**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

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

**Forthe quarterly period ended June 30, 2006**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 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 telephonenumber, 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 the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

Yes x      No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (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

Asof August 4, 2006, there were 29,265,199 shares of our common stock, $.01 parvalue, outstanding.

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES**

**INDEX TO FINANCIAL STATEMENTS**
| Part I.   |   | Financial  Information |       |                                                                                            |   |
|-----------|--------|------------------------|------------|-------------------------------------------------------------------------------------------------|--------|
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item 1.**            | ** ** | **Consolidated  Financial Statements (Unaudited)**                                              |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   |                   |       | Consolidated  Balance Sheets — June 30, 2006 and December 31, 2005                         |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   |                   |       | Consolidated  Statements of Income — Three months ended June 30, 2006 and 2005             |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   |                   |       | Consolidated  Statements of Income — Six months ended June 30, 2006 and 2005               |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   |                   |       | Consolidated  Statements of Cash Flows — Six months ended June 30, 2006 and 2005           |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   |                   |       | Notes  to Consolidated Financial Statements                                                     |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item 2.**            | ** ** | **Management’s Discussion and Analysis of Financial  Condition and Results of Operations** |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item 3.**            | ** ** | **Quantitative and Qualitative Disclosures About Market  Risk**                                 |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item 4.**            | ** ** | **Controls and Procedures.**                                                                    |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
| Part  II. |   | Other  Information     |       |                                                                                            |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item  1.**           | ** ** | **Legal  Proceedings**                                                                          |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item  1A.**          | ** ** | **Risk  Factors**                                                                               |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item 4.**            | ** ** | **Submission of Matters to a Vote of Security Holders**                                         |   |   |   |
|      |   |                   |       |                                                                                            |   |   |   |
|      |   | **Item 6.**            | ** ** | **Exhibits**                                                                                    |   |   |   |

 

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands)(Unaudited)**
| ** **                                                                                                                                                                                          | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                          | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                     |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                          |       | $                       | 10,926     |                        | $          | 14,529 |   |
| Accounts  receivable, less allowance for doubtful accounts of $2,972 and $2,844,  respectively                                                                                                      |       | 34,939                  |       | 40,844                      |       |
| Merchandise  inventories                                                                                                                                                                            |       | 493,173                 |       | 445,771                     |       |
| Prepaid expenses  and other current assets                                                                                                                                                          |       | 17,787                  |       | 15,533                      |       |
| Deferred income  taxes                                                                                                                                                                              |       | 16,334                  |       | 13,492                      |       |
| Total current assets                                                                                                                                                                                |       | 573,159                 |       | 530,169                     |       |
| Property and equipment,  net of accumulated depreciation and amortization of $140,640 and $125,440,  respectively                                                                                   |       | 172,118                 |       | 149,209                     |       |
| Goodwill                                                                                                                                                                                            |       | 95,701                  |       | 85,929                      |       |
| Intangible assets, net                                                                                                                                                                              |       | 8,123                   |       | 9,142                       |       |
| Other assets, net                                                                                                                                                                                   |       | 5,535                   |       | 5,741                       |       |
| Total assets                                                                                                                                                                                        |       | $                       | 854,636    |                        | $          | 780,190 |   |
|                                                                                                                                                                                                |       |                    |       |                        |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                    |       | $                       | 99,382     |                        | $          | 79,497 |   |
| Accrued expenses  and other current liabilities                                                                                                                                                     |       | 64,446                  |       | 106,181                     |       |
| Merchandise  advances                                                                                                                                                                               |       | 20,199                  |       | 25,127                      |       |
| Borrowing under  revolving line of credit                                                                                                                                                           |       | 87,549                  |       | 32,266                      |       |
| Total current  liabilities                                                                                                                                                                          |       | 271,576                 |       | 243,071                     |       |
| Other long-term  liabilities                                                                                                                                                                        |       | 14,433                  |       | 11,995                      |       |
| Deferred income taxes                                                                                                                                                                               |       | 15,112                  |       | 20,307                      |       |
| Long-term debt                                                                                                                                                                                      |       | 99,815                  |       | 100,000                     |       |
| Total liabilities                                                                                                                                                                                   |       | 400,936                 |       | 375,373                     |       |
| Stockholders’ equity:                                                                                                                                                                          |       |                    |       |                        |       |
| Preferred stock,  5,000 authorized, none issued and outstanding                                                                                                                                     |       | —                  |       | —                      |       |
| Common stock,  $0.01 par value, authorized 100,000 shares at June 30, 2006 and 55,000 shares  at December 31, 2005, issued and outstanding 26,374 at June 30, 2006 and 26,092  at December 31, 2005 |       | 264                     |       | 261                         |       |
| Additional  paid-in capital                                                                                                                                                                         |       | 346,499                 |       | 326,755                     |       |
| Retained  earnings                                                                                                                                                                                  |       | 106,937                 |       | 77,801                      |       |
| Total stockholders’  equity                                                                                                                                                                    |       | 453,700                 |       | 404,817                     |       |
| Total liabilities and stockholders’ equity                                                                                                                                                     |       | $                       | 854,636    |                        | $          | 780,190 |   |

 

*See accompanying notes to consolidated financial statements.*

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)(Unaudited)**
| ** **                                                              | ** ** | **Three months ended June 30,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Net sales                                                               |       | $                                                   | 457,978    |   | $ | 402,296 |   |
| Cost of goods sold,  buying and occupancy                               |       | 326,621                                             |       | 286,956 |   |
| Gross profit                                                            |       | 131,357                                             |       | 115,340 |   |
| Selling, general and  administrative expenses                           |       | 107,984                                             |       | 92,429 |   |
| Operating income                                                        |       | 23,373                                              |       | 22,911 |   |
| Interest expense, net  of interest income of $73 and $146, respectively |       | 2,374                                               |       | 1,915 |   |
| Income before income  taxes                                             |       | 20,999                                              |       | 20,996 |   |
| Income taxes                                                            |       | 7,570                                               |       | 8,085 |   |
| Net income                                                              |       | $                                                   | 13,429     |   | $ | 12,911 |   |
|                                                                    |       |                                                |       |   |   |
| Net income per share:                                                   |       |                                                |       |   |   |
| Basic                                                                   |       | $                                                   | 0.51       |   | $ | 0.50 |   |
| Diluted                                                                 |       | $                                                   | 0.47       |   | $ | 0.46 |   |
|                                                                    |       |                                                |       |   |   |
| Weighted average shares  outstanding:                                   |       |                                                |       |   |   |
| Basic                                                                   |       | 26,278                                              |       | 25,885 |   |
| Diluted                                                                 |       | 30,012                                              |       | 29,836 |   |

 

*See accompanying notes toconsolidated financial statements.*

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**GUITAR CENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)(Unaudited)**
| ** **                                                               | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Net sales                                                                |       | $                                                 | 928,725    |   | $ | 798,682 |   |
| Cost of goods sold,  buying and occupancy                                |       | 660,862                                           |       | 572,170 |   |
| Gross profit                                                             |       | 267,863                                           |       | 226,512 |   |
| Selling, general and  administrative expenses                            |       | 217,098                                           |       | 176,900 |   |
| Operating income                                                         |       | 50,765                                            |       | 49,612 |   |
| Interest expense, net  of interest income of $148 and $649, respectively |       | 4,226                                             |       | 2,790 |   |
| Income before income  taxes                                              |       | 46,539                                            |       | 46,822 |   |
| Income taxes                                                             |       | 17,403                                            |       | 18,027 |   |
| Net income                                                               |       | $                                                 | 29,136     |   | $ | 28,795 |   |
|                                                                     |       |                                              |       |   |   |
| Net income per share:                                                    |       |                                              |       |   |   |
| Basic                                                                    |       | $                                                 | 1.11       |   | $ | 1.12 |   |
| Diluted                                                                  |       | $                                                 | 1.03       |   | $ | 1.02 |   |
|                                                                     |       |                                              |       |   |   |
| Weighted average shares  outstanding:                                    |       |                                              |       |   |   |
| Basic                                                                    |       | 26,227                                            |       | 25,740 |   |
| Diluted                                                                  |       | 29,849                                            |       | 29,780 |   |

 

*See accompanying notes toconsolidated financial statements.*

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)**
| ** **                                                                                   | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| **Operating activities:**                                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net income                                                                                   |       | $                                                 | 29,136     |   | $ | 28,795 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                                              |       |   |   |
| Depreciation and  amortization                                                               |       | 17,192                                            |       | 13,317 |   |
| Loss on disposal  of property and equipment                                                  |       | —                                            |       | 1,849 |   |
| Amortization of  deferred financing fees                                                     |       | 485                                               |       | 522 |   |
| Stock-based  compensation                                                                    |       | 11,908                                            |       | — |   |
| Tax benefit from  exercise of stock options                                                  |       | —                                            |       | 7,088 |   |
| Deferred income  taxes                                                                       |       | (7,150                                            | )          | 350 |   |
| Changes in operating  assets and liabilities, net of effect of acquisitions:                 |       |                                              |       |   |   |
| Accounts  receivable                                                                         |       | 6,393                                             |       | 9,746 |   |
| Merchandise  inventories                                                                     |       | (40,769                                           | )          | (45,932 | ) |
| Prepaid expenses  and other current assets                                                   |       | (2,254                                            | )          | (3,107 | ) |
| Other assets,  net                                                                           |       | (279                                              | )          | 20 |   |
| Accounts payable                                                                             |       | 19,885                                            |       | 31,648 |   |
| Accrued expenses  and other current liabilities                                              |       | (43,106                                           | )          | (24,697 | ) |
| Merchandise  advances                                                                        |       | (4,977                                            | )          | (7,040 | ) |
| Other long-term  liabilities                                                                 |       | 2,438                                             |       | 2,803 |   |
| Net cash provided by  (used in) operating activities                                         |       | (11,098                                           | )          | 15,362 |   |
| **Investing activities:**                                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Purchase of  property and equipment                                                          |       | (38,046                                           | )          | (37,829 | ) |
| Purchase of  available-for-sale securities                                                   |       | —                                            |       | (27,305 | ) |
| Proceeds from  sale of available-for-sale securities                                         |       | —                                            |       | 47,460 |   |
| Acquisition of  businesses, net of cash acquired                                             |       | (17,396                                           | )          | (96,251 | ) |
| Net cash used in  investing activities                                                       |       | (55,442                                           | )          | (113,925 | ) |
| **Financing activities:**                                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net change in  borrowing under revolving line of credit                                      |       | 55,283                                            |       | 38,092 |   |
| Proceeds from  exercise of stock options                                                     |       | 4,741                                             |       | 9,042 |   |
| Proceeds from  stock issued under employee purchase plan                                     |       | 1,220                                             |       | 953 |   |
| Excess tax  benefit from exercise of stock options                                           |       | 1,693                                             |       | — |   |
| Net cash provided by  financing activities                                                   |       | 62,937                                            |       | 48,087 |   |
| Net decrease in cash  and cash equivalents                                                   |       | (3,603                                            | )          | (50,476 | ) |
| Cash and cash  equivalents at beginning of period                                            |       | 14,529                                            |       | 60,453 |   |
| Cash and cash equivalents at end of period                                                   |       | $                                                 | 10,926     |   | $ | 9,977 |   |

 

*See accompanying notes toconsolidated financial statements.*

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| **Non-cash investing and  financing activities:**                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Acquisition of  businesses, in which the fair value of assets and liabilities were as  follows: |       |       |       |       |       |
| Accounts  receivable                                                                            |       | $          | 488        |       | $          | 6,024 |   |
| Merchandise  inventories                                                                        |       | 6,633      |       | 56,037     |       |
| Prepaid expenses  and other current assets                                                      |       | —     |       | 677        |       |
| Property and  equipment                                                                         |       | 191        |       | 3,311      |       |
| Goodwill                                                                                        |       | 9,772      |       | 51,938     |       |
| Intangible  assets                                                                              |       | 845        |       | —     |       |
| Other assets                                                                                    |       | —     |       | 5,593      |       |
| Total assets  acquired                                                                          |       | 17,929     |       | 123,580    |       |
| Current  liabilities                                                                            |       | (1,420     | )          | (24,450    | )          |
| Other long-term  liabilities                                                                    |       | —     |       | (460       | )          |
| Deferred income  taxes                                                                          |       | 887        |       | (2,419     | )          |
| Total  liabilities assumed                                                                      |       | (533       | )          | (27,329    | )          |
| Net assets  acquired                                                                            |       | $          | 17,396     |       | $          | 96,251 |   |
|                                                                                            |       |       |       |       |       |
| Conversion of debt to common stock                                                              |       | $          | 185        |       | $          | — |   |

 

*See accompanying notes toconsolidated financial statements.*

5

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

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

*Nature ofBusiness*

GuitarCenter, Inc. (the “Company”) is the leading United States retailer ofguitars, amplifiers, percussion instruments, keyboards and pro-audio andrecording equipment. As of June 30, 2006, our retail subsidiary operated 184Guitar Center stores across the United States consisting of 129 primary formatstores, 53 secondary format stores and 2 tertiary format stores. In addition,as of June 30, 2006, our Music & Arts Center division operated 92stores specializing in band instruments for sale and rental, serving teachers,band directors, 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 catalog andwebsite, www.musiciansfriend.com.

*Basis ofPresentation*

In theopinion of management, the accompanying unaudited consolidated financialstatements contain all adjustments necessary to present fairly the financialposition of the Company as of June 30, 2006, the results of operations for thethree and six months ended June 30, 2006 and 2005, respectively, and its cashflows for the six months ended June 30, 2006 and 2005, respectively. Theaccompanying consolidated financial statements should be read in conjunctionwith the audited consolidated financial statements and notes thereto containedin our Annual Report on Form 10-K for the year ended December 31, 2005.

The Company’sresults of operations and cash flows for the interim periods may not beindicative of the results of operations and cash flows for the full year.

*Use of Estimatesin the Preparation of Financial Statements*

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires that we make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from our estimates.

*Reclassifications*

Areclassification has been made to the December 31, 2005 consolidated balancesheet to separately report intangible assets, net, which was previouslyincluded with other assets, net. This reclassification has no impact on thepreviously reported  net income orstockholders’ equity.

**2.**Acquisitionof Businesses**

Duringthe second quarter of 2006, our Guitar Center division acquired four retaillocations in Texas and the related assets from Hermes Trading Company, Inc., amusical instruments retailer, for approximately $10.8 million.

Duringthe six months ended June 30, 2006, our Music & Arts Center divisionacquired a total of 11 stores and the related assets for an aggregate purchaseprice of approximately $6.4 million.

Theaggregate purchase price for the acquisitions in the six months ended June 30,2006 (including purchase price adjustments of $0.2 million) totaledapproximately $17.4 million, which was principally allocated to merchandise inventoriesof $6.6 million and goodwill of $9.8 million. The increase in goodwill duringthe six months ended June 30, 2006 was related to approximately $8.0 million inour Guitar Center Music division and approximately $1.8 million in our Music& Arts Center division.

Theacquisitions were accounted for under the purchase method of accounting inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “*Business Combinations*.” The results of operations of theacquisitions were not material to the current period consolidated financialstatements and, as such, pro forma financial information is not presented forthese acquisitions. The results of operations of the acquired stores areincluded in the consolidated financial 

6

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statementsfrom the respective dates of acquisition.

OnApril 15, 2005, the Company completed the acquisition of Music &Arts Center, Inc., a Maryland-based musical instruments retailer with anemphasis on the beginning musician. At the time of the acquisition,Music & Arts Center, Inc. operated 61 retail locations, primarilylocated in the Northeast, Mid-Atlantic and Southern regions of the UnitedStates. The Company acquired Music & Arts Center, Inc. to expand ourexisting presence in the band and orchestra instrument business. The acquiredbusiness and our existing American Music Group business were combined into anew division under the Music & Arts Center name.

**3.**IntangibleAssets**

Intangibleassets with definite useful lives are amortized over their respective estimateduseful lives. The following is a summary of intangible assets as of June 30,2006 and December 31, 2005 (dollars in thousands, life in years):
| ** **                | ** ** | ** **                               | ** ** | **June 30, 2006** | ** ** |
|---------------------------|------------|------------------------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | **Weighted-  Average Useful  Life** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
| Unamortized trademark     |       | —                                   |       | $                           | 5,367      |   | $ | — |   | $ | 5,367 |   |
| Amortized                 |       |                                     |       |                        |       |   |   |   |   |
| Customer  contracts       |       | 1.4                                      |       | 3,742                       |       | (3,073 | ) | 669 |   |
| Covenants not to  compete |       | 3.9                                      |       | 2,674                       |       | (936 | ) | 1,738 |   |
| Other                     |       | 2.6                                      |       | 851                         |       | (502 | ) | 349 |   |
| Intangible assets, net    |       |                                     |       | $                           | 12,634     |   | $ | (4,511 | ) | $ | 8,123 |   |

 
| ** **                | ** ** | ** **                               | ** ** | **December 31, 2005** | ** ** |
|---------------------------|------------|------------------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **Weighted-  Average Useful  Life** | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
| Unamortized trademark     |       | —                                   |       | $                               | 5,325      |   | $ | — |   | $ | 5,325 |   |
| Amortized                 |       |                                     |       |                            |       |   |   |   |   |
| Customer contracts        |       | 1.4                                      |       | 3,430                           |       | (1,734 | ) | 1,696 |   |
| Covenants not to  compete |       | 3.7                                      |       | 2,200                           |       | (596 | ) | 1,604 |   |
| Other                     |       | 2.6                                      |       | 834                             |       | (317 | ) | 517 |   |
| Intangible assets, net    |       |                                     |       | $                               | 11,789     |   | $ | (2,647 | ) | $ | 9,142 |   |

 

Amortizationof intangible assets is included in selling, general and administrativeexpenses.

As ofJune 30, 2006, amortization expense related to intangible assets is estimatedto be approximately $1.1 million for the remainder of 2006, $0.8 million in2007, $0.4 million in 2008, $0.2 million in 2009, $0.1 million in 2010 and $0.1million thereafter.

**4. Net Income Per Share**

Thefollowing table summarizes the calculation of basic to diluted weighted averageshares and diluted net income per share for the periods presented below:

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| ** **                                                                | ** ** | **Three months ended June 30,**                | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                | ** ** | **(In thousands, except per share data)** | ** ** |
| Net income, as reported                                                   |       | $                                                                  | 13,429     |                                              | $          | 12,911 |   | $ | 29,136 |   | $ | 28,795 |   |
| Add back interest, net  of tax, on 4% Senior Convertible Notes (a)        |       | 825                                                                |       | 727                                               |       | 1,604 |   | 1,454 |   |
| Net income, excluding  interest expense on 4% Senior Convertible Notes    |       | $                                                                  | 14,254     |                                              | $          | 13,638 |   | $ | 30,740 |   | $ | 30,249 |   |
|                                                                      |       |                                                               |       |                                              |       |   |   |   |   |
| Basic weighted average  shares outstanding                                |       | 26,278                                                             |       | 25,885                                            |       | 26,227 |   | 25,740 |   |
| Dilutive effect of  stock options outstanding                             |       | 842                                                                |       | 1,059                                             |       | 730 |   | 1,148 |   |
| Shares issuable on  assumed conversion of 4% Senior Convertible Notes (b) |       | 2,892                                                              |       | 2,892                                             |       | 2,892 |   | 2,892 |   |
| Diluted weighted  average shares outstanding                              |       | 30,012                                                             |       | 29,836                                            |       | 29,849 |   | 29,780 |   |
|                                                                      |       |                                                               |       |                                              |       |   |   |   |   |
| Basic net income per  share                                               |       | $                                                                  | 0.51       |                                              | $          | 0.50 |   | $ | 1.11 |   | $ | 1.12 |   |
| Diluted net income per share                                              |       | $                                                                  | 0.47       |                                              | $          | 0.46 |   | $ | 1.03 |   | $ | 1.02 |   |

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(a)             Representsthe interest expense, including contingent interest and amortization ofdeferred financing costs, on the 4% Senior Convertible Notes (the “Notes”), netof tax, using an effective tax rate of 36.05% and 37.39% for the three and sixmonths ended June 30, 2006 and 38.50% for the three and six months ended June30, 2005.

(b)            Representsthe weighted-average number of common shares issuable upon the conversion ofthe Notes.

Forthe three and six months ended June 30, 2006 and 2005, the only potentialadditional shares of common stock that could become outstanding were sharesissuable upon exercise of stock options and conversion of the Notes.

Forthe three and six months ended June 30, 2006, options to acquireweighted-average shares of 612,194 and 573,684, respectively, were outstandingbut were excluded from the computation of diluted net income per share becausetheir effect was anti-dilutive. For the three and six months endedJune 30, 2005, all options outstanding had a dilutive effect.

Forthe three and six months ended June 30, 2006 and 2005, the 2.9 million sharesof common stock issuable upon conversion of the Notes issued in June 2003(reflecting an effective conversion price of $34.58) are deemed to be potentialcommon stock and are deemed to be outstanding for the purposes of calculatingdiluted net income per share under the “if-converted” method of accountingunder which the after-tax interest expense, including contingent interest andamortization of deferred financing costs, for the period is added back to netincome. The Notes were called for redemption by the Company on June 15, 2006,and substantially all of the outstanding Notes were converted into common stockprior to the July 15, 2006 redemption date. See Note 9 for further discussionof the Notes.

**5. Segment Information**

Ourreportable business segments are Guitar Center stores, Music & ArtsCenter and Musician’s Friend direct response. Management evaluates segmentperformance based primarily on net sales, operating income (loss) and income(loss) before income taxes. Accounting policies of the segments are the same asthe accounting policies for the consolidated company. There are no differencesbetween the measurements of profits or losses or assets of the reportable segmentsand those of the Company on a consolidated basis.

Thefollowing table summarizes financial information for our operating segments asof June 30, 2006 and December 31, 2005 and for the three and six months endedJune 30, 2006 and 2005 (in thousands):

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| ** **                                     | ** ** | **Three Months Ended June 30, 2006** | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Guitar  Center**                                            | ** ** | **Music &  Arts**                                  | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **Music &  Arts** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net Sales                                      |       | $                                                             | 339,840    |                                                        | $          | 31,805 |   | $ | 86,333 |   | $ | 457,978 |   | $ | 679,131 |   | $ | 64,990 |   | $ | 184,604 |   | $ | 928,725 |   |
| Gross Profit                                   |       | 90,821                                                        |       | 13,913                                                      |       | 26,623 |   | 131,357 |   | 183,204 |   | 29,336 |   | 55,323 |   | 267,863 |   |
| Depreciation and amortization                  |       | 6,588                                                         |       | 1,474                                                       |       | 754 |   | 8,816 |   | 12,939 |   | 2,780 |   | 1,473 |   | 17,192 |   |
| Selling, general and adiministrative  expenses |       | 72,481                                                        |       | 14,500                                                      |       | 21,003 |   | 107,984 |   | 144,115 |   | 29,473 |   | 43,510 |   | 217,098 |   |
| Operating income (loss)                        |       | 18,340                                                        |       | (587                                                        | )          | 5,620 |   | 23,373 |   | 39,089 |   | (137 | ) | 11,813 |   | 50,765 |   |
| Income (loss) before income  tax (benefit)     |       | 18,372                                                        |       | (3,444                                                      | )          | 6,071 |   | 20,999 |   | 39,511 |   | (5,746 | ) | 12,774 |   | 46,539 |   |
| Capital expenditures                           |       | 18,644                                                        |       | 1,006                                                       |       | 2,297 |   | 21,947 |   | 32,334 |   | 1,930 |   | 3,782 |   | 38,046 |   |
|                                                |            |                                                               |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                     | ** ** | **Three Months Ended June 30, 2005** | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Guitar  Center**                                            | ** ** | **Music &  Arts (1)**                         | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **Music &  Arts (1)** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net Sales                                      |       | $                                                             | 299,637    |                                                        | $          | 24,673 |   | $ | 77,986 |   | $ | 402,296 |   | $ | 594,280 |   | $ | 34,911 |   | $ | 169,491 |   | $ | 798,682 |   |
| Gross Profit                                   |       | 80,435                                                        |       | 10,282                                                      |       | 24,623 |   | 115,340 |   | 160,125 |   | 14,114 |   | 52,273 |   | 226,512 |   |
| Depreciation and amortization                  |       | 5,686                                                         |       | 1,212                                                       |       | 560 |   | 7,458 |   | 10,514 |   | 1,722 |   | 1,081 |   | 13,317 |   |
| Selling, general and adiministrative  expenses |       | 60,752                                                        |       | 14,662                                                      |       | 17,015 |   | 92,429 |   | 122,190 |   | 19,826 |   | 34,884 |   | 176,900 |   |
| Operating income (loss)                        |       | 19,683                                                        |       | (4,380                                                      | )          | 7,608 |   | 22,911 |   | 37,935 |   | (5,712 | ) | 17,389 |   | 49,612 |   |
| Income (loss) before income  tax (benefit)     |       | 19,444                                                        |       | (6,446                                                      | )          | 7,998 |   | 20,996 |   | 37,278 |   | (8,549 | ) | 18,093 |   | 46,822 |   |
| Capital expenditures                           |       | 13,225                                                        |       | 252                                                         |       | 1,473 |   | 14,950 |   | 34,681 |   | 495 |   | 2,653 |   | 37,829 |   |
|                                           |       |                                                          |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets at June  30, 2006                 |       |                                                          |       |                                                        |       |   |   |   |   | $ | 565,947 |   | $ | 212,111 |   | $ | 76,578 |   | $ | 854,636 |   |
| Total assets at December 31, 2005              |       |                                                          |       |                                                        |       |   |   |   |   | $ | 512,802 |   | $ | 197,045 |   | $ | 70,343 |   | $ | 780,190 |   |
|                                                |            |                                                               |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)   Theinformation included for the Music & Arts Center division included only theoperation of American Music prior to April 15, 2005.

**6. Stock-Based Compensation**

Effective January 1,2006, the Company adopted the provisions of, and accounts for stock-basedcompensation in accordance with, SFAS No. 123—revised 2004 (“SFAS No. 123(R)”),“*Share-Based Payment*,” whichreplaced SFAS No. 123, “*Accounting forStock-Based Compensation*,” and supersedes AccountingPrinciples Board (“APB”) Opinion No. 25, “*Accounting for StockIssued to Employees*.” Under the fair value recognition provisions ofthis statement, stock-based compensation cost for option awards ismeasured at the grant date based on the fair value of the award and isrecognized as expense on a straight-line basis over the requisite serviceperiod of the award. For performance share awards, stock-based compensationexpense is measured at the market price of the Company’s stock on the date theunderlying plan receives compensation committee approval, or other form of amutual understanding of the key terms and conditions of performance. TheCompany elected the modified prospective method, under which prior periods arenot restated for comparative purposes. The valuation provisions of SFASNo. 123(R) apply to new grants and to grants that were outstanding as ofthe effective date. Estimated compensation for unvested grants that wereoutstanding as of the effective date will be recognized over the remainingservice period using the compensation cost estimated for the SFAS No. 123pro forma disclosures.

9

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Stock-based compensationexpense for all stock award plans included in our consolidated statement ofincome for the three months ended June 30, 2006 was $4.8 million ($3.1 million,net of tax), or $0.10 per diluted share. Stock-based compensation expense forall stock award plans included in our consolidated statement of income for thesix months ended June 30, 2006 was $11.9 million ($7.4 million, net of tax), or$0.25 per diluted share. As a result of adopting SFAS No. 123(R) onJanuary 1, 2006, income before income taxes for the three and six months endedJune 30, 2006 was $3.6 million and $7.9 million lower, respectively, and netincome for the three and six months ended June 30, 2006 was $2.2 million and$4.9 million lower, respectively, than if we had continued to account forstock-based compensation under APB No. 25. If we had not adopted SFASNo. 123(R), our basic and diluted net income per share for the threemonths ended June 30, 2006 would have been increased by $0.08 and $0.07, respectively,and for the six months ended June 30, 2006, basic and diluted income per sharewould have been increased by $0.19 and $0.16, respectively. Under the APB No.25 intrinsic value method, the Company would have not recorded stock-basedcompensation expense in 2006 related to stock option awards, but would haverecorded stock-based compensation expense related to awards of performanceshares, restricted stock, and deferred stock units.

Prior to the adoption ofSFAS No. 123(R), we presented all tax benefits for deductions resultingfrom the exercise of stock options as operating cash flows on our consolidatedstatement of cash flows. SFAS No. 123(R) requires the benefits of taxdeductions in excess of recognized compensation expense to be reported as afinancing cash flow, rather than as an operating cash flow. This requirementwill reduce net operating cash flows and increase net financing cash flows inperiods after adoption. Total cash flow will remain unchanged from what wouldhave been reported under prior accounting rules. For the six months ended June30, 2006, $1.7 million of excess tax benefits from the exercise of stockoptions reported in financing cash flows would have been reported as operatingcash flows had SFAS No. 123(R) not been adopted.

The following tabledetails the effect on net income and net income per share as if we had appliedthe fair value recognition provisions of SFAS No. 123 to stock-basedcompensation during the three and six months ended June 30, 2005 (in thousands,except per share data):
| ** **                                                                                                                                     | ** ** | **Three months ended  June 30, 2005** | ** ** | **Six months ended  June 30, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Net income, as reported                                                                                                                        |       | $                                                         | 12,911     |                                                    | $          | 28,795 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | 1,351                                                     |       | 2,776                                                   |       |
| Pro forma net income                                                                                                                           |       | $                                                         | 11,560     |                                                    | $          | 26,019 |   |
|                                                                                                                                           |       |                                                      |       |                                                    |       |
| Net income per share:                                                                                                                          |       |                                                      |       |                                                    |       |
| Basic - as  reported                                                                                                                           |       | $                                                         | 0.50       |                                                    | $          | 1.12 |   |
| Basic - pro  forma                                                                                                                             |       | $                                                         | 0.45       |                                                    | $          | 1.01 |   |
| Diluted - as  reported                                                                                                                         |       | $                                                         | 0.46       |                                                    | $          | 1.02 |   |
| Diluted - pro  forma                                                                                                                           |       | $                                                         | 0.41       |                                                    | $          | 0.92 |   |

 

*Incentive Compensation Plans*

Our2004 Incentive Stock Award Plan (as amended, the “2004 Plan”) provides for theissuance of stock options, stock appreciation rights, restricted stock,deferred stock, dividend equivalents, performance awards and stock payments, orany combination thereof. Substantially all stock awards are currently issuedunder the 2004 Plan.

Priorto fiscal 2004, the Company had adopted various stock option plans (the “PriorPlans”). A small number of 

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grantsare expected to be made under the Prior Plans, and outstanding awards under thePrior Plans will continue to be in effect.

Underthe 2004 Plan and the Prior Plans, an aggregate of 1.7 million shares of commonstock were available for issuance as of June 30, 2006, which includes 0.7million additional shares approved by our stockholders on April 28, 2006. TheCompany generally issues new shares for stock option exercises, performanceshare awards and restricted stock awards.

*StockOptions*

Optiongrants are issued at market value on the date of grant and generally vest overfour years. Option grants generally expire ten years after the date of grant.

In thesecond quarter of 2005, we converted to a lattice-based binomial model from aBlack-Scholes model. The conversion was implemented beginning with grantsissued during the second quarter of 2005. The fair value of our grants issuedprior to the second quarter of 2005 was determined using the Black-Scholesmodel.

Usingthe lattice-based binomial model, the fair value of each option award isestimated based on the assumptions noted in the following table. Becauselattice-based binomial models incorporate ranges of assumptions for inputs,those ranges are disclosed. Expected volatilities are based on historicalvolatility of the Company’s stock and implied volatilities for open marketexchange-traded options issued “near-the-money”. The Company uses historicaldata to estimate option exercise and employee departure behavior. Assumptionswere developed separately for our senior management from the other participantsof our stock plans, since senior management’s exercise behavior is expected todiffer materially from the other participants. The expected term of shareoptions granted is derived from the output of the option pricing model andrepresents the period of time that options granted are expected to beoutstanding. The range in expected term results from the different post-vestingbehaviors exhibited by senior management and the other participants. The riskfree interest rate is based on US Treasury zero-coupon issues with remainingterms similar to the expected term of the options.

The assumptions used tovalue option grants under the lattice-based binomial model for the three monthsand six months ended June 30, 2006 and 2005 are as follows:
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected volatility  range            |       | 37-49                                               | %          | 32-52                                             | %          | 35-49 | % | 32-52 | % |
| Weighted-average  expected volatility |       | 43.1                                                | %          | 42.0                                              | %          | 43.1 | % | 42.0 | % |
| Expected term  (in years)             |       | 4.75-5.75                                           |       | 5.58                                              |       | 4.75-5.75 |   | 5.58 |   |
| Risk-free  interest rate              |       | 4.4-4.9                                             | %          | 3.5-4.0                                           | %          | 4.4-4.9 | % | 3.5-4.0 | % |
| Expected dividends                    |       | —                                              |       | —                                            |       | — |   | — |   |

 

Stockoption activity for all plans during the six months ended June 30, 2006 is asfollows:
| ** **                        | ** ** | **No. of Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic Value  (in thousands)** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Outstanding at  December 31, 2005 |       | 2,802,394                   |       | $                                       | 31.94      |                                                                      |       |                                                     |       |   |
| Granted                           |       | 132,250                     |       | 53.78                                   |       |                                                                      |       |                                                     |       |
| Exercised                         |       | (243,347                    | )          | 19.48                                   |       |                                                                      |       |                                                     |       |
| Forfeited                         |       | (30,647                     | )          | 49.07                                   |       |                                                                      |       |                                                     |       |
| Expired                           |       | —                      |       | —                                  |       |                                                                      |       |                                                     |       |
| Outstanding at  June 30, 2006     |       | 2,660,650                   |       | $                                       | 33.97      |                                                                      | 6.79       |                                                     | $          | 37,081 |   |
|                              |       |                        |       |                                    |       |                                                                      |       |                                                     |       |
| Exercisable at June 30,  2006     |       | 1,660,295                   |       | $                                       | 25.86      |                                                                      | 5.81       |                                                     | $          | 32,839 |   |

 

The weighted-averagegrant-date fair value of options granted during the three and six months endedJune 30, 2006 

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was $21.65 and $21.54. The weighted-average grant-datefair value of options granted during the six months ended June 30, 2005 was$25.74. There were no stock option grants in the three months ended March 31,2005. The aggregate intrinsic value of options (the amount by which the stockprice on the date of exercise exceeded the stock price of the option on thedate of grant) exercised during the six months ended June 30, 2006 and 2005 was$7.7 million and $23.7 million, respectively.

In February 2006, theCompany entered into a transition agreement with its former Chief FinancialOfficer upon his retirement from the Company, which provided for the immediateacceleration of all of his outstanding options totaling 32,002 shares. Includedin the stock-based compensation expense for the six months ended June 30, 2006is expense related to this acceleration of $0.8 million ($0.5 million net oftax).

*Employee StockPurchase Plan*

OurEmployee Stock Purchase Plan (the “ESPP”) is a tax-qualified employee stockpurchase plan under which options are granted to purchase our common stock at aprice which is eighty-five percent of the stock’s fair market value on eitherthe first or last day of the offering period, whichever price is lower. Theoptions are then automatically exercised on the last business day of theoffering periods, which end in June and December. The participants purchase theshares through payroll deductions.

The assumptions used tovalue the ESPP options under the lattice-based binomial model for the threemonths and six months ended June 30, 2006 are as follows:

|                                                      | ** ** | **Three months and six months  ended June 30, 2006** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| Expected  volatility range                           |       | 32-40                                                                                   | %          |
| Weighted-average  expected volatility                |       | 36.0                                                                                    | %          |
| Expected term                                        |       | 6 months                                                                                |       |
| Risk-free  interest rate                             |       | 4.0                                                                                     | %          |
| Weighted-average  fair value per share at grant date |       | $                                                                                       | 12.88      |   |
|                                                      |            |                                                                                         |            |  |

 

*Long TermIncentive Plan*

InJuly 2005, the Company adopted the Long Term Incentive Plan (the “LTIP”), whichprovides equity incentives to senior management that include not only stockoptions or similar grants, but also a performance share program that measuresperformance on a multi-year basis. The performance period under the LTIP beganon July 1, 2005 and ends on December 31, 2007. Awards under the LTIPare made under the 2004 Plan or any successor plan. It is expected that each participantwill receive an annual grant of stock options under the 2004 Plan, pursuant toits terms. Performance shares in the form of common stock are earned by theparticipants based upon specified objective performance goals during theperformance period of the LTIP. The number of shares issuable could change ifwe add or subtract executives to or from the plan. The compensation committeealso has the discretion to make cash payments in lieu of performance shares.Any subsequent long-term incentive plans established during the performanceperiod for inclusion of new participants are combined for reporting purposeswith the LTIP.

Thetarget number of performance shares potentially issuable under the LTIP isexpected to be 266,182, with the actual number of shares ultimately issuable tobe between zero and twice such amount, depending on actual performance andnumber of participants. Included in the target performance shares are 21,382shares for two new executives added to the plan effective April 1, 2006. Theperformance period for these new participants began on April 1, 2006 and endson December 31, 2007.

Stock-basedcompensation expense related to the LTIP is estimated based on forecastedperformance during the performance period compared to plan targets. At the endof each reporting period, we reevaluate our assessment of performance under theplan and make adjustments to the expense as necessary based on the latestestimates available. The fair value of performance share awards is based on themarket price of the Company’s stock on the date the underlying plan receivescompensation committee approval, or other form of a mutual understanding of thekey terms and conditions of performance.

For the three monthsended June 30, 2006, we recorded stock-based compensation expense related tothe LTIP 

12

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of $1.8 million ($1.2 million net of tax), or $0.04per diluted share. For the six months ended June 30, 2006, we recordedstock-based compensation expense related to the LTIP of $5.1 million ($3.2million net of tax), or $0.11 per diluted share. Included in the $5.1 millionexpense is $1.8 million of stock-based compensation expense recorded in thefirst quarter of 2006 related to the LTIP that should have been recorded in thefourth quarter of 2005 under the variable plan accounting method established byAPB No. 25. The Company does not believe that this misstatement ismaterial to our current or previously issued consolidated financial statements.

*Restricted Stock Awards/DeferredStock Units*

Awards of restrictedstock and deferred stock units have generally been made to the non-employeedirectors of the Company and are measured on the date of grant. Thesetime-based awards vest over three to five years and are forfeitable undercertain conditions.

Asummary of the Company’s awards of performance shares, restricted stock, anddeferred stock units as of and for the six months ended June 30, 2006 ispresented below:
| ** **                              | ** ** | **No. of Shares  (1)** | ** ** | **Weighted-Average  Grant-Date Fair  Value** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|
| Nonvested balance  at December 31, 2005 |       | 502,698                          |       | $                                                 | 56.06      |   |
| Granted                                 |       | 63,051                           |       | 48.88                                             |       |
| Vested                                  |       | (3,486                           | )          | 49.37                                             |       |
| Forfeited                               |       | —                           |       | —                                            |       |
| Nonvested balance at  June 30, 2006     |       | 562,263                          |       | $                                                 | 55.29      |   |

----

(1)             Representsthe maximum number of shares that can be issued based on the achievement ofcertain performance criteria.

*The total fair value of restricted stock vestedduring the six months ended June 30, 2006 was immaterial. Based on our latestestimates, there was $9.6 million ($5.8 million net of tax) of totalunrecognized compensation cost for nonvested shares, as of June 30, 2006, thatis expected to be recognized over a weighted average period of 1.7 years.*

**7. Legal Proceedings**

OnNovember 29, 2005, a case was filed against the Company and otherdefendants, including our Chief Executive Officer, in the United StatesDistrict Court for the Southern District of Florida. The complaint asserts,among other things, violations of the Federal Racketeering Influenced andCorrupt Organization Act (RICO) and a corresponding Florida statute, Sections 1and 2 of the Sherman Antitrust Act, Section 2 of the Clayton Act (asamended by the Robinson-Patman Act), the Antidumping Act of 1916, the FloridaAntitrust Act of 1980, and the Florida Deceptive and Unfair Trade PracticesAct, as well as tortious interference with business relationship under Floridalaw and civil conspiracy under Florida law by some or all of the identifieddefendants in connection with the claimed inability of Ace Pro Sound andRecording, L.L.C. 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.

Whilewe believe this lawsuit is without merit and intend to defend it vigorously, itmay, regardless of the outcome, result in substantial expenses and damages tous and may significantly divert the attention of our management. There can beno assurance that we will be able to achieve a favorable settlement of thislawsuit or obtain a favorable resolution of this lawsuit if it is not settled.An unfavorable resolution of this lawsuit could have a material adverse effecton our business, financial condition and results of operations. Regardless ofthe outcome, the costs and expenses incurred by us to defend this lawsuit couldadversely impact our financial condition.

OnOctober 13, 2004, a putative class action lawsuit entitled CarlosRodriguez v. The Guitar Center, Inc. [sic], Case No. GC322958, wasfiled in the Superior Court of the State of California for the County of LosAngeles. The lawsuit was filed by an individual purporting to represent allhourly retail store employees employed by us within the State of California. 

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OnDecember 15, 2004, a putative class action lawsuit entitled James McClainet. al. v. Guitar Center Stores, Inc., Case No. BC326002, was filedin the Superior Court of the State of California for the County of Los Angeles.The lawsuit was filed by three individuals purporting to represent all hourlyretail store employees employed by us within the State of California. Amongother things, the lawsuits alleged that we improperly failed to document andenforce break-time and lunch-time periods for such employees and sought anunspecified amount of damages, penalties and attorneys’ fees. In March 2006,the court granted its preliminary approval of the proposed class settlementthat we had reached with the other parties on December 15, 2005. Under theterms of the proposed settlement, we will make cash payments of up to $3.5million to fully resolve claims by eligible class members, including paymentsto class members and payments for plaintiff attorneys’ fees and the costs of athird-party administrator.

Inaddition to the lawsuits described above, we are involved in various claims andlegal actions arising in the ordinary course of our business and, while theresults of those proceedings cannot be predicted with certainty, we believethat the final outcome of those matters will not have a material adverse effecton our business, financial condition and results of operations.

**8. CommonStock**

OnApril 28, 2006, the Company’s stockholders approved an amendment to theRestated Certificate of Incorporation to increase the number of authorizedshares of common stock from 55 million to 100 million.

**9. Subsequent Event**

OnJune 15, 2006, the Company called for redemption all of the outstanding Notesdue 2013. The Notes were originally issued on June 13, 2003 in the aggregateprincipal amount of $100 million. Holders were able to convert the Notes intoshares of common stock at an effective conversion price of approximately $34.58per share, in lieu of accepting redemption. In June 2006, holders ofapproximately $185,000 of outstanding Notes elected to convert their Notes tocommon stock. Subsequent to June 30, 2006 but prior to the July 15, 2006redemption date, holders of substantially all of the remaining outstandingNotes elected to convert their Notes into shares of the Company’s common stock.As a result of these conversions, approximately 2.9 million shares of commonstock were issued to the holders that elected to convert their Notes. Inconnection with the redemption of the unconverted Notes, the Company paidapproximately $4,000 in cash, which includes the redemption and premiumpayments and cash paid in lieu of fractional shares. In conjunction with theredemption, the Company will reclassify approximately $1.5 million ofunamortized issuance costs from other assets to additional paid-in capital inthe third quarter.

OnAugust 2, 2006, the Company granted approximately 425,000 stock options toemployees.  These non-qualified stockoptions granted from the 2004 Plan will vest over four years.  The exercise price of the stock optionsgranted was equal to current market price of the Company’s common stock on thegrant date.

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

**General**

GuitarCenter, Inc. is the leading United States retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment.  As of June 30, 2006, our retail subsidiary operated184 Guitar Center stores across the United States consisting of 129 primaryformat stores, 53 secondary format stores and 2 tertiary format stores. Inaddition, as of June 30, 2006, our Music & Arts Center divisionoperated 92 stores specializing in band instruments for sale and rental,serving teachers, band directors, college professors and students. We are alsothe largest direct response retailer of musical instruments in the UnitedStates through our wholly owned subsidiary, Musician’s Friend, Inc., andits catalog and website, www.musiciansfriend.com.

Duringthe second quarter, we opened a total of nine Guitar Center stores, includingfour primary format stores in Country Club Hills, Illinois, Dayton, Ohio,Greenwood, Indiana and Durham, North Carolina and five secondary format storesin Algonquin, Illinois, Joliet, Illinois, Lincoln, Nebraska, Millbury,Massachusetts and Montgomery, Alabama. Additionally, we added four GuitarCenter stores in Texas with our acquisition of Hermes Trading Company, Inc. onJune 15, 2006. The new stores have added 190,000 square feet of retail spaceand brought us to a total of 2.7 million square feet of Guitar Center retailspace at the end of the quarter.

 As we enter new markets, we expect that wewill initially incur higher administrative and promotional costs per store thanis currently experienced in established markets. We expect competition tocontinue to increase as other music product retailers attempt to executenational growth strategies. Our business strategy will also emphasizeopportunities to continue to grow each of our brands, including furtheracquisitions if attractive candidates can be located for reasonable 

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prices.

From2001 to 2005, our net sales grew at an annual compound growth rate of 17%,principally due to the comparable store sales growth of our retail storesaveraging 7% per year, the opening of new stores, and a 21% per year increasein the direct response channel. We believe such volume increases are the resultof the continued success of the implementation of our business strategy,continued growth in the music products industry and increasing consumerawareness of the Guitar Center, Musician’s Friend and Music & ArtsCenter brand names. We achieved comparable store sales growth for our GuitarCenter retail division of 5.1% and 5.7%, respectively, for the three and sixmonth periods ended June 30, 2006 compared to 7.0% and 6.2%, respectively, forthe same periods in 2005. We believe this growth reflects the strength of our merchandiseselection, effective advertising and promotion, and well-trained and committedpersonnel.

**FinancialReporting Change**

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment*(“SFASNo. 123(R)”), effective for a company’s first fiscal year beginning afterJune 15, 2005. SFAS No. 123(R) supersedes Accounting Principles Board(APB) Opinion No. 25, *Accounting for StockIssued to Employees*. SFAS No. 123(R) requires allshare-based compensation to employees, including grants of employee stockoptions, to be recognized in the consolidated statements of income based onfair values rather than pro forma footnote disclosure.

EffectiveJanuary 1, 2006, we adopted SFAS No. 123(R), and elected the modifiedprospective transition method. This method permits us to apply the newrequirements on a prospective basis. For additional information on our adoptionofSFAS No. 123(R), see Note 6, Stock-BasedCompensation, of the Notes to Consolidated Financial Statements in thisQuarterly Report on Form 10-Q.

**Executive Summary**

Consolidatednet sales for the quarter ended June 30, 2006 increased 13.8%, or $55.7million, to $458.0 million compared to $402.3 million in the second quarter of2005. Consolidated net income for the quarter was $13.4 million, an increase of4.0% compared to the second quarter of 2005. Income per diluted share increasedto $0.47 from $0.46 in the second quarter of 2005.

Forthe second quarter, our Guitar Center stores generated 5.1% comparable storesales growth and an increase of 13.4% in total net sales compared to the secondquarter of 2005. Sales from new stores totaled $24.9 million and represented61.9% of the overall increase in net sales. We opened nine new Guitar Centerstores in the quarter and added four new stores via acquisition. We continue toface a more challenging retail environment, which may impact sales andoperating margins trends for the foreseeable future.

Musician’sFriend, our direct response unit, generated an increase in net sales for thesecond quarter of 10.7% to $86.3 million compared to $78.0 million in thesecond quarter of 2005. Gross profit margins decreased by 0.7% of net salescompared to the second quarter of 2005 reflecting a lower margin due to reducedshipping and handling revenue resulting from the competitive environment andhigher freight expense.

OnApril 15, 2005, we completed our acquisition of Music & ArtsCenter, Inc., a Maryland-based musical instrument retailer with anemphasis on the beginning musician. The acquired business was combined with ourformer American Music business into a new division of our retail storesubsidiary that operates under the Music & Arts Center name. Financialresults for the period of January 1, 2005 through April 15, 2005 reflect onlyour former American Music stores and do not include results from the acquiredbusiness. However, comparable sales for the periods are computed using thecombined comparable sales of Music & Arts Center, Inc. andAmerican Music stores.

Primarilyas a result of this acquisition, the net sales for the Music & ArtsCenter business increased to $31.8 million for the three months ended June 30,2006 from $24.7 million for the same period in 2005. Comparable sales growthfor the second quarter was 6.2%. Gross profit margins increased 2.1% of netsales compared to the second quarter of 2005. Excluding an inventory write-downin the prior year period of $0.6 million associated with the acquisition ofMusic & Arts Center, Inc., gross profit margin declined 0.3% in the currentquarter. The decrease was primarily the result of lower selling margin andincreased occupancy costs offset by lower shrink expense.

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**Discussion ofCritical Accounting Policies**

In theordinary course of business, we have made a number of estimates and assumptionsrelating to the reporting of results of operations and financial condition inthe preparation of our financial statements in conformity with accountingprinciples generally accepted in the United States. Actual results could differsignificantly from those estimates under different assumptions and conditions.We believe that the following discussion addresses our most critical accountingpolicies, which are those that are most important to the portrayal of ourfinancial condition and results and require management’s most difficult,subjective and complex judgments, often as a result of the need to makeestimates about the effect of matters that are inherently uncertain. Additionally,the policy described below regarding credits and other vendor allowances isunique to our industry and deserves the attention of a reader of our financialstatements.

*Valuation ofInventory*

Wevalue our merchandise inventory at the lower of cost, using theweighted-average method, or market. Rental inventories are valued at the lowerof cost or market using the specific identification method and are depreciatedon a straight-line basis while out under a rental agreement for rent-to-ownsales. We record adjustments to the value of inventory based upon obsolescenceand changes in market value. Applicable costs associated with bringinginventory through our Guitar Center retail distribution center are capitalizedto inventory. The amounts are expensed to cost of goods sold as the associatedinventory is sold. Management has evaluated the current level of inventoriesconsidering future customer demand for our products, taking into accountgeneral 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-livedassets such as property and equipment and identifiable intangibles with finitelives are 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:

·           Significantunderperformance relative to historical or projected operating results;

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

·           Significantnegative industry or economic trends; and

·           Significantdecline in stock value for a sustained period.

For long-livedassets other than goodwill and intangibles that are not amortized, thedetermination of whether impairment has occurred is based on an estimate ofundiscounted future cash flows attributable to the assets, as compared to thecarrying value of the assets. Assumptions used in these cash flows areconsistent with internal forecasts and consider current and future expectedsales volumes and related operating costs and any anticipated increases ordeclines based on expected market conditions and local business environmentfactors. If a potential impairment is identified, the amount of the impairmentloss recognized would be determined by estimating the fair value of the assetsand recording a loss if the fair value was less than the book value. Fair valuewill be determined based on appraisal values assessed by third parties, ifdeemed necessary, or a discounted future cash flows analysis. For goodwill andother intangibles that are not amortized, impairment to be recognized ismeasured as the amount by which the carrying amount of the assets exceeds thefair value of the related assets of the underlying reporting unit to which thegoodwill relates.

Ourassessment regarding the existence of impairment factors is based on marketconditions and the operational performance of our business. Our review offactors present and the resulting appropriate carrying value of our goodwill,intangibles and other long-lived assets are subject to judgments and estimatesthat management is required to make.

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*Sales Returns*

Aspart of our “satisfaction guaranteed” policy, we allow Guitar Center customersto return product generally within 30 days after the date of purchase, and weallow Musician’s Friend customers to return product within 45 days.Music & Arts Center customers have 30 business days from the date ofpurchase to return product. We regularly review and revise, when deemednecessary, our estimates of sales returns based upon historical trends. Whileour estimates during the past few years have approximated actual results,actual returns may differ significantly from estimate, either favorably orunfavorably, if factors such as economic conditions or the competitiveenvironment differ from our expectations.

*Credits and OtherVendor Allowances*

Wereceive cooperative advertising allowances (i.e., an allowance from themanufacturer to subsidize qualifying advertising and similar promotionalexpenditures we make relating to the vendor’s products), price protectioncredits (i.e., credits from vendors with respect to in-stock inventory if thevendor subsequently lowers their wholesale price for such products) and vendorrebates (i.e., credits or rebates provided by vendors based on the purchase ofspecified products and paid at a later date). Cooperative advertising allowancesare recognized as a reduction to selling, general, and administrative expensewhen we incur the advertising expense eligible for the credit. We recognizedcooperative advertising allowances of $2.8 million and $2.2 million for thethree months ended June 30, 2006 and 2005, respectively. For the six monthsended June 30, 2006 and 2005, we recognized $5.6 million and $3.8 millioncooperative advertising allowances. Price protection credits and vendor rebatesare accounted 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 reserves against cooperative advertising and rebate receivables aredetermined by specifically identifying uncollectible accounts through an agingreview and an analysis of vendor relationships. We received payments for vendorrebates of $8.1 million and $7.4 million for the three months endedJune 30, 2006 and 2005 and $17.6 million and $17.0 million for the sixmonths ended June 30, 2006 and 2005, respectively. We earned and recognizedvendor rebates of $6.8 million and $6.3 million for the three months endedJune 30, 2006 and 2005 and $16.0 million and $13.5 million for the sixmonths ended June 30, 2006 and 2005, respectively. None of these credits arerecorded as revenue.

*Stock-basedCompensation*

EffectiveJanuary 1, 2006, we adopted SFAS No. 123(R) to account for our stock-basedcompensation plans. We elected the modified prospective method of adoption,which permitted application of the new requirements on a prospective basis.Accordingly, prior period amounts have not been restated. Under thisapplication, stock-based compensation is recorded for all awards granted on orafter the date of adoption and for the portion of previously granted awardsthat remain unvested at the date of adoption. Currently, our stock-basedcompensation expense relates to stock options, our employee stock purchaseprogram, performance share awards, restricted stock awards, and deferred stockunits.

UnderSFAS No. 123(R), we determine the fair value of stock options, includingoptions granted under our Employee Stock Purchase Plan (the “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-based compensation expense is recorded net ofestimated forfeitures. The forfeiture rate assumption used in determiningstock-based compensation expense is estimated based on historical data. Theactual forfeiture rate could differ from these estimates.

Stock-basedcompensation expense related to performance share awards issued under our LongTerm Incentive Plan (the “LTIP”) is estimated based on our forecastedperformance compared to plan targets. At the end of each reporting period, wereevaluate our assessment of performance under the plan and make adjustments tothe expense as necessary based on the latest estimates available. Under SFASNo. 123(R), the fair value of performance share awards is based on the marketprice of the Company’s stock on the date the underlying plan receivescompensation committee approval, or other form of a mutual understanding of thekey terms and conditions of performance.

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*Gift Cards*

We sell gift cards to ourcustomers in our Guitar Center retail stores. Revenue from gift card sales isrecognized at redemption of the gift card. Our gift cards do not haveexpiration dates. Based on historical redemption rates, a certain percentage ofgift 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.

**Results ofOperations**

Thefollowing table presents our consolidated statements of income, as a percentageof sales, for the periods indicated:
| ** **                                    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                     |       | 100.0                                               | %          | 100.0                                             | %          | 100.0 | % | 100.0 | % |
| Gross profit                                  |       | 28.7                                                |       | 28.7                                              |       | 28.8 |   | 28.4 |   |
| Selling, general  and administrative expenses |       | 23.6                                                |       | 23.0                                              |       | 23.3 |   | 22.1 |   |
| Operating income                              |       | 5.1                                                 |       | 5.7                                               |       | 5.5 |   | 6.2 |   |
| Interest  expense, net                        |       | 0.5                                                 |       | 0.5                                               |       | 0.5 |   | 0.4 |   |
| Income before  income tax expense             |       | 4.6                                                 |       | 5.2                                               |       | 5.0 |   | 5.9 |   |
| Income taxes                                  |       | 1.7                                                 |       | 2.0                                               |       | 1.9 |   | 2.3 |   |
| Net income                                    |       | 2.9                                                 | %          | 3.2                                               | %          | 3.1 | % | 3.6 | % |

 

**Three MonthsEnded June 30, 2006 Compared to the Three Months Ended June 30, 2005**

Net sales for the three months ended June 30, 2006increased 13.8% to $458.0 million, compared to $402.3 million for the sameperiod in 2005.

Net sales from Guitar Center stores for the threemonths ended June 30, 2006 totaled $339.8 million, a 13.4% increase from $299.6million for the same period in 2005. Sales from new stores were $24.9 millionand represented 61.9% of the total increase in Guitar Center retail storesales. Comparable Guitar Center store sales for the second quarter increased5.1%. Comparable store sales achieved this level despite experiencing a morechallenging retail environment throughout the quarter. Comparable store salesare defined as sales for the comparable periods, excluding net salesattributable to stores not open for 14 months as of the end of the reportingperiod. We believe that comparable store sales are a more useful indicator ofstore performance than the change in total net sales, since comparable storesales exclude the effects of changes in the number of stores open. We continueto face a more challenging retail environment, which may impact sales andoperating margin trends for the foreseeable future.

Thefinancial information for the Music & Arts Center division for the threemonths ended June 30, 2006 includes the results of the combined businesses ofMusic & Arts Center, Inc. and American Music, while the resultsfor the second quarter of 2005 exclude the results of Music & Arts Center,Inc. prior to the acquisition date of April 15, 2005. However, comparable salesfor the quarter are computed using the combined comparable sales ofMusic & Arts Center, Inc. and American Music. Net sales fromMusic & Arts Center for the three months ended June 30, 2006 totaled$31.8 million compared to $24.7 million for the same period in 2005. Theincrease in net sales is primarily due to the acquisition of Music & ArtsCenter, Inc. on April 15, 2005 as well as other acquisitions concluded duringthe past year. Combined comparable sales were 6.2% for the second quarter.

Net sales from the direct response channel totaled$86.3 million for the three months ended June 30, 2006, an $8.3 million, or10.7%, increase from the same period in 2005. The increase in sales primarilyreflects the improved leveraging of an expanding buyer file and advertisingstrategies. We continue to face increased competition in the direct responsechannel, which we expect to impact that segment’s net sales and gross marginfor the foreseeable future.

Consolidated gross profit for the three months endedJune 30, 2006 compared to 2005 increased 13.9% to $131.4 million from $115.3million. Gross profit as a percentage of net sales for the three months endedJune 30, 2006 remained flat at 28.7% compared to the same period in 2005. Asdiscussed below, we define selling margin as net sales less the cost of theassociated merchandise charged by the vendor plus the associated inventorycosts from fulfilling inventory through our distribution center. The cost ofmerchandise inventory is net of all associated vendor discounts and rebates.Freight is not included in selling margin.

Gross profit as a percentage of net sales for GuitarCenter stores was 26.7% in the second quarter of 2006 compared 

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with 26.8%in the second quarter of 2005. The decrease in gross margin was due to higheroccupancy costs 0.3% offset by higher selling margin 0.1% and lower shrink0.1%. The higher occupancy costs were primarily due to higher store rentexpenses. We currently are experiencing a more challenging retail environment,which we expect may continue for the foreseeable future.

The gross profit margin for the Music & ArtsCenter division was 43.7% for the three months ended June 30, 2006 compared to41.7% for the same period in 2005. The margin improvement was primarily due tothe write-down in the prior year period of $0.6 million, or 2.4% of sales, ofinventory carried at American Music resulting from a change in productassortment. Excluding this prior year inventory write-down, the gross margindeclined 0.3% primarily due to lower selling margin 1.7% and higher occupancycosts 0.9% offset by reduced shrink expense 2.3%. The lower selling margin wasimpacted by increased instrument repair costs. The lower shrink expense wasdriven by higher instrument recoveries in the current quarter.

Gross profit margin for the direct response divisionwas 30.8% for the three months ended June 30, 2006 compared to 31.6% in thesecond quarter of 2005. The decrease resulted primarily from reduced shippingand handling revenue 1.7%, higher freight costs 0.3% and increased purchasingcosts 0.2% offset by higher selling margin 1.4%. Reduced shipping and handlingrevenue resulted from expanded free freight offers due to increased onlinecompetition. The increased selling margin benefited from higher product marginsand higher vendor rebates.

Consolidated selling, general and administrativeexpenses for the three months ended June 30, 2006 increased 16.8% to$108.0 million from $92.4 million for the same period in 2005. As apercentage of net sales, selling, general and administrative expenses were23.6% for the second quarter in 2006 compared to 23.0% in the second quarter of2005. The increase was primarily due to the recognition of $4.8 million ofstock-based compensation expenses in the current year quarter, consisting ofexpense under the LTIP totaling $1.8 million, or 0.4% of sales, and expensesfor stock options and other awards totaling $3.0 million, or 0.7% of sales.

Selling, general and administrative expenses for theGuitar Center division in the second quarter of 2006 were 21.3% as a percentageof net sales compared to 20.3% in second quarter of 2005. The increase was primarilydue to stock-based compensation expense allocated to this segment 0.7%, higheradvertising costs 0.3% and higher legal costs 0.2% offset by lower insurancecosts 0.2%. The higher advertising costs resulted primarily from increasedpromotional efforts to drive sales in the current quarter.

Selling, general and administrative expenses for Music& Arts Center were 45.6% of sales in the second quarter of 2006 compared to59.4% in the second quarter of 2005. The reduction in expenses was primarilydue to expenses totaling $2.8 million, or 11.4% of sales, recorded in the prioryear period related to the acquisition of Music & Arts Center, Inc.consisting of the elimination of a redundant point of sales system, severancecosts, and moving costs to relocate certain American Music employees to theMusic & Arts corporate office in Maryland. Excluding the prior yearacquisition-related expenses, the selling, general and administrative expensesdecreased 2.4% of sales compared to the prior year period, which is primarilydue to improved leveraging on the higher revenue base of the combinedbusinesses of Music & Arts Center, Inc. and American Music offsetsomewhat by stock-based compensation expenses allocated to this segment 1.5%.

Selling, general and administrative expenses for thedirect response division were 24.3% of sales in the second quarter of 2006compared to 21.8% in the second quarter of 2005. The increase was primarily dueto stock-based compensation expense allocated to this segment 2.2%, highersalary costs 1.1%, insurance 0.3%, consulting 0.3%, legal 0.2% and bad debtexpense 0.2% offset by lower advertising 1.8%. The lower advertising wasprimarily the result of reduced catalog circulation, offset somewhat by higherweb-based marketing.

Operating income increased 2.0% to $23.4 million forthe three months ended June 30, 2006 from $22.9 million in the comparable 2005period. As a percentage of net sales, consolidated operating income declined to5.1% from 5.7% in the second quarter of 2005. This decline reflects the higherselling, general and administrative expenses resulting primarily from therecognition of stock-based compensation expenses in the current quarter offsetsomewhat by the Music & Arts Center, Inc. acquisition-related charges inthe prior year.

Interestexpense, net for the three months ended June 30, 2006 increased to$2.4 million from $1.9 million in the second quarter of 2005. Theincrease is principally due to higher borrowings under the revolving creditfacility used primarily to fund working capital requirements.

Forthe three months ended June 30, 2006, income tax expense was $7.6 millioncompared to $8.1 million for the same period in 2005. The effective tax rate inthe second quarter was reduced to 36.05%, compared to 38.50% in the prior yearquarter. The lower rate was the result of a $1.0 million, or $0.03 per dilutedshare, reduction in the current quarter of a

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valuationallowance related to a capital loss recorded in 2001. The adjustment to thevaluation allowance was isolated to the current quarter. Partially offsettingthis was a rate increase associated with the tax treatment of incentive stockoptions, or ISO’s, under SFAS 123(R) accounting for $0.4 million, or $0.01 perdiluted share. The effective tax rate is subject to ongoing review andevaluation and may fluctuate in future quarters.

Netincome for the three months ended June 30, 2006 increased 4.0% to $13.4million, compared to $12.9 million in the same period in 2005 as a result ofthe combinations of factors described above.

**SixMonths Ended June 30, 2006 Compared to the Six Months Ended June 30, 2005**

Net sales for the six months ended June 30, 2006 increased16.3% to $928.7 million, compared to $798.7 million for the same period in2005.

Net sales from Guitar Center stores for the six monthsended June 30, 2006 totaled $679.1 million, a 14.3% increase from $594.3million for the same period in 2005. Sales from new stores were $51.2 millionand represented 60.3% of the total increase in Guitar Center retail storesales. Comparable Guitar Center store sales increased 5.7% for the six monthperiod. We continue to face a more challenging retail environment, which mayimpact sales and operating margin trends for the foreseeable future.

Thefinancial information for the Music & Arts Center division for the sixmonths ended June 30, 2006 include the results of the combined businesses ofMusic & Arts Center, Inc. and American Music, while the resultsfor the prior year period exclude the results of Music & Arts Center, Inc.prior to the acquisition date of April 15, 2005. However, comparable sales forthe quarter are computed using the combined comparable sales ofMusic & Arts Center, Inc. and American Music. Net sales from theMusic & Arts Center division for the six months ended June 30, 2006totaled $65.0 million compared to $34.9 million for the same period in 2005.The increase in net sales is primarily due to the acquisition of Music &Arts Center, Inc. on April 15, 2005. Combined comparable sales were 2.1% forthe six month period.

Net sales from the direct response channel totaled$184.6 million for the six months ended June 30, 2006, a $15.1 million, or 8.9%,increase from the same period in 2005. The increase in sales primarily reflectsthe improved leveraging of an expanding buyer file and advertising strategies.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 profit for the six months endedJune 30, 2006 compared to 2005 increased 18.3% to $267.9 million from $226.5million. Gross profit as a percentage of net sales for the six months endedJune 30, 2006 compared to 2005 increased to 28.8% from 28.4%.

Gross profit as a percentage of net sales for GuitarCenter stores was 27.0% in the six month period ended June 30, 2006 comparedwith 26.9% in the same period in 2005. The improvement in gross profit wasprimarily due to higher selling margin 0.4% and reduced shrink 0.1% offset byhigher occupancy costs 0.3% and higher freight 0.1%.

The gross profit margin for the Music & ArtsCenter division was 45.1% for the six months ended June 30, 2006 compared to40.4% for the same period in 2005. The margin improvement was partially due tothe write-down in the prior year period of $0.6 million, or 1.7% of sales, ofinventory carried at American Music resulting from a change in productassortment. Excluding this prior year inventory write-down, the gross marginimproved by 3.0% of sales principally due to higher selling margin 2.6% andlower shrink 0.9% offset by higher occupancy costs 0.5%. The improved sellingmargin was driven by a change in product mix and better pricing under the Music& Arts business as compared to the American Music business in 2005. Wediscontinued our low margin institutional business sales which are not part ofour ongoing Music & Arts Center strategy. The lower shrink expense was dueto higher instrument recoveries in the current period.

Gross profit margin for the direct response divisionwas 30.0% for the six months ended June 30, 2006 compared to 30.8% in the sameperiod in 2005. The decrease resulted primarily from reduced shipping andhandling revenue 1.8%, higher freight costs 0.3% and increased purchasing costs0.1% offset by higher selling margin 1.4%. Reduced shipping and handlingrevenue resulted from expanded free freight offers due to increased onlinecompetition. The increased selling margin benefited from higher product marginsand higher rebates.

Consolidated selling, general and administrativeexpenses for the six months ended June 30, 2006 increased 22.7% to$217.1 million from $176.9 million for the same period in 2005. As apercentage of net sales, selling, general and administrative expenses were23.3% for the six month period in 2006 compared to 22.1% in the same period in2005. The increase was primarily due to the recognition of $11.9 million ofstock-based compensation expenses in the current year 

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period,consisting of expense under the LTIP totaling $5.1 million, or 0.6% of sales,and expenses for stock options and other awards totaling $6.8 million, or 0.7%of sales. The components of stock-based compensation for the six months endedJune 30, 2006 consisted of the following:
| ** **                                                                                                             | ** ** | **Amount in  millions** | ** ** | **As a % of  consolidated  net sales** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------------------------------------|------------|
| **Stock-based  compensation expense for the six months ended June 30, 2006:**                                          | ** ** | ** **                   | ** ** | ** **                                                 | ** ** |
| Stock options and ESPP for the six months ended June  30, 2006                                                         |       | $                            | 6.0        |                                                       | 0.6        | % |
| Acceleration of stock option vesting related to the  retirement of our former Chief Financial Officer in February 2006 |       | 0.8                          |       | 0.1                                                        | %          |
| Total expense from options and ESPP                                                                                    |       | 6.8                          |       | 0.7                                                        | %          |
| LTIP performance related to the fourth quarter of  2005                                                                |       | 1.8                          |       | 0.2                                                        | %          |
| LTIP performance related to the six months ended  June 30, 2006                                                        |       | 3.3                          |       | 0.4                                                        | %          |
| Total expense from LTIP                                                                                                |       | 5.1                          |       | 0.6                                                        | %          |
| Total  stock-based compensation expense                                                                                |       | $                            | 11.9       |                                                       | 1.3        | % |

 

The stock-based compensation related to stock optionsand ESPP was recorded as a result of the adoption of SFAS No. 123(R)effective January 1, 2006. Upon the retirement of our former Chief FinancialOfficer announced in February 2006, all of his remaining unvested optionstotaling 32,002 shares immediately vested. Pursuant to SFAS No. 123(R), astock-based compensation expense in the amount of $0.8 million was recorded dueto the vesting acceleration. A total of $5.1 million of stock-basedcompensation expense related to the LTIP was recorded in the six months endedJune 30, 2006. Included in this figure was $1.8 million of expense that shouldhave been recorded in the consolidated financial statements in the fourthquarter of 2005. The error was discovered subsequent to the issuance of the2005 consolidated financial statements. We do not believe that thismisstatement is material to our current or previously issued consolidatedfinancial statements. The remaining LTIP expense of $3.3 million relates to theinitial adoption of SFAS No. 123(R) and recognition of performance underthe LTIP provisions for the first half of 2006

Selling, general and administrative expenses for theGuitar Center division for the six months ended June 30, 2006 were 21.2% as apercentage of net sales compared to 20.6% in same period in 2005. The increaseis primarily due to stock-based compensation expense allocated to this segment1.0% and higher legal costs 0.2% offset by lower equipment rent costs 0.3% andlower payroll and benefits 0.3%.

Selling, general and administrative expenses for Music& Arts Center were 45.4% of sales for the six months ended June 30, 2006compared to 56.8% in the same period in 2005. The reduction in expenses wasprimarily due to expenses totaling $2.8 million, or 8.1% of sales, recorded inthe prior year period related to the acquisition of Music & Arts Center,Inc. consisting of the elimination of a redundant point of sales system,severance costs, and moving costs to relocate certain American Music employeesto the Music & Arts corporate office in Maryland. Excluding the prior yearacquisition-related expenses, the selling, general and administrative expensesdecreased 3.4% of sales compared to the prior year period, which is primarilydue to improved leveraging on the higher revenue base of the combinedbusinesses of Music & Arts Center, Inc. and American Music offsetsomewhat by stock-based compensation expenses allocated to this segment 1.8%.

Selling, general and administrative expenses for thedirect response division were 23.6% of sales for the six months ended June 30,2006 compared to 20.6% for the same period in 2005. The increase was primarilydue to stock-based compensation expense allocated to this segment 2.3%, higherpayroll costs 1.0%, and higher insurance 0.4% offset by lower advertising 1.4%.Higher payroll costs were driven by higher bonus expense and higher warehousesalaries. The lower advertising was primarily the result of reduced catalogcirculation, offset somewhat by higher web-based marketing.  Other smaller increases were experiencedrelated to computer maintenance expense, bad debt expense, and consultingexpense.

Operating income increased 2.3% to $50.8 million forthe six months ended June 30, 2006 from $49.6 million in the comparable 2005period. As a percentage of net sales, consolidated operating income declined to5.5% from 6.2% in the first half of 2005. This decline reflects the higherselling, general and administrative expenses resulting primarily from therecognition of stock-based compensation expenses in the current year periodoffset somewhat by improved consolidated 

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grossprofit margins in the first half of 2006.

Interestexpense, net for the six months ended June 30, 2006 increased to$4.2 million from $2.8 million in the first half of 2005. The increaseis due to higher borrowings under the revolving credit facility used primarilyto fund the acquisition of Music & Arts Center, Inc. on April 15, 2005 andincreased working capital requirements.

Forthe six months ended June 30, 2006, income tax expense was $17.4 millioncompared to $18.0 million for the same period in 2005. The effective tax ratein the first half of 2006 was reduced to 37.39%, compared to 38.50% in theprior year period. The lower rate was the result of a $1.0 million, or $0.03 perdiluted share, reduction in the current quarter of a valuation allowancerelated to a capital loss recorded in 2001. The adjustment to the valuationallowance was isolated to the second quarter of 2006. Partially offsetting thiswas a rate increase associated with the tax treatment of incentive stockoptions, or ISO’s, under SFAS 123(R) accounting for $0.4 million, or $0.01 perdiluted share.

Netincome for the six months ended June 30, 2006 increased 1.2% to $29.1 million,compared to $28.8 million in the same period in 2005 as a result of thecombinations of factors described above.

### **Liquidity and Capital Resources**

Ourneed for liquidity will arise primarily from the funding of capitalexpenditures, working capital requirements and payments on our indebtedness, aswell as possible acquisitions. We have historically financed our operationsprimarily through internally generated funds and borrowings under our creditfacilities. Please see “Risk Factors” in our Annual Report on Form 10-K filedfor the year ended December 31, 2005 for a discussion of factors which couldreasonably likely result in a decrease in the amount of internally generatedfunds available to finance capital expenditures and working capitalrequirements. As of June 30, 2006, we had $87.5 million in borrowingsoutstanding under our credit facility and had available borrowings of $105.7million (net of $6.7 million of outstanding letters of credit).

Ourcredit facility with a syndicate of banks led by Wells Fargo Retail Finance, asamended through April 26, 2006, permits borrowings up to $200 million (whichmay be increased to $250 million at our option), subject to borrowing baselimitations. The actual amount available is tied to our inventory andreceivable base, and our obligations under the credit facility are secured byliens on our principal assets. Borrowing options are prime rate plus applicableprime margin, or London Interbank Offered Rate (“LIBOR”), plus applicable LIBORmargin. The applicable prime and LIBOR margins are based upon levels of excessavailability and adjusted quarterly. If excess availability is greater than $30million, the applicable prime margin is -0.25% and applicable LIBOR margin is0.75%. If excess availability is less than or equal to $30 million and greaterthan $15 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.00%. If excess availability is less than or equal to $15 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.25%.An unused fee of 0.25% is assessed on the unused portion of the creditfacility. The agreement underlying the credit facility includes significantrestrictive negative covenants. Among other things, these covenants restrict orprohibit our ability to incur debt and issue specified equity instruments,incur liens on our assets, make any significant changes in our corporatestructure or the nature of our business, dispose of assets, make guaranties,prepay debt, engage in a change in control transaction, pay dividends, makeinvestments or acquisitions, engage in transactions with affiliates and incurcapital expenditures. The agreement also includes representations andwarranties which must be true each time we borrow funds under the creditfacility and affirmative covenants. The full text of the contractualrequirements imposed by this financing is set forth in the Amended and RestatedLoan and Security Agreement and related amendments which have been filed withthe Securities and Exchange Commission. Subject to limited cure periods, thelenders under our credit facility may demand repayment of these borrowingsprior to stated maturity upon the occurrence of specified events, including ifwe breach the terms of the agreement, suffer a material adverse change, engagein a change in control transaction, suffer a significant adverse legaljudgment, default on other significant obligations, or in the event ofspecified events of insolvency. The credit agreement matures inDecember 2011.

OnJune 16, 2003, we completed the issuance of $100 million principal amountof 4.00% Senior Convertible Notes (the “Notes”) due 2013. The Notes boreinterest at the rate of 4.00% per annum, subject to the payment of contingentinterest under certain circumstances commencing January 15, 2006 (0.43%per annum for the current payment period due July 15, 2006), and becameconvertible into shares of common stock at a conversion price of $34.58 pershare, subject to adjustment under specified circumstances. Under thecontingent conversion feature of the Notes, subject to certain exceptions, theywere not convertible into common stock unless and until the trading price ofthe common stock reached at least $41.50 for a specified period in advance ofeach quarterly conversion period or designated corporate events occur.

OnJune 15, 2006, as provided for in the provisions of the Notes, we called forredemption of all of our Notes. Holders were able to convert the Notes intoshares of common stock at an effective conversion price of approximately $34.58

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pershare, in lieu of accepting redemption. In June 2006, holders of approximately$185,000 of outstanding Notes elected to convert their Notes to common stock.Subsequent to June 30, 2006 but prior to the July 15, 2006 redemptiondate, holders of substantially all of the remaining outstanding Notes electedto convert their Notes into shares of the Company’s common stock. As a resultof these conversions, approximately 2.9 million shares of common stock wereissued to the holders that elected to convert their Notes. In connection withthe redemption of the unconverted Notes, we paid approximately $4,000 in cash,which includes the redemption and premium payments and cash paid in lieu of fractionalshares.

During2002 we entered into master operating lease agreements with General ElectricCapital Corporation and US Bank to lease equipment and other property primarilyto support 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. The agreements call for monthly payments of $138,000through September 30, 2009.

Theterms of our significant financing agreements, including those related to ourcredit facility and the equipment lease facilities described above, are notdependent on any change in our credit rating. We believe that the keycompany-specific factors affecting our ability to maintain our existing debtand lease financing relationships and to access such capital in the future areour present and expected levels of profitability and cash flow from operations,our working capital and fixed asset collateral bases, our expected level ofcapital expenditures, and the level of our equity capital relative to the levelof debt obligations. In addition, as noted above, our existing agreementsinclude significant restrictions on future financings, including among others,limits on the amount of indebtedness that we may incur and whether or not suchindebtedness may be secured by any of our assets.

As isthe case with most multi-unit retailers, substantially all of the real propertyused in our business is leased under operating lease agreements. Please seeItem 2. Properties, “—Disclosures About Contractual Obligations and CommercialCommitments” and Note 8 to the Consolidated Financial Statements in our AnnualReport on Form 10-K for the year ended December 31, 2005. We anticipate makingadditional capital investments of $4.0 million to $6.0 million for theremainder of fiscal 2006 in connection with the expansion of our Guitar Centerdistribution center and we expect to incur increased rent expense for theexpanded distribution center starting during the third quarter of 2006. On March30, 2006, our Musician’s Friend division executed a lease agreement for a newdistribution center for our direct response business that will have a capacitysignificantly exceeding the capacity of the current distribution center that itwill replace. This lease is treated as an operating-type lease for accountingpurposes. Details of the lease agreement were included in the Current Report onForm 8-K we filed on March 30, 2006.

Netcash used in operating activities was $11.1 million for the six months endedJune 30, 2006 compared to net cash provided by operating activities of$15.4 million for the same period in 2005. The primary use of cash during thesix months ended June 30, 2006 was a decrease in accrued expenses and othercurrent liabilities of $43.1 million and an increase in inventories of $40.8million. The reduction of accrued expenses and other current liabilities wasprimarily due to payments of income taxes and sales taxes. Increase inmerchandise inventories was primarily due to the 19 Guitar Center stores openedin the period and an increase in business volumes across all segments.  The generation of cash during the six monthsended June 30, 2006 resulted from net income of $29.1 million and an increasein accounts payable due mostly to higher business volumes and timing of vendorpayments.

Cashused in investing activities decreased to $55.4 million for the six monthsended June 30, 2006 compared to $113.9 million for the same period in2005. The decrease in cash used in investing activities for 2006 compared to2005 was primarily due to the purchase of Music & Arts Center, Inc. forapproximately $93.0 million and the purchase of available-for-sale securitiespartially offset by proceeds of the sale of available-for-sale securities. Theinvesting activities for the six months ended June 30, 2006 consisted of $38.0million on capital expenditures, comprised primarily of $21.7 million on newstores and remodels, $6.3 million on computer equipment purchases and $4.8million related to the expansion of our distribution center facilities. Also,in the first and second quarters of 2006, our acquisition of businesses for theMusic & Arts Center division totaled $6.4 million.  During the second quarter of 2006, we alsoacquired four retail locations of Hermes Trading Company, Inc. forapproximately $10.8 million.

Cashprovided by financing activities totaled $62.9 million for the six months endedJune 30, 2006 compared to $48.1 million in the same period in 2005. Theincrease in cash provided by financing activities was due to increasedborrowings under the revolving line of credit to support business acquisitions,capital expenditures and working capital requirements.  For the six months ended June 30, 2006,proceeds from the exercise of stock options provided $6.4 million (including$1.7 million in tax-related benefits that are reflected in cash flows fromfinancing activities) and employee purchases of our common stock provided $1.2million.

Webelieve that our current operating cash flows, working capital, cash on hand,borrowings available under our 

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creditfacility and other sources of liquidity will be sufficient to meet ourobligations in the ordinary course of business over the next 12 months,including capital expenditures and new store openings. We anticipate ourcapital expenditures will be between $54.0 million and $60.0 million for theremainder of fiscal 2006.

Ourknown capital resource and liquidity requirements for 2006 are expected to beprimarily provided by net cash flow from operations and borrowings availableunder our credit facility. Traditionally, we have experienced the largest useof cash from operating activities in the latter part of the third quarter andin the fourth quarter due to the build up of inventory to support the holidayseason, resulting in additional borrowings under our line of credit. We believethat our borrowing ability under the recently amended credit facility will besufficient to provide the seasonal liquidity we believe will be required duringthe 2006 fiscal year.

Dependingupon market conditions, we may also elect or be required to raise additionalcapital in the form of common or preferred equity, debt or convertiblesecurities for the purpose of providing additional capital to fund workingcapital needs or continued growth of our existing business or to refinanceexisting obligations. Any such financing activity will be dependent upon manyfactors, including our liquidity needs, market conditions and prevailing marketterms, and we cannot assure you that future external financing for us will beavailable on attractive terms or at all. If we require but are unable to obtainadditional liquidity on favorable terms, we may be required to curtail our growthplans and our financial condition and results of operations would likely bematerially adversely impacted.

Weintend to pursue an aggressive growth strategy by opening additional stores innew and existing markets. During the six months ended June 30, 2006, we openeda total of 19 new Guitar Center stores, consisting of 7 primary format stores,11 secondary format stores and 1 tertiary format store. We expect our cost ofcapital improvements for a primary format Guitar Center store to averageapproximately $1.2 million consisting of leasehold improvements, fixtures andequipment. A new primary format store is also expected to require approximately$2.0 to $2.5 million in gross inventory. We have developed secondary formatGuitar Center stores to build in sites that we do not believe will support ourprimary format units. For our secondary market stores, we expect to require anaverage of approximately $0.9 million in capital improvements and approximately$1.7 to $2.0 million in gross inventory. Our first tertiary format store toserve smaller population centers was opened in late 2005 and our second wasopened in the first quarter of 2006. For our tertiary format stores, we expectto require an average of approximately $0.6 million in capital improvements andapproximately $1.0 million in gross inventory. These capital expendituresreflect the increasing construction costs that we have recently begun toexperience. We expect these increases to continue for the foreseeable future,and these costs may increase above our expectations.

We arealso anticipating additional capital and strategic investments related toimproving our fulfillment facilities and upgrading our technology and systems,including an enterprise data warehouse, retail point of sale systemreplacement, retail inventory management systems improvements, and enterprisesystems replacement for our direct response division. We also continue to makesignificant investments in information technology across our businesses and toincur costs and make investments designed to expand the reach of our businesseson the Internet. The costs of these initiatives and other investments relatedto our businesses will continue to be significant.

Throughoutour history, we have primarily grown organically. However, we also believethere may be attractive opportunities to expand by selectively acquiringexisting music products retailers or other complimentary businesses, ifattractive opportunities can be identified. We believe that our growth atMusic & Arts Center will in large part be driven through many smallacquisitions. While we cannot provide assurance that we will complete anyfurther acquisition transactions, in the ordinary course of our business weinvestigate and engage in negotiations regarding such opportunities.Acquisitions will be financed with cash on hand, drawings under our existingcredit facilities, expansion of our credit facilities, issuance of debt orequity securities, or a combination, depending upon transaction size and marketconditions, among other things.

**Recently IssuedAccounting Pronouncements**

InJune 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “*Accounting for Uncertainty in Income Taxes*.” FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement ofFinancial Accounting Standards No. 109, “*Accountingfor Income Taxes*.” This Interpretation defines the minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 is effective for fiscalyears beginning after December 15, 2006. We are currently evaluatingthe effect that the adoption of FIN 48 will have on our financial position andresults of operations.

InJune 2006, the FASB ratified Emerging Issues Task Force issued Issue 06-3,“*How Sales Taxes Collected From*

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*Customersand Remitted to Governmental Authorities Should Be Presented in the IncomeStatemen*t” (EITF 06-3). EITF 06-3 requires a company todisclose its accounting policy (i.e., gross or net presentation) regarding thepresentation of taxes within the scope of EITF 06-3. If taxes are significant,a company should disclose the amount of such taxes for each period for which anincome statement is presented. The guidance is effective for periods beginningafter December 15, 2006. We are currently evaluating the effect that theadoption of EITF 06-3 will have on our financial position and results ofoperations.

**Seasonality**

Ourbusiness follows a seasonal pattern, peaking during the holiday selling seasonin November and December. Sales in the fourth quarter are typicallysignificantly higher on a per store basis and through the direct response unitthan in any other quarter. In addition, band rental season for ourMusic & Arts Center business starts in August and carries throughmid-October, but that seasonality does not have a significant impact on ourconsolidated results.

**Inflation**

Webelieve that the relatively moderate rates of inflation experienced in recentyears have not had a significant impact on our net sales or profitability.However, in 2006, we have begun to experience rising steel, lumber, concrete,labor, fuel and freight costs related to opening, remodeling, operating and relocatingour stores, expanding our distribution centers and operating our business.

**Forward-LookingStatements; Business Risks**

Thisreport contains forward-looking statements relating to, among other things,future results of operations, growth and investment plans, sales, trends ingross margin, growth in the Internet portion of our direct response businessand other factors affecting growth in sales and earnings. Specificforward-looking statements are provided regarding our management’s currentviews regarding new store openings, capital expenditure levels and the datesnew facilities and systems will become operational. Statements regarding newstore openings are based largely on our current expectations and arenecessarily subject to associated business risks related to, among otherthings, the identification of suitable sites or acquisition opportunities, thetimely construction, staffing and merchandising of those stores and othermatters, some of which are outside of our control. Statements regarding thedates 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, includinggeneral economic conditions, the effectiveness of our promotion andmerchandising strategies, our ability to integrate and profitably operateacquired businesses, the efficient operation of our supply chain, including thecontinued support of our key vendors, our effective management of businessrisks, including litigation, and competitive factors applicable to our retail anddirect response markets.

Inlight of these risks, there can be no assurance that the forward-lookingstatements contained in this report will in fact be realized. The statementsmade by us in this report represent our views as of the date of this report,and it should not be assumed that the statements made herein remain accurate asof any future date. We do not presently intend to update these statements andundertake no duty to any person to affect any such update under anycircumstances.

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

We donot have any assets or liabilities which, in our view, impose upon ussignificant market risk except for our credit facility which has a variablerate of interest generally consisting of stated premiums above LIBOR. AtJune 30, 2006, we had $87.5 million in outstanding borrowings under ourcredit facility. As short-term interest rates fluctuate, the interest expensewe incur on our credit facility will change resulting in either a positive ornegative effect on our financial position, results of operations and cashflows. At this borrowing level for our credit facility, a one percentage pointincrease in interest rates would have an unfavorable impact on pre-tax earningsand cash flows of $0.9 million on an annual basis. The primary interest rateexposure on the credit facility is based on LIBOR. We do not use derivativefinancial instruments in our investment portfolio. Historically, we have notcarried significant cash balances and any cash in excess of our daily operatingneeds has been used to reduce our borrowings. Excess cash is generally investedin short-term, high quality interest bearing investments.

**Item 4. CONTROLS AND PROCEDURES**

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our reports filed pursuant to theExchange Act is recorded, processed, summarized and reported within the timeperiods 

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specifiedin the Securities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowfor timely decisions regarding required disclosure. In designing and evaluatingthe disclosure controls and procedures, management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

Asrequired by Securities and Exchange Commission Rule 13a-15(b), we carriedout an evaluation, under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report. Based on theforegoing, our Chief Executive Officer and Chief Financial Officer concludedthat 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. OTHER INFORMATION**

**Item1. Legal Proceedings**

Forinformation on legal proceedings, see Note 7 of Notes to Consolidated FinancialStatements “Legal Proceedings”, which is incorporated by reference in responseto this Item 1.

**Item1A. Risk Factors**

Exceptfor the risk factor set forth below, there have been no material changes to therisk factors disclosed in Item 1A of Part 1 in our Form 10-K for the year endedDecember 31, 2005. The risk factor set forth below was disclosed in our Form10-K, but has been updated to provide additional information.

*Ourfailure to maintain and expand our distribution centers could adversely impactour business.*

We arein the process of significantly expanding our Guitar Center distribution centerto increase our capacity to support continued expansion. We anticipate makingadditional capital investments and we expect to incur increased rent startingduring the third quarter of 2006. In addition, we are in the process ofreplacing and expanding our direct response distribution center. This expansionalso is expected to require a significant capital commitment. Our failure tocomplete our expansions and replacements on time and on budget may result inthe need for us to expend additional capital and may impair the efficientoperation of our distribution system, which could materially adversely impactour business, results of operations, financial condition and prospects.

**Item4. Submission of Matters to a Vote of Security Holders**

(a)                                  Ourannual meeting of stockholders was held on April 28, 2006.  At that time there were present, in person orby proxy, 24,232,776 shares of our common stock.

(b)                                 Atthe annual meeting, four items were submitted to a vote of stockholders: (1)the election of directors; (2) the approval of an amendment to the 2004 GuitarCenter, Inc. Incentive Stock Award Plan to increase the number of sharesauthorized for issuance; (3)  the approvalof an amendment to our certificate of incorporation to increase the number ofauthorized shares; and (4) the ratification of the selection of KPMG LLP asGuitar Center’s independent auditors for the year ending December 31, 2006.

(c)                                  (1)           The results of voting for theelection of nine directors at the annual meeting were as follows:

| Nominee          | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|------------------|------------|------------|------------|--------------|------------|
| Marty Albertson  |       | 23,128,452 |       | 1,103,704    |       |
| Larry Livingston |       | 23,816,702 |       | 415,454      |       |
| Pat MacMillan    |       | 23,592,740 |       | 639,416      |       |
| Bob L. Martin    |       | 23,120,154 |       | 1,112,002    |       |
| George Mrkonic   |       | 23,885,259 |       | 346,897      |       |
| Kenneth Reiss    |       | 23,863,513 |       | 368,643      |       |
| Walter Rossi     |       | 23,869,989 |       | 362,167      |       |
| Peter Starrett   |       | 23,628,840 |       | 603,316      |       |
| Paul Tarvin      |       | 23,907,946 |       | 324,210      |       |

 

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(2)                                 Theresults of voting for the amendment to the 2004 Guitar Center, Inc. IncentiveStock Award Plan to increase the number of shares authorized for issuance wereas follows:

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** |
|------------|------------|-------------|------------|-------------|------------|----------------------|
| 19,464,983 |       | 2,340,843   |       | 8,693       |       | 2,417,637            |

 

(3)                                 Theresults of voting for the approval of the amendment to our certificate ofincorporation to increase the number of authorized shares were as follows:

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** |
|------------|------------|-------------|------------|-------------|------------|----------------------|
| 20,095,024 |       | 4,123,053   |       | 14,079      |       | 0                    |

 

(4)                                 Theresults of voting to ratify the selection of KPMG LLP as Guitar Center’sindependent auditors for the year ending December 31, 2006 were as follows:

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | ** ** |
|------------|------------|-------------|------------|-------------|------------|------------|
| 23,011,034 |       | 1,209,851   |       | 11,271      |       |       |

** **

**Item6.  Exhibits**
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                           | ** ** |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 10.1            |       | Guitar Center, Inc. 2006 Long Term Incentive Plan  (Incorporated by reference to Exhibit 10.1 of the Company’s Current Report on  Form 8-K dated June 27, 2006).                     |       |
| 10.2            |       | Form of amended and restated Executive Severance  Benefits Agreement relating to certain executives of Guitar Center, Inc.,  Guitar Center Stores, Inc., and Musician’s Friend, Inc. |       |
| 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.                                                             |       |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized as of the 9th day of August 2006.
|        | Guitar Center, Inc.                                                |
|--------|--------------------------------------------------------------------|
|   |                                                               |
|   | /s/ ERICK MASON                                                    |
|        | Erick Mason, Executive Vice President and Chief  Financial Officer |
|   |                                                               |
|   | (Duly Authorized Officer and Principal Financial Officer)          |

 

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