With rumors swirling of an ownership change at debt-laden Guitar Center, all eyes will be on whether the Westlake Village-based company reversed its sagging online sales over the critical holiday season.
Guitar Center has about $1.6 billion in debt, with most of that stemming from Bain Capital’s $2.1 billion private-equity buyout of the company in 2007. In late February, the Wall Street Journal reported that Bain was in talks with Ares Management, which reportedly owns a majority of Guitar Center’s debt, to trade Ares’ notes for an equity stake.
Bain’s buyout of Guitar Center happened at the peak of the market in 2007. The company navigated the recession fairly well: In 2009, its revenues were about $2.2 billion; they rebounded after a slight dip, reaching to $2.1 billion in 2012.
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But Guitar Center’s debts weigh heavily on its balance sheet. A modest $21 million comes due in 2014 and 2015, with payments ballooning to $150 million and $983 million in 2016 and 2017.
Through it all, the company’s core business of running more than 250 Guitar Center stores has remained operationally profitable. In the third quarter, Guitar Center notched an operating loss of $358 million, which was entirely driven by a goodwill writedown of $360 million. Factoring out the goodwill impairment, the profit was still much smaller than usual, however.
“If you look at the EBITDA, with the exception of the third quarter where it tanked, they look very similar to Dick’s Sporting Goods, which people love. It’s a good model, ” said Paul Majeski, publisher of the magazine Music Trades, the biggest source of data on the musical instrument industry. “Musicians do love to go in and shop for gear. It’s not analogous to a Staples, where people are just as happy to get a ream of paper with the click of a button.”
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But a great number of musicians do buy gear online, and those sales are a big part of Guitar Center’s business. In addition to its retail stores and Guitar Center website, it owns Musician’s Friend, one of the biggest online retailers of musical equipment. In 2012, the business segment that contains Musician’s Friend was $353.5 million, or about 16.5 percent of sales.
The problem for Guitar Center is its online segment has been steadily sinking, with sales falling nearly 10 percent between 2010 and 2012. Over the same period, the company’s core Guitar Center sales rose 10 percent.
Meanwhile, at competitor Sweetwater Sound, the next-closest major online retailer, sales grew 20.5 percent to $265 million between 2011 and 2012, according to data provided to the Business Times by Music Trades.
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On top of that, Amazon.com, a major online instrument seller, was a Guitar Center customer back in 2007, using Guitar Center to fulfill orders. That relationship has ended.
But Majeski traces some of the online troubles to Bain Capital’s decision to consolidate the Musician’s Friend team in Oregon with Guitar Center’s California headquarters.
“Every one of the vendors would just talk about Musician’s Friend in glowing terms, ” Majeski said. “[Bain] got rid of the big brain trust up there. That was a devastating blow to the company because they interrupted this great team. Populating a website today and keeping it relevant on the Internet today is a huge undertaking. They broke that.”
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Guitar Center is also fighting larger trends in both the economy and the $4.8 billion musical instrument industry. Eric Garland, a future trend analyst, wrote a blog post titled “Guitar Center and the end of big box retail” in November, shortly after Standard & Poor’s cut Guitar Center’s corporate credit rating to CCC+. The post brought on a deluge of traffic to Garland’s site, some of it from angry Guitar Center executives posting comments.
But he stands by his original assessment that enacting the private-equity playbook of “pump it full of debt, show a lot of topline growth, take it back public, charge a bunch of management fees” isn’t sustainable in the age of diminished consumer spending.
“The customers are broke, ” Garland said. “There’s nobody left to buy these products. We talk about inequality like it’s a philosophical thing. It’s a practical thing.”
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But Majeski of Music Trades said that the role of consumer spending is “overblown” in the musical instrument industry. He said the bigger problem for Guitar Center is online competitors and the used gear market. Old guitars not only remain functional, they tend to increase in value after 20 or 30 years.
As recently as 15 years ago, “when you looked at new product sales, you could say that’s the market, ” Majeski said. “Now what do you do? Ebay has over a billion dollars in music products. Amazon and its affiliates are about $400 million a year. You put that together and it’s 25 percent of the business right there. That’s before you get to Craigslist. … On Craigslist alone, if you do a search, the number of items in a city could [fill] one or two music stores.”Bonds issued by Guitar Center, the biggest retailer of musical instruments in the world, are languishing at record lows on growing concern that the company is going to be overwhelmed by its roughly $1 billion of outstanding bond debt, part of a debt burden that totals about $1.6 billion, once loans and other borrowings are included.
Moody’s Investors Service earlier this month revised the outlook on its B2 rating on the retailer to negative, meaning it could downgrade that rating further into junk territory in the medium term.
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“The outlook revision considers Moody’s view that GCI, similar to other retailers, will continue to be challenged with respect to improving its consolidated revenue and earnings performance, ” said analyst Keith Foley, a senior vice president at Moody’s.
Like many retailers, Guitar Center is suffering from the competition from e-commerce—meaning juggernaut Amazon.com Inc. AMZN, -0.17% —that is weighing on business for many brick-and-mortar retailers. Guitar Center has more than 260 stores across the U.S., selling guitars, amplifiers, drums and keyboards, as well as recording, live sound, DJ and lighting equipment.
Moody’s is concerned that the company will not generate enough free cash flow in the next 12 to 18 months to reduce debt and improve leverage, which will require that its strategic moves to boost revenue and earnings succeed. The company’s lease-adjusted debt-to-EBITDA coverage for 2016 was about 6.3 times, which is just below the 7.0 times that Moody’s expects would trigger a downgrade. The rating agency is further concerned about the limited revenue visibility in the musical instrument space and the company’s “only very modest free cash flow potential, ” which makes the company vulnerable to a rise in leverage.
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The negative outlook reflects the substantial amount of Guitar Center debt coming due in Moody’s two-year rating horizon, said Foley. The company has $615 million of 6.5% notes that mature in April of 2019, which Moody’s rates at B2. Those notes traded last at 83.25 cents on the dollar, according to MarketAxess.
The company has another $325 million of 9.625% notes that mature in April of 2020, which carry a lower rating from Moody’s of Caa1, or seven notches into junk territory. Those notes last traded at 58.10 cents on the dollar, according to MarketAxess.
“From strictly a quantitative perspective, ratings could be lowered if lease-adjusted debt/EBITDA increases to at/near 7.0 times or EBIT/interest drops below 1.0 time, ” said Foley.
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Guitar Center started life in 1959 as a small appliance and home organ store in Hollywood, Calif., and became the Guitar Center in 1964, when it started selling Vox equipment made popular by The Beatles, according to its website.
By the 1980s, it began expanding to other cities after opening a flagship 18, 000-square-foot store on Sunset Boulevard. In the 1990s, the company expanded rapidly to nearly 70 stores, and launched its first branded credit card. In 2002, it opened its 100th store in Little Rock, Ark. In 2014, it opened a Manhattan flagship in New York’s Times Square.
Meanwhile, in 2007, the company was taken private by Mitt Romney’s former private-equity firm Bain Capital in an LBO valued at $2.1 billion that left it saddled with $1.6 billion of high-yield debt. Coming just ahead of the 2008 financial crisis, the company struggled with its high interest payments for several years.
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In 2014, its main creditor, private-equity firm Ares Management LLC, took a controlling stake in the company in a deal in which it converted some of its debt into equity, and left Bain as a partial owner with representation on the board.
Guitar Center is not the only LBO to leave a target company struggling with its debt. Last week, iHeartMedia Inc., the biggest operator of radio stations in the U.S. and headed by Bob Pittman of MTV fame, said it plans to include language in its next quarterly report warning investors that it may not survive another year.
That company is grappling with a $20 billion debt burden, taken on as part of a $24 billion leveraged buyout of then Clear Channel Communications Inc. by Bain Capital and Thomas H. Lee Partners in 2008.
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Also in April, retailer Neiman Marcus said it was making coming interest payments
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