By Eric Garland - This is an obituary for Guitar Center, a chain of big box musical instrument stores that was captured and infected by private equity during a national trend of greed and reckless expansionism in the late-1990s and early-2000s. The company started as a Los Angeles organ store, became a successful purveyor of guitars after the Beatles arrived in the United States, evolved into a national competitor over a period of decades, and shall finish, with sad poetry, as the symbol of everything dysfunctional about American corporate finance, management, and retail in the modern age. Its demise is really the end of a generation of business managers, illustrating how they lost their moral compass as well as any ability to lead individual companies or national economies into a stable, rational, prosperous future. This story will focus on the final days of this one company, but it is really about our painful transition to an economic system that obeys objective reality and serves people in a durable, holistic manner.
The original sin, and events leading to collapse
I have been tracking the evolution of this company for over a year now, and the evidence is incontrovertible: the corporate entity known as Guitar Center, Inc. is in the midst of irreversible collapse dynamics and will cease to hold its position as the industry leader in the short-term. In the mid-term, the company may cease to operate as a going concern and will be reduced to a group of trademarks, service marks and patents that will be sold to a buyer with considerably different plans for the company. Its days as the national industry leader are over.
I shall support my thesis with easily accessible public information, though I also possess considerable insights from industry insiders who prefer not to be named. The idea that this is a doomed entity which can only submerge deeper into dysfunction and, ultimately, oblivion is not widely held. The vast majority of the musical instrument industry exhibits what we intelligence analysts call “normalcy bias,” the attraction to a worldview that things are normal and will remain normal, despite considerable evidence to the contrary. People refer to Guitar Center as “too big to fail,” despite the fact that the firm shares absolutely no characteristics with companies that normally acquire that moniker, such as Citibank, ExxonMobil, or General Electric. They assume that another buyer will emerge to make a simple change of ownership behind the scenes without considering the financial complexities that make such a transaction nearly impossible. Most often, stakeholders in the musical instrument industry assume that the mechanics behind Guitar Center are more complex than they can easily grasp, and so they simple ignore the matter despite its potential impact. As a result, when I visited the NAMM Show in Anaheim, California only days ago, I found that the overwhelming majority of industry figures with whom I spoke spent very little time or energy on the critical analysis of a firm which represents 28% of the industry, a total $2.1 billion out of $7 billion. As a result, we can assume that few people will have contingency plans for potentially disruptive scenarios resulting from Guitar Center’s fate, but that is hardly unprecedented in the history of business. Reality does not need our permission to have its way with our destiny.
Moreover, the media which covers the musical instrument industry is deeply uncritical. Nearly everything I have read regarding the current situation has been either a regurgitation of corporate press releases or a subjective analysis riddled with factual errors and shallow knowledge of business in general and finance in particular. I am told that the tight budgets and intimate nature of the industry make some publishers afraid to engage with controversial subjects that might jeopardize a customer relationship. Either way, many industry professionals are basing their assessment of the market on dangerously incomplete information.
I am not going to provide a long-hand analysis of Guitar Center’s capital structure and every gruesome event in the company’s recent history; if you are so inclined, you may review my past work and browse Google.
A quick summary tells the tale of how close we are to the end, but first we should revisit the beginning. Guitar Center grew with the help of private equity firm Weston Presidio to become a national competitor and, eventually, a publicly-traded company. With the leadership of Marty Albertson, Larry Thomas, and others, the company continued to grow and prosper as a public company until leaders enlisted the help of Bain Capital to take the company private through massive leverage just prior to the largest financial crisis in a century. As you consider any of the other events associated with the present, this Original Sin of the past is the very root of the problem.
Private equity firms like Bain take mid-sized companies and pump them full of debt with the express intent of making them industry-dominating competitors, selling them to the stock market as a candidate for massive growth, and cashing in. To make this possible, private equity’s stake in the company is usually represented by “payment in kind” (PIK) notes, a type of bond that pays crushing interest – in this case 14.09% – but requires no cash outlay until the bond’s maturity. So that 14.09% is accruing, but it isn’t due for years, ideally after the company has been sold to what is often charmingly referred to as “the dumb money,” the retail investors who buy a stock without knowing the company’s true financial position. Before any of the company’s real problems are revealed, the private equity firm receives its payback in the form of stock, since PIK notes can be paid back in any medium of exchange. If all goes to plan, the stock price shoots up after the IPO and the PE firm makes a tidy profit – all in about three to five years.
Bain made two critical mistakes from which it cannot recover. First, it attempted to run this playbook on a company that had just done this very thing with Weston Presidio five years prior. Second, it did so just as the housing fraud and financial insanity which characterized the late 1990s and early 2000s nearly destroyed the U.S. dollar and left us with martial law. Every business maneuver that follows this initial error is too little, too late. Compound interest on debt is the strongest force in the universe, and retail has changed too much for any predictable corporate management technique to have a noticeable effect. The rest of this story is details.
To explain how close the company is to collapse, consider the following timeline:
December 2013: My blog post “Guitar Center and the End of Big Box Retail” goes unexpectedly viral just as GC management is negotiating with its creditors to deal with the fact that it does not expect to be able to honor its financial covenants in the near-term. In response, management claims that the firm is stronger than ever, that every single store is profitable, and that the $1.6 billion in debt with short-term liabilities of over $1 billion is manageable. The company has $25 million in cash going into the Christmas season. The Securities and Exchange Commission begins to investigate irregularities in how GC considers the interest on its bonds to be outside of expenses that would impact EBITDA.
March 2014: The company reaches an agreement with its largest bondholder, Ares Management, to exchange the latter’s PIK notes for equity. $401.8 million in PIK notes are retired in exchange for holding company preferred stock. In a statement by Standard & Poors, the agency expects to lower the corporate credit rating to “SD” which is “selective default” and considered tantamount to bankruptcy because it is a “distressed exchange” in which investors receive less than what they are promised.
April 2014: Bain and Ares offer the bond markets two new bonds to pay back existing bondholders, a $615 million offering of Senior Secured notes with a coupon of 6.5% maturing in 2019, and a $325 million offering of Senior Unsecured notes with a coupon of 9.625% maturing in 2020. These securities are purchased by institutional investors such as LeggMason, GoldmanSachs, and Prudential for their high-yield income funds which go to round out the assets of pension funds, ETFs and other, more conservative portfolios. They produce less than $50 million in free capital for Guitar Center and will still require an all-in coupon payment of around $35 million every six months. Guitar Center press officers attempt to portray this as a dramatic improvement of its financial situation in what is probably the best possible example of the Yiddish word “chutzpah.” Moody’s and Standard & Poors assess the company’s family rating as subprime and its unsecured bonds as junk, with outlook negative. Bond covenant analyses note that the restructuring will only produce enough free cash to pay for the interest on these instruments- there would still be little chance that the company could make strategic moves in the industry. This view assumes that business condition will remain the same or improve. If they get worse, all bets are off.
August 2014: Guitar Center secures a lease in the most expense real estate on earth – Times Square, Midtown Manhattan, New York. CFO Tim Martin claims that not only will this not be a drain on finances, they would make “a lot of money.” He also announces that then-CEO Mike Pratt’s “2020 Vision” was to achieve $3 billion in revenue in just five years – a 20% year-over-year growth in a slow-growing industry. The Times Square Guitar Center debut was accompanied by a 36-second video from the grand opening described as “a new gateway to hell,” featuring fifteen metal guitarists and three drummers playing nonsense simultaneously. It received 500,000 views in the first 48 hours.
November 2014: Guitar Center is forced to admit to bondholders that despite its promises to thrive from its new capital structure, its EBIDTA has slipped 35%, same store sales are down, and total revenue is flat. Secondary debt markets double the yield on its bonds overnight. Investors who committed to the bond months before are willing to take a 10-35% loss in a few short weeks rather than commit to the company’s future. CEO Mike Pratt resigns and is replaced by Darrell Webb, a retired executive whose most recent experience is as CEO of JoAnn Fabrics and the Sports Authority, two companies that also answer to private equity.
December 2014: Guitar Center fires Gene Joly, longtime executive and current president of the Musician’s Friend unit, two days before Christmas.
January 2015: Citing a bloated cost structure that keeps the company from achieving historical profitability, new CEO Darrell Webb fires 42 corporate executives, including the last remnant of Mike Pratt’s team, as well as 28 regional managers. Music Trades reports that the company is down to $10 million in available cash after Christmas.
The constant, smarmy mantra of impenetrability and infallibility has finally been dispelled. Their new executives have, at long last, ceased the comedy routine about how Guitar Center’s stores are always profitable no matter how many times Standard & Poor’s declares them technically in default, or that a billion dollar of debt is totally normal and wonderful and manageable. In a recent email, Webb explains the firings with the dry rationale of needing to be profitable, and foreshadowed that the company will “continue to seek efficiencies.” We seem to be hearing much less about that $3 billion in future revenue and much more about the jobs yet to be cut.
After all the noise, we are entering the final phase.
This is the end, my friends
Nobody can manage this situation, much less lead the organization out of chaos. All reports indicate that Darrell Webb is not there to save a thing – he reportedly has less knowledge of the music business than the Canadian who was just warming his chair. You would think that if Ares Management was serious about saving this company, they would choose a younger, more innovative executive able to lead Guitar Center into a disruptive future, but instead they hired a man who wouldn’t know a Marshall Plexi from a nuclear submarine. I submit that Webb is the perfect choice for his likely mission: to lead the company into an orderly bankruptcy. Should the company achieve Chapter 11 reorganization instead of the final, fatal Chapter 7 liquidation, it must be on good terms with vendors and bondholders. They can lie to employees all they want, but accounts must be in order if there is to be value salvaged from this doomed structure. Thus, the new CEO has been chosen based on a cold-blooded ability to shuffle the books for private equity financiers, not for his ability to lead a musical instrument organization into a disruptive future.
I have already read analyses of Webb’s recruitment as a way for Ares to get somebody more capable of achieving “their” vision. This is a mass hallucination that stems from the old PR team’s attempt to recast the financial failure of 2014 as the addition of a smart, valuable partner with expertise in retail based on that company’s recent takeover of Neiman Marcus alongside their partners, the Canada Pension Plan Investment Board. Commenters in the musical instrument industry seem to understand little about Ares Management, a very large, serious firm that has, since taking equity in Guitar Center, gone public and engaged in a strategy that would put it more in the category of the JP MorganChases and GoldmanSachs of the world. There has not been a single public comment from an Ares employee since 2014 about the future vision for Guitar Center and I suspect that one does not exist. Go look through Ares’ quarterly reports and press releases and search for the word “guitar.” Perhaps that will provide a perspective on the relative importance of this transaction to a company with a much larger financial play in the works.
This is pure speculation, but given the size of their investment I imagine they see Guitar Center as a deal they made back in the mid-2000s before the crisis, one that Bain screwed up. They probably took the equity as the best way to perhaps get something instead of pennies on the dollar. These days, they’re more busy reopening factories in Europe along with national partners. They have better things to worry about than this sad scene, but this is a conclusion that will be very uncomfortable for members of the musical instrument industry who will not want to feel quite so unimportant.
The fact is, the die is cast. In a couple of weeks, Guitar Center will need to report its Christmas performance to its bondholders. If things do not look good, its bonds will be ripped apart like Radio Shack’s. Moreover, if I had to guess, the $10 million in Guitar Center’s coffers will not be enough to make the payment to their bondholders due in April 2015. In advance of that, they will need to seek protection under Chapter 11 of the bankruptcy code. Maybe they have another ultra-complex trick to bring out of the private equity playbook, but this whole thing is a waste of time. None of this sells guitars or inspires kids to be better musicians in a world where laptops play the tunes. We’re all analyzing the most mundane details of the terminal symptoms of this sickness that has seized American business culture in the past twenty years. Perhaps we need to heal that disease before we can back to fun things such as playing guitar and running profitable companies.
Here’s what this really means: it’s the end of big box retail, an irrational addiction to growth, and the scourge of unregulated structured finance. For a few years, unwise urban planning and unregulated banks created a new bubble in the American suburbs. People bought homes they could not afford and turned their houses into lines of credit. This swindle eventually brought the economy to its knees and has taken most a decade to regain some state of uneasy equilibrium. Still, it was particularly stimulating to a certain type of retail that also depended on constant growth and financial trickery. The objective truth is that the growth of the last decade was financed by banking fraud, and that financial trickery of this sort only fools people in the short-term. Eventually, you must have a product people demand, sold by competent people who care about the business, financed in a way that makes sense.
This unforgiving reality will work great for local stores and entrepreneurs with a classic, cautious approach to business management. For a while, suspending our disbelief in reality allowed standard-issue corporate financiers to run a pump-and-dump scheme on all kinds of retail, selling risky ventures to “dumb money” and reaping the rewards for a select few. We are all wiser now, and the market conditions simply will not support that behavior.
This is not a moral judgment, merely an assessment of market engineering. Small and smart will carry the future while big, dumb, complex, and dishonest will bite the dust.
These conclusions were my instincts before I conducted research into the example of Guitar Center. I was reasonably sure then, and I am entirely convinced now. The only remaining question is where the industry will go from here. Go ask the good people at Behringer for a preview. Representatives from their company have informed me that since they parted ways with Guitar Center they discovered a network of smaller, more focused retailers who were more than excited to form a stronger relationship with their company, and in turn delight customers even more. This resulted in the company’s greatest annual revenue in history, both in the United States and throughout the world. Behringer seems to think that a world without a single, corporate, banker-driven industry hegemon is not only possible, it’s preferable.
That’s a bright future, if you choose to share that vision. But whether you believe in it or not, this scenario is unavoidable. Guitar Center is finished. Now the musical instrument industry can get back to business.