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Hedgies May Rock Guitar Center

James Altucher

I think I'm in love, and her name is Guitar Center (GTRC).

First of all, I always love people who are good at math, and Guitar Center has shown aptitude with its numbers: Revenue has climbed in stair-step fashion from $949 million in 2001 to $1.78 billion in 2005, and operating income has grown over the same period from $46.32 million to $132 million.

The company started in 1964 in Westlake, Calif., and it comprises two retail chains: Guitar Center, which has 183 stores that sell, of course, guitars, as well as percussion instruments, keyboards and recording equipment, and 90 Music & Arts Center stores, which primarily sell band and orchestral instruments to students, schools and orchestras.

In its last quarter, Guitar Center grew sales 14% annually; Music & Arts' sales rose 28%. Parents are not letting their kids buy instruments online. They have to buy the best, and they have to touch and play these instruments. In other words, Guitar Center appears to have a moat that keeps e-commerce from encroaching.

However, the company has been in the penalty box recently. It reported only 4% year-over-year net income growth in the last quarter, far below its 18% annual average over the past five years. It also guided to the low end of its $489 million to $501 million revenue range for the year and its 43 cents to 49 cents earnings-per-share range. To keep the numbers growing, management would like to double the number of stores. The question is, how many guitar stores do people really need?

In step the hedge funds. Sageview Capital just filed a 13D stating it owns 6.46% of the company. It bought shares at prices ranging from $37.28 to $40.90; currently the stock is above $44.

Sageview was started by two ex-KKR partners, so it knows a thing or two about taking companies private. While Sageview hasn't said what it wants to do with Guitar Center, it indicated in the filing that it has had discussions with management and may have more in the future.

It's pretty clear to me what Sageview wants management to do: Don't go into too much debt trying to double or even quadruple the number of stores; rather, take on debt to reduce shares, cut costs and perhaps even go private.

Why go private now? The company has a $1.5 billion enterprise value and cash flow of $180 million, so it trades at a multiple of eight over cash flows and is experiencing growth, albeit not double-digit. In other words, it could take on a lot more debt and comfortably pay it down. This is perfect for an LBO firm looking to help management take it private, even at a premium of up to $50-$55 per share.

Even if the company doesn't go private and doesn't continue to grow at a double-digit pace, it's still cheap compared with other retailers such as Target (TGT), which trades at 19 times earnings, as opposed to Guitar Center's 16, or Circuit City (CC), which trades at 26 times earnings.

The vultures are going to start circling -- I think the time to buy is now.