**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                                                                                       |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| ** ** | ** ** | **For the quarterly period ended  March 31, 2005**                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                                                                                      |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| ** ** | ** ** | **For the transition period from                                      to                                       ** |

 

**CommissionFile No.  000 – 22207**

 

**GUITAR CENTER, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

 
| **DELAWARE**                              | ** ** | **95-4600862**          |
|-------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer        |
| incorporation or  organization)           |       | Identification  Number) |
|                                      |       |                    |
| **5795  LINDERO CANYON ROAD**             | ** ** | ** **              |
| **WESTLAKE  VILLAGE, CALIFORNIA**         | ** ** | **91362**               |
| (Address  of principal executive offices) |       | (Zip  Code)             |

 

**(818)735-8800**

Registrant’stelephone number, including area code

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes    ý           No  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 

Yes    ý           No  o

 

As of May 9, 2005, 25,866,109shares of our Common Stock, $.01 par value, were outstanding.

 

 

----

 

**GuitarCenter, Inc. and subsidiaries**

 

#### INDEX

 
| Part I.      | Financial Information                                                                    |                                                                                            |
|--------------|------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------|
|         |                                                                                     |                                                                                            |
|         | **Item 1.**                                                                              | **Consolidated  Financial Statements (Unaudited)**                                              |   |
|         |                                                                                     |                                                                                            |   |
|         | Consolidated Balance Sheets  – March 31, 2005 and December 31, 2004                 |                                                                                            |
|         |                                                                                     |                                                                                            |
|         | Consolidated  Statements of Income – Three months ended March 31, 2005 and 2004     |                                                                                            |
|         |                                                                                     |                                                                                            |
|         | Consolidated  Statements of Cash Flows – Three months ended March 31, 2005 and 2004 |                                                                                            |
|         |                                                                                     |                                                                                            |
|         | Notes to  Consolidated Financial Statements                                              |                                                                                            |
|         |                                                                                     |                                                                                            |
| ** **   | **Item  2.**                                                                             | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations** |   |
|         |                                                                                     |                                                                                            |   |
| ** **   | **Item  3.**                                                                             | **Quantitative  and Qualitative Disclosures About Market Risk**                                 |   |
|         |                                                                                     |                                                                                            |   |
| ** **   | **Item 4.**                                                                              | **Controls and Procedures**                                                                     | ** ** |
|         |                                                                                     |                                                                                            |   |
| **Part II.** | **Other Information**                                                                    | ** **                                                                                      |
| ** **   | ** **                                                                               | ** **                                                                                      | ** ** |
| ** **   | **Item 1.**                                                                              | **Legal Proceedings**                                                                           |   |
|         |                                                                                     |                                                                                            |   |
| ** **   | **Item 6.**                                                                              | **Exhibits**                                                                                    |   |

 

2

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##### **Guitar Center,Inc. and subsidiaries**

# **ConsolidatedBalance Sheets**

(In thousands,except per share data)

(Unaudited)

 
| ** **                                                                                                                                 | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| **Assets**                                                                                                                                 |       |                |       |                   |       |
| Current assets:                                                                                                                            |       |                |       |                   |       |
| Cash and cash equivalents                                                                                                                  |       | $                   | 38,205     |                   | $          | 60,453 |   |
| Investments in  marketable securities                                                                                                      |       | 13,239              |       | 3,810                  |       |
| Accounts  receivable, less allowance for doubtful accounts $2,400 and $3,489,  respectively                                                |       | 20,968              |       | 27,627                 |       |
| Merchandise  inventories                                                                                                                   |       | 328,360             |       | 314,961                |       |
| Prepaid expenses  and deposits                                                                                                             |       | 15,216              |       | 13,367                 |       |
| Deferred income  taxes                                                                                                                     |       | 5,552               |       | 5,552                  |       |
| Total current  assets                                                                                                                      |       | 421,540             |       | 425,770                |       |
|                                                                                                                                       |       |                |       |                   |       |
| Property and  equipment, net of accumulated depreciation of $105,633 and $99,915,  respectively                                            |       | 114,378             |       | 97,349                 |       |
| Investments in  marketable securities                                                                                                      |       | 33,031              |       | 16,997                 |       |
| Goodwill                                                                                                                                   |       | 26,474              |       | 26,474                 |       |
| Deposits and  other assets, net                                                                                                            |       | 7,102               |       | 8,003                  |       |
|                                                                                                                                       |       | $                   | 602,525    |                   | $          | 574,593 |   |
|                                                                                                                                       |       |                |       |                   |       |
| **Liabilities  and Stockholders’ equity**                                                                                             |       |                |       |                   |       |
| Current  liabilities:                                                                                                                      |       |                |       |                   |       |
| Accounts payable                                                                                                                           |       | $                   | 74,948     |                   | $          | 49,771 |   |
| Accrued expenses  and other current liabilities                                                                                            |       | 57,984              |       | 83,606                 |       |
| Merchandise  advances                                                                                                                      |       | 19,536              |       | 22,534                 |       |
| Total current  liabilities                                                                                                                 |       | 152,468             |       | 155,911                |       |
|                                                                                                                                       |       |                |       |                   |       |
| Other long-term  liabilities                                                                                                               |       | 7,776               |       | 6,943                  |       |
| Deferred income  taxes                                                                                                                     |       | 5,057               |       | 5,057                  |       |
| Long-term debt                                                                                                                             |       | 100,000             |       | 100,000                |       |
| Total  liabilities                                                                                                                         |       | 265,301             |       | 267,911                |       |
|                                                                                                                                       |       |                |       |                   |       |
| Stockholders’  equity:                                                                                                                |       |                |       |                   |       |
| Preferred stock;  5,000 authorized, none issued and outstanding                                                                            |       | —              |       | —                 |       |
| Common Stock,  $0.01 par value, authorized 55,000 shares, issued and outstanding 25,865 at  March 31, 2005 and 25,359 at December 31, 2004 |       | 259                 |       | 254                    |       |
| Additional paid  in capital                                                                                                                |       | 320,111             |       | 305,305                |       |
| Retained  earnings                                                                                                                         |       | 17,007              |       | 1,123                  |       |
| Accumulated  other comprehensive loss                                                                                                      |       | (153                | )          | —                 |       |
| Stockholders’  equity                                                                                                                 |       | 337,224             |       | 306,682                |       |
|                                                                                                                                       |       | $                   | 602,525    |                   | $          | 574,593 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

3

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##### **Guitar Center,Inc. and subsidiaries**

# **ConsolidatedStatements of Income**

(In thousands,except per share data)

(Unaudited)

 
| ** **                                   | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                | 396,386    |   | $ | 349,703 |   |
| Cost of goods sold, buying and occupancy     |       | 285,214                          |       | 255,020 |   |
| Gross profit                                 |       | 111,172                          |       | 94,683 |   |
|                                         |       |                             |       |   |   |
| Selling, general and administrative expenses |       | 84,471                           |       | 74,318 |   |
| Operating income                             |       | 26,701                           |       | 20,365 |   |
|                                         |       |                             |       |   |   |
| Interest expense, net                        |       | 875                              |       | 1,363 |   |
|                                         |       |                             |       |   |   |
| Income before income taxes                   |       | 25,826                           |       | 19,002 |   |
|                                         |       |                             |       |   |   |
| Income taxes                                 |       | 9,942                            |       | 7,222 |   |
|                                         |       |                             |       |   |   |
| Net income                                   |       | $                                | 15,884     |   | $ | 11,780 |   |
|                                         |       |                             |       |   |   |
| Net income per share:                        |       |                             |       |   |   |
| Basic                                        |       | $                                | 0.62       |   | $ | 0.49 |   |
| Diluted                                      |       | $                                | 0.56       |   | $ | 0.44 |   |
|                                         |       |                             |       |   |   |
| Weighted average shares outstanding:         |       |                             |       |   |   |
| Basic                                        |       | 25,593                           |       | 24,188 |   |
| Diluted                                      |       | 29,724                           |       | 28,393 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

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**GuitarCenter, Inc. and subsidiaries**

**ConsolidatedStatements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| **Operating activities:**                                                          |       |                             |       |   |   |
| Net income                                                                         |       | $                                | 15,884     |   | $ | 11,780 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                             |       |   |   |
| Depreciation and amortization                                                      |       | 5,859                            |       | 5,358 |   |
| Amortization of deferred financing fees                                            |       | 261                              |       | 261 |   |
| Tax benefit from exercise of stock options                                         |       | 7,059                            |       | 1,641 |   |
| Changes in operating assets and liabilities:                                       |       |                             |       |   |   |
| Accounts receivable                                                                |       | 6,659                            |       | 3,456 |   |
| Merchandise inventories                                                            |       | (13,399                          | )          | (833 | ) |
| Prepaid expenses and deposits                                                      |       | (1,849                           | )          | 1,551 |   |
| Other assets                                                                       |       | 1,011                            |       | (189 | ) |
| Accounts payable                                                                   |       | 25,177                           |       | 8,212 |   |
| Accrued expenses and other current liabilities                                     |       | (25,622                          | )          | (16,994 | ) |
| Other long-term liabilities                                                        |       | 833                              |       | 270 |   |
| Merchandise advances                                                               |       | (2,998                           | )          | (716 | ) |
| Net cash provided by operating activities                                          |       | 18,875                           |       | 13,797 |   |
|                                                                               |       |                             |       |   |   |
| **Investing activities:**                                                          |       |                             |       |   |   |
| Purchase of property and equipment                                                 |       | (22,879                          | )          | (4,783 | ) |
| Purchase of available-for-sale securities                                          |       | (27,305                          | )          | — |   |
| Proceeds from sale of available-for-sale securities                                |       | 1,309                            |       | — |   |
| Net cash used in investing activities                                              |       | (48,875                          | )          | (4,783 | ) |
|                                                                               |       |                             |       |   |   |
| **Financing activities:**                                                          |       |                             |       |   |   |
| Proceeds from exercise of stock options                                            |       | 7,752                            |       | 4,597 |   |
| Net cash provided by financing activities                                          |       | 7,752                            |       | 4,597 |   |
|                                                                               |       |                             |       |   |   |
| Net (decrease) increase in cash and cash equivalents                               |       | (22,248                          | )          | 13,611 |   |
| Cash and cash equivalents at beginning of year                                     |       | 60,453                           |       | 5,350 |   |
|                                                                               |       |                             |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                                | 38,205     |   | $ | 18,961 |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

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**GuitarCenter, Inc. and subsidiaries**

**Notes toConsolidated Financial Statements**

 

1.             Natureof Business and Basis of Presentation

 

Nature of Business

 

GuitarCenter is the nation’s leading retailer of guitars, amplifiers, percussioninstruments, keyboards, live-sound/DJ and recording equipment based on annualrevenue. As of March 31, 2005, our retail subsidiary operated 144 Guitar Centerretail stores, with 119 stores in 47 major markets and 25 stores in secondarymarkets across the United States.  Inaddition, our American Music division operates 15 stores specializing in bandand orchestral instruments for sale and rental, serving teachers, banddirectors, college professors and students and four educational supportcenters. We are also the largest direct response retailer of musicalinstruments in the United States through our wholly-owned subsidiary, Musician’sFriend, Inc., and its catalog and web site, www.musiciansfriend.com.

 

Basis of Presentation

 

In theopinion of management, the accompanying unaudited consolidated financialstatements contain all adjustments necessary to present fairly the financialposition of Guitar Center, Inc. and subsidiaries as of March 31, 2005 andDecember 31, 2004, and the results of operations and cash flows for the threemonths ended March 31, 2005 and 2004. The accompanying consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto contained in our Annual Report on Form10-K for the year ended December 31, 2004.

 

Theresults of operations for the three months ended March 31, 2005 are notnecessarily indicative of the results to be expected for the full year.

 

Use of Estimates in thePreparation of Financial Statements

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States (GAAP) requires us to make estimatesand assumptions. These estimates and assumptions affect the reported amounts inthe consolidated balance sheets and statements of earnings, as well as thedisclosure of contingent liabilities. Actual results could differ from theseestimates and assumptions.

 

2.             EarningsPer Share

 

Thefollowing table summarizes the reconciliation of Basic to Diluted WeightedAverage Shares for the quarter ending March 31, 2005 and 2004:

 
| ** **                                                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|----------|------------|
|                                                                                     |       | **(in  thousands, except per  share data)** |       |
| Net income                                                                               |       | $                                           | 15,884     |     | $          | 11,780 |   |
|                                                                                     |       |                                        |       |     |       |   |   |
| Add: Interest,  net of tax, on 4% Senior Convertible Notes                               |       | 727                                         |       | 733      |       |
| Net income  excluding interest expense on 4% Senior Convertible Notes                    |       | 16,611                                      |       | 12,513   |       |
|                                                                                     |       |                                        |       |     |       |
| Basic shares                                                                             |       | 25,593                                      |       | 24,188   |       |
| Common stock  equivalents - dilutive effect of options outstanding                       |       | 1,239                                       |       | 1,313    |       |
| Common stock  equivalents - dilutive effect of conversion of 4% Senior Convertible Notes |       | 2,892                                       |       | 2,892    |       |
| Diluted shares                                                                           |       | 29,724                                      |       | 28,393   |       |
| Basic net income  per share                                                              |       | $                                           | 0.62       |     | $          | 0.49 |   |
| Diluted net  income per share                                                            |       | $                                           | 0.56       |     | $          | 0.44 |   |

 

6

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Forthe quarters ended March 31, 2005 and 2004, all options outstanding had adilutive effect.

 

For the quarters ended March 31, 2005 and 2004, the2.9 million shares of common stock issuable upon conversion of the 4.00% SeniorConvertible Notes issued in June 2003 (reflecting an effective conversion priceof $34.58) are potential common stock and are deemed to be outstanding for thepurposes of calculating diluted earnings per share under the “if-converted”method of accounting which also provides that the related after-tax interestexpense, including amortization of deferred financing costs, for the period isadded back to net income.

 

In November2004, the Emerging Issues Task Force (“EITF”) reached a consensus thatcontingently convertible debt instruments, such as our 4.00% Senior ConvertibleNotes, should be included in the computation of diluted earnings per shareunder the if-converted method regardless of whether the market price triggerhas been met. The consensus must be applied by retroactive restatement offinancial statements issued for periods ending after December 15, 2004.Accordingly, we retroactively restated all earnings per share measures for thethree months ended March 31, 2004 to reflect the consensus.

 

**3.**             Segment Information

** **

**Our reportable business segments are Guitar Center stores,American Music stores and direct response (Musician’s Friend’s contact centerand Internet).  Management evaluatessegment performance based primarily on net sales and income (loss) beforeincome taxes.  Accounting policies of thesegments are the same as the accounting policies for the consolidated Company.  There are no differences between themeasurements of profits or losses or assets of the reportable segments andthose of the Company on a consolidated basis. The Company business segmentsunder SFAS No. 131, *“Disclosures aboutSegments of an Enterprise and Related Information”* are consistentwith its reporting units under SFAS No. 142, *“Goodwilland Other Intangible Assets.” *SFASNo. 131 establishes standards for the reporting of operating segmentinformation in annual financial statements and in interim financial reportsissued to shareholders. SFAS No. 142 require that goodwill no longer beamortized, reclassifications between goodwill and other intangible assets bemade based upon certain criteria, and, once allocated to reporting units (thebusiness segment level, or one level below), that tests for impairment ofgoodwill be performed at least annually. We will continue to evaluate goodwillannually or whenever events and circumstances indicate that there may be animpairment of the asset value.**

** **

**Net sales, gross margin, depreciation and amortization, selling,general and administrative expenses, income before income taxes and capitalexpenditures for the three months ended March 31, 2005 and 2004 and totalassets as of March 31, 2005 and 2004 are summarized as follows (in thousands):**

** **
| ** **                                    | ** ** | **Guitar Center** | ** ** | **American Music** | ** ** | **Direct Response** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|--------------------|------------|---------------------|------------|------------|------------|
| ** **                                    | ** ** | **2005**          | ** ** | **2005**           | ** ** | **2005**            | ** ** | **Total**  | ** ** |
| ** **                                    | ** ** | ** **        | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** |
| Net sales                                     |       | $                 | 294,643    |               | $          | 10,238              |       | $          | 91,505     |   | $ | 396,386 |   |
| Gross profit                                  |       | 79,690            |       | 3,832              |       | 27,650              |       | 111,172    |       |
| Depreciation and  amortization                |       | 4,828             |       | 510                |       | 521                 |       | 5,859      |       |
| Selling, general  and administrative expenses |       | 61,438            |       | 5,164              |       | 17,869              |       | 84,471     |       |
| Income (loss)  before income taxes            |       | 17,834            |       | (2,103             | )          | 10,095              |       | 25,826     |       |
| Capital  expenditures                         |       | 21,456            |       | 243                |       | 1,180               |       | 22,879     |       |
| Total assets                                  |       | 459,003           |       | 58,834             |       | 84,688              |       | 602,525    |       |
|                                               |            |                   |            |                    |            |                     |            |            |            |  |  |  |  |

 
| ** **                                    | ** ** | **Guitar  Center** | ** ** | **American  Music** | ** ** | **Direct  Response** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|---------------------|------------|----------------------|------------|------------|------------|
| ** **                                    | ** ** | **2004**           | ** ** | **2004**            | ** ** | **2004**             | ** ** | **Total**  | ** ** |
| Net sales                                     |       | $                  | 263,508    |                | $          | 9,378                |       | $          | 76,817     |   | $ | 349,703 |   |
| Gross profit                                  |       | 66,688             |       | 3,385               |       | 24,610               |       | 94,683     |       |
| Depreciation and  amortization                |       | 4,363              |       | 391                 |       | 604                  |       | 5,358      |       |
| Selling, general  and administrative expenses |       | 53,459             |       | 4,325               |       | 16,534               |       | 74,318     |       |
| Income (loss)  before income taxes            |       | 12,343             |       | (1,587              | )          | 8,246                |       | 19,002     |       |
| Capital  expenditures                         |       | 4,025              |       | 118                 |       | 640                  |       | 4,783      |       |
| Total assets                                  |       | 351,644            |       | 60,639              |       | 57,378               |       | 469,661    |       |
|                                               |            |                    |            |                     |            |                      |            |            |            |  |  |  |  |

 

7

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4.             Comprehensiveincome

 

The following tablepresents comprehensive income for the three months ended March 31, (inthousands):

 
| ** **                                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income                                                            |       | $        | 15,884     |     | $          | 11,780 |   |
| Other  comprehensive loss - Unrealized loss on securities, net of tax |       | (153     | )          | —   |       |
| Comprehensive  income                                                 |       | 15,731   |       | 11,780   |       |
|                                                                       |            |          |            |          |            |  |  |

** **

5.             Stock-BasedCompensation

 

We adopted SFAS No. 123, “*Accountingfor Stock-Based Compensation,”*which permits entities to recognizeas expense over the vesting period the fair value of all stock-based awards onthe date of grant.  Alternatively, SFASNo. 123 allows entities to continue to apply the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25 “*Accountingfor Stock Issued to Employees**,”*and relatedinterpretations and provide pro forma net income and pro forma earnings pershare disclosures for employee stock option as if the fair-value-based methoddefined in SFAS No. 123 had been applied. We have elected to continue to apply the provisions of APB Opinion No.25 and provide the pro forma disclosure provisions of SFAS No. 123.  As such, compensation expense for stockoptions issued to employees is recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price.  Had we determined compensation cost basedupon the fair value at the grant date for our stock options under SFAS No. 123using the Black Scholes option pricing model, pro forma net income and proforma net income per share, including the following weighted averageassumptions used in these calculations, would have been as follows for thethree months ended March 31:

 
| ** **                                                                                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                                           |       |     |       |     |       |
| Net income, as  reported                                                                                                                       |       | $        | 15,884     |     | $          | 11,780 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | 1,425    |       | 991      |       |
| Pro forma net  income                                                                                                                          |       | $        | 14,459     |     | $          | 10,789 |   |
|                                                                                                                                           |       |     |       |     |       |
| Earnings per  share:                                                                                                                           |       |     |       |     |       |
| Basic – as  reported                                                                                                                      |       | $        | 0.62       |     | $          | 0.49 |   |
| Basic – pro  forma                                                                                                                        |       | $        | 0.56       |     | $          | 0.45 |   |
| Diluted – as  reported                                                                                                                    |       | $        | 0.56       |     | $          | 0.44 |   |
| Diluted – pro  forma                                                                                                                      |       | $        | 0.51       |     | $          | 0.41 |   |
| Risk free  interest rate                                                                                                                       |       | 4.3      | %          | 3.3      | %          |
| Expected lives                                                                                                                                 |       | 6.36     |       | 6.70     |       |
| Expected  volatility                                                                                                                           |       | 59.7     | %          | 61.8     | %          |
| Expected  dividends                                                                                                                            |       | —   |       | —   |       |

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004)Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R requires that the costfrom all share-based payment transactions, including stock options, be recognizedin the financial statements at fair value. SFAS No. 123R is effective forpublic companies in the first fiscal year beginning on or after January 1,2006.  We will adopt the provisions ofthis statement in the first quarter of 2006. We anticipate adopting SFAS No.123R using the modified prospective

 

8

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method, which willnot require us to restate any prior periods. We are currently evaluating theeffect of adoption of SFAS No. 123R will have on our consolidated financialstatements and have not determined whether the adoption will or will not resultin amounts that are similar to the current pro forma disclosure under SFAS No.123.

 

6.             SubsequentEvent

 

On April 15, 2005, we completed theacquisition of privately held Music & Arts Center, Inc., a Maryland-basedmusical instruments retailer with an emphasis on the beginning musician. Music& Arts operates 62 retail locations primarily located in the Northeast,Mid-Atlantic and Southern regions of the U.S. The acquired business and ourexisting American Music business are being combined into a new division underthe Music & Arts name.

 

Theacquired business generated approximately $85 million in sales in the fiscalyear ended January 31, 2005. The transaction, which has a purchase price of $90million, plus the assumption of debt and certain other deferred obligations, didnot have any impact on our first quarter financial results. The acquisition wasfunded from cash on hand and drawings under our line of credit.

 

**Item2.**                   Management’s Discussion and Analysis of FinancialCondition and Results of Operations

 

**General**

 

Guitar Center isthe nation’s leading retailer of guitars, amplifiers, percussion instruments,keyboards and live-sound/DJ and recording equipment based on annual revenue. Asof March 31, 2005, our retail subsidiary operated 144 Guitar Center retailstores, with 119 stores in 47 major markets and 25 stores in secondary marketsacross the United States.  In addition,our American Music division operates 15 stores specializing in band andorchestral instruments for sale and rental, serving teachers, band directors,college professors and students and four educational support centers. We arealso the largest direct response retailer of musical instruments in the UnitedStates through our wholly-owned subsidiary, Musician’s Friend, Inc., and itscatalog and web site, www.musiciansfriend.com.

 

During the first quarter,we opened five large format Guitar Center stores in Tulsa, Oklahoma,Pittsburgh, Pennsylvania, South Austin, Texas, Orlando, Florida, Birmingham,Alabama and three small format stores in Flint, Michigan, Akron, Ohio and DesMoines, Iowa. These stores added 104,600 square feet of Guitar Center retailspace and brought us to a total of 2.194 million square feet of Guitar Centerretail space at the end of the quarter.

 

 As we enter new markets, we expect that wewill initially incur higher administrative and promotional costs per store thanis currently experienced in established markets.  We expect competition to continue to increaseas other music product retailers attempt to execute national growthstrategies.  Our business strategy willalso emphasize opportunities to continue to grow each of our brands, includingfurther acquisitions if attractive candidates can be located for reasonableprices.

 

From 2000 to 2004, ournet sales grew at an annual compound growth rate of 17%, principally due to thecomparable store sales growth of our retail stores averaging 7% per year, theopening of new stores, and a 22% per year increase in the direct responsechannel. We believe such volume increases are the result of the continuedsuccess of the implementation of our business strategy, continued growth in themusic products industry and increasing consumer awareness of the Guitar Center,Musician’s Friend and American Music brand names. We achieved comparable storesales growth of 5% for the first quarter of 2005 compared to 11% for the firstquarter of 2004 for Guitar Center retail division. Comparable store salescompares net sales for the comparable periods, excluding net sales attributableto stores not open for 14 months as of the end of the latter reportingperiod.  All references in this report tocomparable stores sales are based on this calculation methodology.

 

**Executive Summary**

 

Consolidated net sales for the quarter ended March 31,2005 increased 13.3%, or $46.7 million, to $396.4 million compared to $349.7million in the first quarter of 2004. Net income for the quarter was $15.9million, which is a 35% increase over the $11.8 million we reported in thefirst quarter of 2004. Earnings per diluted share increased to $0.56 comparedto $0.44 in the first quarter of 2004.

 

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Our Guitar Center retaildivision turned in a strong performance for the quarter. Net sales from ourGuitar Center stores increased 11.8% to $294.7 million from $263.5 million inlast year’s first quarter. Sales from new stores contributed $17.2 million andaccounted for 55.2% of the increase. Guitar Center retail’s comparable storesales increased 5%.

 

Musician’s Friend, ourdirect response division, generated a net sales increase of 19.1% for thequarter to $91.5 million compared to $76.8 million in the first quarter of 2004.For the quarter, we achieved an initial fill rate of 92% up from 89% in thesame quarter of 2004. Initial order fill rate reflects the percentage of itemsordered by our customers that we are able to supply in the initial shipment tothat customer.

 

During the quarter, weexperienced relatively uneven sales patterns, making it more difficult toforecast business trends, and our direct response division faced a higher levelof online competition.  Due to thesetrends, we plan to increase our advertising and promotional activities in theremainder of the year to drive store and online traffic.

 

On April 15, 2005, we completed the acquisition ofprivately held Music & Arts Center, Inc., a Maryland-based musicalinstruments retailer with an emphasis on the beginning musician. Music &Arts operates 62 retail locations primarily located in the Northeast,Mid-Atlantic and Southern regions of the U.S. The acquired business and ourexisting American Music business are being combined into a new division underthe Music & Arts name.

 

The acquired business generated approximately $85million in sales in the fiscal year ended January 31, 2005. The transaction,which has a purchase price of $90 million, plus the assumption of debt andcertain other deferred obligations, did not have any impact on our firstquarter financial results and was funded from cash on hand and drawings under ourline of credit.

 

We are focused onleveraging the infrastructure investments we have made to streamline inventorymanagement and improve operating efficiencies across the Company. Continuedexecution of these initiatives will be necessary to meet our businessobjectives for 2005.

 

**Discussion of Critical Accounting Policies**

 

In the ordinary course of business, we have made anumber of estimates and assumptions relating to the reporting of results ofoperations and financial condition in the preparation of our financialstatements in conformity with accounting principles generally accepted in theUnited States of America.  Actual resultscould differ significantly from those estimates under different assumptions andconditions.  We believe that thefollowing discussion addresses our most critical accounting policies, which arethose that are most important to the portrayal of our financial condition andresults and require management’s most difficult, subjective and complexjudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently uncertain. Additionally, the policy described below regarding credits and othervendor allowances is unique to our industry and deserves the attention of areader of our financial statements.

 

*Valuationof Inventory*

 

We value our inventoriesat the lower of cost using the first-in, first-out (FIFO) method or market.Rental inventories are valued at the lower of cost or market using the specificidentification method and are depreciated on a straight-line basis while outunder a rental agreement for rent-to-own sales. We record adjustments to thevalue of inventory based upon obsolescence and changes in market value.  Applicable costs associated with bringinginventory through our Guitar Center retail distribution center are capitalizedto inventory.  The amounts are expensedto cost of goods sold as the associated inventory is sold.  Management has evaluated the current level ofinventories considering future customer demand for our products, taking intoaccount general economic conditions, growth prospects within the marketplace,competition, market acceptance of current and upcoming products, and managementinitiatives.  Based on this evaluation,we have recorded impairment adjustments to cost of goods sold for estimateddecreases in net realizable value.  Thesejudgments are made in the context of our customers’ shifting needs, product andtechnological trends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimatecorrectly, could result in inventory valuation changes as of any given balancesheet date.

 

*Valuationof Long-Lived Assets*

 

Long-lived assets such asproperty and equipment and identifiable intangibles with definite lives arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Goodwill andintangibles that are not amortized is required to be reviewed for impairment onan annual basis, or more frequently when triggering events occur. Factors weconsider important, which could trigger impairment, include, among otherthings:

 

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•      Significantunderperformance relative to historical or projected operating results;

 

•      Significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

 

•      Significantnegative industry or economic trends; and

 

•      Significantdecline in stock value for a sustained period.

 

For long-lived assetsother than goodwill and intangibles that are not amortized, the determinationof whether impairment has occurred is based on an estimate of undiscountedfuture cash flows attributable to the assets, as compared to the carrying valueof the assets.  Assumptions used in thesecash flows are consistent with internal forecasts and consider current andfuture expected sales volumes and related operating costs and any anticipatedincreases or declines based on expected market conditions and local businessenvironment factors. If a potential impairment is identified, the amount of theimpairment loss recognized would be determined by estimating the fair value ofthe assets and recording a loss if the fair value was less than the book value.Fair value will be determined based on appraisal values assessed by thirdparties, if deemed necessary, or a discounted future cash flows analysis. Forgoodwill and other intangibles that are not amortized, impairment to berecognized is measured as the amount by which the carrying amount of the assetsexceeds the fair value of the related assets of the underlying reporting unitto which the goodwill relates.

 

Our assessment regardingthe existence of impairment factors is based on market conditions and theoperational performance of our business. Our review of factors present and theresulting appropriate carrying value of our goodwill, intangibles and otherlong-lived assets are subject to judgments and estimates that management isrequired to make.

 

*Sales Returns*

 

As part of our “satisfactionguaranteed” policy, we allow Guitar Center customers to return productgenerally within 30 days after the date of purchase, and we allow Musician’sFriend customers to return product within 45 days. American Music customershave ten business days from the date of purchase to return product. Weregularly review and revise, when deemed necessary, our estimates of salesreturns based upon historical trends. While our estimates during the past fewyears have approximated actual results, actual returns may differ significantly,either favorably or unfavorably, from estimates if factors such as economicconditions or the competitive environment differ from our expectations.

 

*Creditsand Other Vendor Allowances*

 

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidizequalifying advertising and similar promotional expenditures we make relating tothe vendor’s products), price protection credits (i.e., credits from vendorswith respect to in-stock inventory if the vendor subsequently lowers theirwholesale price for such products) and vendor rebates (i.e., credits or rebatesprovided by vendors based on the purchase of specified products and paid at alater date). Cooperative advertising allowances are recognized as a reductionto selling, general, and administrative expense when we incur the advertisingexpense eligible for the credit. We recognized cooperative advertisingallowances of $1.6 million and $1.5 million in the three months ended March 31,2005 and 2004, respectively, recorded as an offset to selling, general andadministrative expense.  Price protectioncredits and vendor rebates are accounted for as a reduction of the cost ofmerchandise inventory and are recorded at the time the credit or rebate isearned.  The effect of price protectioncredits and vendor rebates is recognized in the income statement at the timethe related inventory is sold as a reduction in cost of goods sold. Weregularly review and revise, when deemed necessary, our estimates of rebatesreserve based upon historical trends. We received payments of $7.8 million and$4.8 million for the three months ended March 31, 2005 and 2004, respectively.We earned vendor rebates of $7.2 million and $6.9 million for the three months endedMarch 31, 2005 and 2004, respectively. None of these credits are recorded asrevenue.

 

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**Results of Operations**

 

The following table presents our consolidatedstatements of income, as a percentage of net sales, for the periods indicated.

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| ** **                                  | ** ** | **March 31,**          | ** ** |
| ** **                                  | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Net sales                                   |       | 100.0                  | %          | 100.0 | % |
| Gross profit                                |       | 28.0                   |       | 27.1 |   |
| Selling, general and administrative expense |       | 21.3                   |       | 21.3 |   |
| Operating income                            |       | 6.7                    |       | 5.8 |   |
| Interest expense, net                       |       | 0.2                    |       | 0.4 |   |
| Income before income tax expense            |       | 6.5                    |       | 5.4 |   |
| Income tax expense                          |       | 2.5                    |       | 2.0 |   |
| Net income                                  |       | 4.0                    | %          | 3.4 | % |

 

**Three Months Ended March 31, 2005Compared to the Three Months Ended March 31, 2004**

 

Net sales for the threemonths ended March 31, 2005 increased 13.3% to $396.4 million, compared to $349.7million for the same period last year. Comparable store sales for our retail division increased 5%.  We believe that comparable store sales are amore useful indicator of store performance than the change in total net sales,since comparable store sales exclude the effects of changes in the number ofstores open.

 

Net sales from GuitarCenter stores for the three months ended March 31, 2005 totaled $294.7 million,a 11.8% increase from $263.5 million for the same period in 2004.  Sales from new stores contributed $17.2million and represent 55.2% of the total increase in retail store sales.  Comparable Guitar Center store sales for the quarterincreased 5%. Net sales from American Music stores for the three months endedMarch 31, 2005 totaled $10.2 compared to $9.4 million in 2004 primarily due tothe acquisition of Karnes Music in the third quarter of 2004. ComparableAmerican Music stores sales for the quarter decreased 1%.

 

Net sales from the directresponse channel totaled $91.5 million for the three months ended March 31, 2005,a $14.7 million, or 19.1%, increase from 2004. This increase primarily reflectsthe improved performance of catalog circulation and advertising strategies.  Sales from the contact center, which representsales placed via phone, live chat, mail and e-mail, increased 13.9% to $38.5million for the three months ended March 31, 2005 from $33.8 million for thecomparable 2004 period. Internet sales from orders placed via the Musician’sFriend and Giardinelli web sites increased 23.3% to $53.0 million from $43.0million for the same period last year. The growth of web-based sales reflects the continued trend of ourcatalog customers’ preference in using the web to place their orders, thesuccess of web-based promotions, and that the web site includes a more completeinventory presentation than our catalogs.

 

Gross profit for thethree months ended March 31, 2005 compared to 2004 increased 17.4% to $111.2million from $94.7 million.  Gross profitas a percentage of net sales for the period ended March 31, 2005 compared to2004 increased to 28.0% from 27.1%. Gross profit as a percentage of net sales for Guitar Center was 27.0% comparedwith 25.3% in the first quarter of 2004. The increase is due to a more favorableproduct mix (0.4%), reduced freight costs (0.3%) with the remainder primarily dueto increased sales of our proprietary products which yield a higher margin. Wedefine selling margin as net sales less the cost of the merchandise charged bythe vendor plus the associated inventory costs from fulfilling inventorythrough our distribution center.  Thecost of merchandise inventory is net of all associated vendor discounts andrebates. Freight is not included in selling margin. The gross profit margin forthe American Music stores was 37.4% compared to 36.1% for the same period lastyear.  The improvement is primarily due todecrease in inventory shrink (2.1%), decrease in freight costs (0.1%), partiallyoffset by an increase in occupancy costs (0.8%). Gross profit margin for thedirect response division was 30.2% for the quarter compared to

 

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32.0% in the first quarter of 2004. The decrease wasprimarily due to increased activity by competitors over the Internet which ledto pricing pressure (2.4%), partially offset by a decrease in freight costs(0.5%).

 

Selling, general andadministrative expenses for the three months ended March 31, 2005 increased 13.7%to $84.5 million from $74.3 million for the same period in 2004. As apercentage of net sales, selling, general and administrative expenses was 21.3%for the first quarter in 2005 and 2004, respectively. Selling, general andadministrative expenses for the Guitar Center stores in the first quarter were20.9% as a percentage of net sales compared to 20.3% in last year’s firstquarter. The increase is primarily due to increased leverage on higher compstore sales in the prior year period, as well as higher salary costs (0.3%),increase in advertising and promotional costs (0.3%) and an increase in rentassociated with leasing store equipment (0.3%), partially offset by a decreasein bad debt (0.2%) due to better collections.  Selling, general and administrative expensesfor the American Music stores were 50.4% of sales in the first quarter comparedto 46.1% in the same period last year. The increase is primarily due to higher payrolland commission costs (4.1%), inclusive of bonus expense (1.1%), higherdepreciation costs related to the corporate office (1.6%) and higheradvertising costs (1.0%), offset by a decrease in bad debt expense (1.1%) as aresult of better collections, decrease in travel expense (0.9%) and a decreasein computer repair costs (0.4%). Selling, general and administrative expensesfor the direct response division were 19.5% of sales compared to 21.5% for thethree month ended March 31, 2005 and 2004, respectively. The improvement isprimarily due to reduction in salaries expense (1.0%), insurance costs (0.4%)and depreciation expense (0.2%). We plan to increase our advertising andpromotional activities in the remainder of the year to drive online traffic. Theforegoing statement is a forward-looking statement and is subject to thequalifications set forth below under “Forward-Looking Statements”.

 

Operating incomeincreased 31.1% to $26.7 for the three months ended March 31, 2005 from $20.4million in the comparable 2004 period. This increase reflects a relatively goodperformance by the Guitar Center and Musician’s Friend businesses, offset somewhatby an operating loss of approximately $1.3 million for the American Musicsegment for the quarter ended March 31, 2005.

 

Interest expense, net forthe three months ended March 31, 2005, decreased to $0.9 million from $1.4 millionin the first quarter of 2004. The reduction in interest expense is dueprimarily to the interest income earned on the investment of excess cash forthe quarter ending March 31, 2005. We did not hold any investments in marketablesecurities during the quarter ending March 31, 2004.

 

In the three months endedMarch 31, 2005, a $9.9 million provision for income taxes was recorded comparedto $7.2 million for the same period last year, based on an effective tax rateof approximately 38.5% and 38%, respectively. There was a change in theeffective tax rate as a result of higher blended state income tax rates.

 

Net income for thethree months ended March 31, 2005 increased 34.8% to $15.9 million, compared to$11.8 million in the same period last year as a result of the combinations offactors described above.

### ** **

### **Liquidityand Capital Resources**

 

Our need for liquiditywill arise primarily from the funding of capital expenditures, working capitalrequirements and payments on our indebtedness, as well as possibleacquisitions. We have historically financed our operations primarily throughinternally generated funds and borrowings under our credit facilities. As ofMarch 31, 2005, we had no borrowings under our credit facility and hadavailable borrowings of $111.1 million (net of $3.9 million of outstandingletters of credit).

 

In February of 2005, weamended our credit facility with a syndicate of banks led by Wells Fargo RetailFinance. The credit facility permits borrowings up to $125 million (which maybe increased to $150 million at our option), subject to borrowing baselimitations. The actual amount available is tied to our inventory andreceivable base, and repayment obligations under the credit facility aresecured by liens on our principal assets. Borrowing options are prime rate (5.75%at March 31, 2005) plus applicable prime margin, or London Interbank OfferedRate, or LIBOR (three month rate at March 31, 2005 was 3.40%) plus applicableLIBOR margin. The applicable prime and LIBOR margins are based upon levels ofexcess availability and adjusted quarterly. If excess availability is greaterthan $20 million, the applicable prime margin is 0.00% and applicable LIBORmargin is 1.0%. If excess availability is less than or equal to $20 million andgreater than $10 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.25%. If excess availability is less than or equalto $10 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.5%. An unused fee of 0.25% is assessed on the unused portion of thecredit facility. The agreement underlying the credit facility includessignificant restrictive negative covenants. Among other things, these covenantsrestrict our ability to incur debt and issue specified equity instruments,incur liens on our

 

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assets, make anysignificant changes in our corporate structure or the nature of our business,dispose of assets, make guaranties, prepay debt, engage in a change in controltransaction, pay dividends, make investments or acquisitions, engage intransactions with affiliates and incur capital expenditures, and also requirethat we satisfy a minimum availability test. The minimum availability testrequires that we maintain $10 million of reserved availability under theagreement based on its borrowing base limitations.  The amount we disclose in our public reportsfrom time to time as available to borrow under the agreement ($111.1 million atMarch 31, 2005) is already reduced by this required reserve and outstandingletters of credit, and thus represents a net amount available under theagreement. The agreement also includes representations and warranties whichmust be true each time we borrow funds under the credit facility andaffirmative covenants.  The full text ofthe contractual requirements imposed by this financing is set forth in theAmended and Restated Loan and Security Agreement and related amendments whichhave been filed with the Securities and Exchange Commission.  We were in compliance with such requirementsas of March 31, 2005.  Subject to limitedcure periods, the lenders under our credit facility may demand repayment ofthese borrowings prior to stated maturity upon the occurrence of specifiedevents, including if we breach the terms of the agreement, suffer a materialadverse change, engage in a change in control transaction, suffer a significantadverse legal judgment, default on other significant obligations, or in theevent of specified events of insolvency. The credit agreement matures in December 2010.

 

On June 16, 2003, wecompleted the issuance of $100 million principal amount of 4.00% SeniorConvertible Notes due 2013 (the Notes). The Notes bear interest at the rate of4.00% per annum, subject to the payment of contingent interest under certaincircumstances, and are convertible into shares of common stock at a conversionprice of $34.58 per share, subject to adjustment under specified circumstances.Under the contingent conversion feature of the Notes, subject to certainexceptions, they are not convertible into common stock unless and until thetrading price of the common stock reaches at least $41.50 for a specifiedperiod in advance of each quarterly conversion period or designated corporateevents occur. As of March 31, 2005, the notes were convertible for the currentquarterly conversion period. The Notes will also become convertible upon theoccurrence of specified corporate transactions and other events described inthe indenture. The final maturity of the Notes is July 2013, although holdersmay require us to repurchase the Notes at their election in July 2008, July2010 or upon the occurrence of a change in control, in each case for a purchaseprice equal to the original principal amount plus accrued interest.  We may call the Notes for redemptioncommencing in July 2006 subject to the payment of a redemption premium of 1.6%if redeemed prior to July 2007 and 0.8% if redeemed prior to July 2008(thereafter there is no redemption premium). The indenture governing the Notesdoes not limit our ability to incur indebtedness or otherwise substantivelyrestrict the operation of our business to any significant degree.  Subject to limited cure periods, the holdersof the Notes may demand repayment of these borrowings prior to the statedmaturity upon the occurrence of specified events, including if we fail to payinterest or principal when due, fail to satisfy our conversion obligation, ifanother obligation of ours having an outstanding principal amount in excess of$15 million is accelerated prior to stated maturity and upon the occurrence ofspecified events of insolvency.

 

During 2002 we enteredinto master operating lease agreements with General Electric CapitalCorporation and US Bank to lease equipment and other property primarily tosupport the operations of the new central distribution center for our GuitarCenter retail stores. Under these agreements, we leased a total of $10.5million in equipment and other property. The agreements call for monthlypayments of $138,000 for a term of 36 months through September 1, 2005 with anoption to extend through September 30, 2009 and monthly payments of $48,000 fora term of 24 months through December 28, 2005.

 

The terms of oursignificant financing agreements, including those related to our creditfacility, the Senior Convertible Notes and the equipment lease facilitiesdescribed above, are not dependent on any change in our credit rating. Webelieve that the key company-specific factors affecting our ability to maintainour existing debt and lease financing relationships and to access such capitalin the future are our present and expected levels of profitability and cashflow from operations, our working capital and fixed asset collateral bases, ourexpected level of capital expenditures, and the level of equity capital of theCompany relative to the level of debt obligations. In addition, as noted above,our existing agreements include significant restrictions on future financings,including among others, limits on the amount of indebtedness that we may incurand whether or not such indebtedness may be secured by any of our assets.

 

As is the case with mostmulti-unit retailers, substantially all of the real property used in ourbusiness is leased under operating lease agreements.  Please see, Item 2. Properties, “—DisclosuresAbout Contractual Obligations and Commercial Commitments” and Note 9 in ourAnnual Report on Form 10-K for the year ended December 31, 2004.

 

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Net cash provided by operatingactivities was $18.9 million for the three months ended March 31, 2005 comparedto $13.8 million for the same period last year. The largest use of cash was anincrease in inventories of $13.4 million. The increase in merchandise inventoryis required to support the eight new stores and reflects our efforts to improvein-stock positions in product categories that have been driving our revenuegrowth. The increase in accounts payable was also primarily due to increasedinventory purchases to replenish inventory levels after the higher thanexpected sales achieved in the fourth quarter of 2004.

 

Cash used in investingactivities increased to $48.9 million for the three months ended March 31, 2005compared to $4.8 million for the same period last year. The current periodcapital expenditures consisted primarily of a corporate airplane of $10.6million, capital expenditures for store expansions and remodels of $9.4 millioncompared to $3.2 million in the prior period and computer equipment purchasesof $1.9 million in the current period compared to $1.3 million in the sameperiod last year. Additionally, we purchased available-for-sale securities of $27.3million in the current period.

 

 Cash provided by financing activities totaled$7.8 million for the three months ended March 31, 2005 compared to $4.6 millionused in the same period last year. The cash provided by financing activitiesconsists of the proceeds received from the exercise of stock options.

 

We believe that ourcurrent operating cash flow, working capital, and cash and cash equivalents onhand will be sufficient to meet our obligations in the ordinary course ofbusiness, including capital expenditures and new store openings. In the secondquarter of 2005, we funded the cash component of the Music & Artsacquisition (including the repayment of assumed debt) with approximately $93.0million from available cash and drawings under our credit facility.

 

We intend to pursue anaggressive growth strategy by opening additional stores in new and existingmarkets.  During the three months ended March31, 2005, we opened eight new Guitar Center stores (five large format and threesmall format stores). Each new large format Guitar Center store typically hasrequired approximately $1.3 to $1.5 million for gross inventory.  Historically, our cost of capitalimprovements for a large format Guitar Center store has been approximately$900,000, consisting of leasehold improvements, fixtures and equipment. Weincur higher costs in some geographic areas, particularly the Northeast, andwhen we build a larger flagship store. We have developed smaller Guitar Center stores to build in secondarymarkets or sites that we do not believe will support our large format units.The first of these units was opened in late 2000 and 26 more had been opened asof March 31, 2005. Our small format stores have typically requiredapproximately $700,000 in capital expenditures and require approximately $1.0million to $1.2 million in inventory.

 

We are also anticipatingadditional capital and strategic requirements related to improving ourfulfillment facilities, upgrading our technology and systems, and pursuing newopportunities in the e-commerce activities of our retail and direct responsedivisions as well as related businesses.

 

Our distribution centerin the Indianapolis, Indiana area supports our Guitar Center retail storeoperations. We have a 10-year agreement to lease the facility and we also havenumerous additional commitments necessary to support the operations of thefacility. Starting in 2003, nearly all products flow through the distributionfacility, with the exception of special orders which will continue, for themost part, to be drop shipped to our stores. A portion of the costs ofoperating this facility are absorbed into our Guitar Center merchandiseinventories and recognized as an element of cost of goods sold when the relatedinventory is sold.

 

We are in the process ofplanning an expansion of our distribution center from 500,000 square feet to750,000 square feet. We anticipate this expansion to be completed in early2006. The larger facility will increase our capacity to support continuedexpansion in 2006 and beyond. We anticipate making additional capitalinvestments of $5.0 to $7.0 million and we will incur increased rent expensewhen the facility is completed in 2006.

 

We also continue to makesignificant investments in information technology across our businesses and toincur costs and make investments designed to expand the reach of our businesseson the Internet.  The costs of theseinitiatives and other investments related to our businesses will continue to besignificant.

 

Our expansion strategy isto continue to increase our market share in existing markets and to penetratestrategically selected new markets.  Weopened a total of 14 Guitar Center stores in each of 2004 and 2003, andcurrently anticipate opening 22 to 26 Guitar Center stores in 2005. Thisincludes 8 to 10 large format stores and 14 to 16 small format stores. On April15, 2005 we completed the acquisition of Music & Arts and we intend to

 

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combine our AmericanMusic business and Music & Arts, with the combined business operating underthe Music & Arts name. We also continue to believe that there exists anumber of additional acquisition opportunities in the relatively fragmentedband instruments market that could be a good fit with our company and continueto pursue acquisition opportunities.

 

Throughout our history,we have primarily grown organically. However, we also believe there may beattractive opportunities to expand by selectively acquiring existing musicproducts retailers or other complimentary businesses, if attractiveopportunities can be identified. For example, in April 2005 we completed theacquisition of Music & Arts, which primarily addresses the beginningmusician, with an emphasis on rentals, music lessons, and band and orchestrainstrument sales. While we cannot provide assurance that we will complete anyfurther acquisition transactions, in the ordinary course of our business weinvestigate and engage in negotiations regarding such opportunities.Acquisitions will be financed with cash on hand, drawings under our existingcredit facilities, expansion of our credit facilities, issuance of debt orequity securities, or a combination, depending upon transaction size and marketconditions, among other things.

 

Our known capitalresource and liquidity requirements for 2005 are presently expected to beprimarily provided by cash on hand, net cash flow from operations andborrowings under our credit facility. Depending upon market conditions, we mayalso elect or be required to raise additional capital in the form of common orpreferred equity, debt or convertible securities for the purpose of providingadditional capital to fund working capital needs or continued growth of ourexisting business, or to refinance existing obligations. Any such financingactivity will be dependent upon many factors, including our liquidity needs,market conditions and prevailing market terms, and we cannot assure you thatfuture external financing for us will be available on attractive terms or atall.

 

### **NewAccounting Pronouncements**

 

In January 2003, the Financial Accounting StandardsBoard issued FASB Interpretation No. 46, *“Consolidation of VariableInterest Entities” (FIN 46).* This interpretation clarifies the application of Accounting ResearchBulletin No. 51, *“Consolidated Financial Statements” (ARB51),* and requires companies to evaluate variable interest entitiesfor specific characteristics to determine whether additional consolidation anddisclosure requirements apply.  Thisinterpretation was immediately applicable for variable interest entitiescreated after January 31, 2003, and applies to the first fiscal year or interimperiod beginning after June 15, 2003 for variable interest entities acquiredprior to February 1, 2003. The adoption of this interpretation did not have anyimpact on our financial position or results of operations. In December 2003,the FASB revised FIN 46 to exempt certain entities from its requirements and toclarify certain issues arising during the implementation of FIN 46. Theadoption of this revised interpretation in the first quarter of 2004 did nothave any impact on our consolidated financial statements.

 

In November2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No.04-8, *“Accounting Issues Related to Certain Features ofContingently Convertible Debt and the Effect on Diluted Earnings per Share”(EITF No. 04-8).* The Task Force reached a consensus thatcontingently convertible debt instruments, such as our 4.00% Senior ConvertibleNotes, should be included in the computation of diluted earnings per shareunder the if-converted method regardless of whether the market price trigger(or other contingent feature) has been met. The EITF 04-8 consensus must beapplied by retroactive restatement based on the term in effect on the last dayof the fiscal period in which the consensus becomes effective. This consensusbecame effective for all financial statements issued after December 15, 2004.Accordingly, we retroactively restated all earnings per share measures for allperiods to reflect the consensus.

 

In December 2004, the FASB issued SFAS No. 123 (revised2004) Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R requires that the fairvalue from all share-based payment transactions, including stock options, berecognized in the financial statements at fair value. SFAS No. 123R iseffective for public companies in the first fiscal year beginning on or afterJanuary 1, 2006. We will adopt the provisions of this statement in the firstquarter of 2006. We anticipate adopting SFAS No. 123R using the modifiedprospective method, which will not require us to restate any priorperiods.  We are currently evaluating theeffect of adoption of SFAS No. 123R will have on our consolidated financialstatements and have not determined whether the adoption will or will not resultin amounts that are similar to the current pro forma disclosure under SFAS No.123.

 

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### **Seasonality**

 

Our operating results arenot highly seasonal, except for the effect of the holiday selling season inNovember and December.  Sales in the fourthquarter are typically significantly higher on a per store basis and through thedirect response unit than in any other quarter.

### ** **

### **Inflation**

 

We believe that therelatively moderate rates of inflation experienced in recent years have not hada significant impact on our net sales or profitability.

 

### **Forward-LookingStatements**

 

This report containsforward-looking statements relating to, among other things, future results ofoperations, growth and investment plans, sales, trends in gross margin, growthin the Internet business and other factors affecting growth in sales andearnings.  Specific forward-lookingstatements are provided regarding our management’s current views regardingcomparable store sales, new store openings, and capital expenditurelevels.  Statements regarding new storeopenings are based largely on our current expectations and are necessarilysubject to associated business risks related to, among other things, theidentification of suitable sites or acquisition opportunities, the timely construction,staffing and merchandising of those stores and other matters, some of which areoutside of our control. Comparable store sales growth is highly dependent uponthe state of the economy, the effectiveness of our sales and promotionstrategies, and the effect of competition, including other national operatorsof music products stores attempting to implement national growth strategies.

 

Sales and earnings trendsare also affected by many other factors including, among others, world andnational political events, general economic conditions, the effectiveness ofour promotion and merchandising strategies, changes in the music productsindustry, retail sales trends and the emergence of new or growing specialtyretailers of music products.  In light ofthese risks, there can be no assurance that the forward-looking statementscontained in this report will in fact be realized.  The statements made by us in this reportrepresent our views as of the date of this report, and it should not be assumedthat the statements made herein remain accurate as of any future date.  We do not presently intend to update thesestatements and undertake no duty to any person to affect any such update underany circumstances.

 

For further discussion ofrisks associated with our business, please see the discussion under the caption“Risks Related to the Business.”

 

**RisksRelated to the Business**

 

An investment in oursecurities involves a high degree of risk. Described below are some of the risks and uncertainties facing our company.There may be additional risks that we do not presently know of or that wecurrently consider immaterial.  All ofthese risks could adversely affect our business, results of operations,liquidity and financial position.  Ashortfall in comparative sales growth in any period will likely cause ashortfall in earnings, and result in financial performance below that for whichwe have planned or the investment community expects.

* *

*We may be unable to meetour Guitar Center retail store growth strategy, which could adversely affectour results of operations.*

 

Our retail store growthstrategy includes opening new stores in new and existing markets and increasingsales at existing locations.  Wecurrently operate 146 Guitar Center stores. We opened a total of 14 Guitar Center stores in 2004, have opened atotal of 10 Guitar Center Stores to date in 2005, and currently expect to opena total of approximately 22 to 26 additional Guitar Center stores in 2005. Thisincludes 8 to 10 large format stores and 14 to 16 small format stores. Ourplanned store opening schedule may be affected by any acquisitions we maytransact during a given period. If we complete any such transactions, ourplanned organic store openings may be reduced.

 

The success of our retailstore expansion plans depend on many factors, including:

 

•      identificationof suitable retail sites and appropriate acquisition candidates;

 

•      negotiationof acceptable lease terms;

 

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•      hiring,training and retention of skilled personnel;

 

•      availabilityof adequate capital;

 

•      sufficientmanagement and financial resources to support the new locations; and

 

•      vendorsupport.

 

A number of these factorsare, to a significant extent, beyond our control.  As a result, we do not know whether we willbe able to continue to open and/or acquire additional Guitar Center stores atthe rates currently anticipated.  If weare unable to achieve our retail store expansion goals, or the new stores underperform our expectations, our results of operations could be adverselyaffected.

 

*We face unique competitive and merchandising challenges inconnection with our plans to open additional Guitar Center retail stores in newmarkets.*

 

As part of our retailgrowth strategy, we plan to open and/or acquire additional Guitar Center storesin new markets, which could include international markets. This expansion intonew markets will present unique competitive and merchandising challenges,including:

 

•      significantstart-up costs, including promotion and advertising;

 

•      higheradvertising and other administrative costs as a percentage of sales than isexperienced in mature markets that are served by multiple stores, particularlyin large urban markets where radio and other media costs are high;

 

•      managementof stores in distant locations or foreign countries;

 

•      availabilityof desirable product lines; and

 

•      ourexpansion may involve acquisitions, including acquisitions in business segmentsin which we have limited or no experience.

 

Any of these factors maylead to a shortfall in revenues or an increase in costs with respect to theoperation of these stores.  If we are notable to operate these stores profitably, our results of operations would beadversely affected.

 

*OurGuitar Center retail store expansion strategy, including our strategy ofclustering retail stores, may adversely impact our comparable store sales.*

 

Historically, we haveachieved significant sales growth in existing Guitar Center stores.  Our quarterly comparable stores sales resultshave fluctuated significantly in the past. Sales growth for comparable periods, excluding net sales attributable tostores not open for 14 months, was as follows for our Guitar Center retailstores:

 
| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Quarter 1  |       | 5        | %          | 11       | %          | 4        | %          |
| Quarter 2  |       | —   | %          | 8        | %          | 5        | %          |
| Quarter 3  |       | —   | %          | 9        | %          | 7        | %          |
| Quarter 4  |       | —   | %          | 10       | %          | 10       | %          |
|       |       |     |       |     |       |     |       |
| Full Year  |       | —   | %          | 10       | %          | 7        | %          |

 

We do not know whether our new stores will achievesales or profitability levels similar to our existing stores.  Our expansion strategy includes clusteringstores in existing markets.  Clusteringhas in the past and may in the future result in the transfer of sales to thenew store and a reduction in the profitability of an existing store.  In addition, a variety of factors affect ourcomparable store sales results, including:

 

•      competition;

 

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•      economicconditions, including in particular, discretionary consumer spending;

 

•      consumerand music trends;

 

•      changesin our merchandise mix;

 

•      productdistribution; and

 

•      timingand effectiveness of our promotional events.

 

A shortfall in comparative sales growth in any periodwill likely cause a shortfall in earnings, and result in financial performancebelow that for which we have planned or the investment community expects.

 

*Our growth plans dependon our completion of acquisitions, and these transactions involve specialrisks.*

 

We believe that ourexpansion may be accelerated by the acquisition of existing music productretailers. For example, on February 8, 2005, we entered into a definitiveagreement to acquire privately held Music & Arts Center, a Maryland-basedmusical instruments retailer, which primarily addresses the beginning musician,with an emphasis on rentals, music lessons, and band and orchestra instrumentsales. Music & Arts operates 62 retail locations primarily located in theNortheast, Mid-Atlantic and Southern regions of the U.S.  We completed the acquisition on April 15,2005 for a purchase price of $90 million, plus the assumption of debt andcertain other deferred obligations.  Theacquisition did not have any impact on the Company’s first quarter financialresults and was funded from cash on hand and drawings under our line of credit.We intend to combine our American Music business and Music & Arts, with thecombined business operating under the Music & Arts name.  Acquisitions such as the Music & Artstransaction involve a number of special risks, including:

 

•      diversionof our management’s attention;

 

•      integrationof the acquired business with our business; and

 

•      unanticipatedlegal liabilities and other circumstances or events.

 

Any failure tosuccessfully complete the integration of the Music & Arts business with ourAmerican Music business could adversely affect our business, results ofoperations, liquidity and financial position. Further, we expect to incursignificant costs and expenses in the initial integration of these twobusinesses.

 

In addition, we regularlyinvestigate acquisition opportunities complementary to our Guitar Center,Musician’s Friend and Music & Arts businesses. Accordingly, in the ordinarycourse of our business, we regularly consider, evaluate and enter intonegotiations related to potential acquisition opportunities. We may pay forthese acquisitions in cash or securities, including equity securities, or acombination of both. We cannot assure you that attractive acquisition targetswill be available at reasonable prices or that we will be successful in anysuch transaction.

 

*We depend on a relatively small number ofmanufacturers, suppliers and common carriers who may not be able or desire tosupply our requirements.*

 

Brand recognition is ofsignificant importance in the retail music products business. As a result, wedepend on a relatively small number of manufacturers and suppliers for both ourexisting retail stores and the direct response unit as well as our expansiongoals for each of these units. We do not have any long-term contracts with oursuppliers, and any failure to maintain our relationships with our key brandname vendors would have a material adverse effect on our business. A number ofthe manufacturers of the products we sell are limited in size and manufacturingcapacity and have significant capital or other constraints. These manufacturersmay not be able or willing to meet our increasing requirements for inventory,and we cannot assure you that sufficient quantities or the appropriate mix ofproducts will be available in the future to supply our existing stores andexpansion plans. These capacity constraints could lead to extended lead timesand shortages of desirable products. The risk is especially prevalent in newmarkets where our vendors have existing agreements with other dealers andthereby may be unwilling or unable for contractual or other reasons to meet ourrequirements. The efficient operation of our distribution center for the GuitarCenter stores is also highly dependent upon compliance by our vendors withprecise requirements as to the timing, format and composition of shipments,which in many instances requires changes and upgrades to the operationalprocedures and

 

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logistics and supply chain management capabilities ofvendors, all of which are outside of our control. Additionally, many of ourvendors receive product from overseas and depend on an extensive supply chainincluding common carriers and port access to transport merchandise into thecountry. Foreign manufacturing is subject to a number of risks, including politicaland economic disruptions, the imposition of tariffs, quotas and other import orexport controls, and changes in governmental policies. We rely on commoncarriers to transport product from our vendors to our central distributioncenter in Indiana, and from the distribution facility to our Guitar Centerstores. Similarly, Musician’s Friend relies on common carriers to transportproduct to its fulfillment center in Kansas City, Missouri and onward toconsumers. Any disruption in the services of common carriers due to employeestrikes or other unforeseen events could impact our ability to maintainsufficient quantities of inventory in our retail locations or to fulfill ordersby direct response customers.

 

*We face products liability risk.*

 

Products that we develop or sell may expose us toliability from claims by users of such products for damages including, but notlimited to, bodily injury or property damage. This risk is expected to increaseas we use the capabilities of our Guitar Center and Musician’s Frienddistribution centers to increase the private label and other proprietaryproduct that we offer. Much of this product is manufactured by small companieslocated overseas. We currently maintain products liability insurance coveragein amounts that we believe are adequate. However, there can be no assurancethat we will be able to maintain such coverage or obtain additional coverage onacceptable terms in the future, or that such insurance will provide adequatecoverage against all potential claims.

 

*We face significantcompetition, and our efforts to increase our market share may be inhibited byexisting or new competitors also trying to execute national expansionstrategies.*

 

The retail music productsindustry is fragmented and highly competitive. We compete with many differenttypes of music product retailers, including conventional retailers, as well asother catalog and e-commerce retailers, who sell many or most of the items wesell. We believe that large format music product retailers such as our companywill seek to expand in part through the acquisition of small, independentlyowned stores or franchises, and we anticipate increased competition in ourexisting markets and planned new markets from these consolidating retailers.These retailers may identify target companies or execute their acquisitionstrategies more effectively than our company. In addition, these retailers may have greater financial resources orother competitive advantages as compared to our company. Our expansion to newmarkets will be inhibited by these and other established competitors. Inaddition, one or more of our competitors may adopt a new, innovative storeformat or retail selling method. If we are not able to compete effectively, wemay fail to achieve market position gains or may lose market share.

 

Several large massmerchants, including Wal-Mart and Costco, have begun to sell musicalinstruments in categories that we compete in, including entry-level guitars,electronic keyboards and band instruments, and thus could represent asignificant source of future competition for our retail and direct responsebusinesses, particularly if these retailers expand their product lines beyondentry-level merchandise.

 

*We must grow our Music & Artsbusiness in order to reach profitability and earn an acceptable return on ourinvestment.*

 

In April 2001, wecompleted our acquisition of American Music Group, a New York-based retailer ofband instruments. We had not previously participated in the band instrumentssegment of the music products business and had no prior experience in thisdistribution channel. The American Music division incurred significantoperating losses in 2003 and 2004. In April 2005, we completed our acquisitionof Music & Arts.  Thus, we face thenormal challenges of any acquisition, such as integration of personnel andsystems as well as the need to learn, understand and further develop thisbusiness. During 2005, we will face further significant challenges as weattempt to combine the Music & Arts business with our existing AmericanMusic business. Failure to execute on the requirements and initiativesdescribed above could result in a poor or no return on our investments inAmerican Music and Music & Arts, constitute a distraction of the efforts ofour management team from the core Guitar Center and Musician’s Friend brandsand potentially require us to recognize an impairment in the significant amountof goodwill recorded in the acquisitions of American Music, M&M Music andKarnes Music, which totaled $21.1 million at March 31, 2005. In addition, werecognized a material increase in this goodwill amount upon the acquisition of Music& Arts.

 

*Our Music& Arts business is dependent on state and local funding of primary andsecondary schools.*

 

Our Music & Artsbusiness derives the majority of its revenue from sales or services to musicstudents in primary and secondary schools. Any decrease in the state and local funding of such music programs couldhave a material adverse effect on our Music & Arts business and its resultsof operations.

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*We depend on keypersonnel including our senior management who are important to the success ofour business.*

 

Historically, we have promoted employees from within ourorganization to fill senior operations, sales and store managementpositions.  In order to achieve ourgrowth plans, we will depend upon our ability to retain and promote existingpersonnel to senior management, and we must attract and retain new personnelwith the skills and expertise to manage our business. If we cannot hire, retainand promote qualified personnel, our business, results of operations, financialcondition and prospects could be adversely affected.

 

*Our retail operationsare concentrated in California, which ties our financial performance to eventsin that state.*

 

As of March 31, 2005, ourcorporate headquarters as well as 23 of our 144 Guitar Center stores werelocated in California, and stores located in that state generated 22.9% and 24.3%of our retail sales for 2004 and 2003, respectively.  Although we have opened and acquired storesin other areas of the United States, a significant percentage of our net salesand results of operations will likely remain concentrated in California for theforeseeable future.  As a result, ourresults of operations and financial condition are heavily dependent upongeneral consumer trends and other general economic conditions in California andare subject to other regional risks, including earthquakes.  We do maintain earthquake insurance, but suchpolicies carry significant deductibles and other restrictions.

 

*Economic conditions or changingconsumer preferences could also adversely impact us.*

 

Our business is sensitiveto consumer spending patterns, which can be affected by prevailing economicconditions. A downturn in economic conditions in one or more of our markets,such as occurred after September 11, 2001, could have a material adverse effecton our results of operations, financial condition, business and prospects.  Although we attempt to stay informed ofconsumer preferences for musical products and accessories typically offered forsale in our stores, any sustained failure on our part to identify and respondto trends would have a material adverse effect on our results of operations,financial condition, business and prospects.

 

*We may need to change the mannerin which we conduct our business if government regulation or taxation imposesadditional costs and adversely affects our financial results.*

 

The adoption or modification of laws or regulations, orrevised interpretations of existing laws, relating to the direct responseindustry could adversely affect the manner in which we currently conduct ourcatalog and e-commerce business and the results of operations of that unit. Forexample, laws and enforcement practices related to the taxation of catalog,telephone and online commercial activity, including the collection of sales taxon direct response sales, remain in flux. In addition, the growth anddevelopment of the market for online commerce may lead to more stringentconsumer protection laws, both in the United States and abroad, that may imposeadditional burdens on us. Laws and regulations directly applicable tocommunications or commerce over the Internet are becoming more prevalent. Thelaw of the Internet, however, remains largely unsettled, even in areas wherethere has been some legislative action. It may take years to determine whetherand how existing laws such as those governing intellectual property, consumerprivacy, sales-based and other taxation of e-commerce transactions and the likeare interpreted and enforced. Any adverse change in any of these laws or in theenforcement, interpretation or scope of existing laws could have a materialadverse effect on our results of operations, financial condition or prospects.

 

*We face risks created bylitigation, governmental proceedings, labor disputes or environmental matters.*

 

We are involved in a number of litigation matters inthe ordinary course of our business. Among these cases are two putative class actions brought against us foralleged violations of what is known as California’s “wage and hour” law.  The plaintiffs have alleged, among otherthings, that we improperly failed to document and enforce break-time andlunch-time periods for employees.  Weintend to defend these matters vigorously. Current and future litigation that our Company is involved in may resultin substantial costs and expenses and significantly divert the attention of ourmanagement regardless of the outcome.  Inaddition, current and future litigation, governmental proceedings, labordisputes or environmental matters could lead to increased costs orinterruptions of our normal business operations.

* *

*We must manageefficiently the expansion of our Direct Response business, including themusiciansfriend.com website, our systems that process orders in our DirectResponse business, and our fulfillment resources in order to service ourcustomers properly.*

 

Our direct responsebusiness, particularly our e-commerce business, will require significantinvestments to respond to anticipated growth and competitive pressures. If wefail to rapidly upgrade our website in order to accommodate increased traffic,we may lose customers, which would reduce our net sales. Furthermore, if wefail

 

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to expand the computersystems that we use to process and ship customer orders and process paymentsand the fulfillment facilities we use to manage and ship our inventory, we maynot be able to successfully distribute customer orders. We experienced somedelays of this sort in 2001 in connection with the consolidation of ourfulfillment centers. As a result, we could incur excessive shipping costs dueto the need to split delayed shipments, increased marketing costs in the formof special offers to affected customers or the loss of customers altogether. Wemay experience difficulty in improving and maintaining such systems if ouremployees or contractors that develop or maintain our key systems becomeunavailable to us.  We have experiencedperiodic service disruptions and interruptions, which we believe will continueto occur, while enhancing and expanding these systems.

 

*Net sales of our e-commercebusiness could decrease if our online security measures fail.*

 

Our relationships withour e-commerce customers may be adversely affected if the security measuresthat we use to protect their personal information, such as credit card numbers,are ineffective.  If, as a result, welose customers, our net sales could decrease. We rely on security andauthentication technology that we license from third parties. With thistechnology, we perform real-time credit card authorization and verificationwith our bank. We cannot predict whether events or developments will result ina compromise or breach of the technology we use to protect a customer’spersonal information.  Furthermore, ourservers may be vulnerable to computer viruses, physical or electronic break-insand similar disruptions. We may need to expend significant additional capitaland other resources to protect against a security breach or to alleviateproblems caused by any breaches. We cannot assure that we can prevent allsecurity breaches.

 

*If we do not respond to rapidtechnological changes, our services could become obsolete and we could losecustomers.*

 

If we face materialdelays in introducing new services, products and enhancements, our e-commercecustomers may forego the use of our services and use those of our competitors.To remain competitive, we must continue to enhance and improve thefunctionality and features of our online store. The Internet and the online commerce industry are rapidly changing. Ifcompetitors introduce new products and services embodying new technologies, orif new industry standards and practices emerge, our existing website andproprietary technology and systems may become obsolete. To develop our websiteand other proprietary technology entails significant technical and business risks.We may use new technologies ineffectively or we may fail to adapt our website,our transaction processing systems and our computer network to meet customerrequirements or emerging industry standards. In addition, the success ofe-commerce may result in greater efficiency and lower prices, which could havean adverse effect on selling prices and margins in our retail store businessand in our catalog business and generally constrain profitability in thespecialty retail business.

 

*Ourhardware and software systems are vital to the efficient operation of ourretail stores and direct response business, and damage to these systems couldharm our business.*

 

We rely on our computerhardware and software systems for the efficient operation of our retail storesand direct response business. Our information systems provide our managementwith real-time inventory, sales and cost information that is essential to theoperation of our business. Due to our number of stores, geographic diversityand other factors, we would be unable to generate this information in a timelyand accurate manner in the event our hardware or software systems wereunavailable. These systems are vulnerable to damage or interruption from anumber of factors, including:

 

•      earthquake,fire, flood and other natural disasters; and

 

•      power loss, computer systemsfailure, Internet and telecommunications or data network failure.

 

A significant informationsystems failure could reduce the quality or quantity of operating dataavailable to our management. If this information were unavailable for anyextended period of time, our management would be unable to efficiently run ourbusiness, which would result in a reduction in our net sales.

 

To attempt to mitigatethese risks we have contracted services from third parties to provide backupsystems for our Guitar Center retail stores in the event of a disaster. Theseservices are designed to permit our “mission critical” systems to be onlinewithin 48 hours following most disasters. Our direct response business does nothave redundant Internet or operating systems and would be vulnerable tocatastrophic events. In the event of a disaster, our direct response businesswould most likely experience delays in processing and shipping orders.

 

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*Our stock price could bevolatile.*

 

The market price of ourcommon stock has been subject to significant fluctuations in response to ouroperating results and other factors, including announcements by ourcompetitors, and those fluctuations will likely continue in the future. Inaddition, the stock market in recent years has experienced significant priceand volume fluctuations that often have been unrelated or disproportionate tothe operating performance of particular companies. These fluctuations, as wellas a shortfall in sales or earnings compared to public market analysts’expectations, changes in analysts’ expectations, changes in analysts’recommendations or projections, and general economic and market conditions, mayadversely affect the market price of our common stock.

# ** **

***Our actual operating results maydiffer significantly from our projections.***

 

From time to time, werelease projections and similar guidance regarding our future performance thatrepresent our management’s estimates as of the date of release. Theseprojections, which are forward looking-statements, are prepared by ourmanagement and are qualified by, and subject to, the assumptions and the otherinformation contained or referred to in the release. Our projections are notprepared with a view toward compliance with published guidelines of theAmerican Institute of Certified Public Accountants, and neither our independentpublic accountants nor any other independent expert or outside party compilesor examines the projections and, accordingly, no such person expresses anyopinion or any other form of assurance with respect thereto.

 

Projections are basedupon a number of assumptions and estimates that, while presented with numericalspecificity, are inherently subject to significant business, economic andcompetitive uncertainties and contingencies, many of which are beyond ourcontrol and are based upon specific assumptions with respect to future businessdecisions, some of which will change. We generally state possible outcomes ashigh and low ranges which are intended to provide a sensitivity analysis asvariables are changed but are not intended to represent that actual resultscould not fall outside of the suggested ranges. The principal reason that we release this data is to provide a basis forour management to discuss our business outlook with analysts and investors. Wedo not accept any responsibility for any projections or reports published byany such persons.

 

Projections arenecessarily speculative in nature, and it can be expected that some or all ofthe assumptions of the projections furnished by us will not materialize or willvary significantly from actual results. Accordingly, our projections are onlyan estimate of what management believes is realizable as of the date ofrelease. Actual results will vary from the projections and the variations maybe material.  Investors should alsorecognize that the reliability of any forecasted financial data diminishes thefarther in the future that the data is projected. In light of the foregoing,investors are urged to put the projections in context and not to place unduereliance on them.

 

Any failure tosuccessfully implement our operating strategy or the occurrence of any of theevents or circumstances set forth in this report could result in the actualoperating results being different than the projections, and such differencesmay be adverse and material.

 

**Item 3.****                    Quantitativeand Qualitative Disclosures About Market Risk**

 

We do not have any assets or liabilities which, in ourview, impose upon us significant market risk except for our outstandingindebtedness represented by $100 million principal amount of Senior ConvertibleNotes due 2013 with a fixed interest rate of 4% (subject to contingent interest)and our credit facility which has a variable rate of interest generallyconsisting of stated premiums above LIBOR. At March 31, 2005, we had no outstanding borrowings under our creditfacility.  To the extent prevailingshort-term interest rates fluctuate, the interest expense we incur on ourcredit facility will change with a resulting effect (positive or negative) onour financial position, results of operations and cash flows. We do not usederivative financial instruments in our investment portfolio.  Historically, we have not carried significantcash balances and any cash in excess of our daily operating needs has been usedto reduce our borrowings.  Excess cash isinvested in short-term, high quality interest bearing investments.

 

**Item 4.****                    Controlsand Procedures**

 

We maintain disclosure controls and proceduresthat are designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate,

 

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toallow for timely decisions regarding required disclosure. In designing andevaluating the disclosure controls and procedures, management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives,and management is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

As required by SEC Rule 13a-15(b), we carriedout an evaluation, under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report.  Based onthe foregoing, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were effective at thereasonable assurance level.

 

There has been no change in our internal controlover financial reporting during our most recent fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting.

 

**Part II.**   **OTHER INFORMATION**

 

**Item 1.****                   ****Legal Proceedings**

 

We are involved in various claims and legal actions arisingin the ordinary course of our business and, while the results of theproceedings cannot be predicted with certainty, we believe that the finaloutcome of such matters will not have a material adverse effect on ourconsolidated financial position or results of operations.

 

On October 13, 2004, a putative class action lawsuitentitled Carlos Rodriguez v. The Guitar Center, Inc. [sic], Case No. GC322958,was filed in the Superior Court of the State of California for the County ofLos Angeles.  The lawsuit was filed by anindividual purporting to represent all hourly retail store employees employedby us within the State of California.  OnDecember 15, 2004, a putative class action lawsuit entitled James McClain et.al. v. Guitar Center Stores, Inc., Case No. BC326002, was filed in the SuperiorCourt of the State of California for the County of Los Angeles.  The lawsuit was filed by three individualspurporting to represent all hourly retail store employees employed by us withinthe State of California.   Among otherthings, the lawsuits allege that we improperly failed to document and enforcebreak-time and lunch-time periods for such employees and seek an unspecifiedamount of damages, penalties and attorneys’ fees.  In the Rodriguez case, we have filed ananswer to the plaintiff’s complaint and are in the process of responding to theplaintiff’s requests for discovery.  TheMcClain complaint has been served on us, and our response to the complaint isdue on May 12, 2005.

 

While we believe these lawsuits are without merit andintend to defend them vigorously, they may, regardless of the outcome, resultin substantial expenses and damages to us and may significantly divert theattention of our management.  There can beno assurance that we will be able to achieve a favorable settlement of theselawsuits or obtain a favorable resolution of such lawsuits if they are notsettled.  An unfavorable resolution ofthese lawsuits could have a material adverse effect on our business, financialcondition and results of operations. Regardless of the outcome, the costs and expenses incurred by us todefend these lawsuits could also have a material adverse effect on ourbusiness, financial condition and results of operations.

 

**Item 6.****                    Exhibits**

 

(a)           Exhibits:

 

31.1         Certification of the Company’s ChiefExecutive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

 

31.2         Certification of the Company’s ChiefFinancial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

 

32.1         Certification of the Company’s ChiefExecutive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of2002.

 

32.2         Certification of the Company’s ChiefFinancial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of2002.

 

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Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized as of the 9th day of May2005.

 
|   | Guitar Center, Inc.                                         |
|--------|-------------------------------------------------------------|
|   |                                                        |
|   | /s/ Bruce L. Ross                                           |   |
|   |                                                        |
|   | Bruce L. Ross,  Executive Vice President,                   |
|   | Chief Financial Officer  and Secretary                      |
|   |                                                        |
|   | (Duly Authorized  Officer and Principal Financial  Officer) |

 

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