Rule Breaker Portfolio Teetering on the Q4 Edge

Looking for investment-banking business, Goldman Sachs raised its Guitar Center rating from "market outperformer" to "recommended list." Everything must go absolutely right for the company to achieve Goldman's highest one-year outlook for the stock. Anything less looks good for shorts. The fourth quarter is the key.

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By Tom Jacobs (TMF Tom9)
November 5, 2002

I had a delightful time last week in Boston at a conference delivered by the Association for Investment Management and Research (AIMR), which is responsible for the Chartered Financial Analyst (CFA) designation. As an organization, they are the good folks, supporters of stock option expensing and many other practices that encourage corporate reporting transparency and responsible analysis.

Wait. Are you reading a Motley Fool writer with a good word about analysts? Yes indeedy do. There are analysts, and there are analysts. For the most part, you must watch out for the sell-siders, those who work for the brokerage arms of large investment banks that want to sell their mergers and acquisitions and other financial services. Their judgments and alleged insights are the most suspect, due to the conflicts of interest that by now are familiar to anyone who has been conscious in recent years.

There are good and bad analysts on the sell or buy side, and some are or aren't CFAs, but the organization that tests, certifies, and represents them stands for the right things.

Guitar Center looks for a way out
I feel some sympathy for the sell-side analysts who put together Goldman Sachs's report, upgrading shares of our newest short position -- Guitar Center (Nasdaq: GTRC) -- to its recommended list on Oct. 24. They "expect to receive or intend to see compensation for investment banking services in the next 3 months from ... Guitar Center, Inc."  Their analysis does not persuasively support their expected performance of the stock, but at least we know why. Business is tough, and you gotta do whatcha gotta, I guess.

It's tough for Guitar Center, too, which is why it's running a national ad campaign offering no payments until 2004 -- 2004! -- for purchases over $299. This may inflate Q4 accounts receivable and cannibalize future  sales for a quarter, but it won't help the company's major current need for cash. That's the reason Guitar Center and Goldman are flirting. The company can't fund additional stores or the construction of its much-vaunted new distribution center through cash flow from operations, so it's taking on more and more short- and long-term debt:

Period     Total Debt                  Sales
        (ST + LT + pref'd) YOY* Change YOY* Change
Q3 '02      $186 mil.      15%         14%
Q2           172           17%         18%
Q1           165           38%         18% 
Q4 '01       144           39%         17%
Q3           162           31%         18%
*Year-over-year

You can see that increased sales come at the expense of more debt. Perhaps the company has reached the limit of what bankers will lend it at rates it can afford. Very roughly, banks will lend to companies with quick ratios in excess of 1.0, though that varies by industry. Specialty non-apparel retailers like Guitar Center have an average 0.4 quick ratio, meaning they have $0.40 of readily convertible assets for each dollar of liabilities. Its Q3 ratio was less than half that, or 0.16, the lowest in nine quarters and steadily declining for the last four.

So, perhaps the company wants to raise cash by selling stock. To do that, you need to find an investment bank willing and able to flog the stock to institutional buyers. In a bull market, you may also be able to sell a chunk to the public. Step one: You have to find a Goldman Sachs (or the like) willing to issue a favorable analyst report.

The Goldman argument
The crux of Goldman's analysis is weak, but not entirely without merit. After the company "sustain[s] a mild sales hit" from this quarter's likely inventory liquidation of Mars (its now-bankrupt competitor), Guitar Center will gain between $0.08 and $0.19 a share over the next year from business that would formerly have gone to, uh, Mars.

Goldman chooses those numbers based on what it calls a "very conservative" 10% operating margin -- operating income divided by sales (both from the income statement) -- on incremental revenue from Mars. Adding $0.08-$0.19 would increase Guitar Center's projected $1.03 to $1.06-a-share earnings this year by 8% to 19% next year. Not insubstantial. Goldman projects a price-to-earnings ratio in the high teens, giving us a stock price of as much as $1.25 times 19, or $23.75. Considering we shorted at $16.49, this would not be good.

Looking more closely
But here's the problem for those who read the analysis carefully: The company hasn't had annual operating margins over 8.1% since 1995, let alone 10%, for as far back as I can see. And its annual average for 1995 to 2001 is 2.1%. Taking out the 1996 loss, it's still only 5.9%, and for the last nine quarters, the range is 2.5% to 7.9% for an average of 4.9%. Yet Goldman assumes that incremental revenue will bring operating margins 25% over Guitar Center's highest since 1995, and says nothing about the rest of its sales. That's not conservative, as I'll show below.

That flimsy guidance
Goldman analysts expected Q3 results in line with guidance (they were) and "in-line fourth quarter earnings guidance." Notice they didn't say they expected Q4 earnings to be in line -- only that the guidance would be. The company predicts Q4 sales from $327 million to $331 million, and EPS of $0.51 to $0.54. For this to happen, net margins will have to be high, but operating margins will have to rise overall in Q4 to levels of what was an excellent retail Q4 last year (a surprising rebuttal to 9/11 in Q3) and towards an even better Q4 in 2000:

                High    Low            2002 
                Q4 est. Q4 est.  Q3    Q2     Q1 
Revenues        $331*   $327    $257  $254   $255 
Operating Inc.  23.8    22.5    10.4   9.6   8.7
Oper. Margin    7.2%    6.9%     4.0%  3.8%  3.4% 
Net Income      12.6    11.9     4.4   4.1   3.4 
Net Margin      3.8%    3.7%     1.7%  1.6%  1.3% 
Diluted Shares  23.39*  same     same  
EPS             $0.54   $0.51   $0.1865
Net Margin/      53%     53%      42%   43%   39%
Oper. Margin 

                    2001             2000 
               Q4    Q3    Q2    Q1    Q4    Q3 
Revenues      $281  $225  $216  $216  $240  $191
Operating Inc. 19.6  5.6   10    11    19    10.1
Oper. Margin   7.0%  2.5%  4.6%  5.1%  7.9%  5.3%
Net Income     6.6   1.4   4.1   5     10    4.3
Net Margin     2.4%  0.6%  1.9%  2.3%  4.2%  2.3%
Net Margin/    34%   25%   41%   45%   53%   43%
Oper. Margin

* In millions

See the problem? To achieve the bottom-line numbers, the EPS of $0.51 to $0.54, Guitar Center must achieve 3.7% to 3.8% net margins -- which it has reached once in the last two Q4s. Not only that, its net margin, which has not exceeded 53% of operating margin for the last nine quarters, implies operating margins must be 6.9% to 7.2% -- certainly consistent with the last two Q4s. But what if it's last year's 34% or 43% or anything less than the top 53%? Then, operating margins for all Q4 revenue would have to be from 8% to over 11% -- higher than Goldman's estimate for future operating margins only for incremental revenue gained from customers of its major competitor, higher than Guitar Center has achieved in its last two Q4s, and higher than it achieved in any full year since 1995 except for 1997 when it touched 8%!

This shows that everything must be absolutely perfect for Guitar Center to bring in a Q4 at its guidance, and there are just too many variables for that to happen. No wonder Goldman says the company will sustain a mild sales hit and has "POTENTIAL for a choppy sales outlook," (capital letters theirs), and only that it expects Guitar Center to issue "in-line fourth quarter earnings guidance" -- not to actually meet it. After all, "near-term results are not central to our call," which means they will put all problems in caps but call 'em short term because they are desperate for investment-banking business to keep their jobs, thank you very much.

Competitor's death is no small thing
I don't doubt that the demise of a competitor could, in a perfect world, mean a sustainable future for Guitar Center, and it does not sell goods as fungible, say, as clothes or widgets. But I question the future that Goldman presents to grab Guitar Center's business and persuade future investors. Goldman says that all the problems are short term. That's good for those who hold short positions, such as the Rule Breaker Portfolio (and me) . But they may not just be short term.

When consumer spending and debt are at all time highs, interest rates are at historic lows, and the economy and employment are hardly robust, Goldman's analysis -- which includes a price-to-earnings ratio in the high teens -- is whistling past the graveyard.

We might be gloriously wrong, in which case we'll cover and take our lumps. Next week, I'll have fun with Guitar Center's Q3 earnings press release and management's efforts to spin it, as well as the lovely topics of inventory and accounts receivable. In the meantime, you can find great analyses of the company's prospects and results in our Guitar Center discussion board!              

Have a most Foolish week! Updated port returns below. 

Tom Jacobs (TMFTom9) plays piano but not guitar. He is the face guy for the Motley Fool Analyst Band that brings you deeply researched, undiscovered stock ideas every month in The Motley Fool Select. Enjoy your 30-day free trial today! At press time, Tom was short Guitar Center. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 11/04/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week       2.79%      2.04%    --       6.13%
Month      5.60%      2.55%    --       5.02%
Year -21.68% -20.88%  --     -28.40%
CAGR
using IRR*** since 8/4/94 21.41%    8.63%  10.37%   8.35%

*Dividends added. Or, danger ahead. Whatever.

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!

Rule Breaker Portfolio

  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  AMZN AMAZON.COM, INC. (0.06) (0.32%) 18.72 
  AOL AOL TIME WARNER INC. 0.24 1.55% 15.77 
  TREE LENDINGTREE INC 0.17 1.44% 12.00 
  EBAY EBAY INC 1.19 1.83% 66.12 
  MLNM MILLENNIUM PHARMACEUTICALS INC 0.71 9.21% 8.42 
 SHORT  SIRI SIRIUS SATELLITE RADIO INC 0.06 5.66% 1.12 
  SBUX STARBUCKS CORP 0.48 2.10% 23.34 
  AMGN AMGEN INC 1.72 3.56% 50.08 
 SHORT  GTRC GUITAR CENTER INC 0.37 2.03% 18.60 
  SPY SPDR TRUST;1 0.72 0.79% 91.85 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 09/09/97 1320 AMZN 3.20 18.72  491.62%
 08/05/94 4020 AOL 0.46 15.77  3,487.87%
 06/03/02 916 TREE 13.72 12.00  -12.47%
 02/26/99 1145 EBAY 46.54 66.12  42.09%
 09/27/01 2260 MLNM 14.69 8.42  -42.66%
 SHORT 01/24/02 2500 SIRI 6.90 1.12  83.77%
 07/02/98 940 SBUX 13.98 23.34  67.09%
 12/16/98 1160 AMGN 21.44 50.08  133.61%
 SHORT 08/21/02 1000 GTRC 16.49 18.60  -12.86%
 04/24/02 290 SPY 110.16 91.85  -16.58%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 09/09/97 1320 AMZN 4,220.20 24,710.40  20,490.20 
 08/05/94 4020 AOL 1,860.42 63,395.40  61,534.98 
 06/03/02 916 TREE 12,565.44 10,992.00  -1,573.44 
 02/26/99 1145 EBAY 53,294.44 75,705.11  22,410.67 
 09/27/01 2260 MLNM 33,207.00 19,029.20  -14,177.80 
 SHORT 01/24/02 2500 SIRI 17,258.26 2,800.00  14,441.74 
 07/02/98 940 SBUX 13,138.62 21,939.60  8,800.98 
 12/16/98 1160 AMGN 24,875.50 58,092.80  33,217.30 
 SHORT 08/21/02 1000 GTRC 16,488.00 18,600.00  -2,128.00 
 04/24/02 290 SPY 31,945.00 26,636.50  -5,308.50 
Cash:573.54 
Total:313,404.55 


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Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.