FOOL ON THE HILL
Profit From the Downturn

Guitar Center has all the makings of a great short candidate: a massive debt load, bloated working capital, declining profit margins, at-risk earnings guidance, and heavy insider selling. The stock's P/E of 24 is roughly twice what it should be for a company with no earnings growth and very low returns on invested capital.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Matt Richey (TMF Matt)
August 13, 2002

I'm hearing rumblings that individual investors are showing an unhealthy appetite for shorting stocks. There's probably some truth to that. Just as the extended bull market of the late 1990s brought speculative long interest on the way up, I'd expect speculative short interest now to increase on the way down.

While I don't want to fan the flames, I do believe shorting is and always will be a superb way to profit from companies that are fraudulent, poorly managed, overhyped, overleveraged, overvalued, and/or on the verge of an unexpected downturn in business.

Guitar Center (Nasdaq: GTRC) embodies several of these distasteful qualities. The company owns a chain of musical instrument stores that operate on a razor-thin margin, piles of inventory, and a massive debt load. Two months ago, I wrote about the many risks I saw emerging in the company's financial statements. At that time, the stock was at $18.19; now, it's at $15.95. (For the record, a week after my article was published, I went short at $19.52.) At one point, the stock had actually dropped below $14, but then it popped higher after the company reported Q2 results on July 25 that beat expectations.

In its press release, the company trumpeted the fact that sales rose 18% and earnings per share beat analysts' expectations by $0.04. The subtext, however, is that net income was flat on a year-over-year basis. So it took 18% more sales to get the same level of profit. Is this anything to get excited about?

I see five distinct reasons Guitar Center's stock is due for a painful re-tuning in the months ahead:

1. Massively leveraged balance sheet
I laughed out loud when, on the July 25 earnings conference call, CFO Bruce Ross said, "Turning to the balance sheet, we continue to maintain a solid financial position." Really? The most glaring flaw in Guitar Center's business is its growing debt load. Interest-bearing debt less cash -- that is, net debt -- grew to $167.1 million in the most recent quarter, or 1.25 times equity. That's an extraordinary amount of leverage. At this time last year, Guitar Center carried $146.2 million in net debt, or 1.27 times equity. That may be a slightly improved ratio of debt to equity, but remember that this additional debt was necessary just for the company to generate the same level of earnings as last year.

As you can imagine, with capital increasing and earnings remaining the same, return on invested capital (ROIC) was on the decline. ROIC for the quarter was only 8.2%, down from an already unimpressive 10.3% a year ago. By way of comparison, a well-run specialty retailer like Best Buy (NYSE: BBY) generates an ROIC of around 26%.

2. Flow Ratio in the danger zone
When working capital accounts such as inventory and accounts receivable begin to get bloated, it's often a sign of larger financial trouble. That's why there is such value in measuring the condition of working capital using the Foolish Flow Ratio, developed by our own Tom Gardner. It was the rising (that is, worsening) Flow Ratio that caught my attention about Lucent's (NYSE: LU) precarious state in late 1999 (as Bill Mann, Tom Gardner, and I wrote). Similarly, a rising Flow Ratio tipped me off to Gap's (NYSE: GPS) declining finances in early 2001, back when the stock was still above $30.

In the case of Gap, its Q1 '01 Flow of 1.47 marked the third consecutive year-over-year worsening in the quality of its working capital. By way of comparison, Guitar Center's Flow Ratio in the latest quarter hit an all-time high of 2.72, up for two consecutive years on a year-over-year basis. Any time a retailer's Flow gets well above 2.0, I consider that the danger zone. Guitar Center is in the process of rolling out a new distribution center, which is supposed to reduce its level of inventory, but I'll believe it when I see it.

3. Deteriorating margins
Guitar Center's 18% sales growth didn't amount to any earnings growth because its two major expense line items -- costs of goods sold (COGS) and selling, general, and administrative (SG&A) expense -- both increased at a rate faster than sales. The result was operating income of $9.6 million, down from $9.9 million a year ago. Were it not for a lower level of interest expense (through lower interest rates on its short-term debt), Guitar Center's net income would've declined. But even as it was with flat net income, Guitar Center's net margin declined to a paltry 1.6%, down from an already low 1.9% a year ago.

4. Risk in full-year earnings guidance
Holding in mind the deteriorating margin situation, let's take a close look at Guitar Center's earnings guidance for the remainder of the year. Typical for retailers, the fourth quarter is Guitar Center's big moneymaking quarter. This year's earnings guidance of $1.02 to $1.07 per share, along with the Q3 guidance of $0.18 to $0.19 per share, implies Q4 EPS of $0.50 to $0.55. Taken with the company's Q4 sales guidance of approximately $330 million, the implied Q4 net margin is 3.5% to 3.8%. Again, remembering the trend of deteriorating margins, consider that last year's Q4 net margin was 2.3%. Are we to believe Guitar Center is prepared to boost its net margin by 59% over the year-ago quarter? I see incredible risk to this assumption.

Also on my mind as I consider the likelihood of Guitar Center meeting its forecast is the recent decline in U.S. consumer spending. Last week, Best Buy shocked the market by announcing sales "softened significantly" in July. With the economy not yet showing signs of a turn around, this year's fourth quarter could be a disappointment for retailers, especially those, like Guitar Center, that sell purely discretionary, high-priced items like guitars. And because Guitar Center's counting on operating leverage in the fourth quarter, if its sales don't achieve the forecasted level, its earnings could miss the mark by a wide margin.

5. Continued insider selling
Fifth and finally, Guitar Center insiders continue to dump their stock. In my June article, I pointed out that over the past six months, insiders had sold 1.71 million shares, or 8.8% of their holdings. At present, the number of shares sold has increased to 2.00 million, or 10.2% of insider shares, according to Yahoo! Finance's GTRC Profile. Say what you want about the difficulty of interpreting the intentions behind insider selling, but no matter how you slice it, two million shares of a company with 23 million shares outstanding is a LOT.

So let's review. Guitar Center has mounting debt, unhealthy working capital management, deteriorating profit margins, at-risk earnings guidance, and insider selling. Given these signs, what's a reasonable valuation for a retailer that's showing zero earnings growth? At the current $15.95, the stock trades at 24 times trailing earnings. Why would anyone pay such a high multiple for a debt-heavy, low-ROIC retailer carrying a massive amount of inventory? I stand by the valuation assessment I presented back in June: The stock deserves a P/E multiple closer to 10. Even if the company manages to achieve its expected 2002 EPS of around $1.05, that's a stock price of $10.50.

As for my short position, my intention is to cover at a price no higher than $10, or possibly lower, if evidence continues to mount that the business is suffering. If the company eventually warns on its guidance for Q3 or Q4, I believe the stock could easily trade into the single digits. Of course, I could be wrong. If, for example, guitars wind up being this Christmas' hottest selling item, and Guitar Center blows past its earnings guidance, pays down its debt, and tightens up its inventory management, then I'll be prepared to cover my short. My rule for any short is to cover if the stock rises 20% above my sell price, which for me would be $23.42. If I saw a meaningful improvement in Guitar Center's fundamentals, I'd also consider covering.

For more information on shorting, and especially the risks therein, please see our FAQ.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he was short Guitar Center via both its common stock and put options. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.