**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe quarterly period ended March 31, 2007**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                                 to**

**CommissionFile No. 000-22207**

**GUITAR CENTER, INC.**

(Exact Name of Registrantas 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’s  telephone number, including area code |

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):
| Large accelerated filer   x | Accelerated filer   o | Non-accelerated filer   o |
|---------------------------------------|---------------------------------|-------------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of May 4, 2007, there were 29,545,000 sharesof our common stock, $.01 par value, outstanding.

 

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**GUITAR CENTER, INC.AND SUBSIDIARIES**

**INDEX**

| Part I.  |       | Financial Information                                                                                   |   |   |   |   |   |
|---------------|------------|---------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|
|          | ** ** | **Item 1. Consolidated Financial Statements (Unaudited)**                                               |   |   |   |   |   |
|          |       | Consolidated Balance Sheets—March 31, 2007 and  December 31, 2006                        |   |   | 1      |   |   |
|          |       | Consolidated Statements of Income—Three months ended  March 31, 2007 and 2006                 |   |   | 2      |   |   |
|          |       | Consolidated Statements of Cash Flows—Three months  ended March 31, 2007 and 2006             |   |   | 3      |   |   |
|          |       | Notes to Consolidated Financial Statements                                                              |   |   | 5      |   |   |
| ** **    | ** ** | **Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations** |   |   | 12     |   |   |
|          | ** ** | **Item 3. Quantitative and Qualitative Disclosures About  Market Risk**                                 |   |   | 22     |   |   |
|          | ** ** | **Item 4. Controls and Procedures**                                                                     |   |   | 22     |   |   |
| Part II. |       | Other  Information                                                                                      |   |   |   |   |   |
|          | ** ** | **Item  1. Legal Proceedings**                                                                          |   |   | 23     |   |   |
|          | ** ** | **Item  1A. Risk Factors**                                                                              |   |   | 23     |   |   |
|          | ** ** | **Item 6.  Exhibits**                                                                                   |   |   | 24     |   |   |

 

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands)(Unaudited)**
|                                                                                                                                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                            | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                            |       |               |       |                  |       |   |   |
| Current assets:                                                                                                                                       |       |               |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                             |       | $                  | 13,879     |                  |       | $ | 15,153 |   |   |
| Accounts receivable, less allowance for doubtful  accounts of $3,365 and $2,618, respectively                                                    |       | 50,899             |       |                  | 53,916     |   |   |
| Merchandise inventories                                                                                                                               |       | 609,356            |       |                  | 578,082    |   |   |
| Prepaid expenses and other current assets                                                                                                             |       | 17,138             |       |                  | 16,178     |   |   |
| Deferred income taxes                                                                                                                                 |       | 22,203             |       |                  | 22,739     |   |   |
| Total current  assets                                                                                                                                 |       | 713,475            |       |                  | 686,068    |   |   |
| Property and  equipment, net of accumulated depreciation and amortization of $163,869 and  $153,033, respectively                                     |       | 212,329            |       |                  | 201,986    |   |   |
| Goodwill                                                                                                                                              |       | 20,067             |       |                  | 18,507     |   |   |
| Intangible  assets, net                                                                                                                               |       | 7,907              |       |                  | 7,612      |   |   |
| Other assets, net                                                                                                                                     |       | 13,460             |       |                  | 13,305     |   |   |
| Total assets                                                                                                                                          |       | $                  | 967,238    |                  |       | $ | 927,478 |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                        |       |               |       |                  |       |   |   |
| Current liabilities:                                                                                                                                  |       |               |       |                  |       |   |   |
| Cash overdraft                                                                                                                                        |       | $                  | 18,467     |                  |       | $ | 20,243 |   |   |
| Accounts payable                                                                                                                                      |       | 113,042            |       |                  | 93,717     |   |   |
| Accrued expenses and other current liabilities                                                                                                        |       | 84,756             |       |                  | 117,595    |   |   |
| Merchandise advances                                                                                                                                  |       | 24,877             |       |                  | 26,830     |   |   |
| Borrowings under revolving line of credit                                                                                                             |       | 135,000            |       |                  | 101,144    |   |   |
| Total current  liabilities                                                                                                                            |       | 376,142            |       |                  | 359,529    |   |   |
| Other long-term  liabilities                                                                                                                          |       | 18,701             |       |                  | 17,292     |   |   |
| Deferred income  taxes                                                                                                                                |       | 4,671              |       |                  | 5,165      |   |   |
| Long-term debt                                                                                                                                        |       | 1,064              |       |                  | 1,416      |   |   |
| Total liabilities                                                                                                                                     |       | 400,578            |       |                  | 383,402    |   |   |
| Minority interest                                                                                                                                     |       | 1,209              |       |                  | 1,339      |   |   |
| Commitments and  contingencies                                                                                                                        |       |               |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                            |       |               |       |                  |       |   |   |
| Preferred stock, 5,000 authorized, none issued and  outstanding                                                                                       |       | —             |       |                  | —     |   |   |
| Common stock, $0.01 par value, authorized 100,000  shares, issued and outstanding 29,543 at March 31, 2007 and 29,469 at  December 31, 2006 |       | 295                |       |                  | 295        |   |   |
| Additional paid-in capital                                                                                                                            |       | 469,706            |       |                  | 464,217    |   |   |
| Retained earnings                                                                                                                                     |       | 95,450             |       |                  | 78,225     |   |   |
| Total  stockholders’ equity                                                                                                                      |       | 565,451            |       |                  | 542,737    |   |   |
| Total liabilities and  stockholders’ equity                                                                                                      |       | $                  | 967,238    |                  |       | $ | 927,478 |   |   |

 

*See accompanying notes to consolidated financial statements.*

1

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)(Unaudited)**
|                                                                         | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                              | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Net sales                                                               |       | $                                                | 534,483    |   | $ | 470,747 |   |
| Cost of goods  sold, buying and occupancy                               |       | 380,107                                          |       | 334,241 |   |
| Gross profit                                                            |       | 154,376                                          |       | 136,506 |   |
| Selling, general  and administrative expenses                           |       | 124,037                                          |       | 109,114 |   |
| Operating income                                                        |       | 30,339                                           |       | 27,392 |   |
| Interest expense,  net of interest income of $225 and $75, respectively |       | 1,793                                            |       | 1,852 |   |
| Income before  income taxes and minority interest                       |       | 28,546                                           |       | 25,540 |   |
| Income taxes                                                            |       | 11,419                                           |       | 9,833 |   |
| Minority interest  in loss                                              |       | (98                                              | )          | — |   |
| Net income                                                              |       | $                                                | 17,225     |   | $ | 15,707 |   |
| Net income per  share:                                                  |       |                                             |       |   |   |
| Basic                                                                   |       | $                                                | 0.58       |   | $ | 0.60 |   |
| Diluted                                                                 |       | $                                                | 0.57       |   | $ | 0.55 |   |
| Weighted average  shares outstanding:                                   |       |                                             |       |   |   |
| Basic                                                                   |       | 29,507                                           |       | 26,176 |   |
| Diluted                                                                 |       | 30,165                                           |       | 29,863 |   |

 

*See accompanying notes to consolidated financial statements.*

2

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)**
|                                                                                    | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Operating activities:**                                                          |       |                                             |       |   |   |
| Net income                                                                         |       | $                                                | 17,225     |   | $ | 15,707 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                      |       | 11,419                                           |       | 8,376 |   |
| Amortization of deferred financing fees                                            |       | 23                                               |       | 261 |   |
| Stock-based compensation                                                           |       | 3,378                                            |       | 7,083 |   |
| Deferred income taxes                                                              |       | 42                                               |       | (2,400 | ) |
| Minority interest in loss                                                          |       | (98                                              | )          | — |   |
| Changes in operating  assets and liabilities, net of effect of acquisitions:       |       |                                             |       |   |   |
| Accounts receivable                                                                |       | 5,717                                            |       | 9,429 |   |
| Merchandise inventories                                                            |       | (4,767                                           | )          | 1,761 |   |
| Prepaid expenses and other current assets                                          |       | 133                                              |       | 845 |   |
| Other assets, net                                                                  |       | (178                                             | )          | (264 | ) |
| Cash overdraft                                                                     |       | (1,776                                           | )          | 880 |   |
| Accounts payable                                                                   |       | 19,325                                           |       | 8,952 |   |
| Accrued expenses and other current liabilities                                     |       | (34,184                                          | )          | (35,312 | ) |
| Merchandise advances                                                               |       | (2,635                                           | )          | (3,196 | ) |
| Other long-term liabilities                                                        |       | 1,409                                            |       | 732 |   |
| Net cash provided  by operating activities                                         |       | 15,033                                           |       | 12,854 |   |
| **Investing activities:**                                                          |       |                                             |       |   |   |
| Purchase of property and equipment                                                 |       | (21,087                                          | )          | (16,099 | ) |
| Acquisition of businesses                                                          |       | (30,474                                          | )          | (3,072 | ) |
| Net cash used in  investing activities                                             |       | (51,561                                          | )          | (19,171 | ) |
| **Financing activities:**                                                          |       |                                             |       |   |   |
| Net change in borrowings under revolving line of  credit                           |       | 33,856                                           |       | (2,217 | ) |
| Proceeds from exercise of stock options                                            |       | 1,550                                            |       | 2,407 |   |
| Excess tax benefit from exercise of stock options                                  |       | 232                                              |       | 1,530 |   |
| Repayment of long-term debt                                                        |       | (352                                             | )          | — |   |
| Other                                                                              |       | (32                                              | )          | — |   |
| Net cash provided  by financing activities                                         |       | 35,254                                           |       | 1,720 |   |
| Net decrease in  cash and cash equivalents                                         |       | (1,274                                           | )          | (4,597 | ) |
| Cash and cash  equivalents at beginning of period                                  |       | 15,153                                           |       | 14,529 |   |
| Cash and cash  equivalents at end of period                                        |       | $                                                | 13,879     |   | $ | 9,932 |   |

 

*See accompanying notes to consolidated financial statements.*

3

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**GUITAR CENTER, INC.AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)(In thousands)(Unaudited)**

 
|                                                                                                | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Non-cash investing and financing activities:**                                               |       |                                             |       |   |   |
| Acquisition of businesses, in which the fair value  of assets and liabilities were as follows: |       |                                             |       |   |   |
| Accounts receivable                                                                            |       | $                                                | 2,700      |   | $ | 336 |   |
| Merchandise inventories                                                                        |       | 26,507                                           |       | 1,884 |   |
| Prepaid expenses and  other current assets                                                     |       | 1,093                                            |       | — |   |
| Deferred income taxes                                                                          |       | —                                           |       | 887 |   |
| Property and equipment                                                                         |       | 191                                              |       | — |   |
| Goodwill                                                                                       |       | 1,560                                            |       | 1,284 |   |
| Intangible assets                                                                              |       | 779                                              |       | 5 |   |
| Total assets acquired                                                                          |       | 32,830                                           |       | 4,396 |   |
| Accrued expenses and  other current liabilities                                                |       | (1,674                                           | )          | (1,324 | ) |
| Merchandise advances                                                                           |       | (682                                             | )          | — |   |
| Total liabilities  assumed                                                                     |       | (2,356                                           | )          | (1,324 | ) |
| Net assets acquired                                                                            |       | $                                                | 30,474     |   | $ | 3,072 |   |

 

*See accompanying notes to consolidated financial statements.*

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**GUITARCENTER, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**1.**   Nature of Businessand Significant Accounting Policies

*Nature of Business*

Guitar Center, Inc.(the “Company”) is the leading United States retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment. As of March 31,2007, our wholly owned retail subsidiary operated 210 Guitar Center storesacross the United States consisting of 139 primary format stores, 68 secondaryformat stores and 3 tertiary format stores. In addition, as of March 31,2007, our Music & Arts division operated 99 stores specializing inband instruments for sale and rental, serving thousands of teachers, banddirectors, college professors and students. We are also the largest directresponse retailer of musical instruments in the United States through ourwholly owned subsidiary, Musician’s Friend, Inc., and its catalogs andwebsites, including www.musiciansfriend.com. www.guitarcenter.com, www.wwbw.com,www.music123.com and related websites.

*Basis of Presentation*

In the opinion ofmanagement, the accompanying unaudited consolidated financial statementscontain all adjustments necessary to present fairly the financial position ofthe Company as of March 31, 2007, the results of operations for the threemonths ended March 31, 2007 and 2006, respectively, and its cash flows forthe three months ended March 31, 2007 and 2006. The accompanyingconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes thereto contained in ourAnnual Report on Form 10-K for the year ended December 31,2006.

The Company’s results ofoperations and cash flows for the interim periods may not be indicative of theresults of operations and cash flows for the full year.

*Use of Estimates in the Preparation of FinancialStatements*

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires the Company to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from our estimates.

*Reclassifications*

A reclassification hasbeen made to the March 31, 2006 consolidated cash flows statement toseparately report cash overdraft, which was previously included with accountspayable. This reclassification has no impact on the previously reported netcash provided by operating activities.

*Recently Issued Accounting Pronouncements*

In June 2006, theFinancial Accounting Standards Board (“FASB”) ratified Emerging Issues TaskForce (“EITF”) Issue 06-3, *How Sales Taxes CollectedFrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statement.* (“EITF 06-3”). EITF 06-3 requiresa company to disclose its accounting policy (i.e., gross or net presentation)regarding the presentation of taxes within the scope of EITF 06-3. Iftaxes are significant, a company should disclose the amount of such taxes foreach period for which an income statement is presented. As required, theCompany adopted EITF 06-3 as of January 1, 2007 and the effect ofthe initial adoption of EITF 06-3 did not have any impact on itsconsolidated financial statements as we have historically presented salesexcluding these taxes.

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In September 2006,the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157,*Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosures about fairvalue measurements. Accordingly, this Statement does not require any new fairvalue measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. The Company is currently evaluating the impact,if any, the adoption of SFAS No. 157 will have on its consolidatedfinancial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilitie*s. SFAS No. 159permits companies to choose to measure certain financial instruments andcertain other items at fair value. The standard requires that unrealized gainsand losses on items for which the fair value option has been elected bereported in earnings. SFAS No. 159 is effective as of the beginning of anentity’s first fiscal year that begins after November 15, 2007, and theCompany is required to adopt SFAS No. 159 in the first quarter of 2008.The Company is currently evaluating the impact that SFAS No. 159 will haveon its consolidated financial statements.

**2.**   Acquisition ofBusinesses

On February 9, 2007,our Musician’s Friend, Inc. subsidiary acquired substantially all of theassets of Dennis Bamber, Inc. and its chapter 11 bankruptcy estate, d/b/aThe Woodwind & The Brasswind, for an aggregate purchase price ofapproximately $24.7 million, which includes $22.5 million in merchandise inventoriesand $2.7 million in accounts receivable. The purchase price is preliminarysubject to final valuation of the related net assets and approval by thebankruptcy court. Any revisions to the purchase price may affect the amount ofgoodwill recorded, which is zero as of March 31, 2007, and the valuationof the related noncurrent assets. The acquisition included a variety of directresponse catalogs and websites, including those under the brand names Woodwind &Brasswind and Music123. The Woodwind & Brasswind brand is targetedprimarily to online and catalog purchases of band and orchestra instruments,while the Music123 brand name is targeted primarily to online purchases ofguitars, amplifiers, percussion instruments, keyboards and pro audio and recordingequipment. The acquired business operates as a division of our Musician’sFriend subsidiary, through an office, retail outlet and warehouse facility anda distribution center facility, both located in South Bend, Indiana.

In the first quarter of2007, our retail subsidiary acquired the Victor’s House of Music retaillocation in Paramus, New Jersey and its related net assets for an aggregatepurchase price of approximately $5.9 million. Net assets for the retail bandand orchestra and rental business were allocated to the Music & Artsdivision, with the remaining net assets and goodwill of $1.6 million allocatedto the Guitar Center Retail division.

The aggregate purchaseprice for the acquisitions in the three months ended March 31, 2007(including purchase price adjustments of $0.1 million) totaled approximately$30.5 million, which was principally allocated to merchandise inventories of$26.5 million, accounts receivable of $2.7 million and goodwill of $1.6million.

The acquisitions wereaccounted for under the purchase method of accounting in accordance with SFAS No. 141,*Business Combinations*. The results ofoperations of the acquisitions were not material to the current periodconsolidated financial statements and, as such, pro forma financial informationis not presented for these acquisitions. The results of operations of theacquired businesses are included in the consolidated financial statements fromthe respective dates of acquisition.

6

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**3.**   Goodwill andIntangible Assets

Goodwillrepresents the excess of the purchase price over the fair value of identifiablenet assets acquired resulting from business acquisitions accounted for underthe purchase method. The changes in the carrying amount of goodwill byreportable segment for the three months ended March 31, 2007 were asfollows (in thousands):
|                                       | ** ** | **Guitar** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|---------------------|------------|------------|------------|
| ** **                            | ** ** | **Center** | ** ** | **Friend**          | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2006    |       | $          | 15,066     |                |       | $          | 3,441      |   |   | $ | 18,507 |   |
| Goodwill resulting  from acquisitions |       | 1,560      |       |                | —     |       |       | 1,560 |   |
| Balance at  March 31, 2007       |       | $          | 16,626     |                |       | $          | 3,441      |   |   | $ | 20,067 |   |

 

Intangibleassets with finite useful lives are amortized over their respective estimateduseful lives. The following is a summary of intangible assets as of March 31,2007 and December 31, 2006 (dollars in thousands, life in years):

| ** **               | ** ** | ** **              | ** ** | **March 31, 2007** | ** ** |
|--------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **               | ** ** | **Weighted-**           | ** ** | **Gross**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Average Useful** | ** ** | **Carrying**                 | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Life**                | ** ** | **Amount**                   | ** ** | **Amortization** | ** ** | **Total** | ** ** |
| Unamortized  trademark   |       |                    | —     |                         |       | $ | 5,325 |   |   | $ | — |   |   | $ | 5,325 |   |
| Amortized                |       |                    |       |                         |       |   |   |   |   |   |   |   |   |
| Customer contracts       |       |                    | 1.4        |                         |       | 1,188 |   |   | (547 | ) |   | 641 |   |
| Covenants not to compete |       |                    | 3.9        |                         |       | 3,430 |   |   | (1,580 | ) |   | 1,850 |   |
| Other                    |       |                    | 2.6        |                         |       | 851 |   |   | (760 | ) |   | 91 |   |
| Intangible assets, net   |       |                    |       |                         |       | $ | 10,794 |   |   | $ | (2,887 | ) |   | $ | 7,907 |   |

 

| ** **               | ** ** | ** **              | ** ** | **December 31, 2006** | ** ** |
|--------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Weighted-**           | ** ** | **Gross**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Average Useful** | ** ** | **Carrying**                    | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Life**                | ** ** | **Amount**                      | ** ** | **Amortization** | ** ** | **Total** | ** ** |
| Unamortized trademark    |       |                    | —     |                            |       | $ | 5,367 |   |   | $ | — |   |   | $ | 5,367 |   |
| Amortized                |       |                    |       |                            |       |   |   |   |   |   |   |   |   |
| Customer contracts       |       |                    | 1.4        |                            |       | 847 |   |   | (379 | ) |   | 468 |   |
| Covenants not to compete |       |                    | 3.5        |                            |       | 2,950 |   |   | (1,350 | ) |   | 1,600 |   |
| Other                    |       |                    | 2.6        |                            |       | 851 |   |   | (674 | ) |   | 177 |   |
| Intangible assets, net   |       |                    |       |                            |       | $10,015 |   |   | $(2,403 | ) |   | $7,612 |   |
|                          |            |                         |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

Amortizationof intangible assets is included in selling, general and administrativeexpenses. Amortization expense for the three months ended March 31, 2007and 2006 was $0.5 million and $0.9 million, respectively. The estimatedamortization expense related to intangible assets for each of the five years asof March 31, 2007 is as follows (in thousands):
| Year ending December 31, | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|
| Remainder of 2007                       |       | $          | 1,089      |       |
| 2008                                    |       | 780        |       |
| 2009                                    |       | 372        |       |
| 2010                                    |       | 204        |       |
| 2011                                    |       | 127        |       |
| 2012                                    |       | 10         |       |
| Total                                   |       | $          | 2,582      |       |

 

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**4.**   Net Income PerShare

Thefollowing table summarizes the calculation of diluted weighted average sharesand diluted net income per share for the periods presented below (in thousands,except per share data):
|                                                                                | ** ** | **Three months ended  March 31** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2007**                                        | ** ** | **2006** | ** ** |
| Net income, as  reported                                                       |       |                                            | $          | 17,225 |   |   | $ | 15,707 |   |
| Add back  interest, net of tax, on 4% Senior Convertible Notes (a)        |       |                                            | —     |   |   | 782 |   |
| Net income,  excluding interest expense on 4% Senior Convertible Notes         |       |                                            | $          | 17,225 |   |   | $ | 16,489 |   |
| Basic weighted average shares outstanding                                      |       |                                            | 29,507     |   |   | 26,176 |   |
| Dilutive effect  of stock options outstanding                                  |       |                                            | 658        |   |   | 795 |   |
| Shares issuable  on assumed conversion of 4% Senior Convertible Notes (b) |       |                                            | —     |   |   | 2,892 |   |
| Diluted weighted  average shares outstanding                                   |       |                                            | 30,165     |   |   | 29,863 |   |
| Basic net income per share                                                     |       |                                            | $          | 0.58 |   |   | $ | 0.60 |   |
| Diluted net income per  share                                                  |       |                                            | $          | 0.57 |   |   | $ | 0.55 |   |

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(a)           Representsthe interest expense for the period the 4% Senior Convertible Notes (the “Notes”)were outstanding, including contingent interest and amortization of deferredfinancing costs, net of tax, using an effective tax rate of 38.5% for the threemonths ended March 31, 2006. The Notes were called for redemption by theCompany on June 15, 2006 and substantially all of the outstanding Noteswere converted into common stock prior to the July 15, 2006 redemptiondate.

(b)          Representsthe weighted-average number of common shares issuable upon the conversion ofthe Notes, up to the date of actual conversion.

For the three months endedMarch 31, 2007, the only potential additional shares of common stock thatcould become outstanding were shares issuable upon exercise of stock options.For the three months ended March 31, 2006, the only potential additionalshares of common stock that could become outstanding were shares issuable uponexercise of stock options and conversion of the Notes up to the date of actualconversion.

For the three months endedMarch  31, 2007 and 2006, options to acquire weighted-average sharesof 1,237,230 and 533,400, respectively, were outstanding but were excluded fromthe computation of diluted net income per share because their effect wasanti-dilutive. Performance shares granted under the long-term incentive planare excluded from the computations of basic and diluted net income per shareuntil the necessary conditions of the plan have been satisfied.

**5.**   SegmentInformation

Our reportable business segments are Guitar Centerstores, Music & Arts stores and Musician’s Friend direct response.Management evaluates segment performance based primarily on net sales,operating income (loss) and income (loss) before income taxes and minorityinterest. Accounting policies of the segments are the same as the accountingpolicies 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.

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Thefollowing table summarizes financial information for our operating segments asof March 31, 2007 and December 31, 2006 and for the three monthsended March 31, 2007 and 2006 (in thousands):
|                                                                    | ** ** | **Three Months Ended March 31, 2007** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Guitar**                                                     | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Center**                                                     | ** ** | **Arts** | ** ** | **Friend** | ** ** | **Total** | ** ** |
| Net Sales                                                          |       | $                                                              | 378,535    |   | $ | 39,589 |   |   | $ | 116,359 |   |   | $ | 534,483 |   |
| Gross Profit                                                       |       | 102,583                                                        |       | 16,979 |   |   | 34,814 |   |   | 154,376 |   |
| Depreciation and  amortization                                     |       | 8,656                                                          |       | 1,318 |   |   | 1,445 |   |   | 11,419 |   |
| Selling, general  and administrative expenses                      |       | 79,610                                                         |       | 17,142 |   |   | 27,285 |   |   | 124,037 |   |
| Operating income  (loss)                                           |       | 22,973                                                         |       | (163 | ) |   | 7,529 |   |   | 30,339 |   |
| Income (loss)  before income taxes (benefit) and minority interest |       | 24,677                                                         |       | (4,176 | ) |   | 8,045 |   |   | 28,546 |   |
| Capital expenditures                                               |       | 17,106                                                         |       | 1,433 |   |   | 2,548 |   |   | 21,087 |   |
|                                                                    |            |                                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                               | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Guitar**                                                     | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Center**                                                     | ** ** | **Arts** | ** ** | **Friend** | ** ** | **Total** | ** ** |
| Net Sales                                     |       | $                                                              | 339,291    |   | $ | 33,185 |   |   | $ | 98,271 |   |   | $ | 470,747 |   |
| Gross Profit                                  |       | 92,383                                                         |       | 15,423 |   |   | 28,700 |   |   | 136,506 |   |
| Depreciation and  amortization                |       | 6,351                                                          |       | 1,306 |   |   | 719 |   |   | 8,376 |   |
| Selling, general  and administrative expenses |       | 71,634                                                         |       | 14,973 |   |   | 22,507 |   |   | 109,114 |   |
| Operating income                              |       | 20,749                                                         |       | 450 |   |   | 6,193 |   |   | 27,392 |   |
| Income (loss)  before income taxes (benefit)  |       | 21,139                                                         |       | (2,302 | ) |   | 6,703 |   |   | 25,540 |   |
| Capital  expenditures                         |       | 13,690                                                         |       | 924 |   |   | 1,485 |   |   | 16,099 |   |
| Total assets at March 31, 2007           |       | 688,469                                                        |       | 160,441 |   |   | 118,328 |   |   | $ | 967,238 |   |
| Total assets at  December 31, 2006       |       | 682,344                                                        |       | 158,503 |   |   | 86,631 |   |   | $ | 927,478 |   |
|                                               |            |                                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**6.**   Stock-BasedCompensation

Stock-basedcompensation expense for all stock award plans included in our consolidatedstatements of income was as follows:

| ** **                              | ** ** | **Three Months  Ended March 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | **2007**                          | ** ** | **2006** | ** ** |
| Stock options                           |       | $                                 | 2,544      |   | $ | 3,537 |   |
| Long-term  incentive plan (LTIP)        |       | 456                               |       | 3,309 |   |
| Employee stock  purchase plan (ESPP)    |       | 214                               |       | 193 |   |
| Restricted and  deferred stock          |       | 164                               |       | 44 |   |
| Total stock-based  compensation expense |       | $                                 | 3,378      |   | $ | 7,083 |   |

 

In the three months ended March 31,2007, options to purchase 19,700 shares of common stock were granted with anexercise price of $47.13 per share and grant-date fair value of $16.64 pershare. For the three months ended March 31, 2006, options to purchase 15,000shares of common stock were granted with an exercise price of $54.72 per shareand grant-date fair value of $19.80 per share. The options were issued with anexercise price equal to fair market value on the date of grant and vest overfour years.

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Theassumptions used to value option grants under the lattice-based binomial modelfor the three months ended March 31, 2007 and 2006 are as follows:
|                                                        | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Expected  volatility range                             |       | 30-48                                            | %          | 35-50 | % |
| Weighted-average  expected volatility                  |       | 39.2                                             | %          | 42.4 | % |
| Expected term (in  years)                              |       | 4.46                                             |       | 4.75 |   |
| Risk-free  interest rate                               |       | 4.7                                              | %          | 4.4-4.8 | % |
| Expected  dividends                                    |       | —                                           |       | — |   |
| Suboptimal exercise term  (multiple of exercise price) |       | 1.5                                              |       | 2.0 |   |

 

Theassumptions used to value the ESPP options under the lattice-based binomialmodel for the three months ended March 31, 2007 and 2006 are as follows:
|                                         | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Expected  volatility range              |       | 29-32                                            | %          | 32-40 | % |
| Weighted-average  expected volatility   |       | 30.3                                             | %          | 36.0 | % |
| Expected term                           |       | 6 months                                         |       | 6 months |   |
| Risk-free  interest rate                |       | 4.9                                              | %          | 4.0 | % |
| Weighted-average  grant-date fair value |       | $10.79                                           |       | $12.88 |   |

 

As of March 31, 2007,the target number of performance shares potentially issuable under the LTIP is 240,221,with the actual number of shares ultimately issuable to be between zero andtwice such amount, depending on actual performance and number of participants.Stock-based compensation expense related to the LTIP is estimated based onforecasted performance during the performance period compared to plan targets.At the end of each reporting period, we reevaluate our assessment ofperformance under the plan and make adjustments to the expense as necessary basedon the latest estimates available. The fair value of performance share awardsis based on the market price of the Company’s stock on the date the underlyingplan receives compensation committee approval, or other form of a mutualunderstanding of the key terms and conditions of performance.

**7.**   IncomeTaxes

In June 2006, the FASB issued FASBInterpretation No. 48 (“FIN 48”), *Accounting for Uncertaintyin Income Taxes.*FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordance withSFAS No. 109, *Accounting for IncomeTaxes*. This Interpretation defines the minimum recognition thresholda tax position is required to meet before being recognized in the financialstatements. The Company adopted FIN 48 on January 1, 2007. As aresult of the implementation, the Company recognized no material adjustment inthe liability of unrecognized income tax benefits. At the adoption date of January 1,2007, we had $1.7 million of unrecognized tax benefits, all of which wouldaffect our effective tax rate if recognized. At March 31, 2007, we had$1.8 million of unrecognized tax benefits. It is reasonably possible that ourrecognized tax benefit could change; however, we do not expect any such changeto be material.

Guitar Center, Inc. and its subsidiaries aresubject to U.S. federal income tax as well as income tax of multiple statejurisdictions. The Company has concluded all U.S. federal income tax mattersfor years through 2002. Substantially all material state and local income taxmatters have been concluded through 2001 or 2002, depending on the statute oflimitations for a given jurisdiction. Federal income tax returns for 2003through 2005 are currently under examination.

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We recognize interest and penalties related touncertain tax positions in income tax expense. At the adoption date of January 1,2007 and March 31, 2007, we had approximately $0.3 million of accruedinterest and penalties related to uncertain tax positions.

A noncurrent receivable isincluded in other assets, net in the amount of $9.3 million for income taxrefunds and associated interest income related to claims for refund for taxyears 2003, 2004, and 2005 for deductions for disqualified dispositions ofincentive stock options not previously claimed on federal and state tax returns.

**8.**   LegalProceedings

On November 29, 2005, a case was filed against usand other defendants, including our Chief Executive Officer, in the UnitedStates District Court for the Southern District of Florida. The complaintasserts, among other things, violations of the Federal Racketeering Influencedand Corrupt Organization Act (“RICO”) and a corresponding Florida statute,Sections 1 and 2 of the Sherman Antitrust Act, Section 2 of the ClaytonAct (as amended by the Robinson-Patman Act), the Antidumping Act of 1916, theFlorida Antitrust Act of 1980, and the Florida Deceptive and Unfair TradePractices Act, as well as tortious interference with business relationshipunder Florida law and civil conspiracy under Florida law by some or all of theidentified defendants in connection with the claimed inability of Ace Pro Soundand Recording, LLC to obtain vendor lines for its store. The complaint purportsto be made as a class action on behalf of all current and former retail sellersof musical instruments and/or sound equipment and/or recording equipment withstores located in geographical regions in the United States wherein some or allof the defendants have carried on business, and seeks compensatory damages,treble damages, punitive damages, injunctive relief and attorneys fees. On April 1,2007, the court entered its order on defendants’ motions to dismiss. The courtdismissed plaintiff’s RICO claims against Mr. Albertson and furthergranted a motion to strike a claim for consequential damages brought under theFlorida Deceptive and Unfair Trade Practices Act. The court denied all othermotions to dismiss. An answer to the complaint is due in May 2007.

On December 6, 2006, a lawsuit named J. KevinSnyder v. Guitar Center Stores, Inc. that is a putative class action wasfiled in Los Angeles Superior Court alleging violations of the Song-BeverlyCredit Card Act, based upon Guitar Center’s allegedly unlawful point-of-salecredit card practices. Discovery has commenced in this matter.

On January 11, 2007, a lawsuit named Michael Kuhlv. Guitar Center Stores, Inc. was filed by a Guitar Center sales associateas a putative class action in the United States District Court for the NorthernDistrict of Illinois. The lawsuit alleges violations of the Illinois WagePayment and Collection Act and the Fair Labor Standards Act, based upon GuitarCenter’s allegedly unlawful payroll deduction policies. The lawsuit has beenbrought on behalf of plaintiff and all former and current hourly employees inIllinois and nationwide. A motion to dismiss was filed on the Company’s behalfon March 26, 2007.

We expect to defend these actions vigorously. However,these actions, regardless of the outcome, may result in substantial expensesand damages to us and may significantly divert the attention of our management.There can be no assurance that we will be able to achieve a favorablesettlement of these lawsuits or obtain a favorable resolution if they are notsettled. An unfavorable resolution of these lawsuits could have a materialadverse effect on our business, financial condition and results of operations.Regardless of the outcome, the costs and expenses incurred by us to defend themcould adversely impact our financial condition.

In addition to the lawsuits described above, we areinvolved in various claims and legal actions arising in the ordinary course ofour business and, while the results of those proceedings cannot be predictedwith certainty, we believe that the final outcome of those matters will nothave a material adverse effect on our business, financial condition and resultsof operations.

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**Item2.**                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**General**

Guitar Center, Inc.is the leading United States retailer of guitars, amplifiers, percussioninstruments, keyboards and pro-audio and recording equipment. As of March 31,2007, our wholly owned retail subsidiary operated 210 Guitar Center storesacross the United States consisting of 139 primary format stores, 68 secondaryformat stores and 3 tertiary format stores. In addition, as of March 31,2007, our Music & Arts division operated 99 stores specializing inband instruments for sale and rental, serving thousands of teachers, banddirectors, college professors and students. We are also the largest directresponse retailer of musical instruments in the United States through ourwholly owned subsidiary, Musician’s Friend, Inc., and its catalogs andwebsites, including www.musiciansfriend.com. www.guitarcenter.com,www.wwbw.com, www.music123.com and related websites.

We acquired thewww.wwbw.com and www.music123.com websites on February 9, 2007 whenMusician’s Friend, Inc. acquired substantially all of the assets of DennisBamber, Inc. and its chapter 11 bankruptcy estate, d/b/a The Woodwindand The Brasswind. We refer to this business as “Woodwind & Brasswind.”

During the first quarter,we opened a total of 11 Guitar Center stores, including 4 primary format storesin Avondale, Arizona, Florence, Kentucky, Maple Grove, Minnesota, and Oakdale,Minnesota and 7 secondary format stores in Amarillo, Texas, Cedar Rapids, Iowa,Johnson City, New York, Lancaster, Pennsylvania, Scranton, Pennsylvania,Springfield, Missouri and Visalia, California. In addition, we added a primaryformat store in Paramus, New Jersey with our acquisition of Victor’s House ofMusic. The new stores added 163,000 square feet of retail space and increasedthe retail space for Guitar Center stores to a total of 3.1 million square feetat the end of the first quarter of 2007.

As we enter new markets,we expect that we will initially incur higher administrative and promotionalcosts per store than is currently experienced in established markets. As weopen multiple stores in markets, we expect that sales at new stores in a marketmay reduce sales at mature stores in that same market, to some extent. Ourbusiness strategy will also emphasize opportunities to continue to grow each ofour brands, including further acquisitions if attractive candidates can belocated for reasonable prices.

**Executive Summary**

Consolidated net sales forthe quarter ended March 31, 2007 increased 13.5%, or $63.7 million, to$534.5 million compared to $470.7 million in the first quarter of 2006. Consolidatednet income for the quarter increased 9.7% to $17.2 million compared to $15.7million in the first quarter of 2006. Net income per diluted share increased to$0.57 from $0.55 in the first quarter of 2006.

For the first quarter of2007, our Guitar Center stores generated 0.7% comparable store sales growth andan increase of 11.6% in total net sales compared to the first quarter of 2006.Sales from new stores totaled $37.0 million and represented 94.4% of theoverall increase in net sales. We opened 12 new Guitar Center stores in thequarter, including one store with the acquisition of Victor’s House of Music.We continue to face a challenging retail environment, which may impact salesand operating margin trends for the foreseeable future.

Musician’s Friend, our direct response unit, generatedan increase in net sales for the first quarter of 18.4% to $116.4 millioncompared to $98.3 million in the first quarter of 2006. The acquired Woodwind &Brasswind business contributed $9.2 million in net sales for the quarter,representing 51% of the overall growth in net sales. Gross profit marginincreased by 0.7% of net sales compared to the first quarter of 2006,reflecting a higher selling margin.

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For the three months endedMarch 31, 2007, net sales for our Music & Arts division increased19.3% to $39.6 million from $33.2 million for the same period in 2006. Theincrease was generated primarily from businesses acquired in 2006. Comparablesales for the first quarter increased 2.6%. Gross profit margin declined by3.6% of net sales compared to the first quarter of 2006. The decrease wasprimarily the result of lower selling margin due to a shift in product mix toinstrument sales relative to rental revenue and increased occupancy costs.Selling, general and administrative expenses (“SG&A”) were reduced to 43.3%of net sales compared to 45.1% in the first quarter of 2006, primarilyreflecting reduced intangibles amortization and lower expense under thelong-term incentive plan (the “LTIP”).

**Discussion of CriticalAccounting Policies**

In the ordinary course ofbusiness, we have made a number of estimates and assumptions relating to thereporting of results of operations and financial condition in the preparationof our financial statements in conformity with accounting principles generallyaccepted in the United States. Actual results could differ significantly fromthose estimates under different assumptions and conditions. 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 belowregarding credits and other vendor allowances is unique to our industry anddeserves the attention of a reader of our financial statements.

*Valuation ofInventory*

We value our merchandiseinventory at the lower of cost, using the weighted-average 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. We record adjustments to the value of inventory basedupon obsolescence and changes in market value. Applicable costs associated withbringing inventory through our Guitar Center retail distribution center arecapitalized to inventory. The amounts are expensed to cost of goods sold as theassociated 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 adjustmentsto inventory and to cost of goods sold for estimated decreases in netrealizable value. These judgments are made in the context of our customers’shifting needs, product and technological trends, and changes in thedemographic mix of our customers. A misinterpretation or misunderstanding ofthese conditions and uncertainties in the future outlook of our industry or theeconomy, or other failure to estimate correctly, could result in inventoryvaluation changes as of any given balance sheet date.

*Valuation ofLong-Lived Assets*

Long-lived assetssuch as property and equipment and identifiable intangibles with finite livesare reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Goodwilland other intangibles with indefinite lives that are not amortized are requiredto be reviewed for impairment on an annual basis, or more frequently whentriggering events occur. Factors we consider important, which could triggerimpairment, include, among other things:

•     Significant underperformancerelative to historical or projected operating results;

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•     Significant changes in themanner of our use of the acquired assets or the strategy of our overallbusiness as well as the individual segments of the business;

•     Significant negative industryor economic trends; and

•     Significant decline in stockvalue for a sustained period.

For long-lived assets other than goodwill andintangibles that are not amortized, the determination of whether impairment hasoccurred is based on an estimate of undiscounted future cash flows attributableto the assets, as compared to the carrying value of the assets. Assumptionsused in these cash flows are consistent with internal forecasts and considercurrent and future expected sales volumes and related operating costs and anyanticipated increases or declines based on expected market conditions and localbusiness environment factors. If a potential impairment is identified, theamount of the impairment loss recognized would be determined by estimating thefair value of the assets and recording a loss if the fair value was less thanthe book value. Fair value will be determined based on appraisal valuesassessed by third parties, if deemed necessary, or a discounted future cashflows analysis. For goodwill and other intangibles that are not amortized, impairmentto be recognized is measured as the amount by which the carrying amount of theassets exceeds the fair value of the related assets of the underlying reportingunit to 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 by management.

*Sales Returns*

As part of our “satisfactionguaranteed” policy, Guitar Center customers are allowed to return productgenerally within 30 days after the date of purchase, and Musician’s Friendcustomers are allowed to return product within 45 days. Music & Artscustomers have 30 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 few yearshave approximated actual results, actual returns may differ significantly fromour estimates, either favorably or unfavorably, if factors such as economicconditions or the competitive environment differ from our expectations.

*Credits and OtherVendor Allowances*

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidizequalifying advertising and similar promotional expenditures relating to thevendor’s products), price protection credits (i.e., credits from vendors withrespect to in-stock inventory if the vendor subsequently lowers their wholesaleprice for such products) and vendor rebates (i.e., credits or rebates providedby vendors based on the purchase of specified products and paid at a laterdate). Cooperative advertising allowances are recognized as a reduction toselling, general, and administrative expense when the advertising expenseeligible for the credit is incurred. We recognized cooperative advertisingallowances of $2.1 million and $2.8 million for the three months ended March 31,2007 and 2006, respectively. Price protection credits and vendor rebates areaccounted for as a reduction of the cost of merchandise inventory and arerecorded at the time the credit or rebate is earned. The effect of priceprotection credits and vendor rebates is recognized in the income statement atthe time the related inventory is sold as a reduction in cost of goods sold.The reserve against rebates receivable is determined by specificallyidentifying uncollectible accounts through an aging review and an analysis ofvendor relationships. We received payments for vendor rebates of $11.4 millionand $9.4 million for the three months ended March 31, 2007 and 2006,respectively. We earned and recognized vendor rebates of $10.7 million and 

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$9.2 millionfor the three months ended March 31, 2007 and 2006, respectively. None ofthese credits are recorded as revenue.

*Stock-basedCompensation*

Effective January 1, 2006, we adopted Statementof Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment* (“SFASNo. 123(R)”) to account for our stock-based compensation plans.Currently, our stock-based compensation expense relates to stock options, ouremployee stock purchase program (ESPP), performance share awards, restrictedstock awards and deferred stock awards.

Under SFAS No. 123(R), we determine the fairvalue of stock options, including options granted under ESPP, using alattice-based binomial model. Assumptions used in the model were developed inconsultation with an outside valuation specialist. The model requires the inputof several assumptions including expected volatility, dividend yield, andrisk-free rate of return, as well as certain assumptions regarding exercisebehavior. Assumptions were developed separately for our senior management fromthe other participants of our stock plans, since senior management’s exercisebehavior is expected to differ materially from the other participants. Theseassumptions reflect management’s best estimates, but they involve inherentuncertainties based on market conditions, generally outside of our control. Asa result, if other assumptions were used, total stock-based compensation cost,as determined in accordance with SFAS No. 123(R) could have beenmaterially impacted. Furthermore, if different assumptions are used for futuregrants, stock-based compensation could be materially impacted in futureperiods.

Also, under SFAS No. 123(R), stock-basedcompensation expense is recorded net of estimated forfeitures. The forfeiturerate assumption used in determining stock-based compensation expense isestimated based on historical data. The actual forfeiture rate could differfrom these estimates.

Stock-based compensationexpense related to performance share awards issued under the LTIP is estimatedbased on our forecasted performance compared to plan targets. At the end ofeach reporting period, we reevaluate our assessment of performance under theplan and make adjustments to the expense as necessary based on the latestestimates available. Under SFAS No. 123(R), the fair value of performanceshare awards is based on the market price of the Company’s stock on the datethe underlying plan receives compensation committee approval, or other form ofa mutual understanding of the key terms and conditions of performance.

*Gift Cards*

We sell gift cards to ourcustomers in our Guitar Center retail stores and on-line. Revenue from giftcard sales is recognized at redemption of the gift card. Our gift cards do nothave expiration dates. Based on historical redemption rates, a certainpercentage of gift cards will never be redeemed, which is referred to as “breakage.”Estimated breakage income is recognized as the remaining gift card values areredeemed and is recorded as a reduction of cost of goods sold.

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**Results of Operations**

Thefollowing table presents our consolidated statements of income, as a percentageof sales, for the periods indicated:
|                                                   | ** ** | **Three months  ended  March 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                     | ** ** | **2006** | ** ** |
| Net sales                                         |       | 100.0                                        | %          | 100.0 | % |
| Gross profit                                      |       | 28.9                                         |       | 29.0 |   |
| Selling, general  and administrative expenses     |       | 23.2                                         |       | 23.2 |   |
| Operating income                                  |       | 5.7                                          |       | 5.8 |   |
| Interest expense,  net                            |       | 0.3                                          |       | 0.4 |   |
| Income before  income taxes and minority interest |       | 5.4                                          |       | 5.4 |   |
| Income taxes                                      |       | 2.1                                          |       | 2.1 |   |
| Minority interest  in loss                        |       | 0.0                                          |       | 0.0 |   |
| Net income                                        |       | 3.2                                          | %          | 3.3 | % |

 

**Three Months Ended March 31, 2007 Compared to theThree Months Ended March 31, 2006**

Consolidated net sales forthe three months ended March 31, 2007 increased 13.5% to $534.5 millioncompared to $470.7 million for the same period in 2006.

Net sales from GuitarCenter stores for the three months ended March 31, 2007 totaled $378.5 million,an 11.6% increase from $339.3 million for the same period in 2006. Sales fromnew stores were $37.0 million and represented 94.4% of the total increase inGuitar Center retail store sales. Comparable Guitar Center store sales for thefirst quarter increased 0.7%. Comparable store sales achieved this leveldespite experiencing a challenging retail environment throughout the quarter.Comparable store sales is defined as sales for the comparable periods,excluding net sales attributable to stores not open for 14 months as of the endof the reporting period. We believe that comparable store sales is a moreuseful indicator of store performance than the change in total net sales, sincecomparable store sales exclude the effects of changes in the number of storesopen. We continue to face a challenging retail environment, which may impactsales and operating margin trends for the foreseeable future.

Net sales from the Music &Arts segment for the three months ended March 31, 2007 increased 19.3% to$39.6 million from $33.2 million for the same period in 2006. Sales from newlocations, primarily acquired businesses and new affiliates, represented 87% ofthe total increase in Music & Arts sales for the quarter. Comparablesales increased 2.6% in the first quarter of 2007. Sales growth was better thanexpected primarily as a result of strong instrument sales.

Net sales from theMusician’s Friend segment totaled $116.4 million for the three months ended March 31,2007, an increase of $18.1 million, or 18.4%, from the same period in 2006. Theacquired Woodwind & Brasswind business contributed $9.2 million in netsales for the quarter, representing 51% of the overall growth in net sales.First quarter sales results also reflected sales generated from our e-commercesite at www.guitarcenter.com of $8.3 million, which was launched in June 2006.We continue to face increased competition in the direct response channel, whichwe expect to impact that segment’s net sales and gross margin for theforeseeable future.

Consolidated gross profitfor the three months ended March 31, 2007 compared to 2006 increased 13.1%to $154.4 million from $136.5 million. Gross profit as a percentage of netsales for the three months ended March 31, 2007 declined slightly to 28.9%from 29.0% in the same period in 2006. As discussed below, we define sellingmargin as net sales less the cost of the associated merchandise charged by thevendor plus the associated inventory costs from fulfilling inventory throughour distribution center. The cost of merchandise inventory is net of allassociated vendor discounts and rebates. Freight is not included in sellingmargin.

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Gross profit as apercentage of net sales for Guitar Center stores was 27.1% in the first quarterof 2007 compared with 27.2% in the first quarter of 2006. The decrease in grossmargin was primarily due to higher occupancy costs of 0.7% partially offset byhigher selling margin of 0.6%. The higher occupancy costs were primarily due tohigher store rent and higher depreciation and amortization expense. Highermargins were realized in the current quarter on accessories, keyboards and proaudio and recording.

Gross profit for the Music &Arts segment was 42.9% for the three months ended March 31, 2007 comparedto 46.5% for the same period in 2006. The decline in gross margin was primarilydue to reduced selling margin of 2.1% and higher occupancy costs of 1.6%. The reduced selling margin was primarilydue to a change in product mix consisting of a higher proportion of instrumentsales and a lower proportion of rental revenues. Higher occupancy costs wereprimarily due to higher depreciation and amortization expense and higher storerent expense.

Gross profit for theMusician’s Friend segment was 29.9% for the three months ended March 31,2007 compared to 29.2% in the first quarter of 2006. The increased gross marginwas primarily due to higher selling margin of 1.4% partially offset byincreased shrink expense of 0.3% and reduced shipping and handling revenue of0.2%. The increase in shrink expense is due to inventory losses resulting fromthe operation of multiple warehouse locations until the new distribution centeris opened later this year.

Consolidated SG&Aexpenses for the three months ended March 31, 2007 increased 13.7% to$124.0 million from $109.1 million for the same period in 2006. As apercentage of net sales, SG&A expenses were 23.2% for both the firstquarter of 2007 and the first quarter 2006. Higher advertising costs andincreased overhead expenses impacted by new and expanded facilities werelargely offset by reduced stock-based compensation expense under the LTIP and a$1.4 million charge in the prior year quarter related to the retirement of ourformer Chief Financial Officer.

Stock-basedcompensation expense for all stock award plans included in our consolidatedstatements of income was as follows:

| ** **                              | ** ** | **Three months ended March 31,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **Pre-tax**                                          | ** ** | **After tax** | ** ** | **Per diluted  share** | ** ** | **Pre-tax** | ** ** | **After tax** | ** ** | **Per diluted  share** | ** ** |
| Stock options                           |       | $                                                    | 2,544      |   |   | $ | 1,529 |   |   |   | $ | 0.05 |   |   | $ | 3,537 |   |   | $ | 2,175 |   |   |   | $ | 0.07 |   |   |
| Long-term incentive  plan (LTIP)        |       | 456                                                  |       |   | 274 |   |   |   | 0.01 |   |   | 3,309 |   |   | 2,035 |   |   |   | 0.07 |   |   |
| Employee stock  purchase plan (ESPP)    |       | 214                                                  |       |   | 129 |   |   |   | — |   |   | 193 |   |   | 119 |   |   |   | — |   |   |
| Restricted and  deferred stock          |       | 164                                                  |       |   | 99 |   |   |   | — |   |   | 44 |   |   | 27 |   |   |   | — |   |   |
| Total stock-based  compensation expense |       | $                                                    | 3,378      |   |   | $ | 2,031 |   |   |   | $ | 0.07 |   |   | $ | 7,083 |   |   | $ | 4,356 |   |   |   | $ | 0.15 |   |   |

 

SG&A expenses for theGuitar Center segment in the first quarter of 2007 were 21.0% as a percentageof net sales compared to 21.1% in the first quarter of 2006. The slightdecrease in expenses included lower stock-based compensation expense under theLTIP of 0.4% and severance and stock-based compensation expense in the prioryear quarter related to the retirement of our former Chief Financial Officer of0.3%, partially offset by increased advertising expense of 0.7%. The higheradvertising costs resulted primarily from increased promotional and marketingefforts.

SG&A expenses for the Music &Arts segment were 43.3% of net sales in the first quarter of 2007 compared to45.1% in the first quarter of 2006. The decrease primarily consisted of lowerintangibles amortization expense of 1.5% and lower stock-based compensationexpense under the LTIP of 1.2% partially offset by higher credit cardprocessing expense of 0.7%. The reduced intangible amortization expense wasprimarily due to the completion of amortization for certain intangiblesacquired from Music & Arts Center, Inc.

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SG&A expenses for theMusician’s Friend segment were 23.4% of sales in the first quarter of 2007compared to 22.9% in the first quarter of 2006, primarily reflecting overheadcosts of 0.3% resulting from our acquisition of Woodwind & Brasswindin February 2007. Also, higher expenses resulted from salary costs of0.7%, consulting projects of 0.6%, depreciation and amortization of 0.5%, andbuilding rent of 0.4% primarily related to the new distribution center to beopened in the third quarter of 2007. Reductions in expense resulted from stock-basedcompensation for stock options and LTIP of 1.4% and improved leveraging ofadvertising costs of 0.5%. Our advertising spending continues to reflect anincreased emphasis on web-based marketing and reductions in catalogcirculation.

Consolidated operatingincome increased 10.8% to $30.3 million for the three months endedMarch 31, 2007 from $27.4 million in the comparable 2006 period. As apercentage of net sales, consolidated operating income declined in the firstquarter of 2007 to 5.7% from 5.8% in the first quarter of 2006.

Interest expense, net for the three months ended March 31,2007 decreased to $1.8 million from $1.9 million in the first quarterof 2006. The slight decrease was due to the conversion of the 4% senior notesto common stock in July 2006 offset by higher borrowings under therevolving credit facility used primarily to fund working capital requirementsand business acquisitions.

For the three months ended March 31, 2007, incometax expense was $11.4 million compared to $9.8 million for the same periodin 2006. The effective tax rate in the first quarter increased to 40.0%compared to 38.5% in the prior year quarter. The rate was impacted by thetreatment of incentive stock options under SFAS 123(R) that were granted inprior years. The effective tax rate is subject to ongoing review and evaluationand may fluctuate in future quarters.

Consolidated net incomefor the three months ended March 31, 2007 increased 9.7% to $17.2 million,compared to $15.7 million in the same period in 2006 as a result of thecombinations of factors described above.

**Liquidity andCapital Resources**

Our need for liquidity will arise primarily from thefunding of capital expenditures, working capital requirements and payments onour indebtedness, as well as possible acquisitions. We have historicallyfinanced our operations primarily through internally generated funds andborrowings under our credit facilities. Please see “Risk Factors” in our AnnualReport on Form 10-K filed for the year ended December 31, 2006for a discussion of factors which could reasonably likely result in a decreasein the amount of internally generated funds available to finance capitalexpenditures and working capital requirements. As of March 31, 2007, wehad $135.0 million in borrowings outstanding under our credit facility and hadavailable borrowings of $68.8 million (net of $6.2 million of outstandingletters of credit).

We have maximum borrowings available under our creditfacility of $200 million, subject to borrowing base limitations. The creditagreement allows for the increase of the maximum borrowings to $250 millionat the option of the Company. As of December 31, 2006, we had elected toincrease the maximum borrowings to $210 million. The maturity date of thefacility is December 2011. The actual amount available is tied to ourinventory and receivable base, and our obligations under the credit facilityare secured by liens on our principal assets. Borrowing options are prime rateplus applicable prime margin, or London Interbank Offered Rate or LIBOR, plusapplicable LIBOR margin. The applicable prime and LIBOR margins are based uponlevels of excess availability and adjusted quarterly. If excess availability isgreater than $30 million, the applicable prime margin is -0.25% andapplicable LIBOR margin is 0.75%. If excess availability is less than or equalto $30 million and greater than $15 million, the applicable prime margin is0.00% and the applicable LIBOR margin is 1.00%. If excess availability is lessthan or equal to $15 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.25%. An unused fee of 0.25% is assessed on theunused portion of the credit facility. The agreement underlying the credit 

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facility includessignificant restrictive negative covenants. Among other things, these covenantsrestrict or prohibit our ability to incur debt and issue specified equityinstruments, incur liens on our assets, make any significant changes in ourcorporate structure or the nature of our business, dispose of assets, makeguaranties, prepay debt, engage in a change in control transaction, paydividends, make investments or acquisitions, engage in transactions withaffiliates and incur capital expenditures. The agreement also includesrepresentations and warranties which must be true each time we borrow fundsunder the credit facility and affirmative covenants. The full text of thecontractual requirements imposed by this financing is set forth in the Amendedand Restated Loan and Security Agreement and related amendments which have beenfiled as exhibits to our periodic reports with the Securities and ExchangeCommission (“SEC”). Subject to limited cure periods, the lenders under ourcredit facility may demand repayment of these borrowings prior to statedmaturity upon the occurrence of specified events, including if we breach theterms of the agreement, suffer a material adverse change, engage in a change incontrol transaction, suffer a significant adverse legal judgment, default onother significant obligations, or in the event of specified events ofinsolvency.

During 2002 we entered into master operating leaseagreements with US Bank to lease equipment and other property primarily tosupport the operations of the distribution center for our Guitar Center retailstores. Under these agreements, we leased a total of $10.5 million in equipmentand other property. In August 2006, we entered into a master operating leaseagreement to lease equipment totaling approximately $13 million to supportthe operations of the distribution center for our Musician’s Friend subsidiary.

The terms of our significant financing agreements,including those related to our credit facility and the equipment leasefacilities described above, are not dependent on any change in our creditrating. We believe that the key company-specific factors affecting our abilityto maintain our existing debt and lease financing relationships and to accesssuch capital in the future are our present and expected levels of profitabilityand cash flow from operations, our working capital and fixed asset collateral bases,our expected level of capital expenditures, and the level of our equity capitalrelative to the level of debt obligations. In addition, as noted above, ourexisting 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 most multi-unit retailers,substantially all of the real property used in our business is leased underoperating lease agreements. Please see Item 2. Properties, and Note 7 to theConsolidated Financial Statements in our Annual Report on Form 10-Kfor the year ended December 31, 2006. For the remainder of fiscal 2007, weanticipate our capital expenditures will be between $52 million and $58million.

Net cash provided by operating activities was $15.0million for the three months ended March 31, 2007 compared to net cashprovided by operating activities of $12.9 million for the same period in 2006.The primary use of cash during the three months ended March 31, 2007 was adecrease in accrued expenses and other current liabilities of $34.2 million.The reduction of accrued expenses and other current liabilities was primarilydue to payments of income taxes and sales taxes. The primary sources of cashwere generated from the current period earnings and an increase in accountspayable of $19.3 million due mostly to higher business volumes and timing ofvendor payments.

Cash used in investing activities was $51.6 millionfor the three months ended March 31, 2007 compared to $19.2 million forthe same period in 2006. The cash used in investing activities for the threemonths ended March 31, 2007 included $30.5 million related to acquisitionsof businesses and $21.1 million of capital expenditures, comprised primarily of$10.7 million on new stores and remodels, $4.5 million on computer software andequipment purchases and $2.4 million on the expansion of our distributionfacilities.

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Cash provided by financing activities totaled $35.3million for the three months ended March 31, 2007 compared to $1.7 millionin the same period in 2006. The cash provided by financing activities in thethree months ended March 31, 2007 was due to increased borrowings underthe revolving line of credit to support business acquisitions, capitalexpenditures and working capital requirements. In addition, proceeds from theexercise of stock options provided $1.8 million (including $0.2 million inexcess tax benefits that are reflected in cash flows from financingactivities).

We believe that our current operating cash flow,working capital, cash on hand, borrowings available under our credit facilityand other sources of liquidity we believe are available to us will besufficient to meet our obligations in the ordinary course of business over thenext 12 months, including capital expenditures and new store openings.

Our known capital resource and liquidity requirementsfor 2007 are expected to be primarily provided by net cash flow from operationsand borrowings available under our credit facility. In addition, the moderationof our growth plans in 2007 by reduced Guitar Center retail store openings andfewer Music & Arts acquisitions will provide us opportunity togenerate incremental cash flows. We are continuing to evaluate the best use ofthose cash flows, including possible changes in our capital structure.

Depending upon market conditions, we may also elect toraise additional capital in the form of common or preferred equity, debt orconvertible securities for the purpose of providing additional capital to fundworking capital needs or continued growth of our existing business, or torefinance existing obligations or changes in our capital structure. Any suchfinancing activity will be dependent upon many factors, including our liquidityneeds, market conditions and prevailing market terms, and we cannot assure youthat future external financing for us will be available on attractive terms orat all.

We intend to open additional stores in new andexisting markets. Each new primary format Guitar Center store typically hasrequired approximately $1.1 million to $1.2 million in gross inventory.Historically, our cost of capital improvements for a primary format GuitarCenter store has been approximately $1.2 million consisting of leaseholdimprovements, fixtures and equipment. We incur higher costs in some geographicareas, particularly the Northeast, and when we build a larger flagship store.We have developed secondary format Guitar Center stores to build in sites thatwe do not believe will support our primary format units. Our secondary formatstores have typically required approximately $0.9 million to $1.0 million ingross inventory and approximately $0.9 million in capital improvements. Ourtertiary format stores have required approximately $0.5 million in grossinventory and approximately $0.6 million in capital improvements. These capitalexpenditures reflect the increasing construction costs that we have beenexperiencing. We expect these increases to continue for the foreseeable futureand these costs may increase above our expectations.

We are also anticipating additional capital andstrategic investments related to improving our fulfillment facilities andupgrading our technology and systems, including an enterprise data warehouse,retail point of sale replacement, retail inventory management systemsimprovements and enterprise systems replacement for our direct responsedivision. We also continue to make significant investments in informationtechnology across our businesses and to incur costs and make investmentsdesigned to expand the reach of our businesses on the Internet. The costs ofthese initiatives and other investments related to our businesses will continueto be significant.

Throughout our history, wehave 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. While we cannot provide assurance that we willcomplete any further acquisition transactions, in the ordinary course of ourbusiness we investigate 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 

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debt orequity securities, or a combination, depending upon transaction size and marketconditions, among other things.

**Recently IssuedAccounting Pronouncements**

In June 2006, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes.*FIN 48 clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, *Accountingfor Income Taxes*. This Interpretation defines the minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. The Company adopted FIN 48 on January 1,2007. As a result of the implementation, the Company recognized no materialadjustment in the liability of unrecognized income tax benefits. See Note 7 tothe Consolidated Financial Statements in this report.

In June 2006, the FASB ratified Emerging IssuesTask Force (EITF) Issue 06-3, *How Sales Taxes CollectedFrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statement.* (“EITF 06-3”). EITF 06-3 requiresa company to disclose its accounting policy (i.e., gross or net presentation)regarding the presentation of taxes within the scope of EITF 06-3. Iftaxes are significant, a company should disclose the amount of such taxes foreach period for which an income statement is presented. As required, theCompany adopted EITF 06-3 as of January 1, 2007 and the effect ofthe initial adoption of EITF 06-3 did not have any impact on itsconsolidated financial statements as we have historically presented salesexcluding these taxes.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards (“SFAS”) No. 157, *Fair ValueMeasurements*. SFAS No. 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. Accordingly, thisStatement does not require any new fair value measurements. SFAS No. 157is effective for fiscal years beginning after November 15, 2007. TheCompany is currently evaluating the impact, if any, the adoption of SFAS No. 157will have on its consolidated financial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilitie*s. SFAS No. 159permits companies to choose to measure certain financial instruments andcertain other items at fair value. The standard requires that unrealized gainsand losses on items for which the fair value option has been elected bereported in earnings. SFAS No. 159 is effective as of the beginning of anentity’s first fiscal year that begins after November 15, 2007, and theCompany is required to adopt SFAS No. 159 in the first quarter of 2008.The Company is currently evaluating the impact that SFAS No. 159 will haveon its consolidated financial statements.

**Seasonality**

Our business follows aseasonal pattern, peaking during the holiday selling season in November andDecember. Sales in the fourth quarter are typically significantly higher on aper store basis and through the direct response unit than in any other quarter.In addition, band rental season for our Music & Arts starts in August andcarries through mid-October, but that seasonality does not have a significantimpact on our consolidated results.

**Inflation**

We believe that therelatively moderate rates of inflation experienced in recent years have not hada significant impact on our net sales or profitability. However, we have beenexperiencing rising steel, lumber, concrete, labor, fuel and freight costsrelated to opening, remodeling, operating and relocating our stores, expandingour distribution centers and operating our business.

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**Forward-LookingStatements; Business Risks**

This report contains forward-looking statementsrelating to, among other things, future results of operations, growth andinvestment plans, sales, trends in gross margin, growth in the Internet portionof our direct response business, the integration of acquisitions and otherfactors affecting growth in sales and earnings. Specific forward-lookingstatements are provided regarding our management’s current views regarding thedates new facilities and systems will become operational. Statements regardingthe dates new facilities and systems will become operational are dependent uponthird parties and events beyond our control, such as the availability of thirdparty consulting resources, construction delays, technology development delaysand other events. Sales and earnings trends are also affected by many otherfactors including, among others, world and national political events, generaleconomic conditions, the effectiveness of our promotion and merchandisingstrategies, our ability to integrate and profitably operate acquiredbusinesses, including Woodwind & Brasswind, the efficient operation ofour supply chain, including the continued support of our key vendors, oureffective management of business risks, including litigation, and competitivefactors applicable to our retail and direct response markets. In addition,during the recent past, we have experienced greater fluctuations in weekly andmonthly operating results than has been our historic experience and thisvolatility has, and is likely to continue to, reduce the reliability of ourfuture projections.

In light of these risks,there can be no assurance that the forward-looking statements contained in thisreport 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 donot presently intend to update these statements and undertake no duty to anyperson to affect any such update under any circumstances.

**Item 3.**                        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We do not have any assetsor liabilities which, in our view, impose upon us significant market riskexcept for our credit facility which has a variable rate of interest generallyconsisting of stated premiums above prime and LIBOR. At March 31, 2007, wehad $135.0 million in outstanding borrowings under our credit facility. Asshort-term interest rates fluctuate, the interest expense we incur on ourcredit facility will change resulting in either a positive or negative effecton our financial position, results of operations and cash flows. At thisborrowing level for our credit facility, a one percentage point increase ininterest rates would have an unfavorable impact on pre-tax earnings of $1.4million on an annual basis. The primary interest rate exposure on the creditfacility is based on LIBOR. We do not use derivative financial instruments inour investment portfolio. Historically, we have not carried significant cashbalances and any cash in excess of our daily operating needs has been used toreduce our borrowings. Excess cash is generally invested in short-term, highquality interest bearing investments.

**Item 4.**                        CONTROLSAND PROCEDURES

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our reportsfiled pursuant to the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and formsand that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

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As required by SEC Rule 13a-15(b),we carried out an evaluation, under the supervision and with the participationof our management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by this report.Based on the foregoing, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were effective to providereasonable assurance that information relating to us and our subsidiaries thatwe are required to disclose in the reports that we file or submit to the SEC isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

**Part II.**                      OTHERINFORMATION

**Item 1.**                        LegalProceedings

For information on legalproceedings, see Note 8 of Notes to Consolidated Financial Statements “LegalProceedings”, which is incorporated by reference in response to this Item 1.

**Item 1A.**                RiskFactors

Except for the riskfactors set forth below, there have been no material changes to the riskfactors disclosed in Item 1A of Part 1 in our Form 10-K for theyear ended December 31, 2006. The risk factors set forth below weredisclosed in our Form 10-K, but have been updated to provide additionalinformation.

*We may beadversely impacted if our security measures fail; we will need to comply withcredit card security regulations.*

Our relationships with ourcustomers may be adversely affected if the security measures that we use toprotect their personal information, such as credit card numbers, areineffective. We primarily rely on security and authentication technology thatwe license from other parties. With this technology, we perform real-time creditcard authorization and verification with our bank and we are subject to thecustomer privacy standards of credit card companies. We cannot predict whetherevents or developments will result in a compromise or breach of the technologywe use to protect our customers’ personal information. If there is a compromiseor breach of this nature, there is the potential that parties could seekdamages from us, and a compromise or breach could lead to loss of confidence ofcustomers or significant fines from credit card companies or regulatoryagencies. Furthermore, our servers may be vulnerable to computer viruses,physical or electronic break-ins and similar disruptions. We may need to expendsignificant additional capital and other resources to protect against asecurity breach or to alleviate problems caused by any breaches. There is noassurance that we can prevent security breaches or systems failures.

We will need to becomecompliant with the Payment Card Industry requirements for security andprotection of customer credit card information. As a merchant who processescredit card payments from customers, we are required to comply with the PaymentCard Industry requirements imposed on us for the protection and security of ourcustomers’ credit card information. If we are unable to successfully complywith these requirements on a timely basis, currently expected to be on or aboutthe end of 2007, our business could be harmed because we could incursignificant fines from credit card companies or we could be prevented in thefuture from accepting customer payments by means of a credit card. In addition,we may need to expend significant management and financial resources inbecoming compliant with these requirements, which could divert these resourcesfrom other initiatives and adversely impact our financial results.

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**Item6.**                        Exhibits
| Exhibit  Number | ** ** | **Description** | ** ** |
|-----------------|------------|-----------------|------------|
|            | 31.1       |            |       | Certification of the  Company’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |   |
|            | 31.2       |            |       | Certification of the  Company’s Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |   |
|            | 32.1       |            |       | Certification of the  Company’s Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |   |
|            | 32.2       |            |       | Certification of the  Company’s Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |   |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized as of the 10th day of May 2007.
|        | GUITAR  CENTER, INC.                                           |
|--------|---------------------------------------------------------------------|
|   | /s/ ERICK MASON                                                     |
|   | Erick Mason,  Executive Vice President and  Chief Financial Officer |

 

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