Music muted at guitar center: disappointing sales could linger in 2007.

What is taking the wind out of Guitar Center's instrument sales?

After several exceptionally strong years, sales have slowed considerably at Guitar Center Inc., dampening initial earnings expectations for the year.

Officials at the Westlake Village-based retailer several weeks ago warned that net income for the fourth quarter, which will be announced on Feb. 8, will fall below expectations and many analysts adjusted their earnings guidance accordingly.

Guitar Center has continued to reap pretty hefty sales increases overall, but its same store sales, the generally accepted measure of sales strength, rose a meager 1.3 percent in the fourth quarter, well below the average same store sales increases reported by most other retailers.

"I think it's a combination of a few factors, a more difficult overall retailing environment, a slowdown in industry sales, especially guitars and tough comparisons with last year," said Richard Nelson, managing director of Stephens Inc., an investment banking firm that holds a position with Guitar Center.

Indeed, to some extent, Guitar Center is a victim of its own growth and recent successes.

The retailer posted year-over-year sales increases of 18.7 percent in 2004 and 17.8 percent in 2005, and earnings in those periods rose 69.8 percent and 23.3 percent respectively.

The company opened 14 Guitar Center stores in 2004 and 25 stores in 2005 and added a whopping 62 Music & Arts division outlets in 2005.

But there is also some evidence that, with discretionary spending overall slowing, the guitars and other musical instruments that Guitar Center sells are falling lower on the list of priorities for shoppers.

"I think the overwhelming majority of this is just the fact that consumer spending in general is slowing," said Michael Souers, an equity analyst with Standard & Poors, which has no affiliation or ownership position with the company. "I think especially this year with money that was spent on consumer electronics and flat screen TVs, maybe some of that money has been diverted."

Guitar Center, which operates Guitar Center stores, Music & Arts Center stores and Musician's Friend, a direct response unit, earlier this month reported that its sales rose 11.7 percent to $628.5 million in the fourth quarter of 2006, from $562.8 million in the fourth quarter of 2005, and its sales for the full year rose 13.9 percent to $2 billion from $1.8 billion in 2005.

Same store Guitar Center sales rose 13 percent to $1.5 billion, but new stores contributed 73.1 percent of that increase.

"We are disappointed that our top line results for the fourth quarter did not meet our previous expectations, primarily due to softer than anticipated sales in our Guitar Center retail and Musician's Friend divisions," said Erick Mason, executive vice president and CFO of Guitar Center in announcing the sales results.

Guitar Center officials were not available at presstime, according to the company's investor relations firm, Financial Dynamics.

The most recent sales results followed a lackluster third quarter, with Guitar Center reporting a 12.3 percent sales increase to $472.7 million, compared to $421 million in the comparable quarter of 2005.

Sales from new stores represented 78.8 percent of that increase and the company's net income decreased 21.4 percent to $11.3 million or $0.38 per share, versus $0.51 per share in the third quarter of 2005.

Guitar Center officials called the retail environment at the time, "challenging," and by the time the company announced its fourth quarter sales, they had downgraded their net income expectations, saying they expected net income for the period to fall below previous guidance, which had ranged between $34 million and $36 million or $1.14 to $1.20 per share. Analysts, meanwhile, reduced their fourth quarter earnings estimates for the company anywhere from $0.04 to $0.11.

Most also expected that the softer sales climate would continue to affect Guitar Center's performance through much of 2007.

"We are lowering our 2007 estimate by $0.20 to $2.85, reflecting a more conservative stance on both our sales and margin assumptions," said Sharon Zackfia, an analyst with William Blair & Co. in a report issued on Jan. 10. William Blair also holds a position with Guitar Center. "We continue to believe Guitar Center is likely to slow its store expansion rate from 2006's high-teens square-footage growth in 2007, likely into the low teens."

Despite the widespread disappointment with its most recent financial performance, most analysts said that Guitar Center continues to have considerable potential for future growth, a belief that seems to be reflected in its stock price, which has remained in the mid-$40 range since late August.

"We're seeing the echo baby boom generation is going to be a pretty large group population-wise for the next couple of years, so we think there are still positive demographics there," Souers said. "As for store base, they have a lot of room to grow."

The music industry is highly fragmented, and Guitar Center is one of the only retailers that has successfully engineered a national chain and brand.

As Nelson said, "They are the 800-pound gorilla in the space."

Guitar Center stores still have much room to grow in secondary and tertiary markets, Nelson said, and the Music and Arts concept is still in fledgling stages.

"There are 8,000 morn and pop family music stores out there," Nelson said. "That can grow into 400-plus stores, so there's still enormous unit growth opportunity."

BY SHELLY GARCIA

Senior Reporter