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The Best Retail Stock for 2007: Guitar Center

Don't sell Guitar Center (Nasdaq: GTRC  ) short.

If you already have, you wouldn't be alone: Approximately 18% of Guitar Center's outstanding float is currently sold short. But remember, this is the same company that the retired Rule Breaker port sold short in 2002 at less than $17 per share. Four and a half years later, with the company trading at $43, Guitar Center has shown that it knows a thing or two about selling musical instruments.

And though I admit the current short interest gives me pause, I believe that Guitar Center could be the best retail stock of 2007 -- starting with its competitive advantages.

Establishing the moat
Guitar Center's focus on guitars and related musical equipment creates a natural barrier to entry. With its aggressive growth strategy, Guitar Center has gone on to establish a dominant position in this market. The company is just now leveraging its fixed costs and using its purchasing power to expand its margins. Guitar Center's scale and focus also add value through depth of inventory selection and knowledgeable sales staff, which national retail chains such as Wal-Mart and Best Buy (NYSE: BBY  ) can't match. So while there is competition, Guitar Center is able to avoid direct and costly challenges toward its business.

Widening the moat
Guitar Center's isn't finished fortifying its moat. Much like Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) with their domination of the home-improvement market, Guitar Center is only getting stronger as it continues to take market share from the fragmented retail musical-instrument market. To increase its market penetration, management added two more store formats, based on population size, to allow the company to operate in smaller cities. Guitar Center's newest division, Music & Arts Center, is also rolling up the local competition as it expands its rental and music-lesson offerings. Add the Musician's Friend online division, and the company is reaching into more and more musicians' wallets.

The downside to Guitar Center's focus on its moat is accepting less-than-stellar fundamentals, something that the shorts have noticed. For years, the company has operated with suboptimal margins, poor inventory efficiencies, and significant capital expenditures as it builds its competitive position. But just as the ugly duckling becomes the black swan, the beauty of Guitar Center's strategy will become clear when it transforms itself into a free-cash-flow powerhouse.

Betting that these free cash flows will occur, I'd say Guitar Center's is easily worth more than its current share price -- not less. Based on moderate growth in invested capital and slowly expanding margins, I value Guitar Center at closer to $52 per share.

But that's what I think. Do you think the shorts have Guitar Center correctly pegged as an ugly duckling? If you agree with the shorts, let us know by joining the Motley Fool CAPS community and entering your underperform rating into the community-intelligence database. If you think Guitar Center is really a black swan and the best retail stock of 2007, give it an outperform rating. Joining the community is absolutely free. Based on your inputs, we'll determine the best retailer for 2007 early next week.

For Related Foolishness:

Go back to the beginning to see what other retail stocks are in the running for our CAPS contest.

Home Depot is a Motley Fool Inside Value recommendation. If you're into bargains as much as the Inside Value team is, check out the service free for 30 days.

Best Buy is a Stock Advisor selection.

Fool contributor Matthew Crews welcomes your feedback -- really! He bought his Fender Telecaster from Guitar Center but has no financial position in the company or in any of the companies mentioned. The Motley Fool has a disclosure policy.

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