LOS ANGELES (Reuters) - Will digital downloads kill the video games store? That's the multibillion dollar question facing retailers from Wal-Mart Stores Inc and Target Corp to GameStop Corp, as Internet distributors continue to grow.

Retailers like Target splashed out on large booths at last week's E3 Expo in Los Angeles, showcasing games like Activision's "Transformers: Revenge of the Fallen."

But gamers -- especially on personal computers -- are increasingly turning to alternative methods to play and buy games, such as downloading or "streaming" online games, rather than trekking to a store.

Take industry veteran Dave Perry, whose Gaikai online system lets PC gamers buy and stream games through their Web browsers without needing to download any content.

"Our solution is not to dive into a fight with Sony (Corp), Microsoft (Corp), Nintendo Co Ltd, as it wouldn't gain any 'new audience' for publishers," Perry said. "Instead, our strategy is 100 percent focused on being an ally to publishers and first-party hardware makers, by delivering them audiences they don't reach today."

Digital downloads are still a small, but fast-growing business. According to the NPD group, 17 percent of games sold in 2008 by PC gamers were digitally downloaded. Microsoft and Sony are trying to convert console gamers who have become accustomed to consuming music and movies digitally via services like Netflix and Apple Inc's iTunes.

Wedbush Morgan Securities analyst Michael Pachter estimates digitally downloaded games will account for roughly 2 percent of industry sales this year, or around $400 million. He expects demand to double annually for a few years, to $800 million in 2010 and $1.6 billion by 2011.

"As broadband penetration increases and the Internet connection migrates to the living room, downloads or cloud computing solutions will become much more viable," he said.

"Downloads will become 20 percent of the market within five years, and probably peak at around 50 percent of the overall market in 10 years," said Pachter. This assumes an overall market growth of 5 to 10 percent annually, he added.

INERTIA

With video game sales growth slowing somewhat, publishers and developers are seeking new channels to reach customers.

Yet some retailers resist the format, arguing that going through a third-party online distributor further saps margins for both developers and retail chains. Analysts say the big retail chains like Wal-Mart and Target have also yet to embrace and invest in digital sales.

"Nothing that has been digitally distributed retains the same value as a retail version; it's always less," GameStop CEO Dan DeMatteo said in September.

Getting content on demand is no stranger to households accustomed to watching movies over set-top boxes, or teens streaming music over the Internet. But spontaneously ordering a game is stymied somewhat by the limits of the gamers' personal computer system.

Some fledgling companies try to work around that.

Over the past seven years, entrepreneur Steve Perlman has been developing a digital distribution box called OnLive. He hopes to offer high-definition PC games on low-end hardware.

OnLive has struck deals with Electronic Arts Inc, Ubisoft, Take Two Interactive, Warner Bros. Interactive Entertainment, THQ, Epic Games, Eidos, Atari and Codemasters. While the company had 16 games on display in March at the Game Developers Conference, it had no presence on the E3 show floor.

OnLive this fall is slated to launch a subscription service similar to Microsoft's Xbox Live.

NPD estimates 18 percent of Xbox 360 users who have a "Gold" membership to Microsoft's Xbox Live service regularly download from Xbox Live Arcade, and 10 percent of PlayStation 3 users regularly buy digitally from Sony's PlayStation Network.

The largest independent games distribution network is Valve Software's Steam, which has 21 million users and 700 games.

Doug Lombardi, vice president of marketing at Valve Software -- known as the groundbreaking backers of the "Half-Life" shooter series -- said digital distribution has already been largely embraced by the industry.

But the real forte of digital distribution may be the ability to provide automatic updates and extras, keeping things new as with the Team Fortress multiplayer-shooter series.

"Now that games can be connected to their audience, they will last and grow well beyond their traditional 6-month to 1-year sales cycle," Lombardi said.

(Reporting by John Gaudiosi; Editing by Edwin Chan, Richard Chang)