed their adoption digital distribution. By “striking the first blow,” retailers open themselves up to a digital distribution counterstrike.

These two forces – used game sales and digital distribution – will have strange and conflicting impacts on consumers. The higher the price of new games, the more likely the consumer is to buy it used for less. A flourishing used game market will drive prices lower. But the more the used game market flourishes, the more publishers will race to adapt digital distribution. With digital distribution, publishers can prevent re-sale and used game trade, both legally and technologically.

“You are already seeing with Xbox Live and Valve and these ties online, theyare trying to use the online hook as a way to enforce their business model. You’re going to see more of a trend towards that,” says the EFF’s Schultz. “It’s part of an overall battle that’s going on in all the content industries.”

Here’s what’s likely to emerge as the new business model: Publishers will release new titles exclusively in digital format at a premium price. Big box retailers will carry the most popular titles in physical form at a sellthrough price point. There’ll be little margin left in used game sales, but it’ll survive with pricing similar to your local Blockbuster’s secondhand DVDs.

And as for GameStop? If you want to know what’s in store, head over to your local college and find the students’ favorite used record store. There’s not a 100% profit margin in sight.

Max Steele is an enigma wrapped inside a riddle. When not actively being mysterious, he passes his time manipulating time and space to fit his plans for world domination.