Guitar Center's Hammering Solo

News of a sluggish finale to 2006 hits a bad note with investors.

Rick Munarriz
Rick Munarriz
Oct 6, 2006 at 12:00AM

After producing more trouble than treble, music gear retailer Guitar Center (NASDAQ:GTRC) got rocked last night. Shares fell 10% in after-hours trading after the company warned that it would miss its top- and bottom-line forecasts for the recently concluded third quarter.

Guitar Center is now looking to earn between $0.36 and $0.38 a share for the period. Add back $0.06 a share in stock-based compensation expenses and kick out a $0.04 one-time real estate sale benefit, and the company will be earning no more than $0.40 a share for the period. Wall Street was expecting net income to chime in at $0.42 a share, well off the $0.51 a share that Guitar Center earned a year earlier. Margins were stung by discounting, lower sales, and high occupancy costs.

Two to four pennies can be plenty, especially since Guitar Center also came up short on top. Net sales climbed just 12% higher, to hit $473 million. The blues-strumming retailer had originally guided analysts to expect sales growth of 16% to 19%. Unfortunately, Guitar Center will also miss net sales forecasts for the current holiday-spiked quarter.

I've always had a soft spot for Guitar Center. It's not just a musician thing. I think the company has a defensible moat against more conventional competition. This isn't like the toy or DVD industries where a discount department store titan like Wal-Mart (NYSE:WMT) can wipe the floor with specialists. The market is too limited for Wal-Mart ever to dedicate serious wall space to shiny new Gibson and Fender axes.

Naturally, my thesis doesn't account for niche competitors or the more damaging possibility that musical gear in general may go out of favor. I don't think the latter is going to happen anytime soon. Sites like News Corp.'s (NYSE:NWS) MySpace and CNET's (NASDAQ:CNET) have become launching pads for local music scenes. The incentive is now greater than ever to get that garage band together.

Even though the company expressed some concern during last night's call that there has been industrywide weakness in guitar sales -- a pretty important category when your name is Guitar Center -- the company also sells a great amount of home recording gear and synthesizers. These items play well into the world of podcasts and those "clip culture" home videos that might need a little customized scoring. The gross margins there aren't as high as on the company's flagship guitars, but it's a good place to be, given our digital future.

I'm not going to give up on Guitar Center just yet. With last night's dip, we're looking at a company that has seen its shares fall by roughly 30% over the past year. Profits are going to decline marginally this year, but these are mostly margin-crunching concerns that should right themselves in 2007. As long as the economy stabilizes, there won't be a reason to discount as deeply over the next few quarters.

So it's up to you, my fellow musicians. Would your niece look good with a new guitar? Didn't you promise your nephew free guitar lessons if he raised his grades? It's time to face the music.

For more licks about Guitar Center:

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Longtime Fool contributor Rick Munarriz really did play in a band that got signed to Columbia Records, though he eventually traded that keyboard for a computer keyboard. He does not own shares in any of the companies mentioned in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.