Video game retailer GameStop (NYSE:GME) generates a significant portion of its profits from the sale of used games. The company buys these pre-owned games from customers, refurbishes them if necessary, and then sells them at a higher price -- often only $5 or so below the retail price of the new version.

While this has served GameStop well over the past few years, helping the company remain relevant as digital distribution has become more popular, the recent entry into the used-games business by retail giant Wal-Mart Stores (NYSE:WMT) is a big reason for concern. Wal-Mart has begun buying pre-owned games, with a plan to eventually begin selling them in stores. And it's clear from the prices Wal-Mart is paying that GameStop's lush margins on used games are likely a thing of the past.

Wmt Game

Source: Wal-Mart.

Disrupting the used-games market
GameStop achieves a gross margin of around 45% by selling used games and hardware. This is GameStop's most profitable segment, and it typically accounts for nearly half of the company's total gross profit. It's a simple business model, buying low and selling high, and it's been extremely successful for the company.

On GameStop's website, trade-in values are listed for a selection of fairly recent games. A game like Titanfall for the Xbox One, for example, fetches $35.10 for a pre-owned version. GameStop then turns around and sells that used copy for $54.99, only $5 less than the price of a new copy and a 57% markup from the trade-in price. This trade-in price includes a 30% promotional bonus, so the typical markup may be even greater.

Wal-Mart lists trade-in prices for all the games it accepts. And it becomes clear after checking a few titles that the retailer has largely delivered on its promise to pay more than anyone else. Of the 10 featured games on GameStop's website for the PlayStation 4 and the Xbox One, Wal-Mart beats GameStop's trade-in value for seven. The average premium that Wal-Mart pays above GameStop's trade-in value for those seven games is a little more than 15%. 

Of course, this is a small sample, but remember that GameStop's trade-in values include a promotional 30% bonus. For non-featured games, the Wal-Mart premium may be even higher.

This is certainly bad news for GameStop, as it means that the retailer may need to boost its trade-in values in order to compete, thus reducing its used-game margins. But the second prong of Wal-Mart's attack on the used-game market will begin when the company actually begins selling these used games. Given that GameStop sells its used games at a very small discount to its new games, there's plenty of room for Wal-Mart to undercut GameStop on price.

In fact, of the 10 previously mentioned featured games, Wal-Mart sells the new version of six of these games at a lower price than GameStop sells the used version. I was stunned when I discovered this. And when Wal-Mart begins selling used games, GameStop's prices will look ludicrous in comparison.

Wal-Mart is attacking GameStop's used-game business model at both ends, paying more for used games and selling them for less, and I don't see a way for GameStop to maintain its margins in the face of this newfound competition. That's not to say that GameStop is doomed, but the company's most important cash cow is in serious trouble.

The bottom line
The used-game market, currently dominated by GameStop, is ripe for disruption, and Wal-Mart has shown that it's serious about upsetting the status quo. The era of outsize used-game margins at GameStop is likely coming to an end, and the result will be a severe hit to the company's profits.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of GameStop. 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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