Guitar Center (NASDAQ:GTRC) is the premier music store in America, based on sales of guitars and other musical instruments and pro-audio and recording equipment. And boy, is there some really cool stuff in its Hollywood store! As an analyst, I got to tour the Sunset Boulevard flagship location and saw some really neat things in the secret back room, including Elvis' blue suede shoes, the original Woodstock sign, and a bunch of Kiss memorabilia.
The company's shares are trading at a level that presents a 17% potential gain to the $63-per-share price for which Guitar Center agreed to sell to Bain Capital Partners. The price variance is abnormally high, especially with the deal expected to close in the fourth quarter. Right now, the market doesn't expect the deal to close at $63.
Guitar Center is one of many companies whose shares trade well off of their deal price now. This is thanks to the market's intensified concern that the repricing of debt and risk could cause many private equity buyers like the Blackstone Group (NYSE:BX) and Bain to back away. Look at poor Accredited Home Lenders (NASDAQ:LEND), for instance. The company is suing Lone Star Fund V to try to make it to stick to its agreement. The private equity player just extended its tender to Aug. 28 to appease Accredited Home Lenders, and might move forward if normalcy is restored to the credit markets.
For this reason, hedge funds focused on merger arbitrage could see one of their best years in recent history, as long as their capital sticks and deals don't fall through. You see, merger-arbitrage funds make their money by owning the shares of firms that have agreed to be acquired. The funds typically leverage up in order to improve the return on the usually small but reliable difference in price. The shares of soon-to-be-acquired firms normally trade at a slight discount to the deal price. That discount exists only because of the time it takes to complete the deal and the perceived risk of it falling through. The increased risk of the deal not going through is causing a wider discount, which could lead to higher returns.
So, what could happen?
If the deal falls through, we'll have to value Guitar Center as it was before the announcement. On the day before, the shares traded at roughly $50 -- 9.1% below the current value. And one has to wonder if the rocking management team relaxed a little bit after signing the big deal, sort of like a star baseball free agent does after he signs a multimillion dollar contract. Guitar Center's second-quarter results were just plain out of tune, in this Fool's view.
Excluding the $0.06 it took in takeover-related charges, the company earned $0.37 a share, two cents below consensus expectations, as compiled by Thomson Financial. Ouch! That was 21% below last year's result. We know retailers are starting to see some consumer softening, but this seems excessive. Net sales were pretty good, but the 13.3% increase still missed Guitar Center's expectations. The company said retail softness and macroeconomic trends played a role, affecting both its flagship branded stores and its direct response unit.
Revenue grew 9% in the Guitar Center segment, but it all came from new stores because same-store sales slipped 0.1%. That's never good. Musician's Friend, the company's direct response segment, grew revenue 28%, but management said about 91.5% of that growth was due to the acquisition of Woodwind & Brasswind in February. Finally, music and arts, the segment focusing on the sale and rental of instruments to the school orchestra, band and lesson market, rose 16.9%.
The important question here is what's Guitar Center worth if the deal falls through. Well, earnings estimates came down after the latest quarterly report, with consensus expectations for 2007 and 2008 now at $2.55 and $3.17, respectively, according to Thomson Financial. At roughly 17 times the forecast for 2008, the shares trade at a discount to the 24% growth analysts foresee next year. Heck, even at 21 times the number for 2007, the shares compare well with near-term growth forecasts. We analytical types usually compare the P/E with long-term growth expectations, though, and applying a five-year growth consensus estimate of 16% provides a PEG ratio of 1.3.
Still, Guitar Center doesn't compare well with Steinway Musical Instruments (NYSE:LVB). Steinway trades at just 10 times the consensus estimate for 2008, versus expected growth of 18% that year. However, this is based on just one analyst's view. Specialty-store rival Office Depot (NYSE:ODP) carries a PEG of 0.8, using the same periods we applied for Guitar Center, and Coldwater Creek (NASDAQ:CWTR) has a PEG of 1.08. So, compared with some specialty retail peers now, Guitar Center isn't cheap.
Still, the risk is bearable, with the worst-case scenario being that the deal is called off. So, if the deal is completed in Q4, investors would receive a roughly 17% return from $54 a share. If it falls through, they would be stuck with a stock valued modestly to its intrinsic growth, assuming those growth assumptions hold. In my view, Guitar Center likely will improve the margin situation in its direct response and music and arts groups. Also, I expect that sales from its school-focused segment are somewhat insulated from consumer softness.
The company believes more than half of its clients are professional or aspiring musicians. Aren't musicians and artists typically poor anyway? So, we have to wonder how much worse it can get for them if the economy softens. (I'm exaggerating!) Sure, Guitar Center stands to lose those bonus keyboard sales around holiday season, but I still like the wager. Worst case, you inherit a company that competes as the leader in a fragmented market. So, even if we sing the blues, the sound might be sweet.
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Fool contributor Markos Kaminis has no ownership interest in any of the companies discussed here, and don't tell anyone that he played violin and sang in the choir in his youth. Markos also writes for his own blog, Wall Street Greek. The Fool has a disclosure policy.
