Special Situation Investing

Wednesday, November 22, 2006

Guitar Center Inc (GTRC) - Growth at a Reasonable Price

First off, let me say that while this is a stock idea, it is not a special situation by any means.

The Company

Guitar Center Inc (GTRC) is a retailer in the music equipment industry. The company operates 3 different store types (2 tradional and 2 online) which taken together pretty much run the full gamut of different musical equipment. Guitars, drums, band, DJ mixing, lessons, used goods, they got it. Even more critical, many of these products are not heavily retailed by the big box behemoths. GTRC is in somewhat of a niche and fragmented market albeit with a relatively small moat.

The company currently operates 194 'Guitar Center' stores in 40 states, ~90 music and arts locations as well as 2 online retail sites. The company still has room for continued expansion in the US and the international market has not been touched. In addition they can segway into new musical segments, as they did by purchasing the Music & Arts division which is in the band instrument and education segment. Management is forecasting long-term revenue growth of 13-15% and earnings growth of 18-20%. While these number are no doubt optimistic, the company has a history of consistent growth going back to their IPO in 1997. Revenue growth over the last few years was ~17% before slowing to ~12% in the most recent quarter.


As of the third quarter report, GTRC has net tangible assets of $464 M or $15.51 per share against a share price of $43.35. The company recently paid off $100 million in debt, leaving no long-term debt oustanding. However, be warned that the majority of their tangible assets are in the form of inventory. In the rare event of bankruptcy I would not expect the liquidation value to be anywhere near the current tangible book level.

Based on the lower end of their forecasts, net income for the year should run around $2.50+, fully diluted. That is the main sore point for the company and the reason the share price is at $43 instead of it's 52-week high of $57. Earnings were hit by the inclusion of stock-based compensation expenses, increased ad and promptional expenses as well as additional overhead as the company expands into new markets. In general, earnings levels are my biggest concern with the company. Currently they are averaging around 4% of revenue and while this is an improvement over the high 2%'s they were getting in years past it is still quite low. Even bulk-retailer Walmart sports higher net margins at 5.8%. By buying this stock you are effectively betting that as the company continues to grow, the scale effect and cost savings will enable it to expand margins. That is what management is forecasting, as mentioned previously, when they peg earnings growth 6% higher than revenue growth.

While the net earnings are nothing to get excited about, ROE came in at 15.8%. While the company doesn't earn great profits based on it's sales, it does generate large earnings relative to the capital required to do so. What this means is that the company doesn't require a lot of equity to grow and hence going forward shouldn't require taking on debt or issuing new shares.

A Few More Things

The balance sheet was one of the first things which caught my eye on GTRC. The lack of long-term debt says alot about the type of management running the firm. Clearly, with nearly $2 billion in sales they could borrow more and expand faster but they have avoided that urge. This type of disciplined approach is something I look for in companies as it leaves room for future contingencies. My opinion was further strengthened by the reasonable, steady rate that the stock has grown at over the past 9 years.

One of the issues that I had with this stock was 'what is going to happen to it if there's a recession'? Isn't the consumer about to die after all? Well it's certainly possible but the company handled the 2001-2002 recession admirably. In fact looking at the numbers you wouldn't even have been aware that there was a downturn. Have a look at the company's revenue since it's IPO (this type of consistency is somewhat rare and usually deserves a premium price):

2005 - $ 1,782,499
2004 - $ 1,513,172
2003 - $ 1,275,059
2002 - $ 1,100,889
2001 - $ 949,284
2000 - $ 794,786
1999 - $ 620,081
1998 - $ 487,714
1997 - $ 367,353


My primary motivation for purchasing GTRC is that is is reasonably priced, has proven it's ability to grow, is in a niche and seems well managed. The biggest risk, in my opinion, is the company's ability to manage expenses and widen profit margins.

I am not banking on quickly doubling my money or seeing any type of event which will spike the stock higher. Not that those type of events couldn't happen, they certainly could, but this is a longer-term investment based on fundamentals. I simply feel that at current prices, GTRC is a stock which will continue to grow and will beat the market over the next 4-6 years.


I purchased shares in GTRC today at a price of $43.65.

Do your own research on this and all stocks mentioned on this blog.


  • As a professional in the music/recording industry, who deals with clients doing new expansions to their home and commercial studios everyday, I can say that Guitar Center is one of, if not the biggest retail outlet that these professional and would-be professional turn to. They carry everything that my clients needs, so it truly is a one-stop shop. I think I might put a move on a few shares myself!.. also, they're really good people and everyone I've interacted with who works there is a knowledgable professional...

    By Anonymous Anonymous, at 12:13 PM  

  • That is good to hear. I don't have a GTRC outlet in my hometown so I don't have any interaction with them. I am violating Peter Lynch's cardinal rule, invest in what you know. It's useful to get some feedback from actual customers.

    By Blogger spinoff, at 10:29 AM  

  • They had no computers system in Minneapolis on black Friday. I was told the whole mid-west had no computers. It was chaos in the store. They had to write the sales down on paper receipt books. I can't imagine they could keep track of things very well that way. The sales process took forever.

    By Anonymous Anonymous, at 6:31 PM  

  • Operating cash flow has been on a downward spiral. 05 was lower than 04, and the coming year appears to be lower still. Does this not worry you?

    By Blogger vinominer, at 7:39 AM  

  • I buy companies that have things wrong with them. That's my style. You want to buy a company that's sailing great and pay 30-40 earnings, go ahead.

    By Blogger spinoff, at 4:02 PM  

  • I agree that valuations based on PE, FCF, and an improving balance sheet are important; but, I think there are enough opportunities for solid companies with PEs under 16. For example, I purchased Hurco about a month ago after it was taken down because of an unfavorable comparison caused by a non-fundamental tax issue. It is up quite a lot lately but still IMO not terribly overvalued.

    By Blogger vinominer, at 5:32 PM  

  • Well I won't disagree with you there. I am always on the hunt for a stock pulling back on a non-fundamental issue. In GTRC case, it is more of a growth story where you aren't paying up. Their margins may suffer in the short-term but barring catastrophe, the company seems poised to continue to grow. Ultimately, the profits will come.

    By Blogger spinoff, at 8:47 PM  

  • sounds good to me


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