Stephen Nellis at the Pacific Coast Business Times wrote a nice article about why Guitar Center’s future hangs in the balance of this last Christmas’ results and the debt-for-equity play by its major creditor. It is a nice summary of what has gone on so far, with a couple of opposing perspectives from Paul Majeski, the publisher of Music Trades magazine, and myself.
Majeski thinks everything is going great, except for that little thing when they wrote down a quarter-billion of the company’s goodwill in September of last year, not to mention the practices that led the ratings agencies to make Guitar Center a junk bond.
“If you look at the EBITDA, with the exception of third quarter where it tanked, they look very similar to Dick’s Sporting Goods. It’s a good model.”
In my book of business analysis, taking $360 million off of goodwill because you are not likely to pay your debts off is quite an exception. Ahem.
Fun fact: The SEC is also interested in how Guitar Center’s EBITDA manages to look so good despite the exposure to very high-risk financial instruments called Payment In Kind (PIK) notes, which are generally higher-risk, higher-reward financial instruments that take the place of bonds or bank debt. The SEC’s questions are around why the interest from Bain Capital’s enormous debt do not appear in operating expenses, which would make EBITDA look less attractive.
Guitar Center Holdings does respond, saying that…if I understand this correctly… the interest payments on the money Guitar Center owes isn’t really an expense because it’s owned by the holding company, which isn’t Guitar Center – it’s Guitar Center Holdings – therefore it isn’t really an expense to Guitar Center:
With respect to Guitar Center’s consolidated statements of cash flows, interest on Holdings’ senior PIK notes is neither a liability nor an expense to Guitar Center. Therefore, the interest expense on the senior PIK notes is not an operating cash outflow in Guitar Center’s separate financial statements.
As a subsidiary of Holdings, Guitar Center is not the issuer of Holdings’ senior PIK notes. In addition, neither Guitar Center nor any of its subsidiaries guarantees the senior PIK notes, and such notes are not secured by any of the assets of Guitar Center or its subsidiaries.
Payments made by Guitar Center to Holdings for use by Holdings in operations represent disbursements/repayments to a parent company. We present these disbursements in Guitar Center’s consolidated statements of cash flows as financing activities under the heading “Repayments to Guitar Center Holdings, Inc.”
In Guitar Center’s separate financial statements, we presented the exchange of cash interest for additional senior notes as a cash inflow and outflow from financing activities because it more clearly reflects a decrease in liabilities payable to the parent company and an increase in long-term debt payable to unaffiliated third parties.
So even though the gross margin earned from the sale of picks and strings and guitar cables goes to pay these debts off, it’s not really an expense. In fact, when they use money they make from selling microphones and drum machines to pay off old debts, this isn’t an expense – it’s actually a reduction in their liabilities, so is double plus extra good non-ungood money.
Oh, OK. This is an elite-level shellgame technicality, but that’s up to the SEC to work out.
The real problem – nobody got no money
My quote in the piece is regarding the fundamental problem – this is a business aimed a shrinking middle class:
“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.”
The response from Mr. Majeski I think actually made me spit some coffee out.
“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 the online competitors…”
Dude, WHAT? This is an industry that depends on consumers – period. There’s no heavy industrial level drumset market. And professional musicians? We ain’t making any more of those compared to past decades that featured a record industry. So in what universe does lower consumer spending not matter?
This is a common self-deception in America in 2014: That we had some recovery and everything is normal.
We did not.
I commend to you one more time Monica Nixon’s perennial essay “THE CUSTOMERS ARE BROKE: That’s why there’s no recovery.”
While not a day goes by that the American populace isn’t told by the Obama Administration and various bought and paid for corporate and banking shills that we are in an economic recovery, quantitative analytics on unemployment paint a starkly different and disturbing picture. Let us not forget, there cannot be a meaningful recovery in the US when 70% of the economy consists of consumer spending unless those consumers have jobs!
With that in mind, let’s have a look into that recovery…
THERE ARE 4 M FEWER PEOPLE EMPLOYED IN 2012 THAN IN 2007, WHILE THE LABOR FORCE INCREASED BY 12M!
A quick look at the BLS Labor Force Statistics database clearly shows that there were more people employed in the US back in 2007 that there were in 2012!
See here: http://www.bls.gov/cps/cpsaat01.htmThat’s right, 146M were employed in 2006 versus 142M in 2012! Keeping in mind the civilian non-institutional population shot up to 243M from 231M. Putting that in perspective, that’s 12 M more folks who need jobs but 4M less people employed! This should certainly lead one to question why exactly the unemployment rate hasn’t gone absolutely parabolic.
Or check out my piece, Your Future Sales Revenue Will Be Going to Student Loan Payments from 2011. Or my essay in Harvard Business Review, What Happens When There’s Is No Growth to Manage?
The statistics available are very clear, and so logical you cannot miss the implications: People without money do not spend it on stuff. Not stuff they need, and certainly not distortion pedals and new amplifiers.
All the private equity guys in the world can build an elaborate financial structure that lists interest expense as profit for every company on Earth for all I care. One way or the other, we must reckon with the harsh reality of having sold out the Middle Class.