YOUR HOMEWORK: GUITAR CENTER (GTRC)... & WHEN TO STRETCH THE PE
Jonathan from Fayetville had a few questions about Guitar Center, sent in 2 separate emails. Here's our correspondence in order:
EMAIL #1:
Hi Phil!
I have finished reading the book, have tons of notes, and have started researching businesses. I have rolled my unmatched, POS, 401k into a traditional IRA with ETrade and will have about 7 grand to get started with. I really like your advice about starting with 1 grand even if you have more to get the hang of it... espicially the emotional aspects of investing. Great advice!
So finally here's the question. I am interested in a company called Guitar Center. It's the biggest music store in the country and maybe even the world. It is so attractive because of its moat.
There is no competition. The only competition is a catalog called musicians friend, which they bought in 1999. The only thing close to comp for them is Sam Ash. They have 61 retail outlets to guitar center's 160!
The meaning is very much there for me. And the CEO [Management] started as a salesman in 1979 and worked his way to the very top.
The numbers are mostly there with the free cash flow reflecting the addition of stores thats been booming since 2000.
The growth numbers are high but have a slight down trend. 34 to 28, 25 to 18, 26 to 17... sort of thing.
Some of the insiders started selling in march for $51 a share, it's trading at $44 a share now, and I figured the sticker to be $71. So it looks like a few months from now it might be at the right price to get in. I guess!
My question is this, even though the numbers pass the test does it look to you like the company is headed for big trouble or is this just how things look while the price creeps down to what we are waiting for? Also, I have had a hard time finding "letters" from the execs. In the book you talk about the importance of the "vibe" of these letters. Any extra tips on finding these?
Ok... I'll leave it at that for now...
Jonathan
MY RESPONSE:
Hi Jonathan,
Guitar Center looks pretty damn awesome to me. The numbers are quite good with the exception of Free Cash Flow which you need to find out about.
Here's the link to the investor relations info where the annual reports are.
If you go to their website, scroll to the bottom and you'll see investor relations. Then click on financial information. Then read five years of CEO letters.
Tell me more!
Now go play!
Phil
EMAIL #2:
I need help with the PE of Guitar Center (GTCR). The big 5 all look strong with the exception of cash flow. I went through the annual report and used their numbers minus capital expendatures and the cash flow seems to be strong based on those.
Intangibles don't seem to be to high either. I hope I did that right.
While in there I looked at the stock options for the execs and they seem to be performance based over a number of years instead of short term goals, I think this means they get more money for long term growth. The Chairman/CEO of Guitar Center worked his way up from salesman in 1979. He was very involved in growing the business from one Hollywood store to the 161 store industry leader they are today.
The CEO of Musicians Friend, a direct retailer they bought in 1999 that accounts for about 30% of their total business, founded that company over 20 years ago with his brother and is still there running it. Everything is great until I try to get the right MOS price. The historical growth of 20% lines up perfectly with the pros predections for the future but their PE is far lower than the historical. Looking over the PE history...
20
18
17
15
21
11
21
17
49I came up with a PE of 20. And got a MOS price of $40. Its trading now at $44. But on the earnings growth est page they are giving it a PE of 15 in 06. Should I take that into more consideration and lower my PE? Doing that I came up with MOS prices around $30 - $35.
The moat for this business is very strong. Guitar Center is a combination of the 2 largest musical inst retailers. They have embraced the realities of online shopping and have recently this year added a huge new distribution center in Kansas City. The other one was in california. So now they have faster shipping services to the entire nation and 70% more floor space to have products on hand to move out the door today. What PE would you use?
Jonathan
MY RESPONSE:
Good question about what PE to use for Guitar Center. By the way, I never heard of these guys until you posted, but I was curious and looked them over and think this is a very remarkable business that might have real long legs on it. Nice call so far.
The business has a lot of meaning to you, obviously. The management is deeply committed and not ripping off the business.
You asked earlier about how to find out if they are willing to tell investors what we need to hear. I looked up their annual reports and was favorably impressed. Not wow-ed by any means at their candidness, but at least they were willing to raise issues. I'd like to see them be even more candid in the future, but all in all I liked the tone. I think these guys are into it. They seem to share a Big Audacious Goal of being THE supplier to the muscians of the world. Gotta like that. And they do have a big brand Moat that's backed up nicely by some very decent Big Five numbers for many years.
So what's the MOS? And that depends on the PE we give it.
Obviously if the historical average PE is higher than our 2X the estimated growth rate (of 20% in this case) then there is no issue. We would use 40 in this case. But it isn't. The average historically is hovering around 20 or so. So we use that and get a Sticker of $80 and from that, the $40 MOS you got. With a current market price of $44, this is in the ball park of buyable -- so we'll wait for the big guys to move on it and jump in there.
But let me add another reason for being so confident about the Sticker Price: You can look on Investools under Phase 2 and click on Performance and you get a 5 year PE ratio high and low year by year.
At MSN Money you can do sort of the same thing by going to Financial Results, Key Ratios, then click on Price Ratios. MSN gives you just the high PE and the low PE for five years.
Not nearly so informative because, again, you can't see if these ratios were consistent year over year. In other words, if the PE ratio every single year is always ranging between say 11 and 24, then we know that we are likely to be able in the future to use a PE ratio at the higher end of the scale for our valuation.
I didn't go into this in the book since it's safer to just use the average. But Guitar Center has one of those consistent PEs: they range every year from 11 to 24. So by using 20 (the month by month average over the last five years) we're well within the ball park of PE's that we can expect in the future.
If I wanted to use 24 for the PE (on a business that could see a PE at 40) I'm not stretching the envelope too much. Obviously that creates a higher Sticker and thereby a higher MOS.
The real advantage of knowing you can stretch this PE thing a bit on occasion (for businesses like GTRC) comes when the price gets up toward the Sticker. Then it's nice to know that there is some room up there that we can let the price balloon toward without getting out.
Now go play!
