Sweet Blues at Guitar Center

With heightened concern that deal funding may be repriced or go away, shareholders and prospective investors are wondering, where does GTRC stand with its suitor?

(Stocks in article: NASDAQ: GTRC, NYSE: LVB, NYSE: ODP, NASDAQ: CWTR, NYSE: BX, NASDAQ: LEND)

Guitar Center (NASDAQ: GTRC) is the premier music store in America, based on sales of guitars, and other musical instruments and pro-audio and recording equipment. And, boy do they have some really neat stuff in their Hollywood store! As an analyst, I got to tour the Sunset Boulevard flagship location, and saw some really cool things in the secret back room, including Elvis’ blue suede shoes, the original Woodstock sign and a bunch of Kiss memorabilia.

GTRC shares are currently trading at a level that presents 7.2% (17% when first authored for Motley Fool) potential gain to the $63 price the company agreed to sell to Bain Capital Partners, LLC. Yes, that’s the firm that Mitt Romney once headed up. The price variance is abnormally high, with the deal expected to close in the fourth quarter. Guitar Center is one of many companies whose shares trade well off of their deal price now. This is thanks to the market’s intensified concern that the repricing of debt and risk could cause many private equity buyers like the Blackstone Group (NYSE: BX) and Bain to back away. Look at poor Accredited Home Lenders (NASDAQ: LEND) for instance. The company is suing Lone Star Fund V LP to try to make it to stick to its agreement. The private equity player just extended the time period for its tender to August 28th in order to appease LEND, and maybe move forward if normalcy were restored to credit markets.

For this reason, hedge funds that are focused on merger arbitrage could potentially see one of their best years in recent history, as long as their capital sticks and deals don’t fall through. You see, merger-arb funds make their money by owning the shares of firms that have agreed to be acquired. The funds typically leverage up in order to improve the return on the usually small but reliable difference in price. You see, the shares of soon to be acquired firms normally trade at just a slight discount to the deal price. That discount exists only because of the time to consummation and perceived risk of it falling though. That increased risk has now enhanced appreciation potential for merger-arb players.

The merger arbitrage funds had a poor month in July, dropping 2.04% according to Hedge Fund Research, as spreads widened on deals they were already participating in. Still, we suspect that if their capital sticks, these funds will double down and benefit in the long run. We called a merger-arb manager in order to get a grip on what the difference really is in today’s market versus normal, and to see what he thought about the GTRC contract. These guys are usually tuned into what’s going on, however, he never got back to us. We called Guitar Center also, but we didn’t expect anything less than positive feedback from them. Even so, they didn’t return our call either.

So, what if the deal does fall through?
Well then, GTRC will have to be valued as it was before the announcement. On the day before, the shares traded at roughly $50, that’s 15% (9.1% when first authored) below current value. And one has to wonder if the rocking management team relaxed a little bit after signing the big deal, sort of like a superstar baseball free agent does after he signs a multi-million dollar contract. We say this because GTRC’s second quarter results were just plain out of tune, in the Greek’s view.

Excluding the $0.06 it took in takeover related charges, the company earned $0.37 a share, two cents below consensus expectations, as compiled by Thomson Financial. Ouch! That was 21% below last year’s result. We know retailers are starting to see some consumer softening, but this seems excessive. Net sales were not too shabby though, but still missed company expectations while climbing 13.3%. The company said retail softness and macroeconomic trends played a role, impacting both the company’s flagship branded stores and its direct response unit.

The Guitar Center segment saw revenue grow 9%, but it all came from new stores since same-store sales slipped 0.1%. That’s never good… Musician’s Friend, GTRC’s direct response segment, grew revenues 28%, but management said some 91.5% of that growth was due to the acquisition of Woodwind & Brasswind, which it bought in February. Finally, Music & Arts, GTRC’s segment that focuses on the sale and rental of instruments to the school band, orchestra and lesson market, rose 16.9%.

The big problem was that the acquired business impacted margins, as gross margin in the direct response segment narrowed by 140 basis points. Excluding the acquisition, the margin would have widened by 180 points.

The important question here is what’s GTRC worth if the deal falls through. Well, earnings estimates came down after the report, with consensus expectations for 2007 and 2008 now at $2.55 and $3.17, respectively, according to Thomson Financial. At roughly 18.5X (17X a week ago) 2008’s forecast, the shares trade at a discount to the 24% growth analysts foresee next year. Heck, even at 23X (21X) 2007’s number, the shares compare well to near-term growth forecasts. We analytical types usually compare the P/E to long-term growth expectations though, and applying a five-year growth consensus estimate of 16% provides a PEG ratio of 1.4 (1.3 last week).

GTRC does not compare well to music industry peer, Steinway Musical Instruments (NYSE: LVB). LVB trades at just 10.6X the consensus estimate for ’08, versus an 18% growth expectation that year. However, this is based on just one analyst’s view. Specialty store rival Office Depot (NYSE: ODP) carries a PEG of 0.9 using the same periods we applied for GTRC, and Coldwater Creek (NASDAQ: CWTR) has a PEG of 0.9 (1.08 last week). So, compared to some specialty retail peers now, GTRC isn’t cheap.

Still, we view the risk bearable, with the worst-case scenario being that the deal is called off. So, if the deal is consummated in Q4, investors receive a roughly 7% return (17% last week) from $58.75 ($54 last week) a share. If it falls through, you’re stuck with a stock valued somewhat modestly to its intrinsic growth, assuming those growth assumptions hold. In our view, GTRC will likely improve the margin situation in its direct response group. Also, we expect that sales from its school focused segment are somewhat insulated from consumer softness.

The company believes more than half of its clientele are professional or aspiring musicians. Aren’t musicians and artist typically poor anyway? So, we have to wonder how much worse it can get for them if the economy softens. I’m exaggerating! Sure, GTRC stands to lose those bonus keyboard sales around holiday season, but we still like the gamble. Worst case, you inherit a company that competes as the leader in a fragmented market. So, even if we sing the blues, the sound might be sweet.

This article was initially published at Motley Fool. Wall Street Greek has the exclusive right to republish this article. Receive Wall Street Greek FREE via email by subscribing here. (disclosure)