There are a lot of people who say, ‘They can’t service their debt load,’ Well, duh! We never intended to. Guitar Center Chief Financial Officer Tim Martin: MMR
The Wall Street Journal is reporting that Ares Management is in talks to take over control of Guitar Center Holdings Inc. from Bain Capital. Ares has loaned GC a lot of money and instead of waiting for them to pay it back, Ares is looking to take payment in the form of ownership of the company. Where I come from, that’s a job for the Repo Man.
So far, details are murky. And, they will be for a while. Since these are being called “advanced discussions,” this is a thing that’s probably going to happen. Financial companies don’t usually enter into advanced discussions until both parties are pretty comfortable with what’s on the table. WSJ does say that Bain will retain some small stake in the company. Although how much control they will hold on to isn’t clear.
WSJ also claims that Bain and Ares are working their magic behind the scenes to help keep GC out of the bankruptcy courts. A claim that GC denied faster than you could say “Quiznos.” Either way, these deals need to be carefully structured in order to keep investors interested and to retain bond value.
Who’s going to make out on this deal?
For all of the criticism that gets thrown at Bain Capital, you can’t call them dumb. They’ve continued to make millions buying, restructuring, and selling companies since 1984. It would be difficult to imagine that they would let go of GC without making some sort of profit off of it. On the other hand, it’s possible that Bain irrationally thought they could apply the same structuring formula to GC that they’ve had success with regarding other investments like Staples. How will this Ares takeover benefit Bain? Or, will they just have to lose their asses on this one?
Keep in mind, when Bain bought BC, they did so at 26% more than the going price back in 2007. At the time, GC’s debt was estimated to be about 200 million. Of course, Bain took around 1.4 billion in additional debt in order to buy GC in the first place.
But, I wouldn’t worry too much about poor old Bain. Generally, leveraged buyouts are usually done with 60% to 90% borrowed money. Of course, Bain won’t be left on the hook for that money if Ares takes over. What’s probably going to happen is that Bain will walk away mostly unscathed, exept for their pride.
Word on the street is that Ares will take over the company, slash, burn, and possibly sell off the remnants. While word on the street can only go so far, GC’s relationship with Fender might help support this theory.
Back in September of last year, Fender made the announcement that they were making the move to factory direct with much of their product.
While they only specified that these would include “custom configurable” guitars and some parts, the move signified a trend of thought that seems to coincide with Fender CEO’s, Larry Thomas, comments about learning from the mistakes of big box retailers. More word on the street is that Fender may be pulling out completely from even some of their more successful retailers.
Word on the street aside, nobody can ignore that Fender has chosen to distance themselves from, even if it is just a little, GC by taking orders directly from the consumer.
Why is Ares looking to buy in now?
“The reality is, if interest payments ever became a problem for the company and we were not able to make a payment to this entity, there is absolutely no way they would ever let something happen, because the guys who are above them in the capital structure, who own less of the debt than them, would get control. There’s no way they’re going to let that happen.” Tim Martin MMR
Well, interest payments did become a problem for the company. As we noted in our article back in July of last year GC had to borrow against their assets in order to meet its interest payment. To most people, that would be what we call a “problem.”
At the exact same time that they were paying their April bills with more borrowed money, GC announced that they were appointing a new CEO, former Best Buy guy Mike Pratt. Because that Best Buy business model is the model that GC really should be chasing.
After that there was a slew of interviews from GC’s entire management team. Most notable was the MMR article titled: Guitar Center – Inside the Big Box. Besides for including interviews with GC’s biggest management players – accompanied by some extravagantly photoshopped portraits – MMR’s interview made it clear that GC was sure that GC would never go away because GC makes way too much money.
Then this happened.
During the third quarter of 2013, operating income at our Guitar Center segment fell significantly below our expectations. Based on a forward projection of our recent operating performance, we determined that if current trends were to continue there would be uncertainty as to when or whether our Guitar Center business would be able to achieve historical operating results. Given these uncertainties, we determined it was appropriate to revise our projections of future cash flows from the segment. Management concluded that these changes in facts and circumstances represented a triggering event, requiring us to again test the reporting unit’s goodwill for impairment – Yahoo Finance
In the 3rd quarter of 2013, GC had a loss of $358 Million.
Things are super! Thanks for asking!
The reason for GC’s $358 Million third quarter loss is a $360 shortfall in what, in financial circles, is known as “goodwill.”
In the real world, goodwill would be helping an old lady across the street. In financial terms, it means something completely different. When a company buys another company, they’re not just paying fair market value, they’re also paying for “goodwill.”
Goodwill is basically a company saying, “Hey. I know what everybody thinks we’re worth, but I think it’s much more than that because, we’re…um. Special.”
But, one of the many problems with goodwill is that it’s subjective.
Remember, when Bain bought GC, they paid 26% more than fair market value. Meaning that they paid 26% of 1.9 billion in “goodwill.” So, 494,000,000 was what was likely estimated as goodwill at the time that Bain bought GC. And, according to their 3rd quarter report, Bain thinks that amount may have been overestimated by $360,000,000.
I’m no mathematician, but I’m pretty sure that kind of overestimation in calculation could mean the difference between landing a man on the moon and accidentally setting yourself on fire while making breakfast.
If you asked me, “how much for that Twix bar?” and I told you, “A thousand bucks,” you would start to get an idea for how off base this goodwill estimate was.
Because goodwill is subjective, and companies are not required to reveal fair value of goodwill, even to investors, there’s no telling what factors have gone into those valuations and, more importantly, what has been left out.
What’s worse is that the loans that GC has taken out are contingent on maintaining certain operating ratios. Those ratios fluctuate when a company has to report an impairment of goodwill. And, if those ratios aren’t maintained, the loans can go into default. Or, it could keep them from being able to refinance.
Would GC be interested in refinancing? Well, let’s ask them!
The capital structure and how we deal with the debt scenario may be a different answer. Maybe it will be refinancing. It could be an equity infusion. It could be an IPO. There are a million different answers. We’ve got years to deal with that, and some very patient owners. Tim Martin
Well, I guess they didn’t really have as much time as they thought.
Who’s Ares? And, again. What now?
Ares is yet another investment firm that has its hands in everything from oil and natural gas to aerospace and defense. http://www.aresmgmt.com/our-business/private-equity/portfolio Those are deep pockets. But, it’s hard to imagine that they’re going to pay a premium for a company that struggling the way that GC is. Ares could be attempting a Leveraged Buyout, where a company uses the money that it already has loaned or invested in a company as leverage to well…buy someone out. But we won’t know the details of the deal for a while. The word it out there. So, they’re undoubtably going to want to squash speculation as soon as possible so they don’t scare off investors. Or, even worse, get their credit downgraded again.
Maybe some manufacturers are seeing the writing on the wall. Mesa/Boogie pulled all of their product from GC. PRS began limiting the amount of gear they would distribute to GC stores. Not to mention, Fender is also making some moves of its own. The companies that can are probably going to make some moves to distance themselves from Guitar Center.
The question surrounding Guitar Center has started to shift from what to when. Many people are praising this as the return to the small independent guitar shop. Guitar Center is big, and when something that big falls, it’s probably going to take more than a few things down with it.
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About the Author: Marc published his first novel Becoming in 2010. It’s a kick-ass book with monsters and dreams and stuff, and you should buy it. Since then, he’s written thousands of articles for TheToneKing.com, many of which have been picked up for circulation by manufacturers and other news outlets. His next book, Drugs and Pancakes, should be available early 2014 if his alcoholic editor can find time to work on it in-between destroying his liver and screaming about punctuation. He graduated from Roosevelt University with honors, which means that he’s not as dumb as he looks. He’s been playing guitar for over 25 years, which is almost twice as long as most of his students have been alive.