By Ryan Fuhrmann, CFA
I recently read that certain corporate CEOs have begun to blow off steam by starting bands. Perhaps they’re picking up their favorite gear at the planet’s only big-box music chain, GuitarCenter(Nasdaq: GTRC). At a recent investor conference, management suggested that the Internet is drawing in customers by making it easier for bands to record music, distribute songs, and find an audience. This trend helped Guitar Center’s online results for the most recent quarter, but will it prove enough of a boon to the company in the long term?
In second-quarter results released yesterday, Guitar Center’s impressive sales growth continued at almost 14% year over year, but net income growth was a rather measly 4%. Same-store sales grew 5.1% at the namesake Guitar Center locations, which account for nearly 75% of the company’s total sales. Nonetheless, management reduced forward guidance.
For the third quarter, management expects sales at the low end of the $489 million-$501 million range it provided in February. It also projects earnings toward the bottom of its earlier $0.43-$0.49-per-share range. Shorter-term analysts frequently worry that reduced guidance is a sign of deteriorating fundamentals, but that’s not always the case.
The company’s two smaller concepts continue to grow strongly. Musician’s Friend and Music & Arts grew sales at 10.7% and 28.9% respectively, accounting for 19% and 7% of total sales for the quarter. Musician’s Friend is the company’s catalog and Internet segment, while the recently acquired Music & Arts aims more toward school-age band geeks and “orch dorks,” as my wife and I may have been referred to back in high school.
Guitar Center has an impressive long-term track record of double-digit growth. Sales have grown almost 18% annually in the past five years, and earnings growth has averaged 21% in the same period. Guitar Center’s net income has been a good proxy for its free cash flow, except for last year — capex exceeded operating cash flow, and the company also made a sizeable acquisition. I’m interested to see whether free cash flow trends for 2006 return to historical levels.
Investors’ greatest current concern: How much growth is left in those stores? At first glance, Guitar Center’s store count of 187 (as of the end of the second quarter) sounds tiny, as does Music & Arts’ 94 stores. But to a number of more bearish investors, that number may be enough to saturate the music-supply market, when combined with local mom-and-pop stores and steady migration toward online purchases. However, management intends to more than double the number of Guitar Centers, and it believes that Music & Arts can grow four times as large — and that’s just domestically.
At about 15 times trailing earnings, Guitar Center is not overly pricey, but it still probably needs double-digit growth each year for five to 10 years to justify its current price. The Internet could help spur demand for musical equipment, but I’d still like to dig deeper into the size of the overall market and Guitar Center’s chances at grabbing a bigger piece of the pie.
Guitar Center is an interesting play on music retailing, but there are equally compelling large-cap retailers out there these days, trading at similar valuations. Investors should check out Target(NYSE: TGT), Wal-Mart(NYSE: WMT), Lowe’s(NYSE: LOW), or Best Buy(NYSE: BBY) in the big-box category. Compared to Guitar Center, they make up for their larger size and slower growth prospects with generally stable and predictable cash flows.
There’s no word, however, on how well their CEOs can sing.
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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. The Fool has an ironclad disclosure policy. Feel free to email Ryan with feedback or to discuss any companies mentioned further.