Most individual investors check their companies' progress quarterly via press releases, conference calls, and 10-Qs. But as with political spin, these communications are best viewed with a critical eye. Attention to detail on your part can reveal all sorts of useful clues as to how things are really going. Let's do just that with Guitar Center's (Nasdaq: GTRC) Q3 earnings press release, to add to last week's discussion of why the company is teetering on the Q4 edge.
Speaking of Q4 and beyond, the music equipment retailer just announced a Webcast this Thursday for management to discuss its 2003 outlook. This portfolio has a short position in Guitar Center. The percentage of the float that was short as of Oct. 15 is over 40%, leaving about 7.7 days to cover at the average daily volume of 250,000. We like to see seven days or fewer to cover. So we expect volatility, and as discussed last week in this space, fully expect management (and Goldman Sachs) to continue efforts to boost the stock price. Those who hold Guitar Center long certainly are interested in much more than this pivotal Q4, but we think the reasons that Q4 may disappoint apply to the company's health for whatever period.
Guitar Center's Q3 press release begins with the big, bold headline "Guitar Center Third Quarter 2002 Net Income Increases 218% On a Year-Over-Year Basis." Not bad. That means earnings per share (EPS) more than tripled over the same quarter last year. Who wouldn't trumpet that?
But then there's the subheadline: "Third Quarter Net Sales Increase 13%." Hmm. The company was hugely more profitable, yet only on a bit more sales. A 13% year-over-year sales increase would normally be quite good, except that Q3 last year was... yes, that quarter. There were 19 days after Sept. 11th, or 21% of a 91.25-day quarter (365 days divided by 4). So the real way of reading this is: Against a quarter whose results were 21% impaired by the worst public domestic disaster in the last decades, the company improved sales only 13%. Yes, you heard me mouth "only."
Where's the cash flow statement?
The company's press release includes its unaudited quarterly income statement, which contains the calculation of net income. Remember that if the balance sheet is a loan application (assets versus liabilities), the income statement is the company's tax return. Like you, the company pays taxes only on a portion of the money coming in, according to all sorts of accounting stuff. To find the actual cash generated by a business in a given period, you must check the cash flow statement, where you find net cash provided by operating activities.
But Guitar Center doesn't release its cash flow statement in the press release. I don't blame them, from a spin perspective. You, too, would trumpet your tax return's EPS increase if you produced no free cash flow for five of the last seven years, and six of the last eight quarters.
I love when I point this out and people say, "Well, do you know how many companies don't, either?" Yes, and that's about as persuasive an argument as when you told your parents (or your kids tell you), "But Ernestine (or Abner) does!" There is no reason -- none -- that any investor should accept the usual earnings press release flim-flammery of producing a balance sheet and income statement but delaying the cash flow statement until its SEC filing, when no one is allegedly looking.
By the way, when Guitar Center's cash flow statement appears in its SEC 10-Q filing, it will almost certainly reveal yet another quarter of no free cash flow (cash from operations minus capital expenditures). This might be reasonable for a newer, rapidly expanding retailer, but this business, established in 1964, is neither brand-new nor young. It cannot claim that every dollar of cash flow from operations must go to store buildout (capital expenditures). Guitar Center's growth is coming at a cost.
What the press release does tell us
Some favorite red flags from this Q3 earnings press release:
"The lower than expected sales at American Music were due to..."
Certainly nothing that was our fault!
"Musician's Friend sales increased almost 23% from selling the same period last year, which was slightly softer than expected due to economic trends and the subsequent effect on our hobbyist customer base."
Customers bought more, but less than we hoped -- I mean, hyped.
"Last year's results, particularly net income, reflected disruption after the events of September 11, 2001."
(This, coming in the second paragraph, is news for alert readers.) Even our bold headline must be understood in light of a lousy comparison.
"The reduction reflects cost containment in the Guitar Center stores and improved leveraging at the corporate level, partially offset by negative leveraging from the American Music stores."
Our American Music stores were inefficient. But our corporate office, which is not our business despite what you may think from reading our net dilution from stock option grants, is more efficient. Hey, if you believe that, I've got a mint-condition 1954 Fender Stratocaster I'll sell you for....
Then it comes:
"Our ability to provide guidance is somewhat constrained by continuing uncertainty regarding general economic conditions, especially as they impact hobbyists and other general consumers who purchase from [us.] Also, we have not attempted to predict the impact on our business of the court-ordered liquidation of the Mars Music chain which is expected to include "going out of business" sales in its remaining stores. Many of these stores are in markets also served by our Guitar Center stores, and the liquidation represents competition for direct response sales by Musician's Friend."
Among the warnings here is that the Mars "liquidation represents competition for direct response sales by Musician's Friend," a Guitar Center Web sales operation that is supposedly growing and could provide higher margins. Longs may not care about this potentially short-term factor. But what gobbledygook is this: "Our ability to provide guidance is somewhat constrained by continuing uncertainty regarding economic conditions, especially as they impact hobbyists and other general consumers who purchase from [us]." Who else is there? Did these people ever have English teachers or editors? How about, "We don't know what the heck is happening because our customers are skittish"?
I may be paranoid, but someone from the planet Mars, not the bankrupt competitor, might see the language of this release as a setup for an earnings warning -- especially in light of growth in inventory relative to sales.
One last thing. Just look at the rate of increase of sales, inventory, and days sales in inventory:
2002 2001 Q3 Q2 Q1 Q4 Q3 Q2 % YOY Sales Growth 14% 18% 18% 17% 18% 21% % YOY Inv.* Growth 17% 15% 26% 25% 31% 28% Days Sales in Inv.* 140 131 125 112 137 134 Sequential Increase 9 6 13 -25 3 17 YOY Increase 3 -3 8 8 14 8 2001 2000 1999 Q1 Q4 Q3 Q2 Q1 Q4 % YOY Sales Growth 23% 25% 25% 28% 30% 62% % YOY Inv. Growth 22% 24% 30% 24% 58% 104% Days Sales in Inv. 117 104 123 127 119 104 Sequential Increase 13 -19 -4 8 14 -14 YOY Increase -2 0 4 -5 21 20
Sales growth (largely through expansion) has been declining for three years. But any sales growth means inventory growth -- unless your efficiency, or inventory turns, increase. Guitar Center's days sales in inventory (the number of days of inventory at current sales rates) are increasing both sequentially (except for expected annual Q4 sequential decreases) and on the whole year-over-year, meaning that the company is adding more inventory relative to sales. But the company is less efficient each year, with inventory turns of 4.1 in 1997, 3.4 in 1998, 3.2 in 1999, 3.2 in 2000, 3.1 in 2001, and 2.9 for trailing-12-months. This is all leading to a lousy quarter, and most likely many more. The piper must be paid.
Last week, I said that the first indicator was Guitar Center's holiday season offer of no payments until 2004 on purchases over $299. It's an effort to boost sales and net income for Q4 but with ballooning accounts receivable. Every retailer is desperate for Q4 sales, but cannibalizing future sales only puts off the day of reckoning -- just check the car companies. (Fool Community member UsuallyReasonabl offers a different take on the issue.)
As I also said last week, we might be entirely wrong -- as with any investment --but we know our investing thesis and are prepared to accept the consequences. Stay tuned!
Have a most Foolish week! Updated port returns below.
Tom Jacobs (TMFTom9) joins the team of Motley Fool analysts to bring 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 11/11/02 Market Close:
RB S&P S&P 500 Port 500 DA* Nasdaq Week -3.61% -3.54 -- - 5.54% Month 1.78% -1.08% -- - 0.79%
Year -24.51% -23.68% -- -32.36%
using IRR*** since 8/4/94 20.69% 8.14% 11.07% 7.59%
*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!