Description

SHORT INVESTMENT THESIS. I originally wrote this investment thesis on GTRC last fall and have updated it quarterly. The stock recently hit a 52 week high with the annual report/10K financials released. I will post an update on these in short order, but I expect more of the same. GTRC should be a single digit stock with over 50% downside.

Description:
Retailer of guitars, amplifiers, percussion instruments, keyboards, and pro audio and recording equipment. Operates 93 Guitar Center stories in 38 major markets and 10 stores in secondary markets across the country. Also, operates 19 American Music stores specializing in band instruments for sale and rental, serving thousands of teachers, band leaders and students. Through its wholly-owned subsidiary, Musician’s Friend, is the largest direct response retailer of musical instruments.

Competition -- Sam Ash (12 markets) and MARS (19 markets). Competitors have slowed expansion, with MARS closing several stores. Top five retailers (including GTRC, Sam Ash and MARS) only account for an estimated 23% of the market in 2000 compared to an estimated 60% market share held by the top ten specialty retailers in the consumer electronics, home improvement and toy industries.

Investment Thesis:
o Declining Margins: Double-digit revenue growth with negative earnings growth
o Declining Same-Store Sales Growth
o Negative Free Cash Flow
o Working Capital Issues
o Heavily Leveraged: Net Debt has increased, zero growth and significant CapEx ahead
o Heavy Insider Selling
o Overvalued

Declining Margins:
While GTRC has grown the top-ling in excess of 17% YoY over the last 5 quarters, expenses have grown even faster, resulting in earnings growth that have been declining or remained flat.

The disparity would have been even more pronounced as GTRC receives an annual earnings boost of ~$1mm ($0.05 EPS) in 2002 with amortization going away.

6/30/02 3/31/02 12/31/01 9/30/01 6/30/01
Revenue Growth - YoY (%) 17.8% 17.9% 20.7% 19.2% 20.7%
Earning Growth - YoY (%) -0.4% -30.8% 1.0% -67.9% 1.4%

YoY margin erosion is significant in an already razon-thin margin industry.
6/30/02 6/30/01 3/31/02 3/31/01 12/31/01 12/31/00 9/30/01 9/30/00
Gross Margin 25.7% 26.0% 25.2% 25.4% 27.1% 27.2% 25.3% 25.2%
Oper. Margin 3.8% 4.6% 3.4% 5.1% 6.8% 7.9% 2.5% 5.3%
Net Margin 1.6% 1.9% 1.3% 2.3% 3.5% 4.2% 0.6% 2.2%


Declining Same-Store Sales Growth:
From 1999 thru 2001, GTRC comparable sales growth dropped from 10% to 6%. GTRC has experienced declining annual and quarterly YoY same-stores sales growth for just about every year, except the most recent quarter. The reversal of this trend in Q2 2002 was as a result of heavy advertising and the closure of 11 Mars Music stores in markets that GTRC competed in. Management itself expects long-term comparable sales of 4-6%, and 5-7% for the rest of 2002.

Guitar Center Comparable Sales Growth (stores open <14 months):
2002 2001 2000 1999
Quarter 1 5 % 7 % 8 % 10 %
Quarter 2 8 % 5 % 7 % 7 %
Quarter 3 3 % 6 % 11 %
Quarter 4 6 % 7 % 11 %
Full Year 6 % 7 % 10 %

2001 2000
Number of stores operated for the full year 83 69
Average net sales per square foot $ 537 $ 535
Average net sales per store 8,657,000 8,720,000
Average store-level operating income (1) 871,000 945,000
Average store-level operating income margin (1) 10.1 % 10.8 %
(1)Store-level operating income includes individual store revenue and expenses plus allocated rebates, cash discounts and purchasing department salaries (based upon individual store sales).


Negative Free Cash Flow:
GTRC has had negative free cash flow for every quarter over the past 10 quarters, except for the Christmas season (Merry Xmas). Again, the company has been financing its growth (read “no growth”) through its debt facilities. GTRC continues to forge ahead on its aggressive growth and acquisition strategy, but does not have enough cash ($4.8mm) or revolver ($20.2mm) to support its planned CapEx next year.

2002:Q2 2002:Q1 2001:Q4 2001:Q3 2001:Q2 2001:Q1 2000:Q4 2000:Q3 2000:Q2 2000:Q1
Free Cash Flow $ (7.8) $ (34.0) $ 29.0 $ (10.1) $ (33.6) $ (22.0) $ 20.8 $ (0.9) $ (3.2) $ (3.5)


Working Capital:
Inventories are ballooning, Accounts receivable are generally up as are accounts payable. To its credit, GTRC is building a centralized distribution center for better inventory controls and management. Translation: Additional CapEx with rewards far in the future.

Also, the cash conversion cycle is up in every quarter from the previous period – it is taking longer for GTRC to collect the cash after purchasing inventory, etc.

6/30/02 6/30/01 3/31/02 3/31/01 12/31/01 12/31/00 9/30/01 9/30/00
Accounts Payable $ 68.39 $ 68.91 $ 72.58 $ 62.35 $ 78.29 $ 72.30 $ 80.21 $ 60.72
Accounts Receivable 19.18 18.01 21.51 18.14 19.24 20.49 22.82 15.71
Inventory 271.43 234.97 261.07 206.57 249.69 199.29 252.12 192.66

A/P Growth - YoY (%) -0.8% 16.4% 8.3% 32.1%
A/R Growth - YoY (%) 6.5% 18.6% -6.1% 45.3%
Inv. Growth - YoY (%) 15.5% 26.4% 25.3% 30.9%

DPO 33 39 35 35 34 38 43 39
DSO 7 8 8 8 6 8 9 8
DSI 131 134 125 117 108 104 135 123
Cash Conv. Cycle 105 103 98 89 80 74 101 92
Difference +3 +9 +6 +10


Highly Leveraged:
GTRC has pursued an aggressive acquisition strategy over the past year, utilizing bank debt and credit facilities to finance this “growth”. Total debt grew to $171.9mm in the June quarter, representing 56.3% D/TC ratio, compared to $146.2mm or 55.9% D/TC -- significant leverage to generate flat earnings.

GTRC also has ~$20-25mm in annual operating lease commitments and only $20.2mm available under their revolver, as of 6/30/02. Over the coming quarters, GTRC plans to continue making acquisitions as part of their growth strategy and plans to incur the following capital expenditures over the next 12 months (~$20-22mm):

Capital Expenditures:
Rest of 2002:
-- Centralized retail distribution center for the Guitar Center stores
-- Expansion of the Musician's Friend fulfillment center
-- Implementation of new IT systems at American Music
-- 1 small format store/5 Guitar Center stores
-- 2 American Music stores

2003:
-- Open 18-22 new Guitar Center stores
-- Open 14-16 new American Music stores (7 new/7 acqs.)

With all of these capital expenditures on the horizon AND GTRC not generating significant free cash, GTRC must draw down their remaining revolver and/or issue more equity and debt. At 56% Debt/Total Capital, further leverage will be unwieldy. If the market will bear it, new equity securities will put downward pressure on the stock. Either way, the share price drops.

Heavy Insider Selling:
Year to date, insiders have been dumping the stock aggressively – selling over 3mm shares (~15% of insider shares). JP Morgan, for example, has sold appromixately 2.2mm shares thus far this year.

Rich Valuation:
At $21.55, GTRC trades at 20.7x ’02 P/E and 17.1x projected P/E (if you believe the “E”). GTRC is heavily leveraged, not growing earnings and operates in a razor-thin margin retailing business – its multiple is undeserved.

o Lower Interest Rates: GTRC benefited from lower interest expense from renegotiatin their revolver – annualized savings of $1-1.2mm ($0.05-0.06 EPS).
o No Amortization Expense: With amortization going away, GTRC receives an annual earnings boost of ~$1mm ($0.05 EPS) in 2002 with amortization going away.

Q3 UPDATE:

· According to published reports, Mars Music, Inc. filed for Chapter 11 protection with the U.S. Bankruptcy Court in Ft. Lauderdale, Florida. The Company stated that it has already secured $60 million in debtor-in-possession financing needed to continue operating under Chapter 11 protection.
· Inventory up 6.5 days. Blaming it on west coast port. Blamed $5-7mm on "pro-active" management of port issue. Cost containment included a "Push off of advertising."
· Payables were down. Inventories up. DSI up from 97.6 to 104 days q/q.
· Expecting 8-9% yr/yr square footage growth. New stores add 350 per square foot.
· New Distribution Center:
· FASB 142: $820k for the year in 2001.
· FCF: CFFO $24mm in trailing 12 months. -$53mm for working cap. -$18mm for capex.TTM FCF -$50mm estimated.
· Mars closures: getting sales increases of 1.5-2% increases due to closures.
· Mars had 30-35k square foot stores.
· Debt up $14mm.
· SSS up 6% at GTRC and 5% at all formats. 52% of sales increase was from new stores.

Other Q3/Q4 musings:
· Goldman Sachs raised its Guitar Center rating from "market outperformer" to "recommended list."
· Projects GTRC will have 10% Oper. Mgns –GTRC hasn’t had ever had 10% margins.
· Goldman Sachs is their banker.
· GTRC running national ad campaign offering no payments until 2004 – for purchases over $299.
· A/R inflated; future sales cannibalized – GTRC still needs cash. A secondary is in the offing, if the market can bear it.

March 2003:
- Insider selling continues. Every single insider. Massive. Seems to be the only headline.
- Board member resigns.
- SSS up 7%. Some help from MARS closings.
- $459mm market cap. 100 stores. $4.5mm per store...seems pricey.
Short interst is huge: 3.1mm shares
- Total sales up 16%; inventories up 21%, store count +22%.
- Debt $148mm.
- Accrued expenses rose steeply, up $22mm.
- Paid $446k for a store in NC. Acquired 5 stores from M&M for $6mm ($1.2mm/store). Right now, GTRC has an EV of $600mm or $5.5mm a store. At least 5x private market. A mall based retailer genrally costs about $250-500k to open.

Catalyst

Reasons stated above. As with all shorts, patience is key. With GTRC it is not a matter of if, but when. The stock should trade in the single digits. If it cannot support its debt load, GTRC will be a Ch. 11 and follow the fate of many in this industry.