Guitar Center Inc., which dominates the retail market for guitars, band instruments and recording equipment, has found a new key to success: opening smaller stores.


The Westlake Village-based company, whose stock is up 26 percent in the past year, is expected to skew its growth in the next five years to more compact retail spaces, which benefit from lower rents, less expensive advertising and fewer negotiations over price.


Though Guitar Center has been a sweetheart of momentum investors on Wall Street, with the stock above $57 a share last week there were doubts about how high it can go.


Still, there is plenty of attraction to a company that appears to be all tuned up and ready to rock.


Guitar Center boasted a strong second-quarter performance with a 14 percent jump in sales to $299.6 million for its core Guitar Stores business. But the most telling statistic came from its new stores which accounted for more than 50 percent of the total sales increase.


Sharon Zackfia, an analyst at William Blair & Co., has an "outperform" rating on Guitar Center, with a 52-week price target of $66 a share.


She believes Guitar Center is one of the few chains with the opportunity to control 40 percent of market share a rare phenomenon in the retail world.


Guitar Center already dominates markets in Los Angeles and Chicago, two cities "that boast some of the highest absolute levels of musical instrument spending, as well as some of the most intense competition," said Zackfia.


Some analysts even credit Guitar Center for playing a role in the proliferation of new rock bands and young musicians' disdain for major music labels. That's because the cost to create a professional home recording studio has plummeted to $2,500 from $10,000 five years ago. That has lowered the barrier to entry for more rock bands and indie labels.


More compelling for investors is that, even though Guitar Center is the largest player in the $7 billion musical instrument industry, the market is still so fragmented that its overall share is just 16 percent. That gives it roughly three times the girth of its closest competitor, Sam Ash Music Corp., while most other rivals are mom-and-pop operators.


Change in leadership
Guitar Center opened its first store in Hollywood in 1964. Larry Thomas, the firm's former chairman and co-chief executive, retired last year after 27 years with the chain. He played a key role in expanding the company from a two-store operation to a national chain, now with $1.5 billion in annual sales.


Marty Albertson, who was co-chief executive, took over the role of chairman and chief executive and remains the driving force behind the company.


Guitar Center has hit some sour notes.


The company is trying to leverage its investments in its money-losing American Music unit, which is now being folded into the newly acquired Music & Arts Center division. That division caters to band and orchestra instruments and posted an operating loss of $4.4 million in the second quarter, on sales of $24.7 million.


Rick Nelson, a managing director at Stephens Inc., has an "overweight" rating on Guitar Center's stock and has encouraged investors to add to their positions.


Guitar Center executives didn't return calls. Analysts say the company plans to grow the Music & Arts division to as many as 425 stores, up from just 77 stores today, primarily through a roll-up strategy that is expected to begin in 2007 with purchases of small retailers in the Midwest and East Coast.


Management also plans to expand its direct-response music unit, called Musician's Friend, by expanding the current fulfillment center that can support up to $800 million in sales, compared with $311 million in sales last year, according to Zackfia.

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