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Guitar Center vs. the Internet

Look past the surface of this retailer; it's not as attractive as the bulls think.

This column was originally published on RealMoney on Oct. 9 at 10:33 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Last week, after musical-instrument retailer

Guitar Center

(GTRC)

preannounced weaker-than-expected third-quarter numbers, I said I would

take a look at the stock.

On the surface, Guitar Center has quite a bit going for it: huge market share in a highly fragmented market, significant negotiating leverage with vendors, and the possibility of a takeover, potentially in the form of a leveraged buyout.

At the same time, Wall Street remains very bullish on Guitar Center despite its recent stumblings. Seven analysts rate it a buy and one rates it a hold, with an average target price of $54. Nobody has been screaming "Sell!" except for the shorts, who account for about 14% of the float, according to Capital IQ.

However, Guitar Center has several things working against it, one of the biggest being the rise of the Internet as an instrument distribution channel. Guitar Center faces enormous competition online from sites like zzounds.com and the online operations of rival retailers like Sam Ash, which creates enormous price competition, forcing sellers to offer expensive perks such as free shipping -- not a good thing when quite a bit of this stuff is really heavy.

In addition, many investors seem to think that consumers would be hesitant to order expensive instruments online, given the importance of feeling an instrument in your hands. Nothing could be further from the truth. Just look at

eBay

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, which is creating huge competition for the likes of Guitar Center, serving as an effective sales channel for both individuals and mom-and-pop music stores. eBay sellers aren't exactly the most trusted of merchants, but that hasn't stopped the buyers. Searching for popular high-priced instruments (for fellow guitar nerds who want to play along at home, I searched for Fender Custom Shop, Gibson Les Paul Reissue and PRS Custom), I found plenty of buyers willing to fork up big bucks for expensive guitars, sight unseen. That's not a good thing for brick-and-mortar.

Now, Guitar Center itself is doing OK moving high-priced goods online. On GuitarCenter.com, four of the top 10 selling electric guitars are more than $1,000, with the third most popular costing $2,300. It may seem like a good thing that such expensive items can effectively be sold online, but it is actually a substantial negative because of the free shipping offers, which heavily weigh on margins. What is the point of being able to sell all this expensive stuff online if the margins get squeezed?

In the interest of brevity, I won't get into the company's problems exploiting the boom in high-end guitars, the general downtrend in guitar sales and its weak appeal to big-spending baby boomers, so I'll wrap this up.

From a financial standpoint, Guitar Center isn't very attractive, either. The company has a weak balance sheet, with just $11 million in cash, $100 million in debt and $88 million borrowed under a credit facility. Cash flow has been fairly weak as well, with just $39 million in operating cash flow over the last 12 months and capital expenditures of $76 million over the same time period.

From a fundamental standpoint, it appears that the major bull case for Guitar Center is a takeover bid. Given an uneven environment for retail in general, investors are better off seeking out retail stocks with healthy balance sheets and/or robust product cycles. Guitar Center just doesn't fit that bill.

In keeping with TSC's editorial policy, Michael Comeau doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Comeau is a research analyst at TheStreet.com. In this role he performs stock analysis for

TheStreet.com Breakout Stocks

, and is also a regular contributor to RealMoney.com. Prior to his arrival at TSC in June 2004, Comeau worked as a Consultant to Toyota Motor North America, performing in-depth research on automotive industry issues, primarily in the areas of alternative engine technologies, competitive analysis and macroeconomics. His primary market interests include consumer technology, specialty retail, and small-caps. Comeau received a bachelor's degree in Finance from Brooklyn College, and has completed Level 1 of the CFA program.. He appreciates your feedback;

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