It just keeps getting worse for GameStop (NYSE:GME). Not only is it facing growing competition from its own suppliers, Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE), but soon it will have to take on the world's largest retailer, Wal-Mart (NYSE:WMT).

While Wal-Mart has been selling video games (both hardware and software) for years, the discount chain is about to challenge GameStop in an entirely new way: Later this month, Wal-Mart will begin dealing in used video games. While I wouldn't expect Wal-Mart's new initiative to obliterate GameStop's business overnight, it's only increasing the pressure on a retailer that's becoming less relevant by the day.

The looming threat of digital distribution
GameStop is one of the most heavily shorted stocks in the S&P 500, with a short float near 30%. While different investors may be working from different theses, the larger case against GameStop primarily centers around the promise of digital distribution.

It's no secret that the video game industry is going digital. Like movies and music before them, video games are increasingly shifting from physical discs to digital downloads. Owners of Microsoft's and Sony's latest consoles, the Xbox One and PlayStation 4, can, if they so desire, deal exclusively in digital -- downloading all of their games directly from the companies' respective digital storefronts, something that couldn't be done with prior machines.

But there are still many reasons that gamers would prefer to own a physical copy, and so physical games live on for the time being. Some gamers lack the robust broadband connections required for large game downloads, while others may prefer to have a physical copy that they could sell or lend to a friend. These obstacles cannot be overlooked, but should be overcome in time.

For their part, both Microsoft and Sony are working hard to encourage gamers to embrace digital distribution. Microsoft has begun to offer aggressive discounts on digital versions of its games, a strategy that allowed Valve to dominate the PC gaming space. Sony has similar "flash" sales, but has taken it a step further.

This summer, Sony's "PlayStation Now" service will roll out to owners of its PlayStation 4 video game console, allowing them to stream digital versions of games directly over the Internet. It remains to be seen if the service will be successful, but if it catches on, it will pose an obvious threat, particularly if Sony can expand PlayStation Now to include newer titles.

While most sell-side analysts continue to downplay the threat posed by digital distribution, some of them have begun to come around. Last month, Longbow Research downgraded GameStop to underperform, citing the risks posed by digital distribution.

Wal-Mart comes after GameStop's core market
With its suppliers in open rebellion, GameStop's problems are about to intensify. Whatever market remains for used video games in the coming years, GameStop will have to share it with Wal-Mart. GameStop has a number of advantages over Wal-Mart -- a smaller, more focused operation; more knowledgeable employees; and its PowerUp Rewards program -- but Wal-Mart has advantages of its own.

Namely, Wal-Mart plans to offer traders general store credit -- meaning that a pile of old video games could be traded for a cart of groceries, a tank of gas, a new TV, or any of the tens of thousands of items Wal-Mart stocks. In contrast, video games traded in to GameStop can only become more games, video game-related hardware, or used mobile devices. (Admittedly, GameStop will pay cash, but far less than what it pays in credit.)

Given that used video game products account for about one-quarter of GameStop's revenue and almost half of its profit, Wal-Mart's entrance into the space cannot be discounted. Either GameStop will lose market share or it will be forced to work harder to retain its market, sacrificing margins in the process.

The war for your living room begins now
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Sam Mattera is short shares of GameStop. The Motley Fool owns shares of GameStop and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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