Shares of Guitar Center
Being short the stock, my perspective is that woefully little attention was given to the company's declining returns on capital, rapidly increasing debt, or bloated inventory situation. Nor was there discussion of the company's aggressive promotional tactics, including a current offer of no payments until 2004 for purchases over $299. All the signs point to a company that's trying to juice sales at all costs.
But let's not waste too much time with such trivialities as the balance sheet, when there's so much good news to share about next year's income statement. On the call, management pulled back the curtain on its 2003 forecast and wowed analysts with mid-range estimated revenue of $1.26 billion and estimated earnings of $1.25 to $1.35 per share. That would represent revenue growth of about 15% and earnings growth of around 25%.
This higher forecast is premised upon a boost in both gross and operating margins, which would mark a noteworthy departure from the company's multi-year trend of declining margins. Specifically, Guitar Center is calling for gross margins of 26.2% to 26.5% and operating margins of 4.9% to 5.2%, representing an increase of 35 to 45 basis points (0.35% to 0.45%) over that achieved for the trailing 12 months.
Next year's forecast is also based on a plan to roll out 16 to 19 new Guitar Center stores. That's up from an estimated 11 stores added in 2002. The problem with this continued rapid store expansion is that with each new store, returns on capital are declining. Each store requires a massive investment of inventory, which is then turned over very slowly. Guitar Center's inventory turnover ratio of 2.9 is pitifully low compared to a well-run big-box retailer, such as Best Buy
Management isn't oblivious to its inventory problem. The company recently completed a new centralized distribution center, which it hopes will improve its inventory efficiency. Management touts the new distribution center and "reduced freight costs" as the cure for all its ills. I don't buy it (and neither do the Rule Breaker managers). Fools should watch the company's inventory situation closely because, if inventory continues to grow faster than sales (as it has for five out of the past six quarters), it could spell trouble.
Debt (which is becoming quite high, at 1.3 times equity) is funding the inventory growth. Also, if inventory remains excessive, it could force the company to discount its merchandise in order to move inventory out the door. Such discounting could spoil the company's hopes of higher gross margins, which are essential to meeting its earnings guidance.