**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | **For the  quarterly period ended June 30, 2005**                                                                                                                                                                                                                                                                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                                                                                                                                                                                                                                               |
|       |       | **For the  transition period from                                     to                                  ** |

 

**Commission File No.  000 – 22207**

 

**GUITAR CENTER, INC.**

(Exact Name of Registrant as Specified in its Charter)

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

 

**(818) 735-8800**

Registrant’s telephone number, including area code

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 
|   | Yes | ý | No | o |   |
|--------|-----|--------|----|---|--------|

 

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

 
|   | Yes | ý | No | o |   |
|--------|-----|--------|----|---|--------|

 

As of August 4,2005, 25,981,092 shares of our Common Stock, $.01 par value, were outstanding.

 

 

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**Guitar Center, Inc. and subsidiaries**

 

INDEX

 
| Part I.      | Financial  Information                                                                                             |       |
|-------------------|--------------------------------------------------------------------------------------------------------------------|------------|
|              |                                                                                                               |       |
|              | **Item 1.  Consolidated Financial Statements (Unaudited)**                                                         |       |
|              |                                                                                                               |       |
|              | Consolidated Balance Sheets – June 30,  2005 and December 31, 2004                                  |       |
|              |                                                                                                               |       |
|              | Consolidated Statements of  Income – Three months ended June 30, 2005 and 2004                           |       |
|              |                                                                                                               |       |
|              | Consolidated Statements of  Income – Six months ended June 30, 2005 and 2004                             |       |
|              |                                                                                                               |       |
|              | Consolidated Statements of  Cash Flows – Six months ended June 30, 2005 and 2004                         |       |
|              |                                                                                                               |       |
|              | Notes to Consolidated  Financial Statements                                                                        |       |
|              |                                                                                                               |       |
| ** **        | **Item 2.  Management’s Discussion and Analysis  of Financial Condition and Results of Operations** |       |
|              |                                                                                                               |       |
|              | **Item  3.  Quantitative and Qualitative Disclosures About Market Risk**                                 |       |
|              |                                                                                                               |       |
|              | **Item  4.  Controls and Procedures**                                                                    |       |
|              |                                                                                                               |       |
| **Part II.** | **Other Information**                                                                                              | ** ** |
| ** **        | ** **                                                                                                         | ** ** |
|              | Item1.  **Legal Proceedings**                                                                            |       |
|              |                                                                                                               |       |
|              | Item  4.  **Submission of Matters to a Vote of Security  Holders**                                       |       |
|              |                                                                                                               |       |
|              | Item 6.  **Exhibits**                                                                                    |       |

 

2

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

# **ConsolidatedBalance Sheets**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                                                                                                                                              | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                              |       |                    |       |                        |       |
| Current assets:                                                                                                                                                         |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                               |       | $                       | 9,977      |                        | $          | 60,453 |   |
| Investments in marketable securities                                                                                                                                    |       | —                  |       | 3,810                       |       |
| Accounts receivable, less allowance for doubtful  accounts $4,292 and $3,489, respectively                                                                              |       | 23,905                  |       | 27,627                      |       |
| Merchandise inventories                                                                                                                                                 |       | 416,566                 |       | 314,961                     |       |
| Prepaid expenses and deposits                                                                                                                                           |       | 17,151                  |       | 13,367                      |       |
| Deferred income taxes                                                                                                                                                   |       | 5,137                   |       | 5,552                       |       |
| Total current assets                                                                                                                                                    |       | 472,736                 |       | 425,770                     |       |
|                                                                                                                                                                    |       |                    |       |                        |       |
| Property and equipment, net of accumulated  depreciation of $111,072 and $99,915, respectively                                                                          |       | 124,176                 |       | 97,349                      |       |
| Investments in marketable securities                                                                                                                                    |       | —                  |       | 16,997                      |       |
| Goodwill                                                                                                                                                                |       | 78,412                  |       | 26,474                      |       |
| Deposits and other assets, net                                                                                                                                          |       | 13,217                  |       | 8,003                       |       |
|                                                                                                                                                                    |       | $                       | 688,541    |                        | $          | 574,593 |   |
|                                                                                                                                                                    |       |                    |       |                        |       |
| **Liabilities and Stockholders’ equity**                                                                                                                           |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                    |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                        |       | $                       | 94,930     |                        | $          | 49,771 |   |
| Accrued expenses and other current liabilities                                                                                                                          |       | 65,550                  |       | 83,606                      |       |
| Merchandise advances                                                                                                                                                    |       | 19,792                  |       | 22,534                      |       |
| Revolving line of credit                                                                                                                                                |       | 38,092                  |       | —                      |       |
| Total current liabilities                                                                                                                                               |       | 218,364                 |       | 155,911                     |       |
|                                                                                                                                                                    |       |                    |       |                        |       |
| Other long-term liabilities                                                                                                                                             |       | 10,206                  |       | 6,943                       |       |
| Deferred income taxes                                                                                                                                                   |       | 7,411                   |       | 5,057                       |       |
| Long-term debt                                                                                                                                                          |       | 100,000                 |       | 100,000                     |       |
| Total liabilities                                                                                                                                                       |       | 335,981                 |       | 267,911                     |       |
|                                                                                                                                                                    |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                              |       |                    |       |                        |       |
| Preferred stock; 5,000 authorized, none issued and  outstanding                                                                                                         |       | —                  |       | —                      |       |
| Common Stock, $0.01 par value,  authorized  55,000 shares, issued  and outstanding  25,944 at June 30,  2005 and 25,359 at  December 31,  2004 |       | 260                     |       | 254                         |       |
| Additional paid in capital                                                                                                                                              |       | 322,382                 |       | 305,305                     |       |
| Retained earnings                                                                                                                                                       |       | 29,918                  |       | 1,123                       |       |
| Stockholders’ equity                                                                                                                                               |       | 352,560                 |       | 306,682                     |       |
|                                                                                                                                                                    |       | $                       | 688,541    |                        | $          | 574,593 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

3

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

# **ConsolidatedStatements of Income**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                    | ** ** | **Three  months ended June 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Net sales                                     |       | $                                     | 402,296    |   | $ | 339,622 |   |
| Cost of goods sold, buying and  occupancy     |       | 286,956                               |       | 245,409 |   |
| Gross profit                                  |       | 115,340                               |       | 94,213 |   |
|                                          |       |                                  |       |   |   |
| Selling, general and  administrative expenses |       | 92,429                                |       | 73,200 |   |
| Operating income                              |       | 22,911                                |       | 21,013 |   |
|                                          |       |                                  |       |   |   |
| Interest expense, net                         |       | 1,915                                 |       | 1,425 |   |
|                                          |       |                                  |       |   |   |
| Income before income taxes                    |       | 20,996                                |       | 19,588 |   |
|                                          |       |                                  |       |   |   |
| Income taxes                                  |       | 8,085                                 |       | 7,444 |   |
|                                          |       |                                  |       |   |   |
| Net income                                    |       | $                                     | 12,911     |   | $ | 12,144 |   |
|                                          |       |                                  |       |   |   |
| Net income per share:                         |       |                                  |       |   |   |
| Basic                                         |       | $                                     | 0.50       |   | $ | 0.49 |   |
| Diluted                                       |       | $                                     | 0.46       |   | $ | 0.45 |   |
|                                          |       |                                  |       |   |   |
| Weighted average shares  outstanding:         |       |                                  |       |   |   |
| Basic                                         |       | 25,885                                |       | 24,676 |   |
| Diluted                                       |       | 29,836                                |       | 28,859 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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

# **ConsolidatedStatements of Income**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                    | ** ** | **Six  months ended June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                    | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Net sales                                     |       | $                                   | 798,682    |   | $ | 689,325 |   |
| Cost of goods sold, buying and  occupancy     |       | 572,170                             |       | 500,429 |   |
| Gross profit                                  |       | 226,512                             |       | 188,896 |   |
|                                          |       |                                |       |   |   |
| Selling, general and  administrative expenses |       | 176,900                             |       | 147,518 |   |
| Operating income                              |       | 49,612                              |       | 41,378 |   |
|                                          |       |                                |       |   |   |
| Interest expense, net                         |       | 2,790                               |       | 2,788 |   |
|                                          |       |                                |       |   |   |
| Income before income taxes                    |       | 46,822                              |       | 38,590 |   |
|                                          |       |                                |       |   |   |
| Income taxes                                  |       | 18,027                              |       | 14,666 |   |
|                                          |       |                                |       |   |   |
| Net income                                    |       | $                                   | 28,795     |   | $ | 23,924 |   |
|                                          |       |                                |       |   |   |
| Net income per share:                         |       |                                |       |   |   |
| Basic                                         |       | $                                   | 1.12       |   | $ | 0.98 |   |
| Diluted                                       |       | $                                   | 1.02       |   | $ | 0.89 |   |
|                                          |       |                                |       |   |   |
| Weighted average shares  outstanding:         |       |                                |       |   |   |
| Basic                                         |       | 25,740                              |       | 24,432 |   |
| Diluted                                       |       | 29,780                              |       | 28,636 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**Guitar Center, Inc. and subsidiaries**

**Consolidated Statements of CashFlows**

(In thousands)

(Unaudited)

 
| ** **                                                                                   | ** ** | **Six  months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Operating activities:**                                                                    |       |                                |       |   |   |
| Net income                                                                                   |       | $                                   | 28,795     |   | $ | 23,924 |   |
| Adjustments to reconcile net  income to net cash provided by (used in) operating activities: |       |                                |       |   |   |
| Depreciation and amortization                                                                |       | 13,317                              |       | 11,209 |   |
| Loss on disposal of property  and equipment                                                  |       | 1,849                               |       | — |   |
| Amortization of deferred  financing fees                                                     |       | 522                                 |       | 522 |   |
| Tax benefit from exercise of  stock options                                                  |       | 7,088                               |       | 8,481 |   |
| Deferred income taxes                                                                        |       | 350                                 |       | — |   |
| Changes in operating assets  and liabilities, net of effects of   acquired businesses:  |       |                                |       |   |   |
| Accounts receivable                                                                          |       | 9,746                               |       | 5,172 |   |
| Merchandise inventories                                                                      |       | (45,932                             | )          | (24,334 | ) |
| Prepaid expenses and deposits                                                                |       | (3,107                              | )          | (7,260 | ) |
| Other assets                                                                                 |       | 20                                  |       | 78 |   |
| Accounts payable                                                                             |       | 31,648                              |       | (2,826 | ) |
| Accrued expenses and other  current liabilities                                              |       | (24,697                             | )          | (21,448 | ) |
| Other long-term liabilities                                                                  |       | 2,803                               |       | 446 |   |
| Merchandise advances                                                                         |       | (7,040                              | )          | (511 | ) |
| Net cash provided by (used in)  operating activities                                         |       | 15,362                              |       | (6,547 | ) |
|                                                                                         |       |                                |       |   |   |
| **Investing activities:**                                                                    |       |                                |       |   |   |
| Purchase of property and  equipment                                                          |       | (37,829                             | )          | (10,835 | ) |
| Acquisition of businesses, net  of cash acquired                                             |       | (96,251                             | )          | — |   |
| Purchase of available-for-sale-securities                                                    |       | (27,305                             | )          | — |   |
| Proceeds from the sale of  available-for-sale-securities                                     |       | 47,460                              |       | — |   |
| Net cash used in investing  activities                                                       |       | (113,925                            | )          | (10,835 | ) |
|                                                                                         |       |                                |       |   |   |
| **Financing activities:**                                                                    |       |                                |       |   |   |
| Net increase in revolving debt  facility                                                     |       | 38,092                              |       | — |   |
| Proceeds from exercise of  stock options                                                     |       | 9,042                               |       | 15,143 |   |
| Proceeds from stock issued  under employee purchase plan                                     |       | 953                                 |       | 706 |   |
| Net cash provided by financing  activities                                                   |       | 48,087                              |       | 15,849 |   |
|                                                                                         |       |                                |       |   |   |
| Net decrease cash and cash  equivalents                                                      |       | (50,476                             | )          | (1,533 | ) |
| Cash and cash equivalents at  beginning of year                                              |       | 60,453                              |       | 5,350 |   |
|                                                                                         |       |                                |       |   |   |
| Cash and cash equivalents at  end of period                                                  |       | $                                   | 9,977      |   | $ | 3,817 |   |

 

See accompanying notes to consolidated financial statements.

 

6

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| ** **                                                                                                                 | ** ** | **Six  months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2005**                            | ** ** |
| **Non-cash investing activities**                                                                                          | ** ** | ** **                          | ** ** |
| ** **                                                                                                                 | ** ** | ** **                          | ** ** |
| Acquisition of businesses, in which the preliminary  estimate of the fair value of assets and liabilities were as follows: |       |                                |       |
|                                                                                                                       |       |                                |       |
| Current assets                                                                                                             |       | $                                   | 6,701      |   |
| Inventory                                                                                                                  |       | 56,037                              |       |
| Property & equipment                                                                                              |       | 3,311                               |       |
| Other assets                                                                                                               |       | 5,593                               |       |
| Goodwill                                                                                                                   |       | 51,938                              |       |
| Total assets acquired                                                                                                      |       | 123,580                             |       |
| Current liabilities                                                                                                        |       | (24,450                             | )          |
| Deferred income tax liability                                                                                              |       | (2,419                              | )          |
| Other long-term liabilities                                                                                                |       | (460                                | )          |
| Total liabilities assumed                                                                                                  |       | (27,329                             | )          |
| Net cash paid for acquisition                                                                                              |       | $                                   | 96,251     |   |

 

See accompanying notes to consolidated financial statements.

 

7

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**Guitar Center, Inc. and subsidiaries**

**Notes to Consolidated FinancialStatements**

 

1.                                       Natureof Business and Basis of Presentation

 

Natureof Business

 

Guitar Center is the nation’s leading retailer ofguitars, amplifiers, percussion instruments, keyboards, live-sound/DJ andrecording equipment based on annual revenue. As of June 30, 2005, weoperated 149 Guitar Center retail stores, with 120 stores in 48 major marketsand 29 stores in secondary markets across the United States. Included in the149 Guitar Center retail stores are 119 large format stores (square footage ofapproximately 16,000 to 20,000) and 30 small format (square footage ofapproximately 10,000 to 12,000).  Thefirst of these small format units was opened in late 2000 and 29 more had beenopened as of June 30, 2005. As a result of our acquisition of Music &Arts, which has been integrated with our American Music division, Music &Arts operate 77 retail stores specializing in band and orchestral instrumentsfor sale and rental, serving teachers, band directors, college professors andstudents and 7 educational support centers as of June 30, 2005. We arealso the largest direct response retailer of musical instruments in the UnitedStates through our wholly-owned subsidiary, Musician’s Friend, Inc., andits catalog and web site, www.musiciansfriend.com.

 

Basisof Presentation

 

In the opinion of management, the accompanyingunaudited consolidated financial statements contain all adjustments necessaryto present fairly the financial position of Guitar Center, Inc. andsubsidiaries as of June 30, 2005 and December 31, 2004, and theresults of operations and cash flows for the three and six months ended June 30,2005 and 2004. The accompanying consolidated financial statements should beread in conjunction with the audited consolidated financial statements and notesthereto contained in our Annual Report on Form 10-K for the year ended December 31,2004.

 

The results of operations for the three and six monthsended June 30, 2005 are not necessarily indicative of the results to beexpected for the full year.

 

The purchase price accounting related to the Music &Arts Center, Inc. acquisition completed April 15, 2005 is beingfinalized and, as a result, there may be a subsequent reclassification ofcertain items presented on the balance sheet as of June 30, 2005.

 

Use ofEstimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requires usto make estimates and assumptions. These estimates and assumptions affect thereported amounts in the consolidated balance sheets and statements of income,as well as the disclosure of contingent liabilities. Actual results coulddiffer from these estimates and assumptions.

 

2.                                       Acquisitionof businesses

 

On April 15, 2005, we completedthe acquisition of all the outstanding shares of the common stock of Music &Arts Center, Inc. (“MAC”), a Maryland-based musical instruments retailerwith an emphasis on the beginning musician. Music & Arts operated 61retail locations, primarily located in the Northeast, Mid-Atlantic and Southernregions of the U.S. The acquired business and our existing American Musicbusiness are being combined into a new division under the Music & Artsname.

OnJune 10, 2005, our Musician’s Friend unit completed the asset acquisitionof Harmony-Central.com, an Internet content and information site.  The acquired company will be separatelymaintained 

 

8

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andoperated by Musician’s Friend as Harmony Central Group, LLC. The results ofoperations and the assets of Harmony-Central.com were not material to GuitarCenter’s historical consolidated financial statements and, as such, pro-formafinancial information is not presented. The results of operations are includedin Guitar Center’s consolidated financial statements from the date of theacquisition.

 

The purchase price of both companies was approximately$96 million and was funded from cash on hand and drawings under our line ofcredit. The consideration described above was allocated to the following assetsacquired and liabilities assumed at their estimated fair value (in thousands):

 
| Current assets                |   | $       | 6,701  |   |
|-------------------------------|--------|---------|--------|--------|
| Inventory                     |   | 56,037  |   |
| Property & equipment |   | 3,311   |   |
| Other assets                  |   | 5,593   |   |
| Goodwill                      |   | 51,938  |   |
| Total assets acquired         |   | 123,580 |   |
| Current liabilities           |   | (24,450 | )      |
| Deferred income tax liability |   | (2,419  | )      |
| Other long-term liabilities   |   | (460    | )      |
| Total liabilities assumed     |   | (27,329 | )      |
| Total purchase price          |   | $       | 96,251 |   |

 

The priceallocation described above resulted in our recording approximately $52 million ingoodwill, which is not being amortized, but will be evaluated for impairmentannually or when a triggering event occurs which may require an impairmenttest.

 

Results of operations for Music & Arts areincluded in the consolidated financial statements since April 15, 2005,the date of acquisition. The following table summarizes pro forma financialinformation assuming the Music & Arts acquisition had occurred as ofthe beginning of the periods presented below:

 
| ** **          | ** ** | **Three months ended  June 30,**      | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------|------------|--------------------------------------------|------------|-------------------------------------|------------|
| ** **          | ** ** | **2005**                                   | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **          | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net sales           |       | $                                          | 405,183    |                                | $          | 357,243 |   | $ | 825,137 |   | $ | 726,980 |   |
| Net income          |       | 8,783                                      |       | 12,025                              |       | 25,248 |   | 24,458 |   |
|                |       |                                       |       |                                |       |   |   |   |   |
| Earnings per share: |       |                                       |       |                                |       |   |   |   |   |
| Basic               |       | 0.34                                       |       | 0.49                                |       | 0.98 |   | 1.00 |   |
| Diluted             |       | 0.32                                       |       | 0.44                                |       | 0.90 |   | 0.91 |   |
|                     |            |                                            |            |                                     |            |  |  |  |  |  |  |  |  |

 

Included in net income for the quarter ended June 30,2005 are charges of $5.9 million (0.12 per diluted per share) for bonuspayments and legal fees associated with the acquisition. These charges wereincurred prior to Guitar Center acquiring Music & Arts, Inc. on April 15,2005. In addition, in conjunction with the acquisition, charges of $3.4 million(0.07 per diluted per share) were incurred primarily from the elimination of aredundant point of sales system, severance costs and moving costs to relocatecertain American Music employees to the Music & Arts corporate officein Maryland, and the write down of inventory carried at American Music resultingfrom a change in inventory assortment. These charges were incurred during theperiod of April 15, 2005 through June 30, 2005.

 

The purchase price accounting related to the Music &Arts Center, Inc. acquisition is being finalized and, as a result, there maybe a subsequent reclassification of certain items presented on the balancesheet as of June 30, 2005. The pro forma information is not necessarilyindicative of the operating results that would have occurred had theacquisition been made at the beginning of the periods presented nor are theynecessarily indicative of any future operating results.

 

9

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3.                                       EarningsPer Share

 

The following table summarizes the reconciliation of thenumerator and denominator for basic and diluted earnings per shares for thethree and six months ended June 30, 2005 and 2004:

 
| ** **                                                            | ** ** | **Three months ended  June 30,**      | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                   | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net income                                                            |       | $                                          | 12,911     |                                | $          | 12,144 |   | $ | 28,795 |   | $ | 23,924 |   |
| Add: Interest, net of tax on 4% Senior Convertible  Notes             |       | 727                                        |       | 733                                 |       | 1,454 |   | 1,466 |   |
| Net income excluding interest expense on 4% Senior  Convertible Notes |       | 13,638                                     |       | 12,877                              |       | 30,249 |   | 25,390 |   |
|                                                                  |       |                                       |       |                                |       |   |   |   |   |
| Basic shares                                                          |       | 25,885                                     |       | 24,676                              |       | 25,740 |   | 24,432 |   |
| Dilutive effect of options outstanding                                |       | 1,059                                      |       | 1,291                               |       | 1,148 |   | 1,312 |   |
| Dilutive effect of conversion of 4% Senior  Convertible Notes         |       | 2,892                                      |       | 2,892                               |       | 2,892 |   | 2,892 |   |
| Diluted shares                                                        |       | 29,836                                     |       | 28,859                              |       | 29,780 |   | 28,636 |   |
| Basic net income per share                                            |       | $                                          | 0.50       |                                | $          | 0.49 |   | $ | 1.12 |   | $ | 0.98 |   |
| Diluted net income per share                                          |       | $                                          | 0.46       |                                | $          | 0.45 |   | $ | 1.02 |   | $ | 0.89 |   |

 

For the three and six months ended June 30, 2005and 2004, all options outstanding had a dilutive effect.

 

For the three and six months ended June 30, 2005and 2004, the 2.9 million shares of common stock issuable upon conversion ofthe 4.00% Senior Convertible Notes issued in June 2003 (reflecting aneffective conversion price of $34.58) are potential common stock and are deemedto be outstanding for the purposes of calculating diluted earnings per shareunder the “if-converted” method of accounting which also provides that therelated after-tax interest expense, including amortization of deferredfinancing costs, for the period is added back to net income.

 

In November 2004, the Emerging Issues Task Force(“EITF”) reached a consensus that contingently convertible debt instruments,such as our 4.00% Senior Convertible Notes, should be included in thecomputation of diluted earnings per share under the if-converted methodregardless of whether the market price trigger has been met. The consensus mustbe applied by retroactive restatement of financial statements issued forperiods ending after December 15, 2004. Accordingly, we retroactivelyrestated all earnings per share measures for the three and six months ended June 30,2004 to reflect the consensus.

 

**4.**                                       Segment Information

** **

**Our reportable business segmentsare Guitar Center stores, Music & Arts stores and Musician’s Friend directresponse (contact center and Internet). Prior to the acquisition of Music &Arts, that segment was referred to as American Music stores. Both brands havesimilar operations and there has been no change to the internal structure ofthe organization and therefore there has been no change in the nature of thecompany segment reporting. Management evaluates segment performance basedprimarily on net sales and income (loss) before income taxes.  Accounting policies of the segments are thesame as the accounting policies for the consolidated Company.  There are no differences between themeasurements of profits or losses or assets of the reportable segments andthose of the Company on a consolidated basis. The Company business segmentsunder Statement of Financial Accounting Standards (“SFAS”) No. 131, *“Disclosures about Segments of an Enterprise and Related Information”*are**

 

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**consistent with its reporting units under SFAS No. 142,*“Goodwill and Other Intangible Assets.” *SFAS No. 131 establishesstandards for the reporting of operating segment information in annualfinancial statements and in interim financial reports issued to shareholders.SFAS No. 142 requires that goodwill no longer be amortized, reclassificationsbetween goodwill and other intangible assets be made based upon certaincriteria, and, once allocated to reporting units (the business segment level,or one level below), that tests for impairment of goodwill be performed atleast annually. We will continue to evaluate goodwill annually or wheneverevents and circumstances indicate that there may be an impairment of the assetvalue.**

** **

**Net sales, gross margin,depreciation and amortization, selling, general and administrative expenses,income before income taxes and capital expenditures for the three and sixmonths ended June 30, 2005 and 2004 and total assets as of June 30,2005 and 2004 are summarized as follows (in thousands):**

** **
| ** **                                    | ** ** | **Three Months Ended June 30,  2005** | ** ** | **Six Months Ended June 30,  2005** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | **Guitar  Center**                         | ** ** | **Music &  Arts**               | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **Music &  Arts** | ** ** | **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  administrative expenses |       | 60,752                                     |       | 14,662                                   |       | 17,015 |   | 92,429 |   | 122,190 |   | 19,826 |   | 34,884 |   | 176,900 |   |
| Income (loss) before income  taxes            |       | 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                                  |       |                                       |       |                                     |       |   |   |   |   | 422,554 |   | 181,089 |   | 84,898 |   | 688,541 |   |
|                                               |            |                                            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                    | ** ** | **Three Months Ended June 30,  2004** | ** ** | **Six Months Ended June 30,  2004** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | **Guitar  Center**                         | ** ** | **Music &  Arts (1)**           | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **Music &  Arts (1)** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net sales                                     |       | $                                          | 262,879    |                                     | $          | 8,592 |   | $ | 68,151 |   | $ | 339,622 |   | $ | 526,387 |   | $ | 17,970 |   | $ | 144,968 |   | $ | 689,325 |   |
| Gross profit                                  |       | 68,380                                     |       | 2,846                                    |       | 22,987 |   | 94,213 |   | 135,068 |   | 6,231 |   | 47,597 |   | 188,896 |   |
| Depreciation and amortization                 |       | 4,980                                      |       | 327                                      |       | 544 |   | 5,851 |   | 9,343 |   | 718 |   | 1,148 |   | 11,209 |   |
| Selling, general and  administrative expenses |       | 54,254                                     |       | 4,362                                    |       | 14,584 |   | 73,200 |   | 107,713 |   | 8,687 |   | 31,118 |   | 147,518 |   |
| Income (loss) before income  taxes            |       | 13,212                                     |       | (2,156                                   | )          | 8,532 |   | 19,588 |   | 25,555 |   | (3,743 | ) | 16,778 |   | 38,590 |   |
| Capital expenditures                          |       | 5,173                                      |       | 445                                      |       | 434 |   | 6,052 |   | 9,198 |   | 563 |   | 1,074 |   | 10,835 |   |
| Total assets                                  |       |                                       |       |                                     |       |   |   |   |   | 365,565 |   | 57,984 |   | 61,236 |   | 484,785 |   |
|                                               |            |                                            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**(1) The information includedfor Music & Arts in 2004 included only the operation of AmericanMusic.**

 

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5.                                       Stock-BasedCompensation

 

We have adopted SFAS No. 123, “Accounting forStock-Based Compensation,” which permits entities to recognize as expense overthe vesting period the fair value of all stock-based awards on the date ofgrant.  Alternatively, SFAS No. 123allows entities to continue to apply the provisions of Accounting PrinciplesBoard (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees,”and related interpretations and provide pro forma net income and pro formaearnings per share disclosures for employee stock options as if the fair-value-basedmethod defined in SFAS No. 123 had been applied.  We have elected to continue to apply theprovisions of APB Opinion No. 25 and provide the pro forma disclosureprovisions of SFAS No. 123.

 

However, in December 2004, the FinancialAccounting Standards Board  issued SFAS No. 123(revised 2004) Share-Based Payment (“SFAS No. 123R”). SFAS No. 123Rrequires that the cost from all share-based payment transactions, includingstock options, be recognized in the financial statements at fair value. SFAS No. 123Ris effective for public companies in the first fiscal year beginning after December 15,2005. We will adopt the provisions of this statement effective January 1,2006. We anticipate adopting SFAS No. 123R using the modified prospectivemethod, which will not require us to restate any prior periods.

 

In the second quarter of 2005, we converted to alattice-based binomial model from a Black-Scholes model, which managementbelieves to be a superior method for valuing the impact of different employeeoption exercise patterns under various economic and market conditions. Thischange in methodology did not have a significant impact on pro forma resultsfor the second quarter of 2005.  The conversionwas implemented beginning with grants issued during the second quarter of2005.  The fair value of our grants,issued prior to the second quarter of 2005 were determined using best-estimateassumptions effective as of the grant date using the Black-Scholes model.

 

                Assumptionsused to determine the fair value of options granted during the second quarterof 2005 using the lattice-based binomial model were developed in consultationwith an outside valuation specialist. The lattice-based binomial model requires the input of several assumptionsincluding expected volatility, the dividend yield, and risk-free rate ofreturn, as well as certain assumptions regarding early exercise behavior.  Unlike the Black-Scholes model where theexpected term is an input assumption, the expected-term is an output variableof the lattice-based binomial model.  Theexpected volatility assumption was developed based on an analysis of historicalprices of our stock and open market exchanged options.  The risk free interest rate varies byduration, from 3.5% to 4.0%, based on the term.

 

 Assumptionswere developed separately for our senior management from the other participantsof our stock plans since their early exercise behavior is expected to differmaterially from the other participants.

 

Compensation expense for stock options issued toemployees is recorded on the date of grant only if the current market price ofthe underlying stock exceeded the exercise price.  Had we determined compensation cost basedupon the fair value at the grant date for our stock options using themethodologies described above, pro forma net income and pro forma net incomeper share, including the following weighted average assumptions used in thesecalculations, would have been as follows for the three and six months ended June 30:

 
| ** **                                                                                                                                     | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months  ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2005**                                      | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as reported                                                                                                                        |       | $                                             | 12,911     |                                        | $          | 12,144 |   | $ | 28,795 |   | $ | 23,924 |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based methods for all awards, net of  related tax effects |       | 1,351                                         |       | 927                                         |       | 2,776 |   | 1,918 |   |
| Pro forma net income                                                                                                                           |       | $                                             | 11,560     |                                        | $          | 11,217 |   | $ | 26,019 |   | $ | 22,006 |   |
|                                                                                                                                           |       |                                          |       |                                        |       |   |   |   |   |
| Earnings per share:                                                                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| Basic -as reported                                                                                                                             |       | 0.50                                          |       | 0.49                                        |       | 1.12 |   | 0.98 |   |
| Basic - pro forma                                                                                                                              |       | 0.45                                          |       | 0.45                                        |       | 1.01 |   | 0.90 |   |
| Diluted - as reported                                                                                                                          |       | 0.46                                          |       | 0.45                                        |       | 1.02 |   | 0.89 |   |
| Diluted - pro forma                                                                                                                            |       | 0.41                                          |       | 0.41                                        |       | 0.92 |   | 0.82 |   |
| Risk free interest rate                                                                                                                        |       | 3.5%- 4                                       | %          | 4.4                                         | %          | 3.5%- 4 | % | 4.4 | % |
| Expected life of options                                                                                                                       |       | 5.58                                          |       | 6.74                                        |       | 5.58 |   | 6.74 |   |
| Expected volatility                                                                                                                            |       | 42.0                                          | %          | 61.3                                        | %          | 42.0 | % | 61.3 | % |
| Expected dividends                                                                                                                             |       | —                                        |       | —                                      |       | — |   | — |   |

 

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6.                                       LegalProceedings

 

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

 

On October 13,2004, a putative class action lawsuit entitled Carlos Rodriguez v. The GuitarCenter, Inc. [sic], Case No. GC322958, was filed in the SuperiorCourt of the State of California for the County of Los Angeles.  The lawsuit was filed by an individualpurporting to represent all hourly retail store employees employed by us withinthe State of California.  On December 15,2004, a putative class action lawsuit entitled James McClain et. al. v. GuitarCenter Stores, Inc., Case No. BC326002, was filed in the SuperiorCourt of the State of California for the County of Los Angeles.  The lawsuit was filed by three individualspurporting to represent all hourly retail store employees employed by us withinthe State of California.   Among otherthings, the lawsuits allege that we improperly failed to document and enforcebreak-time and lunch-time periods for such employees and seek an unspecifiedamount of damages, penalties and attorneys’ fees.  In the Rodriguez case, we have filed ananswer to the plaintiff’s complaint and are in the process of responding to theplaintiff’s requests for discovery.  TheMcClain complaint has been served on us, and our response to the complaint wasfiled on May 11, 2005.  The McClainand Rodriguez lawsuits are now pending before the same court.  Both matters have been consolidated formediation purposes.

 

On May 6,2005, a lawsuit entitled Farnam Street Financial, Inc. v. Guitar Center, Inc.,Case No. CT 05-6546, was filed in the Fourth Judicial District in theState of Minnesota for the County of Hennepin. The lawsuit, which was filed by a Minnesota corporation, alleges breachof contract in connection with the lease of certain equipment located in ourcorporate office and retail stores. Among other things, the lawsuit alleges that we have breached thecontract by our failure to comply with the terms and conditions in connectionwith the return of the equipment and seeks an unspecified amount of damages andattorneys’ fees.  We have filed an answerto the complaint and are in the process of propounding discovery on theplaintiff as well as responding to plaintiff’s requests for discovery.

 

While webelieve these lawsuits are without merit and intend to defend them vigorously,they may, regardless of the outcome, result in substantial expenses and damagesto us and may significantly divert the attention of our management.  There can be no assurance that we will beable to achieve a favorable settlement of these lawsuits or obtain a favorableresolution of such lawsuits if they are not settled.  An unfavorable resolution of these lawsuitscould have a material adverse effect on our business, financial condition andresults of operations.  Regardless of theoutcome, the costs and expenses incurred by us to defend these lawsuits couldalso have a material adverse effect on our business, financial condition andresults of operations.

 

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

** **

### **General**

### ** **

GuitarCenter is the nation’s leading retailer of guitars, amplifiers, percussioninstruments, keyboards and live-sound/DJ and recording equipment based onannual revenue. As of June 30, 2005, we operated 149 Guitar Center retailstores, with 120 stores in 48 major markets and 29 stores in secondary marketsacross the United States. We completed our acquisition of Music & ArtsCenter, Inc. on April 15, 2005 and the acquired business and ourformer American Music business were combined into a new division that operatesunder the Music & Arts name. As a result, our Music & Artsdivision operates 77 retail locations specializing in band instruments for saleand rental, serving thousands of teachers, band directors, college professorsand students and 7 educational support centers. We

 

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are also the largestdirect response retailer of musical instruments in the United States throughour wholly-owned subsidiary, Musician’s Friend, Inc., and its catalog andweb site, www.musiciansfriend.com.

 

Duringthe second quarter, we opened two large format Guitar Center stores inJacksonville, Florida and Syracuse, New York and three small format stores inYoungstown, Ohio, Tallahassee, Florida and Jackson, Mississippi. These storesadded 58,700 square feet of Guitar Center retail space and brought us to atotal of 2.253 million square feet of Guitar Center retail space at the end ofthe quarter.

 

As weenter new markets, we expect that we will initially incur higher administrativeand promotional costs per store than is currently experienced in establishedmarkets.  We expect competition tocontinue to increase as other music product retailers attempt to executenational growth strategies.  Our businessstrategy will also emphasize opportunities to continue to grow each of ourbrands, including further acquisitions if attractive candidates can be locatedfor reasonable prices.

 

From2000 to 2004, our consolidated net sales grew at an annual compound growth rateof 17%, principally due to the comparable store sales growth of our retailstores averaging 7% per year, the opening of new stores, and a 22% per yearincrease in the direct response channel. We believe such volume increases arethe result of the continued success of the implementation of our businessstrategy, continued growth in the music products industry and increasingconsumer awareness of the Guitar Center, Musician’s Friend and Music &Arts brand names. We achieved comparable store sales growth of 5% and 7% forthe first and second quarters of 2005 compared to 11% and 8% for the first and secondquarters of 2004 for the Guitar Center retail division. Comparable store salescompares net sales for the comparable periods, excluding net sales attributableto stores not open for 14 months as of the end of the latter reportingperiod.  All references in this report tocomparable stores sales are based on this calculation methodology.

 

**Executive Summary**

 

Consolidatednet sales for the quarter ended June 30, 2005 increased 18.5%, or $62.7million, to $402.3 million compared to $339.6 million in the second quarter of2004. Net income for the quarter was $12.9 million, which is a 6.3% increaseover the $12.1 million we reported in the second quarter of 2004. Our secondquarter net income includes charges of $2.1 million after-tax, or $0.07 perdiluted share, related to the acquisition of Music & Arts Center, Inc.

 

OurGuitar Center retail division turned in a strong performance for the quarter.Net sales from our Guitar Center stores increased 14.0% to $299.6 million from$262.9 million in last year’s second quarter. Sales from new stores contributed$18.5 million and accounted for 50.3% of the increase. Guitar Center retail’scomparable store sales increased 7%.

 

Musician’sFriend, our direct response division, generated a net sales increase of 14.4%for the quarter to $78.0 million compared to $68.2 million in the secondquarter of 2004. We expect this trend of increased competition in the directresponse channel and its negative impact on that segment’s net sales and grossmargin to continue though at least the end of 2005. For the quarter, weachieved an initial fill rate of 95% up from 94% in the same quarter of 2004.Initial order fill rate reflects the percentage of items ordered by ourcustomers that we are able to supply in the initial shipment to that customer.

 

Wecompleted the acquisition of Music & Arts Center, Inc. on April 15,2005 and the acquired business and our former American Music business werecombined into a new division that operates under the Music & Artsname. Second quarter 2004 results only reflect results for our former AmericanMusic stores and do not include results from the acquired business. Net salesfrom our Music & Arts division were $24.7 million compared to $8.6million in the second quarter of 2004. Comparable net sales for the Music &Arts division increased 3%, including the acquired Music & Arts locations.  The comparable store sales increase for Music& Arts was computed using sales for comparable American Music stores forthe full quarter 2005 compared to the full quarter 2004 combined with sales forcomparable Music & Arts, Inc. stores from April 15, 2005 through June 30,2005 compared against the same period in the prior year.

 

**Discussion of Critical 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 of America.  Actual results could differ significantlyfrom those estimates under different assumptions and conditions.  We believe that the following discussionaddresses our most critical accounting policies, which are those that are mostimportant to the portrayal of our financial condition and results and requiremanagement’s most difficult, subjective and complex judgments, often as aresult of the need to make estimates about the effect of matters that are inherently

 

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uncertain.  Additionally, the policy described belowregarding credits and other vendor allowances is unique to our industry anddeserves the attention of a reader of our financial statements.

 

*Valuationof Inventory*

 

Wevalue our inventories at the lower of cost using the first-in, first-out (FIFO)method or market. Rental inventories are valued at the lower of cost or marketusing the specific identification method and are depreciated on a straight-linebasis while out under a rental agreement for rent-to-own sales. We recordadjustments to the value of inventory based upon obsolescence and changes inmarket value.  Applicable costsassociated with bringing inventory through our Guitar Center retaildistribution center are capitalized to inventory.  The amounts are expensed to cost of goodssold as the associated inventory is sold. Management has evaluated the current level of inventories consideringfuture customer demand for our products, taking into account general economicconditions, growth prospects within the marketplace, competition, marketacceptance of current and upcoming products, and management initiatives.  Based on this evaluation, we have recordedimpairment adjustments to cost of goods sold for estimated decreases in netrealizable value.  These judgments aremade in the context of our customers’ shifting needs, product and technologicaltrends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimatecorrectly, could result in inventory valuation changes as of any given balancesheet date.

 

*Valuationof Long-Lived Assets*

 

Long-livedassets such as property and equipment and identifiable intangibles withdefinite lives are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Goodwill and other intangibles that are not amortized are requiredto be reviewed for impairment on an annual basis, or more frequently whentriggering events occur. Factors we consider important, which could triggerimpairment, include, among other things:

 

•                  Significant underperformance relativeto historical or projected operating results;

 

•                  Significant changes in the manner ofour use of the acquired assets or the strategy of our overall business;

 

•                  Significant negative industry oreconomic trends; and

 

•                  Significant decline in stock valuefor a sustained period.

 

Forlong-lived assets other than goodwill and intangibles that are not amortized,the determination 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 are consistent with internalforecasts and consider current and future expected sales volumes and relatedoperating costs and any anticipated increases or declines based on expectedmarket conditions and local business environment factors. If a potentialimpairment is identified, the amount of the impairment loss recognized would bedetermined by estimating the fair value of the assets and recording a loss if thefair value was less than the book value. Fair value will be determined based onappraisal values assessed by third parties, if deemed necessary, or adiscounted future cash flows analysis. For goodwill and other intangibles thatare not amortized, impairment to be recognized is measured as the amount bywhich the carrying amount of the assets exceeds the fair value of the relatedassets of the underlying reporting unit to which the goodwill 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.

 

*SalesReturns*

 

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 customers have 14 business days from the date of purchase to returnproduct. We

 

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regularly review andrevise, when deemed necessary, our estimates of sales returns based uponhistorical trends. While our estimates during the past few years haveapproximated actual results, actual returns may differ significantly, eitherfavorably or unfavorably, from estimates if factors such as economic conditionsor the competitive environment differ from our expectations.

 

*Creditsand Other Vendor 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 advertisingallowances are recognized as a reduction to selling, general, andadministrative expense when we incur the advertising expense eligible for thecredit. We recognized cooperative advertising allowances of $2.2 million and $1.4million in the three months ended June 30, 2005 and 2004, respectively.For the six months ended June 30, 2005 and 2004 we recognized $3.8 millionand $2.9 million cooperative advertising allowances, recorded as an offset toselling, general and administrative expense. Price protection credits and vendor rebates are accounted for as areduction of the cost of merchandise inventory and are recorded at the time thecredit or rebate is earned.  The effectof price protection credits and vendor rebates is recognized in the incomestatement at the time the related inventory is sold as a reduction in cost ofgoods sold. We regularly review and revise, when deemed necessary, ourestimates of rebates reserve based upon historical trends. We received vendorrebate payments of $7.4 million and $5.3 million for the three months ended June 30,2005 and 2004 and $17.0 million and $12.0 million for the six months ended June 30,2005 and 2004, respectively. We earned vendor rebates of $6.3 million and $4.2million for the three months ended June 30, 2005 and 2004 and $13.5million and $11.1 million for the six months ended June 30, 2005 and 2004,respectively. None of these credits are recorded as revenue.

 

**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,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                   | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                    |       | 100.0                                 | %          | 100.0                               | %          | 100.0 | % | 100.0 | % |
| Gross profit                                 |       | 28.7                                  | %          | 27.7                                | %          | 28.4 | % | 27.4 | % |
| Selling, general and  administrative expense |       | 23.0                                  | %          | 21.5                                | %          | 22.1 | % | 21.4 | % |
| Operating income                             |       | 5.7                                   | %          | 6.2                                 | %          | 6.2 | % | 6.0 | % |
| Interest expense, net                        |       | 0.5                                   | %          | 0.4                                 | %          | 0.4 | % | 0.4 | % |
| Income before income tax expense             |       | 5.2                                   | %          | 5.8                                 | %          | 5.9 | % | 5.6 | % |
| Income tax expense                           |       | 2.0                                   | %          | 2.2                                 | %          | 2.3 | % | 2.1 | % |
| Net income                                   |       | 3.2                                   | %          | 3.6                                 | %          | 3.6 | % | 3.5 | % |

 

**ThreeMonths Ended June 30, 2005 Compared to the Three Months Ended June 30,2004**

 

Netsales for the three months ended June 30, 2005 increased 18.5% to $402.3million, compared to $339.6 million for the same period last year. Net salesfrom Guitar Center stores for the three months ended June 30, 2005 totaled$299.6 million, a 14.0% increase from $262.9 million for the same period in2004.  Sales from new stores contributed$18.5 million and represent 50.3% of the total increase in retail storesales.  Comparable store sales for ourGuitar Center division increased 7%.  Webelieve that comparable store sales are a more useful indicator of store performancethan the change in total net sales, since comparable store sales exclude theeffects of changes in the number of stores open.

 

Wecompleted our acquisition of Music & Arts Center, Inc. on April 15,2005 and the acquired business and our former American Music business werecombined into a new division that operates under the Music & 

 

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Arts name. The combinedoperations of American Music and Music & Arts  (collectively “Music & Arts”) for thequarter reflect the combined results of American Music for the full quarter andMusic & Arts from April 15, 2005 through June 30, 2005. Netsales from Music & Arts for the quarter ended June 30, 2005totaled $24.7 compared to $8.6 million in 2004 primarily due to the acquisition.Comparable Music & Arts store sales for the quarter increased 3%.

 

Netsales from the direct response channel totaled $78.0 million for the threemonths ended June 30, 2005, a $9.8 million, or 14.4%, increase from 2004.This increase primarily reflects the improved leveraging of an expanding buyerfile and advertising strategies offset by increased competition. We expect thistrend of increased competition in the direct response channel and its negativeimpact on that segment’s net sales and gross margin to continue through atleast the end of 2005. Sales from the contact center, which represent salesplaced via phone, live chat, mail and e-mail, increased 4.5% to $32.2 millionfor the three months ended June 30, 2005 from $30.8 million for thecomparable 2004 period. Internet sales from orders placed via the Musician’sFriend and Giardinelli web sites increased 22.5% to $45.8 million from $37.4million for the same period last year. The growth of web-based sales reflects the continued trend of ourcatalog customers’ preference in using the web to place their orders, thesuccess of web-based promotions, and that the web site includes a more completeinventory presentation than our catalogs.

 

Grossprofit for the three months ended June 30, 2005 compared to 2004 increased22.4% to $115.3 million from $94.2 million. Gross profit as a percentage of net sales for the three month periodended June 30, 2005 compared to 2004 increased to 28.7% from 27.7%.  Gross profit as a percentage of net sales forGuitar Center retail was 26.8% compared with 26.0% in the second quarter of2004.  The increase is primarily due tohigher selling margin (1.3%), partially offset by increased freight costs(0.2%) and higher occupancy costs (0.2%) due to an increase in depreciation forstore equipment. We realized higher selling margin principally from expansionof our proprietary product which yield a higher margin, a change in product mixand better pricing from vendors.  Wedefine selling margin as net sales less the cost of the merchandise charged bythe vendor plus the associated inventory costs from fulfilling inventorythrough our distribution center.  Thecost of merchandise inventory is net of all associated vendor discounts andrebates. Freight is not included in selling margin. The gross profit margin forthe Music & Arts division was 41.7% compared to 33.1% for the sameperiod last year. The higher margin is due to the higher margin delivered byMusic & Arts as compared to American Music. Gross profit margin forthe direct response division was 31.6% for the quarter compared to 33.7% in thesecond quarter of 2004. The decrease was primarily due to increased activity bycompetitors over the Internet which led to pricing pressure (2.4%), partiallyoffset by a decrease in freight costs (0.3%).

 

Selling,general and administrative expenses for the three months ended June 30,2005 increased 26.3% to $92.4 million from $73.2 million for the sameperiod in 2004. As a percentage of net sales, selling, general and administrativeexpense was 23.0% for the second quarter in 2005 compared to 21.5% for the sameperiod in 2004. Selling, general and administrative expenses for the GuitarCenter stores in the second quarter were 20.3% as a percentage of net salescompared to 20.6% in last year’s first quarter. The decrease is primarily dueto a decrease in advertising and promotional costs (0.4%), a decrease in salarycosts (0.2%), partially offset by an increase in travel and entertainment(0.2%) and medical insurance (0.1%).

 

Selling,general and administrative expenses for the Music & Arts division were59.4% of sales in the second quarter compared to 50.8% in the same period lastyear. Excluding the $2.8 million of the acquisition charges recorded as SG& A, selling, general and administrative expenses were 47.7% of salescompared to 50.8% for the same period last year. The lower selling, general andadministrative expenses, excluding the acquisition charges, is due to the lowerselling, general and administrative expenses delivered by Music & Artsas compared to American Music.

 

Selling,general and administrative expenses for the direct response division were 21.8%of sales compared to 21.4% for the three month periods ended June 30, 2005and 2004, respectively. The increase is primarily due to increased on-lineadvertising costs (1.2%), partially offset by a reduction in bonus expense(0.3%), a decrease in credit card fees (0.2%) and a decrease in generalinsurance costs (0.2%).

 

Operatingincome increased 9.0% to $22.9 for the three months ended June 30, 2005from $21.0 million in the comparable 2004 period. This increase reflects arelatively good performance by the Guitar Center and Musician’s Friendbusinesses, offset by an operating loss of approximately $4.4 million for theMusic & Arts segment. As expected, the Music & Arts operatingloss includes $2.8 million of acquisition charges resulting primarily from theelimination of a redundant point of sales system, severance costs and movingcosts to relocate certain American Music employees to the Music & Artscorporate office in Maryland and $0.6 million related to the write down ofinventory carried at Music & Arts resulting from a change in inventoryassortment.

 

Interestexpense, net for the three months ended June 30, 2005, increased to $1.9 millionfrom $1.4 million in the second quarter of 2004. The increase in interestexpense is due primarily to the interest

 

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expense incurred onborrowing related to the acquisition of Music & Arts Center, Inc.,partially offset by income earned on the investment of excess cash for thequarter.

 

In thethree months ended June 30, 2005, a $8.1 million provision for incometaxes was recorded compared to $7.4 million for the same period last year,based on effective tax rates of approximately 38.5% and 38%, respectively.There was a change in the effective tax rate as a result of higher blendedstate income tax rates.

 

Netincome for the three months ended June 30, 2005 increased 6.3% to $12.9million, compared to $12.1 million in the same period last year as a result ofthe combinations of factors described above.

 

**SixMonths Ended June 30, 2005 Compared to the Six Months Ended June 30,2004**

 

Netsales for the six months ended June 30, 2005 increased 15.9% to $798.7 million,compared to $689.3 million in the same period last year. Net sales from GuitarCenter stores for the six months ended June 30, 2005 totaled $594.3million, a 12.9% increase from $526.4 million for the same period in 2004.  Sales from new stores contributed $35.7million and represent 52.5% of the total increase in retail store sales. Comparablestore sales from our Guitar Center division increased 6%.

 

The operationsof American Music and Music & Arts for the six months ended June 30,2005 reflect the combined results of American Music for the entire period andMusic & Arts from April 15, 2005 through June 30, 2005. Netsales from Music & Arts for the six months ended June 30, 2005totaled $34.9 compared to $18.0 million in 2004 primarily due to theacquisition. Comparable Music & Arts stores sales increased 2%.

 

Netsales from the direct response channel totaled $169.5 million for the sixmonths ended June 30, 2005, a $24.5 million, or 16.9%, increase from 2004.This increase primarily reflects the improved leveraging of an expanding buyerfile and advertising costs offset by increased competition. We expect thistrend of increased competition in the direct response channel and its negativeimpact on that segment’s net sales and gross margin to continue through atleast the end of 2005. Sales from the contact center, which represent salesplaced via phone, live chat, mail and e-mail, increased 9.4% to $70.8 millionfrom $64.6 million for the six months ended June 30, 2005 compared to 2004.Internet sales from orders placed via the Musician’s Friend and Giardinelli websites increased 22.8% to $98.7 million from $80.4 million for the same periodlast year. The growth of web-based sales reflects the continued trend of our catalogcustomers’ preference in using the web to place their orders, the success ofweb-based promotions, and that the web site a more complete inventorypresentation than our catalogs.

 

Grossprofit for the six months ended June 30, 2005 compared to 2004 increased 19.9%to $226.5 million from $188.9 million. Gross profit as a percentage of net sales for the six months ended June 30,2005 compared to 2004 increased to 28.4% from 27.4%. Gross profit as apercentage of net sales for Guitar Center retail was 26.9% compared with 25.7%for the six months ended June 30, 2004.  The increase is due to a higher selling margin(1.1%) and reduced freight costs (0.1%). We realized higher selling marginprincipally from expansion of our proprietary product which yield a highermargin, a change in product mix and better pricing from our vendors.  The gross profit margin for the Music &Arts stores was 40.4% compared to 34.7% for the same period last year.  The higher margin is due to the higher margindelivered by Music & Arts  ascompared to American Music. Gross profit margin for the direct responsedivision was 30.8% for the six months ended June 30, 2005 compared to 32.8%in the same period last year. The decrease was primarily due to increasedactivity by competitors over the Internet which led to pricing pressure (2.4%),partially offset by a decrease in freight costs (0.4%).

 

Selling,general and administrative expenses for the six months ended June 30, 2005increased 19.9% to $176.9 million from $147.5 million for the sameperiod in 2004. Selling, general and administrative expenses as a percentage ofnet sales, for the six months ended June 30, 2005 compared to 2004, increasedto 22.1% from 21.4%. The primary reason for the increase was $2.8 million ofthe acquisition charges associated with the acquisition of Music &Arts Center, Inc were recorded as SG & A. Selling, general andadministrative expenses for the Guitar Center stores were 20.6% as a percentageof sales for the six months ended June 30, 2005 compared to 20.5% for thesame period last year. The slight increase is due to an increase in rentassociated with leasing store equipment (0.2%), an increase in medicalinsurance (0.1%), partially offset by decreased bad debt (0.1%) due to bettercollections and a decrease in advertising and promotional costs (0.1%).

 

Selling,general and administrative expenses for the Music & Arts division were56.8% of sales for the six months ended June 30, 2005 compared to 48.3% inthe same period last year. Excluding the acquisition 

 

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charges of $2.8 million,selling, general and administrative expense were 48.5% of sales compared to48.3% for the same period last year.

 

Selling,general and administrative expenses for the direct response division were 20.6%of sales compared to 21.5% for the six months ended June 30, 2005 and 2004,respectively. The improvement is primarily due to a reduction in bonus costs(0.7%), a decrease in bad debt (0.1%), a decrease in depreciation and amortization(0.2%), a decrease in credit card expense (0.1%), a decrease in generalinsurance (0.2%), partially offset by an increase in advertising expenseprimarily related to programs to increase web traffic (0.4%).

 

Operatingincome increased 19.9% to $49.6 million from $41.4 million for the six monthsended June 30, 2005. This increase reflects a relatively good performanceby the Guitar Center and Musician’s Friend businesses, offset somewhat by anoperating loss of approximately $5.7 million for the Music & Artssegment for the six months ended June 30, 2005. As expected, the Music &Arts operating loss includes $3.4 million of acquisition charges resultingprimarily from 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 and the write down ofinventory carried at Music & Arts resulting from a change in inventoryassortment.

 

Interestexpense, net for both the six months ended June 30, 2005 and 2004 was $2.8 million.Interest expense includes interest on borrowings in support of the acquisitionof Music & Arts Center, Inc., partially offset by income earnedon the investment of excess cash for the period ending June 30, 2005.

 

In thesix months ended June 30, 2005, a $18.0 million provision for income taxeswas recorded compared to $14.7 million for the same period last year, based onan effective tax rate of approximately 38.5% and 38%, respectively. There was achange in the effective tax rate as a result of higher blended state income taxrates.

 

Netincome for the six months ended June 30, 2005 increased 20.4% to $28.8 million,compared to $23.9 million in the same period last year as a result of thefactors 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. As of June 30, 2005, we had $38.1 million in borrowings underour credit facility and had available borrowings of $68.9 million (net of $8.0million of outstanding letters of credit).

 

In February of2005, we amended our credit facility with a syndicate of banks led by WellsFargo Retail Finance. The credit facility permits borrowings up to $125 million(which may be increased to $150 million at our option), subject to borrowingbase limitations. The actual amount available is tied to our inventory andreceivable base, and repayment obligations under the credit facility aresecured by liens on our principal assets. Borrowing options are prime rate (6.25%at June 30, 2005) plus applicable prime margin, or London InterbankOffered Rate (“LIBOR”), or LIBOR (six month rate at June 30, 2005 was 3.7%)plus applicable LIBOR margin. The applicable prime and LIBOR margins are basedupon levels of excess availability and adjusted quarterly. If excessavailability is greater than $20 million, the applicable prime margin is 0.00%and applicable LIBOR margin is 1.0%. If excess availability is less than orequal to $20 million and greater than $10 million, the applicable prime marginis 0.00% and the applicable LIBOR margin is 1.25%. If excess availability isless than or equal to $10 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.5%. An unused fee of 0.25% is assessed on theunused portion of the credit facility. The agreement underlying the creditfacility includes significant restrictive negative covenants. Among otherthings, these covenants restrict our ability to incur debt and issue specifiedequity instruments, incur liens on our assets, make any significant changes inour corporate structure or the nature of our business, dispose of assets, makeguaranties, prepay debt, engage in a change in control transaction, paydividends, make investments or acquisitions, engage in transactions with affiliatesand incur capital expenditures, and also require that we satisfy a minimumavailability test. The minimum availability test requires that we maintain $10million of reserved availability under the agreement based on its borrowingbase limitations.  The amount we disclosein our public reports from time to time as available to borrow under theagreement is already reduced by this required reserve and outstanding lettersof credit, and thus represents a net amount available under the agreement. Theagreement also includes representations and warranties which must be true eachtime we borrow 

 

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funds under thecredit facility and affirmative covenants. The full text of the contractual requirements imposed by this financingis set forth in the Amended and Restated Loan and Security Agreement andrelated amendments which have been filed with the Securities and ExchangeCommission.  We were in compliance withsuch requirements as of June 30, 2005. Subject to limited cure periods, the lenders under our credit facilitymay demand repayment of these borrowings prior to stated maturity upon theoccurrence of specified events, including if we breach the terms of theagreement, suffer a material adverse change, engage in a change in controltransaction, suffer a significant adverse legal judgment, default on othersignificant obligations, or in the event of specified events ofinsolvency.  The credit agreement maturesin December 2010.

 

On June 16,2003, we completed the issuance of $100 million principal amount of 4.00%Senior Convertible Notes due 2013 (the “Notes”). The Notes bear interest at therate of 4.00% per annum, subject to the payment of contingent interest undercertain circumstances, and are convertible into shares of common stock at aconversion price of $34.58 per share, subject to adjustment under specifiedcircumstances. Under the contingent conversion feature of the Notes, subject tocertain exceptions, they are not convertible into common stock unless and untilthe trading price of the common stock reaches at least $41.50 for a specifiedperiod in advance of each quarterly conversion period or designated corporateevents occur. As of June 30, 2005, the notes were convertible for thecurrent quarterly conversion period. The Notes will also become convertibleupon the occurrence of specified corporate transactions and other eventsdescribed in the indenture. The final maturity of the Notes is July 2013,although holders may require us to repurchase the Notes at their election in July 2008,July 2010 or upon the occurrence of a change in control, in each case fora purchase price equal to the original principal amount plus accruedinterest.  We may call the Notes forredemption commencing in July 2006 subject to the payment of a redemptionpremium of 1.6% if redeemed prior to July 2007 and 0.8% if redeemed priorto July 2008 (thereafter there is no redemption premium). The indenturegoverning the Notes does not limit our ability to incur indebtedness orotherwise substantively restrict the operation of our business to anysignificant degree.  Subject to limitedcure periods, the holders of the Notes may demand repayment of these borrowingsprior to the stated maturity upon the occurrence of specified events, includingif we fail to pay interest or principal when due, fail to satisfy ourconversion obligation, if another obligation of ours having an outstandingprincipal amount in excess of $15 million is accelerated prior to statedmaturity and upon the occurrence of specified events of insolvency.

 

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 Centerretail stores. Under these agreements, we leased a total of $10.5 million inequipment and other property. The agreements call for monthly payments of$138,000 for a term of 36 months through September 1, 2005 with an optionto extend through September 30, 2009 and monthly payments of $48,000 for aterm of 24 months through December 28, 2005.

 

Theterms of our significant financing agreements, including those related to ourcredit facility, the Senior Convertible Notes and the equipment leasefacilities described above, are not dependent on any change in our creditrating. We believe that the key company-specific factors affecting our abilityto maintain our existing debt and lease financing relationships and to accesssuch capital in the future are our present and expected levels of profitabilityand cash flow from operations, our working capital and fixed asset collateralbases, our expected level of capital expenditures, and the level of equitycapital of the Company relative to the level of debt obligations. In addition,as noted above, our existing agreements include significant restrictions onfuture financings, including among others, limits on the amount of indebtednessthat we may incur and whether or not such indebtedness may be secured by any ofour 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 see, Item 2. Properties, “—DisclosuresAbout Contractual Obligations and Commercial Commitments” and Note 9 to theConsolidated Financial Statements in our Annual Report on Form 10-K forthe year ended December 31, 2004.

 

Netcash provided by operating activities was $15.4 million for the six monthsended June 30, 2005 compared to net cash used in operating activities of $6.5million for the same period last year. The largest use of cash was an increasein inventories of $45.9 million. The increase in merchandise inventory is primarilydue to the thirteen new Guitar Center stores and a more aggressive purchasingstrategy by our merchandising group to prepare for sales promotions expected inthe third quarter. The increase in accounts payable was due mostly to higherbusiness volumes and the timing of vendor payments.

 

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Cashused in investing activities increased to $113.9 million for the six monthsended June 30, 2005 compared to $10.8 million for the same period lastyear. The current period investing activites consisted primarily of thepurchase of Music & Arts, Inc. for approximately $93.0 million, acorporate airplane of $10.6 million, capital expenditures for store expansionsand remodels of $19.4 million compared to $6.8 million in the prior period, andcomputer equipment purchases of $6.3 million in the current period compared to$3.4 million in the same period last year. Additionally, we received proceedsfrom the sale of available-for-sale securities of $20.1 million.

 

Cashprovided by financing activities totaled $48.1 million for the six months endedJune 30, 2005 compared to $15.8 million used in the same period last year.The cash provided by financing activities consists primarily of the borrowingsunder our credit facility of $38.1 million and remaining from the proceedsreceived from the exercise of stock options and employee purchase of our commonstock. The increase in borrowings was required to support the Music &Arts acquisition.

 

Webelieve that our current operating cash flow, working capital, and cash andcash equivalents on hand will be sufficient to meet our obligations in theordinary course of business, including capital expenditures and new storeopenings. In the second quarter of 2005, we funded the cash component of theMusic & Arts acquisition (including the repayment of assumed debt)with approximately $93.0 million from available cash, sales of marketablesecurities and borrowings under our credit facility.

 

Weintend to pursue an aggressive growth strategy by opening additional stores innew and existing markets.  During the sixmonths ended June 30, 2005, we opened thirteen new Guitar Center stores (sevenlarge format and six small format stores). Each new large format Guitar Centerstore typically has required approximately $1.3 to $1.5 million for grossinventory.  Historically, our cost ofcapital improvements for a large format Guitar Center store has beenapproximately $900,000, consisting of leasehold improvements, fixtures andequipment. We incur higher costs in some geographic areas, particularly theNortheast, and when we build a larger flagship store.  The first of the small format units wasopened in late 2000 and 29 more have been opened as of June 30, 2005. Oursmall format stores have typically required approximately $700,000 in capitalexpenditures and require approximately $1.0 million to $1.2 million ininventory.

 

We arealso anticipating additional capital and strategic requirements related toimproving our fulfillment facilities, upgrading our technology and systems, andpursuing new opportunities in the e-commerce activities of our retail anddirect response divisions as well as related businesses.

 

Ourdistribution center in the Indianapolis, Indiana area supports our GuitarCenter retail store operations. We have a 10-year agreement to lease thefacility and we also have numerous additional commitments necessary to supportthe operations of the facility. Starting in 2003, nearly all product flowsthrough the distribution facility, with the exception of special orders whichwill continue, for the most part, to be drop shipped to our stores. A portionof the costs of operating this facility are absorbed into our Guitar Centermerchandise inventories and recognized as an element of cost of goods sold whenthe related inventory is sold.

 

We arein the process of planning an expansion of our Guitar Center distributioncenter from 500,000 square feet to 750,000 square feet. We anticipate thisexpansion to be completed in early 2006. The larger facility will increase ourcapacity to support continued expansion in 2006 and beyond. We anticipatemaking additional capital investments of $6.0 to $8.0 million and we will incurincreased rent expense when the facility is completed in 2006.

 

Wealso continue to make significant investments in information technology acrossour businesses and to incur costs and make investments designed to expand thereach of our businesses on the Internet. The costs of these initiatives and other investments related to ourbusinesses will continue to be significant.

 

Ourexpansion strategy is to continue to increase our market share in existingmarkets and to penetrate strategically selected new markets.  We opened a total of 14 Guitar Center storesin each of 2004 and 2003, and currently anticipate opening 22 to 26 GuitarCenter stores in 2005. This includes 11-13 large format stores and 11-13 smallformat stores. On April 15, 2005 we completed the acquisition of Music &Arts Center, Inc. and we combined our American Music business and Music &Arts, with the combined business operating under the Music & Arts name.We also continue to believe that there exists a number of additionalacquisition opportunities in the relatively fragmented band instruments marketthat could be a good fit with our company and continue to pursue acquisitionopportunities.

 

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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. While we cannot provide assurancethat we will complete any further acquisition transactions, in the ordinarycourse of our business we investigate and engage in negotiations regarding suchopportunities. Acquisitions will be financed with cash on hand, drawings underour existing credit facilities, expansion of our credit facilities, issuance ofdebt or equity securities, or a combination, depending upon transaction sizeand market conditions, among other things.

 

Ourknown capital resource and liquidity requirements for 2005 are presentlyexpected to be primarily provided by cash on hand, net cash flow fromoperations and borrowings under our credit facility. Depending upon marketconditions, we may also elect or be required to raise additional capital in theform of common or preferred equity, debt or convertible securities for thepurpose of providing additional capital to fund working capital needs orcontinued growth of our existing business, or to refinance existingobligations. Any such financing activity will be dependent upon many factors,including our liquidity needs, market conditions and prevailing market terms,and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

 

### **New Accounting Pronouncements**

### ** **

In May 2005, theFASB issued SFAS 154, *“Accounting Changes andError Corrections,” which replaces APB Opinion No. 20, “AccountingChanges,”* and supersedes FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements—an amendment of APB Opinion No. 28.”SFAS 154 requires retrospective application to prior periods’ financialstatements of changes in accounting principle, unless it is impracticable todetermine either the period-specific effects or the cumulative effect of thechange. When it is impracticable to determine the period-specific effects of anaccounting change on one or more individual prior periods presented, SFAS 154requires that the new accounting principle be applied to the balances of assetsand liabilities as of the beginning of the earliest period for whichretrospective application is practicable and that a corresponding adjustment bemade to the opening balance of retained earnings for that period rather thanbeing reported in an income statement. When it is impracticable to determinethe cumulative effect of applying a change in accounting principle to all priorperiods, SFAS 154 requires that the new accounting principle be applied as ifit were adopted prospectively from the earliest date practicable. SFAS 154 willbe effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. This statement does not changethe transition provisions of any existing accounting pronouncements, includingthose that are in a transition phase as of the effective date of thisstatement. We do not expect the provisions of the SFAS 154 to have asignificant impact on our results of operations.

 

In November 2004, the FASBissued Statement of Financial Accounting Standards, or SFAS No. 151, “*Inventory Costs - An Amendment of ARB No. 43, Chapter 4*”.SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, “*Inventory Pricing*”, to clarify the accounting for abnormalamounts of idle facility expense, freight, handling costs, and wasted material(spoilage). SFAS No. 151 is effective for fiscal years beginning after June 15,2005 and is required to be adopted in the first quarter of fiscal 2006. We donot expect the adoption of SFAS No. 151 to have a material impact on ourconsolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004)Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R requires thatthe fair value from all share-based payment transactions, including stockoptions, be recognized in the financial statements at fair value. SFAS No. 123Ris effective for public companies in the first fiscal year beginning on orafter January 1, 2006. We will adopt the provisions of this statement inthe first quarter of 2006. We anticipate adopting SFAS No. 123R using themodified prospective method, which will not require us to restate any priorperiods.  We are currently evaluating theeffect of adoption of SFAS No. 123R will have on our consolidatedfinancial statements and have not determined whether the adoption will resultin amounts that are similar to the current pro forma disclosure under SFAS No. 123.

 

### **Seasonality**

### ** **

Ouroperating results are not highly seasonal, except for the effect of the holidayselling season in November and December. Sales in the fourth quarter are typically significantly higher on a perstore basis and through the direct response unit than in any other quarter. Inaddition, band rental season for Music & Arts starts in August andcarries through mid-October.

 

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### **Inflation**

### ** **

Webelieve that the relatively moderate rates of inflation experienced in recentyears have not had a significant impact on our net sales or profitability.

 

### **Forward-Looking Statements**

### ** **

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 business and other factors affectinggrowth in sales and earnings.  Specificforward-looking statements are provided regarding our management’s currentviews regarding comparable store sales, new store openings, and capitalexpenditure levels.  Statements regardingnew store 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. Comparable store salesgrowth is highly dependent upon the state of the economy, the effectiveness ofour sales and promotion strategies, and the effect of competition, includingother national operators of music products stores attempting to implementnational growth strategies.

 

Salesand earnings trends are also affected by many other factors including, amongothers, world and national political events, general economic conditions, theeffectiveness of our promotion and merchandising strategies, changes in themusic products industry, retail sales trends and the emergence of new orgrowing specialty retailers of music products. In light of these risks, there can be no assurance that theforward-looking statements contained in this report will in fact berealized.  The statements made by us inthis report represent our views as of the date of this report, and it shouldnot be assumed that the statements made herein remain accurate as of any futuredate.  We do not presently intend toupdate these statements and undertake no duty to any person to affect any suchupdate under any circumstances.

 

Forfurther discussion of risks associated with our business, please see thediscussion under the caption “Risks Related to the Business.”

 

**RisksRelated to the Business**

 

Aninvestment in our securities involves a high degree of risk.  Described below are some of the risks anduncertainties facing our company. There may be additional risks that we do notpresently know of or that we currently consider immaterial.  All of these risks could adversely affect ourbusiness, results of operations, liquidity and financial position.  A shortfall in comparative sales growth inany period will likely cause a shortfall in earnings, and result in financialperformance below that for which we have planned or the investment communityexpects.

 

*Wemay be unable to meet our Guitar Center retail store growth strategy, whichcould adversely affect our results of operations.*

* *

Ourretail store growth strategy includes opening new stores in new and existingmarkets and increasing sales at existing locations.  As of June 30, 2005 we  operated 149 Guitar Center stores.  We opened a total of 14 Guitar Center stores in2004, have opened a total of 13 Guitar Center Stores to date in 2005, andcurrently expect to open a total of approximately 22 to 26 Guitar Center storesin 2005. This includes 11-13 large format stores and 11-13 small format stores.Our planned store opening schedule may be affected by any acquisitions wemay transact during a given period. If we complete any such transactions, ourplanned organic store openings may be reduced.

 

Thesuccess of our Guitar Center retail store expansion plans depend on manyfactors, including:

 

•                  identification of suitable retailsites and appropriate acquisition candidates;

 

•                  negotiation of acceptable leaseterms;

 

•                  hiring, training and retention ofskilled personnel;

 

•                  availability of adequate capital;

 

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•                  sufficient management and financialresources to support the new locations; and

 

•                  vendor support.

 

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

 

*We face unique competitive and merchandising challengesin connection with our plans to open additional Guitar Center retail stores innew markets.*

 

Aspart of our retail growth strategy, we plan to open and/or acquire additionalGuitar Center stores in new markets, which could include international markets.This expansion into new markets will present unique competitive andmerchandising challenges, including:

 

•                  significant start-up costs, includingpromotion and advertising;

 

•                  higher advertising and otheradministrative costs as a percentage of sales than is experienced in maturemarkets that are served by multiple stores, particularly in large urban marketswhere radio and other media costs are high;

 

•                  management of stores in distantlocations or foreign countries;

 

•                  availability of desirable productlines; and

 

•                  our expansion may involveacquisitions, including acquisitions in business segments in which we havelimited or no experience.

 

Any of thesefactors may lead to a shortfall in revenues or an increase in costs withrespect to the operation of these stores. If we are not able to operate these stores profitably, our results ofoperations would be adversely affected.

 

*Our Guitar Center retail store expansion strategy, includingour strategy of clustering retail stores, may adversely impact our comparablestore sales.*

 

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

 

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

 

We donot know whether our new stores will achieve sales or profitability levelssimilar to our existing stores.  Ourexpansion strategy includes clustering stores in existing markets.  Clustering has in the past and may in thefuture result in the transfer of sales to the new store and a reduction in theprofitability of an existing store.  In addition,a variety of factors affect our comparable store sales results, including:

 

•                  competition;

 

•                  economic conditions, including  in particular, discretionary consumerspending;

 

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•                  consumer and music trends;

 

•                  changes in our merchandise mix;

 

•                  product distribution; and

 

•                  timing and effectiveness of ourpromotional events.

 

A shortfall incomparative sales growth in any period will likely cause a shortfall inearnings, and result in financial performance below that for which we haveplanned or the investment community expects.

 

*Ourgrowth plans depend on our completion of acquisitions, and these transactionsinvolve special risks.*

* *

Webelieve that our expansion may be accelerated by the acquisition of existingmusic product retailers. For example, we completed the acquisition of Music &Arts Center, Inc. on April 15, 2005. The combined operations ofAmerican Music and Music & Arts for the second quarter reflect thecombined results of American Music for the full quarter and Music &Arts from April 15, 2005 through June 30, 2005. Acquisitions such asthe Music & Arts Center, Inc. transaction involve a number ofspecial risks, including:

 

•                  diversion of our management’sattention;

 

•                  integration of the acquired businesswith our business; and

 

•                  unanticipated legal liabilities andother circumstances or events.

 

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

 

Inaddition, we regularly investigate acquisition opportunities complementary toour Guitar Center, Musician’s Friend and Music & Arts businesses.Accordingly, in the ordinary course of our business, we regularly consider,evaluate and enter into negotiations related to potential acquisitionopportunities. We may pay for these acquisitions in cash or securities,including equity securities, or a combination of both. We cannot assure youthat attractive acquisition targets will be available at reasonable prices orthat we will be successful in any such transaction.

 

*We depend on a relatively small number of manufacturers,suppliers and common carriers who may not be able or desire to supply ourrequirements.*

* *

Brand recognitionis of significant importance in the retail music products business. As aresult, we depend on a relatively small number of manufacturers and suppliersfor both our existing retail stores and the direct response unit as well as ourexpansion goals for each of these units. We do not have any long-term contractswith our suppliers, and any failure to maintain our relationships with our keybrand name vendors would have a material adverse effect on our business. Anumber of the manufacturers of the products we sell are limited in size andmanufacturing capacity and have significant capital or other constraints. Thesemanufacturers may not be able or willing to meet our increasing requirements forinventory, and we cannot assure you that sufficient quantities or theappropriate mix of products will be available in the future to supply ourexisting stores and expansion plans. These capacity constraints could lead toextended lead times and shortages of desirable products. The risk is especiallyprevalent in new markets where our vendors have existing agreements with otherdealers and thereby may be unwilling or unable for contractual or other reasonsto meet our requirements. The efficient operation of our distribution centerfor the Guitar Center stores is also highly dependent upon compliance by ourvendors with precise requirements as to the timing, format and composition ofshipments, which in many instances requires changes and upgrades to the operationalprocedures and logistics and supply chain management capabilities of vendors,all of which are outside of our control. Additionally, many of our vendorsreceive product from overseas and depend on an extensive supply chain includingcommon carriers and port access to transport merchandise into the country.Foreign manufacturing is subject to a number of risks, including political andeconomic disruptions, the imposition of tariffs, quotas and other import orexport controls, and changes in governmental policies. We rely on commoncarriers to transport product from our vendors to our central distributioncenter in Indiana, and from the

 

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distribution facility toour Guitar Center stores. Similarly, Musician’s Friend relies on commoncarriers to transport product to its fulfillment center in Kansas City,Missouri and onward to consumers. Any disruption in the services of commoncarriers due to employee strikes or other unforeseen events could impact ourability to maintain sufficient quantities of inventory in our retail locationsor to fulfill orders by direct response customers.

 

*We face products liability risk.*

 

Products that we developor sell may expose us to liability from claims by users of such products fordamages including, but not limited to, bodily injury or property damage. Thisrisk is expected to increase as we use the capabilities of our Guitar Centerand Musician’s Friend distribution centers to increase the private label andother proprietary product that we offer. Much of this product is manufacturedby small companies located overseas. We currently maintain products liabilityinsurance coverage in amounts that we believe are adequate. However, there canbe no assurance that we will be able to maintain such coverage or obtainadditional coverage on acceptable terms in the future, or that such insurancewill provide adequate coverage against all potential claims.

 

*Weface significant competition, and our efforts to increase our market share maybe inhibited by existing or new competitors also trying to execute nationalexpansion strategies.*

* *

Theretail music products industry is fragmented and highly competitive. We competewith many different types of music product retailers, including conventionalretailers, as well as other catalog and e-commerce retailers, who sell many ormost of the items we sell. We believe that large format music product retailerssuch as our company will seek to expand in part through the acquisition ofsmall, independently owned stores or franchises, and we anticipate increasedcompetition in our existing markets and planned new markets from theseconsolidating retailers. These retailers may identify target companies orexecute their acquisition strategies more effectively than our company.  In addition, these retailers may have greaterfinancial resources or other competitive advantages as compared to our company.Our expansion to new markets will be inhibited by these and other establishedcompetitors. In addition, one or more of our competitors may adopt a new,innovative store format or retail selling method. If we are not able to competeeffectively, we may fail to achieve market position gains or may lose marketshare.

 

Severallarge mass merchants, including Wal-Mart and Costco, sell musical instrumentsin categories that we compete in, including entry-level guitars, electronickeyboards and band instruments, and thus could represent a significant sourceof future competition for our retail and direct response businesses,particularly if these retailers expand their product lines beyond entry-levelmerchandise.

 

*We must grow our Music &Arts business in order to reach profitability and earn an acceptable return onour investment.*

 

In April 2001,we completed our acquisition of American Music Group, a New York-based retailerof band instruments. We had not previously participated in the band instrumentssegment of the music products business and had no prior experience in thisdistribution channel. The American Music division incurred significantoperating losses in 2003 and 2004. In April 2005, we completed ouracquisition of Music & Arts. Thus, we face the normal challenges of any acquisition, such asintegration of personnel and systems as well as the need to learn, understandand further develop this business. During 2005, we will face furthersignificant challenges as we attempt to combine the Music & Artsbusiness with our existing American Music business. Failure to execute on therequirements and initiatives described above could result in a poor or noreturn on our investments in American Music and Music & Arts,constitute a distraction of the efforts of our management team from the GuitarCenter and Musician’s Friend brands and potentially require us to recognize animpairment in the significant amount of goodwill recorded in the acquisitionsof American Music, Music & Arts and several other smaller companies,which totaled $78.4 million at June 30, 2005.

 

*Our Music & Artsbusiness is dependent on state and local funding of primary and secondaryschools.*

 

*Our Music & Arts businessderives the majority of its revenue from sales or services to music students enrolledin primary and secondary schools.  Anydecrease in the state and local funding of such music programs could have amaterial adverse effect on our Music & Arts business and its resultsof operations.*

 

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*Wedepend on key personnel including our senior management who are important tothe success of our business.*

 

Historically,we have promoted employees from within our organization to fill senioroperations, sales and store management positions.  In order to achieve our growth plans, we willdepend upon our ability to retain and promote existing personnel to seniormanagement, and we must attract and retain new personnel with the skills andexpertise to manage our business. If we cannot hire, retain and promotequalified personnel, our business, results of operations, financial conditionand prospects could be adversely affected.

 

*Ourretail operations are concentrated in California, which ties our financialperformance to events in that state.*

* *

As of June 30,2005, our corporate headquarters as well as 23 of our 149 Guitar Center storeswere located in California, and stores located in that state generated 23.2%and 24.6% of our Guitar Center retail sales for the second quarter of 2005 and2004, respectively.  Although we haveopened and acquired stores in other areas of the United States, a significant percentageof our net sales and results of operations will likely remain concentrated inCalifornia for the foreseeable future. As a result, our results of operations and financial condition areheavily dependent upon general consumer trends and other general economicconditions in California and are subject to other regional risks, includingearthquakes.  We do maintain earthquakeinsurance, but such policies carry significant deductibles and otherrestrictions.

 

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

 

Ourbusiness is sensitive to consumer spending patterns, which can be affected byprevailing economic conditions. A downturn in economic conditions in one ormore of our markets, such as occurred after September 11, 2001, could havea material adverse effect on our results of operations, financial condition,business and prospects.  Although weattempt to stay informed of consumer preferences for musical products andaccessories typically offered for sale in our stores, any sustained failure onour part to identify and respond to trends would have a material adverse effecton our results of operations, financial condition, business and prospects.

 

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

 

Theadoption or modification of laws or regulations, or revised interpretations ofexisting laws, relating to the direct response industry could adversely affectthe manner in which we currently conduct our catalog and e-commerce businessand the results of operations of that unit. For example, laws and enforcementpractices related to the taxation of catalog, telephone and online commercialactivity, including the collection of sales tax on direct response sales,remain in flux. In addition, the growth and development of the market foronline commerce may lead to more stringent consumer protection laws, both inthe United States and abroad, that may impose additional burdens on us. Lawsand regulations directly applicable to communications or commerce over theInternet are becoming more prevalent. The law of the Internet, however, remainslargely unsettled, even in areas where there has been some legislative action.It may take years to determine whether and how existing laws such as thosegoverning intellectual property, consumer privacy, sales-based and othertaxation of e-commerce transactions and the like are interpreted and enforced.Any adverse change in any of these laws or in the enforcement, interpretationor scope of existing laws could have a material adverse effect on our resultsof operations, financial condition or prospects.

 

*We facerisks created by litigation, governmental proceedings, labor disputes orenvironmental matters.*

 

We are involved in anumber of litigation matters in the ordinary course of our business.  Among these cases are two putative classactions brought against us for alleged violations of what is known asCalifornia’s “wage and hour” law.  Theplaintiffs have alleged, among other things, that we improperly failed todocument and enforce break-time and lunch-time periods for employees.  We intend to defend these mattersvigorously.  Current and futurelitigation that our Company is involved in may result in substantial costs andexpenses and significantly divert the attention of our management regardless ofthe outcome.  In addition, current andfuture litigation, governmental proceedings, labor disputes or environmental matterscould lead to increased costs or interruptions of our normal businessoperations.

 

*Wemust manage efficiently the expansion of our Direct Response business,including the musiciansfriend.com website, our systems that process orders inour Direct Response business, and our fulfillment resources in order to serviceour customers properly.*

* *

Ourdirect response business, particularly our e-commerce business, will requiresignificant investments to respond to anticipated growth and competitivepressures. If we fail to rapidly upgrade our website in order to

 

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accommodate increasedtraffic, we may lose customers, which would reduce our net sales. Furthermore,if we fail to expand the computer systems that we use to process and shipcustomer orders and process payments and the fulfillment facilities we use tomanage and ship our inventory, we may not be able to successfully distributecustomer orders. We experienced some delays of this sort in 2001 in connectionwith the consolidation of our fulfillment centers. As a result, we could incurexcessive shipping costs due to the need to split delayed shipments, increasedmarketing costs in the form of special offers to affected customers or the lossof customers altogether. We may experience difficulty in improving andmaintaining such systems if our employees or contractors that develop ormaintain our key systems become unavailable to us.  We have experienced periodic servicedisruptions and interruptions, which we believe will continue to occur, whileenhancing and expanding these systems.

 

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

 

Ourrelationships with our e-commerce customers may be adversely affected if thesecurity measures that we use to protect their personal information, such ascredit card numbers, are ineffective. If, as a result, we lose customers, our net sales could decrease. Werely on security and authentication technology that we license from third parties.With this technology, we perform real-time credit card authorization andverification with our bank. We cannot predict whether events or developmentswill result in a compromise or breach of the technology we use to protect acustomer’s personal information. Furthermore, our servers may be vulnerable to computer viruses, physicalor electronic break-ins and similar disruptions. We may need to expendsignificant additional capital and other resources to protect against asecurity breach or to alleviate problems caused by any breaches. We cannotassure that we can prevent all security breaches.

 

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

 

If weface material delays in introducing new services, products and enhancements,our e-commerce customers may forego the use of our services and use those ofour competitors. To remain competitive, we must continue to enhance and improvethe functionality and features of our online store.  The Internet and the online commerce industryare rapidly changing. If competitors introduce new products and servicesembodying new technologies, or if new industry standards and practices emerge,our existing website and proprietary technology and systems may becomeobsolete. To develop our website and other proprietary technology entailssignificant technical and business risks. We may use new technologiesineffectively or we may fail to adapt our website, our transaction processingsystems and our computer network to meet customer requirements or emergingindustry standards. In addition, the success of e-commerce may result ingreater efficiency and lower prices, which could have an adverse effect onselling prices and margins in our retail store business and in our catalogbusiness and generally constrain profitability in the specialty retailbusiness.

 

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

 

Werely on our computer hardware and software systems for the efficient operationof our retail stores and direct response business. Our information systemsprovide our management with real-time inventory, sales and cost information thatis essential to the operation of our business. Due to our number of stores,geographic diversity and other factors, we would be unable to generate thisinformation in a timely and accurate manner in the event our hardware orsoftware systems were unavailable. These systems are vulnerable to damage orinterruption from a number of factors, including:

 

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

 

•                  powerloss, computer systems failure, Internet and telecommunications or data networkfailure.

 

Asignificant information systems failure could reduce the quality or quantity ofoperating data available to our management. If this information wereunavailable for any extended period of time, our management would be unable toefficiently run our business, which would result in a reduction in our netsales.

 

Toattempt to mitigate these risks we have contracted services from third partiesto provide backup systems for our Guitar Center retail stores in the event of adisaster. These services are designed to permit our

 

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“mission critical”systems to be online within 48 hours following most disasters. Our Music &Arts and direct response business does not have redundant systems and would bevulnerable to catastrophic events. In the event of a disaster, our businesseswould most likely experience delays in processing and shipping orders.

 

*Our stock price could bevolatile.*

 

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

 

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

** **

Fromtime to time, we release projections and similar guidance regarding our futureperformance that represent our management’s estimates as of the date ofrelease. These projections, which are forward looking-statements, are preparedby our management and are qualified by, and subject to, the assumptions and theother information contained or referred to in the release. Our projections arenot prepared with a view toward compliance with published guidelines of theAmerican Institute of Certified Public Accountants, and neither our registeredpublic accountants nor any other independent expert or outside party compilesor examines the projections and, accordingly, no such person expresses anyopinion or any other form of assurance with respect thereto.

 

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

 

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

 

Anyfailure to successfully implement our operating strategy or the occurrence ofany of the events or circumstances set forth in this report could result in theactual operating results being different than the projections, and suchdifferences may be adverse and material.

 

**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 outstanding indebtedness represented by$100 million principal amount of Senior Convertible Notes due 2013 with a fixedinterest rate of 4% (subject to contingent interest) and our credit facilitywhich has a variable rate of interest generally consisting of stated premiumsabove LIBOR.  At June 30, 2005, wehad $38.1 million outstanding borrowings under our credit facility.  To the extent prevailing short-term interestrates fluctuate, the interest expense we incur on our credit facility willchange with a resulting effect (positive or negative) on our financial position,results of operations and cash flows. We do not use derivative financialinstruments in our investment portfolio. Historically, we have not carried significant cash balances and any cashin excess of our daily operating needs has been used to reduce ourborrowings.  Excess cash is invested inshort-term, high quality interest bearing investments.

 

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

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Exchange Act reports is recorded, processed, summarizedand reported within the time periods specified in the Securities and ExchangeCommission’s rules and forms and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow for timely decisions regardingrequired disclosure. In designing and evaluating the disclosure controls andprocedures, management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management is required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

As required by SEC Rule 13a-15(b),we carried out an evaluation, under the supervision and with the participationof our management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by thisreport.  Based on the foregoing, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures wereeffective.

 

Therehas been no change in our internal control over financial reporting during ourmost recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, our internal controls over financial reporting

 

**Part II.**          **OTHERINFORMATION**

 

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

 

In addition to those describedbelow, we are involved in various claims and legal actions arising in theordinary course of our business and, while the results of the proceedingscannot be predicted with certainty, we believe that the final outcome of suchmatters will not have a material adverse effect on our consolidated financialposition or results of operations.

 

On October 13, 2004, aputative class action lawsuit entitled Carlos Rodriguez v. The Guitar Center, Inc.[sic], Case No. GC322958, was filed in the Superior Court of the State ofCalifornia for the County of Los Angeles. The lawsuit was filed by an individual purporting to represent allhourly retail store employees employed by us within the State ofCalifornia.  On December 15, 2004, aputative class action lawsuit entitled James McClain et. al. v. Guitar CenterStores, Inc., Case No. BC326002, was filed in the Superior Court ofthe State of California for the County of Los Angeles.  The lawsuit was filed by three individualspurporting to represent all hourly retail store employees employed by us withinthe State of California.   Among otherthings, the lawsuits allege that we improperly failed to document and enforcebreak-time and lunch-time periods for such employees and seek an unspecifiedamount of damages, penalties and attorneys’ fees.  In the Rodriguez case, we have filed ananswer to the plaintiff’s complaint and are in the process of responding to theplaintiff’s requests for discovery.  TheMcClain complaint has been served on us, and our response to the complaint wasfiled on May 11, 2005.  The McClainand Rodriguez lawsuits are now pending before the same court.  Both matters have been consolidated formediation purposes.

 

On May 6, 2005, a lawsuitentitled Farnam Street Financial, Inc. v. Guitar Center, Inc., Case No. CT05-6546, was filed in the Fourth Judicial District in the State of Minnesotafor the County of Hennepin.  The lawsuit,which was filed by a Minnesota corporation, alleges breach of contract inconnection with the lease of certain equipment located in our corporate officeand retail stores.  Among other things,the lawsuit alleges that we have breached the contract by our failure to complywith the terms and conditions in connection with the return of the equipmentand seeks an unspecified amount of damages and attorneys’ fees.  We have filed an answer to the complaint andare in the process of propounding discovery on the plaintiff as well asresponding to plaintiff’s requests for discovery.

 

While we believe these lawsuits arewithout merit and intend to defend them vigorously, they may, regardless of theoutcome, result in substantial expenses and damages to us and may significantlydivert the attention of our management. There can be no assurance that we will be able to achieve a favorablesettlement of these lawsuits or obtain a favorable resolution of such lawsuitsif they are not settled.  An unfavorableresolution of these lawsuits could have a material adverse effect on ourbusiness, financial condition and results of operations.  Regardless of the outcome, the costs andexpenses incurred by us to defend these lawsuits could also have a materialadverse effect on our business, financial condition and results of operations.

 

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**Item 4.****                                                           Submissionof Matters to a Vote of Security Holders**

 

(a)                                  Ourannual meeting of stockholders (the “Annual Meeting”) was held on May 5,2005.  At that time there were present,in person or by proxy, 25,862,877 shares of our common stock.

 

(b)                                 Atthe annual meeting, four items were submitted to a vote of stockholders: (1) theelection 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 approval of an amendment to the 2004Guitar Center, Inc. Incentive Stock Award Plan to increase the authorizedcash award limit; and (4) to ratify the selection of KPMG LLP as GuitarCenter’s independent registered public accounting firm for the year ending December 31,2005.

 

(c)                                  (1)                                  Theresults of voting for the election of seven directors at the Annual Meetingwere as follows:

 

| **Nominee**      | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|------------------|------------|------------|------------|--------------|------------|
|             |       |       |       |         |       |
| Marty Albertson  |       | 22,933,440 |       | 933,224      |       |
| George Jones     |       | 23,548,038 |       | 318,626      |       |
| Larry Livingston |       | 23,496,786 |       | 369,878      |       |
| George Mrkonic   |       | 23,196,718 |       | 669,946      |       |
| Kenneth Reiss    |       | 23,550,929 |       | 315,735      |       |
| Walter Rossi     |       | 23,048,904 |       | 817,760      |       |
| Peter Starrett   |       | 22,421,403 |       | 1,445,261    |       |

 

 

(2)                                  Theresults of voting for the amendment to the 2004 Guitar Center, Inc.Incentive Stock Award Plan to increase the number of shares authorized forissuance were as follows:

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| 16,639,009 |       | 4,141,771   |       | 17,245      |       | 0                    |       |

 

(3)                                  Theresults of voting for the approval of the amendment to the 2004 Guitar Center, Inc.Incentive Stock Award Plan to increase the authorized cash award limit were asfollows:

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| 17,957,388 |       | 2,819,120   |       | 21,517      |       | 0                    |       |

 

(4)                                  Theresults of voting for the approval of the selection of KPMG LLP as GuitarCenter’s independent registered public accounting firm for the year ending December 31,2005 were as follows:

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| 22,906,372 |       | 952,581     |       | 7,709       |       | 0                    |       |

 

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

 

(a)                                  Exhibits:

 
| 31                                    Certification  of the Company’s Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                               |
| 31.1                           Certification  of the Company’s Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                     |
|                                                                                                                                                                                                                                                                                                                                               |
| 32                                    Certification  of the Company’s Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|                                                                                                                                                                                                                                                                                                                                               |
| 32.1                           Certification  of the Company’s Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                     |

 

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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 5th day of August 2005.

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

 

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