GameStop's (NYSE:GME) stock dropped more than 4% Tuesday morning on reports that Wal-Mart (NYSE:WMT) would be announcing its foray into the used game trade business. The market is rife with rumors that Wal-Mart will start offering store credit to customers looking to trade in their old video games.  Used game sales account for 30% of GameStop's revenues and half of the company's gross profit.
GameStop recently reported a 7% increase in used game sales during the holiday season driven by strong demand for previous generation used-games.  The company has successfully warded off competition from Best Buy (NYSE:BBY), which entered the used game domain in 2010, but it now faces a new threat from Wal-Mart. 
GameStop is expected to report earnings for the fourth quarter of 2013 later this month. 
Can Wal-Mart Take Market Share From GameStop?
GameStop is the biggest video game retailer in the U.S. with more than half of the Xbox 360 and PS3 titles sold in the U.S. during the September quarter coming through the company's stores. Wal-Mart also offers games and consoles at its stores but has so far been unable to take market share from GameStop.
Wal-Mart is well known for its low-price strategy and also offers a variety of items for shoppers, whereas GameStop offers just video games and consoles. Exchanging used games for store credit might be more lucrative for customers who are not just looking to trade in their old game for another game but can use the store credit to buy other items such as groceries or apparel. Electronics or entertainment items account for around 10% of Wal-Mart's revenues, but it still has a market share of 15% in consumer electronics. On the other hand, Best Buy, which specializes in consumer electronics, has a market share of 22%. 
However, GameStop has a loyal customer base with over 31 million PowerUp Reward members. The company offers special deals and has built up good relations with its customers. For example, during the launch of Disney Infinity, GameStop offered customers the opportunity to pre-order over $400 worth of characters playable in the game. GameStop was also the only U.S. retailer to offer the exclusive $150 collector's edition of Grand Theft Auto V. The loyalty of this base and the specialization in the niche video game market is GameStop's biggest strong point, which might help it ward off the Wal-Mart threat.
Unlike Best Buy, GameStop has been relatively unfazed by the "showrooming" phenomena, whereby customers go to a brick and mortar store to see a product and eventually buy from online retailers like Amazon (NASDAQ:AMZN) and eBay (NASDAQ:EBAY). The company's market share has remained largely unchanged for the last few years.
GameStop's used game sales are highly correlated with new game sales as the latter help replenish the company's inventory - pre-owned game sales have consistently been around 65% of new software sales for the last four years. We expect the company to suffer a minor loss in market share, but it will still be able to gain as the new-console cycle progresses. We expect a 5% increase in used game sales through the coming years, but there is a 15% downside to our price estimate for GameStop should the growth be below 3% through the decade.
Disclosure: No positions.