FOOL ON THE HILL
Broken Strings at Guitar Center

With retail stocks up dramatically this past year, some of the chaff seems to have risen with the wheat. That seems to be the case with Guitar Center, which has been fueling its sales growth with large infusions of debt and inventory. Return on invested capital has declined every year for the past five years, and yet the company continues to pursue the growth mandate. Foolish investors with a taste for risk may want to consider shorting this one.

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By Matt Richey (TMF Matt)
June 11, 2002

I find it amusing how companies always try to put their best foot forward with their earnings press releases. Consider, for example, this April 25 headline from musical instrument retailer Guitar Center (Nasdaq: GTRC): "First Quarter 2002 Sales Increase 18% On a Year-over-year Basis." Sounds good, right? What they don't tell you, however, is that earnings per share declined 32%, inventories jumped 26%, and net debt increased by 42%. Ugly!

Amazingly, Guitar Center's stock is up 28% over the past year and it sports a P/E of 26.5. If this company is a six-string guitar, I see five broken strings, and the one good one left is worth a heckuva lot less than the current $18 share price.

1. Inventories stacking up
One of the major capital costs that Guitar Center faces is inventory. To support its chain of 106 retail stores, Guitar Center had $261.1 million of inventory on the books at the end of the most recent quarter. That amount represents 67% of the company's tangible assets. Lately, inventory growth has been outpacing sales growth. Not by a whole lot, but fast enough to be a drain on cash that must be spent to fund the inventory expansion. Here's a comparison of inventory and sales growth over the past four quarters:

                  Q2'01  Q3'01  Q4'01  Q1'02
Sales Growth      19.5%  18.0%  19.2%  18.0%
Inventory Growth  27.6%  30.8%  25.3%  26.4%

Given the rapid growth of inventory, I wasn't surprised to see deterioration in the gross margin, which declined in the most recent quarter to 25.5%, down from 25.7% last year. The reason for the gross margin decline is that as inventories stack up, the company will reduce its prices to try to clear out inventory. Reducing prices means cost of goods sold represents a higher percentage of the sales price, and thus gross margin declines. Guitar Center's gross margin erosion may seem minor, but for a low-margin operator, every basis point counts.

2. Reported earnings overstate economic earnings
Over the past five years, Guitar Center has reported net income in four of those years that exceeded cash flow from operations. What this means is that Guitar Center is systematically overstating the cash economics of its business. The most recent quarter was no exception, with net income of $3.4 million and cash from operations bleeding to the tune of negative $25.8 million. Given this state of affairs, it should come as no surprise that the company has rarely generated any free cash flow. For the five years from 1997 to 2001, Guitar Center only once reported positive free cash flow (in 2000).

3. Mounting debt
Without any free cash flow, Guitar Center has used gobs of debt to fund its retail store growth. The company had 40 stores at the end of 1997 and now has 106 stores. Most of these stores were built from the ground up, while a few have been acquired. But all have involved a significant investment, mostly funded by debt. Since the end of 1997, the company's net debt (total debt minus cash) has increased from $59 million to $160 million. For a company with shareholders' equity of $128 million, this is a fairly significant amount of debt.

Personally, I'm leery of companies that fund their growth with external financing. Corporate debt, like personal debt, is easily abused. If a company takes on debt, I like to see it paid off quickly. That's not been the case at Guitar Center where debt has been a way of life for funding its growth.

4. Declining ROIC over past five years
One of the least attractive aspects of all this debt-funded expansion has been the fact that each dollar invested has brought a lower return than the last. One aspect of this decline in capital productivity can be seen in the direction of same-store sales growth over the past three years. In 1999, same-store sales were roaring along at 10%. Then, in 2000, the pace slowed to 7%. In 2001, the rate of growth slowed further to 6%. Now, in the first quarter of 2002, same-store sales growth is down to 5%.

Now don't get me wrong, same-store sales growth of 5% is not bad, but what's concerning is the direction of this trend. The obvious implication is that each new store is less productive than the last. Quantifying this reduced level of store productivity can best be seen in the dramatic year-to-year declines in return on invested capital (ROIC) over each of the past five years:

        1997   1998   1999   2000   2001
ROIC   48.6%  24.8%  18.3%  15.7%  11.8% 

5. Major insider selling
Insider selling has been fierce lately. According to Yahoo! Finance, insiders have sold 1.71 million shares over the last six months, representing 8.8% of insiders' holdings. This includes sells by the company's chairman and president, both of whom sold stock individually worth more than $1 million. There's nothing wrong with their actions, of course. Heck, I think they're making the right decision! Which brings us to our conclusion.

Conclusion
For a retailer like Guitar Center with weak economic earnings and a proven inability to grow those earnings, I wouldn't pay more than a P/E of 10. Even being generous and applying this multiple to estimated 2002 earnings of $1.00, the stock is only worth $10. Why a multiple of 10? Flip over a P/E of 10 and you get an earnings yield of 10%. That's about the right return to demand of a retailer like this, in my opinion. Unless Guitar Center can soon demonstrate higher returns on its capital, I think the company will eventually be in a position where it has to close stores in order to restore economic profitability.

Depending on your taste for risk, Guitar Center may be a good short candidate at the current price of $18.19.

For more on shorting, see our FAQ. We also have a discussion board devoted to shorting.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.