Sterne Agee CRT analyst, Arvind Bhatia, sees physical electronic gaming continuing to decline but believes GameStop's (NYSE: GME) diversification can shield the company. He has a Neutral rating rather than a Sell because more than 30% of operating earnings in 2016 are expected to be derived from sources other than physical gaming and the mix is expected to be 50% by the end of 2019. Looking at the guidance however, the tone of his note is more negative.

GME’s 2016 guidance is the clearest acknowledgement yet from management that physical gaming is now in decline but also indicative of the rapid pace at which this management team is diversifying and transforming the company.

Management’s 2016 guidance calls for a 10% decline in hardware sales, a 5% to 10% decline in new software and flattish preowned sales. The analyst agrees with the guidance on hardware sales and new software sales but feels pre-owned guidance could prove aggressive. In 2015 there was a nearly a 7 point gap between the growth rate in pre-owned and new (preowned = -0.6%; new= -6%). The 2016 guidance seems to assume a similar trend. As the shift to digital full game downloads continues, the supply of preowned physical games will decrease more rapidly, leading to either lower sales or lower margins in pre-owned. As such, we think pre-owned will most likely be down mid-single digits, especially if new software declines 10%. This is obviously key given pre-owned gross profits represented 38% of the overall mix in 2015. Each 1% lower growth in pre-owned equates to $0.07( ~2%) lower EPS for 2016.

Management’s strategy to transform Game Stop is two-fold: a) to increase non-physical gaming sources of revenue inside of Game Stop branded stores and; 2) to increase sales of Tech brand stores (Spring Mobile, Simply Mac, Cricket).

Diversification within the Game Stop branded stores is ongoing and consists of efforts to push sales of a) digital gaming (DLC, etc.) and; b) collectibles. Digital gaming generated $1B in non-GAAP gross receipts in 2015 (+11% y/y, as reported), $188M in net revenue (-13% y/y -- impacted by an accounting change) and $150M in gross profits (flat y/y). Collectibles, as a category, grew significantly y/y, reaching $310M in revenue in 2015, up from $75M in 2014. This was from a combination of organic growth and the acquisition of Geeknet. Collectibles is expected to grow 45% y/y to $450M in 2016.

Tech brands generated $534M in revenue in 2015 (+63% y/y). Revenue from this business is expected to double in 2016 and reach $1B, including the pending acquisition of 500 AT&T re-seller stores. Even before the acquisitions, the segment was expected to grow 50% to 60% y/y from growth and full-year contribution of the 2015 store base of 1,036.

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Shares of GameStop closed at $30.27 yesterday.