**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

| **ý**                                      |                                               | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                     |
|-------------------------------------------------|----------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                            | **For the quarterly period ended  March 31, 2004** |
|                                            |
| **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 Registrantas Specified in its Charter)

 

| **DELAWARE**                                                     |   | **95-4600862**                           |
|------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification Number) |
|                                                             |   |                                     |
| **5795  LINDERO CANYON ROAD  WESTLAKE VILLAGE, CALIFORNIA**      |   | **91362**                                |
| (Address of principal  executive offices)                        |   | (Zip Code)                               |
|                                                             |
| **(818) 735-8800**                                               |
| Registrant’s telephone  number, including area code         |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

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

 

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

 

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

 

As of May 3, 2004, 22,344,001 shares of our Common Stock, $.01 parvalue, 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  – March 31, 2004 and December 31, 2003                                       | 3      |
|         |                                                                                                           |   |
|         | Consolidated  Statements of Income – Three months ended March 31, 2004 and 2003                           | 4      |
|         |                                                                                                           |   |
|         | Consolidated  Statements of Cash Flows – Three months ended March 31, 2004 and 2003                       | 5      |
|         |                                                                                                           |   |
|         | Notes to  Consolidated Financial Statements                                                                    | 6      |
|         |                                                                                                           |   |
|         | **Item  2.  Management’s Discussion and  Analysis of Financial Condition and Results of Operations** | 8      |
|         |                                                                                                           |   |
|         | **Item  3.  Quantitative and Qualitative  Disclosures About Market Risk**                                 | 22     |
|         |                                                                                                           |   |
|         | **Item 4.  Controls and Procedures**                                                                      | 23     |
|         |                                                                                                           |   |
| **Part II.** | **Other Information**                                                                                          |   |
|         |                                                                                                           |   |
|         | **Item 6.  Exhibits**                                                                                     | 23     |

 

2

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**Guitar Center, Inc. and subsidiaries**

**Consolidated Balance Sheets******(In thousands, except per share amounts)

 
|                                                                                                                                                          |   | **March 31,****2004** |    | **December 31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|---------|------------------------|--------|
| **Assets**                                                                                                                                                    |   |                  |    |                   |   |
| Current assets:                                                                                                                                               |   |                  |    |                   |   |
| Cash and cash equivalents                                                                                                                                     |   | $                     | 18,961  |                   | $      | 5,350 |   |
| Accounts receivable, net                                                                                                                                      |   | 20,358                |    | 23,814                 |   |
| Merchandise inventories                                                                                                                                       |   | 289,708               |    | 288,873                |   |
| Prepaid expenses and deposits                                                                                                                                 |   | 9,992                 |    | 11,543                 |   |
| Deferred income taxes                                                                                                                                         |   | 5,631                 |    | 5,631                  |   |
| Total current assets                                                                                                                                          |   | 344,650               |    | 335,211                |   |
|                                                                                                                                                          |   |                  |    |                   |   |
| Property and equipment, net                                                                                                                                   |   | 92,779                |    | 93,347                 |   |
| Goodwill                                                                                                                                                      |   | 25,995                |    | 25,995                 |   |
| Deposits and other assets, net                                                                                                                                |   | 6,237                 |    | 6,318                  |   |
|                                                                                                                                                          |   | $                     | 469,661 |                   | $      | 460,871 |   |
|                                                                                                                                                          |   |                  |    |                   |   |
| **Liabilities and stockholders’ equity**                                                                                                                 |   |                  |    |                   |   |
| Current liabilities:                                                                                                                                          |   |                  |    |                   |   |
| Accounts payable                                                                                                                                              |   | $                     | 55,990  |                   | $      | 47,778 |   |
| Accrued expenses and other current liabilities                                                                                                                |   | 54,622                |    | 71,616                 |   |
| Merchandise advances                                                                                                                                          |   | 16,388                |    | 17,104                 |   |
| Total current liabilities                                                                                                                                     |   | 127,000               |    | 136,498                |   |
|                                                                                                                                                          |   |                  |    |                   |   |
| Other long-term liabilities                                                                                                                                   |   | 6,252                 |    | 5,982                  |   |
| Deferred income taxes                                                                                                                                         |   | 4,220                 |    | 4,220                  |   |
| Long-term debt                                                                                                                                                |   | 100,000               |    | 100,000                |   |
| Total liabilities                                                                                                                                             |   | 237,472               |    | 246,700                |   |
|                                                                                                                                                          |   |                  |    |                   |   |
| Stockholders’ equity:                                                                                                                                    |   |                  |    |                   |   |
| Preferred Stock; authorized 5,000 shares at  March  31, 2004 and December 31, 2003,   none issued and outstanding                                   |   | —                |    | —                 |   |
| Common Stock, $0.01 par value, authorized  55,000  shares, issued and outstanding   24,321 at March 31, 2004 and  23,998 at  December 31, 2003 |   | 243                   |    | 240                    |   |
| Additional paid in capital                                                                                                                                    |   | 282,468               |    | 276,233                |   |
| Accumulated deficit                                                                                                                                           |   | (50,522               | )       | (62,302                | )      |
| Total stockholders’ equity                                                                                                                               |   | 232,189               |    | 214,171                |   |
|                                                                                                                                                          |   | $                     | 469,661 |                   | $      | 460,871 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

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**GuitarCenter, Inc. and subsidiaries**

**Consolidated Statements of Income**

(In thousands, except pershare data)

 
|                                         |   | **Three months ended March 31,** |    |
|----------------------------------------------|--------|----------------------------------|---------|
|                                         |   | **2004**                         |    | **2003** |   |
|                                         |   |                             |    |   |   |
| Net sales                                    |   | $                                | 349,703 |   | $ | 287,542 |   |
| Cost of goods sold, buying and occupancy     |   | 255,020                          |    | 212,886 |   |
| Gross profit                                 |   | 94,683                           |    | 74,656 |   |
|                                         |   |                             |    |   |   |
| Selling, general and administrative expenses |   | 74,318                           |    | 62,998 |   |
| Operating income                             |   | 20,365                           |    | 11,658 |   |
|                                         |   |                             |    |   |   |
| Interest expense, net                        |   | 1,363                            |    | 3,139 |   |
|                                         |   |                             |    |   |   |
| Income before income taxes                   |   | 19,002                           |    | 8,519 |   |
|                                         |   |                             |    |   |   |
| Income taxes                                 |   | 7,222                            |    | 3,242 |   |
|                                         |   |                             |    |   |   |
| Net income                                   |   | $                                | 11,780  |   | $ | 5,277 |   |
|                                         |   |                             |    |   |   |
| Net income per share                         |   |                             |    |   |   |
| Basic                                        |   | $                                | 0.49    |   | $ | 0.23 |   |
| Diluted                                      |   | $                                | 0.46    |   | $ | 0.22 |   |
|                                         |   |                             |    |   |   |
| Weighted average shares outstanding          |   |                             |    |   |   |
| Basic                                        |   | 24,188                           |    | 22,791 |   |
| Diluted                                      |   | 25,501                           |    | 23,652 |   |

 

See accompanying notes toconsolidated financial statements.

 

4

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**Guitar Center, Inc. and subsidiaries**

**Consolidated Statements of Cash Flows**

(In thousands)

 
|                                                                                         |   | **Three months ended March 31,** |   |
|----------------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                         |   | **2004**                         |   | **2003** |   |
| **Operating activities:**                                                                    |   |                             |   |   |   |
| Net income                                                                                   |   | $                                | 11,780 |   | $ | 5,277 |   |
| Adjustments to reconcile net income to net cash provided by (used in)  operating activities: |   |                             |   |   |   |
| Depreciation and amortization                                                                |   | 5,358                            |   | 4,857 |   |
| Amortization of deferred financing fees                                                      |   | 261                              |   | 176 |   |
| Tax benefit from exercise of stock options                                                   |   | 1,641                            |   | — |   |
| Changes in operating assets and liabilities:                                                 |   |                             |   |   |   |
| Accounts receivable                                                                          |   | 3,456                            |   | 2,863 |   |
| Merchandise inventories                                                                      |   | (833                             | )      | (1,246 | ) |
| Prepaid expenses and deposits                                                                |   | 1,551                            |   | 577 |   |
| Other assets                                                                                 |   | (189                             | )      | (148 | ) |
| Accounts payable                                                                             |   | 8,212                            |   | (7,435 | ) |
| Accrued expenses and other current liabilities                                               |   | (16,994                          | )      | (9,555 | ) |
| Other long-term liabilities                                                                  |   | 270                              |   | 70 |   |
| Merchandise advances                                                                         |   | (716                             | )      | (759 | ) |
| Net cash provided by (used in) operating activities                                          |   | 13,797                           |   | (5,323 | ) |
|                                                                                         |   |                             |   |   |   |
| **Investing activities:**                                                                    |   |                             |   |   |   |
| Purchase of property and equipment                                                           |   | (4,783                           | )      | (5,479 | ) |
| Net cash used in investing activities                                                        |   | (4,783                           | )      | (5,479 | ) |
|                                                                                         |   |                             |   |   |   |
| **Financing activities:**                                                                    |   |                             |   |   |   |
| Net increase in revolving debt facility                                                      |   | —                           |   | 8,936 |   |
| Proceeds from exercise of stock options                                                      |   | 4,597                            |   | 1,471 |   |
| Payments under capital leases                                                                |   | —                           |   | (61 | ) |
| Net cash provided by financing activities                                                    |   | 4,597                            |   | 10,346 |   |
|                                                                                         |   |                             |   |   |   |
| Net decrease in cash and cash equivalents                                                    |   | 13,611                           |   | (456 | ) |
| Cash and cash equivalents at beginning of year                                               |   | 5,350                            |   | 5,931 |   |
|                                                                                         |   |                             |   |   |   |
| Cash and cash equivalents at end of period                                                   |   | $                                | 18,961 |   | $ | 5,475 |   |

 

See accompanying notes toconsolidated financial statements.

 

5

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**Guitar Center, Inc. and subsidiaries**

**Notes to Consolidated Financial Statements**

 

1.                                       Natureof Business and Basis of Presentation

 

Nature of Business

 

Guitar Center, Inc., andsubsidiaries (“Guitar Center,” the “Company,” “we,” “us” or “our”) is thenation’s leading retailer of guitars, amplifiers, percussion instruments,keyboards and pro-audio and recording equipment based on annual revenue. As ofMarch 31, 2004, we operated 127 Guitar Center retail stores, with 108 stores in46 major markets and 19 stores in secondary markets across the UnitedStates.  In addition, our American Musicdivision operates 19 family music stores specializing in band and orchestralinstruments for sale and rental, serving teachers, band directors, collegeprofessors and students. We are also the largest direct response retailer ofmusical instruments in the United States through our wholly-owned subsidiary,Musician’s Friend, Inc., and its catalog and web site, www.musiciansfriend.com.

 

Basis of Presentation

 

In the opinion ofmanagement, the accompanying unaudited consolidated financial statementscontain all adjustments necessary to present fairly the financial position ofGuitar Center, Inc. and subsidiaries as of March 31, 2004 and December 31,2003, and the results of operations and cash flows for the three months endedMarch 31, 2004 and 2003. The accompanying consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto contained in our Annual Report on Form 10-K forthe year ended December 31, 2003.

 

The results of operationsfor the three months ended March 31, 2004 are not necessarily indicative of theresults to be expected for the full year.

 

2.                                       EarningsPer Share

 

The following tablesummarizes the reconciliation of Basic to Diluted Weighted Average Shares forthe quarter ending March 31, 2004 and 2003:

 
|                                                                          |   | **2004**            |   | **2003** |   |
|-------------------------------------------------------------------------------|--------|---------------------|--------|----------|--------|
|                                                                          |   | **(in  thousands)** |   |
| Basic shares                                                                  |   | 24,188              |   | 22,791   |   |
| Common stock  equivalents – dilutive effect of stock options outstanding |   | 1,313               |   | 861      |   |
| Diluted shares                                                                |   | 25,501              |   | 23,652   |   |

 

For the quarters endedMarch 31, 2004 and 2003, the only common stock equivalents deemed outstandingare stock options.  For the quarterended March 31, 2004, all options outstanding had a dilutive effect.  During the quarter ended March 31, 2003,options to purchase 595,000 shares, at prices ranging from $19.96 to $28.56,were outstanding but were not included in the computation of diluted earningsper share because the exercise prices of these options were greater than theaverage market price of our Common Stock.

 

For the three monthsended March 31, 2004, the 2.9 million shares of common stock issuable uponconversion of the 4% Senior Convertible Notes issued in June 2003 (reflectingan effective conversion price of $34.58) were not deemed to be common stockequivalents and thus not considered in the calculation of earnings pershare.  At such time that those Notesbecome convertible (generally involving trading prices above $41.50 per sharefor a specified period and designated corporate events), the security will betreated under the as-if converted method, whereby for earnings per sharepurposes the 2.9 million conversion shares will be deemed outstanding and theafter-tax interest expense for the period will be added back to net income.

 

6

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3.                                       Segment Information

 

Our reportable businesssegments are Guitar Center stores, American Music stores and direct response(Musician’s Friend’s catalog and Internet). Management evaluates segmentperformance based primarily 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 nodifferences between the measurements of profits or losses or assets of thereportable segments and those of the Company on a consolidated basis. TheCompany business segments under SFAS No. 131 are consistent with its reportingunits under SFAS No. 142.

 

Net sales, gross margin,depreciation and amortization, selling, general and administrative expenses,income before income taxes and capital expenditures for the three months endedMarch 31, 2004 and 2003 and total assets as of March 31, 2004 and 2003 aresummarized as follows (in thousands):

 
|                                          |   | **Guitar  Center  2004** |    | **American  Music  2004** |   | **Direct  Response  2004** |   | **Total** | ** ** |
|-----------------------------------------------|--------|--------------------------|---------|---------------------------|--------|----------------------------|--------|-----------|------------|
| Net sales                                     |   | $                        | 263,508 |                      | $      | 9,378                      |   | $         | 76,817     |   | $ | 349,703 |   |
| Gross profit                                  |   | 66,688                   |    | 3,385                     |   | 24,610                     |   | 94,683    |       |
| Depreciation and  amortization                |   | 4,363                    |    | 391                       |   | 604                        |   | 5,358     |       |
| Selling, general  and administrative expenses |   | 53,459                   |    | 4,325                     |   | 16,534                     |   | 74,318    |       |
| Income (loss)  before income taxes            |   | 12,343                   |    | (1,587                    | )      | 8,246                      |   | 19,002    |       |
| Capital  expenditures                         |   | 4,025                    |    | 118                       |   | 640                        |   | 4,783     |       |
| Total assets                                  |   | 351,644                  |    | 60,639                    |   | 57,378                     |   | 469,661   |       |
|                                          |   |                     |    |                      |   |                       |   |      |       |
|                                          |   | **Guitar  Center  2003** |    | **American  Music  2003** |   | **Direct  Response  2003** |   | **Total** | ** ** |
| Net sales                                     |   | $                        | 218,347 |                      | $      | 9,254                      |   | $         | 59,941     |   | $ | 287,542 |   |
| Gross profit                                  |   | 52,444                   |    | 3,441                     |   | 18,771                     |   | 74,656    |       |
| Depreciation and  amortization                |   | 3,915                    |    | 275                       |   | 667                        |   | 4,857     |       |
| Selling, general  and administrative expenses |   | 45,549                   |    | 3,816                     |   | 13,633                     |   | 62,998    |       |
| Income(loss)  before income taxes             |   | 4,691                    |    | (1,130                    | )      | 4,958                      |   | 8,519     |       |
| Capital  expenditures                         |   | 4,480                    |    | 350                       |   | 649                        |   | 5,479     |       |
| Total assets                                  |   | 354,862                  |    | 57,461                    |   | 38,020                     |   | 450,343   |       |

 

4.                                       Stock-BasedCompensation

 

We adopted SFAS No. 123,“*Accountingfor Stock-Based Compensation,”*which permits entities to recognizeas expense over the vesting period the fair value of all stock-based awards onthe date of grant.  Alternatively, SFASNo. 123 also allows entities to continue to apply the provisions of AccountingPrinciples Board (“*APB”*) Opinion No. 25 “*Accounting for Stock Issued to Employees**,”*andrelated interpretations and provide pro forma net income and pro forma earningsper 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 the provisions of APBOpinion No. 25 and provide the pro forma disclosure provisions of SFAS No.123.  As such, compensation expense forstock options issued to employees is recorded on the date of grant only if thethen-current market price of the underlying stock exceeded the exerciseprice.  Had we determined compensationcost based upon the fair value at the grant date for our stock options underSFAS No. 123 using the Black Scholes option pricing model, pro forma net incomeand pro forma net income per share, including the following weighted averageassumptions used in these calculations, would have been as follows:

 

7

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|                                                                                                                                                 |   | **March 31,2004** |   | **2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|----------|--------|
|                                                                                                                                                 |   |              |   |     |   |
| Net income, as  reported                                                                                                                             |   | $                 | 11,780 |     | $      | 5,277 |   |
| Deduct:  Total stock-based employee compensation  expense determined under fair value based methods for all awards, net of  related tax effects |   | 1,078             |   | 1,045    |   |
| Pro forma net  income                                                                                                                                |   | $                 | 10,702 |     | $      | 4,232 |   |
|                                                                                                                                                 |   |              |   |     |   |
| Earnings per  share:                                                                                                                                 |   |              |   |     |   |
| Basic – as  reported                                                                                                                            |   | $                 | 0.49   |     | $      | 0.23 |   |
| Basic – pro  forma                                                                                                                              |   | $                 | 0.44   |     | $      | 0.19 |   |
| Diluted – as  reported                                                                                                                          |   | $                 | 0.46   |     | $      | 0.22 |   |
| Diluted – pro  forma                                                                                                                            |   | $                 | 0.42   |     | $      | 0.18 |   |
| Risk free  interest rate                                                                                                                             |   | 3.3               | %      | 3.3      | %      |
| Expected lives                                                                                                                                       |   | 6.70              |   | 6.73     |   |
| Expected volatility                                                                                                                                  |   | 61.8              | %      | 67.9     | %      |
| Expected  dividends                                                                                                                                  |   | —            |   | —   |   |

 

5.**                                      **ConvertibleNotes Offering

 

On June 16, 2003, wecompleted the issuance of $100 million principal amount of 4.00% SeniorConvertible Notes due 2013.  Of the netproceeds from the offering, approximately $68.2 million was used in July 2003to retire all outstanding Senior Notes and pay the related redemption premium,and the balance was used to reduce the amount outstanding under our creditagreement and pay offering expenses.  InJuly 2003, we called for the redemption of $66.7 million of Senior Notesoutstanding. Interest expense related to the redemption premium and thewrite-off of deferred financing costs associated with the Senior Notes redeemedwas $1.9 million.

 

**Item 2.****                     Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**General**

 

Guitar Center is the nation’s leading retailer ofguitars, amplifiers, percussion instruments, keyboards and pro-audio andrecording equipment based on annual revenue. We operated 127 Guitar Centerretail locations as of March 31, 2004, with 108 stores in 46 major markets and19 stores in secondary markets across the United States. In addition, at March31, 2004 our American Music division operated 19 family music storesspecializing in band and orchestral instruments for sale and rental, servingteachers, band directors, college professors and students. We are also thelargest direct response retailer of musical instruments in the United Statesthrough our wholly owned subsidiary, Musician’s Friend, Inc., and its catalogand web site, www.musiciansfriend.com.

 

During the first quarter,we opened a large format Guitar Center store in Brookfield, Wisconsin and smallformat stores in Mobile, Alabama, Ft. Myers, Florida, Albuquerque, New Mexico andToledo, Ohio. These stores added 63,450 square feet of Guitar Center retailspace and brought us to a total of 1.959 million square feet of Guitar Centerretail space at the end of the quarter.

 

As we enter new markets, we expect that we willinitially incur higher administrative and promotional costs per store than iscurrently experienced in established markets. We expect competition to continue to increase as other music productretailers attempt to execute national growth strategies.  Our business strategy will also emphasizeopportunities to continue to grow each of our brands, including furtheracquisitions if attractive candidates can be located for reasonable prices.

 

From 1999 to 2003, ournet sales grew at an annual compound growth rate of 19%, principally due to thecomparable store sales growth of our retail stores averaging 7% per year, theopening of new stores, and a 31% per year increase in the direct responsechannel. We believe such volume increases are the result of the continued successof the implementation of our business strategy, continued growth in the musicproducts industry and increasing consumer awareness of the Guitar Center,Musician’s Friend and American Music brand names. We achieved comparable storesales growth of 11% for the first quarter of

 

8

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2004 compared to 4% for the first quarter of 2003. We believe thisgrowth reflects the strength of our merchandise selection, effectiveadvertising and promotion, and well-trained and committed personnel. Also,sales in the first quarter of 2003 were relatively weak in advance of the warin Iraq. Comparable store sales compares net sales for the comparable periods,excluding net sales attributable to stores not open for 14 months as of the endof the latter reporting period. All references in this report to comparablestore sales are based on this calculation methodology.

 

**Executive Summary**

 

Consolidated net sales for the quarter ended March 31,2004 increased 21.6%, or $62.2 million, to $349.7 million compared to $287.5million in the first quarter of 2003. Net income for the quarter was $11.8million, which is a 123% increase over the $5.3 million we reported in thefirst quarter of 2003. Earnings per diluted share increased to $0.46 comparedto $0.22 in the first quarter of 2003.

 

Our Guitar Center retail division turned in a strongperformance for the quarter. Net sales from our Guitar Center stores increased20.7% to $263.5 million from $218.3 million in last year’s first quarter. Salesfrom new stores contributed $21.2 million and accounted for 46.8% of theincrease. Guitar Center comparable store sales increased 11%.

 

Musician’s Friend, our direct response division,generated a net sales increase of 28.2% for the quarter to $76.8 millioncompared to $59.9 million in the first quarter of 2003 and operating income wasabove our expectations. For the quarter, we achieved an initial fill rate of89.4%, the same as in the first quarter of 2003. Initial order fill ratereflects the percentage of items ordered by our customers that we are able tosupply in the initial shipment to that customer. Inventory turn improved to 5.9times on a trailing twelve-month basis compared to 4.4 times in the firstquarter of 2003. The improvements that were made to the Musician’s Friend website over the last year, as well as the infrastructure and systems at thedirect response call center and fulfillment center, permitted us to capitalizeon high demand.

 

We continued to focus on remerchandising, systems executionand infrastructure build out at American Music during the quarter. AmericanMusic incurred an operating loss of $940,000 for the quarter on a pre-taxbasis, which was in line with our expectations. Failure to execute on therequirements and initiatives described above could potentially require us torecognize an impairment in the significant amount of goodwill recorded in theacquisitions of American Music and M&M Music, which totaled $20.6 millionat March 31, 2004. No such impairment has been recorded through March 31, 2004.

 

We are focused on leveraging the infrastructureinvestments we have made to streamline inventory management and improveoperating efficiencies across the company. Continued execution of theseinitiatives will be necessary to meet our business objectives for 2004.

 

**Discussion of Critical AccountingPolicies**

 

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

 

*Valuationof Inventory*

 

We value our inventories at the lower of cost ormarket using the first-in, first-out (FIFO) method.  Rental inventories are valued at the lower of cost or marketusing the specific identification method and are depreciated on a straight-linebasis over the term of the associated rental agreement for rent-to-own sales,or over the estimated useful life of the rented instrument for rental onlyitems.  We record adjustments to thevalue of inventory based upon obsolescence and changes in market value.  Applicable costs associated with bringinginventory through our Guitar Center retail distribution center are capitalizedto inventory.  The amounts are expensedto cost of goods sold as the associated inventory is sold.  Management has evaluated the current levelof inventories considering future customer demand for our products, taking intoaccount general economic conditions, growth prospects within the marketplace,competition, market acceptance of current and upcoming products, and managementinitiatives.  Based on this evaluation,we have recorded impairment adjustments to cost of goods sold for estimateddecreases in net realizable value. These judgments are made in the context of our customers’ shiftingneeds, product and technological trends, and changes in the demographic mix ofour customers. A misinterpretation or

 

9

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misunderstanding of these conditions and uncertainties in the futureoutlook of our industry or the economy, or other failure to estimateaccurately, could result in inventory valuation changes in the future.

 

*Valuation of Long-Lived Assets*

 

Long-lived assets such asproperty and equipment and identifiable intangibles are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Goodwill is required to be reviewed forimpairment on an annual basis, or more frequently when triggering events occur.Factors we consider important, which could trigger impairment, include, amongother things:

 

•                  Significantunderperformance relative to historical or projected operating results;

 

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

 

•                  Significantnegative industry or economic trends; and

 

•                  Significantdecline in stock value for a sustained period.

 

For long-lived assetsother than goodwill and intangibles that are not amortized, the determinationof whether impairment has occurred is based on an estimate of undiscountedfuture cash flows attributable to the assets, as compared to the carrying valueof the assets.  Assumptions used inthese cash flows are consistent with internal forecasts and consider currentand future expected sales volumes and related operating costs and anyanticipated increases or declines based on expected market conditions and localbusiness environment factors. If a potential impairment is identified, theamount of the impairment loss recognized would be determined by estimating thefair value of the assets and recording a loss if the fair value was less thanthe book value. Fair value will be determined based on appraisal valuesassessed by third parties, if deemed necessary, or a discounted future cashflows analysis. For goodwill and other intangibles that are not amortized,impairment to be recognized is measured as the amount by which the carryingamount of the assets exceeds the fair value of the related assets of theunderlying segment to which the goodwill relates.

 

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

 

*Sales Returns*

 

As part of our “satisfaction guaranteed” policy, weallow Guitar Center customers to return product generally within 30 days afterthe date of purchase, and we allow Musician’s Friend customers to returnproduct within 45 days. American Music customers have ten business days fromthe date of purchase to return product. We regularly review and revise, whendeemed necessary, our estimates of sales returns based upon historical trends.While our estimates during the past few years have closely approximated actualresults, actual returns may differ significantly, either favorably orunfavorably, from estimates if factors such as economic conditions or thecompetitive environment differ from our expectations.

 

*Credits and Other Vendor Allowances*

 

We receive cooperative advertising allowances (i.e.,an allowance from the manufacturer to subsidize qualifying advertising andsimilar promotional expenditures we make relating to the vendor’s products),price protection credits (i.e., credits from vendors with respect to in-stockinventory if the vendor subsequently lowers their wholesale price for suchproducts) and vendor rebates (i.e., credits or rebates provided by vendorsbased on the purchase of specified products and paid at a later date).Cooperative advertising allowances are recognized as a reduction to selling,general, and administrative expense when we incur the advertising expenseeligible for the credit. We recognized cooperative advertising allowances of$1.5 million and $1.2 million in the three months ended March 31, 2004 and2003, respectively.  Price protectioncredits and vendor rebates are accounted for as a reduction of the cost ofmerchandise inventory and are recorded at the time the credit or rebate isearned.  The effect of price protectioncredits and vendor rebates is recognized in the income statement at the timethe related inventory is sold, as a reduction in cost of goods sold. None ofthese credits are recorded as revenue.

 

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**Resultsof Operations**

 

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

 
|                                        |   | **Three Months Ended  March 31,** |   |
|---------------------------------------------|--------|-----------------------------------|--------|
|                                        |   | **2004**                          |   | **2003** |   |
| Net sales                                   |   | 100.0                             | %      | 100.0 | % |
| Gross profit                                |   | 27.1                              |   | 26.0 |   |
| Selling, general and administrative expense |   | 21.3                              |   | 21.9 |   |
| Operating income                            |   | 5.8                               |   | 4.1 |   |
| Interest expense, net                       |   | 0.4                               |   | 1.1 |   |
| Income before income tax expense            |   | 5.4                               |   | 3.0 |   |
| Income tax expense                          |   | 2.0                               |   | 1.2 |   |
| Net income                                  |   | 3.4                               |   | 1.8 |   |

 

**ThreeMonths Ended March 31, 2004 Compared to the Three Months Ended March 31, 2003**

 

Net sales for the threemonths ended March 31, 2004 increased 21.6% to $349.7 million, compared to$287.5 million same period last year. Comparable store sales increased 11%. We believe that comparable store sales are a more useful indicator ofstore performance than the change in total net sales, since comparable storesales exclude the effects of changes in the number of stores open.

 

Net sales from GuitarCenter stores for the three months ended March 31, 2004 totaled $263.5 million,a 20.7% increase from $218.3 million for the same period in 2003.  Sales from new stores contributed $21.2million and represent 46.8% of the total increase in retail store sales.  Comparable Guitar Center store sales for thequarter increased 11%.  The increase incomparable store sales was due to good response to our advertising andmarketing strategy for our Guitar Center stores.  Our management is presently anticipating comparable store salesgrowth for the Guitar Center stores of 6% to 8% for the second quarter in 2004.Please see “Forward-Looking Statements; Business Risks,” below. Net sales fromAmerican Music stores for the three months ended March 31, 2004 totaled $9.4compared to $9.3 million in 2003. Comparable American Music stores sales for the quarter wereapproximately flat with the prior year.

 

Net sales from the directresponse channel totaled $76.8 million for the three months ended March 31,2004, a $16.9 million, or 28.2%, increase from 2003. This increase primarilyreflects the improved performance of catalog circulation strategies.  Sales from the contact center, whichrepresent sales placed via phone, live chat, mail and e-mail, increased 18.2%to $33.8 million from $28.6 million for the three months ended March 31, 2004compared to 2003. Internet sales from orders placed via the Musician’s Friendand Giardinelli web sites increased 37.4% to $43.0 million from $31.3 millionfor the same period last year.  Thegrowth 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 includes a more complete inventorypresentation than our catalogs.

 

Gross profit for thethree months ended March 31, 2004 compared to 2003 increased 26.8% to $94.7million from $74.7 million.  Grossprofit as a percentage of net sales for the period ended March 31, 2004compared to 2003 increased to 27.1% from 26.0%.  Gross profit as a percentage of net sales for Guitar Center was25.3% compared with 24.0% in the first quarter of 2003. The increase is due tohigher selling margin (1.8%), lower inventory shrink expense (0.2%), leveragedoccupancy costs (0.4%), offset by increased freight costs (1.1%). The grossprofit margin for the American Music stores was 36.1% compared to 37.2% for thesame period last year. The decrease is primarily due to increase in inventoryshrink (2.6%), increase in occupancy costs (1.2%), offset by improved sellingmargin (1.5%) and decrease in freight (1.2%). Gross profit margin for thedirect response division was 32.0% for the quarter compared to 31.3% in the firstquarter of 2003.  The increase is due tohigher selling margin resulting from better buying performance and favorableproduct mix (0.7%).

 

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Selling, general andadministrative expenses for the three months ended March 31, 2004 increased18.0% to $74.3 million from $63.0 million for the same period in2003. As a percentage of net sales, selling, general and administrativeexpenses for the first quarter in 2004 decreased to 21.3% from 21.9% in thesame period last year. Selling, general and administrative expenses for theGuitar Center stores in the first quarter were 20.3% as a percentage of netsales compared to 20.9% in last year’s first quarter. The decrease reflectsleveraging due to higher than expected sales, partially offset by increasedinsurance expense (0.04%), bonus accruals (0.3%), and consulting fees (0.1%).Selling, general and administrative expenses for the American Music stores were46.1% of sales in the first quarter compared to 41.2% in the same period lastyear. The increase is primarily due to increased salary costs (2.7%), bad debtexpense (1.0%), travel (0.6%), and insurance expense (0.3%).

 

Selling, general andadministrative expenses for the direct response division were 21.5% of salescompared to 22.7% for the three month ended March 31, 2004 and 2003,respectively. The improvement is primarily due to leveraging on better thanexpected sales and increased operational efficiencies as indicated by areduction in payroll costs (1.1%), offset by an increase in advertising expense(0.7%) related to higher catalog circulation.

 

Operating incomeincreased 74.7% to $20.4 million from $11.7 million for the three months endedMarch 31, 2004. This increase reflects performance of the Guitar Center andMusician’s Friend businesses at or above expected levels, offset somewhat bycontinued spending on our remerchandising efforts and systems andinfrastructure build out at the American Music stores resulting in an operatingloss of approximately $0.9 million for this segment for the period ending March31, 2004.

 

Interest expense, net for the three months ended March31, 2004, decreased to $1.4 million from $3.1 million in the firstquarter of 2003. The reduction in interest expense is due primarily to theretirement of $67 million in 11% senior notes through a $100 million 4%convertible bond offering completed in June 2003 and the use of cash flow fromoperations to pay off on the line of credit borrowings.

 

In the threemonths ended March 31, 2004, a $7.2 million provision for income taxes wasrecorded compared to $3.2 million for the same period last year, both based onan effective tax rate of approximately 38%. There were no significant changesin the Company’s operation that resulted in a change to the effective tax rate.

 

Net income for thethree months ended March 31, 2004 increased 123% to $11.8 million, compared to$5.3 million in the same period last year as a result of the combinations offactors described above.

 

**Liquidity and Capital Resources**

 

Our need forliquidity will arise primarily from the funding of capital expenditures,working capital requirements and payments on our indebtedness, as well aspossible acquisitions. We have historically financed our operations primarilythrough internally generated funds and borrowings under our credit facilities.As of March 31, 2004, we had no borrowings under our credit facility and hadavailable borrowings of $110.1 million (net of $4.9 million of outstandingletters of credit).

 

In the fourthquarter of 2003, we amended our credit facility with a syndicate of banks ledby Wells Fargo Retail Finance. The credit facility permits borrowings up to$125 million, subject to borrowing base limitations ($115 million at March 31,2004).  The actual amount available istied to our inventory and receivable base, and repayment obligations under thecredit facility are secured by liens on our principal assets. Borrowing optionsare prime rate (4.00% at March 31, 2004) plus applicable prime margin, or LondonInterbank Offered Rate, or LIBOR (three month rate at March 31, 2004 was1.11%), plus applicable LIBOR margin. The applicable prime and LIBOR marginsare fixed for the first six months of the amended agreement at 0.00% and 1.50%,respectively. After the initial six months, the applicable prime and LIBORmargins are based upon levels of excess availability and adjusted quarterly. Ifexcess availability is greater than $20 million, the applicable prime margin is0.00% and applicable LIBOR margin is 1.50%. If excess availability is less thanor equal to $20 million and greater than $10 million, the applicable primemargin is 0.00% and the applicable LIBOR margin is 1.75%. If excessavailability is less than or equal to $10 million, the applicable prime marginis 0.25% and the applicable LIBOR margin is 2.00%. An unused fee is assessed onthe unused portion of the credit facility based upon levels of excessavailability. If excess availability is greater than $10 million, the unusedfee is 0.25%. If excess availability is less than or equal to $10 million, theunused fee is 0.375%. The agreement underlying the credit facility includessignificant restrictive negative covenants. Among other things, these covenantsrestrict our ability to incur debt and issue specified equity instruments,incur liens on our assets, make any significant change in our corporatestructure or the nature of our business, dispose of assets, make guaranties,prepay debt, engage in a change in control transaction, pay dividends, make investmentsor acquisitions, engage in transactions with affiliates and incur capitalexpenditures, and also require that we satisfy a minimum availability test. Theminimum availability test requires that we maintain $10

 

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million of reserved availability under the agreement based on itsborrowing base limitations.  The amountwe disclose in our public reports from time to time as available to borrowunder the agreement ($110.1 million at March 31, 2004) is already reduced bythis required reserve and outstanding letters of credit, and thus represents anet amount available under the agreement. The agreement also includesrepresentations and warranties which must be true each time we borrow fundsunder the credit facility and affirmative covenants.  The full text of the contractual requirements imposed by thisfinancing is set forth in the Amended and Restated Loan and Security Agreementand restated amendments which have been filed with the Securities and ExchangeCommission.  We were in compliance withsuch requirements as of March 31, 2004. Subject to limited cure periods, the lenders under our credit facilitymay demand repayment of any 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 agreementmatures in December 2007.

 

On June 16, 2003, we completed the issuance of $100million principal amount of 4.00% Senior Convertible Notes due 2013.  Of the net proceeds from the offering,approximately $68.2 million was used in July 2003 to retire all outstandingSenior Notes and pay the related redemption premium, and the balance was usedto reduce the amount outstanding under our credit agreement and pay offeringexpenses.  The Notes bear interest atthe rate of 4.00% per annum, subject to the payment of contingent interestunder certain circumstances, and are convertible into shares of common stock ata conversion 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 or designated corporate events occur. The final maturity of the Notes is July 2013, although holders mayrequire us to repurchase the Notes at their election in July 2008, July 2010 orupon the occurrence of a change in control, in each case for a purchase priceequal to the original principal amount plus accrued interest.  We may call the Notes for redemptioncommencing in July 2006 subject to the payment of a redemption premium of 1.6%if redeemed prior to July 2007 and 0.8% if redeemed prior to July 2008(thereafter there is no redemption premium). The indenture governing the Notesdoes not limit our ability to incur indebtedness or otherwise substantivelyrestrict the operation of our business to any significant degree.  Subject to limited cure periods, the holdersof the Notes may demand repayment of these borrowings prior to the statedmaturity upon the occurrence of specified events, including if we fail to payinterest or principal when due, fail to satisfy our conversion obligation, ifanother obligation of ours having an outstanding principal amount in excess of$15 million is accelerated prior to stated maturity and upon the occurrence ofspecified events of insolvency.

 

During 2002 we entered into master operating leaseagreements with General Electric Capital Corporation and US Bank to lease equipmentand other property primarily to support the operations of the new centraldistribution center for our Guitar Center retail stores. Under theseagreements, we leased a total of $10.5 million in equipment and other property.The agreement calls for monthly payments of $138,000 for a term of 36 monthsthrough September 1, 2005 with an option to extend through September 30, 2009and monthly payments of $48,000 for a term of 24 months through December 28,2005.

 

The terms of our significant financing agreements,including those related to our credit facility, the Senior Convertible Notesand the equipment lease facilities described above are not dependent on anychange in our credit rating. We believe that the key company-specific factorsaffecting our ability to maintain our existing debt and lease financingrelationships and to access such capital in the future are our present andexpected levels of profitability and cash flow from operations, our workingcapital and fixed asset collateral bases, our expected level of capitalexpenditures, and the level of equity capital of the company relative to thelevel of debt obligations. In addition, as noted above, our existing agreementsinclude significant restrictions on future financings, including among others, limitson the amount of indebtedness that we may incur and whether or not suchindebtedness may be secured by any of our assets.

 

As is the case with most multi-unit retailers,substantially all of the real property used in our business is leased under operatinglease agreements.  Please see, Item 2.Properties, “—Disclosures About Contractual Obligations and CommercialCommitments” and Note 8 in our Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

Net cash provided by operating activities was $13.8million for the three months ended March 31, 2004 compared to net cash used inoperating activities of $5.3 million for the same period last year. Theincrease in net cash provided by operating activities is primarily due to anincrease in net income and continued improvements in our use of working capitalprimarily through better inventory management.

 

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Cash used in investing activities decreased to $4.8million for the three months ended March 31, 2004 compared to $5.5 million forthe same period last year. The current period capital expenditures consistedprimarily of capital expenditures for store expansions of $3.0 million compared$3.3 million in the prior period and computer equipment purchases $1.3 millionin the current period compared to $1.7 million in the same period last year.

 

 Cash providedby financing activities totaled $4.6 million for the three month ended March31, 2004 compared to $10.3 million for the same period last year. The decreaseis primarily due to the substantial increase in net cash provided by operatingactivities referred to above, which allowed us not to draw on our line ofcredit during the first quarter of 2004. In addition, proceeds from theexercise of stock options in the first quarter of 2004 were $4.6 millioncompared to $1.5 million in the first quarter of 2003.

 

We intend to pursue an aggressive growth strategy byopening additional stores in new and existing markets.  During the three months ended March 31,2004, we opened five new Guitar Center stores (one large format and four smallformat stores). Each new large format Guitar Center store typically hasrequired approximately $1.6 to $1.8 million for gross inventory.  Historically, our cost of capital improvementsfor a large format Guitar Center store has been approximately $850,000,consisting of leasehold improvements, fixtures and equipment. We incur highercosts in some geographic areas, particularly the Northeast, and when we build alarger flagship store.  We havedeveloped smaller Guitar Center stores to build in secondary markets or sitesthat we do not believe will support our large format units. The first of theseunits was opened in late 2000 and 18 more had been opened as of March 31, 2004.Our small format stores have typically incurred approximately $560,000 incapital expenditures and require approximately $1.1 million to $1.2 million ininventory.

 

We are also anticipating additional capital andstrategic requirements related to improving our fulfillment facilities,upgrading our technology and systems, and pursuing new opportunities in thee-commerce activities of our retail and direct response divisions as well asrelated businesses.

 

Our distribution center in the Indianapolis, Indianaarea supports our Guitar Center retail store operations. We have a 10-yearagreement to lease the facility and we also have numerous additionalcommitments necessary to support the operations of the facility. In 2003,nearly all products flowed through the distribution facility, with theexception of special orders which will continue, for the most part, to be dropshipped to our stores. Migration from our former “drop-ship” model to acentralized distribution model is an important development in our operatingstrategy and has required the allocation of significant financial andmanagerial resources. In accordance with generally accepted accountingprinciples, a portion of the costs of operating this facility are absorbed intoour Guitar Center merchandise inventories and recognized as an element of costof goods sold when the related inventory is sold. This can result in a slightdecrease in reported gross margin depending on our success in defraying theseadditional costs, although we also expect to realize efficiencies involvingother costs such as selling, general and administrative expense and interestexpense.

 

We also continue to make significant investments ininformation technology across our businesses and to incur costs and makeinvestments designed to expand the reach of our businesses on theInternet.  The costs of theseinitiatives and other investments related to our businesses will continue to besignificant.

 

Our expansion strategy is to continue to increase ourmarket share in existing markets and to penetrate strategically selected newmarkets.  We opened a total of 14 GuitarCenter stores in 2003 and 12 stores in 2002, and currently anticipate opening16 to 18 Guitar Center stores in 2004. Approximately half of the stores plannedfor 2004 are smaller format units designed for secondary markets. Our plannedstore opening schedule for 2004 may be affected by any acquisitions we maytransact during the year. If we complete any such transactions, our plannedorganic store openings may be reduced. We opened a total of eight AmericanMusic stores in 2002, five of the eight by acquisition of M&M Music, a bandinstrument and retail merchandise retailer. In 2003, we opened one and closedtwo American Music stores. As of March 31, 2004, we have 19 American Musicstores. For the remainder of 2004, we do not presently plan to open anyAmerican Music stores. We have slowed our planned growth of the American Musicdivision because our infrastructure and remerchandising projects at thisbusiness have to date required more time and resources than originallyanticipated. We do, however, believe there exists a number of acquisitionopportunities in the relatively fragmented band instruments market that couldbe a good fit into our American Music platform and we continue to pursueacquisition opportunities.

 

Throughout our history, we have primarily grownorganically, and we do not expect this to change. 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.

 

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Our known capital resource and liquidity requirementsfor 2004 are presently expected to be primarily provided by cash on hand, netcash flow from operations and borrowings under our credit facility. Dependingupon market conditions, we may also elect or be required to raise additionalcapital in the form of common or preferred equity, debt or convertiblesecurities for the purpose of providing additional capital to fund workingcapital needs or continued growth of our existing business, or to refinanceexisting obligations. Any such financing activity will be dependent upon manyfactors, including our liquidity needs, market conditions and prevailing marketterms, and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

 

**New Accounting Pronouncements**

 

In January 2003, the Financial Accounting StandardsBoard issued FASB Interpretation No. 46, *“Consolidation of Variable Interest Entities” (FIN46).*  This interpretationclarifies the application of Accounting Research Bulletin No. 51, *“ConsolidatedFinancial Statements” (ARB 51),* and requires companies to evaluatevariable interest entities for specific characteristics to determine whetheradditional consolidation and disclosure requirements apply.  This interpretation is immediatelyapplicable for variable interest entities created after January 31, 2003, andapplies to the first fiscal year or interim period beginning after June 15,2003 for variable interest entities acquired prior to February 1, 2003. Theadoption of this interpretation did not have any impact on our financialposition or results of operations. In December 2003, the FASB revised FIN 46 toexempt certain entities from its requirements and to clarify certain issuesarising during the implementation of FIN 46. The adoption of this revisedinterpretation in the first quarter of 2004 did not have any impact on ourconsolidated financial statements.

 

In May 2003, the Financial Accounting Standards Boardissued Statement No. 150, *“Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity” (SFAS No. 150). *The statement establishes standardsfor how an issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability (or anasset in some circumstances). It is effective for financial instruments enteredinto or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003.  We adopted this standard effective July 1,2003, and it did not have a material effect on our consolidated financialstatements.

 

**Seasonality**

 

Our operatingresults are not highly seasonal, except for the effect of the holiday sellingseason in November and December.  Salesin the fourth quarter are typically significantly higher on a per store basisand through the direct response unit than in any other quarter.

 

**Inflation**

 

We believe thatthe relatively moderate rates of inflation experienced in recent years have nothad a significant impact on our net sales or profitability.

 

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**Forward-Looking Statements**

 

This reportcontains forward-looking statements relating to, among other things, futureresults of operations, growth and investment plans, sales, trends in grossmargin, growth in the Internet business and other factors affecting growth insales and earnings.  Specificforward-looking statements are provided regarding our management’s currentviews regarding comparable store sales, new store openings, and capitalexpenditure levels.  Statementsregarding new store openings are based largely on our current expectations andare necessarily 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. The American Music business has in the past and mayin the future give rise to significant fluctuations from period to period as wereformat their store model and build-out the information technology andmanagement structure. The American Music stores incurred significant operatinglosses in 2003 and we presently expect this situation to continue in 2004.

 

Sales and earnings trends are also affected by manyother factors including, among others, world and national political events,general economic conditions, the effectiveness of our promotion andmerchandising strategies, changes in the music products industry, retail salestrends and the emergence of new or growing specialty retailers of musicproducts.  In light of these risks,there can be no assurance that the forward-looking statements contained in thisreport will in fact be realized.  Thestatements made by us in this report represent our views as of the date of thisreport, and it should not be assumed that the statements made herein remainaccurate as of any future date.  We donot presently intend to update these statements and undertake no duty to anyperson to affect any such update under any circumstances.

 

For further discussion of risks associated with ourbusiness, please see the discussion under the caption “Risks Related to theBusiness.”

 

**Risks Related to the Business**

 

An investment in our securities involves a high degreeof risk.  Described below are some ofthe risks and uncertainties facing our company.  There may be additional risks that we do not presently know of orthat we currently consider immaterial. Any of these risks could adversely affect our business, results ofoperations, liquidity and financial position. A shortfall in comparative sales growth in any period will likely causea shortfall in earnings, and result in financial performance below that forwhich we have planned or the investment community expects.

 

*We may be unable to meet our GuitarCenter and American Music retail store growth strategy, which could adverselyaffect our results of operations.*

 

Our retail store growth strategy includes opening newstores in new and existing markets and increasing sales at existinglocations.  As of March 31, 2004, weoperated 127 Guitar Center stores and 19 American Music stores.  We opened a total of 14 Guitar Center storesin 2003, and currently expect to open approximately 16 to 18 additional GuitarCenter stores in 2004.  Approximatelyhalf of the Guitar Center stores planned for 2004 are expected to be smallerformat units designed for secondary markets. Our planned store opening schedulefor 2004 may be affected by any acquisitions we may transact during the year.If we complete any such transactions, our planned organic store openings may bereduced.

 

We opened a total of eight American Music stores in2002, five of which were acquired in connection with American Music’s acquisitionof M&M Music, a band instrument retailer. In 2003, we opened one AmericanMusic store and closed two. In 2004, we do not plan to open any additionalAmerican Music stores.    Wedo, however, believe there exist a number of acquisition opportunities in therelatively fragmented band instruments market that could be a good fit into ourAmerican Music platform. However, we have slowed our planned growth of theAmerican Music division because our infrastructure and remerchandising projectsat this business have to date required more time and resources than originallyanticipated.  As a result of thesefactors, the American Music stores incurred significant operating losses in2003 and we presently expect this situation to continue in 2004.

 

The success of our retail store expansion plans dependon many factors, including:

 

•                  identificationof suitable retail sites and appropriate acquisition candidates;

 

•                  negotiation ofacceptable lease terms;

 

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•                  hiring, trainingand retention of skilled personnel;

 

•                  availability ofadequate capital;

 

•                  sufficientmanagement and financial resources to support the new locations;

 

•                  vendor support;and

 

•                  successfulcompletion of our new management information system and infrastructurebuild-out and remerchandising initiative at American Music.

 

A number of thesefactors 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 andAmerican Music stores at the rates currently anticipated.  If we are unable to achieve our retail storeexpansion goals, or the new stores underperform our expectations, our resultsof operations could be adversely affected.

 

*We face uniquecompetitive and merchandising challenges in connection with our plans to openadditional Guitar Center and American Music retail stores in new markets.*

 

As part of ourretail growth strategy, we plan to open and/or acquire additional Guitar Centerand American Music stores in new markets. This expansion into new markets will present unique competitive andmerchandising challenges, including:

 

•                  significantstart-up costs, including promotion and advertising;

 

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

 

•                  management ofstores in distant locations;

 

•                  availability ofdesirable product lines; and

 

•                  our expansionmay involve acquisitions, including acquisitions in business segments in whichwe have limited 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.

 

*Ourretail store expansion strategy, including our strategy of clustering retailstores, may adversely impact our comparable store sales.*

 

Historically, wehave achieved significant sales growth in existing stores.  Our quarterly comparable stores salesresults have fluctuated significantly in the past.  Sales growth for comparable periods, excluding net salesattributable to stores not open for 14 months, was as follows for our retailstores:

 
|      |   | **2004** |   | **2003** |   | **2002** |   |
|-----------|--------|----------|--------|----------|--------|----------|--------|
| Quarter 1 |   | 11       | %      | 4        | %      | 5        | %      |
| Quarter 2 |   | —   | %      | 5        | %      | 8        | %      |
| Quarter 3 |   | —   | %      | 7        | %      | 5        | %      |
| Quarter 4 |   | —   | %      | 10       | %      | 7        | %      |
|      |   |     |   |     |   |     |   |
| Full Year |   | —   | %      | 7        | %      | 6        | %      |

 

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

 

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•                  competition;

 

•                  economicconditions, including  in particular,discretionary consumer spending;

 

•                  consumer andmusic trends;

 

•                  changes in ourmerchandise mix;

 

•                  productdistribution; and

 

•                  timing andeffectiveness of our promotional events.

 

Our management ispresently anticipating comparable store sales growth of 6% to 8% for the secondquarter of 2004. A shortfall in comparative sales growth in any period willlikely cause a shortfall in earnings, and result in financial performance belowthat for which we have planned or the investment community expects.

 

*Our growth plans depend on ourcompletion of acquisitions, and these transactions involve special risks.*

 

We believe thatour expansion may be accelerated by the acquisition of existing music productretailers. For example, in April 2001 we acquired the business of AmericanMusic Group, a New York-based retailer of band instruments, a business in whichwe were not previously engaged. Our growth plans for the American Musicbusiness contemplate a significant number of relatively small acquisitions. Forexample, in June 2002 American Music acquired M&M Music, a band instrumentretailer. We also regularly investigate acquisition opportunities complimentaryto our Guitar Center and Musician’s Friend businesses. Accordingly, in theordinary course of our business, we regularly consider, evaluate and enter intonegotiations related to potential acquisition opportunities. We may pay forthese acquisitions in cash or securities, including equity securities, or acombination of both. We cannot assure you that attractive acquisition targetswill be available at reasonable prices or that we will be successful in anysuch transaction.  Acquisitions involvea number of special risks, including:

 

•                  diversion of ourmanagement’s attention;

 

•                  integration ofthe acquired business with our business; and

 

•                  unanticipatedlegal liabilities and other circumstances or events.

 

*We depend on a relatively smallnumber of manufacturers, suppliers and common carriers who may not be able ordesire to supply our requirements.*

 

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 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 requirementsfor inventory, 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 theoperational procedures and logistics and supply chain management capabilitiesof vendors, all of which are outside of our control. Additionally, many of ourvendors receive product from overseas and depend on an extensive supply chainincluding common carriers and port access to transport merchandise into thecountry. Foreign manufacturing is subject to a number of risks, includingpolitical and economic disruptions, the imposition of tariffs, quotas and otherimport or export controls, and changes in governmental policies. We also relyon common carriers to transport product from our vendors to our centraldistribution center in Indiana, and from the distribution facility to ourGuitar Center stores. Similarly, Musician’s Friend relies on common carriers totransport product to its fulfillment center in Kansas City, Missouri and onwardto consumers. Any disruption in the services of common carriers due to

 

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employee strikes or other unforeseen events could impact our ability tomaintain sufficient quantities of inventory in our retail locations or tofulfill orders by direct response customers.

 

*We face significant competition, andour efforts to increase our market share may be inhibited by existing or newcompetitors also trying to execute national expansion strategies.*

 

The retail music products industry is fragmented andhighly competitive. We compete with many different types of music productretailers, including conventional retailers, as well as other catalog ande-commerce retailers, who sell many or most of the items we sell. We believethat large format music product retailers such as our company will seek toexpand in part through the acquisition of small, independently owned stores orfranchises, and we anticipate increased competition in our existing markets andplanned new markets from these consolidating retailers. These retailers mayidentify target companies or execute their acquisition strategies moreeffectively than our company.  Inaddition, these retailers may have greater financial resources or other competitiveadvantages as compared to our company. Our expansion to new markets will beinhibited by these and other established competitors. In addition, one or moreof our competitors may adopt a new, innovative store format or retail sellingmethod. If we are not able to compete effectively, we may fail to achievemarket position gains or may lose market share.

 

Recently, several large mass merchants, includingWal-Mart and Costco, have begun to sell musical instruments in categories thatwe compete in, including entry-level guitars, electronic keyboards and bandinstruments, and thus could represent a significant source of futurecompetition for our retail and direct response businesses, particularly ifthese retailers expand their product lines beyond entry-level merchandise.

 

*We must efficiently integrateAmerican Music and grow its family music business in order to earn anacceptable return on that investment.*

 

In April 2001, we completed our acquisition ofAmerican Music Group, a New York-based retailer of band instruments. We had notpreviously participated in the band instruments segment of the music productsbusiness and had no prior experience in this distribution channel. We intend touse the acquired American Music business as a platform to develop and grow afamily music store concept that will emphasize band instruments and also sellselected “combo” products sold by our Guitar Center stores, such as guitars,drums and the like. Thus, we face the normal challenges of any acquisition,such as integration of personnel and systems as well as the need to learn,understand and further develop this business. We are installing a newmanagement information system at American Music, which has proven to be achallenging project requiring more time and resources than originallyanticipated. This implementation is an important project to facilitate furtherintegrating of American Music with our other businesses and to provide asystems backbone to permit growth of this division. In addition, we have begunmarketing through the American Music stores some Guitar Center products notpreviously carried by American Music and offering lessons. This change inmerchandising strategy from the historic focus of American Music on bandinstruments is in process and is an important element of our family music storeconcept for this brand.  Thisremerchandising strategy is not yet proven. Further, we have slowed our plannedgrowth of the American Music division because the challenges posed by ourinfrastructure and remerchandising projects. As a result of these factors, the American Music stores incurredsignificant operating losses in 2003 and we presently expect this situation tocontinue in 2004. Failure to execute on the requirements and initiativesdescribed above could result in a poor or no return on our investment,constitute a distraction of the efforts of our management team from the coreGuitar Center and Musician’s Friend brands and potentially require us torecognize an impairment in the significant amount of goodwill recorded in theacquisitions of American Music and M&M Music, which totaled $20.6 millionat March 31, 2004.

 

*We depend on key personnel includingour senior management who are important to the success of our business.*

 

Our success depends to a significant extent on the services of LarryThomas, our Chairman and Co-CEO, Marty Albertson, our President and Co-CEO,Robert Eastman, the CEO of our wholly-owned subsidiary, Musician’s Friend,Inc., and David Fleming, President and Chief Operating Officer of AmericanMusic, as well as our ability to attractand retain additional key personnel with the skills necessary to manage ourexisting business and growth plans. During 2001 we entered into a five yearemployment contract with each of Mr. Thomas and Mr. Albertson and in 2003entered into a three year employment agreement with Mr. Eastman. The loss ofone or more of these individuals or other key personnel could have a materialadverse effect on our business, results of operations, liquidity and financialposition.

 

Historically, we have promoted employees from within our organization tofill senior operations, sales and store management positions.  In order to achieve our growth plans, wewill depend upon our ability to retain and

 

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promote existing personnel to senior management,and we must attract and retain new personnel with the skills and expertise tomanage our business. If we cannot hire, retain and promote qualified personnel,our business, results of operations, financial condition and prospects could beadversely affected.

 

*The implementation of ourdistribution center for the Guitar Center retail stores presents operationalrisks and represents a significant investment.*

 

Our distributioncenter in the Indianapolis, Indiana area supports our Guitar Center retailstore operations. The conveyor systems, the warehouse management system, andall other technology systems and infrastructure commenced operations in July2002. Migration from our former “drop-ship” model to a centralized distributionmodel is an important development in our operating strategy. The efficientoperation of the distribution center is also dependent upon the performance ofthird parties that we do not control, such as vendors who must comply with newoperating procedures and common carriers who must deliver product on time. Thisprogram involves financial and operating risks that could include the need toexpend greater funds than presently budgeted or disruptions in retail store operationsand the loss of sales if inventory is not timely provided in the requiredquantities. Further, one of the key underlying economic assumptions of ourdistribution center project is that this program will permit us to reduceoverall inventory levels as a percentage of sales thereby resulting insignificantly reduced working capital requirements. Any failure to reach ourinventory reduction targets will adversely affect our future financialperformance and capital needs, potentially in a material manner. Failure toexecute on these requirements could result in a poor or no return on ourinvestment, disruption of our retail store business and a distraction of theefforts of our management team.

 

*Our retail operations areconcentrated in California, which ties our financial performance to events inthat state.*

** **

As of March 31,2004, our corporate headquarters as well as 23 of our 127 Guitar Center storeswere located in California, and stores located in that state generated 24.4%and 27.5% of our retail sales for the first quarter of 2004 and 2003,respectively.  Although we have openedand acquired stores in other areas of the United States, a significantpercentage of our net sales and results of operations will likely remainconcentrated in California for the foreseeable future.  As a result, our results of operations andfinancial condition are heavily dependent upon general consumer trends andother general economic conditions in California and are subject to otherregional risks, including earthquakes.  Wedo maintain earthquake insurance, but such policies carry significantdeductibles and other restrictions.

 

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

 

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

 

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

 

The adoption or modification of laws or regulations, or revisedinterpretations of existing laws, relating to the direct response industrycould adversely affect the manner in which we currently conduct our catalog ande-commerce business and the results of operations of that unit. For example,laws and enforcement practices related to the taxation of catalog, telephoneand online commercial activity, including direct response sales, remain influx. In addition, the growth and development of the market for online commercemay lead to more stringent consumer protection laws, both in the United Statesand abroad, that may impose additional burdens on us. Laws and regulationsdirectly applicable to communications or commerce over the Internet arebecoming more prevalent. The law of the Internet, however, remains largelyunsettled, even in areas where there has been some legislative action. It maytake years to determine whether and how existing laws such as those governingintellectual property, consumer privacy, sales-based and other taxation ofe-commerce transactions and the like are interpreted and enforced. Any adversechange in any of these laws or in the enforcement, interpretation or scope ofexisting laws could have a material adverse effect on our results ofoperations, financial condition or prospects.

 

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

 

We are involved in a number of litigation matters.Litigation may result in substantial costs and expenses and significantlydivert the attention of our management regardless of the outcome.  In addition, current and future litigation,governmental proceedings, labor disputes or environmental matters could lead toincreased costs or interruptions of our normal business operations.

 

*We must manage efficiently theexpansion of our Direct Response business, including the musiciansfriend.comwebsite, our systems that process orders in our Direct Response business, andour fulfillment resources in order to service our customers properly.*

 

Our direct response business, particularly oure-commerce business, will require significant investments to respond toanticipated growth and competitive pressures. If we fail to rapidly upgrade ourwebsite in order to accommodate increased traffic, we may lose customers, whichwould reduce our net sales. Furthermore, if we fail to expand the computersystems that we use to process and ship customer orders and process paymentsand the fulfillment facilities we use to manage and ship our inventory, we maynot be able to successfully distribute customer orders. We experienced somedelays of this sort in 2001 in connection with the consolidation of ourfulfillment centers. As a result, we could incur excessive shipping costs dueto the need to split delayed shipments, increased marketing costs in the formof special offers to affected customers or the loss of customers altogether. Wemay experience difficulty in improving and maintaining such systems if ouremployees or contractors that develop or maintain our key systems becomeunavailable to us.  We have experiencedperiodic service disruptions and interruptions, which we believe will continueto occur, while enhancing and expanding these systems.

 

*Net sales of our e-commerce businesscould decrease if our online security measures fail.*

 

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

 

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

 

If we face material delays in introducing newservices, products and enhancements, our e-commerce customers may forego theuse of our services and use those of our competitors. To remain competitive, wemust continue to enhance and improve the functionality and features of ouronline store.  The Internet and theonline commerce industry are rapidly changing. If competitors introduce newproducts and services embodying new technologies, or if new industry standardsand practices emerge, our existing website and proprietary technology andsystems may become obsolete. To develop our website and other proprietarytechnology entails significant technical and business risks. We may use newtechnologies ineffectively or we may fail to adapt our website, our transactionprocessing systems and our computer network to meet customer requirements oremerging industry standards. In addition, the success of e-commerce may resultin greater 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.

 

*Our hardware and software systemsare vital to the efficient operation of our retail stores and Direct Responsebusiness, and damage to these systems could harm our business.*

 

We rely on ourcomputer hardware and software systems for the efficient operation of ourretail stores and direct response business. Our information systems provide ourmanagement with real-time inventory, sales and cost information that isessential 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 naturaldisasters; and

 

•      power loss, computer systems failure, Internetand telecommunications or data network failure.

 

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A significant information systems failure could reducethe quality or quantity of operating data available to our management. If thisinformation were unavailable for any extended period of time, our managementwould be unable to efficiently run our business, which would result in areduction in our net sales.

 

To attempt to mitigate these risks we have contractedservices from third parties to provide backup systems for our Guitar Centerretail stores in the event of a disaster. These services are designed to permitour “mission critical” systems to be online within 48 hours following mostdisasters. Our direct response business does not have redundant Internet oroperating systems and would be vulnerable to catastrophic events. In the eventof a disaster, our direct response business would most likely experience delaysin processing and shipping orders.

 

*Our stock price could be volatile.*

 

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.*

 

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

 

Projections arebased 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 abasis for our management to discuss our business outlook with analysts andinvestors. We do not accept any responsibility for any projections or reportspublished by any such persons.

 

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

 

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

 

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

 

We do not have any assets or liabilities which, in ourview, impose upon us significant market risk except for our outstandingindebtedness represented by $100 million principal amount of Senior ConvertibleNotes due 2013 with a fixed interest rate of 4% (subject to contingentinterest) and our credit facility which has a variable rate of interestgenerally consisting of stated premiums above LIBOR.  At March 31, 2004, we had no outstanding borrowings under ourcredit facility.  To the extentprevailing short-term interest rates fluctuate, the interest expense we incuron our credit facility will change with a resulting effect (positive ornegative) on our financial position, results of operations and cash flows. Wedo not use derivative financial instruments in our investment portfolio.  Historically, we have not carriedsignificant cash balances and any cash in excess of our daily operating needshas

 

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been used to reduce our borrowings. Excess cash is invested in short-term, high quality interest bearinginvestments.

 

**Item4.****                     Controlsand Procedures**

 

We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms and that such information is accumulatedand communicated to our management, including our Co-Chief Executive Officersand Chief Financial Officer, as appropriate, to allow for timely decisionsregarding required disclosure. In designing and evaluating the disclosurecontrols and procedures, management recognizes that any controls and procedures,no matter how well designed and operated, can provide only reasonable assuranceof achieving the desired control objectives, and management is required toapply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

 

As required by SECRule 13a-15(b), we carried out an evaluation, under the supervision and withthe participation of our management, including our Co-Chief Executive Officersand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as of the end of the period coveredby this report.  Based on the foregoing, our Co-Chief Executive Officersand Chief Financial Officer concluded that our disclosure controls andprocedures were effective at the reasonable assurance level.

 

There has been nochange in our internal controls over financial reporting during our most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal controls over financial reporting.

 

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

 

**Item 6.****                     Exhibits andReports on Form 8-K**

 

(a)                                     Exhibits:

 

31.         Certification of theCompany’s Co-Chief Executive Officers and Chief Financial Officer pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.

 

32.         Certification of theCompany’s Co-Chief Executive Officers and Chief Financial Officer pursuant toSection 906 of the Sarbanes-Oxley Act of 2002.

 

(b)                                    Reportson Form 8-K:

 

We filed a Current Reporton Form 8-K on January 6, 2004 furnishing, under caption of Item 12, financialinformation for the quarter ended December 31, 2003.

 

We filed a Current Reporton Form 8-K on January 29, 2004 disclosing, under caption of Items 5 and 12,financial information for the quarter ended December 31, 2003.

 

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Pursuant to the requirements of the Securities andExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized as of the 5th day ofMay 2004.

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

 

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