GameStop Fuels M&A Fire

Its Electronics Boutique buy could be the impetus for more consolidation in the space.
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Though GameStop's (GME) - Get Report move to acquire Electronics Boutique (ELBO) may not have been the type of deal video game industry watchers were anticipating, it might be the impetus for more consolidation in the space.

The game industry has been abuzz in recent months with talk of large media companies such as

Disney

(DIS) - Get Report

and

Viacom

(VIAB) - Get Report

wanting to buy into the space. That type of a deal may yet happen. But the

GameStop-Electronics Boutique merger may speed the consolidation that has already been happening: The gobbling up of smaller game developers by big publishing houses.

The merger will create a retailing giant with more than 20% of the video game market in the U.S., analysts say. Even with that kind of market power, the combined company still likely won't be able to put much pressure on heavyweight video game publishers such as

Electronic Arts

(ERTS)

,

Activision

(ATVI) - Get Report

or even

Atari

(ATAR)

.

But the new, larger GameStop, to be called GameStop postmerger, could put pressure on the smaller, mostly private developers, by shrinking its assortment, devoting less shelf space to minor titles and asking more in the way of promotional fees.

That type of squeeze -- in tandem with other pressures on small publishing houses -- could well lead many of them to figure they can't make it on their own, analysts say.

In the past, publishers could play Electronics Boutique off GameStop in an effort to gain shelf space or promotions, says one publishing industry executive. That point of leverage will be gone after the merger, the executive says.

"You're now dealing with a behemoth of a company. The leverage swings right to retail," says the executive. "It becomes a lot more difficult if you're a small publisher."

And the smaller publishers' loss could be their larger rivals' gain. Publishers such as EA and Activision may see incremental sales gains from buying their smaller rivals, distributing their titles -- or pushing them off the shelves.

As part of the deal announced Monday, GameStop has agreed to purchase Electronics Boutique for about $1.44 billion in a stock and cash deal.

Subject to shareholder and regulatory approval, the agreement would create a combined entity comprising 3,200 U.S. and 600 international stores totaling $3.8 billion in sales. That would rank the company with

Wal-Mart

(WMT) - Get Report

in terms of market presence, analysts say.

Both companies separately are already major customers of the video game publishers and receive favorable terms on wholesale costs of games and promotional fees, executives of the companies said on a conference call. The combined entity likely won't see better prices from publishers as a result of the merger, they said.

But the combined company likely will have a cheaper cost structure, the companies said. And some of those savings should come from a centralized inventory system for both companies that will presumably hold fewer titles, analysts said.

If each company's store currently holds about 800 different titles in its inventory, the combined company may well scale that number down to roughly 750, says Michael Pachter, who covers the video game industry as an analyst at Wedbush Morgan Securities. Such a pruning isn't likely to hurt the larger publishers of well-known titles, he says. But it could hurt the dozens of smaller development houses competing for shelf space.

The dropped titles "are not going be the 50 best-selling games," says Pachter, whose firm has done banking business for

Majesco

(COOL)

and Atari in the video game sector, but not for the other publishers or for the two game retailers. Instead, it will be a small publisher such as

BAM Entertainment

that "has a problem," he says.

The merger is one more pressure on the small publishers. The industry is beginning one of its periodic transition phases, as hardware makers get ready to roll out their next-generation consoles. Analysts and publishers have predicted that development costs for the new machines will jump as much as 2 to 3 times current costs to $10 million or more per title.

Those prospective costs could be daunting to many small publishers. Unlike their bigger rivals, which typically have a portfolio of titles, smaller firms often depend largely on the success of one or two hits and thus can be more vulnerable to flops. With development costs expected to greatly increase, smaller publishers may also have to worry about selling enough copies to recoup their expenses.

Such considerations have already led to consolidation in the space. U.K.-based

Eidos

(EIDSY)

, for instance, which publishes the

Tomb Raider

series, recently agreed to be acquired by

SCi Entertainment

. In recent months, EA

bought a 20% stake in French publisher

Ubisoft

and the U.K.'s

Criterion Software Group

, which developed EA's

Burnout

series. Activision,

Midway Games

(MWY)

and

Take-Two Interactive Software

(TTWO) - Get Report

have also snapped up smaller developers in the last year.

That pace could pick up with the GameStop acquisition, says the industry executive.

"This is just another factor that will contribute to further consolidation in the industry," the executive says.

However, consolidation might not come in the form of outright acquisitions, notes Pachter. Some companies might respond to the GameStop-Electronics Boutique deal by turning to the larger publishers for distribution. In addition to publishing their own games, Take-Two and EA, for instance, both have significant side businesses in distributing games for other publishers.