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Tuesday, June 15, 1999

Guitar Center Inc.
(Nasdaq: GTRC)
Website: www.guitarcenter.com
Phone:  1-800-905-0585
Price  (6/14/99): $9 5/8


As the retail category killer in the realm of musical instruments, Guitar Center went public two years ago to a standing ovation.

The March 1997 debut, with the company offering 7.8 million shares at $15, was a hit. By the end of the year the stock was at $23 and the melody was about to get even catchier. In 1998 same-store sales rose 12.8% and the shares peaked just above $33. Then came the fade out.

With breakneck expansion, the company was supposed to be another superstore success story. This year began with a 29% uptick in sales, but with lower earnings than 1998's March quarter. With almost half of the stores having opened since the IPO, it would be easy to fault the recent shortcomings on the large number of immature stores. However, that was not the drag on earnings this time around. Operating earnings were actually higher earlier this year -- the company had just used up its tax loss carryforward and is now taking on the full brunt of its 38% tax rate.

Despite the strength in sales and operating income, Wall Street turned a deaf ear to Guitar Center's music. Even in May, when the company announced the purchase of Musician's Friend, a music catalog retailer that claims to be the largest direct mail musical equipment company in the world, Guitar Center didn't find much of an audience. Even to an investment community that typically embraces an Internet play, Guitar Center was hitting the rewind button.


Guitar Center opened its first store in 1964, just as The Beatles were breathing new life into the electric six-string guitars on the Ed Sullivan Show. Today, after the Musician's Friend merger, the company sports 61 stores selling a wide variety of musical instruments and pro recording gear.

The united companies sport a combined mailing list of 4 million customers with two distribution centers in Oregon and Tennessee.


Income Statement
12-month sales:     $416.3 million 
12-month income:     $26   million
12-month EPS:         $1.25
Profit Margin:         6.2%
Market Cap:         $200.2 million

Balance Sheet
Cash:                 $0.1 million
Current Assets:     $123.2 million
Current Liabilities: $50.5 million 
Long-term Debt:      $67.1 million    

Price-to-earnings:     7.7
Price-to-sales:        0.5


Earlier this month, the weak shares of Guitar Center hit another diminished chord when it announced that earnings would falter in the June quarter. Sales trends seemed to indicate that the company would come in four pennies a share below expectations in June, but would make up half of that ground with a two-cent bonus come the fourth quarter. Weakness in the pro recording gear and dj equipment subsidiaries was the primary culprit.

To make matters worse, now that the Musician's Friend deal has been completed, the company expects the new venture to be dilutive to the tune of $0.08 a share this year. That should not have come as a surprise. Back in May when the company first announced its intention to acquire the catalog and online specialist, it stated that it would be dilutive to earnings this year, have no effect next year, and be accretive in 2001.

Despite the corporate guidance, many analysts did not adjust their earnings projections. So the fiscal shortfall was easy to see coming -- the company had made it perfectly clear.


In the world of music you have minor and major scales. This appears to be a case of Wall Street looking at Guitar Center's minor problems and blasting it on a major scale. Paine Webber had a "buy" rating on the company when the going was good, and now it downgrades it to "neutral" when it is selling for a third of its previous highs?

With the company already expecting some favorable momentum by the end of the year, it will be hard to justify knocking down next year's $1.25 per share estimate. That places a single-digit P/E ratio on a company that is still growing.

The synergy of the Musician's Friend deal also seems lost on the public. With the stock now hammered to $10 a share, that values the merger (which involved the assumption of $18.4 million in debt and the issuance of almost two million new shares) at just $38 million. Last year Musician's Friend generated $97 million in revenues. With the nine Musician's Friend outlets getting Guitar Center makeovers, margins should improve. Meanwhile, the print and online catalog business of Musician's Friend just picked up the prized mailing list of patrons at all of Guitar Center's 52 stores -- and counting.

While Musician's Friend may be seen as a risky debt-laden venture for the company to absorb, it seems to me as if the new growth possibilities will make Musician's Friend a friend indeed for Guitar Center. And, you know, the company will get by with a little help from its friends.

-Rick Aristotle Munarriz (tmfedible@aol.com)

Make a Living Foolin' Around.

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