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The future of brick and mortar gaming stores has recently become a subject of debate, where many believe GameStop (NYSE:GME) will sooner or later face the growing popularity of digital console games. In order to stay relevant in this changing market, some argue GME must revamp its business model and follow the current trends, or else face extinction. From an investment perspective, the prospect of declining revenue in the next years, is factored in the current share price. However, in order to attract long-term buyers, GME must show a strong initiative for adaptation beyond the traditional model.

Many authors have already discussed about the gradual shift in the industry towards digital. What does this mean for GameStop? First, it means declining number of stores. The number of U.S. locations peaked in 2011 and has been steadily declining ever since. Canada is following the same trend. Across the ocean, the number of stores in Australia and Europe are now growing at a slower rate as in the past. The second consequence is declining revenue per store. Only European revenue has been mostly inching higher for the last 3 years, whereas the other 3 regions have been declining. Both the number of overall stores and the amount customers spend have declined.

How is GameStop addressing declining revenue?

At almost a third of revenue, pre-owned video games represent a significant chunk of sales. Not to mention that it also offers the highest gross profit margin, around 45%. Customers that trade in their old video games are the lifeblood of this operating segment. It makes sense then to see GME offer additional in-store perks, as opposed to online ones. For example, at the time of this article, GameStop advertised on its main website that customers will receive 30% extra in-store credit when they trade in games, accessories or mobile devices. Additionally, those trading in either Xbox One or PS4 games would receive $10 in-store credit. We see this as a move to ensure buyers will frequent its stores and continue purchasing physical copies to keep sales momentum going.

Not all odds are against GameStop though. The biggest upside of owning a hard copy is the ability to resell it. Even if the value is small, as it usually is for non-recent titles, the customer still receives some of the initial cost back. For this reason alone, digital download or streaming is not something all users will opt for. However, sitting on the sidelines, as opposed to finding a way to take advantage of this growing market may not be a profitable strategy for GameStop.

Entering New Markets

A recent initiative of GME is the recent entrance into the market for used and refurbished mobile devices. GameStop has recently acquired Spring Mobile, an exclusive national AT&T (NYSE:T) dealer, with 152 stores throughout the country. The company is entering what we believe to be an established market, with online places like Amazon (NASDAQ:AMZN) and eBay (NASDAQ:EBAY) functioning as the medium for buyers and sellers. In order to drive significant traffic away from these marketplaces, GME must offer buyers lower prices for devices. We do not believe GME currently offers any discounts from other competitors. At the time of this article, GME advertised a LG Nexus 4 Android device for $349 in used condition. The very same device purchased directly from the manufacturer cost $100 less in brand new condition. This is just one example among the many models GameStop offers for sale. Moreover, pre-owned devices also have a very limited warranty, as items are only eligible for a full refund within the first week of purchase. This is an extreme example, but enough in our opinion to suggest that mobile devices may not play an integral part in the near future, due to the competitiveness of what is an already established market.

Pricing/Valuation

From a valuation standpoint, we think GME is fair valued. We took into consideration a modestly rising store count propelled by international growth and a declining overall revenue per store. The recent console releases will undoubtedly boost revenue in the short term, but past 2014, we may see the same consoles taking that revenue back, through online sales of both new and used games.

We believe operating income will decline in the next 5 years, along with capital spending, due to a contracting store expansion rate. We used a 2% residual growth rate and a tax rate in the mid to high 30%. Our price target is $42 for the next 12 months, which leaves room for a decent 15% upside for the next 12 months. However, due to investor uncertainty over the long-term prospect of the company, we may not see a definite upward trend forming. The only way to see shares post strong growth will be if GME lays out a plan on how to address the potential of video game sales declining in the near future.

Conclusion

The true test for GME will come after the buzz surrounding the new consoles settles. Based solely on current developments, we do not see mobile devices as the turning point. Whether GME rises to the challenge and finds a way to tap into the growing digital market, or whether it continues on the current less promising path remains a question to be answered.

Source: Can GameStop Adapt To New Trends?

Additional disclosure: Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by Adrian Moraru, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.