GameStop Isn't DOA Despite the Threat of Wal-Mart

You don't have to be a parent to know if you ask pretty much any kid to choose between a pit stop at Wal-Mart Stores (NYSE: WMT  ) or GameStop (NYSE: GME  ) , he or she is going to choose the latter. Now that Wal-Mart has become synonymous with frozen peas (in light of its grocery push), it doesn't evoke the same kind of anticipation that a visit to a store with game in the name might. And this stands to work in the favor of GameStop now that its much larger peer has entered its turf.

Wal-Mart last month revealed it would be entering the used video game market, facilitating trade-ins and selling used games at its famously low prices. While the move might have blindsided the competition, in hindsight the development really isn't that shocking.

Wal-Mart's sales at its supercenters have been slumping amid an evolving consumer and heightened competition from the likes of dollar stores. The giant retailer is fighting back. In addition to investing more heavily in e-commerce and opening a wave of smaller-format stores, it has set its sights on the $2 billion market for used video games. 

GameStop execs are playing it cool, but they've got everything to lose if Wal-Mart succeeds. Used games and trade-ins are Grapevine, Texas-based GameStop's bread and butter, with margins from pre-owned video games historically in the 46% to 49% range. Plus GameStop has been fighting its own battle to remain relevant amid a shift toward mobile gaming and digital gaming software.

Elephant in the room
On GameStop's March 27 earnings call, even company officials couldn't ignore Wal-Mart. Company execs remain sanguine, offering a backhanded compliment to the elephant in the room. 

...it is a great sign for the category that large competitors return after previous attempts as they see that the pre-owned video game business has a lot of growth ahead.-Paul Raines, GameStop CEO on the March 27 earnings conference call

GameStop isn't in denial, it's just got what could prove to be an ace up its sleeve. 

[More than] 75% of all trades made at GameStop stores are immediately used to buy new products, a business model that last year
added [more than] $1 billion of sales to the new software and hardware industry. Our publishers know that trades made at GameStop stay in the gaming ecosystem.

Not so at Wal-Mart, where customers can apply store credit toward any one of a number of product categories at the company's namesake stores or Sam's Club. If it came down to it, video game suppliers might be inclined to offer more favorable terms to GameStop over Wal-Mart in an attempt to keep the store credit contained to the industry. 

Nevertheless, Wal-Mart doesn't have too much to lose by entering the used video game market. While current investments into the e-commerce channel and smaller-format stores will weigh on financial results in the short term, its used video game initiative is an extension of its existing shelf space and isn't capital intensive; Wal-Mart isn't investing heavily in new infrastructure or manpower to provide the trade-in service. Unlike GameStop, which has a game-refurbishment center on the premises in Grapevine, Texas, the Arkansas-based retailer will be outsourcing the game-refurbishment process; it has everything to gain as an industry disrupter and little to lose. 

But GameStop has 25 million strong loyalty members, from whom the company generates three-quarters of its sales. Many customers aren't going to pick up and go to Wal-Mart just because they can. GameStop has a reputation as a small business that families can visit and be greeted on a first-name basis. GameStop seems to take pride in that, and it's going to be difficult if not impossible for Wal-Mart to replicate that experience. 

On a valuation basis, GameStop and Wal-Mart have competitive trailing earnings multiples at around 15 and 16, respectively. To evaluate the companies based on sales just isn't an apples-to-apples comparison, as Wal-Mart generated nearly $500 billion in sales last year to GameStop's $9 billion in fiscal 2013.

But where they're comparable is the fact that both have something to prove. Wal-Mart's experiment to enter the used video game market is one of several initiatives to remain relevant and it doesn't have to disrupt GameStop. If anything, it's put a fire under the feet of GameStop management to fight for a greater stake in a market they already dominate.

Foolish conclusion
Brand loyalty begins at a young age, and GameStop since the turn of the century has established trust with its consumer base. GameStop might not be able to replicate Wal-Mart's size and scale, but Wal-Mart can't compete with GameStop's small town feel, the very characteristics that stand to work in the Texas-based retailer's favor. As such, I wouldn't give up on GameStop just yet.  

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