Why Are GameStop Shares Sinking?

NEW YORK (TheStreet) - GameStop (GME) shares were sinking 4.7% to $37.88 on Tuesday after Wal-Mart (WMT) announced it was about to creep onto the video game retailer's trade-in and pre-owned business.

Walmart said that it was launching a video game trade-in program, in which the big box retailer will go after the $2 billion used video game market. 

Starting March 26, approximately 3,100 U.S. Walmart stores will begin accepting video game trade-ins. The traded-in games will be sent to be refurbished and made available for purchase in like-new condition both online and in stores. The video games will be labeled "Certified Pre-Owned," which means the product is fully refurbished and in like-new condition, Walmart says.

"We're going to shake up the market place," said Duncan Mac Naughton, chief merchandising and marketing officer for Walmart U.S., in a conference call with reporters. "We're not participating in the $2 billion used gaming industry at all."

The move will place pressure on Best Buy (BBY)and Amazon (AMZN), but it will especially hit GameStop as the Grapevine, Texas-based company formed a niche selling video games and gaming hardware.

"This WMT news will very likely represent the latest worry for GME investors and make for another weight upon shares at least near term. WMT is retailing's '800 lb. gorilla,' and we cannot discount any of its moves," Oppenheimer analyst Brian Nagel wrote in a note to clients.

That said, any "buy-sell-trade" model is "notoriously difficult for even seasoned retail chains to execute," Nagel said. "GME has been successful in the business for a long time. We are very hesitant to discount meaningfully the dominance of GME in the category, even against WMT. The market has worried that used video games might become the next 'dinosaur' in consumer products. We view WMT's move into the category as a validation of the category's longevity." Oppenheimer's Nagel rates GameStop at a "outperform."

Bank of America Merrill Lynch analyst Curtis Nagle gave equal confidence to GameStop's used-gaming business even as Walmart bears down.

"While we view this as another multiple headwind to GME, ultimately, we do not think that it bears a meaningful risk to their used-gaming business (27% of sales, 44% of GP), as it is a very difficult business to scale and manage," Nagle writes in a note. "We note that, in 2011, BBY entered the used-gaming business and was largely unsuccessful. GME management has stated that BBY's entry had no impact to their business and we believe the same will be true with WMT." Nagle rates GameStop at "neutral."

"GME is the number one player in used gaming, with a 70% share. Over the past 20 years, GME has built a set of key competencies and capabilities that will continue to make it a very tough competitor for new entrants, including WMT," BofA's Nagle adds. "First and foremost, GME is the destination for gamers, particularly hardcore gamers that have a higher propensity to trade-in games. In fact, 90% of GME's used sales are attributable to its 26mn PowerUp Rewards members and we believe GME will continue to leverage its powerful direct marketing program to bolster its used business. GME also has a far larger selection of used games (WMT will initially not offer any used games), which is a critical component establishing legitimacy among used gamers."

"Ultimately, we think the most important advantage for GME is that they have full control of their supply chain, as well as a world-class refurbishment center and an algorithmic pricing system with 20 years of data," the BofA analyst goes on to say. "This has allowed them to manage pricing and inventory efficiency as effectively as possible, and GME has never taken a writedown on used gaming inventory. With WMT lacking these key assets, we believe it will be very difficult for them to successfully scale and manage a used-gaming business."

GameStop reports fourth-quarter earnings on March 27.

--Written by Laurie Kulikowski in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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