I call it Mallas' Law: At some point in life, everyone wishes that he or she had either become a musician or a filmmaker. Don't believe me? Poll your friends -- see how many are either aspiring drummers or screenwriters. (Or both.) This law makes businesses like GuitarCenter (NASDAQ:GTRC) interesting long-term ideas, and today I'd like to take a closer look at the musical-instrument retailer. Does the recent boost in its share price affect its prospects as a long-term investment?
Let's jump right to the 2004 annual report, filed this past March, for some free cash flow results. (You can find the 10K SEC filing here at the company's website; just set the filter for annual filings.) The following list shows Guitar Center's free cash flow -- remember, that's net cash from operations minus property and equipment expenditures -- for the past three years:
| Year | Free Cash Flow |
|---|---|
| 2002 | -$14,061 |
| 2003 | $33,760 |
| 2004 | $59.355 |
As you can see, free cash flow rose considerably between 2002 and 2004. Don't automatically assume that 2005 will continue the upward trend, though. According to the 10-Q Guitar Center filed in August, free cash flow was actually negative for the first half of fiscal 2005 (ended June 30). Net cash from operations totaled $15.362 million, but capital expenditures were $37.829 million, creating a $22.467 million deficit in cash flow. Compare that with the first half of fiscal 2004, when capital expenditures were only $10.835 million, but net cash from operations was in the red to the tune of $6.547 million.
Yes, free cash flow for 1H 2005 is still worse than its year-ago counterpart, but there might be a silver lining. As Will Ashworth reported at the end of May, Guitar Center plans to open a bunch of stores this year. These stores aren't cheap; operational cash flow and free cash flow will likely both take a hit to fund the expansion. However, Guitar Center's growth strategy could pay off if same-store sales and overall earnings also rise as new stores open -- and the numbers look good so far.
According to the 10-Q, same-store sales grew at an average rate of 7% from 2000 through 2004. Coupled with new store openings and nice expansion in the direct response segment, that helped net sales revenues to appreciate at an annual rate of 17% in the same four-year period. Net income per diluted share was $1.09 in 2002; by 2004, it had risen to $2.29.
Those increases have continued in recent quarters. For the first six months of 2005, net income rose to $1.02 per diluted share, more than 14% higher than the first six months of 2004.
I once placed Guitar Center in a fantasy portfolio at around $36 a stub. Take a look at the following chart, and you'll see why I'm angry for not converting fantasy into stock-ownership reality.
I believe that Guitar Center is a worthy long-term growth vehicle for a portfolio, but you should definitely perform your own due diligence before buying. The company's expansion strategy could falter, and same-store sales could conceivably suffer if fewer people aspire to become musicians. The company has also cautioned that the clustering strategies it might employ could conceivably cannibalize sales of existing locations. But keeping Mallas' Law in mind, I see additional growth down the line.
For related Foolishness:
- Guitar Center Makes Beautiful Music
- Stairway to Profits
- Discuss Guitar Center with other Foolish investors.
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Fool contributor Steven Mallas owns none of the companies mentioned -- but he does have a screenplay or two lurking in his hard drive. The Fool has a disclosure policy.
